Happy Memorial Day.

Happy Memorial Day!

In our town of River Forest one of the highlights of our year is the Memorial Day parade which runs right down our street passing in front of Global HQ. We fly two American flags between now and the 4th of July.

The flag you see off to the side of HQ was carried by my brother-in-law who flew Harrier jets for the marines in Afghanistan. We honor his service and all others who are serving or who have served in our armed forces.

Happy Memorial Day everybody. Hope its sunny!

Einhorn On Debt.

Excellent New York Times op-ed on our structural deficits.  Excerpts with highlights.

Easy Money, Hard Truths

By DAVID EINHORN

Published: May 26, 2010


Are you worried that we are passing our debt on to future generations? Well, you need not worry.  Before this recession it appeared that absent action, the government’s long-term commitments would become a problem in a few decades. I believe the government response to the recession has created budgetary stress sufficient to bring about the crisis much sooner. Our generation — not our grandchildren’s — will have to deal with the consequences.

According to the Bank for International Settlements, the United States’ structural deficit — the amount of our deficit adjusted for the economic cycle — has increased from 3.1 percent of gross domestic product in 2007 to 9.2 percent in 2010. This does not take into account the very large liabilities the government has taken on by socializing losses in the housing market. ....Government accounting is done on a cash basis, so promises to pay in the future — whether Social Security benefits or loan guarantees — do not count in the budget until the money goes out the door.

A good percentage of the structural increase in the deficit is because last year’s “stimulus” was not stimulus in the traditional sense. Rather than a one-time injection of spending to replace a cyclical reduction in private demand, the vast majority of the stimulus has been a permanent increase in the base level of government spending — including spending on federal jobs. How different is the government today from what General Motors was a decade ago? Government employees are expensive and difficult to fire. Bloomberg News reported that from the last peak businesses have let go 8.5 million people, or 7.4 percent of the work force, while local governments have cut only 141,000 workers, or less than 1 percent.

Public sector jobs used to offer greater job security but lower pay. Not anymore. In 2008, according to the Cato Institute, the average federal civilian salary with benefits was $119,982, compared with $59,909 for the average private sector worker; the disparity has grown enormously over the last decade.

The question we need to ask is this: If we don’t change direction, how long can we travel down this path without having a crisis? The answer lies in two critical issues. First, how long will the capital markets continue to finance government borrowings that may be refinanced but never repaid on reasonable terms? And second, to what extent can obligations that are not financed through traditional fiscal means be satisfied through central bank monetization of debts — that is, by the printing of money?.......At what level of government debt and future commitments does government default go from being unthinkable to inevitable, and how does our government think about that risk?

I recently posed this question to one of the president’s senior economic advisers. He answered that the government is different from financial institutions because it can print money, and statistically the United States is not as bad off as some other countries. For an investor, these responses do not inspire confidence.

....If we are going to spend more now, it is imperative that we lay out a credible plan to avoid falling into a debt trap. Even using the administration’s optimistic 10-year forecast, it is clear that we will have problematic deficits for the next decade, which ends just as our commitments to baby boomers accelerate.

Modern Keynesianism works great until it doesn’t. No one really knows where the line is. One obvious lesson from the economic crisis is that we should get rid of the official credit ratings that inspire false confidence and, worse, are pro-cyclical, aggravating slowdowns and inflating booms......

Consider this: When Treasury Secretary Timothy Geithner promises that the United States will never lose its AAA rating, he chooses to become dependent on the whims of the Standard & Poor’s ratings committee rather than the diverse views of the many participants in the capital markets. It is not hard to imagine a crisis where just as the Treasury secretary seeks buyers of government debt in the face of deteriorating market confidence, a rating agency issues an untimely downgrade, setting off a rush of sales by existing bondholders. This has been the experience of many troubled corporations, where downgrades served as the coup de grâce.

The current upset in the European sovereign debt market is a prequel to what might happen here......As we saw first in Dubai and now in Greece, it appears that governments’ response to the failure of Lehman Brothers is to use any means necessary to avoid another Lehman-like event. This policy transfers risk from the weak to the strong — or at least the less weak — setting up the possibility of the crisis ultimately spreading from the “too small to fails,” like Greece, to “too big to bails,” like members of the Group of 7 industrialized nations.....

....I don’t believe a United States debt default is inevitable. On the other hand, I don’t see the political will to steer the country away from crisis. If we wait until the markets force action, as they have in Greece, we might find ourselves negotiating austerity programs with foreign creditors.

Some believe this could be avoided by printing money..... That the recent round of money printing has not led to headline inflation may give central bankers the confidence that they can pursue this course without inflationary consequences. However, printing money can go only so far without creating inflation.  Government statistics are about the last place one should look to find inflation, as they are designed to not show much.....this doesn’t even take into account inflation we ignore by using a basket of goods that don’t match the real-world cost of living. (For example, health care costs are one-sixth of G.D.P. but only one-sixteenth of the price index, and rising income and payroll taxes do not count as inflation at all.)

Why does the government understate rising costs? Low official inflation benefits the government by reducing inflation-indexed payments, including Social Security. Lower official inflation means higher reported real G.D.P., higher reported real income and higher reported productivity.  Subdued reported inflation also enables the Fed to rationalize easy money. The Fed wants to have low interest rates to fight unemployment, which, in a new version of the trickle-down theory, it believes can be addressed through higher stock prices. The Fed hopes that by denying savers an adequate return in risk-free assets like savings deposits, it will force them to speculate in stocks and other “risky assets.” This speculation drives stock prices higher, which creates a “wealth effect” when the lucky speculators spend some of their gains on goods and services. The purchases increase aggregate demand and lead to job creation.

Easy money also aids the banks, helping them earn back their still unacknowledged losses. This has the perverse effect of discouraging banks from making new loans. If banks can lend to the government, with no capital charge and no perceived risk and earn an adequate spread, then they have little incentive to lend to small businesses or consumers. (For this reason, higher short-term rates could very well stimulate additional lending to the private sector.)
Easy money also helps the fiscal position of the government. Lower borrowing costs mean lower deficits. In effect, negative real interest rates are indirect debt monetization.  Allowing borrowers, including the government, to get addicted to unsustainably low rates creates enormous solvency risks when rates eventually rise.

