Friday, December 31, 2010



by Peter T Treadway, PhD

1. US Net Exports Have to Pick Up — Since 1992 the US has been registering ever larger current account and net export deficits.(Net exports are the major item in the current account.) At the same time other so-called developing countries, notably China in recent years, have registered massive current account and net export surpluses. This trend was only partially reversed by the cyclical fall off in US imports during the Great Recession in 2008. These massive current account and trade deficits have to be financed and this financing has resulted in equally massive dollar reserve holdings by China and other so—called developing countries. They also are also consistent with the view that American manufacturing jobs have suffered from this process.

Simple economic theory would suggest that capital intensive developed countries like the United States run current account surpluses with the relatively less capital intensive developing world. Developing labor intensive countries like China would run current account deficits. Admittedly this simple picture is complicated by the role the dollar plays as the world’s international currency. The United States needs to provide dollars to the world (something it has done with unbridled enthusiasm.)

Still on a structural basis one would expect that this trend of large US current account and net export deficits cannot go on forever. One might expect that the economic signals—including a cheaper dollar against the countries of East Asia– would favor US exports. My forecast would be that US companies that have an international scope and are able to access capital will fare relatively well in the coming years (assuming no major global recession). Moreover US has an expertise in technology. Approaching this from a macro top down perspective, I would conclude that larger companies with comfortable cash positions, global brand names and preferably technology niches would be well positioned as this necessary structural change in the global economic order unfolds.

2. Buy Gold, Sell Treasuries — The international monetary and domestic banking systems will continue to provide an inflationary global bias. In issue after issue of The Dismal Optimist I have argued that the global and domestic financial systems are inherently inflationary and dysfunctional and lack automatic mechanisms to correct imbalances. Thus China can hold down the value of the renmimbi by buying dollars thereby inflating Chinese high powered money supply, increasing Chinese holdings of US dollar assets and lowering US interest rates. Thus the Federal Reserve can get away with reckless printing of US high powered money, aka QEII, and finance the burgeoning US government debt.

Several respected economists, notably Gary Shilling, have argued persuasively that the US will be in a real estate driven debt deflation for the next several years and that long term Treasuries are a good investment. I might agree with this if the United States operated in isolation. But I think the global picture is inflationary thanks to the dysfunctional international monetary system and the army of money printing and currency manipulating central banks around the world. Inflation will creep into the US from abroad even as painful debt deflation continues to affect the domestic consumer. The worst of all worlds.

One can argue about the real factors affecting global inflation and their effects on commodity prices. One can argue that continued technology driven productivity enhancements combined with the addition to the global economy of giant labor pools from countries like India and China will provide what Shilling calls “good deflation.” Offsetting that is the view that all these new Indian and Chinese consumers will add to global demand on agricultural, energy and industrial commodities and thereby provide an inflationary commodity price bias. I tend towards the later view although a Chinese hard landing in 2011 could cut global demand and temporarily slow down the commodity story especially in the non-agricultural area. But either way, the massive increases in global money supplies thanks to our dysfunctional international monetary system are going to push commodity prices up.

I continue to believe gold should be in the typical investor’s portfolio. Fiat money is not trustworthy as the inflationary record of the US shows. For example, what you could buy for $1.00 in 1914—the year the Federal Reserve began operations and the gold standard was by and large abandoned – would cost $21.16 in 2009. What you could buy for $1.00 in 1871—the year financial historians assign to the advent of a universally accepted gold standard – would have cost $.84 in 1914. (If you want to play with these numbers yourself, check out

I also think nominal interest rates globally will trend up in 2011 in response to the global monetary inflation and disastrous US fiscal situation. The market’s response to QE2 has been higher long term US Treasury interest rates. The world has started to mistrust the US government and its debt. The alternative explanation, paraded endlessly in the financial media, that long rates have risen because QE2 was going to be so successful in stimulating the economy , belongs in the realm of standup comedy.

3. Get Ready for Troubles with US State and Local Governments Over a year ago I wrote that public sector wages, benefits and pension plans would overwhelm the finances of many states and municipalities. This is now old news. The so-called stimulus package last year helped bail out the states. But this year with a Republican House and burgeoning Federal deficits there will be tremendous political resistance to further bailouts. The financial media has now caught up with this issue. Meredith Whitney, the only sell side equity analyst to have correctly called the subprime crisis, is raising warnings on this issue. There’s a lot of pain ahead on this and cuts in public sector wages, benefits and pensions will have to come but they won’t come easily. New York, California and Illinois in particular are three large states in very large fiscal trouble.

My question: Can the stock market do well when bombs are going off in the state and municipal sectors? Will stocks become a place of refuge or do we go back to the “everything goes down” mode of 2008. My best guess is that well capitalized, large cap, export oriented, technology oriented US companies will be seen as a place of refuge. As will gold. Stocks of banks that own large quantities of municipal bonds are another matter.

4. 2011 Looks to Be a Difficult Year for China – Chinese interest rates though still negative in real terms are going up, massive bank lending in 2009 and 2010 must have brought with it significant yet-to-be-revealed non-performing loans, the country has over invested in infrastructure projects and real estate, the currency is still undervalued, inflation is a real problem thanks to strong money growth, environmental problems are legion. The list goes on. Most analysts are debating whether China will have a hard or soft landing in 2001. Nobody knows the answer to this, especially for a country where statistics are sparse and unreliable and transparency is lacking. It is no accident that in renminbi terms the Shanghai A share market was down almost 17% in 2010. The market doesn’t like what it sees.

Longer term I remain very bullish on China. For the last few thousand years, China has gone through long cycles of increasing power, national unity and expansion, followed by slow decline and then national disintegration. And then the cycle repeats. With the ascent of Deng Xiaoping in the late 1970s and the disaster of the Cultural Revolution imprinted on all minds, the national disintegration phase ended. China is now in the up-phase of increasing power, national unity and expansion. I have no doubt that a nation of 1.3 billion hard working talented people with a religious craving for material improvement is a great long run place to put your money. I regard forecasts of China collapsing due to social unrest or regional problems as fundamentally at variance with the long run historical trend.

The US in the nineteenth century was the world’s rising economic power. But it wasn’t all smooth sailing. Occasional crises were experienced along the way such as the defaults of the states in the 1840s, the Civil War of 1860-65, the Panics of 1873 and 1893. Foreign investors from time to time lost their collective shirts as the US marched on to greatness. But the US emerged stronger after each crisis as economic and political imbalances were corrected. Crises correct imbalances and force the resolution of heretofore unsolvable political problems. For example, India’s early 1990s ditching of the so-called “License Raj” only came response to a foreign exchange crisis.

I am not wishing a crisis on China. But China in my opinion needs to make some tough decisions and these decisions will benefit investors in the long run. China is following what has been called the East Asia Model, i.e. a high degree of protectionism with all kinds of administrative and tariff restrictions on imports, an undervalued exchange rate, an over-emphasis on investment, an over-emphasis on exports, a massive interference in the markets, a predatory approach to foreign technology, an over-accumulation of dollar reserves and over-investment in designated favored industries. This fundamentally mercantilist model takes advantage of the international monetary system which allows countries to hold their currencies below equilibrium levels and the expense of employment in the United States.

The East Asia Model may have reached the end of its usefulness for China. It certainly has for Japan. The time to really load up on Chinese stocks will be when it appears the government has decided to turn away from this model. Whether the government will take the necessary decisions in a gradual, rational way or whether it needs to be forced to do so by a crisis remains to be seen.

5. The Euro Will Survive – Spanish pesetas, Italian liras, Maltese liras, French francs, Belgian francs, Luxembourgian francs, Dutch guilders, Portuguese escudos, German deutschmarks, Finnish markkas, Irish pounds, Cypriot pounds, Danish krones, Austrian shillings, Greek drachmas – yuk ! Who needs them all.

In fact, Europe does not. The euro represents huge financial value added as compared with the bewildering smorgasbord of currencies that existed before. History, politics, technology and geography are all lined up in support of the euro. The euro represents a tremendous step forward in European integration. The Europeans spent a good part of the twentieth century killing one another. It’s an unpleasant experience they don’t want to repeat. At the same time telecommunications and transportation technology are bringing the already geographically contiguous European nations even closer together. Don’t underestimate the power of a fiber optic cable! The Germans will pay and pay to support the euro, however contrary to their self interest some of their actions may appear from time to time. And in my opinion, no countries will leave the euro. If you think Greece is having problems now with street demonstrations, just imagine if one day Greeks woke up to find their bank accounts were suddenly denominated in drachmas (draculas?) instead of euros.

Of course the euro does suffer from the same fault as all fiat currencies. Gold is still an investment alternative for euro area investors. But against the dollar the euro will play musical chairs. When Ireland, Greece, Portugal or Spain are in the headlines (Belgium and Italy?) the euro will decline against the dollar. When California, Illinois or New York take center stage, the dollar will down against the euro. I see plenty of opportunities for traders but no trend here.

6. Take a Look at India — India is an emerging market story in its own right. It’s the odd man out in the BRIC thesis. Brazil and Russia supply commodities to China and are part of the China story. To a large extent the fate of Brazil and Russia (and numerous other emerging markets) depends on how China does in 2011. India’s not a major part of this China picture although India-China trade has been growing.

India and China may be in Asia and have a lot of people coming off the countryside, but that’s where the similarity ends. China is homogeneous (92 % Han), relatively monolithic with one national language and with a government that is, in its own mercantilist way, pro-business. India on the other hand is a heterogeneous collection of peoples, cultures and languages. Indian technology firms are global and among the best in the world. The Indian business sector operates in English and compared to China is transparent and follows the rule of law. But from an economic/business viewpoint the bureaucratic, populist Indian government although democratic can be a major obstacle. It is often said that companies succeed in China because of the government while they succeed in India in spite of the government. Still longer term that could be a positive for India. Governments usually support losers and in fact create them by insulating companies from competition and offering subsidized access to capital which encourages low productivity. Examples of this abound in China. With the exception of some state owned firms, Indian companies are private and have to compete for capital and customers without any government coddling.

Indian stocks compared to other emerging markets are not cheap. But I think typical portfolios should have some Indian exposure. In addition, because the India/China stories are not so interwoven, India offers some advantages of diversification.


