My Two Cents - Extemporania

During recent testimony, members of Congress expressed an overall unwillingness to give financial assistance to Big Car. Among the reasons cited for this unwillingness were the perception that many of Big Car’s wounds were ’self-inflicted’.

Of course, this rationale is dripping with hypocrisy. Just over a month ago, the same Congress lavished $700 Billion in taxpayer money on Wall Street for wounds that were entirely self-inflicted. Greed was the cannon  - derivatives, mortgage-backed securities, and leverage were the bullets. Wall Street blew its own foot off and now the American taxpayer is left to play podiatrist.

There is an important distinction to be made with regards to the bailout money. It has been made very clear time and time again that this money is only for the financial system. This was never an economic stabilization package as it was named and touted. Every action and testimony since the passage of the bill has hammered home this reality.

Despite their obvious problems, GM, Ford, and Chrysler are much more important to the real economy than Fannie, AIG, and Lehman. If anyone was going to be bailed out, it should have been the Big Three as opposed to the Big Fleece.

While at first glance it might appear that this missive would be about global equity markets, such is not the case. However, it might as well be. With bad economic news rolling off the presses daily, equity markets have taken quite a tumble recently albeit in much quieter a fashion than in late September and early October. It is a pretty good bet that the combination of 516,000 first time unemployment claims this past week coupled with a 2.8% drop in retail sales in October won’t help matters much.

Rather, it is worthwhile to focus on the US Dollar and it’s current reprieve from the clutches of oblivion. Make no mistake about it though. This is not so much a Dollar rally as it is other Central Banks staging a global game of one-upsmanship. Disinflationary forces are sneaking into economies around the world and nobody wants to be Japan circa 1992-2008. Despite perma-low interest rates, the Japanese economy has been stuck in a rut for almost 2 decades. Or has it? Despite all its problems, Japan has managed to be one of our biggest creditors, owning roughly $586 Billion in Treasury bonds as of August 2008. Ironically, we can be happy the Japanese have had the ‘problems’ they have or else the party would have ended long ago.

Almost immediately after last Friday’s jobs report, the markets rallied on the notion that the Fed would cut interest rates at its next meeting. Folks, we’re already at 1%. How much lower can they really go? Frankly, it doesn’t matter. There is no longer any doubt that yields across the full spectrum of US Bills, Notes, and Bonds are negative. So they might as well take them to nothing. Not to be outdone, Mervyn King, head of the Bank of England emphatically pronounced that BOE was prepared to cut interest rates to 0% to save their economy. I guess Mr. King has his own fleet of helicopters ready to save the English from deflation much in the same way our beloved Ben has envisioned. You can’t make this stuff up. And it isn’t just the two of them. The ECB has cut rates as have the Bank of Canada and Australia as well. Even the Chinese have gotten into stimulus mode and their growth is still around 9% on an annual basis!

From a purely technical standpoint, the Dollar’s rally is already on borrowed time. It is important to understand that the overwhelming majority of the rally has been driven by the ongoing global liquidation and triggering of credit default swaps and other OTC derivatives (See Chart). This has created a dream scenario for anyone wanting to purchase real assets. Oil has been reduced to $55/barrel, gold to the low $700’s, and Silver to single digits. The situation is similar across the full spectrum of tangible assets.

To help stem the bleeding from OTC derivatives, the Fed has been in the lending business for nearly the past year. The recent numbers have been astounding. The Fed has been lending at a rate of over one-half Trillion per week for the past month or so. Keep in mind this is above and beyond the commitments of the Treasury. The Congress has had no say in this lending activity at all not to mention the American people. Worst of all, no one really knows who is getting what. So much for transparency.

