How I Learned to Stop Worrying and Lote the Stock Market

There's no typo in the title. "Lote" is a combination of love and hate. Here's a precis of why that's my current attitude toward the stock market.

By the 'stock market', I mean operating companies as opposed to funds of various sorts, preferred stocks, and other securities that would not qualify for consideration for entry into a stock index such as the S&P 500 or the Russell 2000.

From my start in the financial markets in 1979, I was always oriented toward the stock market, taking a brief timeout only in 1981-2, when bonds were very high-yielding and a severe recession raged and triple-tax exempt New York City bonds made sense for a professional couple earning the munificent combined income of $40,000 yearly.

That pro-stock posture continued until the tech-growth stock/"Nifty Fifty" stock bubble peaked in 2000, and the revelation of widespread corporate fraud at such companies as Worldcom and Enron, plus my own experience with some high-flying local companies, led me to swear that never again would I go all in with common stocks.

I did go half in in spring 2003 and then all out in the summer of 2007.

At this point, with money rates still at or below the price inflation rate in most countries, my posture toward stocks is that I would want to see what would happen if governments simply taxed as much as they spent. What would the effect on economic activity and corporate profits be? I suspect there would be a severe shrinkage of the percentage of reported corporate profits to GDP.

For example, about one out of every six dollars in the U. S. goes to the health care "industry". What would that ratio be without government support? Much less, I suppose.

In fact, the tech sector receives little in the way governmental subsidies. It has to prove its worth to businesses and its attractiveness to consumers every day. Perhaps that is why it has rebounded strongly.

So you can sense the hate part.

Now for the love.

Companies have proven to be decent stores of wealth in high-inflation states, though not as good as gold, silver, or oil. If one is in the (amazingly still small) minority that "gets" what the central authorities are up to, and especially if one is in the yet smaller minority that "gets" that central banks generally do as they are told by their political masters, one will be able to direct one's stock investments more appropriately than people who continue with traditional balanced portfolios or people who make the mistake of looking at dividend yields as indicating value.

When governments are directing their central banks to create money at below-market interest rates, that is usually the time when yield plays start to not work. Think the 1940s and the mid-1960s through January 1980.

Bulls on the stock market will tell you that historically nothing beats the stock market.

As a reliable predictor of the future, of course that statement is irrelevant. Perhaps the historical outperformance of the stock market has used up its future outperformance. Perhaps it's all a random walk. What will tomorrow bring, and tomorrow, and tomorrow? That is the question.

The government of the U. S. has changed. When the Fed was being formed, the issue of issuing currency tied to the issuance of debt was criticized. The Federal government had, after, almost no outstanding debt. Would there not be insufficient debt issuance to allow enough currency to be created?

We all know the answer to that question.

So I would paraphrase Edgar from King Lear (Act V, Scene II), to continue the Shakespearean theme. When I look at the financial markets on a tomorrow-tomorrow-and-tomorrow basis, I think that money-printing is all. Everything else is secondary.

Companies can raise prices over time to adjust for changes in the general price level, and with good fortune an investor may do OK even with companies that see shrinking margins, such as price-takers in the inflation rather than producers of the products (such as precious metals, usually) that see strong price increases.

Thus I lote the stock market.

Copyright (C) Long Lake LLC 2011

Inflationary Signals in More Places

While savers continue to receive, incredibly, shrinking interest rates on money market-type deposits, the money-printing that Dr. Bernanke has been pouring down the gullet of a thirsty Street has been working its usual magic. A case in point is seen in the accompanying graph of a Markit index that relates to commercial mortgage-backed securities. (Click on image to enlarge. Click on AA.4 on the linked Markit web page for this specific index, or click on any other index for a similar price-time display.)

It would appear from this and other charts available on the Markit site that commercial real estate prices, or at least prices of securitized mortgage pools, have joined gold and silver in strong uptrends, or, in the case of CRE, in the reversal of a strong downtrend. Relativistically it's sort of the same thing.

The increase in the money supply over the past few years is working its way gradually through the economy. Wages and employment are reacting slowly, given all the malinvestment that occurred in the U. S. Thus what I suggested in my Fire and Ice post of January 2009 might happen is happening. Here is a quote from that post:

. . . we must consider the possibility of a mixed inflation-deflation. Houses and municipal bonds, which you may own, can continue down in price and the cost of a haircut or cereal, which you purchase can go up. You can lose both ways.

Fire and ice.

The fire of price increases is becoming apparent in the food stores of America. There is nothing more fundamental than food and water (still mostly free) to staying alive, so of course there is no justification for excluding it from measures of living costs. And since so much food Americans eat is processed, the prices we pay for food have relatively little to do with so-called "volatile" costs of the underlying foodstuff. Increases in food prices have everything to do with packaging and transportation costs, lack of "deflation" in total compensation including taxes and benefits, and profit margins.

This blog repeatedly pointed to the "deflation" talk in the media the past months as a deliberate diversion (to use a favorite word of the President) to hide the money-printing that was going to ensue once again. How the 2-10 year Treasury complex keeps trending down in yield is incomprehensible if yields were responding to a free market or unless the "market" knows that something is going to blow, such as BofA pulling a Bear or Lehman. In which case gold is to the moon (and probably Treasuries as well), with the dollar probably moving in an opposite direction.

Once again, the broad stock averages continue in their downtrend compared to gold. Within the stock market, though, divergences in relative value have continued to appear and allow certain stocks to represent good value, it being understood that the flood of "money" that the Fed has created is so large that arguably no important financial asset is truly "good value".

