Monday, December 20, 2010

The great bank heist of 2010

By Brett Arends

Wall Street wins, Main Street pays — again. This was the year America finally took on the power and greed of the Wall Street banks. And the banks won.

They dodged the bullet of real reform, probably for all time. They bounced back to post huge profits, helped by legal theft from the middle class. They completed their takeover of both political parties — and bought themselves a new Congress even more pliable than the old one.

Middle-class America is flattened, devastated and broke. The bankers that caused it all have escaped punishment. They’re raking in huge profits. Oh, and the tax cuts just got extended for high earners, too!
Game over.

Of all the signs of Wall Street’s gloating and arrogance this year, which one stands out the most?

The image of the president of the republic, traveling to New York to reassure them that they wouldn’t suffer too much from new regulations?

Or maybe billionaire Steve Schwarzman, the private-equity oligarch at Blackstone Group, complaining that any attempt to make him pay actual income tax on his income was akin to “when Hitler invaded Poland.”

Not France. Not Belgium. Poland.

In the aftermath, he grudgingly issued a partial retraction.

In any civilized society he would now be pariah. He’d have to eat alone at unfashionable restaurants, and the waiters would spit in his soup.

Instead, as the year drew to a close, I saw him being interviewed on TV, the hosts hanging on his every word.

In 2010, Wall Street’s year, Schwarzman’s only real sin was getting caught flaunting his contempt for the nation.

Far worse went on behind closed doors.

Consider the Dodd-Frank reform act — all 2,300 pages of it. Sure, it fills in a few regulatory gaps, ends a couple of the more gratuitous abuses. You have to throw a few scraps to the masses.

But most of the reforms are meaningless. New rule books and committees. Bah. They’re like half-built fences. Anyone can just walk around them.

As for the new consumer finance watchdog? The agency that’s supposed to stand up to the banks will be housed… within the Federal Reserve. Literally, it will be a tenant of the banking system.

Champions of the “reforms” say this won’t really matter. But if that’s the case, why did Wall Street fight so hard to make sure it happened?
There are no coincidences in Washington.

Meanwhile, missing from this giant “reform” bill was any actual, serious reform like threatening crooked bankers with real jail time. Or ending the “other people’s money” racket of securitization, or smashing “too big to fail” megabanks into smaller firms that can never again threaten the republic.

Instead we’ve enshrined “too big to fail” as national policy. A standing taxpayer guarantee to the biggest banks. What a deal!

It’s amazing when you think about it.

Look at the chaos and catastrophe these guys have left in their wake. One middle-aged man in five is out of work. Tens of millions of families have been financially wiped out. The national debt has nearly doubled.

If inner-city gangs had done this to America, we’d have martial law. If Arabs had done it, we’d have launched another war.

Wall Street bankers? They’ve walked away scot free. And they’re actually being rewarded.

By keeping short-term interest rates near zero, the Fed is basically robbing your grandmother, and other hard-working savers, and giving to Wall Street. The banks borrow from us for free, and then lend us back our own money at interest by purchasing Treasury bonds.

And in a perfect circle of cynicism, the beneficiaries of bailouts are now spending some of their loot lobbying our Congress to overrule us on reform.

The commercial banks and investment firms spent a total of $118 million lobbying just in 2010, according to the Center for Responsive Politics.

That included $4 million spent directly by Citigroup Inc. (NYSE:C) , nearly $3 million by Bank of America Corp. (NYSE:BAC) , $3.5 million by Goldman Sachs Group Inc. (NYSE:GS) and $2.8 million by Schwarzman’s Blackstone.

This is in addition to the vast campaign contributions the top brass at these firms have lavished on pliable congressman, and indirect political lobbying through trade bodies like the American Bankers Association.

But it’s unfair to give the bankers all the credit for subverting democracy.

They couldn’t have done it without the Democrats.

Wall Street has spent years capturing the party establishment.

Think of the lavish campaign checks. The lucrative hedge fund “adviser” jobs. The pervasive influence of pinstriped “progressives” like Larry Summers and Bob Rubin.

This was the year the investment paid off. Big time.

Top Democrats were too terrified of alienating their sugar daddies to pass real reform.

But the joke was on them.

First, Wall Street’s campaign contributions aren’t that important — they only account for about 10% of the party’s money. The Democrats could have lost all of it (an unlikely scenario in any event) and still been in business.

Second, the Democrats would have got a lot more credit — and contributions — from the rest of America if they’d stood up to Wall Street.

And third: Sucking up to Wall Street didn’t help them anyway. Wall Street still turned Republican. The American Bankers Association, J.P. Morgan Chase & Co. (NYSE:JPM) , Citigroup, Bank of America, even Goldman Sachs: This time around, more than half their donations went to the GOP.

Most Americans don’t realize it, but this talk of a “grassroots” and “anti-establishment” election was a bunch of hooey. What really happened was that Wall Street has just bought itself a new, even more compliant

The new Republicans are already fawning over the bankers. They’re promising to stop the restrictions on (ahem) “financial innovation.” Congressman Spencer Bachus — the next chairman of the House Financial Services Committee — actually said “Washington and the regulators are there to serve the banks.” Let the good times roll!

It was the greatest heist in history. The bankers pulled it off under everyone’s nose.

(Ref: MarketWatch, December 21, 2010)

State Budgets. Meredith Whitney on California Munis

Meredith Whitney sat down with Steve Kroft on “60 Minutes” Sunday, December 18, night to rehash her well-known views about the threat the finances of states and localities pose for the economy. “It has tentacles as wide as anythign I’ve seen. I think next to housing this is the single most important issue in the United States and certainly the largest threat to the U.S. economy,” she says.