With trillions of fresh cash pumped into the banking system just looking for a place to go it is a matter of when not if in terms of this liquidity causing problems. There are more hand grenades still in the Treasury market where the Fed is going to be forced to further monetize debt by buying US Treasury bonds directly. The foreign money hasn’t been there the past two months, and the Treasury is going to have a truckload of new bonds to sell if it hopes to fund the bailouts it has already committed to plus the ones that are going to be demanded moving forward.
Under the direct monetization of debt, the Fed will hand the Treasury fresh Dollars which the Treasury will use to fund government bailouts and other largesse. This money will end up in the financial markets, bank balance sheets, economic stimulus packages and the like. Despite jumping on the bully pulpit and putting up the appearance that he wants the banks to lend the bailout money, Henry Paulson wants them to do anything but. A release into the economy of that magnitude would cause an immediate hyperinflation. Instead, Secy Paulson will try to manage how the money moves throughout the economy. This endeavor will be an epic failure and will likely result in dislocations such as shortages of goods and credit – most likely both as well as surpluses of labor, durable goods and production capacity. We’re already seeing some of these dislocations emerge.

Recessions don’t guarantee falling prices

The notion that consumer prices have to fall because of a recession is pure nonsense. This argument is rooted in fantasy and demonstrates a total lack of understanding of how money works. The more money that is made available, the higher nominal prices will go – regardless of economic growth. We have already gotten one stimulus so far in 2008. It is a good bet another will be in place for the critical holiday shopping season. A shopping hiatus during this holiday season will be catastrophic. If you think the number of Chapter 11 filings is high now, wait until after 1/1/2009. In a $13 Trillion economy, 70% of which is consumer spending a mere 10% cutback in consumer spending (we’re more than a quarter of the way there just in October) will amount to nearly a Trillion dollars yanked from the US economy or a 7% contraction in GDP. And that is just the result of a 10% cutback by consumers. These are the unintended consequences of building an economy on consumption. We’ve already got the recession. When the fresh fiat created to fatten bank balance sheets and lubricate credit markets works its way to Main Street, we’ll have rising consumer prices as well.

How does all this play into the Dollar? Quite simply, in the absence of tangible backing, a currency is backed by economic activity or perhaps implicitly by natural resources as in the case of Canada, Australia, and Russia. US economic growth is fading fast, and as for the full faith and credit of the US Government? Enough said. While there is no official measure of the full faith and credit aspect, the willingness of foreigners to buy debt is a pretty good proxy. And during the past two months, foreigners have been less than inspired to take on more US Government debt. In short, there is no fundamental reason whatsoever for the Dollar to gain value. The current situation is an opportunity to get real. Get real assets and buckle your seatbelts because the currencies of the world are about to play a good old-fashioned game of meet me at the bottom. Lucky for us Gold won’t be participating in the game.

Back in September, Congress was threatened with economic catastrophe if the $700 Billion bailout bill wasn’t passed. The rhetoric and assertions that the financial system would collapse ‘within days’ intensified after the House valiantly resisted on Monday of that week. By Friday, however, they had capitulated and the fear mongers once again got their way.

It would seem they’re at it again this time in the form of automakers. Big Car, unable to generate any type of profits whatsoever is now lobbying for some of the bailout money as well. And the dire predictions of economic catastrophe if money isn’t given immediately are beginning to surface once again. Obviously, there is some resistance to including big Car as doing so will likely necessitate another financial rescue package in the not so distant future. Watch the rhetoric moving forward, especially if a majority of the House of Representatives come out in opposition to the plan.

In an unrelated but important matter, the media is once again doing its job of trying to bolster some degree of optimism by saying the credit markets are unfrozen. They point to the fact that corporate bond sales in October were higher. This market had previously been frozen solid. However, lost in the details was the fact that we already know who the buyer was - the Fed through it’s Commercial Paper Lending Facility. The difference between the facts here and the intended conclusion is obvious.

In what is probably the most accurate leading indicator moving forward, new unemployment claims blew through the 500,000 mark for this past week coming in at 516,000. One only needs now to wonder how long it will be before some type of bailout will be required for unemployment insurance programs since they were originally designed to provide 26 weeks of coverage, and are currently covering up to 39 weeks. To make matters worse, there is a good chance that number will be expanded to a full year of coverage.

No, this isn’t a real bill - yet. However, given the current gleeful environment surrounding Washington with lobbyists, banks, and every other sort of entity who might cry poverty lined up at the taxpayer funded bailout trough, we should expect another bill - and soon.

The fact of the matter is the $700 Billion bailout fund is nearly empty. What was once intended only for financial firms has become an oasis for any and all firms including automakers, credit card companies, and even retailers. Everybody wants some. And our representatives, now firmly entrenched for a few more years are eager to curry favor.

