Happy Holidays!

In order to enjoy time with family and friends, we will take a short break from our weekly postings over the holiday season. We will resume again on January 8, 2010. Best wishes in the upcoming year!

What's Next in the Year Ahead?

First, we would like to take a moment to wish you and your family a Merry Christmas, Happy Hanukkah, and a very happy New Year! Please enjoy the time with family and friends as we begin a new decade come January 1, 2010.


In recent weeks economic data continues to show improvement for the U.S. economy. Economic data, like most things in life, are usually measured on a relative basis. The economy looks fantastic relative to where it was a year ago and today it would be difficult to find someone who would argue that point.

But the past is the past and is now forever part of history. We must focus on the future and what lies ahead. In the financial world there is always an abundance of opinions and ideas. However, the smartest minds in the investment business and economic arena are theorizing totally different outcomes in 2010 and the years ahead. Some are expecting low inflation and slow growth for a number of years, while others expect a fairly robust worldwide recovery along with higher levels of inflation. We suspect the various economic outcomes will be debated heavily in future months. So what's possible for the economy and the markets in the years ahead?

First, we have to expect that interest rates will move higher in 2010 and beyond. A number of determinants have held down interest rates over the past year - a near-zero interest rate policy by the Fed, a surplus of savings around the world, government interest rate intervention and stimulus, a banking industry reluctant to loan, low current inflation readings and future inflation expectations, and quantitative easing by the Fed to jump start growth.

However, the higher probability of a reviving world economy, the structural imbalances and worsening financial conditions of our state and local governments, the liabilities associated with an aging population and the need to finance our federal deficit will likely weigh on the bond markets and interest rates in the year ahead. While it is always easy seeing the world from a rear view mirror, the difficulty, of course, is in figuring out when the turn will come. If economic growth is robust, the turn may come sooner. If growth is not as robust as expected, interest rates could remain at lower levels.

Second, we should expect higher inflation in the future. Again, it will be difficult to predict when it will start to accelerate, but we can be fairly certain it will arrive. The Fed is determined to bring inflation back and current policies will likely bring about their desired result. With so much liquidity being pumped into the global financial system through extremely low interest rates, massive government stimulus programs, along with Federal Reserve and other world government's monetary policies, we should expect a pickup in inflation, especially if we have no clear and definitive program in place to withdraw the excess liquidity from the system.

Third, just as the 1% interest rate policy and massive liquidity injections under the Greenspan administration caused the housing bubble and relatively lack luster economic growth coming out of the last recession; we can expect the 0% interest rate policy along with an obscene amount of liquidity injections under Bernanke will have unknown implications and unintended consequences. Unfortunately, it is extremely difficult to predict what will happen and where it will manifest. The unexpected could surface in a year from now, 2 years from now, or 5 years from now, but we can be almost 100% certain something will result from current policies.

Finally, there seems to be a societal and political shift towards more populist ideals in this country. Since the crisis began, more people are questioning the structure and perceived inequalities of capitalism and are beginning to think about alternative ideas on how to structure society. Citizens are collectively moving toward the belief that they are entitled to have access to what they need in order to live a full life. Of course, in our society, human needs have always come before private profits. These include access to food, housing, education, and medical care. However, "human needs" is a very broad term and is expanding to include other wants to which citizens believe they are entitled.

While this populist shift may not have an immediate impact on capital markets, if the movement gains traction there could be an impact on economic growth and corporate profitability in the future. If the economy recovers and the unemployment rate declines significantly, we should expect the movement to lose traction. However, if the unemployment rate remains high, the populist movement could really begin to impact policy coming out of Washington.

While we can attach a higher probability of certain outcomes in the coming years based on current economic conditions and market expectations, we can't predict the timing or possibility of another crisis, which would dramatically impact the probabilities of the various outcomes discussed. The next several years could prove to be very interesting and we look forward to navigating through whatever environment unfolds.

Pay Mortgage or Walk Away

Debtor's Dilemma: Pay the Mortgage or Walk Away

By JAMES R. HAGERTY and NICK TIMIRAOS (WSJ)

PHOENIX -- Should I stay or should I go? That is the question more Americans are asking as the housing market continues to drag.

In good times, it would have been unthinkable to stop paying the mortgage. But for Derek Figg, a 30-year-old software engineer, it now seems like the best option.

Mr. Figg felt trapped in a home he bought two years ago in the Phoenix suburb of Tempe for $340,000. He still owes about $318,000 but figures the home's value has dropped to $230,000 or less. After agonizing over the pros and cons, he decided recently to stop making loan payments, even though he can afford them.

Mr. Figg plans to rent an apartment nearby, saving about $700 a month.

A growing number of people in Arizona, California, Florida and Nevada, where home prices have plunged, are considering what is known as a "strategic default," walking away from their mortgages not out of necessity but because they believe it is in their best financial interests.

A standard mortgage-loan document reads, "I promise to pay" the amount borrowed plus interest, and some people say that promise should remain good even if it is no longer convenient.

George Brenkert, a professor of business ethics at Georgetown University, says borrowers who can pay -- and weren't deceived by the lender about the nature of the loan -- have a moral responsibility to keep paying. It would be disastrous for the economy if Americans concluded they were free to walk away from such commitments, he says.

Walking away isn't risk-free. A foreclosure stays on a consumer's credit record for seven years and can send a credit score (based on a scale of 300 to 850) plunging by as much as 160 points, according to Fair Isaac Corp., which provides tools for analyzing credit records. A lower credit score means auto and other loans are likely to come with much higher interest rates, and credit card issuers may charge more interest or refuse to issue a card.

In addition, many states give lenders varying degrees of scope to seize bank deposits, cars or other assets of people who default on mortgages.

Even so, in neighborhoods with high concentrations of foreclosures, "it's going to be really difficult to prevent a cascade effect" as one strategic default emboldens others to take that drastic step, says Paola Sapienza, a professor of finance at Northwestern University. A study by researchers at Northwestern and the University of Chicago found that as many as one in four defaults may be strategic.

Derek Figg sits in his Tempe, Ariz., home on Tuesday. He stopped making mortgage payments in September. Driving this phenomenon is the rising number of households that are deeply "under water," owing much more than the current value of their homes. First American CoreLogic, a real-estate information company, estimates that 5.3 million U.S. households have mortgage balances at least 20% higher than their homes' value, and 2.2 million of those households are at least 50% under water. The problem is concentrated in Arizona, California, Florida, Michigan and Nevada.

Josh Cotner, who owns an insurance agency, says his mortgage balance is about $100,000 more than the market value of his home in Gilbert, Ariz. Mr. Cotner could rent a bigger home nearby for $600 a month, far below the $1,655 he now pays on his mortgage, home insurance and property tax. He says he recently stopped making mortgage payments because his lender wouldn't help him reduce the principal on his loan under a federal program in which he believes he is qualified to participate. Given the sometimes lengthy legal process of foreclosure, he may be able to stay in the home for at least another nine months without making any payments.

Banks warn they may get tough with strategic defaulters by pursuing legal claims on a borrower's other assets. "We will try to reduce people's payments if they have a hardship," says Thomas Kelly, a spokesman for J.P. Morgan Chase & Co. "But we have a financial responsibility to get people to pay what they owe if they can afford it."

Steven Olson, a loan officer and roof installer in Roseville, Minn., defaulted in 2007 on a plot of land in Florida he had bought as an investment. "I thought I could move on with my life," he says. But the lender, RBC Bank, a subsidiary of Royal Bank of Canada, sued him, seeking to make him pay more than $400,000 to the bank to cover its losses on the loan. Mr. Olson has hired a Florida lawyer, Roy Oppenheim, to resist the claim. An RBC spokesman declined to comment.

States where lenders generally can pursue such legal claims include Florida and Nevada but not California and Arizona, where laws generally prohibit lenders from pursuing other assets of mortgage borrowers. A new Nevada law will protect many borrowers from these judgments if they bought a home for their own use after Sept 30, 2009.