Saturday, December 4, 2010

Reflection Series: Market Prediction by Garrett Jones

In the “The Sequence of Events in the Cycle," Garrett Jones explained his philosophy on market cycles:

In covering the sequence of events in the Long Wave cycle, we need a starting point. A logical point would be the absolute economic bottom that was the beginning of the cycle we are currently in. That would be 1933. At the bottom of the cycle, we slowly begin to rebuild a devastated economy. After the crash (1929 to 1932), debt is wiped out because most of it results in default. People are hungry and desperate -- so they are willing to work hard. There are no "slackers" because slackers don't get hired. The work that is produced is of the highest quality because there are few jobs available and only the best workers are hired. This philosophy permeates the society. If you want a job, you've got to work hard and produce a top quality product.

The process is slow, but once the economy begins to grow, debt creeps back into the picture. As businesses grow and seek expansion, the most logical and efficient method for acquiring capital is to get a loan. As the cycle progresses, business begins to boom and debt increases at a much faster rate to compensate for the demand (1960s). Demand translates into necessity. The necessity brings on inflation and the inflation begins to rise at an increasing rate (late 1970s). Inflation then peaks due to leverage, reduced returns and increased debt (1980). The peak in inflation is usually followed by a recession lasting a year or two. This is followed by the Plateau Period which is the period following the peak in inflation. I’m sure you have heard the term “necessity is the mother of invention” – the increased demand of the period leading into the peak in inflation brings about a new technology in the Plateau Period. The semi conductor boom of the late 60s led to the computer craze of the 1980s and 1990s – the New Technology.

This ushered in the Information Age at the expense of the Industrial Age. The Plateau Period is characterized by declining rates of inflation; declining interest rates; a psychological return to "normalcy" and a roaring bull market in paper assets. The plateau period is a period of disinflation -- initially, this is inflation where the rate of inflation is declining. This new technology enhances production and, ultimately, leads to overproduction. The high debt and overproduction set the stage for deflation after many years of disinflation during the Plateau Period. The breadth of the stock market peaks (1998) which ultimately predicts a peak in stock prices (2000). This sets up a crash in the stock market (2000 to 2002). At this point in the cycle the stock market is the market of choice and is the vehicle where the vast majority of investment funds reside. Later, this trend changes from disinflation to deflation.

When the stock market peaks and ultimately crashes, it puts extreme pressure on all other investments (2007). At this point, due to the high level of debt and unemployment, people are forced into liquidation -- initially liquidating their investments, but later their homes and other valued possessions. This ultimate liquidation in society brings us to the bottom and completes the cycle. As you can see, each separate phase of the cycle sets up the next. It is perfectly logical -- it should be, Mother Nature doesn't make many mistakes.

Now that we are familiar with the cycle, how do we utilize it? I have said from the very beginning the most important part of the cycle is knowing the sequence of events. The reason you want to know the sequence of events is so you can determine where you are in the cycle. If you know where you are, then you know what economic events should follow. If you know what is coming, you can plan for it and use it to your advantage rather than having it take advantage of you. It's really that simple.

Now that you have a comfortable idea of the cycle from this information, let's see if we can determine where we are in the cycle at this point in time. Once we determine where we are we will then be able to determine what economic events are likely to follow -- in other words, what are the implications of our current position in the overall cycle? Once we know the implications we can act accordingly i.e. we either seek protection or opportunity … or both. Note: For simplicity, the sequence of events in the cycle is listed in bullet points later in this communication.

We have already had the peak in inflation. That was in 1980 when gold hit $877/oz., silver was $50/oz.; Oil was over $40/bbl., CRB futures price index at 337.60, etc. There was a one to two year recession that followed in 1981-82. The stock market took off in 1982 and peaked in 2000. There has been a market crash that was primarily centered in the area of the “new technology”. This was an 83.5% peak-to-valley crash in the NASDAQ 100, the market of choice. That was “the first shoe dropping” i.e. the warning shot for mankind to “pay attention”. There is always a warning. In the prior cycle it was the real estate boom and bust in Florida in 1927. In fact, we have had the same warning this time – once again with Florida real estate.

This was followed by another inflationary run where both the Dow Jones Industrials and the S&P 500 went to an all time high in October 2007, but the institutional index peaked in 2000 and could only generate a 61.8% Fibonacci retracement – thus creating a major divergence with the all time highs of the major indices. Remember, it is the institutions that run the show. This is a very interesting and very major point that was missed by virtually all of Wall Street – but it was blatantly there for all to see.

Wall Street is aware that bear markets correct the bull markets that immediately precede them. The1982-2000 bull market was corrected by the 2000-2002 bear market. In a similar manner, the bull market of 1932-1937 was corrected by th
e bear market of 1938-1942 … and, the bull market of 1942-1966 was corrected by the bear market of 1966-1982 (with major lows in 1974 and 1982). Unfortunately, most people don’t realize that the larger cycles also have corrections. Markets are constantly in the process of going from one extreme to the other. Larger cycles (Long Wave cycles) comprise three bull markets and roughly cover the time span of an average lifetime. The current Long Wave cycle began with the stock market extreme low in

1932 and corresponds with the extreme economic low in 1933. It completed its ‘orthodox’ high in 2000 with the stock market top and “real value” peak in 1999 (the stock market peak in terms of real value). This was followed by the final thrust higher to the market’s all time peak in October 2007 (a higher market price, but divergence in real value). It is this advance (from the all time stock market low in 1932 to the all time high in 2007) that is now in the process of being corrected. Correcting an advance that spans 75 years is much more significant than merely correcting the advance of the most recent bull market. The chart below will give you an idea of the potential for what can happen when an entire cycle faces a correction. Note that in just the first wave down, the market has corrected almost the equivalent of the entire 2000-2002 bear market.

