October - 2009 - Economic Brief

So why the rally?

It goes something like this, the S&P 500 posted a new closing high for the year this past month, Dollar Index down to fresh 11-month lows, crude oil gained 3% to settle at $70.93/bbl, while gold closed at $1006 per ounce.

Good News:
Retail sales spurted 2.7% in August vs July, the largest monthly pop in more than three years, thanks to the cash for clunkers program, higher fuel prices and deep discounting.

Bad News:
Retail sales are down 5% year over year, and the Commerce Department said that wholesale inventories fell for the 11th month running in July to the lowest level in nearly 3 years.

Yet,
Fed Chairman Ben Bernanke. said that the U.S. recession has “very likely” ended...

To which I ask, “Are you kidding me?” As evidence, I offer a few of Bernanke’s spectacularly poor miss-pronouncements.

You can watch it by following the link just here to see for yourself. http://www.youtube.com/watch?v=HQ79Pt2GNJo&feature=player_embedded

In fact:

Sales for companies listed in the S&P 500 fell 16% in the second quarter, compared to last year. That follows a decline of 14% in the first quarter. Of course, most analysts haven’t focused on that. All they seem to care about is that profit margins are improving.


“Beating Expectations”

If you expected your kid to get an “F” in math class and he came home with a “D”, would you celebrate? Of course not. It’s only slightly better than outright failure.

But over and over again, the media and the investment world celebrate when companies “beat expectations”, even when those companies post a substantial loss. This is what I call “the fog” of the markets.

Hello...

We are in the late stage of the bear market rally.

It’s expensive out there. Right now the dividend yield is a paltry 2.8 percent for the Dow Jones Industrial Average, 2.5 percent for the S&P 500 and a miniscule 0.4 percent for the Nasdaq 100.

So according to this time-proven indicator, the stock market has to be rated expensive because historically, the stock market was a bargain when the dividend yield was 6 percent or higher calculated by just dividing the annual dividend payment by the share price.

Another indicator, price-to-earnings ratio on earnings calculated using Generally Accepted Accounting Principles (GAAP).

Regular readers know that GAAP is under assault by the government who has forced them to change their rules to help out the banks and their “troubled assets” late last year. Anyway, flawed as GAAP is, it is what we have and by that standard the normal historical range for the GAAP P/E is less than 10 (undervalued) to 20 (overvalued). The current figure is 137 ... a record high! So according to this indicator, stocks are extremely overvalued. Did you know that the Price to Actual Earnings is actually higher now than at the top of the market in 2007?

Bottom line:
Based on the two classic valuation methods, this market definitely does not look cheap.

So why the rally?

Did you know that the amount of leverage in the banking system is even greater today than at its peak in 2007?

But at what cost?



Many foreign governments and central bankers are now demanding that the greenback be abandoned as the world’s reserve currency.

• China is already lobbying — aggressively — for a new global reserve currency and leading the campaign to establish an Asian currency reserve fund.

o For example, it announced last month that it will sell $880 million worth of renminbi-denominated bonds in Hong Kong. That marks the first time Beijing will offer renminbi bonds to foreign investors.
o Additionally, China recently established a $95 billion currency swap with other Southeast Asian countries, and a $10 billion currency swap with Argentina. It is the first major Yuan swap agreement with a Latin American country — and directly threatens the dollar south of the border. Its goal: To aggressively take its Yuan to the next sphere of influence in the currency markets, forcing a worldwide monetary change...
o In June, China became a net SELLER of U.S. Treasury notes and bonds!

• Over the past few weeks, the U.N., France, India, Russia, Brazil and several other nations — as well as economic thinkers such as George Soros and Nobel Prize winning economist Joseph Stiglitz — have joined China in demands to replace the dollar as the world’s reserve currency.

• The G-7’s recent funding of the IMF with $1 trillion of “fiat” money... new regulatory powers ... and broader use of the IMF’s Special Depository Receipts, or SDRs confirms that the stage is being set for a new global monetary order.

• Even South America’s Bank of the South is preparing to open its doors soon with seed capital from Argentina, Brazil, Venezuela, Bolivia, Ecuador, Paraguay and Uruguay. Its objective: Independence from the U.S. dollar!

On a related note, I noted with interest that Tim Geithner, the Goldman Sachs Secretary of the Treasury, has gone on record as saying that the government will withdraw its $3 trillion backstop guarantee from the money market fund industry, thus the expiration of the government’s guarantees for money market funds. Is your money in a Money Market?

Why would the government do this?

By simply looking at that of one of the world’s largest money market funds, one can see that 38% of the portfolio is made up of CDs issued by foreign banks, 9.9% in short-term corporate paper, and 12.3% in medium-term paper, much of it hitched to the fates of portfolios of car loans, insurance companies, and a variety of corporate entities.

SO?

