Dollars and Sense

Economic Recovery Dubious at Best

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In this article, we continue to explore the state of capital markets from a more fundamental, economic perspective. Some of us (including one Paul Volcker) continue to believe the outlook is dubious at best. So we ask the reader to consider a series of related observations, some anecdotal, some only partially substantiated, but all intended to evoke common sense thinking towards the future that lies directly ahead.

Dollars & Sense - Economic Recovery Dubious at Best

In mid 2008, as the Fed began unprecedented intervention in capital markets, Wall Street Greek warned of the possible ill and unintended effects of excess liquidity:

"But will the central bank engage in a more concerted asset-targeting effort to (in the words of Alan Greenspan, 1994) 'prick the … market bubble?' Or, in a rare but biased show of self-restraint, will the Fed let the market respond naturally to deflationary forces? In either case, the temporary strengthening of the dollar, coupled with coordinated currency support from central banks abroad could have 'unexpected' results. After all, such price oscillation is to be expected in a nearly frictionless system with boiling money sloshing around between asset classes."

Indeed, it seems that the stock market is in another bubble, poised for rapid deflation if and when the greenback bounces off near historically low levels.

• Consider the imminent impact of a stronger dollar. Even reports of a strengthening economy can put immediate pressure on US capital markets. As we have seen in the case of the Yen, an appreciating currency leads to rapid, broad-based deleveraging among foreign investors as they exit the easy money carry trade.


• Consider too the wizard behind the equities facade, errrr… curtain, Helicopter Ben. Does anyone doubt that ill-conceived bailouts, liquidity injections and negative real interest rates, not economic rebound, are the real reason behind current stock valuations?


• Consider that capital allocation has brought current leverage almost to the same level as 2007, so that we are seemingly poised for yet another deflationary drop as banks race to deleverage:

• Consider that stocks are fairly valued only if we see strong economic growth and earnings reports in 2010. Otherwise, trailing S&P P/E ratios are well above 125 on average. Improved bottom line profits generated by cost-cutting simply do not produce the kind of growth that will justify current, forward-looking valuations. Economic risks, which are substantial, are NOT factored in.


• Consider as another example the Contango carry trade. Oil index funds are borrowing money (i.e. applying more leverage) in order to buy and store oil at $70 with the expectation that it will be valued at $110 in 2010 when the inelastic demand and inflationary forces return! Never mind the demand destruction that we expect from alternative energy, or more likely, the future absence of any real economic growth.


• Consider that the Fed is already testing deleveraging mechanisms through reverse repos. And along with the US Treasury Department, the Fed is liquidating TARP stocks and warrants. Banks are quietly following suit with the sale of their own stocks to raise cash. Why are they all selling now if bank stocks, which constitute a large portion of major indices, have further appreciation in store?


• Consider the implications of continuing stimulus programs (e.g. cash for caulkers). If the economy has recovered as the main stream media suggests; if strong growth is to return in 2010, as portended by the forward-looking markets; then why in the world do we need more stimulus?! Why do the Obama administration, the Fed and the rest of the G-20 seem unwilling to take this economy off its training wheels?


• Consider instead the teetering reality that many manufacturing firms, particularly those in the heart of the Country and its true economic engine, the Midwest, are not growing at all. Though production levels have stabilized for some, further contraction is still looming for others. Certainly none are bursting at the seams with new growth!


• Consider that recent order stabilization has come at least in part from production of electric and hybrid vehicles, products that I work on daily. Almost without exception, emerging solutions offer no reasonable payback on initial investment. Even the VP of Advanced Storage Solutions at Johnson Controls, a major battery supplier, acknowledges that demand depends heavily on government incentives. This strongly implies industry growth will abate when government incentives (not to mention global warming myths) disappear!


• Consider that banks, flush with cash created out of thin air and borrowed at next to nothing, are still reticent to lend. For example, even though the SBA will offer government guarantees up to 80% for a small business loan, banks are yet demanding 75% collateral. Consider too the historic yield spreads lenders are demanding on 30-year mortgages, despite unprecedented rate intervention. Reluctance to lend at fair rates to businesses or even to new homeowners is stifling economic rebound.


• Consider all the purported loan modification programs to help out struggling home owners. In many cases, the rate may indeed be reduced to allow for a lower monthly payment, but the increased length of the loan makes the overall interest payout the same or higher. Securing a reduction in principal for upside down mortgages is like pulling teeth. These guys sure are generous after our trillion dollar bailout for their moral hazard! (More on that in a future piece.)


• Consider the millions of homeowners who continue to struggle despite these programs. Here in the geographic center of the Country, the economy has certainly shrunk, but the housing market has been relatively inert. Nevertheless, I know many, many homeowners who, despite recent modifications, are still upside-down in debt and well behind on lowered payments. Why aren't they able to keep up? THEY HAVE NO JOBS! A jobless recovery simply is not possible. That is not a matter of opinion. That is a fact.


• Consider the rash of new ARM resets and interest-only loans that have yet to hit critical mass. With them, more defaults are undoubtedly on the way. And with the expiration of the homebuyer stimulus tax credit in April 2010, artificial demand cannot re-inflate real estate forever.


• Consider commercial real estate losses that loom even more imminently. Banks continue to mark all of these assets to magic, make-believe maturity levels. A developer here in Missouri recently offered to buy several hundred acres of land which had just been seized through foreclosure. He offered an amount that was slightly above fair value based on comparable property sales and which would have covered the loan losses for the lender. But the bank, having restored capital reserve ratios courtesy of the US taxpayer, insisted on holding out for 2007 peak pricing when the property was first purchased. This seems pure fantasy and greed. So, while the developer would have created more construction jobs at the planned development site, the bank insisted that it would be better to keep one bookkeeper a bit busier.


• Consider the financial condition of Federal and State governments. Consider dealers who were never reimbursed by the Federal Government for the clunkers they purchased. Consider how much tax revenues are way down even as over-compensated hordes of government employees have yet to suffer layoffs en masse. Meanwhile, consider those out of work who fail to receive state unemployment checks on time or at all. Consider the states already borrowing from the Federal Government to make these payments. Last, consider those states which are completely insolvent. The list of those is growing. Maybe raising taxes will help? Oh right, people without jobs don't pay much in the way of taxes. Those with jobs may not afford their homes if taxes go up. And businesses cannot grow if their tax expenses increase. What an economic conundrum!


• Consider all these things and then help me see the economic rebound. Help me see why stocks are valued so richly. Help me see how we will avoid more bailouts, more taxes and more inflation, which would only stifle any and all future growth.

In my opinion, we have only one choice. And that choice is right now: Let go! Laissez-faire! Let free markets stand on their own. It may hurt in the short-term, but then too, capitalism might just survive.

The alternative, probably inevitable at this point, is One World Government under One World Currency. Socialism and secularism are upon us. Babylon is on the way. Either this is the culmination of some grand conspiracy wrought by bankers and oligarchs across the globe, or it is simply the result of a lack of plain old common sense. Plenty of dollars, but lack of sense!

A penny for your thoughts? Please discuss the topic here.


Editor's Note: This article should interest investors in Goldman Sachs (NYSE: GS), Bank of America (NYSE: BAC), Citigroup (NYSE: C), Wells Fargo (NYSE: WFC), J.P. Morgan Chase (NYSE: JPM), Morgan Stanley (NYSE: MS), Toronto Dominion (NYSE: TD), Fannie Mae (NYSE: FNM), Freddie Mac (NYSE: FRE), AIG (NYSE: AIG) and PNC Financial (NYSE: PNC).

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