We live in a world that is defined by cycles. One of the best examples of this is the seasonal growing cycle. We can all readily relate to summer, autumn, winter and spring. Each season comes at the same time every year and has the same characteristics. The seasons can be intense or mild; extended (an Indian summer) or contracted (a short winter); but they happen in order and their characteristics remain the same. The growing season follows the same seasonal pattern and provides an example of why each individual season actually set up the season that follows. For example, in the spring, seeds germinate with the warming temperature and rain to nourish them. In the summer they flourish into mature plants. In the autumn, the plants are harvested. Finally, in the winter, the process rests by going dormant.

This process is classic action in a cycle. Once you have defined the cycle, it becomes quite logical and follows a defined process. As you can see in the seasonal growing cycle, each predecessor phase (season) augments the one that follows. This same process occurs in the economic cycle. By spending some time going over the sequence of events, you will soon see how logical this process is and how well it defines any particular phase of the cycle. It is an incredibly helpful tool in business and investment planning and it brings logic and explanation to difficult economic times that otherwise confuse economists and other economic observers.






  • Increasing Inflation (DEMAND becomes NECESSITY brings on INFLATION)




  • Overproduction (NEW TECHNOLOGY enhances production and, ultimately, OVERPRODUCTION)

  • Stock Market Peak (FOLLOWS PEAK IN BREADTH)


  • Disinflation becomes Deflation (PRICES OF ASSETS FALL)

  • Bankruptcies and Liquidation (DUE TO DEFLATION, UNEMPLOYMENT & HIGH DEBT LEVEL)





The Psychology of the Market:

It is important to tie the cyclical information in with the psychology of the market. The market is driven by two forces, fear and greed. It’s interesting to note that both are negative. It is also interesting to be aware that the stock market is unique when compared to other markets – particularly, on a psychological level. If you want to attract buyers in a retail market, you have a “sale” – the attraction is lower prices. In the stock market, you attract participants by raising prices. Go figure.

Anyway, when you analyze the psychology of the market and how it fits in with the sequence of events in the cycle, it is important to be aware of the nuances. I’ve put together two charts that deal with the phase of the market (and the economy) that are the most important. Interesting things occur throughout the cycle, but the real challenge, as one might expect, occurs at its conclusion. During the body of the cycle, the worst you have to deal with is recessions. Some of them have been quite serious, but they are recessions nonetheless. Further, after these recessions conclude, the market and economy have always moved on to new all time highs. This can lull one into complacency and cause one to assuming that you 1) never get anything worse than a recession, and 2) once the recession is over, the market will always rally to a new high. This is a reasonable assumption throughout the cycle … and a very dangerous assumption as you approach the end of a cycle.

It is psychology and emotion that drive markets – both up and down. The chart that follows shows the most basic of the emotions that have driven the market over the past 15 years. The chart tells a lot. First of all, you have had two bull cycles and two bear cycles. It is obvious that the strongest motivator is fear. Markets can move up quickly, but they fall much faster. For example, have you ever noticed that you can run faster when you are feeling fear than when you are feeling greed? The market reacts the same way.

The following chart shows essentially the same thing as the above chart, but it breaks down the emotions from basics to specifics. The distinctions are very important because the basics don’t do justice to the reality of the situation. The move from 1994 to the market top in 2000 was a mania, driven by technology stocks. It was a “new economy” and the pundits said the extreme valuations were justified because “it’s different this time” -- a comment made at every major market top in US stock market history. After the mania, the market had the initial collapse where the S&P fell by about 50%, but the real story was in the technology stocks where the decline was much larger. The NASDAQ 100 had a peak-to-valley collapse of 83.5%. That was the “first shoe dropping” and a serious warning to “smart money” investors.

In the stock market, “smart money” is not defined as educated people with money. As we have recently seen, these people have gotten hurt just as badly as those with less savvy and far less money. An argument can be made that the CEOs of Lehman, Bear Stearns, Wachovia, Merrill Lynch and others were the dumbest of all – and these are very smart people with an abundance of money. They are not “smart money”. Smart money is that rare investor who inherently has a feel for where we are in the cycle and acts on those feelings. These are people with “anticipatory intelligence”. Everyone else essentially “fights the last war” i.e. they assume what is happening will continue – therefore, any change will be a surprise.

Following the mania and the initial collapse is the denial phase. A snappy rally ensues and everyone is bullish again and expecting the worst is over. These feelings carry into a peak of hope where there is knowledge of serious problems such as debt, deficits, war, derivatives, lack of leadership and a myriad of other such negatives – however, they are digested and, essentially ignored. At the peak of the hope phase, some markets set new all-time highs (such as the Dow Jones Industrials and the S&P 500) and some don’t (such as the NASDAQ and the Institutional Index).

This is followed by the recognition phase – where the market crashes and creates a year like 2008 where you have the worst performing year for the stock market in 77 years (and 2009 beginning with the worst performing January in history). In the recognition phase, everyone realizes there are problems and that the problems are quite serious. There is general recognition that there is no quick fix.

The next phase is the reprieve phase. Here the market rallies because there is a belief that 1) the worst is over and, 2) the government’s actions will help to solve the problem(s). This is a dangerous phase because it gets everyone leaning in the wrong direction. When it becomes clear that the worst is nowhere near being over and the government’s actions have actually exacerbated the problem, it leads into the liquidation phase. This is where people sell their assets because they need the money to survive. This malaise continues and spreads throughout the society – it is accompanied by fear and anger. At the extreme of this phase, you enter the final phase – CAPITULATION. Markets are always in the process of moving from one extreme to the other. At this point, the market is at the opposite extreme of the bull market top – it is at its lowest ebb. It is a time where everyone hates the stock market – including those who are employed by it (in one form or another). People swear they will never buy another stock for the rest of their lives. The capitulation phase, by definition, is the best buying opportunity you will ever have – unfortunately, most will never benefit from it because the market psychology is so overwhelmingly negative that everyone will hate everything about the stock market at that point. In fact, at the point of capitulation people hate all forms of investing because everything they have ever believed in has been devastated.