While one can debate where we are in the recovery, one thing is clear — the worst of the last crisis has passed. Nominal G.D.P. growth is running in the mid-single digits. The emergency has passed and yet the Fed continues with an emergency zero-interest rate policy. Perhaps easy money is still appropriate — but a zero-rate policy creates enormous distortions in incentives and increases the likelihood of a significant crisis later. It was not lost on the market that during this month’s sell-off, with rates around zero, there is no room for further cuts should the economy roll over.....

...Though we don’t know what’s going to happen next, the good news for our grandchildren is that we will have to face our own debts. If we realize that our own future is at risk, we might be more serious about changing course. If we don’t, Mr. Geithner and others might regret having never said never about America’s rating.

David Einhorn is the president of Greenlight Capital, a hedge fund, and the author of “Fooling Some of the People All of the Time.” Investment accounts managed by Greenlight may have a position (long or short) in the securities discussed in this article.

Link:   Easy Money Hard Truths.

Europe: Conclusion

My thoughts on Europe are simple. The European Union will be saved. It will likely emerge from this economic situation in a different and stronger form, although it will probably take us a few years to understand exactly how it's going to look. It's also increasingly likely that whatever ultimate form it takes will feature a stronger Berlin, Paris & London axis although power will likely still be wielded out of Brussels.

The reason for this analysis is simple. Europe together has either the 2nd largest or the world's largest GDP. Alone these are in most cases tiny countries. The US has for example 14 states with larger GDP's than Greece. Its economy is about the size of Massachusetts.

At the end of the day these countries are going to hang together or hang separately. For them bigger is better.

Europe Saving the Euro?

The last of our series on the European Union.

The Embattled Euro


One way or another Europe will save the euro--and the currency is indeed worth saving. It has facilitated flows of capital and reduced the cost of doing business across borders. Greece's economic behavior has been bad, even by European standards, but that doesn't discount the idea of having a uniform currency. Illinois may well be the worst fiscally managed state in the Union these days, but that doesn't mean the dollar will collapse. It just means the citizens of Illinois will suffer disproportionately, and they will have to pay more to borrow money.

In fact, the euro has spared Greece from an even greater disaster: poverty-inducing hyperinflation. If Athens were still using the drachma the government's response to its fiscal difficulties would have been to turn on the printing presses, thus engulfing the nation in terrible inflation. This impoverishment would have been far more extensive and destructive than what the Greek people are currently experiencing. Just look at what hyperinflation did to Germany in the early 1920s.

The European central bank could firmly shore up the euro by fixing the currency to gold. Unfortunately, given the current intellectual state of economic thinking, that won't happen.

Link: Saving The Euro.

Decimalization

Individuals haven't really been in love with stocks for most of the last decade. While the lack of annualized return is mostly blamed for this, I also think one of the chief culprits is volatility. Traders love volatility but individual investors hate it. They're really not in the business of seeing their assets decline 10-15% in relatively short periods of time. They also have a hard time understanding how something can be worth x on one day and then y (often lower) just a few days later.

Individuals and most investors have no real appreciation for the mechanics of how stocks are bought and sold. That is most don't understand what happens when the buy and sell buttons are pushed. There has to be somebody on the other side of their trade. In the old days that function was mostly performed by specialists and market makers. In the old days however stocks traded in 1/8s to 1/4s. There was money to be made in market making so there was an incentive to stabilize prices and to handle large blocks of stock.

Decimalization did away with all that. Today there's no money to be made on the spread for firms and therefore no incentive to stabilize markets. As a result stocks trade down to their own levels. That's one of the main reasons why when sell-offs occur they tend to be much more intense and violent than they were in the past. Today's chart shows that action. This is a yearly chart of the S&P 500 showing when decimalization came into effect. Stocks have gone on wild swings since this happened and volatility is now much higher than it was ten years ago.

*Long ETFs related to the S&P 500 in client and personal accounts.

an tSionna 5.24.10

*Long ETFs related to the S&P 500 in client and personal accounts.

Summer Hours

The weather's warming up and thoughts turn to the great outdoors.  We're starting "summer hours" on the blog this weekend.  We'll still post Monday through Thursday until Labor Day but we'll reserve the weekends for family.  Rest assured we'll be first on line if events this summer make it necessary to do so.

See you outside!

We Are Not Europe

Excellent editorial from Wall Street Journal.  Excerpts and highlights:

The We're-Not-Europe Party

By DANIEL HENNINGER

One of the constant criticisms of Barack Obama's first year is that he's making us "more like Europe." But that's hard to define and lacks broad political appeal. Until now. Any U.S. politician purporting to run the presidency of the United States should be asked why the economic policies he or she is proposing won't take us where Europe arrived this week.

...For Americans, this has been a two-week cram course in what not to be if you hope to have a vibrant future. What was once an unfocused criticism of Mr. Obama and the Democrats, that they are nudging America toward a European-style social-market economy, came to awful life in the panicked, stricken faces of Europe's leadership: Merkel, Sarkozy, Brown, Papandreou. They look like that because Europe has just seen the bond-market devil. The bond market is a good bargain—if you live more or less within your means. The Europeans, however, pushed a good bargain into a Faustian bargain, which the world calls a sovereign debt crisis.

In the German legend, Faust was a scholar who sold his soul to the devil many years hence in return for a life now of intellectual brilliance and physical comfort. In our version of the legend, Europe's governments told the devil that, more than anything, they wanted a life of social protection and income fairness no matter the cost. Life was good. A fortnight ago, the bond devil arrived and asked for his money.

..... A Democratic Party whose current budget takes U.S. spending from a recent average of about 21% of GDP up to 25% is outside that comfort zone. It's headed toward the euro zone. After Europe's abject humiliation, the chance is at hand for the Republicans to do some useful self-definition. They should make clear to the American people that the GOP is "The We're Not Europe Party." Their Democratic opposition could not attempt such a claim because they do not wish to.