Another risk for defaulters is that banks could sell the rights to pursue claims to collection agencies or other firms, which could then dun the borrowers for up to 20 years after a foreclosure. Such threats appear to deter some borrowers. A recent study from the Federal Reserve Bank of Richmond found that under-water borrowers were 20% more likely to default in a state where mortgage lenders can't pursue claims on other assets than in those where they can.

Brent White, an associate law professor at the University of Arizona who has written about this issue, says homeowners should make the decision on whether to keep paying based on their own interests, "unclouded by unnecessary guilt or shame." He says borrowers can take a cue from lenders that "ruthlessly seek to maximize profits or minimize losses irrespective of concerns of morality or social responsibility."

But it isn't just a matter of the borrower's personal interest, says John Courson, chief executive of the Mortgage Bankers Association, a trade group. Defaults hurt neighborhoods by lowering property values, he says, adding: "What about the message they will send to their family and their kids and their friends?"

In Mesa, another suburb of Phoenix, low prices are helping to draw buyers who may walk away from other homes. Christina Delapp bought a house out of foreclosure in July for $49,000 in cash. She says she will stop paying the mortgage on another home she still owns in Tempe if she can't sell in the next few months for more than the $312,000 that she owes.

Ms. Delapp, who has been jobless for 18 months, says that the new home is part of her survival strategy. "I feel very fortunate," she says. "Regardless of what happens to my credit, we've managed to put together the best safety plan that I possibly could."

Sovereign Default Risk

According to the CMA Sovereign Rate Risk Monitor, below is a list of the top ten countries with the highest default probilities on their respective debt based on current CDS (credit default swap) pricing.


Venezuela 60.71%
Ukraine 53.75%
Argentina 50.93%
Pakistan 36.21%
Dubai 31.14%
Latvia 30.38%
Iceland 25.65%
Lithuania 19.67%
California 19.16%
Romania 17.35%


Notice number 9 on the list? While there is usually always a mix of countries and republics, it was surpising to see a US state on the top ten list. It may mean something or may mean nothing, but interesting none the less.

Funny Cartoon

Unemployment Rate Declines

Nonfarm payrolls fell by just 11,000 last month, slowing down from a downwardly revised 111,000 drop seen in October, reported the Labor Department.

It was the best showing in payrolls since December 2007, when the recession began and payrolls had risen by 120,000. Economists surveyed by Dow Jones Newswires had expected a payroll decrease of 125,000.

The unemployment rate, calculated using a survey of households as opposed to companies, edged lower to 10% in November from 10.2%. Economists had forecast the jobless rate would remain at October's level of 10.2%, the highest level since April 1983.

The payroll data reflect the first notable improvement in the jobs market since the recession began two years ago; although we still have yet to see net job growth. However, it seems as though we should see some job growth in the payroll data in the coming months.

Employment in the service sector -- the main source of U.S. jobs -- rose by 58,000 in November. But that was more than offset by manufacturing companies shedding 41,000jobs and construction companies cutting 27,000.

Health-care employment continued to rise in November, by 21,000. The industry has added 613,000 jobs since the recession began at the end of 2007.

With unemployment still at 10%, the Federal Reserve's view that interest rates must remain at a record low to bolster a soft recovery should remain unchanged. The central bank left interest rates close to zero a month ago in the face of low inflation and still-high unemployment.

Favorite Clips

We would like to wish you and your family and very Happy Thanksgiving! Please remember our armed forces throughout the world as you celebrate with family and friends.

Below is a small collection of funny video clips we have either received or come across over the years, which we thought you would find enjoyable. Enjoy the clips and have a wonderful holiday!

2010 Roth Conversion Opportunity

In 2010, any taxpayer regardless of income will be eligible to convert an existing IRA to a Roth IRA. As the law stands right now, you can’t convert from a traditional IRA to a Roth IRA if your modified adjusted gross income (MAGI) on your federal income tax return is over $100,000. Beginning in 2010 (and beyond) that limitation is abolished (unless there are changes to the tax code in the future). In addition, there's a special rule in place for 2010 only that will allow you to recognize 100% of the conversion income in 2010 or split it equally between the next two tax years.

Even though you will have to pay current income tax on the amount you convert to a Roth IRA, it still might make sense if:

1) You think you will be in the same or a higher tax bracket at retirement.
2) You have a long enough time horizon.
3) You can pay the tax from sources other than your IRA.
4) You don’t need the money and want to leave tax-free funds to your heirs.

A few important notes about paying the conversion tax:

If you pay the tax from your IRA, you would lose the potential benefit of tax-free growth on that amount, defeating the purpose. Of course, if you’re under 59½, withdrawing money from your IRA to pay the tax would be an even worse idea, since you would also incur a 10% federal penalty. (State penalties may also apply.)

Ideally, you will have cash on hand to pay the income tax. If you need to sell appreciated assets to pay the conversion tax, the additional capital gains tax would work against the case for a Roth conversion. Assuming you have the cash available elsewhere to pay the conversion tax, you still need to account for the “opportunity cost” of what that money could have earned had it remained invested in a taxable account.

Income taxes aside, individuals may find that converting part or all of a traditional IRA to a Roth is advantageous for estate-planning purposes, especially if there is a significant IRA balance that doesn’t need to be tapped during the owner’s lifetime. Though the value of a Roth will still be included in the gross estate, because there are no required minimum distributions, the account could grow larger than it otherwise might under traditional IRA distribution rules; leaving more for heirs to withdraw income-tax-free over their lifetimes. What's more, the income tax paid at the time of conversion (preferably from assets other than the IRA) will reduce the owner’s gross estate. In effect, the account owner is prepaying income tax on behalf of future beneficiaries without it really counting as a taxable gift.

We will be discussing Roth Conversions with clients in the coming months to determine if a conversion would be advantageous as we do expect future tax rates to be higher than they are today. In the meantime, if you have any questions please let us know.

Liquidity, Liquidity, Liquidity

The chart below is only a few days old and can be found on the St Louis Federal Reserve website (stlouisfed.org). It shows a very clear historical picture of how much liquidity is being pumped into the system. At some point, this liquidity is going to have unintended consequences.

It should be noted that this chart represents assets issued directly by the Treasury or Federal Reserve Bank and the monetary base figure changes only if the Treasury or Federal Reserve take action to permit the change.

The little blip on the chart just before the year 2000 was the Federal Reserve pumping billions of dollars into the system over fears of Y2K.


(double click on chart for bigger image)

Home Buyer Tax Credit Extension

As expected, President Obama signed into law an extension and expansion of the home buyer's tax credit this past week. It's part of the unemployment compensation extension bill.

The home Buyer's credit originated in February as part of an economic stimulus bill and was due to expire on December 1, 2009. It has now been extended to home purchases that are entered into agreement before May 1, 2010, and closed before July 1, 2010.

The original credit amount for a "first-time home buyer" remains at 10 percent of the purchase price, up to a maximum of $8,000. A first-time home buyer is defined as someone (or a spouse) who has not owned a home in the last three years. The credit was phased out for singles with Adjusted Gross Income (AGI) of $75,000 and married couples with AGI of $150,000, but the new law increases the phaseouts to $125,000 and $225,000, respectively.

In addition to the extensions of the credit for first-time home buyers, the new law allows for a tax credit for home buyers that already own homes. A new credit of 10 percent of the purchase price, up to $6,500, is available to buyers who have lived in their present homes for 5 consecutive years of the past 8 years. This credit is meant to spur on "move up" buyers. The same income phaseout limits apply.

The credit, whether used by a first-time home buyer or a long-time resident home buyer, applies only to primary residences, and the purchase price must not exceed $800,000. There seems to be general consensus that this law will not be extended again.

All homes with a purchase price of less than $800,000 qualify, including newly-constructed or resale, and single-family detached, townhomes or condominiums, provided that the home will be used as the principal residence. Vacation home and rental property purchases DO NOT qualify.

Here is one important and potentially critical oddity about this credit: you may claim it on your 2009 tax return, even if you buy your house in 2010!! So, even though the home purchase may occur in 2010, you have the right to claim it for 2009, if you extend your return or amend your already-filed 2009 return. In this way you will receive your cash much sooner than waiting until you file your tax return for 2010. However, keep in mind the AGI limits mentioned above; these limits apply to the year in which you claim the credit.