In many ways, the recognition phase is the most critical phase of the cycle because there is recognition of the problem, but no one has any idea of what to do about it. There is no guarantee how long the reprieve phase will last, but you can count it will last long enough for most investor to believe “the worst is over”. This has been a very large and extended cycle – which means that the downside will almost assuredly be extreme – it already has been and it’s far from over. This is the final chance to prepare for the final two phases (liquidation and capitulation). It will be difficult to do because all the “professionals” who did so poorly in the recognition phase will make a comeback during the reprieve phase. These people who completely missed the top will now chime in and say the worst is over. They don’t understand the cycle; they didn’t see the fall coming; and they don’t understand what caused it, but they will be the biggest cheerleaders that the bear is dead. Ironically, most investors will remain with these people even though they have proven they have little to no ability in markets that go in a direction other than up. Now, at the most critical stage of the cycle, people will continue to trust their funds to people who have just proven their worth in turbulent markets. In addition, these questionable “professionals” have zero knowledge of the long wave cycle. They will parrot what the financial news media says and assure you that the worst is over. Most likely, they will be correct for awhile.

You now have the information in your hands to be your own best advisor, however, the “smart money” player realizes that knowledge is only one part of the equation for success. There are two other mandatory components. The first is discipline. Knowledge without discipline is like having money without a place to intelligently spend it. The third component is experience. You have a roadmap – one that took me decades to perfect. The combination of knowledge, discipline and experience will allow you to navigate the roadmap.

If you take the time to learn the sequence of events in the cycle, you will have a very valuable tool that will assist in business and investment planning and providing you with the knowledge and peace of mind in knowing where you are in the cycle. Knowing what is next to come in a cycle removes the element of surprise and replaces it with expectation. Expectation allows one to plan and take advantage of the situation as opposed to having the situation take advantage of you. In closing, the quotations by Marx, Twain, and Livermore on page 2 are interesting, but the focus should be on the content of the article. No one really knows if a quote from someone in the past is valid or not. At this phase in the cycle, it is absolutely imperative to be focused on where we are in the cycle and the extreme implications of being there. If you missed seeing the top in 2000 or the more recent top in October 2007 and were hurt by what followed, you now have no excuse to not be paying attention.

Important: Note that the charts are all updated to October 2009 with the exception of the chart on page 8 which was not updated. The purpose is so you can see what my expectation for the market was on February 24, 2009 when this report was initially written. If you compare the chart on page 8 with the chart below – the expectation became reality. That is the benefit of learning the sequence of events in the cycle. When you consider that bearishness and fear were extreme in February 2009, it was impressive to predict 1) the market going lower, and 2) then having a sharp rally into this time period. It is also important to be aware that my Special Alerts called the July 2007 top and the October 2007 top as indicated with the arrows below. Clearly, expecting that top would have saved one from losing a lot of money. In a similar manner, expecting the March bottom would have saved further loss and presented an opportunity. Without question, the study of the sequence of events in the cycle can be quite helpful to an investor or businessman.

The chart below shows the two “bubble” tops of this decade in the stock market. The 2000 top was the Tech Bubble and it resulted in an 83.5% peak-to-valley loss in the NASDAQ 100 (the leading market index at that time). The 2007 top was the Stocks Bubble and it resulted in the worst loss for the benchmark S&P 500 Index in 77 years – down 57.7%. These losses were absolutely devastating for most investors and money managers. In fact, the recent decade is the worst performing decade in US history.

I was interviewed by Dave Allman of Wall Street Uncut in June 1999 when the stock market and technology stocks in particular were in an explosive move to the upside – an extremely bullish time. I commented that I expected two more rallies and then expected the market to top – so the 2000 top was not a surprise either – it was an expectation. That is the significance of learning the sequence of events in the cycle – it provides a roadmap of sorts and helps to remove the surprises.

As you can see, the Reprieve rally began as expected. Bullish sentiment was 2% (an obvious extreme). The rally got everyone bullish – with bullish sentiment well over 90% at times. The belief is that “the worst if over” and we are in a new bull market. What you must not forget is that this is followed by the Liquidation phase of the cycle and, ultimately, Capitulation. The cycle suggests a depression with the potential to be worse than the Great Depression. This phase of the cycle separates almost everyone from their money – the rich and poor as well as the intelligent and the ignorant. It is an “Equal Opportunity Destroyer”-- it has already devastated a number of rich and intelligent people – yet another hint as to where we are in the cycle … but will anyone listen? Frankly, that is the whole reason for studying the Long Wave Cycle – to give you an advantage in knowing what to expect. The market’s job is to fool most of the people – particularly at critical points – and we are about to enter the most critical phase in the past 80 years.

Sunday, November 14, 2010

Andy Xie on G-20 in Seoul

The G-20 in Seoul was supposed to be a pressure cooker for China. Geithner coordinated a united front against China before the ministerial gathering by signaling that the euro and yen were high enough, emerging economies could restrict capital inflows and resource exporters would be exempt from the proposed 4 percent limit over GDP of the current account surplus ceilings. The coast was clear for everyone except China. The hope was for the G-20 to gang up on China at the Summit. Instead, it became a festival of global backlash against the Fed's QE 2. Some people are just too clever for their own good.

How are emerging economies curbing capital inflows?

A war of words is unfolding before the Summit and the battle lines have been clearly delineated. Germany is leading the charge against QE 2. China is more than willing to echo the sentiment. On the other side, the U.S. is leading the push for capping current account surpluses. It is backed by India's support for its QE 2. But an element of the absurd is at play here by targeting surpluses. Why isn't the onus on the largest deficit economies to rein in the deficits on their own?