The state of Europe can be summed up in one word: stagnation. Jean-Claude Trichet, the European Central Bank president who just agreed to monetize the debt that Europeans can't or won't pay, noted in a 2006 speech that "over the period from 1996 to 2005, euro area output grew on average 1.3 percentage points less than in the U.S., and the gap appears to be persistent."

....Stagnation isn't death. Economies don't die. Greece proves that. They slow down. Europe's low growth rates allow its populations to pretend that real, productive work is being done somewhere by someone. But new jobs are created slowly, if at all. Younger workers lose heart. Economic stagnation is a kind of purgatory. Once there, it's not clear how you get out.....

The antidote to stagnation is economic growth. Not just growth, but strong growth. A 4% growth rate, which Europe will never see again, pays social dividends innumerably greater than 2.5% growth. Which path are we on?

Barack Obama would never say it is his intention to make the U.S. go stagnant by suppressing wealth creation in return for a Faustian deal on social equity. But his health system required an astonishing array of new taxes on growth industries. He is raising taxes on incomes, dividends, capital gains and interest. His energy reform requires massive taxes. His government revels in "keeping a boot on the neck" of a struggling private firm. Wall Street's business is being criminalized.

Economic stagnation arrives like a slow poison. Look at the floundering United Kingdom, whose failed prime minister, Gordon Brown, said on leaving, "I tried to make the country fairer." Maybe there's a more important goal.  A We're-Not-Europe Party would promise the American people to avoid and oppose any policy that makes us more like them and less like us

Link:  We're not Europe.

Market Cycles

Barry Ritholtz over at The Big Picture posted recently on market cycles.  It's one of the best pieces I've ever read in terms of explaining the rhythms of the market year, the sturm und drang of how money is invested around the globe.  I have discussed this in the past and these cycles are one of the components of our money flow analysis.  If you ever want to understand one of the key drivers of the professional investor class read this excerpt.  {My highlights.}

The Greatest Show on Earth:

Welcome back my friends to the show that never ends
We’re so glad you could attend
Come inside! Come inside!
Come inside, the show’s about to start
guaranteed to blow your head apart
Rest assured you’ll get your money’s worth
The greatest show in Heaven, Hell or Earth


-Karn Evil 9
Emerson, Lake and Palmer
Brain Salad Surgery

For the past few decades, the greatest show on earth has been the global stock markets. The gyrations of markets make for a compelling narrative: From boom to bust and back again to boom and bust.

Welcome back my friends to the show that never ends

If you manage to survive in the market for a long enough period of time ...you begin to notice the repetitiveness of cycles. You begin to notice the show never ends. There is a daily rhythm of the market open, the initial lift or fade, the counter rally, success or failure, the reasserting of the initial move. The midday slow down (traders gots to eat too!). The mid-afternoon move, (and at times, the terrible remorseless march of the margin clerks). Then the close. I suspect most (human) traders and quants live in the context of a daily grind.

We’re so glad you could attend

There are the weekly cycles — Monday’s excitement, the turnaround Tuesdays, the squaring of positions on Friday before the weekend. Weekly retail, unemployment, and economic reports.  Many sales people live in a weekly context....its the weekly rhythms that define their schedule, their meetings and sales. Brokers, Institutional Sales, Mutual fund hawkers, even Bloomberg terminals sales people are weekly.

Come inside, the show’s about to start

The monthly cycles are an entire different animal. The big economic data points are out monthly: Non Farm Payroll, GDP and revisions, Inflation numbers like CPI/PPI. Absolute return strategies get measured monthly. Hedge funds and others report their gains/losses monthly. Indeed, hedge fund mangers and Economists live in an environment of a monthly data cycles.

Guaranteed to blow your head apart

The quarterly cycle begins with earnings. Pre-announcment season, the early warnings of misses. Then the earnings parade begins. The 60% average beat rate, the surprise misses, the understated expectations game, the folly of forecasts. The post mortem: How many companies beat? By how much?  CEOs, CFOs, accoutants and Analysts live in a world of quarters.

Rest assured you’ll get your money’s worth

As the earth makes its annual sojourn around the sun, we see a steady cycle of key factors: Year end contributions to tax deferred accounts, Christmas shopping, bonus season. April 15th. The school year, Sell in May, the dangers of September and October.  Strategists, mutual fund managers, retailers, compensation consultants live on this annual cycle.

The greatest show in Heaven, Hell or Earth

The secular bull bear market cycle, with its cyclical counter points, has become the greatest of all these shows. Its too long of a period to comprehend as a first hand witness — the many intervening cycles prevent you from feeling it.Its not the sort of thing you sense or intuit, given the extended frame of reference. But you can comprehend it intellectually. You can learn about the longer cycles from history. Its in the charts, its within the data.

If you ignore the secular and cyclical, you will miss the greatest show on earth.

Link:  The Greatest Show on Earth!

Europe: Postponing The Day Of Reckoning

David Ignatius of the Washington Post wrote this editorial last week. Excerpt & highlights:

Europeans just did something that they talk about endlessly in the abstract but rarely achieve in practice: They took collective financial action in a crisis.....{T}he Europeans assembled a creative bailout policy that's reminiscent, in some ways, of what the Federal Reserve hammered together during the Wall Street panic of 2008.

The problem with the European package is that it postpones problems rather than resolves them. It will delay Eurobond defaults another year or two, and it will add some fiscal discipline that could eventually make the 16 eurozone nations operate more like one economy. But there's nothing to address the deeper structural imbalances between high-saving northern Europe and the spendthrift "Club Med" countries of southern Europe that used the euro as a credit card......

.....What's innovative (and potentially destabilizing) about this rescue plan is that in exchange for bailout loans, the European Commission will be able to demand austerity measures to, say, cut salaries and pensions in debtor countries. This is the sort of "conditionality" that comes with aid from the International Monetary Fund to destitute Third World countries. And in fact, the IMF will be kicking in an additional $321 billion in bailout money, with the usual strings attached.