The credit is a true credit for tax purposes. Therefore, if you complete your tax return and are due a refund of let's say $1,000, you would add the $8,000 credit to this amount for a total refund of $9,000. Please consult your tax advisor for more details.

Health Care Reform

With so much discussion about healthcare reform and proposed legislation in the news, we thought it would be helpful to list some links to websites about healthcare reform so you may have a better understanding of the proposals and legislation being discussed. Below are a few links to websites covering discussions and facts about current healthcare reform. You will need to cut and paste the links into your browser.

http://www.opencongress.org/bill/111-h3200/show

http://www.healthreform.gov/

http://www.aarp.org/health/articles/health_reform_get_the_facts.html

http://healthcarereform.nejm.org/


Have a nice weekend and happy reading!

Third Quarter Update

After a brief pullback to start the third quarter of this year, the global markets continued higher, again turning in one of the best quarterly performances in over 10 years after a significant rally in the second quarter. The quarter was marked by town hall meetings on health care reform, speculation concerning Iran’s actual nuclear capabilities, and the Cash for Clunkers program, which helped drive sales at the automakers. The Federal Reserve held interest rates at zero, while the dollar continued its decline against most major currencies.

To be perfectly honest, we have been very surprised by the 50% move in the U.S. markets in the past 6 months – the sharpest on record. We underestimated the sharpness of the recovery off the March lows and the liquidity impact of government stimulus in the capital markets. For what it’s worth, after the October 1987 crash (which could be considered similar to October 2008 in terms of magnitude and impact), it took the market about 21 months to move 50%.

As we move toward 2010, many of the same uncertainties regarding consumer demand and global economic growth are still with us. However, it is important to remember that markets can disconnect from economic fundamentals if there is a collective perception the global economy is recovering and corporate earnings are improving; which is currently happening. This doesn’t signal economic improvement is certain or uncertain for that matter. It is the collective perception of improvement or non-improvement that typically moves markets at any given time. At the moment any possible fundamental concerns have been put aside by most market participants who seem to be placing more emphasis on bottom line cost cutting, which has improved short-term profits. Whether companies are able to achieve longer term profitability growth remains to be seen and will be important to watch moving into 2010.

In addition, both the stock and bond markets are benefiting from a surge of liquidity into those markets, based on a Federal Reserve zero interest rate policy on cash, which essentially forces market participants to accept more risk in order to earn any return.

Our current assessment is that the US market averages (based on S&P 500) are at the higher end of fair valuation based on current earnings estimates for 2009 and forward estimates for 2010. As we move toward the end of a given year, focus tends to move to earnings in the following year – in this case 2010. As of October 1, 2009 earnings estimates for the S&P 500 are $54.75 for 2009 and $73.50 for 2010 – a 34% increase. While we do believe earnings will likely increase in 2010, a 34% increase in factoring for a very sharp, robust recovery and significant revenue growth. While this result is certainly achievable, we should keep an open mind toward other possible outcomes. Analysts tend to be most optimistic regarding future earnings estimates at the end of the preceding year and adjust accordingly as the year progresses. Earnings estimates for 2010 have remained in a rather tight range over the past few months; estimates are not being raised, but they are also not being lowered.

Going forward, we are likely entering a highly complex and unpredictable period with various possible outcomes - both positive and negative. What makes the environment difficult is that the most obvious concern may not be the one that we actually need to watch for. Given this environment, while we can certainly hope for one, it is highly unlikely we will see another 50% rally in the markets over the next 6 months. The overall direction of the stock markets will likely be impacted by which outcome ultimately plays out.

Puzzle Pieces

In determining where to allocate funds, there must be an understanding of the interaction of asset classes given certain scenarios. Outcomes can be vastly different from one scenario to the next. Understanding the interactions between asset classes is a bit like discovering puzzle pieces in a random box and trying to fit them together without really knowing what the finished puzzle is supposed to look like, because there is no finished picture to reference.

Right now, there are essentially two primary scenarios and most analysts and theorists are stating some version of these scenarios.

Scenario 1: Dollar decline, lower bond prices, higher stock prices, higher commodity prices, higher gold

Scenario 2: Dollar rises (as of function of deleveraging), higher bond prices, lower stock prices, lower commodity prices (as a function of a reduction in global demand.)

These two scenarios are conventional wisdom in the marketplace. Some believe scenario 1 is happening right now. Some believe scenario 1 has already occurred and is currently in the end stages before scenario 2 prevails. Some believe scenario 2 will be coming shortly, followed by scenario 1. So far the scenario 1 camp has been right, but what comes next? More of 1 or the beginning of 2?

It is a little troublesome when there seems to be such confidence in each of the opposing camps. Essentially, these sides represent the extremes for each scenario - one side the hyperinflationary theorists; and on the other are the deflationary depression forecasters. The reality is that we likely find a path somewhere in between. We could even move between the two scenarios for various periods of time. How the pieces of the puzzle come together will ultimately determine asset class selection.

Risk Control

One of the keys to achieving superior investment returns is to know when to follow the herd and when not to follow the herd. If one is wrongly positioned relative to the herd, the hope is not to be eaten alive! In other words, one needs to know when to add risk and when to decrease risk.

For example, if you are a zebra and live in a herd, the key decision you have to make is where to stand in relation to the rest of the herd. When you think conditions are safe, the outside of the herd is best, for there the grass is green and fresh, while the middle sees only grass that is eaten and trampled down. The aggressive zebras, on the outside of the herd, eat much better. On the other hand, there comes a time when lions approach. The outside zebras end up as lunch while the skinny zebras in the middle of the herd may eat less, but they are still alive.

We believe there are still multiple underlying fundamental concerns that could hold negative implications for longer term corporate profit and economic growth. It is hard to envision a self sustaining economic recovery over the next business cycle, that is unless the government continues to provide endless amounts of stimulus, which could be a possibility. We must be aware of the posssible short-term benefits as well as long term implications of such action.

At the moment these fundamental concerns have been put aside by most market participants who seem to be placing more emphasis on bottom line cost cutting, which has improved short-term profits. In addition, both the stock and bond markets are benefiting from a surge of liquidity into those markets, based on a Federal Reserve zero interest rate policy on cash.

That said, risk control can be almost as important as being positioned properly when it comes to producing above average investment returns. If one has not lost too much capital at any given time, even if wrongly positioned versus the herd, one can be well-positioned and take advantage of opportunities when one gets back on track. The key to success is moving within the confines of the herd, but not living in the very middle or on the extreme outside.

Dollar Devaluation

Over the last several months there has been a very close, some could argue almost perfect correlation between the US dollar and the US stock market, as measured by the S&P 500. As the dollar declines against other currencies, US exports become cheaper to foreign buyers, in turn increasing US corporate revenues. At the same time a weaker dollar typically turns investors towards riskier assets such as stocks.

If this correlation continues, any increase in the value of the dollar could correspond to a decline in the stock market. Conversely, if the dollar continues to decline, we should expect the stock market to continue to rise; as long as the correlation exists.

(Click on chart for larger image)

Baltic Dry Index Update

The Baltic Dry Index (BDI) is a daily average of prices to ship raw materials. It represents the cost paid by an end customer to have a shipping company transport raw materials across seas on the Baltic Exchange, the global marketplace for shipping contracts.

The BDI is one of the purest leading indicators of economic activity. It measures the demand to move raw materials and precursors to production, as well as the supply of ships available to move this cargo. Consumer spending and other economic indicators are typically backward looking, meaning they examine what has already occurred. The BDI offers as close to a real time glimpse at global raw material and infrastructure demand as any indicator. Unlike stock and commodities markets, the Baltic Dry Index is totally devoid of speculative players. The trading is limited only to the member companies, and the only relevant parties securing contracts are those who have actual cargo to move and those who have the ships to move the cargo.