Dr. Peter T Treadway is an independent consultant and money manager and Adjunct Professor in Asia. He is currently is principal of Historical Analytics, a consulting and investment management. He pens a monthly letter (The Dismal Optimist) for clients. He is also Chief Economist for C T RISKS, a new Hong Kong company that will assist Asian financial institutions with their risk management problems.

Dr. Treadway previously served as Chief Economist at Fannie Mae (1978-81), and prior to that, was an institutional equity analyst at Smith Barney (1985-98). He was ranked as “all star” analyst eleven times by Institutional Investor Magazine. Dr. Treadway also worked at The Board of Governors of the Federal Reserve. He holds a PhD in economics from the University of North Carolina at Chapel Hill, an MBA from New York University and a BA in English from Fordham University in New York.

Wednesday, December 29, 2010

15 Surprises To Watch For In 2011

Doug Kass is a leading markets commentator, and writes daily for RealMoney Silver.

“Never make predictions, especially about the future.”
-Casey Stengel

There are five lessons I have learned since my first surprise list for 2003:

1. how wrong conventional wisdom can be;

2. that uncertainty will persist;

3. to expect the unexpected;

4. that the occurrence of Black Swan events are growing in frequency; and

5. with rapidly changing conditions, investors can’t change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

Eight years ago, I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien’s playbook , who originally delivered his list while chief investment strategist at Morgan Stanley, then Pequot Capital Management and now at Blackstone. (Here was Byron Wien’s surprise list for 2010.)

Importantly, my surprises are not intended to be predictions but rather events that have a reasonable chance of occurring despite being at odds with the consensus.

I call these “possible improbable” events. In sports, betting my surprises would be called an “overlay,” a term commonly used when the odds on a proposition are in favor of the bettor rather than the house.
The real purpose of this endeavor is to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs.

Since the mid 1990s , the quality of Wall Street research has deteriorated in quantity and quality (due to competition for human capital at hedge funds, brokerage industry consolidation and former New York Attorney General Eliot Spitzer-initiated reforms) and remains, more than ever, maintenance-oriented, conventional and groupthink (or groupstink, as I prefer to call it). Mainstream and consensus expectations are just that, and in most cases, they are deeply embedded into today’s stock prices.

It has been said that if life was predictable, it would cease to be life, so if I succeed in making you think (and possibly position) for outlier events, then my endeavor has been worthwhile. My annual exercise recognizes that over the course of time, conventional wisdom is often wrong. As a society (and as investors), we are consistently bamboozled by appearance and consensus. Too often we are played as suckers as we just accept the trend, momentum and/or the superficial as certain truth without a shred of criticism. Just look at those who bought into the success of Enron, Saddam Hussein’s weapons of mass destruction, the heroic home-run production of steroid-laced Major League Baseball players Barry Bonds and Mark McGwire, the financial supermarket concept at what was once the largest money center bank (Citigroup (C)), the uninterrupted profit growth at Fannie Mae (FNM) and Freddie Mac (FRE), housing’s new paradigm of noncyclical growth and ever-rising home prices, the uncompromising principles of former New York Governor Eliot Spitzer, the morality of other politicians (e.g., John Edwards, John Ensign and Larry Craig), the consistency of Bernie Madoff’s investment returns (and those of other hucksters) and the clean-cut image of Tiger Woods.

In an excellent essay published over the past week, GMO’S James Montier makes note of the consistent weakness embodied in consensus forecasts.

Attempting to invest on the back of economic forecasts is an exercise in extreme folly, even in normal times. Economists are probably the one group who make astrologers look like professionals when it comes to telling the future. Even a cursory glance at Exhibit 4 reveals that economists are simply useless when it comes to forecasting. They have missed every recession in the last four decades! And it isn’t just growth that economists can’t forecast: it’s also inflation, bond yields, and pretty much everything else. If we add greater uncertainty, as refl ected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!

For 2011, consensus estimates for economic growth, corporate profits, stock price targets and interest rates are grouped in an extraordinarily tight range. I have chosen to use Goldman Sachs’ forecasts as a proxy for the consensus.

Here are Goldman Sachs’ principal views of expected economic growth, corporate profits, inflation, interest rates and stock market performance:

• 2011 GDP up 3.4% (global GDP up 4.7%);

• 2011 S&P 500 operating profits of $94 a share;

• year-end S&P 500 price target at 1,450 (a gain of about 15%);

• 2011 inflation of 0.5%; and

• the 2011 closing yield on the U.S.10-year Treasury note at 3.75%.

Looking beyond 2011, it appears that the consensus further expects that the domestic economy is well on its way toward delivering a smooth and self-sustaining and normal historical recovery that (from start to finish) should last about four years. The clustering of that consensus suggests that any short- or intermediate-term variant outcomes could be destabilizing to the markets, both to the upside and to the downside.

To some degree, my surprises for 2011 attack some of the similar, non-variant and nearly universally optimistic expectations on the part of money managers, strategists, economists and members of the fourth estate. As such, I want to emphasize that my intention is not to be a Cassandra or to be a contrarian for contrary’s sake but rather to recognize that most prefer the dreams of the future to the history of the past. My surprise list for 2011 recognizes an often repeated lesson of history: What seems easy for (bullish) investors to imagine today might prove more difficult to deliver, as prospect is often better than possession.

More than almost any time I can remember, there exists few variant views relative to consensus as we enter the New Year. Perhaps leading that minority is Gluskin Sheff’s David Rosenberg, who, though thoughtful and thorough in analysis, is pigeonholed by the media as a dogmatic standard-bearer for the bear case. (Gluskin Sheff’s David Rosenberg succinctly underscores and questions the universal optimism in his commentary this week.)

“Those who cannot remember the past are condemned to repeat it.”

-George Santayana

Looking at history, there was no better example of misplaced optimism than in the period leading up to the Great Decession of 2008-2009, providing a vivid reminder of the poor forecasting ability and investment risks associated with the crowd’s baseline expectations and the value of a surprise list that deviates from that consensus.

Only the remnants anticipated anything near the magnitude of the fall in the world’s economies and capital markets, despite what appeared to be clear and accumulating evidence of economic uncertainty and growing credit risks (and abuses). The analysis of multi-decade charts and economic series convinced most (along with other conclusions) that home prices were incapable of ever dropping, that derivatives and no-/low-document mortgage loans were safe, that there was no level of leverage (institutional and individual) too high and that rating agencies were responsible in their analysis. Importantly, they also failed to see the signposts of an imminent deterioration in business and consumer confidence that was to result in the deepest economic and credit crisis since the early 1930s.

From my perch, many of those who are now expressing the most extreme levels of optimism were the most wrong-footed two years ago and experienced not inconsequential pain in the last investment cycle. (Perhaps the recovery in equities was so swift in time and sizeable in magnitude that memories simply have been erased to the risks that are still omnipresent today.)

Back then and, to a lesser degree, today, many investors appear similar to victims of Plato’s allegory of the cave, a parable about the difficulty of people who exist in a world shaped by false perceptions to contemplate truths that contradict their beliefs. This is why so many investors were blindsided by the last downturn and, from my perch, continue to remain conditioned to wearing rose-colored glasses.

In the famous simile of the cave, Plato compares men to prisoners in a cave who are bound and can look in only one direction. They have a fire behind them and see on a wall the shadows of themselves and of objects behind them. Since they see nothing but the shadows, they regard those shadows as real and are not aware of the objects. Finally one of the prisoners escapes and comes from the cave into the light of the sun. For the first time, he sees real things and realizes that he had been deceived hitherto by the shadows. For the first time, he knows the truth and thinks only with sorrow of his long life in the darkness.

-Werner Heisenberg, Physics and Philosophy

Last year’s surprise list had relatively poor results. Only about 40% of my surprises were achieved in 2010, well under the success ratio in previous years. By means of background, about 50% of my 2009 surprises were realized, 60% in 2008, 50% in 2007, one-third in 2006 , one-fifth in 2005, 45% in 2004 and one-third came to pass in the first year of our surprises in 2003.

While my surprise list for 2010 hit on some of the important themes that dominated the investment and economic landscape this year, I failed to expect the announcement of further quantitative easing and did not accurately gauge investors’ animal spirits that followed the proclamation of QE2.

Here is a list of some of my meticulous surprises from last year’s list:

• Economy. Real GDP and corporate profit growth was, as I suggested, far better than expected during the first half of 2010, and my surprise that U.S. equities would weaken (and that P/E ratios would contract) despite that strength was accurate (in that stocks exhibited a negative return during that period).

• Housing and jobs. Despite the overall economic strength, both housing and employment failed to recover.

• Interest rates. My surprise that the yield on the 10-year U.S. note would fall under 3% by midyear and end 2010 at about 3% was prescient.

• SEC investigations. The broadening of the SEC’s assault on insider trading was a featured story in 2010.

• The Oracle of Omaha. Though Warren Buffett is still at the helm, our surprise that he would announce a possible successor was accurate.

• Hedge funds. Brilliant and legendary hedge-hogger Stanley Druckenmiller announced that he was leaving the investment business — in line with our surprise that a leading hedge-hogger would announce his retirement.

What follows is my list of 15 Surprises for 2011 — reduced from 20 surprises in previous year in order to be more on point. I have listed my surprises in four categories — economic (surprise Nos. 1-3), stock market (surprise Nos. 4-6), political (surprise Nos. 7-9) and general (surprise Nos. 10-15).

1. In line with consensus, the domestic economy experiences a strong first half, but several factors conspire to produce a weakening second half, which jeopardizes corporate profit growth forecasts.

• The improving momentum of domestic growth at the end of 2010 continues into the first half of 2011 but proves ephemeral by the summer.

• That improving momentum turns out to be nothing more than a brief respite and “recession fatigue,” as reality and a new normal sets in.

• Americans remain in a foul mood, as the jobs market fails to improve despite the recent downtick in claims.

• Over there, multiple country austerity programs move Europe back into recession by year-end 2011. (Share prices of many large multinational industrials falter in the year’s second half.)

• China continues to tighten, but inflation remains persistent, economic growth disappoints (see surprise No. 15), and it’s stock market weakens further.

• Political gridlock and inertia in tackling the deficit incite the bond vigilantes. The yield on the 10-year U.S. note rises above 4.50% by the spring (see surprise No. 2).

• Trust continues to be lost, as the uncertainty brought by changes in the administration (see surprise No. 7) and the emergence of a third political party (see surprise No. 8) adversely impacts consumer and corporate confidence.