The piling of sandbags against a deluge of hot money has begun. Taiwan is restoring restrictions on foreign holdings of local currency bonds. Korea is proposing a hefty tax on foreign holdings of its bonds. China is stepping up checks on sources of foreign capital inflows. Most of its foreign exchange reserves are not from trade surpluses, but from hot money. If the government is really serious, it could surely stop the inflows.

The fight against inflation is heating up too. Australia just raised interest rates again. China increased its deposit reserve ratio. The market is pricing in four rate hikes in the next 12 months. I think the rate hikes will continue. India's central bank just raised its interest rates too, in an effort to curb real estate loans.

When the U.S. is engaging in super loose monetary policy, emerging economies must curb capital inflows and increase interest rates to fight inflation and asset bubbles. It seems that the Fed's QE 2 has convinced everyone of this path. The measures may have come too late for some. Inflation in emerging economies may be already in double digit territory. It seems underreporting CPI has become fashionable, under the pretenses of prolonging an economic boom. The consequences could be severe.

Negative real interest rates and an increasingly large current account deficit are a lethal combination for emerging economies. History has shown repeatedly that it leads to crisis. Brazil and India are in that camp today. Brazil is running a surplus. But, it is too small to offset the Fed's impact on commodity prices. When commodity prices are so high, a country like Brazil should run a large surplus like Russia. India is running a huge deficit outright. Its real interest rate is severely negative by some measurement. Its boom continues because the Fed's policy encourages speculative capital to fund its deficit and support its currency value.

China and Russia have inflation too. But they have large current account surpluses and wouldn't have a liquidity crisis when the Fed is forced to abandon its policy. Brazil and India don't have the same cushion. Unless they tighten substantially in the coming year, they may feature big time in the looming 2012 crisis.

Can rich countries grow?

Germany is upset with the U.S.'s policy and for good reason. A decade ago, it was left for dead. Its economy was saddled with high cost commodity industries. As East Asian countries like China and Korea were charging into them, few thought Germany had a chance. The Germans didn't give up. They cut costs dramatically, even wines, to the Frenchmen's astonishment. In addition, they innovated and turned many commodity businesses into IPR-dependent ones. With low costs and pricing power, Germany is enjoying the fruits of an export boom. But, the Americans want to turn it into an exchange rate issue. It is facing many issues that Germany faced before. Instead of restructuring, it is looking for a quick way out through devaluation.

Even though Germany is very competitive, it's not growing rapidly like an emerging economy – and it shouldn't. High growth belongs to emerging economies. If rich economies try to grow fast, it will run huge deficits and lose wealth. The reason is globalization.

Information technology created the 21st century multinational corporation and made the current wave of globalization different from the previous ones. A multinational corporation is a company in name and substance. But it has the breadth of empire. It has transformed the world through investment and trade into one economy. Both demand and supply are global now. Cost arbitrage by multinational corporations have made it necessary for labor in developed economies not to compete against that in the developing economies. The wage difference is too big to be bridged in the foreseeable future. This force ensures that demand stimulus in developed economies will lead to widening trade deficit and limited impact on employment.

Europe and Japan have accepted this reality and have gone into the wealth preservation mode: focusing on pricing power, not volume in exports, targeting low growth rates and cushioning displaced workers with benefits. The U.S. is in so much trouble because it wants to grow out of its problems. When labor costs ten times that in developing countries and, adding to this is the fact that the other side has ten times as many people, this sort of thinking seems irrational. Yes, technology and quality can improve exports. But, this will barely affect trade volume. When the U.S.'s best product idea – the iPhone – doesn't lead to a rise in production at home, one should be wary of optimistic sound bites.

The U.S. government wants to change the global reality by rearranging the exchange rates. If this idea works, one must lift the standard of living in countries like China and India instantaneously to that in developed economies or lower the U.S.'s living standard to that of China and India's. Neither is possible. The political atmosphere in the U.S.'s requires solutions that generate instantaneous effects. The world can't offer that. As long as the U.S. continues to search for the impossible, the world will be a dangerous place.

Where are the real fault lines?

Rising incomes and widening wealth gaps are a global phenomenon. The top 1 percent of the U.S.'s population takes one fourth of the national income and 40 percent of the wealth. China's household income is below 40 percent of GDP, probably the lowest in the world.

The process of globalization should lead to increasing gaps in wealth. It is demonstrated in the strong balance sheets and good earnings of the top global companies, even as major economies struggle with low growth rates and high unemployment rates. But, globalization is not the only reason, and may not be the most important one in explaining highly concentrated wealth.

Financial bubbles, created by loose monetary policy from people like Alan Greenspan, are the most important factor for the rising inequality. The bubbles mislead low income people to borrow and spend on fictitious paper wealth. Their debt becomes the profits for a few. When the bubble bursts, the lower income groups spend less and cut the labor demand for themselves. Lower income demand usually produces lower income employment.

China's low consumption is due to excessive government power, not from low exchange rates. The force that pushes the economy forward is the government's desire and plans for big investment. It then raises money through taxes, property sales or state monopolies overcharging. Under such a system, consumption can't possibly play a leading role. Focusing on the exchange rate won't solve anything and may make the situation worse.

How will the U.S. treasury market fare?

The U.S. is obsessed with manipulating demand, through lowering or increasing debt cost, to manage its economy. It doesn't recognize that supply side management is the key in an era of multinational corporation-led globalization, because the latter doesn't provide instant gratification. Under political pressure to bring down unemployment rates quickly, it will continue to muck around with the money supply and the dollar's value in search of a quick fix. It will stop only when it can't do so anymore. Only a collapse of the treasury market can play that role.