The good side of the austerity measures is that they are a step in the direction of economic integration, which has been the missing link in the eurozone since the Maastricht Treaty of 1992. The conditionality of the rescue plan opens the possibility for a common European fiscal policy that, over time, would make the common currency sustainable.
But the austerity measures have two big drawbacks, one economic and the other political. The economic problem is that imposing harsh budget cuts and other belt-tightening on the "Club Med" countries, while appealing to German workers, may not make sense when the European recovery is so fragile.

The trickier problem is building political support for the austerity measures that are coming. Looking at Greek rioters chanting about demon bankers and government ministers who threaten their pensions is a reminder that Europeans believe in the welfare state as a matter of social entitlement. A different social contract may need to be written, more in line with economic and demographic realities. But that won't be any easier in Europe than in the United States.

.....It doesn't help the Greek worker who may be out of a job soon, but the `underlying problem here is the global imbalance that produced a savings glut in some parts of the world (China, Germany) that, in turn, fueled low interest rates that understated the riskiness of some investments (subprime mortgages, Greek bonds). Until those imbalances are checked, we can look forward to new asset bubbles and new panics.....

I don't envy the Chinese authorities. They're sitting atop what is arguably the last big bubble. Bloomberg News reported Tuesday that China's inflation accelerated in April, its bank lending exceeded forecasts and its property prices jumped by a record amount. As the Chinese watch rioters in the streets of Athens, they get a stark reminder of the cost of getting economic policy wrong -- and of allowing too much free-flowing capital to distort the real risks of economic activity.

Next:  Saving the Euro.

Link: Postponing the Reckoning.

*Long ETFs with European exposure in client and personal accounts.  Long ETFS with exposure to China and the far east markets in client and personal accounts.

Europe's Shared Fate Part II

The Question of European Identity

During the generation of prosperity between the early 1990s and 2008, the question of European identity and national identity really did not arise. Being a European was completely compatible with being a Greek. Prosperity meant there was no choice to make. Economic crisis meant that choices had to be made, between the interests of Europe, the interests of Germany and the interests of Greece, as they were no longer the same. What happened was not a European solution, but a series of national calculations on self-interest; it was a negotiation between foreign countries, not a European solution growing organically from the recognition of a single, shared fate.

Ultimately, Europe was an abstraction. The nation-state was real. We could see this earliest and best not in the economic arena, but in the area of foreign policy and national defense. The Europeans as a whole never managed to develop either. The foreign policies of the United Kingdom, Germany and Poland were quite different and in many ways at odds. And war, even more than economics, is the sphere in which nations endure the greatest pain and risk. None of the European nations was prepared to abandon national sovereignty in this area, meaning no country was prepared to put the bulk of its armed forces under the command of a European government — nor were they prepared to cooperate in defense matters unless it was in their interest.

The unwillingness of the Europeans to transfer sovereignty in foreign and defense matters to the European Parliament and a European president was the clearest sign that the Europeans had not managed to reconcile European and national identity. Europeans knew that when it came down to it, the nation mattered more than Europe. And that understanding, under the pressure of crisis, has emerged in economics as well. When there is danger, your fate rests with your country....

... Most of the European nations, individually, were regional powers at best, unable to operate globally. They were therefore weaker than the United States. Europe united would not only be able to operate globally, it would be the equal of the United States. If the nation-states of Europe were no longer great individually, Europe as a whole could be.....

That clearly is not going to happen. There is no European foreign and defense policy, no European army, no European commander in chief. There is not even a common banking or budgetary policy (which cuts to the heart of today’s crisis). Europe will not counterbalance the United States because, in the end, Europeans do not share a common vision of Europe, a common interest in the world or a mutual trust, much less a common conception of exactly what counterbalancing the United States would mean....The Europeans like their nations and want to retain them. After all, the nation is who they actually are.

That means that they approach the financial crisis of Mediterranean Europe in a national, as opposed to European, fashion. Both those in trouble and those who might help calculate their moves not as Europeans but as Germans or Greeks. The question, then, is simple: Given that Europe never came together in terms of identity, and given that the economic crisis is elevating national interest well over European interest, where does this all wind up?

The European Union is an association — at most an alliance — and not a transnational state.....In the end, what we have learned is that Europe is not a country. It is a region, and in this region there are nations and these nations are comprised of people united by shared history and shared fates. The other nations of Europe may pose problems for these people, but in the end, they share neither a common moral commitment nor a common fate.

This means that nationalism is not dead in Europe, and neither is history. And the complacency with which Europeans have faced their future, particularly when it has concerned geopolitical tensions within Europe, might well prove premature. Europe is Europe, and its history cannot be dismissed as obsolete, much less over.

Tomorrow: Postponing the day of reckoning.

*Long ETFs with European exposure in client and personal accounts.

an tSionna 5.17.10

I've discussed over the past couple of weeks the market's change of investment character. Right now what we've seen has been a market sell off followed by a weak attempt to rally which has then been met with further selling. This is not usually a high probability level from which markets begin a new rally. At best this usually means stocks churn about and at worst it often signals that a decline could resume. This level also leaves us stuck between support levels in the 1115-1120 range and resistance levels between roughly 1145-1175 on the S&P 500. Money flows are now showing up with more neutral readings but are nowhere near suggesting higher probability buying signals at this time on the overall indices.

There are some specific sectors that are beginning to look like they're washing out and we will keep an eye out there for attractive entry levels per our client mandates, especially since certain ETFs have come down to levels where their dividend yields have again become compelling. Over all however I will keep my Net Market Neutral stance regarding the larger market indices for the time being. I am a tepid Net Market Positive in the very short term. You can click here for a definition of those terms.

*Long ETFs related to the S&P 500.

Europe's Shared Fate Part I

We're going to take a part of the next few weeks and look at the European Union from the basic principle of whether it will survive as a single economic entity.  Today and tomorrow we'll excerpt an excellent Stratfor article on Europe's shared fate.  

Europe, Nationalism and Shared Fate

By George Friedman

The European financial crisis is moving to a new level. The Germans have finally consented to lead a bailout effort for Greece. The effort has angered the German public, which has acceded with sullen reluctance. It does not accept the idea that it is Germans’ responsibility to save Greeks from their own actions. The Greeks are enraged at the reluctance, having understood that membership in the European Union meant that Greece’s problems were Europe’s.