• Housing fades under the pressure of higher mortgage rates and the supply of shadow inventory coming onto the market in an avalanche of foreclosures. (A housing czar is named to implement a Marshall Plan for housing.)

• An across-the-board spike in commodities pressures corporate profit margins and real disposable incomes (see surprise No. 3).

• Price controls are briefly considered (and then rejected) by the Obama Administration as oil soars to over $125/barrel.

2. Partisan politics cuts into business and consumer confidence and economic growth in the last half of 2011.

“The first thing we do, let’s kill all the lawyers.

– William Shakespeare, Henry VI, Part 2

Increased hostilities between the Republicans and Democrats become a challenge to the market and to the economic recovery next year. As the 2012 election moves closer, President Obama reverses his seemingly newly minted centrist views, as newly appointed Vice President Hillary Clinton becomes the administration’s pit bull against the Republican opposition.

“The day the Fed came into being in 1913 may have been the beginning of the end, but the powers it caused took a long time to become a serious issue and a concern for the average Americans.” –Ron Paul, “End of the Fed”

On the other side of the pew, as Chairman of the Subcommittee on Domestic Monetary Policy, Congressman Ron Paul’s fervent criticism of monetary policy and the lack of transparency of the Fed leads to further friction between the parties.

“‘Refudiate,’ ‘misunderestimate,’ ‘wee-wee’d up.’ English is a living language. Shakespeare liked to coin new words, too. Got to celebrate it!’” –Sarah Palin

Sarah Palin, who can see the 2012 Presidential election from her home in Alaska, continues her barbs against the opposition party and holds a large lead to be her party’s Presidential candidate in early 2011, but continued verbal and nonverbal blunders and policy errors coupled with an announcement that she has separated from her husband causes Palin to announce that she will not run on the Republican ticket. Massachusetts’ Mitt Romney, Wisconsin’s Paul Ryan and South Dakota’s John Thune emerge as the leading Republican Presidential candidates by year-end 2011.

The resulting bickering yields little progress on deficit reduction. Nor does the rancor allow for an advancement of much-needed and focused legislation geared toward reversing the continued weak jobs market.

The yield on the 10-year U.S. note, despite a stuttering economic recovery visible by third quarter 2011, rises to over 4.25%, as the bond vigilantes take control of the markets. The rate rise serves to put a further dent in the U.S. housing market, which continues to be plagued by an avalanche of unsold home inventory into the market as the mortgage putback issue is slowly resolved.

During the second half of the year, housing stocks crater and the financial sector’s shares erase the (sector-leading) gains made in late 2010 and early 2011.

3. Rising commodities prices becomes the single greatest concern for u.s. stock market and economy.

Scarcity of water boosts agricultural prices and causes a military confrontation between China and India. The continued effect of global warming, the resumption of swifter worldwide economic growth in 2011, normal population increases and an accelerated industrialization in emerging markets (and the associated water contamination and pollution that follows) contribute importantly to more droughts and the growing scarcity of water, forcing a continued and almost geometric rise in the price of agricultural commodities (which becomes one of the most important economic and stock market themes in 2011). Increased scarcity of water and higher agricultural commodity prices (corn, wheat, beans, etc.) not only have broad economic consequences, but they become a destabilizing factor and serve as the basis for a developing powder keg in the relations between China and India.

China has about 23% of the world’s population but only approximately 7% of the world’s fresh water supply. Moreover, China’s water resources are not distributed proportionately; the 550 million residents in the more industrialized northern area of the country are supported by only one-fifth of the fresh water and the 700 million in the southern region of China have the other 80% of the country’s fresh water supply. The shared resources of water supply have been a focal point of conflict between China and India since the 1962 Indo-China War.

My big surprise is that in early 2011, tension intensifies based on a decision by the Chinese government to materially expand the plans for the diversion of the 1,800-mile long Brahmaputra River, which hugs the Chinese border before dipping into India, from the south back up to the water-deprived northern China area in an expansion of the Zangmu Dam project, original construction plans of which were announced earlier this year. At first, trade sanctions are imposed by India against China. Later in the year, the impoverished northeastern India region is the setting for massive protests aimed at China; ultimately, groups of Indian rebels, fearful of reduced availability of fresh water and the likelihood of flooding, actually invade Southern China in retaliation.

4. The market moves sideways during 2011.

While the general consensus forecast is for a rise of about 10% to 15% for the S&P 500 in 2011, the index ends up exactly where it closes the year in 2010. A flat year is a fairly rare occurrence. Since 1900, there have only been six times when the averages recorded a year-over-year price change of less than 3% (plus or minus); 2011 will mark the seventh time.

Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry. –William Shakespeare, Hamlet

With a return profile reminiscent of the sideways markets of 1953 (-0.80%), 1960 (-0.74%) and 1994 (+1.19%), the senior averages also exhibit one of the least volatile and narrow price ranges ever. The S&P 500 never falls below 1150 and never rises above 1300, as the tension between the cyclical tailwind of monetary ease (and the cyclical economic recovery it brings) are offset by numerous nontraditional secular challenges (e.g., fiscal imbalances in the U.S. and Europe; a persistently high unemployment rate that fails to decline much, as structural domestic unemployment issues plague the jobs market), and the continued low level of business confidence (reinforced by increased animosity between the Republicans and Democrats) exacerbates an already weak jobs market and retards capital-spending plans.

Despite the current unambiguous signs of an improving domestic economy, as the year progresses the growing expectation of consistently improving economic growth and a self-sustaining recovery is adversely influenced by continued blows to confidence from Washington, D.C., serving to contribute to a more uneven path of economic growth than the bulls envision.

With traditional economic analysis again failing to accurately predict the path of economic growth (as it did in 2008-2009), behavioral economic analysis, linking psychology to the business cycle, gains popularity. Yale’s Dr. Robert Shiller and former Fed Chairman Dr. Alan Greenspan write books on behavioral economics that become the No. 1 and No. 2 books on the New York Times nonfiction best-seller list

The sideways market of 2011 will prove to be a good year for opportunistic traders but a poor one for the buy-and-hold crowd as neither the bulls nor the bears will be rejoicing next Christmas.

5. Food and restaurant companies are among the worst performers in the S&P 500.

(This surprise is an extension of surprise No. 3.) Several well-known multinational food companies and a host of domestic restaurant chains face margin and earnings pressures as they are unable to pass on the violent rise in agricultural costs on to the consumer. Profit guidance for 2011 is taken down by Kellogg (K), Kraft (KFT), General Mills (GIS) and many other exposed food companies. Publicly traded restaurant chains such as Darden Restaurants (DRI), McDonald’s (MCD), Yum! Brands (YUM), Brinker International (EAT) and Ruby Tuesday (RT) all take a hit owing to the abrupt contraction in profit margins as product demand swoons in the face of higher prices. As a consequence, food companies and restaurant chains are among the worst performers in the S&P next year.

6. The shares of asset managers suffer.

I expect a series of populist initiatives by the current administration beginning by a frontal assault on mutual fund 12b-1 fees. The asset managers — Franklin Resources (BEN), T. Rowe Price (TROW) and Waddell & Reed (WDR) — are exposed, and I am short all three of them.

7. Vice President Joe Biden and Secretary of State Hillary Clinton switch jobs by midyear 2011, 18 months before the 2012 Presidential election.

It is generally recognized that President Obama has been seriously weakened politically, but the situation gets worse early next year. A sustained and high level of unemployment and a quiescent housing market fail to revive, forcing the administration to consider some radical changes in order to survive in the Presidential election of 2012. (While such a switch is unconventional, this move can be accomplished as the twenty-fifth amendment sets out that the majorities in both houses of Congress would have to confirm Vice President Clinton and Secretary of State Biden would only have to be confirmed by the Senate.)The other benefits to the switcheroo:

• Hillary Clinton would have almost a year and a half of experience and credibility in the Vice President’s office.

• She would be well-prepared to campaign for a Democratic ticket.

• An Obama/Clinton ticket would be viewed by many as unbeatable. Clinton is a relentless campaigner and she would be a far more effect drawer of votes than Biden. (Consider how many votes Obama and Clinton combined received in the 2008 Presidential primary campaign.)

• Clinton will be seen as very capable of deflecting the women’s vote from Sarah Palin in 2012.

• Clinton still likely harbors dreams of the White House. She would immediately become the overwhelming favorite to garner the Democratic Party’s Presidential nomination in 2016. She will only be 69 years old at that time.

• On experience alone, Clinton would be considered far more qualified than most of the other Republicans now being considered (e.g., Bobby Jindal, Mitt Romney and Tim Pawlenty)

• Fears of former-President interference in the White House have dissipated. Bill Clinton has stayed out of the limelight and has been discreet with regard to his private life.

8. Speaker of the House John Boehner is replaced by Congressman Paul Ryan during the summer.

A tearful Boehner proves too dogmatic. Within the context of a gridlock-impacted interest rate rise and slowing economy coupled with the emergence of a threat from an increasingly powerful third party (see surprise No. 9), Wisconsin’s Paul Ryan replaces Boehner.

9. A new political party emerges.

Screwflation becomes a theme that has broadening economic social and political implications. Similar to its first cousin stagflation, screwflation is an expression of a period of slow and uneven economic growth, but, in addition, it holds the existence of inflationary consequences that have an outsized impact on a specific group. The emergence of screwflation hurts just the group that authorities want to protect — namely, the middle class, a segment of the population that has already spent a decade experiencing an erosion in disposable income and a painful period (at least over the past several years) of lower stock and home prices.Importantly, quantitative easing is designed to lower real interest rates and, at the same time, raise inflation. A lower interest rate policy hurts the savings classes — both the middle class and the elderly. And inflation in the costs of food, energy and everything else consumed (without a concomitant increase in salaries) will screw the average American who doesn’t benefit from QE2.

Stagnating wages and ever higher food and other costs energize Middle America, the chief victim of screwflation, and a new party, the American Party, emerges chiefly through a viral campaign begun on Facebook. This centrist initiative initially is endorsed by several independent Republican and Democratic Congressmen, but a ratification by Senator Joe Lieberman (Connecticut) leads to several Senatorial endorsements as it becomes clear that the American Party’s ranks are growing rapidly. (Both the Tea Party and Sarah Palin abruptly disappear from the public dialogue.)