Below is the most recent chart of the Baltic Dry Index. The BDI has been declining since June of this year, just as many economists believe a global economic recovery is underway. While the latest decline may be a pause in shipping activity before countries such as China begin restocking raw materials for the end of the year, the BDI should be monitored as it is a leading indicator of economic activity. If the BDI continues to decline in the coming weeks and months, it could be an indication that economic growth forecasts may be too optimistic.

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View the full BALDRY chart at Wikinvest

What is Deflation?

We found an article this morning written by an anonymous risk manager which explains deflation in easy to understand terms. Given the ongoing battle between deflationary forces and inflationary forces, we thought this would be a great article to post.


"Deflation is the contraction (reduction) of money and credit. It occurs when the economic system is carrying too much debt to be supported by the level of income generated by economic activity. It occurs because too much debt has been incurred to create unproductive assets that don’t generate income. Deflation is a corrective process, it’s simply the market not being able to service debt, so we must forfeit.

Since central banks and accepted economic theory are all about creating debt to grow (artificially) economies, periods of inflation (creating money-debt and credit) last a long time: Debt is accumulated incrementally until there is too much of it. So people don’t really understand the tells of deflation.

For example, the things that drive currency movements are quite different. If we’re in an inflationary period (expanding credit) and we get a good economic number, people expect the value of the dollar to rise: A growing economy will attract investment so foreigners buy dollars to invest in US stocks. If you get a bad economic number on the margin, you’d expect the dollar to fall as the opposite is true.

We just this morning saw a disappointing durable goods number. If we were in an inflationary period, you would see the dollar fall. The number actually made the dollar rise by 30 basis points. Why?

In deflation, there’s too much debt. If the economy is slowing down, it makes it more difficult to pay back that debt and you would expect more to default. The more debt that forfeits, the more dollars are destroyed. The more dollars destroyed, the more they’re worth.

Central banks of countries with massive external debt (the US) are desperate to create inflation (keep credit from contracting), but the mechanism to do that is broken (because there’s too much debt in the system).

It is important to always ask the question why something is happening rather than just observe patterns because patterns can change depending on the environment."

Consumers Continue Reducing Debt

The main constraint on spending going forward will be the desire to beef up savings and reduce debt burdens. However, with layoffs slowing down, it is only a matter of time before the economy starts to generate positive job growth. While a larger portion of incomes will likely be deposited into savings accounts, it's hard to imagine the savings rate will increase dramatically from here. From its low point of under 1 percent in early 2008, the savings rate has risen to almost 5 percent over the past three months, which is actually a full percentage point above the average that prevailed between 1994 and 2008, although below the 7 percent average during the 1980s. We suspect that households will want to build up a larger cushion of savings to guard against possible adversity and to replace some of their wealth lost to the housing and stock market declines in 2008.

As people become more optimistic, personal spending may begin to improve. Also, the debt side of the household balance sheet is being rapidly brought down. Households started to seriously reduce debt burdens late last year, but their efforts have proceeded at an astonishing pace in recent months. In July, consumers paid down an unprecedented $21.6 billion more debt than they took out, following six consecutive monthly paydowns averaging $14.2 billion. At the end of the month, consumer debt stood 4.2 percent below the level of a year earlier. That's a swing of about 10 percentage points from the 5.2 percent average growth rate in consumer debt that fueled spending during 2007 and early 2008. Needless to say, the debt pullback has contributed significantly to the spending retrenchment that has since occurred. (See chart for details)

To be sure, not all of the debt paydowns reflect a newfound sense of frugality on the part of households. A good deal of it simply reflects tighter lending standards by risk-averse banks and other institutions striving to restore profitability. To this end, credit card rates have been lifted, stiffer fees have been imposed and credit limits have been lowered. But there is little question that households have greater access to credit now than was the case during the height of the credit crisis late last year and earlier this year.

Indeed, it may well be that the astonishing reduction in consumer debt this year has as much to do with banks writing off bad loans as it does with households paying off their obligations. As the chart shows, the rate of bank chargeoffs of consumer loans has surged over the past year, reflecting the heightened stress on households budgets amidst huge job losses during the recession. During the second quarter, nearly 10 percent of credit card debt was written off, the highest since records first began in 1985. That trend likely continued into the third quarter, and may have accounted for the lion's share of the record debt paydown in July. If so, that would explain why nonrevolving credit fell even as auto sales spiked under the cash for clunkers program.

Economic Activity Stabilizing

Recent reports from the 12 Federal Reserve Districts indicate that economic activity continued to stabilize in July and August. Relative to the last report, Dallas indicated that economic activity had firmed, while Boston, Cleveland, Philadelphia, Richmond, and San Francisco mentioned signs of improvement. Atlanta, Chicago, Kansas City, Minneapolis, and New York generally described economic activity as stable or showing signs of stabilization; St. Louis remarked that the pace of decline appeared to be moderating. Most Districts noted that the outlook for economic activity among their business contacts remained cautiously positive. The majority of Districts reported flat retail sales.
Residential real estate markets remained weak, but signs of improvement continued to be noted. Chicago, Richmond, Boston, and San Francisco observed an uptick in sales over the last six weeks, while sales in the Philadelphia District were described as steady. Most Districts noted that demand remained stronger at the low-end of the housing market. Boston, Cleveland, Dallas, Kansas City, Richmond, and New York indicated that the first-time home buyer tax incentive was spurring sales. However, Philadelphia did note an upturn in sales at the high-end of the market. Reports on house prices generally indicated ongoing downward pressures.

Reports on commercial real estate markets indicated that demand for space remained weak and that construction continued to decline in all Districts. Atlanta, Philadelphia, Richmond, and San Francisco reported that vacancy rates increased, while rates held steady in the Boston and Kansas City Districts and were mixed in New York. Commercial rents declined according to Boston, Chicago, New York, Philadelphia, and Richmond. Rent concessions were reported in the Richmond and San Francisco markets, and Richmond noted that some landlords had postponed property improvements in an effort to conserve cash. Construction remained at very low levels, with modest improvements noted in public construction in the Chicago, Cleveland, and Minneapolis Districts.

Information taken from most recent Federal Reserve Beige Book report.

Long Term Chart Revisited

Above is a long term monthly chart of the S&P 500 Index going back to 1995 to present, which was first posted back in April of this year. The chart is helpful because it is a big picture view of the market. (Click on image for larger view)

As a refresher, notice the red and blue price lines right below the monthly chart of the S&P 500. These lines basically measure average prices over a rolling period of time, in this case monthly. The red line measures a shorter term average price and the blue line a longer term average price. The newest monthly pricing data is added and the oldest monthly pricing data is dropped from each average each month. These lines essentially show us if prices are moving higher on average or lower on average over a longer period of time. When the red line (shorter term average) crosses the blue line (longer term average) to the downside, prices are moving lower on average and vice versa when the red line crosses up through the blue line.

Back in April, both the red and blue lines of this chart were moving lower, despite the recent 20% rally in the index. We also stated that based on the current readings, it would likely take several months of stable prices or base building in the index before the red and blue lines begin to stop moving down and then begin to curl upward as they did in 2003.

Well, here we are several months later and, as of August 31st, the short-term moving average just slightly crossed the longer term moving average indicating a change in trend in the average price of the index. Instead of moving lower on average, prices are now moving higher on average, given this particular indicator. Although the fundamental backdrop of the economy may still be suspect, the market believes a recovery is on the way. While there is no guarantee a change in trend is here to stay; in the past this moving average "crossover" has represented a long-term favorable trend change for stocks. With this trend change typically comes a change in psychology. Instead of selling every time the market moves higher in anticipation of lower prices, market participants are now buying every time the market moves lower in anticipation of higher prices. Institutions have also shown modest accumulation in recent weeks.

We believe we have returned to more normal market conditions; barring any major crisis. Corrections in the markets should be viewed as a chance to opportunistically rebuild allocations for long-term appreciation. Of course, if market conditions change drastically or the environment becomes more volatile, it may be appropriate to revisit our outlook.