This action speaks volumes as to who really runs the country. It isn’t us. The American People spoke out over 90% against this disgraceful action yet had it rammed down our throats anyway. We were assured that there would be transparency, and that the Treasury would be mindful that they were using taxpayer dollars. However, when we ask for disclosure of who is getting the funds, we get meeting minutes that look like a child’s crayon drawing with all the important details blacked out. Bloomberg News files a FOIA request against the Fed for disclosure of the Trillions they have been handing out APART from the bailout program. They are summarily dismissed.

It is pretty clear that when the current $700 Billion is exhausted that the same people who pushed through Bailout I will be back. This time the argument will be that $700 billion has already been spent, why not spend another Trillion and do the job right. The problem with that logic is that by the time it is done ‘right’, the Dollar will be worthless and the American taxpayer will be under a pile of bills that makes the current national debt look like arcade money.

In twenty-first century financial lore, we have heard words like “black box”, “quants”, and “credit default swaps”. We’re going to need another term for what happens when Congress needs to bailout a bailout.

Zombie firm AIG has now gotten an addition to its IV; another shot of financial epinephrine into its waning lifeline. Just three months into the bailout frenzy, we are already at the second level. Reasonable arguments could be made that we’ve been there for a while now as the Fed has essentially opened the back door of the vault these past few weeks.

Now Congress is clamoring to get an auto industry bailout bill going - and fast. Has anyone ever noticed that these things are always done on an emergency basis? Anyone with two brain cells to rub together has seen the GM situation coming for a while now. Even this humble publication has mentioned GM by name on at least several occasions as a candidate for a government bailout.

I hope that everyone who read my column nearly 18 months ago entitled “Bailouts - A historical perspective” now knows where I was going with that. Once this started it’ll never stop. This isn’t the S&L crisis or Long Term Capital Management. This is the entire global financial system. A bunch of computers with pimply faced kids manning the controls that purported to know a thing or two about finance and in reality knew nothing but how to bring the system to its knees.

My forecast moving forward is that we are going to have several rounds of bailouts left, and a relative calm in the markets until such a time that the bailout bowl is empty. Once that happens and an honest survey of the financial landscape commences, we will get to reap the whirlwind of Weimar Republic hyperinflation. The good news is there are some ways to prepare for this very likely eventuality. The Centsible Investor newsletter is one of them. It provides no-nonsense approaches, analysis, and insight you won’t get anywhere else. Check it out here.

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The happy rhetoric of earlier this year has faded. The Treasury Secretary and Fed Chairman are no longer extolling America’s strong economic fundamentals. The media is no longer talking about a soft landing and I haven’t heard the term ‘Goldilocks’ mentioned in what feels like a dog’s age. While our leaders have referred to the ‘challenges’ that we face and the very real possibility of a ‘downturn’, it is very obviously out of vogue to call this reality what it is – a recession. However, history has left us with some pretty good indicators that may be used to either confirm or deny a recession and along with it give us one of the many answers to what is bothering Wall Street these days.

In fact, as recently as yesterday, mainstream financial websites were still entertaining debate as to whether or not the economy is in recession. While it is important to debunk a common misconception that the health of the stock market equals the state of the economy, there are plenty of other dead canaries in the coal mine. So for the benefit of the mainstream press and others still unconvinced, here goes.

Overall Business Conditions

One of the more accurate indicators of recession is the Philadelphia Fed Survey of business conditions. While this survey is generally limited to the Northeast portion of the country, and data is only available from 1968, it has done a marvelous job of nailing recessions (see chart below). Note how each recession since 1968 was preceded by a significant drop in business activity in the Philadelphia District. Despite the serious nature of the current downturn, it is easy to see that things were much worse in the 1975 and 1980 recessions. It is also noteworthy to comment that business conditions have never been this poor as measured by the survey without an official recession. 1996 was the lone period where the measure was significantly below zero without an official recession being declared. The take-home point here is that precipitous drops in the survey have acted as a reliable leading indicator in terms of forecasting recessions. What the survey lacks is the ability to forecast the magnitude of any such recession. The depth and acceleration in the drops in the 1970’s would have portended much more severe economic downturns – even worse than what was experienced - but that proved not to be the case.