By the end of 2011, between 5% and 10% of all U.S. voters are believed to be members of the American Party. With its newfound popularity, the American Party asks New York City Mayor Bloomberg to become its leader. By year-end 2011, he has not yet made a decision.

10. The price of gold plummets by more than $250 an ounce in a four-week period in 2011 and is among the worst asset classes of the new year.

The commodity experiences wild volatility in price (on five to 10 occasions, the price has a daily price change of at least $75), briefly trading under $1,050 an ounce during the year and ending the year between $1,100 and $1,200 an ounce.By means of background, the price of gold has risen from about $250 an ounce 11 years ago to about $1,370 an ounce today — compounding at more than a 16% rate annually. As a result, investing in gold has become de rigeur for hedge-hoggers and other institutional investors – and in due course gold has become a favored investment among individual investors.

My surprise is that next year the price of gold has the potential to become the modern-day equivalent of Hans Christian Andersen’s “The Emperor’s New Clothes,” a short tale about two weavers who promise an emperor a new suit of clothes that are invisible to those unfit for their positions, stupid or incompetent. When the emperor parades before his subjects in his new clothes, a child cries out, “But he isn’t wearing anything at all!”

With a finite supply, gold has historically been viewed as a tangible asset that increases in value during uncertain (and inflationary) times. No wonder it has become such a desirable asset class following the Great Decession and credit crisis of 2008-09. Gold bugs remind the nonbelievers that for thousands of years, gold has been a store of value and, given the current state of the world’s financial system, gold is the best house in a bad neighborhood of asset classes.

But gold, which may be the most crowded trade around, is viewed now as a commodity for all seasons — during inflation, deflation, low or high economic growth.

There is a body of thought that maintains gold holds little value, that it is only a shiny metal with limited industrial value that throws off no income or cash flow (and, as such, its value cannot be determined or analyzed with any precision based on interest rates or any other measure). Those nonbelievers compare the dizzying price of gold to the unsustainable rise in comic book prices (and other collectibles) in the early 1990s, Internet stock prices in early 2000 or home prices in 2006-07.

Here is how Oaktree Management’s Howard Marks draws a colorful parallel between gold and religion, over the past weekend in his always-thoughtful commentary on the markets:

My view is simple and starts with the observation that gold is a lot like religion. No one can prove that God exists … or that God doesn’t exist. The believer can’t convince the atheist, and the atheist can’t convince the believer. It’s incredibly simple: either you believe in God or you don’t. Well, that’s exactly the way I think it is with gold. Either you’re a believer or you’re not.

What we do know is that gold is valued in an auction market based on the price where buyers (“the believers”) and sellers (“the atheists”) meet.

With an inability to gauge gold’s intrinsic value, wide price swings remain possible. And wide price swings are what I expect in 2011.

There are numerous catalysts that can contribute to a surprising weakness in the price of gold in the upcoming year. But most likely, a large drop in the price of gold might simply be the result in a swing in sentiment that can be induced by a number of factors (or maybe even sentiment that the emperor (and gold investors/traders) aren’t wearing anything at all!):

• Investors might grow increasingly comfortable in a self-sustaining, inflation-free worldwide economic recovery.

• Interest rates could ratchet higher, providing competition for non-income producing assets (like gold).

• The world stock markets could surprise to the upside, reducing investors’ interest in real assets (like gold).

• The U.S. government might (astonishingly) address the deficit.

In addition, there are numerous cautionary and anecdotal signs that are reminiscent of prior unsustainable asset class cycles or bubbles:

1. Macro funds, like those managed by John Paulson, have outsized weightings in gold or even have established dedicated gold hedge funds.

2. On Okeechobee Boulevard in West Palm Beach, Fla., handheld placards that used to advertise condominiums and single-family homes for sale (during the housing bubble) have been replaced by handheld signs advertising “We Buy Gold.” On this well-populated street, gold exchange stores have replaced the omnipresent real estate and cell phone stores of the last speculative cycle. (“We Buy Gold,” “Sell Your Unwanted Gold,” “Get Cash Now For Your Gold” are names of a few of the retail outlets).

3. Gold is even being dispensed in an ATM machine in the Town Center Mall in Boca Raton, Fla. and at a hotel in Abu Dhabi.

4. The company that dispenses the gold is PMX Communities, a Boca Raton-based company listed on the pink sheets. According to a recent release, the ATM gold dispensing machines now operate in 12 locations around the world.

5. My spam emails normally consist of Viagra and “male enlargement” solicitations, but offer to buy gold have been on the rise over the last few months.

11. Among the most notable takeover deals in 2011, Microsoft launches a tender offer for Yahoo! at $21.50 a share.

With the company in play, News Corporation (NWS) follows with a competing and higher bid. The private equity community joins the fray. Microsoft (MSFT) ultimately prevails and pays $24 a share for Yahoo! (YHOO).Currently, Yahoo! is universally viewed as a dysfunctional company, and few expect that Microsoft has an interest in the company. But a deal could be profitable and advantageous (more critical mass and immediate exposure to the rapidly growing Chinese market) to Microsoft:

• Microsoft is hemorrhaging cash in its Internet operations (estimated $2.5 billion of losses in the last 12 months). Yahoo! will immediately contribute $1.25 billion-plus of cash flow. (Applying a normal multiple, 6x to 9x creates $8.5 billion of value to Microsoft from Yahoo!’s current earnings before interest, taxes, depreciation and amortization).

• Yahoo! boasts net cash of $3.4 billion.

• Yahoo!’s public holdings total $9.5 billion of value ( and Yahoo! Japan).

• Yahoo!’s private holdings total $6.0 billion.

Yahoo owns 40% of private AliBaba through two assets:

1. A call option on Chinese search via Microsoft joint venture. Based on the value of Baidu, if Yahoo gets a 10% share of $50 billion Chinese search market the value is $5 billion – the value to Yahoo is about $1 billion for each 10% of search share (40% of 50%).

2. 40% of AliPay. This is the elephant in the room. Current AliPay payments are about two thirds of PayPal, but the company is growing much faster than PayPal and its market potential is far greater. PayPal is currently worth $18 billion – making AliPay valued at $12 billion. Yahoo!’s 40% is worth $5 billion now but will easily be $10 billion in three years.

By means of background, on Feb. 1, 2008, Microsoft offered $31 a share, or $45 billion, to acquire Yahoo! in an unsolicited bid that included a combination of stock and cash. At that time, Yahoo!’s shares stood at $19 a share, and Microsoft was trading at $32 a share. (Today Microsoft trades at $27 a share, and Yahoo! trades at $16 a share.)

Yahoo! rejected the bid, claiming that it “substantially undervalued” the company and was not in the interest of its shareholders. In January 2009, Carol Bartz replaced Yahoo! cofounder Jerry Yang, and six months later Microsoft and Yahoo! entered into a search joint venture.

12. The Internet becomes the tactical nuke of the digital age.

Cybercrime likely explodes exponentially as the Web is invaded by hackers. A specific target next year will be the NYSE, and I predict an attack that causes a week-long hiatus in trading and an abrupt slowdown in domestic business activity.

13. The SEC’s insider trading case expands dramatically, reaching much further into the canyons of some of the largest hedge funds and mutual funds and to several West Coast-based technology companies.

This surprise is an extension of surprise No. 13 from last year’s 20 Surprises for 2010:Insider trading charges expand. The SEC alleges, in a broad-ranging sting, the existence of extensive exchange of information that goes well beyond Galleon’s Silicon Valley executive connections. Several well-known long-only mutual funds are implicated in the sting, which reveals that they have consistently received privileged information from some of the largest public companies over the past decade.

The next SEC target is directed at some of the world’s largest tech companies, including one of the leading manufacturers of flash memory cards, one of the largest contract manufacturers and a big producer of integrated circuits. A high-profile very senior executive in one of these companies is implicated and is forced out of his position.

With the depth of the investigations moving toward the center of some of the largest hedge and mutual funds, many of the more active traders are temporarily in “lockdown” mode as the hedge fund community’s trading activity freezes up.

• New York Stock Exchange volume and price volatility dries up (see surprise No. 4 on the sideways market).

• Fox Business Network closes because of lack of interest.

• CNBC reduces its live broadcasting schedule and resorts to paid programming before 6:00 a.m. and after 8:00 p.m.

• Particularly hard-hit is Greenwich, Connecticut — the home of many of the biggest hedge-hoggers who are alleged to have committed insider trading violations. The residential real estate market in Greenwich collapses.

14. There is a peaceful regime change in Iran.

15. China overplays it’s economic hand by implementing multiple tightening and by its unwillingness to allow its currency to appreciate.

Saturday, December 25, 2010


DeDude Says:

I wonder if fact-based decision-making will ever have a comeback.

After WWII science and engineering delivered huge progress and their methods gained great respect. At the same time corporate media were for the most part clearly devoted to similar approaches of finding truth/facts and delivering them in an understandable way to the public. In the political system the manipulation did not occur that much at the level of facts but rather at the level of interpretation; because they knew that any attempt at faking facts would uniformly be revealed/condemned by media and get a very negative response from the public. Experts were generally trusted and importantly also generally trustworthy – when they were wrong it was usually the result of honest errors.

This did not work so well for the predators, those who collect more for themselves with little or no ethic/moral constraint on how they get it (or what they do to other people in the process of getting it). Predators start up with the conclusion (whatever gives me a better chance to get more) and work back to arguments that will support that conclusion, and then cherry-pick, manipulate or invent “facts” that support their arguments. This last step really gets in trouble in a society where truth and facts are being collected and respected.

Therefore, predators initiated an attack on experts and expertise to soften peoples trust in sources of complicated facts. Mistakes and misconduct from individual experts were blown up to “prove” that you cannot trust ANY expert. They build their own think tanks where “experts” used perverted semi-scientific approaches to produce “facts” that could support the predators forgone conclusions. Similarly, they build their own media networks and invaded existing networks, replacing real truth seeking journalism with a perverted propaganda format that would have made a 1930’ies dictator proud. Finally they found ways to drive out politicians with integrity and replace them with some that would serve their money masters before they serve their constituents.

Markets in 2011

There are forecasts everywhere of better times ahead in terms of employment, retail, inflation, GDP.

David Rosenberg is having none of it. He sees the market as heavily propped up by the Fed.