And this is not just a Greek matter. Geographically, the problem is the different levels of development of Mediterranean Europe versus Northern Europe. During the last generation, the Mediterranean countries have undergone major structural changes and economic development. They have also undergone the inevitable political tensions that rapid growth generates. As a result, their political and economic condition is substantially different from that of Northern Europe, whose development surge took place a generation before and whose political structure has come into alignment with its economic condition.

European Unity and Diversity

Northern and Southern Europe are very different places, as are the former Soviet satellites still recovering from decades of occupation. Even on this broad scale, Europe is thus an extraordinarily diverse portrait of economic, political and social conditions. The foundation of the European project was the idea that these nations could be combined into a single economic regime and that that economic regime would mature into a single united political entity.....

Europeans, of course, do not think of themselves as Mediterranean or Northern European. They think of themselves as Greek or Spanish, Danish or French. Europe is divided into nations, and for most Europeans, identification with their particular nation comes first. This is deeply embedded in European history....

There is a paradox in the European mindset. On the one hand, the recollection of the two world wars imbued Europeans with a deep mistrust of the national impulse. On the other hand, one of the reasons nationalism was distrusted was because of its tendency to make war on other nation-states and try to submerge their identities....

The European Union was designed to create a European identity while retaining the nation-state. The problem was not in the principle, as it is possible for people to have multiple identities. For example, there is no tension between being an Iowan and an American. But there is a problem with the issue of shared fate. Iowans and Texans share a bond that transcends their respective local identities.... A crisis in Iowa is a crisis in the United States.....

The Europeans tried to finesse this problem. There was to be a European identity, yet national identities would remain intact. They wrote a nearly 400-page-long constitution, an extraordinary length. But it was not really a constitution. Rather, it was a treaty that sought to reconcile the concept of Europe as a single entity while retaining the principle of national sovereignty that Europe had struggled with for centuries. At root, Europe’s dilemma was no different from the American dilemma — only the Americans ultimately decided, in the Civil War, that being an American transcended being a Virginian.....

When the Berlin Wall came down in 1989, there was no question among the Germans that East and West Germany would be united. Nor were serious questions raised that the cost of economically and socially reviving East Germany would be borne by West Germany. Germany was a single country that history had divided, and when history allowed them to be reunited, Germans would share the burdens.....This was the same for the rest of Europe that organized itself into nation-states, where the individual identified his fate with the fate of the nation. For a Pole or an Irishman, the fate of his country was part of his fate. But a Pole was not an Irishman and an Irishman was not a Pole. They might share interests, but not fates. The nation is the place of tradition, language and culture — all of the things that, for better or worse, define who you are. The nation is the place where an economic crisis is inescapably part of your life.

When the Greek financial crisis emerged, other Europeans asked the simple question, “What has this to do with me?” From their point of view, the Greeks were foreigners....The Germans might be affected by the crisis — German banks held Greek debt — but the Germans were not Greeks, and they did not share the Greeks’ fate. And this was not just the view of Germany, the economic leader of Europe, by any means...

The bailout of Greece is designed not because Greece is part of Europe, but because it is in the rest of Europe’s interest to bail Greece out. But the heart of the matter is that Greece is a foreign country.

Tomorrow:  The Question of European Identity

*Note I am long in client and personal accounts ETFs that have part of their investments in certain European countries.

A Few Things Under The Radar.

Meanwhile as we've been worrying about Greece, market crashes and oil spilling in the Gulf of Mexico, I thought I'd link to a few items that peaked my interest.  These are just little things for us to store in our collective intelligence.  None will make us a dime today and none will matter until some point in time when they do!

Robert Bennett: All incumbents beware!  2010 likely going to turn into a "Throw the bums out year".

Mexico struggles to replace oil reserves.  Mexico is almost a failed state.  That is going to be the real issue as immigration looms larger in this election year.

Who guards the guardians?-Moodys receives a Wells Notice.

Out Today

I am out visiting clients today.  There will be no posting.

Jobs: Non Farm Payrolls

Chart of the Day graphs last week's non farm payroll report.

"{Last week}, the Labor Department reported that nonfarm payrolls (jobs) increased by 290,000 in April -- the largest increase in four years. Today's chart puts the latest data into perspective by comparing job losses following the beginning of the current economic recession (solid red line) to that of the last recession (dashed gold line) and the average recession from 1950-1999 (dashed blue line). As today's chart illustrates, the current job market has suffered losses that are more than triple as much as what occurs at the lows of the average recession/job loss cycle. However, today's relatively positive jobs report provides an early indication that the current job market is moving into a phase of expansion."

Link: Jobs Data.

Capital Markets.

I read this recently over at the Dorsey Wright Blog and wanted to excerpt it last week but events moved  in the way.  My highlights.

Naked Truth About Capital Markets

Here is the naked truth: capital markets are designed to reallocate money from dumb people to smart people. If that weren’t true, smart people wouldn’t play. Smart people don’t play unless they have a probability of winning. For example, smart people don’t tend to play the lottery....This might be the real reason that the rich continue to get richer....{B}eing smart about the capital markets requires a very specific skill set consisting of three things.

1) Knowledge. Smart means understanding which return factors are likely to outperform over time. If you plow through all of the investment literature as we have, you will see that it largely boils down to two return factors: relative strength {my note:  relative strenght plays a part of the calculation in our studies of money flows} and value. Both are robust and work in numerous formulations...... Success is mainly a matter of consistently exposing the portfolio to the return factor. Pick one–or both–because they complement one another extremely well. If you have just this small nugget of knowledge, you are miles ahead of the game.

2) Discipline. Smart means understanding that execution is more important than knowledge. It’s not enough to have the knowledge of which return factors will likely work over time. You need to have a systematic method of exposing the portfolio to your chosen return factor in a disciplined fashion.....  If you consistently expose your investment capital to a good return factor in a disciplined way, you are light years ahead of your competition.