We have experienced volatility surpassing anything in history followed by one of the fastest and most powerful rallies in the markets on record; which in and of itself is absolutely astonishing. Our view as to why the markets have shifted so quickly is the possibility that market participants are now ignoring any bad news and possible unknowns based on a collective belief the US Government will continue to backstop the markets and economy. While this is a move toward a more socialistic society, it adds a backstop to the markets. The perception is that they (the Government) will do whatever it takes to move the country back on a path to economic growth; in addition to protecting capital markets from any future crisis which may develop.

In addition to a Government backstop, company's earnings comparisons for the next several months should be relatively easy given the awful earnings posted in the second half of 2008 and cost cutting measures most have taken over the past year. It is very likely a majority of companies will have much better than expected earnings results in both the 3rd and 4th quarters of this year.

Finally, on the political front, there is a feeling that many democratic, hot button political issues, such as health care reform, could be dead. Many believe that Obama's honeymoon is over and he is going to have to move toward the middle or risk losing the upcoming election in 2010 and control of Congress. This is also helping markets and investor psychology as there is a sense it will be difficult for any major legislation to pass.

There is a wildcard to throw into the mix - the consumer. It is hard to know to what level the consumer will spend heading into the holidays and into 2010. Some economists believe spending will return to a modest level in the coming year and others believe it will take an improved housing and job market for consumers to feel more confident. It is difficult to predict how this recovery cycle will play out as US consumers lost trillions in wealth over the past few years. The next few months of economic data should give us some clues into the recovery cycle.

Enjoy your Labor Day weekend!

New Home Sales

Although new home sales jumped by 9.6% in the most recent month and the pace of home sales accelerated to 430,000; the chart below (which doesn't included the latest data point) shows just how far new home sales have declined over the past 3 years. The decline in home sales is the most severe on record and the chart bears the steepness of the decline.

According to most reports, many the new home sales can be attributed to the $8,000 tax credit implemented earlier this year. The program has helped to boost the housing figures since its inception in mid February. What will be interesting is to see in the coming months is what happens to new home sales when the tax credit program ends in November? It is possible the finalization of the program could bring an end to the recent uptick in home sales, which continues to remain underwater compared to last year’s levels. In comparison, rate of sales of new homes in 2008 were approximately 12.5 percent higher on average and median prices that were 10 percent higher at $230,000. (Click on chart for larger image)

Summer Hiatus

With only a few weeks left of summer and many taking vacations, we will be taking a hiatus from the weekly updates during the month of August. BAM weekly updates will resume in September. Enjoy the rest of your summer!

Earnings Estimates Decline?

As we have mentioned a few times in previous updates, the stock markets typically follow earnings. Stock valuations are based on cash flows and earnings so it makes sense that when earnings increase stocks move higher and vice versa. We stated in our mid-year update a few weeks ago that the economy is secondary to earnings and in the long run earnings are what drive stock valuations. Focusing on statistics and earnings estimates also helps remove emotion from the decision making process.

Last year earnings fell about 40% from the results posted in 2007 and the stock market (based on the S&P 500) declined roughly 40%. Earlier this year the stock market dropped about 20% based on expectations of a significant drop in earnings for 2009. When earnings estimates stabilized and expectations for a recovery in the second half of this year began to take hold, the stock markets increased in anticipation.

However, we recently reviewed the current estimates for the S&P 500 for 2009 and noticed earnings estimates have actually declined (as of August 5th) as the stock markets have moved materially higher. Roughly a month ago, earning estimates for 2009 were starting to increase. Earnings estimates increased from roughly $55 to roughly $56 per our mid year update. As of August 5th, estimates for 2009 have actually declined - yes, declined - from $56 to $54.28 and estimates for 2010 have declined from over $76 to $73.18. This decline is on the heels of many companies reporting better than expect earnings for the quarter and many analysts revising earnings estimates for the balance of the year.

So as the markets move higher, earnings estimates decline. It could be that estimates have not been updated and earnings estimates will move higher in the coming weeks. However, this is not likely as these estimates are updated weekly on Standard and Poor's website. In the end something will need to change. Either the stock market declines to better reflect lower earnings or earnings estimates increase markedly to help support current valuations, which continue to increase by the day. While anything is possible and we will continue to watch estimates, we could be setting up for another interesting 4th quarter.

Definition of a Trend

In the market as in life, perception always trumps reality. In one year the mantra is that it doesn’t matter what you pay for the new paradigm Internet stocks – the next year many of those same names are out of business. One year the oil is going to $200 a barrel and the next year it trades in the 30's. For at least 5 years into 2003, US Steel Corp couldn’t catch a break and was close to going out of business, for the next 5 years it couldn't produce enough steel to meet demand. One year it’s all virtual and digital, a few years latter it’s back to basics and basic materials with brick and mortar outshining the net. Let us not forget that at one time Lucent, the spin off of AT&T, was the single largest owned name in the United States. A few years later it was trading under $3 and its technology virtually obsolete. Did the underlying fundamentals change that drastically and that quickly or did the underlying perceptions simply get discredited rapidly?

If you go on the assumption that perception trumps reality your decision making can be derived from the idea that it is the state of mind of the masses that determines the fundamentals rather than the other way around. Our world is the image our brain constructs prompted by neural relationships, i.e. patterns. We do not know how real the mental images are relative to the objects they refer to. All our memory exists in ‘stored’ form--in other words beliefs that are not currently being considered by the mind but stored in memory waiting to become an image or action. We construct these images in a constant flow of pattern-recognition and memory retrieval. This flow constitutes our consciousness. Basically, we think in images.

Past patterns in the stock market in price and time will tend to affect the mass of market participants whether consciously or subconsciously. We never experience the “present” as a unique singular moment; it is a flow of images in the context of the world around us and the world before us, literally, and figuratively. In the cognitive process, we endeavor to create meaning. Meaning gives us a sense of security and control. We constantly look for patterns to match them with something stored in our memory. Learning is pattern seeking - the constant up and down of the stock market is the supply and demand of trying to make sense on multiple time frames (i.e. short-term and long-term).

The interaction of perceptions and interpretations in the market creates a constant information flow which in turn changes forthcoming interpretations. Sometimes that flow is interpreted as meaning. The thing to consider is not to confuse information with enlightenment. We try to make sense all the time and communicate this to others. A single individual communicates to another individual, then to a group, then throughout society and the cultural dynamics that create what we call trend.

For example, the coincidence of Obama saying stocks ‘may represent a value’ and Bernanke saying he sees 'green shoots' within days of the beginning of the largest rallies in a decade. Subjective vision becomes ‘accepted’ by followers if there is a convergence or coincidence of the idea. Being ‘trendy’ simply means to comply with a present state of idea within the market place (or society). A market trend can also be described as a trajectory of constantly and dynamically changing ideas within an overall pattern of price and time. We look for a pattern and create a narrative around it.

A trend is perceived as a correlation of patterns. The longer a trend has persisted and the more force it has demonstrated in a change over what preceded it, the observed trend is obvious. Yet we are always forecasting. We build patterns into the future. If we did not continuously infer into the immediate future, we would be constantly surprised by the present. In life as in the markets in the process of making sense, we inevitably project our own beliefs and expectations.

Likewise, because we are innately pattern seekers, it is all too easy to see patterns and to deduct connections which are not there. To arrive at a strategy that is useful, it is necessary to see the big picture first and always see the big picture. Something that is difficult as we can all too easily get swept up by the momentary story and act on emotion. The driving force of every trend is an idea of a world which lies in the future. We imagine the future. The question we should stop and ask ourselves is: does somebody else imagine this future for us or do we imagine it ourselves?

Smart Money / Dumb Money Update

Below is the most recent update from the SentimentTrader.com website showing the latest spread between smart money and dumb money represented by the green and red lines, respectively. As the market continues to rally, the dumb money confidence continues to climb, while the smart money confidence has remained relatively flat. (Click on picture for larger image)

Roubini's Recent Comments

Nouriel Roubini was right. A few years ago, at a time when the likes of Alan Greenspan were dismissing concerns about excessive home prices and stating that banks were stronger than ever, Roubini warned about a bubble in the housing market and that the bursting of that bubble would cause much of the financial system to collapse. And so it has turned out, with even the most seemingly outlandish of Roubini's predictions matched or even exceeded by reality. He is one of only a handful of economists who saw the crisis looming. Of course, you are only as good as your last forecast. However, since he was correct about the financial crisis it seems prudent to pay attention to what he expects to happen in the future.