The value of your dollars — have plunged more than 14% in the last 6 months.

(In the mean time, the Swiss franc has climbed 13 percent, the Canadian dollar has risen 18 percent, the Brazilian real has jumped 32 percent, the Australian dollar has soared 35 percent and the New Zealand dollar has vaulted 41 percent.)

This is the greatest economic convulsion in FIVE CENTURIES and its taking place right before your very eyes.

The domino effect of the financial crisis and economic downturn around the globe clearly shows how interconnected and interdependent economies have become under globalization.

Even the United Nations...

U.N. agency calls for reducing dollar's role as reserve currency
The world could reduce the risk of economic crises and prevent attacks on currencies by speculators if it reduces the role of the U.S. dollar as a reserve currency, a U.N. agency said in a report. The report calls for introducing a supranational currency, special drawing rights administered by the International Monetary Fund. "If we established an exchange rate system that would guarantee more stable exchange rates, the need for foreign exchange reserves would be much reduced," said Detlef Kott, a U.N. economist. "Therefore, in our report, we focus very much on the reform of the international system to determine the exchange rates." Russia Today (08 Sep.)

Meanwhile, the Chinese government is encouraging its citizens to buy gold and silver. If 1.3 billion Chinese citizens start buying gold and silver, even in tiny quantities, imagine what that will do to the market!

Why might the Chinese be pushing gold? While it’s only conjecture, and wild conjecture at that, China has a lot of gold – in the ground (it is now the world’s largest gold producer) and in its reserves (with the clear intention to increase its holdings, most likely from local production). Could they now be looking to actively encourage higher prices? This would decrease the relative importance of their U.S. dollars in their reserves and increase the overall quality of their reserves by a greater focus on a tangible asset. Who can say what motivates the cadre that calls the shots in China? But one thing is clear, precious metals are on their minds and that’s not the only metal, have you heard of Lithium Batteries, well, Lithium comes from Tibet... but I digress.

So what's next?

Will China dump the rest of its estimated $876 billion hoard of U.S. Treasuries, roughly 22% of our US government debt? NO, but China is a game changer and they know it.

China and The US: A Good Old-Fashion Trade War

China voiced unusually strong objections to tariffs put on its tire exports to the US. The American government believes that the Chinese are targeting the industry which is costing US jobs. Labor unions will like the decision, as will a number of members of Congress who think China does not work on a level playing field when it comes to trade.

China has a large advantage over the US on the trade issue. Large American companies like Wal-Mart (WMT) source so many good from China that the supply chain could not be replaced by getting manufactured goods elsewhere. China does not rely as much on American imports as the balance of trade shows every month.

The temptation to take actions against China for instances where it ships goods to America at what appear to be below market prices will increase as unemployment moves to 10% and beyond. But, it is a sucker’s game for the US. China has the factories and America has the consumers. All locking out China’s products does is drive up consumer prices and drive down consumer spending which is still the engine of US GDP.

One thing seems clear: One of Washington's most dependable sources of loans to finance our own out-of-control deficits is drying up. That means demand for longer-term Treasuries is softening.

That also means you can pretty much count on much higher interest rates in 2010 and beyond — and you can count on those higher rates to crush any chances of a vigorous recovery or rapidly rising stock prices going forward. Did I mention higher taxes too?

China's 500 biggest firms outperform U.S. counterparts
For the first time, profit generated by China's 500 largest firms outstripped earnings of the 500 biggest companies in the U.S., according to a report from the China Enterprise Confederation and the China Enterprise Directors Association. Last year, the Chinese companies produced $170.6 billion, compared with $98.9 billion in the U.S. "Chinese enterprises enjoy relatively better policies and domestic market environment," said Wang Jiming, vice president of the China Enterprise Confederation. "But Chinese companies still lag behind the world's leading enterprises in resource allocation, innovation, international presence, business models and corporate culture." China Daily (Beijing)/Xinhua News Agency (07 Sep.)

Switzerland replaces U.S. as most competitive economy
Switzerland has become the world's most competitive economy, with the U.S. slipping to second place for the first time, according to a report by the World Economic Forum. Economies that earn a large percentage of GDP from financial services, such as the U.K. and the U.S., were hurt in the crisis, according to the report. The BRIC countries -- Brazil, Russia, India and China -- all moved higher in the ranking, while trust for banks in both Switzerland and the U.S. fell to record lows. Reuters (08 Sep.)

The World Economic Forum released a report this month that rated the U.S. 108th for financial trustworthiness, 106th for access to financing and 93rd for economic stability. Ouch!

On the home front:

A mortgage trade group reported Thursday that more than 13% of the nation's mortgage holders were delinquent on their mortgages or in the process of having their homes repossessed during the second quarter of this year. That's the highest figure since tracking began in 1972. California's rate, 15.2%, was among the highest of all states

And it’s not just residential.