3) Patience. Smart means understanding that great patience is required. Most investors, I suppose, would like to get rich quick. That’s unlikely to happen. In a karmic kind of way, the universe actually makes you earn your money by going through trials and tribulations. The E-ticket ride you get in capital markets is never easy, and often not pleasant. Both

Link:  The Naked Truth About Capital Markets

an tSionna 05.10.10 (Yesterday's Trade)

*Long ETFs related to the S&P 500 in client accounts.

Net Market Neutral

Given today's advance I am changing my short term view to Net Market Neutral.  I view the market in that regard now in all three of the time frames I follow.  See this link for the definition and disclaimer of that term.

Net Market Positive

In light of last week's market action I am changing my short term market views to Net Market Positve.  I am changing only my short term view to this.  I am currently Net Market Neutral in my intermediate and longer term viewpoints. You can double click here for definition of these terms.

What The Playbook Says.

Our playbook is the situational analysis of markets based on historical results. We study how money flows into and out of securities along with the disciplines of fundamental and valuation analysis to see how markets have responded to historical events. The playbook helps by giving us different market scenarios to current trading activity and helps us formulate a game plan for current market events.

The game plan is a tactical and strategic allocation of clients assets based on what the playbook tells us has historically occurred. It gives us a direction for our various investment strategies and is further refined to the specific risk/reward parameters of our various client groups. Often the game plan can be implemented across the board in all client accounts or in a specific investment strategy. At other times portions of the game plan can be specifically implemented in individual client accounts where events or certain client events may warrant such action.

The playbook states that we start with what we know right now. We know that the market has basically given back all of its gains for 2010 in four trading sessions. We know that the market is now over sold short term but has not reached that point by our analysis in either of the intermediate or longer time frames that we follow. We know that there is both political & economic uncertainty in Europe, that there is an oil well spilling something like 40,000 gallons of crude into the Gulf of Mexico every day and we know that financial firms like Goldman Sachs continue to square off against the Government-a legacy of events that nearly ruined the world two years ago. We also know that the economic news here at home is getting better. These positive reports ended up being background noise on Friday but I think it will get more attention in the weeks ahead.

The playbook says that an improving economic environment coupled with the rapid decline we experienced last week usually equals a snap back advance. I think it is likely we'll see markets rally some point next week. We have now seen the inverse of the last two months advance.  In this case stocks have likely fallen too far too fast. Stocks fell over 6% last week. That's a pretty healthy decline in a very short period of time and it means stocks are now as vulnerable to a reversal to the upside at some point as they were to a decline a few weeks ago. That advance could be violent and fast if investors get some sense that the European situation will somehow be resolved.

That does not necessarily mean that the correction is over. The market will give us clues about its character by how stocks react on any advance. The playbook tells us that stocks should now struggle as they encounter higher price levels. This is because traders who are holding shares at higher prices often will sell as prices advance and they get back or close to even money. This is what is known as resistance and it's often an initial barrier to price advance. A market that can eat through these various resistance levels would be indicative of one that wants to shrug off our current events and resume its rally. Likewise a rally that fails from these levels and turns decisively south could indicate that we have a bigger problem on our hands than is currently indicated. In that case we will activate additional defensive tactics for our clients. In general this would likely mean another level of raising cash.

Since stocks are short term over sold, the game plan says to look for tactical trading opportunities in some of our more aggressive trading strategies and for more aggressive client accounts. Eventually stocks will reach a point of being so over sold as to be attractive to a larger majority of our client base and our investment strategies. A few more days like last week could mean that point arrives soon. Then we will look to add to longer term client holdings. As usual we primarily focus on ETFs for equity exposure.

Besides some of our broader index strategies, we are attracted to ETFs that currently have attractive yields as well as the potential for capital appreciation. For our growth oriented investments areas of concentration include energy, technology, certain segments of health care and certain segments in financial services. I also think that it is time to take a more serious look at foreign ETFs given the nature of this sell off which has more severely affected their markets than here in the US.

I discussed yesterday why I think our issues are short term in nature. I still think the weight of the evidence suggests that stocks will be higher by year end. But I want to again remind us what the consigliere-the gentlemen who taught me this business-used to say, "stocks will do what they have to do to prove the most amount of people wrong". Today I think what would cause the most pain is for stocks to do.....nothing.

I think its likely that once the markets find some level of equilibrium that stocks could go to sleep for perhaps 4-5 months as they digest the last year's gains. The old phrase "sell in May and go away!" could be on target this summer and stocks could be range bound until the leaves turn color in the fall. The market has been telling us for a few weeks that a change in its character was coming. We've been in need of a wash out for a few months. A rest while stocks churn about in a trading range could set the stage for better opportunities later in the year.

*Long ETFs related to the S&P 500 in client and personal accounts. The information presented here should be used for informational purposes and relates solely to the management of client accounts by our firm. Casual readers of this blog should consult their own investment advisor or do their own homework before acting on any information posted here. This should not be construed as a guarantee that any future event shall occur. Since I only know the unique characteristics of my clients outside readers of this blog use this information at their own risk.

Thursday's Decline-Correction Or Something Worse?

The weight of evidence currently suggests that we are experiencing nothing more than a normal correction. 

The market was very over bought at the end of April. I have discussed that before here and here. Equities become over bought when they reach a point where there are no buyers at current prices. At best stocks will then trade in place while they work off these conditions. Often what happens is that they decline to price levels that again attracts the interest of investors. That is what seems to be occurring now. Stocks staged an impressive 13% rally from early February to the end of April. At some point this rally was destined to roll over given the nature of that advance. All that was needed was an event to set a decline in motion. I'll argue that it was a combination of the Government's case against Goldman Sachs, the oil leak in the Gulf and the economic troubles in Greece that lit the fuse. Even if none of these events had occurred I think there would have been something else giving investors a reason to take profits.

The economy is on the mend. Lost in the background is the fact that the economy is improving. This is in sharp contrast to when the market crashed in October, 2008. Back then there was ample evidence that economic growth was already decelerating. In contrast corporate earnings are beating estimates for the fifth quarter in a row** According to a report issued by Deutsche Bank this week, corporate earnings per share have come in a strong 20% above consensus for the firms that have already reported this quarter. Estimates going forward are also being revised higher.