Roubini, whos dire economic forecasts earned him the nickname "Doctor Doom", recently told CNBC this past week that the economic recovery is going to be "very ugly." "The recovery is going to be subpar," Roubini said. "I see a one percent growth in the economy in the next few years. There will also be 11 percent unemployment next year and the recovery is going to be slow. It's going to feel like a recession even when it ends."

Asked about his comments in a speech last week about the recession ending in 2009, Roubini said, "I've been saying all along the recession is going to last 24 months. It started in December of 2007 and my view is that it won't be over until December of this year." Click on the video below for the full interview.

Mid Year Update 2009

As we pass the mid point of the year, many analysts and economists are predicting an economic recovery beginning sometime in the next six months. Whether or not this actually happens remains to be seen. These are the same people who have been predicting improvement in the second half of 2009 since the beginning of this year. Well, we are now in the second half of 2009 and each day that passes is one less day.

While we remain hopeful and optimistic about the chances for recovery, the economic data so far has been mixed; so we have to be realistic to the facts at hand. Stock price appreciation during the second quarter ending in June, which resulted in one of the best quarterly performances for the S&P 500 Index in the past decade, has basically discounted the expected improvement in the economy. In other words, everyone now believes the economy will improve sometime in the next six months and the stock market has moved higher in anticipation of that improvement. However, we believe there are several headwinds facing the markets as we move into the back half of 2009.

• The trajectory of economic growth could be weaker than most expect
• Savings rates (consumer and corporate) will probably remain high, curbing consumption
• Consumer expenditures could remain low for an extended period of time
• The likelihood of higher taxes in the future could impact any recovery
• Deleveraging of corporate and consumer balance sheets continues for some time.

Although the recession from a statistical standpoint is probably over, we should consider the possibility of a W-shaped economic recovery, wherein a brief period of positive growth over the few quarters (brought about by massive amounts of fiscal stimulus), would be followed by another economic setback sometime in 2010; given the headwinds above. This scenario seems more possible than a rapid V-shaped recovery. More importantly, we feel it is the unknown, not the known, that has the potential to move markets and in turn impact the economy. The biggest unknown is what will be the ultimate impact of deleveraging, new government policies/regulation, and massive fiscal stimulus all occurring simultaneously.

Just as an increasing of the money supply caused the stimulation in the economy and appreciation of asset prices earlier this decade, the destruction of money is causing a widespread global economic contraction. This contraction could last longer and impact an economic recovery more than most expect, perhaps into 2010. It should be understood that if money creation stimulates an economy then the destruction of massive amounts of money through deleveraging should have an opposite effect and diminish the hopes of a rapid and sustained recovery. Only time will tell.

According to some estimates, US households have lost over $13 trillion in wealth since the beginning of 2008; the worst decline on record. It is likely that this kind of destruction in wealth will have some lingering effects and undoubtedly influence consumer attitudes in the future. How does the government hope to replace over $13 trillion in lost wealth? The answer is simple - it can't. Time is the only instrument which will cure what ails us. Time is what will ultimately heal the economy.

As for the stock market, the economy is secondary to earnings. For the stock market it's all about earnings. Our current assessment is that the US market averages (based on S&P 500) are in the range of fair valuation based on current earnings estimates for 2009, along with the assumption earnings estimates increase this year. Our valuation assumes earnings estimates for the S&P 500 will increase to roughly $60 before year end; about where the consensus was at the beginning of the year. Current estimates for S&P 500 earnings for 2009 are roughly $56, a slight increase from one month ago. Earnings are just starting to be adjusted upward, which is a positive sign. If conditions continue to improve, we could expect upward adjustments to earnings estimates after second quarter earnings are released by companies this month. If earnings estimates increase, this will help support current valuations.

As we enter the back half of 2009, our hope is that the second half of this year is better than the second half of last year. We are sure you will agree!

State Budget Deficits Growing

One of the economic problems stemming from the housing/credit crisis is the impact on state budgets. The decline in revenue has resulted in many states trying to patch billion dollar deficits. Several factors could make it particularly difficult for states to recover from the current fiscal situation.

First, housing markets might be slow to fully recover; their decline already has depressed consumption and sales tax revenue as people refrain from buying furniture, appliances, construction materials, etc. This also would depress property tax revenues, increasing the likelihood that local governments will look to states to help address the squeeze on local and education budgets. And as the employment situation continues to deteriorate, income tax revenues will weaken further and there will be further downward pressure on sales tax revenues as consumers are reluctant or unable to spend.

Unlike the federal government, the vast majority of states are governed under rules that prohibit them from running a deficit or borrowing to cover their operating expenses. As a result, states have three primary actions they can take during a fiscal crisis: draw down available reserves, cut spending, and raise taxes. States already have begun drawing down reserves; the remaining reserves are not sufficient to allow states to weather the remainder of the recession. The other alternatives — spending cuts and tax increases — can further slow a state’s economy during a downturn which produces a cumulative negative impact on a national recovery as well.

The combination of Federal budget issues and State budget deficits could have a significant impact on any future economic recovery, especially if spending cuts and tax increases are enacted. The budget issues facing the various states bearing watching as it could be the fly in the oinment to a sustained economic recovery.

Below is a list of the top 20 states with the highest budget gaps as a percentage of the state's respective budget. Of course California is in a dire fiscal situation; but there are many states facing large budget deficits - all on the list have deficits in the billions of dollars. (Click on chart for full size)

Can continuing claims predict end of recession?

It’s possible one of the best predictors of the end of the US economic recession could be a moderation in continuing unemployment claims. As discussed in the May weekly update Unemployment Rate, typically continuing unemployment claims peak and then moderate toward the end of recessions. At the time the May update was written continuing claims were showing no signs of moderation and were actually setting weekly records.

Well, last week that changed as continuing unemployment claims declined by roughly 150,000, halting a streak of 21 straight weekly increases in continuing claims, including 19 that were new records.

After companies made deep job cuts earlier this year, the drop in continuing claims is a welcome change. Companies have slashed more than 6 million jobs since the recession officially began in December 2007. Of course, the statistics don’t reveal whether workers on government rolls are successfully finding new jobs or just dropping off because their benefits have simply run out after the normal allotment of 26 weeks. It could be a combination of both circumstances, but more likely unemployed workers have simply run out of benefits and have dropped off the rolls.

To obtain a better perspective on unemployment during past recessions, below is a chart of initial claims (those filing for unemployment benefits for the first time) along with continuing claims (those who continue to receive weekly benefits) dating back to 1971. (Click on chart for larger image)

Looking at the chart, the red line represents continuing claims while the blue line represents initial weekly claims. Let's take a look back at the last three recessions to gain a better understanding of past recessionary cycles.

The early 1980's recession officially lasted from January 1980 until November 1982. As you can see on the chart the peak in continuing claims as well as initial weekly claims came in November 1982. Both the initial weekly claims and continuing claims dropped significantly over the next two years as the economy experienced a robust recovery. Economic growth was spurred by the Fed lowering interest rates and Congress reducing tax rates.

The early 1990's recession officially lasted from July 1990 until March 1991. Reviewing the chart we can see that the peak in continuing claims (red line) occurred in the first quarter of 1991. Although the recession ended in the beginning of 1991, it wasn't until the second half of 1992 (when continuing claims dropped) that the economy began a robust recovery.

The early 2000's recession lasted from March 2001 until November 2001; again the recession ended as the continuing claims figured reached a peak. Unfortunately, the ensuing recovery was rather anemic and job creation was below past recovery levels. The economy didn't really gain meaningful traction until the end of first quarter of 2003, many months after the recession officially ended. Interestingly, the US stock market reached a low in March of 2003, before beginning a multi-year bull market that ended in 2007, driven by expanding liquidity and excess credit. Again, the economy actually gained momentum after the continuing claims figure began to decline, which also corresponded to a turnaround in the US stock markets.