The U.S. government is running a budget deficit close to 10 percent of GDP. The U.S. runs a current account deficit of nearly 5 percent of GDP. The dollar is so weak that inflation is likely to run above average. But, the treasury yields are close to historical lows. Investors justify their holdings by assuming that they can sell to the Fed at higher prices. This perceived Bernanke "put option" is similar to the Greenspan "put option." Investors bought crazy financial instruments, because they counted on Greenspan to bail them out in a crisis. But these maneuvers only work on the market's faith. But the Fed cannot buy all the treasuries out there. It will cause hyperinflation.

The trigger for the crisis will be something that panics treasury holders. It could be the worry over another maxi-dollar devaluation or inflation. Most American policy thinkers don't believe that inflation will come. Otherwise, they would have to pull back the dollar printing presses. But, when one looks at food and oil prices, it seems it's only a matter of time before inflation hits the U.S. via emerging economies and commodities.

Brace yourself for turbulence ahead. Unfortunately, it will likely end with another crisis. Hopefully, the world will be better off after 2012.

(Ref. Group Study Questions, for 20, Nov 12, 2010)

Thursday, October 28, 2010

How will Republican House affect the Treasury yields?

Just as Bill Clinton was forced to abandon spending initiatives after Republicans took over the House and Senate in the 1994 elections, President Barack Obama's agenda may be constrained as voter concerns over the budget deficit grows. The latest Bloomberg News polls show likely voters favor Republicans.

With spending held in check, 10-year Treasury yields fell to 5.57 percent by the end of 1995 from 8.03 percent after the November 1994 election while stocks rallied and the Federal Reserve cut interest rates as the economy slowed. The Fed is now debating how to bolster growth after reducing benchmark rates to almost zero failed to lower the unemployment rate.

“There are parallels,” said Thomas di Galoma, head of U.S. rates trading at Guggenheim Capital Markets LLC, a New-York based brokerage for institutional investors. “The Republicans will draw a line in the sand about what money can be spent. That's very supportive of the bond market.”

Yields on Treasuries due in five years or less are already at record lows, providing less scope for a rally like in 1995 when they gained 18.5 percent as measured by Bank of America Merrill Lynch index data. Even so, yields are unlikely to rise to levels that restrict the economy as lawmakers tangle over spending. Treasuries have returned 8.45 percent this year.

“Gridlock is good,” said Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management, which oversees $22 billion.

The median estimate of 59 economists, strategists and analysts surveyed by Bloomberg News is for the 10-year yield to rise to 3.25 percent by the end of 2011, from 2.56 percent on Oct. 15. A month ago, the median estimate was 3.5 percent.

The yield on the benchmark 2.625 percent note due in August 2020 rose 17 basis points last week. Two-year note yields dropped as low as 0.327 percent on Oct. 12 before finishing the week at 0.359 percent, while five-year yields, which closed at 1.19 percent on Oct. 15, touched 1.07 percent on Oct. 8.

Ten-year yields fell 6 basis points, or 0.06 percentage point, to 2.50 percent at 1:44 p.m. in New York. Five-year notes yielded 1.12 percent, while the two-year rate was 0.35 percent.

Democrats have controlled the House of Representatives and Senate since Obama was elected, as during the first two years of the Clinton administration. The Senate has 59 Democrats, while the House is divided 255 to 178, with two seats vacant.

The U.S. government posted its second straight federal budget deficit in excess of $1 trillion from costs associated with the bailout of the financial system. The $862 billion in fiscal stimulus spending passed by Congress in 2009 has helped push the total amount of marketable Treasury debt outstanding to $8.5 trillion from less than $6 trillion at the start of 2009.

The results of a Bloomberg National Poll released last week shows more than half of likely voters agreed the federal budget deficit is “dangerously out of control and threatens our economic future.” The poll interviewed 721 likely voters and has a margin of error of plus or minus 3.7 percentage points.

The most motivated voters -- those who say they will definitely vote and are extremely interested in the election -- lean Republican over Democrat, 51 percent to 37 percent.

Senator Orrin Hatch, who is line to chair the Senate Finance Committee if Republicans win control in the Nov. 2 elections, said he sees fewer prospects for bipartisanship in the next Congress. Democrats have created strains by expanding government the last two years, particularly taking power from states under a health-care program he helped establish for lower-income children, he said.

“I've got to say, that was almost the final straw to me,” the Utah senator said in an interview on “Political Capital with Al Hunt” on Bloomberg Television. “I'm certainly not going to let them keep spending and taxing us and building more government.”

From a deficit of $203.1 billion in 1994, Clinton worked with a Republican Congress to produce a $70.2 billion surplus by 1998, the first since 1969 when Republican Richard Nixon was President and Democrats controlled both houses. The surplus reached $236.9 billion in 2000.

Obama may veto efforts to block spending and make it more difficult for elected officials to reach agreements on extending the tax cuts enacted under the George W. Bush administration, continuing unemployment benefits and spending on infrastructure, said Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch in New York. The firm is one of 18 primary dealers of U.S. securities that trade with the Fed and are obligated to bid at Treasury debt auctions.

“The problem is right now you actually need action to be taken,” said Misra, who predicts that 10-year note yields may fall as low as 2 percent. “It's a negative for the economy, but it will keep a bid in Treasuries.”

Fiscal stimulus can work with monetary policy to boost an economy. Christina Romer, the former chairman of Obama's Council of Economic Advisers, said the President pushed the largest possible stimulus bill, the American Recovery and Reinvestment Act, through Congress, though ideally it should have been larger.

“Given how we were just falling off the edge of a cliff, that act absolutely was crucially important to stopping the fall and helping us to turn the corner,” Romer said in an interview last week with Bloomberg Television. “Given where we were, we needed to do more.”