The Labor Department reported yesterday that non farm payrolls rose 290,000 in April with gains reported across almost every business sector. This was the the fastest pace of job gains in four years. and also the largest gain since March 2006. Adding this to March job revisions, this suggest that nearly a half million jobs have been created in the past two months. You simply do not get this kind of job growth when corporate managers are concerned about economic contraction.

Corporate earnings continue to be revised higher. S&P 500 earnings estimates have recently been moving north of $80 per share for 2010. Earnings for 2011 are currently in the $85-90 dollar range per share. Critics of these numbers forget that the S&P 500 earned $86 per share in 2007.  I think that upside to this year's earnings number may back off a bit soon due to the troubles in Europe and oil spill in the Gulf. But I still think $80 per share is a pretty good baseline on which to gage market valuation by year end.

Valuations are still attractive. In an expanding economy with ultra low interest rates, traditional valuation methods suggest a price to earnings multiple of 14-17 times that S&P $80 earnings number. Traditional valuation methods would therefore suggest a price potential of 1120-1360. That gives us a market that is either fairly valued at current levels to one that has the potential to gain 12-21% by years end.  Also the earnings yield-the earnings divided by stock price-for the S& P 500 currently is about 7%.  This compares favorably with corporate bond rates and money market accounts yielding almost nothing. 

There is of course no guarantee that such levels will be reached or that markets might not head lower even in the short term. Indeed our current problems could prove this analysis moot. Greece for example could lead to a larger European problem, especially if it does spread to Spain, Portugal or Ireland. Also an unforeseen event such as a successful terrorist incident on par with 9-11-2001 or a massive natural disaster would negate much of my current analysis. I am constantly checking what I believe about the market to the facts on the ground and I stand ready to change my thinking should events warrant. But given what we know at this time there is the potential for stock prices to reach these levels on a six-nine month basis.

Tomorrow I'll discuss how the playbook says we should adjust the game plan to current events.

*Long ETFs related to the S&P 500 in client accounts.

(Blue highlights represents links to older posts)
**Source Deutsche Bank, US Equity Strategy, Chadha, Binky, 04.27.2010

an tSionna {Update}

Stocks held barely to their support levels today.  Will have to see what Monday brings.  There are rumors swirling about a more aggressive move by the European Central Bank over the weekend.  Such a move if it happens could help stocks find a floor.

*Long ETFs related to the S&P 500 in client and personal accounts.

an tSionna {Yesterday's Decline}

Most of us are  aware that stocks suffered a rather large decline yesterday. Much of the snap commentary has focused on the probable computer glitch that knocked an additional 500 points off of the Dow Jones Industrials for about 10 minutes. Unless you sit glued to a computer screen all day you probably didn't even know there had been a problem until you turned on the news or went on the internet.

This is not the first time that stocks have suffered a computer meltdown and it will probably not be the last. Unfortunately that is the price we pay for the way modern markets operate, which by the way also includes increased liquidity and lowered commissions as benefits.

While not trying to minimize what happened, I think it will ultimately be found to be a combination of human error and computer trading gone amok. Indeed the exchanges have already stated that they will likely cancel certain trades executed during that time. Ultimately whatever caused that part of the decline will be discovered and addressed.

However, markets were already down before that event and ended up losing nearly 3% by the close. I think its more important to focus on that portion of yesterday's decline and to also address what that means going forward.  

First as a review, I noted at the end of March that I had started to change my thinking to a more defensive posture given the advance we'd seen off the February lows and what my money flow analysis was beginning to suggest was a subtle change of trend. I also said on April 28th "that the market may be using the news out of Greece and Europe as an excuse to sell. The real culprit likely is that we've experienced a great rally and stocks are tired."

That defensive orientation included a review of all client accounts by investment strategy and risk. This has already meant raising some cash on a tactical basis based on account strategy, size and client risk parameters (see that same April 28th post and our game plan: An update post). In all cases it has included a strategic review of our exposure to the markets given the criteria previously mentioned. That review has also identified additional levels where we would become even more defensive in the event this correction morphs into something more serious. 

As I'm writing this, stocks have currently declined a bit more than 8% from their late April highs. This is similar to the other corrections we've seen since this rally began back in March 2009. I've shown for comparison in the chart above how this decline stacks up with our two most recent declines. {You can double click on the chart to make it larger and easier to see}. The previous two corrections in October and January of this year were nasty, brutish and short. So far this correction seems to fit with those previous events in both the intensity of its decline and the approximate number of days it's taken to get to this point.   Also a 2-3% one day decline while not common does occur more frequently than is commonly thought.  On average markets will experience a day like today 2-3 times a year.

This current decline has now taken us back to the same levels that stocks traded as recently as January-which was an area of consolidation where stocks have some support. One of our first clues as to future market direction will be how stocks react to this support level which resides around 1110-1115 on the S&P 500. {Again you can see that in the chart at the top of this page.}

Of course the real question is whether this is a correction similar to the half dozen or so we've seen since last spring or the start of something much worse.  I'll discuss  tomorrow what the evidence suggest about this current decline. 

*Long ETFS related to the S&P 500 in client accounts.

(Blue highlights represents links to older posts)

Jobs: Productivity

We've said in the past that many of the nearly 8 million jobs lost since this recession began are never coming back due to increases in productivity.  Simply stated advances in technology have made it so that one or two people can do the work of four to five in the past.  24/7 Wall Street highlighted this trend today after reviewing the latest Bureau of Labor Statistics {BLS} report.

Although productivity is not rising at the rate it did in the first quarter, the increase is still too “hot” to help employment. According to the BLS: 

“Nonfarm business sector labor productivity increased at a 3.6% annual rate during the first quarter of 2010, the U.S. Bureau of Labor Statistics reported, with output rising 4.4% and hours worked rising .8%.”

It was hoped that the rate would level out, which would probably indicate that employers would have to increase hiring to improve their ability to handle a rising demand goods and services. As it is, the workforce appears to be ”working harder” to remain employed. Looking for new jobs is nearly impossible as the ratio of job seekers to open jobs is 5.5 to 1.