This is his look forward for 2011:

1. In Barron’s look-ahead piece, not one strategist sees the prospect for a market decline. This is called group-think. Moreover, the percentage of brokerage house analysts and economists to raise their 2011 GDP forecasts has risen substantially. Out of 49 economists surveyed, 35 say the U.S. economy will outperform the already upwardly revised GDP forecasts, only 14 say we will underperform. This is capitulation of historical proportions.
The last time S&P yields were around this level was in the summer of 2000, and we know what happened shortly after that.

2. The weekly fund flow data from the ICI showed not only massive outflows, but in aggregate, retail investors withdrew a RECORD net $8.6 billion from bond funds during the week ended December 15 (on top of the $1.7 billion of outflows in the prior week). Maybe now all the bond bears will shut their traps over this “bond-bubble” nonsense.

3. Investors Intelligence now shows the bull share heading up to 58.8% from 55.8% a week ago, and the bear share is up to 20.6% from 20.5%. So bullish sentiment has now reached a new high for the year and is now the highest since 2007 ― just ahead of the market slide.

4. It may pay to have a look at Dow 1929-1949 analog lined up with January 2000. We are getting very close to the May 1940 sell-off when Germany invaded France. As a loyal reader and trusted friend notified us yesterday, “fighting” war may be similar to the sovereign debt war raging in Europe today. (Have a look at the jarring article on page 20 of today’s FT — Germany is not immune to the contagion gripping Europe.)

5. What about the S&P 500 dividend yield, and this comes courtesy of an old pal from Merrill Lynch who is currently an investment advisor. Over the course of 2010, numerous analysts were saying that people must own stocks because the dividend yields will be more than that of the 10-year Treasury. But alas, here we are today with the S&P 500 dividend yield at 2% and the 10-year T-note yield at 3.3%.

From a historical standpoint, the yield on the S&P 500 is very low ― too low, in fact. This smacks of a market top and underscores the point that the market is too optimistic in the sense that investors are willing to forgo yield because they assume that they will get the return via the capital gain. In essence, dividend yields are supposed to be higher than the risk free yield in a fairly valued market because the higher yield is “supposed to” compensate the investor for taking on extra risk. The last time S&P yields were around this level was in the summer of 2000, and we know what happened shortly after that. When the S&P yield gets to its long-term average of 4.35%, maybe even a little higher, then stocks will likely be a long-term buy.

6. The equity market in gold terms has been plummeting for about a decade and will continue to do so. When measured in Federal Reserve Notes, the Dow has done great. But there has been no market recovery when benchmarked against the most reliable currency in the world. Back in 2000, it took over 40oz of gold to buy the Dow; now it takes a little more than 8oz. This is typical of secular bear markets and this ends when the Dow can be bought with less than 2oz of gold. Even then, an undershoot could very well take the ratio to 1:1.

7. As Bob Farrell is clearly indicating in his work, momentum and market breadth have been lacking. The number of stocks in the S&P 500 that are making 52-week highs is declining even though the index continues to make new 52-week highs.

8. Stocks are overvalued at the present levels. For December, the Shiller P/E ratio says stocks are now trading at a whopping 22.7 times earnings! In normal economic periods, the Shiller P/E is between 14 and 16 times earnings. Coming out of the bursting of a credit bubble, the P/E ratio historically is 12. Coming out of a credit bubble of the magnitude we just had, the P/E should be at single digits.

9. The potential for a significant down-leg in home prices is being underestimated. The unsold existing inventory is still 80% above the historical norm, at 3.7 million. And that does not include the ‘shadow’ foreclosed inventory. According to some superb research conducted by the Dallas Fed, completing the mean-reversion process would entail a further 23% decline in real home prices from here. In a near zero percent inflation environment, that is one massive decline in nominal terms. Prices may not hit their ultimate bottom until some point in 2015.

10. Arguably the most understated, yet significant, issue facing both U.S. economy and U.S. markets is the escalating fiscal strains at the state and local government levels, particularly those jurisdictions with uncomfortably high pension liabilities. Have a look at Alabama town shows the cost of neglecting a pension fund on the front page of the NYT as well as Chapter 9 weighed in pension woes on page C1 on WSJ.

Consumer spending was taken down 0.4 of a percentage point to 2.4%, which of course you never would have guessed from those “ripping” retail sales numbers.

In the absence of Chapter 9 declarations or dramatic federal aid, fixing the fiscal problems at lower levels of government is very likely going to require some radical restraint, perhaps even breaking up existing contracts for current retirees and tapping tax payers for additional revenues. The story has some how become lost in all the excitement over the New Tax Deal cobbled together between the White House and the lame duck Congress just a few weeks ago.

Sunday, December 19, 2010

Kicking the Can Down the Road

December 17, 2010

By John Mauldin

How often did we as young kids go down the street kicking a can? “Kicking the can down the road” is a universally understood metaphor that has come to mean not dealing with the problem but putting a band-aid on it, knowing we will have to deal with something maybe even worse in the future.

While the US Congress is certainly an adept player at that game, I think the world champions at the present time have to be the political and economic leaders of Europe. Today we look at the extent of the problem and how it could affect every corner of the world, if not played to perfection. Everything must go mostly right or the recent credit crisis will look like a walk in the Jardin des Tuileries in Paris in April compared to what could ensue.

From the point of view of not wanting to so soon endure another banking and credit crisis, we must applaud the leaders of Europe. The PIIGS collectively owe over $2 trillion to European and US banks. German, French, British, Dutch, and Spanish banks are owed some $1.5 trillion of that by Portugal, Ireland, Spain, and Greece by the end of June, 2010. That figure is down some $400 billion so far this year, which means that the ECB is taking on that debt, helping banks push it off their balance sheets. For what it’s worth, the US holds, according to the Bank for International Settlements, about $353 billion, or 17%, of that debt, which is not an inconsequential number.

Robert Lenzner notes something very interesting about the latest BIS report, out this week:

“What’s curious, though, is that for the first time the BIS has broken out a new debt category termed ‘other exposures, which it defines as ‘other exposures consist of the positive market value of derivative contracts, guarantees extended and credit commitments.’ These ‘other exposures’ – quite clearly meant to be abstruse – amount to $668 billion of the $2 trillion in loans to the PIIGS.

“So, bank analysts everywhere; you now have to cope with evaluating derivative contracts that could expose lenders to losses on sovereign debt. Be on notice!”

What did I write just last week? That it is derivative exposure to European banks that is a very major concern for the world and the US in particular. It is not just a European problem. I predicted in 2006 that the subprime problem would show up in Europe and Asia. This time around, European banks present a similar if not greater risk to the US.

A collapse of a major European bank could trigger all sorts of counterparty mayhem in the US banking system, at least among our major investment banks. And then people would want to know which bank was next. This is yet another reason why the recent financial-system reform was not real reform. We still have investment banks committing bank capital to derivatives trading overseen by regulators who don’t really understand the risk. Who knew that AIG was a counterparty risk until it was? Lehman was solid only a month before until it evaporated. On paper, I am sure that every one of our banks is solid – good as gold – because they have their risks balanced with counterparties all over the globe and they have their models to show why you should go back to sleep.

Kicking the Can Down the Road
And that is why I applaud the ECB for stepping in and taking some risk off the table. We do not know how close we came to another debacle. Does anyone really think Jean-Claude Trichet willingly said, “Give me your tired, your poor, your soon-to-default sovereign debt?” Right up until he relented he was saying “Non! Non!” He did it because he walked to the edge of the abyss and looked over. It was a long way down. Bailing out European banks at the bottom would have cost more than what he has spent so far. It was, I am sure, a very difficult calculation.

I remember writing a letter not so long ago, quoting Trichet on that very topic. He was vehemently opposed to any ECB involvement in something that looked like a bailout. And then he wasn’t. I do hope he writes a very candid memoir. It will be interesting reading. The reality is that there was nowhere else to turn. There were no mechanisms in the Maastricht Treaty for dealing with this situation. What I wrote the following week (or thereabouts) still stands. This was and is a bailout for European banks in order to avoid a banking crisis. Many European banks, large and small, have bought massive sums on huge leverage of sovereign debt, on the theory that sovereign debt does not default. Some banks are leveraged 40 to 1!

The ECB is now earnestly continuing to kick the can down the road, buying ever more debt off the books of banks, buying time for the banks to acquire enough capital, either through raising new money or making profits or reducing their private loan portfolios, to be able to deal with what will be inevitable write-downs. It they can kick the can long enough and far enough they might be able to pull it off.

There is historical precedent. In the late ’70s and early ’80s, US banks figured out that if you bought bonds from South American countries at high rates of interest and applied a little leverage, you could practically mint money. And everyone knew that sovereign countries would not default. That is, until they did.

Technically, every major bank in the US was insolvent then. I mean really toes-up, no-heartbeat bankrupt. So what happened? Mean old Paul Volker – he who willingly plunged the US into recession to vanquish the specter of inflation – allowed the banks to carry those South American bonds on their books at full face value. He kicked the can down the road. And the banks raised capital and made profits, shoring up their balance sheets.

In 1986 Citibank was the first bank to begin to write down those Latin American bonds. Then came Brady bonds in 1989. Remember those? Brady bonds were as complicated as they were innovative. The key innovation behind their introduction was to allow the commercial banks to convert their claims on developing countries into tradable instruments, allowing them to get the debt off their balance sheets. This reduced the concentration risk to the banks. (To learn more about Brady bonds, and a very interesting period, go to and also google “Brady bonds.”)

So it worked. Kicking the can down the road bought time until the banks were capable of dealing with the crisis.

Different Cans for Different Folks
The ECB has chosen a different way to kick that old can (and a large and noisy one it is!), but it is not without consequences. Trichet has let it be known that dealing with sovereign-debt default issues should not be the central bank’s problem, it should be a problem for the European Union as a whole. And I think he is right, for what that’s worth.

If the ECB were to keep this up, even in a deflationary, deleveraging world it would eventually bring about inflation and the lowering of the value of the euro against other currencies. That is not the stuff that German Bundesbankers are made of. So they have been pushing for a European Union solution.

At first, the political types came up with the stabilization pact in conjunction with the IMF. But this was never a real solution, other than for the immediate case of Greece … and then Ireland. It has some real problems associated with it. It could deal with Portugal but is clearly not large enough for Spain. It is worth nothing that the political leaders of both the latter countries have loudly denied they need any help. Hmm. I seem to remember the same vows just the week before Ireland decided to take the money.