The default rate for commercial mortgages jumped from 1.62% to 2.25% in the first quarter and should hit 4.1% by the end of the year, says Sam Chandan, president of Real Estate Econometrics.

Unwilling to seize devalued properties in a moribund market, lenders have foreclosed on fewer than 10% of the loans, says Real Capital Analytics. That's prolonging the crisis by keeping properties from being resold at lower prices, says New York real estate lawyer Edward Mermelstein.

A bigger problem: the nearly $1 trillion in short-term commercial mortgages slated to mature by the end of 2010. With property owners unable to refinance, even solid loans could go into default.

Seven Foods for Thought:
1.
Cross-state purchase of health insurance. Interesting that the one power the Constitution grants Congress, that is, to prevent states from interfering with cross-state business contracts, is the one they refuse to use. One of the reasons that health insurance costs so much is because of mandated state coverages. (Drug treatment, alcohol treatment, acupuncturists, hair pieces, etc., and so forth.)

If a senior citizen wanted to opt out of Medicare and get private insurance, the rules now state that failure to accept Medicare means you cannot collect Social Security payments. Thus, the vast majority cannot opt out of the government plan even though a recent Harvard study concluded that the US health care crisis is costing more than 44,000 lives each year and the New England Medical Journal claims that medical treatment comes in behind cancer and heart disease as the number three reason for death in the US.


2.
Senator Timothy Wirth will be prosecuted for deliberately manipulating Congress during the sessions that ultimately led to the passage of punitive and scientifically unsound global warming legislation. You can read more and watch the senator smugly confess here. http://wattsupwiththat.com/2009/08/15/getting-steamed-about-global-warming-not-coming-to-a-theatre-near-you/

3.
Federal District Judge Jed S. Rakoff was supposed to a approve a $33 million settlement between the SEC and Bank of America over the issue of the financial firm making inaccurate statements regarding Merrill Lynch compensation. The SEC and Bank of America will have to return to court for a trial on February 1. The most important issue at hand will be that the judge says that BAC “materially lied” in its disclosures about the Merrill bonuses.

The unexpected action by the judge threatens to kill a time-honored gentlemen’s agreement between the SEC and major American public companies. That being, when the SEC catches corporations doing something that violates the securities laws, rather than take up the commission’s time which could be better used chasing people like Bernard Madoff, the companies are allowed to settle charges by paying large fines. This usually means that the company does not admit to anything, although its guilt is generally assumed. Why would a firm that is entirely innocent make a payment to settle charges? I digress.

4.
Senate Democrats might wait on climate-change legislation
Senate Democrats' consideration of putting climate change on the back burner might force U.S. President Barack Obama to send diplomats empty-handed to negotiations in December in Copenhagen. Obama was expected to offer congressional approval of concrete measures limiting emissions as evidence that the U.S. is serious about dealing with global warming. Senate Majority Leader Harry Reid suggested that Democrats want to handle health care before climate change and that global warming could be addressed next year. The Guardian (London) (16 Sep.)

5.
Part of the solution:

Contraception is almost five times cheaper as a means of preventing climate change than conventional green technologies, according to research by the London School of Economics.

6.
Right now the FDIC insures around $4.5 trillion of banking reserves. That’s the money you and I count as “safe” when we deposit it in almost any American bank account.

I think it’s important to knock some of the mystery off these almost incomprehensibly large numbers – because for most people, $1 billion is just about as unthinkably large as $1 trillion when it comes down to it. To further illustrate the point, it takes one thousand piles of $1 million to equal $1 billion. To get $1 trillion, you need a million piles of $1 million.

Doing some quick math, we can see that $10.4 billion goes into $4.5 trillion 432 times. So essentially, the FDIC insures every $432 of deposits with one lonely dollar.

The FDIC currently insures 8,153 banks. So far this year, 81 have failed – or 1% (in 2007, just three banks failed). And there are another 416 banks on a watch list. What happens if another 1% fails?

Well, the FDIC has a reinsurer of its own, sort of. It’s called the U.S. taxpayer, backed by the full faith and credit of the Fed’s printing presses. If they can’t tax us enough, they’ll backstop the FDIC with newly created dollars – the very definition of inflation.

6.
So much about the FDIC, what about the FHLB?
Who is the FHLB? Even if you heard their name, you probably haven't been worrying about what they do. They were created in 1932 as a government-sponsored entity (GSE) made up of 12 regional Federal Home Loan Banks, each of which is an individual corporation. Founded in the depression, they have carried on, providing money for mortgages. are 8,100 member banks, thrift and credit unions, and insurance companies that provide the mortgages. That's why you rarely hear about them – they are a bankers’ bank. They don't lend directly to buyers but only through banks. Banks collateralize their advances from the FHLB by the mortgages they make.