Manufacturing Sector Employment

Another excellent measure of recessions is employment within the goods-producing sector. By way of inference, the below chart also proves one of the tenets of Austrian economic theory – in order to prosper, a nation must first produce. This nagging reality is something that American policymakers would much prefer to forget in favor of building an economy on cheap imported goods then borrowing the money to do so.

In looking at the data from 1939, it is noted that every major drop in manufacturing employment either preceded or corresponded with a recession. What is particularly noteworthy in the above chart is the fact that bottoms in manufacturing employment almost always marked the END of recessions EXCEPT once we got to 1991 and moving forward. This is the same period in time when the inflation metrics started to see major changes and substitution effect and other hedonic adjustments began to emerge. It should also be noted that since 1939 we have never seen a prolonged period of contraction in manufacturing employment without a corresponding recession – until now. In fact, since 2001, we have lost nearly 20% of our manufacturing jobs with only a very minor recession in 2001 being admitted.

Unemployment (Total)

Closely related to manufacturing sector employment, but worthy of its own analysis is the overall unemployment rate. The linkage between unemployment and economic growth is clear, however, the main reason I chose to include this chart is the disconnects in latter recessions between peaks in unemployment and the duration of the concomitant recessions. Ironically, this dislocation started around the same period during which inflation metrics were changed in favor of more hedonic methodologies. However, unemployment is not adjusted for inflation. Instead, BLS uses a ‘birth-death’ model to predict the number of jobs either created or lost in terms of the startup-shutdown of businesses. Also, drop-offs are no longer calculated in the unemployment rate. If an individual collects for the maximum time allotted and drops off the unemployment rolls it is assumed that they found a job. The measures also fail to properly quantify discouraged workers. Looking at the chart, it is easy to see how significant peaks always corresponded with recessions going back to 1948. In fact, until 2006, the largest prior increase in unemployment without a declared recession was in 1963 when unemployment went from 5.7% to 5.9%. However, during the last 2 years, the unemployment rate has gone from 4.7% to 6.5% and up until recently, we were still hearing about strong fundamentals. A similar occurrence of a jump of this magnitude without a recession simply cannot be found in the data.

Consumers – The little engine that can’t

Consumers are responsible for upwards of 70% of GDP in America, so it is very logical to expect that how their fiscal health goes, so goes the economy. It is undisputable that this economy cannot prosper or grow in the absence of consumer participation, and I’ll take that one step further and include the consumer’s willingness to take on debt. We have previously demonstrated the high level of correlation between consumer debt and GDP growth.

While the Personal Consumption Expenditures (PCE) graphing doesn’t jump out like some of the other indicators, it becomes very obvious upon closer examination of the areas inside the circles that almost any type of disruption in consumption corresponds with a recession. 1988 and the current period would be two possible examples where this observation failed to play out. However, in the case of the current period, we can observe a period of relative stagnation and then a subsequent DROP in consumption. These observations highlight the fragile relationship between consumption and economic health. Similar to the human body, once homeostasis is disrupted, bad things happen.

It is more and more obvious that as we entered the new century that something changed at a very fundamental level. Since the beginning of the 21st century, America has now undergone 3 major economic dislocations, each one larger than the last. During the majority of this period, the assertions have been that America’s economic fundamentals are strong and that the future is bright. These assertions, more ridiculous by the day, continued until just recently. Whether it is the end of the state of denial or recognition of the fact that we have reached the point of unsustainability remains unclear. What is clear is that the recession is here. The talk should no longer focus on how to prevent it, but on how to get through it without doing any more damage. We are living in a dangerous time. Historically, depressions have ensued not because of inaction, but as the result of too much misguided action. The free market would actually prefer if nothing were done. The free market does not need to be massaged and managed. It is this misunderstanding that has led to the growing cacophony of policy mistakes over the past 75 years. Our economy needs to be cleansed of greed and malinvestment by the free market. Bailouts and other palliative political pandering will only serve to make matters worse.