It's possible our current recession could be close to ending, especially if continuing claims continue to decrease or begin to level off in the coming weeks. Officially the end of the recession won't be recorded and announced for several months after it ends, as it takes time for statistics to be finalized. It will be wonderful to finally declare this recession over and we hope things begin to improve. However, it is likely we could experience a recovery that will be very similar to the most recent recessions in the early 90's and earlier this decade; where continuing claims remain elevated or clustered and economic growth experiences rather anemic trends until continuing claims begin to decline.

It is also possible the US stock markets may take their cue from both initial jobless claims and continuing claims in attempting to forecast future economic growth and the pace of corporate earnings. If the past holds any key to the future these numbers bear watching.

Cash for Clunkers Program

Today, Congress officially House approved a "cash for clunkers" program that aims to boost new auto sales by allowing consumers to turn in their gas-guzzling cars and trucks for vouchers worth up to $4,500 toward more fuel-efficient vehicles.

Under the program, car owners could get a voucher worth $3,500 if they traded in a vehicle getting 18 miles per gallon or less for one getting at least 22 miles per gallon. The value of the voucher would grow to $4,500 if the mileage of the new car is 10 mpg higher than the old vehicle. The miles per gallon figures are listed on the window sticker.

Owners of sport utility vehicles, pickup trucks or minivans that get 18 mpg or less could receive a voucher for $3,500 if their new truck or SUV is at least 2 mpg higher than their old vehicle. The voucher would increase to $4,500 if the mileage of the new truck or SUV is at least 5 mpg higher than the older vehicle. It is also possible consumers could also receive vouchers for leased vehicles. It is important to remember that this voucher is taken into account after you receive and discounts or dealer incentives, so the total savings could be significant.

There are two key points to remember:

1. Trade in a car that — this is important — has been registered and in use for at least a year (under the same registration), and has a federal combined city/highway fuel-economy rating of 18 or fewer miles per gallon.

2. Buy a new car, priced at $45,000 or less and rated at least 4 mpg better than the old one to get the $3,500 voucher. If the new one gets at least 10 mpg better, you get the full $4,500.

Representative Betty Sutton, D-Ohio, the bill's chief sponsor, said the bill showed that "the multiple goals of helping consumers purchase more fuel efficient vehicles, improving our environment and boosting auto sales can be achieved."

The program would direct dealers to ensure that the older vehicles are crushed or shredded to get the clunkers off the road. It was intended to help replace older vehicles built in model year 1984 or later.

To determine the combined gas mileage on your current vehicle, you can visit http://www.fueleconomy.gov/. Go to the lower right hand corner of the main page on click on the “1985-2010 MPG estimates.” It is right below the “2009 Fuel Economy Guide” box.

Details of the program can be found at http://www.cashforclunkersheadquarters.com/

Federal Reserve Insolvent?

One of the issues that bears close watching in the coming weeks is a little know bill in the House of Representatives called HR 1207 – Federal Reserve Transparency Act. It is probably going to become more known because Rep. Ed Perlmutter (D-CO) and Rep. Chris Lee (R-NY), both House Financial Services Committee members, as well as Rep. John Boehner (R-OH), Minority Leader of the House just became co-sponsors of the bill. Currently, just 11 more cosponsors are needed for a majority to be reached in the House.

If enacted, HR 1207 will amend title 31 of the United States Code and reform the manner in which the Board of Governors of the Federal Reserve System is audited by the Comptroller General of the United States. In other words, for the first time since 1950, the independent financial powerhouse that creates and regulates all money in the US will be forced by law to open its books.

This news also dovetails with reports detailing how the House Oversight and Government Reform Committee, the panel responsible for investigating the use of bailout money, has issued a subpoena to the Federal Reserve, asking them to hand over all documents relating to the takeover of Merrill Lynch by the Bank of America.

Claims by New York Attorney-General Andrew Cuomo that former Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke strong-armed Bank of America into buying Merrill, are giving politics and power a new definition in Washington.

If this bill passes the House, expect the debate to be significantly loud and fierce in the US Senate. This bill and corresponding debate could have a definite impact on stocks, bonds, and the dollar as many believe the Federal Reserve is not well capitalized. Even Jim Grant made a comment this week on CNBC stating the Federal Reserve probably couldn’t survive a conventional audit and would have be shut down. His discussion on the Federal Reserve can be seen below.

Market Update 6/1/09

Global stock markets continue to display strong underlying strength as the “end of the world” scenario has seemingly been taken off the table, investors return to more normal trading patterns, and institutions begin to adjust price based on perceived risk. The US markets, both bond and stock, have become more stable and more rational since last fall. Investors are becoming more confident as volatility decreases. As reported by AMG data services, both bond and stock mutual funds are receiving more cash on a weekly basis.

Our risk assessment is that the US market averages (S&P 500) are in the range of fair valuation as mentioned in the Earnings Matter article on May 8th. Our fair valuation assumes earnings for the S&P 500 will increase to roughly $62 by year end; the estimate at the end of the first quarter. Current estimates for S&P 500 earnings for 2009 are $54.00, a slight decrease from one month ago. Earnings are not yet being adjusted upward, but are not being lowered at a rapid pace. If conditions continue to improve, we could expect upward adjustments to earnings estimates after second quarter earnings are released by companies in July. If earnings estimates increase, this will help support higher stock valuations. If earnings estimates don't increase and markets continue higher, stocks will likely become significantly overvalued.

Investors seem to be pricing in a full recovery and significant earnings growth by the end of 2009. While this is definitely possible and recent economic indicators are less bad, any deviation from this implied recovery scenario could result in more volatile markets as risk and valuations are adjusted. In other words, markets are preparing for best case scenario and if it doesn't happen, volatility will likely increase. Since markets are extremely dynamic, outlooks and assumptions change constantly. There is no predetermined direction or course of action. In March, market participants were pricing in a very dire economic environment. As conditions have become less bad, market participants are quickly pricing in a full recovery.

So where do we go from here? Do we have a full recovery or do economic conditions begin to deteriorate again? It is difficult to know for sure, but it is likely something between these two extremes is the probable direction for the economy. The market currently has a great deal of positive momentum and this can continue for an extended period of time. We believe in this type of environment the best course of action is to contemplate various scenarios (positive and negative) and prepare for possible outcomes. It is difficult to intellectually and emotionally make decisions going against the market trend – such as, buying if the Dow drops 2,000 points or selling if it increases 2,000 points. This is why preparation is important. Too many people make decisions either based on emotion at the moment or without proper thought.

So, with financial Armageddon not likely given the massive liquidity intervention by the government (this liquidity push will have other unintended consequences, but we’ll save that for another day) and stocks more or less near fair valuation given an increase in earnings, investors want to remain patient and focus on an opportunistic approach of adding selective stock, bond, country, and commodity exposure as opportunities arise; especially if corporate earnings estimates begin to increase. Of course, the actual level of exposure should be dictated by one's own risk profile and tolerance for volatility. In addition, one wants to be prepared for any adverse conditions which may arise (another crisis for example) or a negative change to the perceived strength of the economic recovery.

Unemployment Rate

Initial claims for state unemployment insurance benefits surprised expectations by dropping for the second consecutive week yesterday. At 623,000 for the week ending May 23, initial claims dropped 13,000 from the prior week’s upwardly revised level of 636,000. Particularly important, the four-week moving average of initial claims dropped for the third straight week, reaching 626,750. This is a decline from the peak four-week moving average of 658,750 recorded in the week ending April 4. Although the labor markets continue to be weak, the drop in initial claims in both the weekly and the four-week moving average are positive developments.

However, continuing claims in the week ending May 16 reached a record high for the 17th consecutive week at 6.788 million. Continuing claims are representative of those that are still receiving unemployment benefits. Although the weekly initial claims figures have declined, the continued rise in continuing claims is troublesome as more an more workers remain unemployed. At the end of recessions, the continuing claims figure typically moderates as workers begin finding employment. So far this data point shows no moderation.