Chances for additional fiscal stimulus aren't good because people now “treat it like a dirty word,” Romer said. “We need some more of it. And it's something that would help put people back to work.”

Economists have slashed their GDP growth estimates for 2010, to 2.7 percent from 3.3 percent in May, based on the median of 83 economists surveyed by Bloomberg. For 2011, it's 2.45 percent. Fed Chairman Ben S. Bernanke said in an Oct. 15 speech that additional monetary stimulus may be warranted because inflation is too low and unemployment is too high.

“There would appear -- all else being equal -- to be a case for further action,” Bernanke said in remarks to a Federal Reserve Bank of Boston conference.

Gridlock in Congress also may be unable to reduce the deficit, potentially damping demand for Treasuries at a time when some parts of the market are signaling the securities are too expensive.

A Fed measure of risk in Treasuries that includes expectations for interest rates, growth and inflation shows the securities are the most overvalued since the financial crisis in December 2008, just before 10-year note yields almost doubled in the following six months.

Last week yields on 30-year bonds rose 23 basis points to 3.98 percent, or a record 1.42 percentage points more than 10- year rates in a sign that bond investors expect moves by the Fed to spark growth and inflation will work.

“The market is buying into the Fed mantra that it will work to get us out of this low inflationary environment,” said Michael Pond, an interest-rate strategist in New York at Barclays Plc, another primary dealer.

While spending cuts are usually good for bonds, they may hurt companies that count on federal contracts. A Goldman Sachs Group Inc. index of corporations getting 20 percent or more of revenue from government lagged behind the Standard & Poor's 500 index last quarter after beating it since September 2009.

Bethesda, Maryland-based Lockheed Martin Corp., which gets almost all its revenue from defense projects, has fallen 5 percent since July as the S&P 500 rallied 15 percent. Tenet Healthcare Corp., based in Dallas, depends on the U.S. for half its revenue and is trailing the market by 7 percentage points.

The September employment report, which showed state governments cutting positions for teachers and other workers, leading to a 95,000 drop in payrolls, is a sign that lack of federal spending to help municipal governments is hurting the recovery, said David Brownlee, head of fixed income at Sentinel Asset Management in Montpelier, Vermont.

“If they're going to play that game of chicken, it could be to the point where they throw cold water on the economy,” said Brownlee, whose firm manages $22 billion. “We've got more problems than answers.”

(ref: Bloomberg News, October 19, 2010)

Saturday, October 23, 2010

Gundlach's `No Normal' pressure cooker

Jeffrey Gundlach, the lone bond manager to beat Bill Gross in the past 5, 10 and 15 years, said there won’t be any “new normal” to guide investors until policy makers repair the damage caused by the financial crisis.

“I think ‘no normal’ is a good phrase, as opposed to ‘new normal,’ ” Gundlach, chief executive officer of DoubleLine Capital LP, said during an interview in his office in Los Angeles. “Some major policy shift has to happen that will turn everything on its ear. So this idea that we’ll go into some quasi-similar paradigm, some sort of new thing -- no way.”

Gross and Mohamed El-Erian, co-chief investment officers at Pacific Investment Management Co., use “new normal” as shorthand for their forecast that the U.S. will endure below- average economic growth of 2 percent or less for the next three to five years and unemployment peaking at 10.5 percent to 11 percent, from 9.6 percent in August. It’s entered the Wall Street lexicon to describe a post-crisis world in which the U.S. and Europe no longer offer the best investment prospects.

Gundlach, who until December managed the top-ranked TCW Total Return Bond Fund, doesn’t disagree with Pimco’s outlook. His point is that “new normal” fails to recognize that all previous economic and investment assumptions have been permanently altered by the financial crisis.

“Massive” policy changes will be required to bolster the economy and cut the U.S. budget deficit, projected to be at about $1.47 trillion, Gundlach said. The timing and nature of the potential regulatory changes are unpredictable, causing him to shorten the length of time he holds investments.

“You cannot go on with these policies for too very long,” said Gundlach, 50. “The problem is the debt burden is very high to begin with and it’s growing fast.”

The U.S. government will have to increase tax rates, now at historic lows, as it tries to reduce its budget deficit, Gundlach said. It will also have to wean itself from borrowing money to stimulate the economy, he said.

Pimco developed the concept of “new normal” about a year- and-a-half ago as an “attempt to move the general thinking beyond the notion that the crisis was a mere flesh wound, easily healed with time,” El-Erian, 52, said in an interview.

“The crisis cut to the bone, resulting from an extraordinary, multiyear period of debt and credit entitlement which was anything but normal,” he said.

New normal was less about what should happen than “what was likely to happen given our analysis of national and global factors,” El-Erian said.

In an April speech at Princeton University in New Jersey, Christina Romer, then head of the White House Council of Economic Advisers, said she found the fatalism of the new normal distressing. She said that shorter-term cyclical events such as the decline in demand for goods and services were the real drag on job creation.

“Unemployment is high fundamentally because the economy is producing dramatically below its capacity,” Romer said. “That is, far from being the new normal, it is the old cyclical.”

In September, as she exited the Obama administration, Romer said she had underestimated the severity of job cuts and that this “has not been a normal recession.”

Gundlach managed the TCW Total Return Bond Fund until Dec. 4, when he was ousted as chief investment officer of TCW Group Inc. after the company accused him of planning to start his own investment firm. Gundlach said he was fired to reduce expenses.

Co-manager Philip Barach and more than 40 members of Gundlach’s team followed him to DoubleLine, which started three fixed-income mutual funds and plans an exchange-traded fund focusing on emerging-market bonds. Assets in DoubleLine Total Return Bond Fund, run by Gundlach and Barach, have grown to $2.7 billion since its inception on April 6, according to data compiled by Bloomberg.