One of my favorite writers, Michael Pettis penned this note:

“Its official – Spain and Portugal will need to be bailed out soon. How do I know? In one of my favorite TV shows, Yes Minister, the all-knowing civil servant Sir Humphrey explains to cabinet minister Jim Hacker that you can never be certain that something will happen until the government denies it.”

Ultimately, the EU has three options. But before they get there – or maybe better said, before there is a crisis that forces them to get there – they will continue to kick the can down the road. They are really very good at it. We will consider those options in a little bit; but first, let’s look at just one aspect of the problem that will lend some context to the various paths among which they must choose. And that will take us on a detour back to our old friend Greece, where this all started.

More Debt is NOT the Solution to Too Much Debt

Greece is being forced into an austerity program in order to be able to continue to borrow money. But it has come with a cost. Unemployment is now at 12.6%, up from less than 7% just two years ago. And Greek GDP continues to slide. Greek GDP is down over 7% for the last 9 quarters, and there is no reason to believe there will be a reversal any time soon.

A declining GDP is just not good for the country, but it also makes it more difficult for Greece to get back into compliance with its EU fiscal deficit-to-GDP requirements. The problem is that GDP is declining faster than the fiscal deficit. Normally, a country would devalue its currency (and thus its debt), maybe restructure its external debt (or default), and then try to grow its way out of the crisis.

Let’s go back and look at what Iceland did, as compared to Ireland, which is trying to take on more debt to bail out its banks, that is, to bail out German and French and British banks.

This is what I wrote a few weeks ago, and it bears repeating:

Look at how upset the UK got when Iceland decided not to back their banks. Never mind that the bank debt was 12 times Iceland’s national GDP. Never mind that there was no way in hell that the 300,000 people of Iceland could ever pay that much money back in multiples lifetimes. The Icelanders did the sensible thing: they just said no.

Yet Ireland has decided to try and save its banks by taking on massive public debt. The current government is willing to go down to a very resounding defeat in the near future because it thinks this is so important. And it is not clear that, with a slim majority of one vote, it will be able to hold its coalition together to do so. This is what the Bank Credit Analyst sent out this morning:

“The different adjustment paths of Ireland and Iceland are classic examples of devaluation versus deflation.

“Iceland and Ireland experienced similar economic illnesses prior to their respective crises: Both economies had too much private-sector debt and the banking system was massively overleveraged. Iceland’s total external debt reached close to 1000% of its GDP in 2008. By the end of the year, Iceland’s entire banking system was crushed and the stock market dropped by more than 95% from its 2007 highs. Since then, Iceland has followed the classic adjustment path of a debt crisis-stricken economy: The krona was devalued by more than 60% against the euro and the government was forced to implement draconian austerity programs.

“In Ireland, the boom in real estate prices triggered a massive borrowing binge, driving total private non-financial sector debt to almost 200% of GDP, among the highest in the euro area economy. In stark contrast to the Icelandic situation, however, the Irish economy has become stuck in a debt-deflation spiral. The government has lost all other options but to accept the E85 billion bailout package from the EU and the IMF. The big problem for Ireland is that fiscal austerity without a large currency devaluation is like committing economic suicide – without a cheapened currency to re-create nominal growth, fiscal austerity can only serve to crush aggregate demand and precipitate an economic downward spiral. The sad reality is that unlike Iceland, Ireland does not have the option of devaluing its own currency, implying that further harsh economic adjustment is likely.”

Iceland is seeing its nominal GDP rise while Ireland is still in freefall, even after doing the “right thing” by taking on their bank debt.

Greek five-year bonds are now paying 12.8%. It is hard to grow your way out of a problem when you are paying interest rates higher than your growth rate and you keep adding debt and increasing your debt burden.

Each move to deepen government cuts in Greece will result in further short-term deterioration of GDP, which makes it even harder to dig out of the hole. And Greece is a particularly thorny problem. The taxi drivers are outraged that they might have to use meters. Why? Because that means someone could actually track the amount of money they take in. Government workers are striking over 10% pay cuts. And on and on.

It is the same song but with a different verse for the rest of the countries in Europe that have problems. While Ireland is very different from Greece, assuming massive debt in a deflating economy will only turn Ireland into an ever-larger burden unless they can get on the path to growth again. Ditto for Portgual, Spain, and….

Et Tu, Belgium?
One country after another in Europe is coming under pressure. This week the debt of Belgium was downgraded, and the accompanying note from Standard and Poor’s observed that:

“Belgian’s current caretaker government may be ill-equipped to respond to shocks to public finances. The federal government’s projected 2011 gross borrowing requirements of around 11 percent of GDP leaves it exposed to rising real interest rates.”

At some point, if a country does not get its fiscal deficit below nominal GDP (and this is true for the US as well!) it will run into the wall. Credit markets will no longer lend to it. In Europe, the lender has become the ECB, but that may – and I emphasize may – change with the establishment of a new authority for the European Union to sell bonds and use the proceeds to fund nations in crisis. Under the proposal, each nation would assume a portion of the total debt risk. That may be a tough sale, as it appears there will need to be a treaty change and then country-by-country votes for such a change.

It will also mean that countries that accept such largesse will endure a very stern hand in their fiscal affairs. This is potentially a very real surrender of sovereignty. Some countries may decide it’s worth the price. Others, on the funding side of the equation, may decide they have to “take one” for the good of the European team.

This fund is to be launched in 2013, which gives EU leaders some time to flesh out the idea and sell it.

A second choice is for some countries to leave the euro but stay in the EU. Not all members of the EU participate in the eurozone. Leaving would be hugely messy. It is hard to figure out how it could be done without serious collateral damage. Even if Germany were to decide to be the one to leave, which they actually could, as the new German currency would rise over time, it would also mean their exports would be less competitive within Europe.

A third choice (which could be combined with the first choice) is radical debt restructuring. Convert Greek bonds into 100-year low-interest bonds, giving the Greeks (or Irish or Portuguese …) the time and ability to service the debt, along with real controls on their spending. Of course, that is default by another name, but it allows the fiction. Something like Brady bonds. You hit the reset button and kick the can a long way down the road.

That choice too has political and economic consequences. Someone has to cover the losses on the mark-to-market for those bonds. Who takes the hit?

Let me close with this bit of insight from one of my favorite analysts, MartinWolfe of the Financial Times (

“This leads to my final question: could the eurozone survive a wave of debt restructurings? Here the immediate point is that the crisis could be huge, since one restructuring seems sure to trigger others. In addition, the banking system would be deeply affected: at the end of 2009, for example, consolidated claims of French and German banks on the four most vulnerable members were 16 per cent and 15 per cent of their GDP, respectively. For European banks, as a group, the claims were 14 per cent of GDP. Thus, any serious likelihood of sovereign restructuring would risk creating runs by creditors and, at worst, another leg of the global financial crisis. Further injections of official capital into banks would also be needed. This is why the Irish have been “persuaded” to rescue the senior creditors of their banks, at the expense of the national taxpayer.

“Yet even such a crisis would not entail dissolution of the monetary union. On the contrary, it is perfectly possible for monetary unions to survive financial crises and public sector defaults. The question is one of political will. What lies ahead is a mixture of fiscal transfers from the creditworthy with austerity among the uncreditworthy. The bigger are the former, the smaller will be the latter. This tension might be manageable if a swift return to normality were plausible. It is not. There is a good chance that this situation will become long-lasting.

“Still worse, once a country has been forced to restructure its public debt and seen a substantial part of its financial system disappear as well, the additional costs of re-establishing its currency must seem rather smaller. This, too, must be clear to investors. Again, such fears increase the chances of runs from liabilities of weaker countries.

“For sceptics the question has always been how robust a currency union among diverse economies with less than unlimited mutual solidarity can be. Only a crisis could answer that question. Unfortunately, the crisis we have is the biggest for 80 years. Will what the eurozone is able to agree to do be enough to keep it together? I do not know. We all will, however, in the fairly near future.”

My only small disagreement is on whether it will be in the “near future.” World champion can kickers can put off the day of reckoning longer than you might think. On the other hand, when that day does come, it will seem to have come so quickly and with so little warning. There is no way to know what the markets will do about this, so it pays to stay especially vigilant and flexible.

Thursday, December 16, 2010

Wall Street Fraud

Failing to Prosecute Wall Street Fraud Is Extending Our Economic Problems

From: Washington’s Blog

Bill Gross, Nouriel Roubini, Laurence Kotlikoff, Steve Keen, Michel Chossudovsky and the Wall Street Journal all say that the U.S. economy is a giant Ponzi scheme.

Virtually all independent economists and financial experts say that rampant fraud was largely responsible for the financial crisis. See this and this.

But many on Wall Street and in D.C. – and many investors – believe that we should just “go with the flow”. They hope that we can restart our economy and make some more money if we just let things continue the way they are.

But the assumption that a system built on fraud can continue without crashing is false.

In fact, top economists and financial experts agree that – unless fraud is prosecuted – the economy cannot recover.

Fraud Leads to a Break Down in Trust and Instability in the Markets

As Alan Greenspan said recently:

Fraud creates very considerable instability in competitive markets. If you cannot trust your counterparties, it would not work

Similarly, leading economist Anna Schwartz – co-author of the leading book on the Great Depression with Milton Friedman – told the Wall Street journal in 2008:

“The Fed … has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible.”

So even though the Fed has flooded the credit markets with cash, spreads haven’t budged because banks don’t know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is “the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue.”


Today, the banks have a problem on the asset side of their ledgers — “all these exotic securities that the market does not know how to value.”

“Why are they ‘toxic’?” Ms. Schwartz asks. “They’re toxic because you cannot sell them, you don’t know what they’re worth, your balance sheet is not credible and the whole market freezes up. We don’t know whom to lend to because we don’t know who is sound. So if you could get rid of them, that would be an improvement.”

And economics professor and former Secretary of Labor Robert Reich wrote in 2008:

The underlying problem isn’t a liquidity problem. As I’ve noted elsewhere, the problem is that lenders and investors don’t trust they’ll get their money back because no one trusts that the numbers that purport to value securities are anything but wishful thinking. The trouble, in a nutshell, is that the financial entrepreneurship of recent years — the derivatives, credit default swaps, collateralized debt instruments, and so on — has undermined all notion of true value.