Looking at the reaction of the financial markets to the US election over the past two days, the action has been anything but a ringing endorsement of Tuesday’s results. It would seem, however, that the markets are reacting more to Congressional elections than the Presidential election, the results of which were no big surprise.

I am going to float the notion that the markets were looking for some sort of government gridlock. In other words, the markets have it right to some degree in that what needs to be done right now is nothing. At least not on the part of government. Government has already done more than enough. Having some gridlock might have prevented more damage from being done.  This should not be taken as some sort of indictment against the controlling party. There is plenty of blame to fully cover everyone. Both sides of the aisle were the problem, now we’re supposed to believe that both sides of the aisle will be the solution. I think not.

Apparently the markets agree with me. The DOW has lost nearly 900 points since Tuesday, and the S&P 500 abandoned its rally at the 1000 level and is now back down near 900.  What little euphoria existed last week has been abandoned as focus returns to our deteriorating economic fundamentals.

Our weekly commentary, due out tomorrow will focus on various economic indicators, their uncanny ability to call prior recessions, and their ‘failure’ to do so currently. I contend this ‘failure’ is the responsibility of methodological and statistical shenanigans as opposed to a flaw in the indicators themselves.

Today the US Treasury announced its funding requirements for the last three months of 2008. As anyone could imagine, the need for additional borrowing is astronomical. That target is $550 Billion. The borrowing in the third quarter was $530 Billion. The national debt is ballooning.

Tragically, the Federal Reserve has been the source of much of the funding so far, and is expected to be a major source of funds moving forward. There is one problem with this. The Fed is broke. Busted. Bankrupt. It is lending money to the banking system at a rate of over half a trillion dollars a week now. Its resources have long been exhausted, and it is now resorting to unchecked monetary creation to fund any and all future packages, bailouts, and/or stimulus packages.

This is a death sentence for the Dollar. This Dollar rally has been caused not by fundamentals, but by a squeeze due to the liquidation of global assets. There are no fundamentals for the Dollar. It will soon be created in Weimar fashion to keep up with the evaporation of wealth in the US and abroad. Our 5 point strategy from 2006 has been, is, and will continue to be a sound way to protect your wealth from the hyperinflation that now lies dead ahead.

See our 5 point strategy here

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Today’s news headlines were covered with stories of General Motors and Starbucks going on record as saying the worst of the fallout from the biggest financial dislocation in the history of the world has already passed. These calls of bottom are eerily similar to early calls for the bottom of the housing market from NAR econ guru David Lereah (now no longer employed by NAR) and others.

It is relatively amazing how, despite the overwhelming evidence that we have a long way to go at least in terms of economic fallout, so many are fooled. Their lack of understanding comes from a failure to recognize that the Fed cannot print prosperity, savings or real capital. We are now paying the price for decades of failed Keynesian economic policies which center around monetary inflation and the general belief that the economy can be ‘managed’ so that recessions never occur. This is pure nonsense.

So while Starbucks and GM continue call ‘bottom’, ask yourselves these questions: If GM believes the bottom is in, then why does it need billions in a taxpayer bailout? Shouldn’t it be able to weather the remnants of the storm since things are about to get so much better? And if Starbucks thought the bottom was in, why aren’t they canceling earlier plans to close 600 stores and the development of that many more?

As is usually the case, actions speak louder than words.

Amazingly, despite the fact that nearly every one of Wall Street’s big firms is crying poverty and pining for your tax dollars, they have somehow found billions for year end bonuses. When I read this story, I had the unmistakable image in my mind of Wall Street executives dispatching their legions of idle associates to scour the couches looking for spare change. Let’s keep score a second. In 2008,

• 5 major financial firms have gone broke or required a bailout
• At least 3 others narrowly averted bankruptcy (thanks JP Morgan - oh WHERE do you get all that money?)
• More than a dozen banks have failed with more on the way
• Thousands of jobs have been lost just in the financial sector
• Shareholders didn’t just lose their shirts; they lost their pants and socks too
• US taxpayers will bear the cost for at least 10 generations - Yes I did say 10.

And after all that there is still plenty of money for bonuses? Are you kidding me? Bonuses are supposed to reward a job well done. Instead, these folks have been allowed to bankrupt a nation and will get to hit the cookie jar one more time.