TCW Total Return under Gundlach averaged gains of 7.5 percent in the five years ended Dec. 4, topping Pimco Total Return Fund, which rose 7 percent in the same period. The TCW fund also beat Gross in the 10- and 15-year periods. He’s the only intermediate-term bond manager to post higher returns than Gross, 66, in each of the three periods, according to Chicago- based Morningstar Inc.

Pimco Total Return is the world’s largest mutual fund, with $252 billion in assets.

DoubleLine Total Return Bond Fund has increased 15 percent from inception through Oct. 4, compared with 7.3 percent by Pimco Total Return, Bloomberg data show.

Gundlach, who is known for his expertise in mortgage-backed securities, was early to spot signs of trouble in the U.S. property market, and by August 2006 he had started a distressed real-estate fund to take advantage of declining prices. He correctly called an end to the five-year property boom and said falling real-estate prices would weaken the U.S. economy.

“He is considered a wunderkind in the bond-fund world,” Jeff Tjornehoj, a senior research analyst at fund researcher Lipper in Denver, said in an interview. “He’s not as well-known as Gross, but he’s well-respected, and part of that reputation comes from being at the right place at the right time.”

Gundlach wasn’t immune to fallout from the subprime- mortgage collapse, investing in securities that lost value during the crisis. Under Gundlach, TCW became the biggest manager of collateralized-debt obligations, with $41.3 billion under management as of Sept. 30, 2007, according to data from Standard & Poor’s. Gundlach has said his CDOs got out of high- risk home loans early in the credit crisis and missed the worst of the losses from those securities.

Confidence in financial markets collapsed in 2008 after the debt securities derived from defaulted properties -- many of which were purchased with subprime loans -- became so toxic that credit dried up for companies and individuals. The bankruptcy of Lehman Brothers Holdings Inc. and ensuing panic-selling of all but the safest government bills and bonds prompted an unprecedented $1.49 trillion rescue of banks and the economy, now recovering from the worst recession since the Great Depression.

The economy grew at a 1.7 percent annual rate during the second quarter, compared with 3.7 percent in the first three months of the year, according to government data.

“The GDP isn’t really growing now, counting all this debt that is being used to prop up consumption over the short term,” Gundlach said.

That the stock market hasn’t declined this year amid predictions of a global economic slowdown and the debt crisis in Europe is “impressive” and signals demand from investors looking for higher returns as interest rates have hovered near zero for the last two years, Gundlach said.

The MSCI AC World Index has climbed 1.8 percent this year, while the Standard & Poor’s 500 Index has advanced 2 percent.

Gundlach said he is less bearish on the market than he was in 2006 and 2007, largely because he was worried about the solvency of the nation’s banks and because securities were “egregiously overvalued.” The S&P 500 peaked at 1,565.15 in October 2007, falling to a low of 676.53 in March 2009.

Investor demand for dividend-paying stocks bears the hallmarks of the next investment “disaster,” he said.

“People that think dividend-paying stocks are a good bond surrogate are greatly mismatching the risk,” he said. “This has the characteristics of something that could potentially be a debacle.”

Gundlach said equities haven’t declined enough to be attractive investments, especially shares of investment banks such as Goldman Sachs Group Inc. He compared bank stocks to those of airlines, as they haven’t made money for investors over the long term. In the past five years,airline stocks fell at an annual rate of 4.9 percent, compared with a decline of 11 percent for financial stocks.

“Banks and investment banks are horrible investments at the top of a debt cycle,” Gundlach said.

As concerns over regulation and the economy have increased, Gundlach said he’s investing in government bonds as well as mortgage-backed securities that will do well as they rebound from deeply discounted values. DoubleLine’s funds, including the Core Fixed Income Fund, haven’t completely sold holdings in 10- year Treasuries, which have the potential to do “reasonably well” in a weak economy where interest rates are low, Gundlach said. The securities can hold up in the event of deflation, which Gundlach said is a possibility.

The funds are also invested in non-guaranteed mortgage securities that Gundlach and his team believe are trading below what they are worth. These bonds, if purchased at the correct valuation, aren’t sensitive to interest-rate increases and inflation, or rising prices.

“It’s the ultimate inflation hedge,” Gundlach said.

In the past couple of months, DoubleLine also bought below investment-grade corporate bonds because they will be in favor for at least a year and yields are 7 percent to 8 percent. Gundlach doesn’t like junk bonds in the long term because there is risk of default, he said.

Gundlach, who joined TCW in 1985 as a quantitative analyst, later became a fund manager and was named chief investment officer of the Los Angeles-based company in 2005. TCW fired him last year, saying that Gundlach had threatened to leave and take key employees with him. Gundlach said he was dismissed so the company could cut costs.

TCW sued Gundlach and three other former employees in January, alleging they secretly downloaded proprietary information that was used to form DoubleLine. Gundlach has sued TCW, claiming he is owed as much as $1.25 billion in anticipated fee income, and said the allegations that he used information from TCW are untrue.

Assets in TCW Total Return, now managed by a team overseen by Tad Rivelle, have fallen by more than half to $5.3 billion since Gundlach’s departure. It has returned an average of 8.7 percent over the past five years.

DoubleLine started with backing from Howard Marks’s Oaktree Capital Management LP, a Los Angeles-based firm that focuses on high-yield and distressed debt. DoubleLine Total Return Fund had the fastest start for a mutual fund, according to Morningstar. It took 16 years for the TCW Total Return Bond Fund to reach $2 billion in assets under management, Gundlach said.

DoubleLine’s assets under management have risen to $5.5 billion, helping the firm turn profitable, according to Gundlach.

(Bloomberg, October 5, 2010)