Robert Shiller – one of the top housing experts in the United States – said recently that failing to address the legal issues will cause Americans to lose faith in business and the government:

Shiller said the danger of foreclosuregate — the scandal in which it has come to light that the biggest banks have routinely mishandled homeownership documents, putting the legality of foreclosures and related sales in doubt — is a replay of the 1930s, when Americans lost faith that institutions such as business and government were dealing fairly.

Nobel prize-winning economist Joseph Stiglitz says about the failure to prosecute Wall Street fraud:

The legal system is supposed to be the codification of our norms and beliefs, things that we need to make our system work. If the legal system is seen as exploitative, then confidence in our whole system starts eroding. And that’s really the problem that’s going on.


I think we ought to go do what we did in the S&L [crisis] and actually put many of these guys in prison. Absolutely. These are not just white-collar crimes or little accidents. There were victims. That’s the point. There were victims all over the world.


Economists focus on the whole notion of incentives. People have an incentive sometimes to behave badly, because they can make more money if they can cheat. If our economic system is going to work then we have to make sure that what they gain when they cheat is offset by a system of penalties.

Wall Street insider and New York Times columnist Andrew Ross Sorkin writes:

“They will pick on minor misdemeanors by individual market participants,” said David Einhorn, the hedge fund manager who was among the Cassandras before the financial crisis. To Mr. Einhorn, the government is “not willing to take on significant misbehavior by sizable” firms. “But since there have been almost no big prosecutions, there’s very little evidence that it has stopped bad actors from behaving badly.”***

Fraud at big corporations surely dwarfs by orders of magnitude the shareholders’ losses of $8 billion that Mr. Holder highlighted. If the government spent half the time trying to ferret out fraud at major companies that it does tracking pump-and-dump schemes, we might have been able to stop the financial crisis, or at least we’d have a fighting chance at stopping the next one.

Economics professor James Galbraith says:

There will have to be full-scale investigation and cleaning up of the residue of that, before you can have, I think, a return of confidence in the financial sector. And that’s a process which needs to get underway.

No wonder Galbraith says that economists should move into the background, and “criminologists to the forefront”.

Failure to Stop Fraud and Prosecute Criminals Causes a Loss of Trust in Government, Which Makes Government Less Effective

As Shiller stated in the quote above, the failure of government officials to stop fraud and prosecute the financial fraudsters has caused a lack of trust in government itself.

Indeed, polls show that people no longer trust our economic “leaders”. See this and this


A psychologist wrote an essay published by the Wharton School of Business arguing that restoring trust is the key to recovery, and that trust cannot be restored until wrongdoers are held accountable:

According to David M. Sachs, a training and supervision analyst at the Psychoanalytic Center of Philadelphia, the crisis today is not one of confidence, but one of trust. “Abusive financial practices were unchecked by personal moral controls that prohibit individual criminal behavior, as in the case of [Bernard] Madoff, and by complex financial manipulations, as in the case of AIG.” The public, expecting to be protected from such abuse, has suffered a trauma of loss similar to that after 9/11. “Normal expectations of what is safe and dependable were abruptly shattered,” Sachs noted. “As is typical of post-traumatic states, planning for the future could not be based on old assumptions about what is safe and what is dangerous. A radical reversal of how to be gratified occurred.”

People now feel more gratified saving money than spending it, Sachs suggested. They have trouble trusting promises from the government because they feel the government has let them down.

He framed his argument with a fictional patient named Betty Q. Public, a librarian with two teenage children and a husband, John, who had recently lost his job. “She felt betrayed because she and her husband had invested conservatively and were double-crossed by dishonest, greedy businessmen, and now she distrusted the government that had failed to protect them from corporate dishonesty. Not only that, but she had little trust in things turning around soon enough to enable her and her husband to accomplish their previous goals.

“By no means a sophisticated economist, she knew … that some people had become fantastically wealthy by misusing other people’s money — hers included,” Sachs said. “In short, John and Betty had done everything right and were being punished, while the dishonest people were going unpunished.”

Helping an individual recover from a traumatic experience provides a useful analogy for understanding how to help the economy recover from its own traumatic experience, Sachs pointed out. The public will need to “hold the perpetrators of the economic disaster responsible and take what actions they can to prevent them from harming the economy again.” In addition, the public will have to see proof that government and business leaders can behave responsibly before they will trust them again, he argued.

Government regulators know this – or at least pay lip service to it – as well. For example, as the Director of the Securities and Exchange Commission’s enforcement division told Congress:

Recovery from the fallout of the financial crisis requires important efforts on various fronts, and vigorous enforcement is an essential component, as aggressive and even-handed enforcement will meet the public’s fair expectation that those whose violations of the law caused severe loss and hardship will be held accountable. And vigorous law enforcement efforts will help vindicate the principles that are fundamental to the fair and proper functioning of our markets: that no one should have an unjust advantage in our markets; that investors have a right to disclosure that complies with the federal securities laws; and that there is a level playing field for all investors.

If people don’t trust their government to enforce the law, government will become more and more impotent in addressing our economic problems. If government leaders take action, the market will not necessarily respond as expected. When government leaders make optimistic statements about the economy, people will no longer believe them.

Trying to Cover Up the Truth Extends Financial Crises

Elizabeth Warren, William Black and others say that attempting to cover up the truth extended Japan’s financial problems into an entire “Lost Decade”.

As Joseph Stiglitz said about Wall Street fraud:

So the whole strategy of the banks has been to hide the losses, muddle through and get the government to keep interest rates really low.

As long as we keep up this strategy, it’s going to be a long time before the economy recovers ….

Pam Martens – who worked on Wall Street for 21 years – writes:

The massive losses by big Wall Street firms, now topping those of the Great Depression in relative terms, have yet to be adequately explained. Wall Street power players are obfuscating and Congress is too embarrassed or frightened to ask, preferring to just throw money at the problem and hope it goes away. But as job losses and foreclosures mount and pensions and 401(k)s shrink, public policy measures to address the economic stresses require a full set of unembellished facts…

It was four years after the crash of 1929 before the major titans of Wall Street were forced to give testimony under oath to Congress and the full magnitude of the fraud emerged. That delay may well have contributed to the depth and duration of the Great Depression. The modern-day Wall Street corruption hearings in Congress … must now resume in earnest and with sworn testimony if we are to escape a similar fate.

To the extent that the government tries to cover up – instead of openly discuss – financial fraud, it will only extend America’s economic malaise.

Failing to Prosecute Fraud Encourages Financial Players to Take Bigger and More Blatantly Illegal Actions

Nobel prize winning economist George Akerlof has demonstrated that failure to punish white collar criminals – and instead bailing them out- creates incentives for more economic crimes and further destruction of the economy in the future. Joseph Stiglitz, Professor Black, and many others agree. See this, this and this.

It was largely fraud which brought down the financial system in 2008. Unless we prosecute the fraudsters, they will do even bigger, stupider and more blatantly illegal things in the future which will lead to even bigger crises.

Failure to Prosecute Fraud Exacerbates the Sovereign Debt Crisis

The governments of the world have spent trillions trying to paper over the fraud and prop up the big, insolvent banks, instead of forcing them to restructure and forcing bondholders and shareholders to take a haircut.

A study of 124 banking crises by the International Monetary Fund found that propping up banks which are only pretending to be solvent drives up the costs to the country:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.


All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.

The American banks and government have certainly pretended that all of the big banks are solvent. As ABC wrote in October 2009:

The Treasury Department and the Federal Reserve lied to the American public last fall when they said that the first nine banks to receive government bailout funds were healthy, [the special inspector general for the Troubled Asset Relief Program] states in a new report released today.

Similarly, the stress tests were a complete and utter sham.

The government has given the giant banks huge amounts in loans and guarantees based upon their false representations about their financial health. The Fed has larded up its balance sheet with toxic assets from the banks.

Debt levels are also getting dangerously close to the level that they become a drag on the economy. See this and this. When Keynesian economists argue that debt does not harm the economy, they are talking about debt incurred to pay for stimulus and productive things for the economy. But throwing trillions at the giant banks – who are mainly using the money to gamble – is not stimulus. It helps the executives of the big banks and their shareholders and bondholders, but not the broader economy.

Indeed, attempting to prop up big, insolvent banks is preventing stimulus from getting out into the economy.

Fraud Causes Growing Inequality, Which Undermines the Economy

Growing inequality is very harmful to our economy. Indeed, if wealth is concentrated in too few hands, the “poker game” ends, as one or two fat cats are left with all of the chips. See this, this, this and this.

Fraud benefits the wealthy more than the poor, because the big banks and big companies have the inside knowledge and the resources to leverage fraud into profits. Joseph Stiglitz noted in September that giants like Goldman are using their size to manipulate the market. The giants (especially Goldman Sachs) have also used high-frequency program trading (representing up to 70% of all stock trades) and high proportions of other trades as well). This not only distorts the markets, but which also lets the program trading giants take a sneak peak at what the real traders are buying and selling, and then trade on the insider information. See this, this, this, this and this.

Similarly, JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together hold 80% of the country’s derivatives risk, and 96% of the exposure to credit derivatives. They use their dominance to manipulate the market.

Fraud disproportionally benefits the big players (and helps them to become big in the first place), increasing inequality and warping the market.

Fraud Increases the Severity of Boom-Bust Cycles

More and more people – such as the Bank of International Settlements and Barons – are saying that bubbles inevitably lead to busts, thus destabilizing the economy.

Professor Black says that fraud is a large part of the mechanism through which bubbles are blown.

Without strong laws against fraud, bubble after bubble will be blown, guaranteeing that the financial system cannot be stabilized in any fundamental sense.

Failure to Prosecute Fraud Is Worsening the Housing Crisis

Finally, failure to prosecute mortgage fraud is arguably worsening the housing crisis. See this and this.

So trying to ignore the fraud will not work.

Tuesday, December 14, 2010

Ten-Year Yields Are Rising

Unintended Consequences

December 10, 2010
By John Mauldin

Correct me if I’m wrong, but I seem to remember that one of the reasons for QE2 was to lower rates on the longer end of the US yield curve. Clearly, that has not happened?

The yield on ten-year US bonds has been rising since the beginning of QE2. But it is not just US bonds; European and UK bonds are moving up as well. This has also meant that mortgage rates in the US are up almost a half percent in the last few months. That certainly has not helped housing prices or sales, as it makes housing less affordable.