To gain some perspective on our current unemployment rate and recession versus previous downturns, below are a couple of Bureau of Labor Statistics graphs. The first showing the acceleration in the unemployment rate (%) since the beginning of last year... (Click on graph for full size image)















...and the unemployment rate (%) from 1970 until April 2009.














As you can see we are close to the level reached in the mid 1970's recession, but still below the peak level reached in the early 1980's recession. However, we are well above both unemployment levels reached in the past 20 years. While the Federal government has the unemployment rate peaking around 10% later this year, some economics believe the number could reach as high as 12% before the recession ends. It should noted that the government stress tests for the banks were based on unemployment of 10%, so a number above 10% could have an adverse impact on US banks' capital requirements.

Best of the Web

With the long weekend upon us, let's take a break from the financial world (if just for one week) and dive right into exploring the Internet. While almost everyone uses the web to read news stories, research certain topics, and check their checking account balance, there are a whole list of sites that are useful, fun, and informative. However, we would never know of these sites unless someone told us about them. With that in mind and to hopefully make your experience on the web more interesting and enjoyable, below is a list of sites on a wide range of topics - none of which are finance related :)

http://www.tripadvisor.com/ - travel rating service by travelers


http://www.howcast.com/ - video how-to instruction manuals, some with a touch of humor


http://www.geni.com/ - a site that allows you to build and save your family tree


http://www.mapjack.com/ - a relatively new site for viewing cities, great photos


http://www.searchme.com/ - an interactive, easy to use multi-media search engine


http://www.imeem.com/ - streaming Internet radio station with thousands of songs


http://www.freerice.com/ - site that donates rice for every question answered correctly


http://www.nibbledish.com/ - site for cooks and foodies with tons of recipes


http://www.trulia.com/ - real estate site with town and neighborhood searches


http://www.pando.com/ - great way to send large files (IE photos) through the web

Enjoy the sites and enjoy the long Memorial Day weekend with family and friends!

What could an economic recovery look like?

With the release of the April Jobs report a few weeks ago, job losses were not as great as the previous months. This decrease in job losses is consistent with an array of other recent economic indicators suggesting that the recession could be getting closer to a bottom. That perception is being increasingly discussed by officials at the Fed and others in Washington, who believe the economy should move on to a positive growth track sometime during the second half of the year. If this is correct, the deepest recession in the postwar period will come to an end. The end of a recession doesn't necessarily translate to robust growth. As we possibly move closer to the end of the recession, the question to ask is “what will the recovery period look like?”

Historically, very deep recessions tend to be followed by very robust recoveries. That was the case following the three deep downturns of 1957-58, 1973-74 and 1981-82. Conversely, the mild recessions of 1990-91 and 2001-2002 were followed by relatively mild growth. Most likely the eventual recovery is probably going to resemble the mild type rather than a typical strong growth period following a deep recession.

The recessions of the 1950s, 1970s and 1980s were brought on by an inflation-fighting monetary policies by sending interest rates higher and restricting credit availability. Once the inflation threat moderated during the recession, the Fed would reverse monetary policy, lowering rates and increasing liquidity in the economy. Personal consumption would in turn increase sharply, launching the economy into a robust recovery.

In our current situation things are slightly different. Our current recession was not brought on by tight monetary policy but by an unprecedented housing meltdown and credit crisis. The housing collapse has vaporized trillions of dollars of household wealth that will take many years to rebuild. The Fed lowering interest rates and increasing liquidity, as it has done in this cycle, is a function of trying to stop the economy from falling off a cliff and providing support to the financial system. Currently, with consumers deleveraging and reducing expenditures, there is hardly any pent-up demand that could spur consumer spending into a brisk recovery coming out of this recession.

Based on our current situation, we could expect economic growth to lack the firepower typical of a reversal from a deep recession and the eventual recovery will likely turn out to be much weaker than usual, at least here in the U.S. It is possible that a recovery could be weaker than normal for longer than most expect. We should expect there will be sectors of the economy that see above average growth while many sectors experience below average growth.

How much is a trillion dollars?

If a picture is worth a thousand words, then the chart to the left is worth a trillion dollars. The chart displays each of the various programs set forth by the different branches of government in addressing our problems. Remember at some point this spending needs to be addressed.

Double click on the chart to view full-size.

Earnings Matter

Now while we understand the whole "It's declining but not as bad as it had been", we have to wonder how “less bad” has suddenly become the new black. From an economic standpoint the main thesis for an economic recovery is we are no longer falling off a cliff and investors along with consumers are no longer white knuckled from fear. This thesis is hardly a recipe for a sustainable recovery. While “less bad” is certainly better and we need to see economic conditions improve in order to put us on a path to recovery, corporate earnings are the true driver of stock valuations. A better economy should generate an improvement in corporate earnings, which in turn should result in higher stock valuations.

Corporate earnings and present value cash flows of future earnings are what typically drive markets over short and longer term time frames. Last year the S&P 500 Index dropped roughly 40% in value corresponding to a drop in corporate earnings. According to Standard and Poor’s website, actual S&P 500 operating earnings for 2007 were $82.50 and in 2008 were $49.51; a drop of 40%, not surprising. In other words, earnings matter and stocks ultimately follow earnings.

Now let’s take a look at current earnings estimates for the S&P 500 index. In January of 2009, estimates for the S&P 500 companies for 2009 were $86.00. As of April 1st, the number had fallen to $62.00 and the current reading (as of May 5th) is $56.00. While earnings estimates continue to fall, the markets have rallied. This rally is based on the expectation that the worst is behind us and earnings for this year will begin to improve by the end of the year. In order to determine a fair valuation for the S&P 500 based on estimate earnings we can use a price earnings (P/E) multiple of 15, which is close to the historical long term average. A price earnings multiple of 15 suggests a fair valuation of around 840 on the S&P 500 index; using current estimates of $56.00. If earnings estimates move back to the $62 level or roughly 10% above current estimates and 25% above last year; a fair valuation would be roughly 930 on the S&P 500 index, or about where we are today.

What we can observe from earnings estimates is that stock valuations are likely in the fair value range given current expectations, plus or minus a few percent. However, this fair valuation assumes an increase in earnings this year and that profit margins will permanently recover to some of the highest levels in history, largely driven by leverage which, for all intensive purposes, is gone. If profit margins are now lower, more revenues will likely be needed to produce higher level of earnings as companies have already reduced expenses. If revenues don’t increase to a level to offset lower profit margins, earnings estimates will be impacted.

While we work through our economic and financial issues, deleveraging is still happening around the globe and will likely continue for some time. Deleveraging will likely have a negative impact on corporate earnings as companies shed businesses, sell assets, or raise additional capital which can dilute (lower) future earnings. At the end of the day we suspect earnings still matter and will continue to drive valuations.

Market Update 5/1/09

The US stock markets have displayed strong underlying strength over the past several weeks. Both good news and bad news has been taken in stride as every short-term decline has been greeted with buyers. Although the markets remain somewhat volatile, some stability has returned in recent weeks, which in turn has brought about an increase in investor confidence.

Perceptions are changing with respect to the stability of the global financial system and the possible turnaround in the global economy. The timing of a turnaround in the global economy is at best a guess, given the multitude of uncertainties. However, credit conditions are improving, credit markets are loosening, interest rates are very low by historical standards, and credit spreads are much better, although still elevated. The recent upswing in the US markets feels like participants are buying stocks just because they are going up, not because they are convinced a turn in the economy has occurred. Whether this is true or not remains to be seen.

We expect we will have more clarity on an economic turnaround after the first significant decline (since this recent upswing began) in the market occurs. Since this financial crisis began, credit markets have dictated the direction of stocks and we believe any positive or negative development in credit will have an impact on stocks. Therefore, if credit conditions continue to improve and institutional investors are confident in the improvement and become large buyers into any stock market decline, this will be a very positive sign and should indicate an overall improvement in economic conditions. It would be at this point one would want to become much more positive about stocks and adjust allocations accordingly.

We also remain long-term positive on commodities as they remain a finite resource in a world of seemingly infinite demand. With major cuts in production over the past six months across the commodity spectrum, we believe these "hard assets" could offer the best long-term appreciation as global economic conditions improve and supplies become scarce.