They have $1,147 trillion of assets and liabilities. They have $45.8 billion of total capital. So they are highly leveraged at about 25 to 1.

Even though there is no explicit government guarantee, the FHLB has been able to borrow at attractively low rates, because the public assumes such a guarantee. (Sound familiar? Fannie and Freddie pop to mind?) As such, the debt issued by FHLB is considered AAA by Standard & Poor's – so it's used regularly as a substitute for cash. Municipalities often invest here.

The next wave of mortgage difficulties is expected to include large amounts of Option ARM (adjustable-rate mortgage) loans that are scheduled to be resettled over the next year or two. That sets the stage for another federal government takeover or receivership like Fannie and Freddie. That means even more bailouts, and eventual Fed monetization to fund it. Credit collapse is destructive for housing, but it is dollar-destructive to bail out everybody. My bet is some of both will happen, with the easy path toward bailouts and dollar destruction being the more likely.

7.
Back to Tibet
Rare Earth Elements are exceedingly rare and hard to locate. They are found in sufficient quantities only in certain parts of the world. And the demand for these metals is increasing rapidly.

They are used to enhance the power of magnets in computer hard drives. They are used in wind turbines… catalytic converters… and the motors of hybrid cars. They are used to make lasers. And they are found in just about every iPod, BlackBerry, plasma TV, and mobile phone on the planet. They can even help filter viruses and bacteria from water.

China controls 95% of the world supply of Rare Earth Elements. That’s because most of these materials come from mines in Inner Mongolia and Tibet. And two weeks ago, the Chinese Ministry of Industry and Information Technology called for a total ban on the exports of most of them. Others will be restricted by quotas.

Did you know that Obama refused to see the Dali Lama because of China’s request that he not be received. Oh, let’s just sweep this under the rug or good old fashioned bad-boy politics.


Quotes of the month:

“But why do people have to pay 5,6,7 percent sales taxes in stores, but the derivative dealers on Wall Street pay no sales tax on hundreds of trillions of transactions every year? Seems like a hefty double standard.” – Ralph Nader
Which is why Cong. Peter DeFazio (Dem. Oregon) has introduced legislation to tax such speculation. (HR 1068)

“...you can make a moral argument that you shouldn’t buy T-Bills, because they will be repaid with stolen money – taxes.” - Doug Casey

And finanlly,

“One hundred senators, 435 congressmen, one president, and nine Supreme Court justices equates to 545 human beings out of the 300 million are directly, legally, morally, and individually responsible for the domestic problems that plague this country.

I excluded the members of the Federal Reserve Board because that problem was created by the Congress. In 1913, Congress delegated its Constitutional duty to provide a sound currency to a federally chartered, but private, central bank.

I excluded all the special interests and lobbyists for a sound reason. They have no legal authority. They have no ability to coerce a senator, a congressman, or a president to do one cotton-picking thing. I don't care if they offer a politician $1 million dollars in cash. The politician has the power to accept or reject it. No matter what the lobbyist promises, it is the legislator's responsibility to determine how he votes.

It seems inconceivable to me that a nation of 300 million cannot replace 545 people who stand convicted -- by present facts -- of incompetence and irresponsibility. I can't think of a single domestic problem that is not traceable directly to those 545 people. When you fully grasp the plain truth that 545 people exercise the power of the federal government, then it must follow that what exists is what they want to exist. Do not let these 545 people shift the blame to bureaucrats, whom they hire and whose jobs they can abolish; to lobbyists, whose gifts and advice they can reject; to regulators, to whom they give the power to regulate and from whom they can take this power. Above all, do not let them con you into the belief that there exists disembodied mystical forces like "the economy," "inflation," or "politics" that prevent them from doing what they take an oath to do.” - Charlie Reese, a former columnist of the Orlando Sentinel Newspaper

Note to readers:
One may wonder how it is that I accumulate such a mass of information, let alone have the time for this blog. First, it is purely self-interest as I too have to navigate these markets and since I am making the time to do the reading and discovery, why not share it with a larger audience, my colleagues, and so I do. Second, my sources are many and varied and what I do is take the best of the best, cut and paste, and string together a somewhat coherent thesis. I has been said, "When you take stuff from one writer it's plagiarism; but when you take it from many writers, it's research." In reference to my sources this month, they include in no particular order:

Brain Rich, Gregory Spear, Doug Casey, CNNMoney.com;Bob Irish, Porter Stansberry, Doug Casey, Kevin McElroy, Larry Edelson, Douglas A. McIntyre, Dan Weil, Richard Young, Gregory Spear’s Market Commentary; Daily Wealth Reader; The Daily Crux, Money and Markets/Mike Larsen, Martin Weiss; The New York Times/The Associated Press; The Washington Post; The Wall Street Journal; Reuters; China Daily (Beijing)/Xinhua News Agency; The Guardian (London) and Bloomberg.