But it is not just the US and UK. Look at what is happening to German bonds, supposedly the safest in Europe. They are up about as much as their counterparts.

And then we look at Japan and we see the same phenomenon. Japanese real rates going up? Really? What is up with that?

In Europe it is now cheaper to hedge against corporate default than sovereign default. That is not the way it is supposed to be.

My friend and fishing buddy David Kotok of Cumberland Advisors is in London at a conference where they are discussing this very issue. He sent a note that says:

“In meetings today we speculated that the sell-off is not a US-only phenomenon. We speculated that it is more than a reaction to Bernanke’s QE2. If all benchmark 10-year debt is selling off by about the same amount in price change, could it be that this selling is the reallocation of globally indexed funds away from sovereign debt and into something else?

“Think of yourself as a Persian Gulf fund. You usually hold foreign sovereign debt in proportion to an index or benchmark. Now you want to reduce your exposure to some of the countries in the index. You either have to sell proportionately from all of the countries in the index or you will face a concentration that violates your index or benchmark. Worldwide sell-off in benchmark sovereign debt suggests this reallocation is underway. Otherwise, how can you account for the Japanese government bond, the German Bund, and the US Treasury note all moving in a correlated way?”

I think that is part of it. I also think that investors and non-core central banks (those in the emerging world especially) are asking themselves about the wisdom of holding sovereign debt in currencies that are either in trouble (the euro) or have central banks that are printing money (the US, UK, and Japan). Couple that with the US having just done a tax compromise that is one huge stimulus bill, on top of extending the tax cuts, and it is enough to make investors consider the wisdom of holding longer-term debt at low rates.

Earlier this year I did one of my Conversations with John Mauldin with professors Carmen Reinhart and Ken Rogoff, who wrote the book This Time is Different. Here is a quote from Ken:

“I would say that virtually every country in the world is grappling right now with how fast we get out of our fiscal stimulus and how much do we worry about this longer term problem of debt. And I fear that all together too many countries will wait too long, which doesn’t mean you end up getting forced to default, it just means the choices get more painful. Something we just find as a recurrent theme, is you’re just rolling along, borrowing money and it seems okay, and that’s what a lot of people say and wham, you hit some limit. No one knows where it is, what it is, but we know you hit it. Carmen and I do have numbers of what are really high debts and what aren’t. And the U.S. will hit that [limit] and there are people who say it is not a problem and everyone loves us, greatest country in the world, where else will the Chinese invest? And you want to hear a great, “this time it’s different” theme that’s a new one.

“John, you started out this conversation on how we got started in this research and this was one of the things in our 2003 paper that is now built into the early chapter or two of the book that just got us really excited was this realization of how not only theoretically, but quantitatively you see it, that countries have the threshold that they hit that we’ve found ways to try and crudely measure, where the interest rates you’re charged just explode.

“It was an epiphany for us because it helped us understand in a really clear way, why it was that the IMF program that we were involved with, and watching and commenting on, so many of them seemed to run awry. We would be presented with this calculation with, “Oh well their debt is 50 percent, and we’re going to let them go slow and run it up to 55 percent before we start getting it down.” But you know if they are running into trouble at 50 percent, and you let it go up to 55 percent, the interest rate could just explode on you as the markets just don’t have confidence. And then in our more recent works that we just finished this paper, Growth in a Time of Debt, we found that there was a parallel effect for advanced countries where they hit these growth limits at 90 and 100 percent.”

In their book (a must read!) they write:

“Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! – confidence collapses, lenders disappear, and a crisis hits.”

Bang is the right word. It is the nature of human beings to assume that the current trend will work out, that things can’t really be that bad. The trend is your friend … until it ends. Look at the bond markets just a few months before World War I. There was no sign of an impending war. Everyone “knew” that cooler heads would prevail.

We can look back now and see where we made mistakes in the recent crisis. We actually believed that this time was different, that we had better financial instruments, smarter regulators, and were so, well, modern. Times were different. We knew how to deal with leverage. Borrowing against your home was a good thing. Housing values would always go up. Etc.

Now there are bullish voices telling us that things are headed back to normal. Mainstream forecasts for GDP growth next year (2011) are quite robust, north of 3.5-4% for the year, based on evidence from past recoveries. However, the underlying fundamentals of a banking crisis are far different from those of a typical business-cycle recession, as Reinhart and Rogoff’s work so clearly reveals. It typically takes years to work off excess leverage in a banking crisis, with unemployment often rising for 4 years running.

An Uptick in Consumer Credit? Not!

The Fed Flow of Funds data came out this week, and it is a treasure trove for those of us with no social life. Look at the following chart. This is basically credit card debt, and it is continuing to fall.

The New York Times reports:

“The lowest percentage of shoppers in the 27-year-history of a national survey said they used credit cards over the Thanksgiving weekend, while the use of general credit cards like Visa and MasterCard fell 11 percent in the third quarter from a year earlier, according to the credit bureau TransUnion.

“Britt Beemer, chief executive of America’s Research Group, a survey firm, said ‘The consumer really feels a lot of pressure from previous debts, and they just aren’t going to dig themselves into that kind of hole,’ he said.

“After the Thanksgiving shopping weekend, the group found that just about 17 percent were paying with credit … just over half of last year’s level and the lowest rate in the 27 years it has conducted a survey.” (hat tip: Mike Shedlock)

Credit lines have been reduced and cards have gone away. Debit cards are the current growth area, but such a drop-off in credit card debt is unprecedented, and the graph above and the NYT-cited survey give no indications that it’s going to change soon.

Then the next chart is total consumer credit outstanding. Interestingly, when I looked at it this week I noted an uptick. That seemed odd and didn’t square with the credit card data. I put it into my mental file to figure out what was happening.

And then I read fellow data miner and good friend David Rosenberg, who looked a little deeper into the data. Seems that they now count student loans as consumer credit, whereas they did not in the past. I guess I missed that memo. (Which makes using past data a bitch. I wish they would keep the data consistent or just create another series, if they think it is that important.) This from David:

“Is The Credit Contraction Over?

“What do you know? Outstanding U.S. consumer credit expanded $3.3 billion in October after eking out a $1.3 billion increase in September. This is the first back-to-back gain since just before Hank Paulson took out his bazooka in the summer of 2008.

“Does this mean the credit contraction is over? Hell no.

“First, the raw not seasonally adjusted data show a $700 million decline.

Once again, it was federally-supported credit (ie. student-backed loans) that accounted for all the increase last month – a record $31.8 billion expansion. Commercial banks, securitized pools and finance companies posted huge declines – to the point where excluding federal loans, consumer credit plunged $32.5 billion, to the lowest level since November 2004 (not to mention down a record 9% YoY). Over the past three months consumer credit outstanding net of federal student assisted loans has collapsed $76 billion … this degree of contraction is without precedent.”

That makes a lot more sense. But then how is it that consumer spending is rising as much as it has recently? Seems the savings rate is back down to 4% and people are hitting their savings.

I want us to look at these few paragraphs from a Bloomberg story quoted by Merrill:

” ‘Ford Investing $600 million, Hiring 1,800 at SUV plant.’ — According to Bloomberg, Ford is hiring 1,800 workers and spending $600 million to overhaul a factory in Louisville, Kentucky that builds sport utility vehicles. Once the overhaul is complete, the plant will operate with two shifts employing 2,900 workers which is an increase from the current one shift that only employs 1,100. However, while work on the plant is being performed (starting December 16th) 700 workers will be laid off from the plant but they will return in the fourth quarter of 2011. Overall, 1,000 new employees will be added to Ford’s payroll due to the plant’s overhaul while the rest are relocated from other factories. New hires will be paid $14.50 an hour.”

That works out to about $29,000 a year. Take away Social Security and other taxes and that does not leave a lot, certainly not enough to buy one of those SUVs. But that is the wave of the future, as we now compete in a global economy. I know I keep talking about my kids, but I can see every time we talk how tough it is. I get it.

But what do interest rates, QE2, debt, and lower wages have to do with each other?

QE2 and the nervousness of investors around the world are pushing up interest rates. We in the US may not have as much time as we think we do before Bang! and rates start moving up with a vengeance. And no amount of QE3-4-5 will bring rates down when the bond vigilantes strike fear into the markets.

Further, that money is not showing up in new loans to either consumers or businesses. It is showing up in asset prices like stocks, emerging markets, and commodities. Oil at $90 and gasoline at $3 per gallon is a tax on consumers, especially at the lower end of the scale. Food prices climb as grains explode, along with the metals that go into our products. And rising interest rates are not good for mortgages. QE2 is not helping consumers or the housing market. Those are unintended consequences. I am sure that was not the plan. It is helping banks with a steeper yield curve. And maybe that is the plan.

Some Thoughts for Ben
Ben. Get a clue. The world is not responding to your theories. What it is doing is getting worried about a central bank that will debase a currency. I agree that your current QE is not all that much in the grand scheme of things, but it is perception and NOT the actual use of those new dollars that is driving rates up.

Further, I am sure you are paying attention to the problems over in Europe. There is the real potential for another credit crisis, where we may in fact need some liquidity injections. You are wasting your bullets on the wrong targets. It is NOT working.

Further, what if the Irish go to the polls in a few months and vote in a new government that repudiates the current agreement (for Irish taxpayers to back Irish bank debt that is owed to German and French banks), and then when the ECB and the Germans tell them no one will buy any new debt they simply say, “Fine, we won’t pay you on anything.” Think that wouldn’t throw a wrench in the gears? Can you 100% assure me that it won’t happen?

(As an aside, I might vote for that if I were Irish. Given where they are, how much worse can it get? Here in Texas we lost all our banks in the oil and real estate crash of the ’80s. Now we are doing just fine. It would be tough, but the Irish are being asked to shoulder a massive amount of bank debt, far beyond their real means to pay. Erin Go Bragh.)

I can’t get any real data on how closely tied US banks are to European banks. The ties were certainly close in the last credit crisis. How much has that changed? If we actually need the Fed to step in once again, the markets could get really spooked, as the next QE rounds might not be accepted so sanguinely.

Then maybe I am just a natural-born worrier, sitting back here in the cheap seats. The markets are going up. The call-to-put ratio is high and rising. Bull-bear sentiment is very high. The world is bullish. What could go wrong? Bartender, another round, please.