Link: Jobs & Productivity.

Why Population Growth Bodes Well For Us.

I've discussed in the past how population growth is a postive for America's economy in the rule of three.  Here is an essay on this subject.  Excerpt with my highlights.

400 Million People Can’t Be Wrong

Why America's new baby boom bodes well for our future.

By Joel Kotkin, NEWSWEEK

Published Apr 16, 2010 {From the magazine issue dated Apr 26, 2010}

....{W}e don't have to wait for the census results to get a basic picture of America's demographic future. The operative word is "more": by 2050, about 100 million more people will inhabit this vast country, bringing the total U.S. population to more than 400 million.

With a fertility rate 50 percent higher than Russia, Germany, or Japan, and well above that of China, Italy, Singapore, South Korea, and virtually all of Eastern Europe, the United States has become an outlier among its traditional competitors, all of whose populations are stagnant and seem destined to eventually decline. Thirty years ago, Russia constituted the core of a vast Soviet empire that was considerably more populous than the United States. Today, Russia's low birthrate and high mortality rate suggest that its population will drop by 30 percent by 2050, to less than one third that of the United States.....

Perhaps an even more important demographic gap is emerging between the United States and East Asia.....{W}ithin the next four decades, a third or more of their populations will be older than 65, compared with only a fifth in America. By 2050, according to the United Nations, roughly 30 percent of China's population will be more than 60 years old. Lacking a developed social-security system, China's rapid aging will start cutting deep into the country's savings and per capita income rates......

...Between 2000 and 2050 the U.S. population aged 15 to 64—the key working and school-age group—will grow 42 percent, while the same group will decline by 10 percent in China, nearly 25 percent in Europe, and 44 percent in Japan. Unlike its rivals, America's economic imperative will lie not in meeting the needs of the aging, but in providing job and income growth for our expanding workforce. What the United States does with its "demographic dividend"—that is, its relatively young working-age population—will depend largely on whether the private sector can generate jobs, an issue that's particularly critical now, with more than 15 million unemployed.

Immigrants may be one force that will lead the way: between 1990 and 2005 immigrants started one quarter of all venture-backed public companies. This enterprising spirit is crucial, because U.S. employment has been shifting not to mega corporations but to individuals; between 1980 and 2000, the number of self-employed people expanded tenfold to make up 16 percent of the workforce.

To create jobs, America needs to pay attention not only to high-tech industries but also the basic ones—construction, manufacturing, agriculture, energy—that will employ our expanding blue-collar workforce.....With the mobilization of our entrepreneurs and supportive government policies, the United States should be able to exploit its vibrant demography to assure its preeminence over the next four decades. If we fail to start taking these steps now, our current leaders will have earned the opprobrium that future generations will heap upon them.

Kotkin is a Distinguished Presidential Fellow at Chapman University and author of The Next Hundred Million: America in 2050, published by Penguin Press. © 2010

Link:  Why 400 Million People Can't Be Wrong.

Game Plan: An Update

I discussed the current game plan here last week.  In accordance with that thinking I sold a second tranche of securities out of risk appropriate accounts in most of our portfolio strategies today.  Again it is possible that I will be wrong.  In fact it is likely that we will see some sort of snapback in the next few days.  But I think prudence dictates that we remain on the defensive shorter term.

*Long ETFs related to the S&P 500 in client accounts.  Again please note this is information for the clients and friends of our firm about our thinking and should not be construed as investment advice.  Casual readers of our blog should either do their own homework or discuss the markets with their own investment advisors.

Jobs & Government Hiring

Long time readers of this blog know that I think job growth in the next several years will be anemic, particularly for those trying to find jobs at the lower end of the manufacturing and services pool.  I also think job growth is going to be constrained as the public sector is forced to contract.  24/7 Wall Street weighs in on this same topic today regarding job growth and Federal hirings.  Excerpt with my highlights.

Signs Of The Apocalypse: Federal Government Hiring Drives Jobs Growth

Douglas A. McIntyre

The major concern about the March employment numbers is that the economy added 162,000 jobs, but of those, 48,000 were temporary workers who have been hired for the 2010 Census. Economists pointed out that this Census employee trend does very little for long-term job creation. It will take years to replace the eight million jobs lost during the recession. The government will have to do a lot of hiring....

....Gallup’s Job Creation Index for April shows that the federal government was the primary engine for new hiring during the month. The private sector made a very modest contribution, and state and local governments continue to aggressively lay people off as their taxes bases go through rapid contractions. This process at the local level is not over. Property taxes are a great part of the money brought in by cities and municipalities. Real estate prices are still down over 30% from their peaks three-years ago. Whatever money comes from local income taxes has been eroded by high unemployment.

Gallup reports that “The overall Index value for American workers in April tilts positive, with 27% of workers saying their places of employment are hiring, and 22% saying their employers are letting people go — resulting in an overall +5 Job Creation Index.”

The most noteworthy data may be the extent to which businesses are still firing people. There is a popular assumption that lay-offs are largely lower and that employers, while not hiring, are in a steady state of worker retention. Productivity has gone up so much in the last two quarters that the amount of work that any one person can do has probably reached a point past which is cannot reasonably go. The fact that over one out of five enterprises, private and public, are still letting workers go is a sign the aftershocks of the recession are still powerful.

The federal government is trying to make up for the deficit in the private and local sectors. Some portion of the $787 billion stimulus package went to programs that are strictly federal. Washington has turned that into a hiring binge.  :By almost a 2-to-1 margin, federal employees say their employer is hiring rather than firing....

....Employment will have to grow quickly in the federal and private parts of the economy to help offset the plunge in local and state government jobs. Gallup’s data shows that hiring has gone up 14% according to respondents who work for state governments, while 42% say their employers are reducing workforce size. The local numbers are not much better with the ratio of 16% to 42%

The Gallup data is a sign that the belief the number of unemployed or underemployed people in the US will drop by any meaningful extent is wrong. The government’s stimulus packages have helped create jobs at the federal level. Stimulus dollars have had very little effect on the private sector at all, and aid to the states is not being used for hiring.....

Link:  Hiring