Copyright (C) Long Lake LLC 2010

Irrational Optimism about Housing among Experts; Continued Consumer Pessimism

ABC News reports Economic Pessimism at a Yearlong High:

For the third straight month significantly more Americans say the economy is getting worse, 38 percent, than say it’s getting better, 22 percent. The rest, 37 percent, say it’s staying the same, which for nearly all of them means bad.

The gap between pessimists and optimists has grown from 6 points in July and 11 points in August to 16 points now, its biggest since September 2009. Economic optimism is at its low going even further back, to March 2009.

Stock prices are of course much higher than in March 2009. Contrarians who want to "buy" pessimism should realize that with mutual fund cash at or near a modern record low as a % of assets under management, facts do not support that idea that the stock market is especially either oversold.

There is however some optimism, and some of it may be misplaced.

Some of the optimists who should be realists are real estate experts who should know better. Bloomberg.com reports U.S. Home Prices Face Three-Year Drop as Supply Gains and describes a hold-on-and-wait viewpoint from two interesting players:

Brandi Miner, director of marketing for the Georgia Association of Realtors, is holding back on selling her one- bedroom condominium in Atlanta’s Buckhead district because she has an underwater mortgage. She paid $155,000 for the property in 2005.

“I’m stuck,” Miner said. “I thought it was a stepping stone to a house.”

Miner pays about $1,100 a month for her mortgage plus $225 in condo dues, a higher price than she would spend for a three- bedroom house in a good Atlanta-area neighborhood at today’s prices, she said. Selling now would cost her $10,000 to $15,000, Miner estimated.

“I’m not $200,000 in the hole, thank God,” she said. “But the quarter of the country that’s underwater -- that’s me.”

Ms. Miner would not "cost" her a specific amount if she sold now, other than closing and moving costs. Her home has lost value. Another person who appears to have an optimistic point of view about prices bouncing back is even more surprising:

The slide in values and record-low interest rates may offer some bargains for property hunters. Prices have returned to historically affordable levels, said Karl Case, professor emeritus of economics at Wellesley College in Wellesley, Massachusetts, and co-creator of the S&P/Case-Shiller index. He estimates a bottom for prices in six months. . .

Case is an example of a homeowner waiting to sell because of low demand. He’s seeking to sell the A-frame on 15 acres near Cooperstown, New York, that he bought for $190,000 in 2005.

“I want to keep it if I can’t get what I want,” he said. “It’s a terrific little getaway and I’m not going to give it away.”

In the meantime, all the Fed and Federal programs (including bank forbearance) have kept housing prices above their equilibrium price. Waiting for any specific property to come back to the price you like is quite a gamble. It's like buying Oracle at 30 but it's now 2002, not 1999 and it's and 10, or 20, or whatever. It may never come back.

I am looking for housing to play the role that tech played for years following the tech bust: a deflationary or relatively disinflationary force. I also expect short-term interest rates to stay below the rate of consumer price rises for some time. This could be the 1940s and early 1950s again, with very low interest rates due both to public fear and active purchase of Treasury debt by the Fed coupled with high rate of price rises; let us hope no worse war comes along.

Under this scenario, classic inflation hedges beat general common stocks, and Treasuries are trading vehicles; and cash is trash until and unless the U. S. actually enters a sustained period of generalized price decreases.

Copyright (C) Long Lake LLC 2010

Hedging Against U. S. Dollar Weakness Caused by Federal Reserve Policy

The major theme I am focusing on these days is prospective U. S. dollar weakness and how to invest accordingly as a U. S.-based individual.

You may click on the enclosed charts to enlarge them.


This is Part I, with one or more additional parts to follow.

I think that most investors based in the U. S. continue to have the vast proportion of their assets tied to the dollar, or naturally so if the holding is real estate based in the U. S. Our dollar has been the reserve currency of the world for everyone's investment lifetime . . . but it's been having its ups and downs. Here are some reasons why I have been allocating an increasingly large proportion of my financial assets in non-dollar and anti-dollar vehicles, and commentaries of which vehicles I have chosen.

The case that the U. S. dollar is fundamentally overvalued is well made by John Hussman in a post from a few weeks ago titled Why Quantitative Easing is Likely to Trigger a Collapse of the U.S. Dollar.

Please read the discussion as he presents it. My thumbnail summary is that by suppressing the rates on Treasuries below market via its various debt purchases (creating "inflation" in the Austrian sense of the term), the Fed is inducing markets to rapidly and substantially decide to devalue the exchange rate of the U. S. dollar (the "dollar" herein, as opposed to dollars of other countries such as New Zealand). I agree and want to hedge against a de facto dollar devaluation. This multi-part series begins with a mention of gold and then introduces other assets I have been accumulating for at least six months.

The purest way to hedge against the dollar's decline is by owning currencies against which said decline will occur, as opposed to indirectly doing so by owning stocks of companies doing business in foreign countries.

It appears to me that this trend predicted by Dr. Hussman is playing out quietly under cover of a euro that is at this time even weaker than the dollar. I am not involved in investments that have a short-term focus, however. This is more of an intermediate (months to years) strategy in my mind.

Once again, the commentary provided is mine alone, the opinions are mine, and nothing represents investment advice.

At this juncture in the markets, the ultimate "currency" continues to be gold. Gold has just set what has to be the quietest all-time closing high for a major asset class in memory. I was lucky enough to successfully trade an important intermediate top in gold and described said tactical trades in a post on December 3, 2009. The major reasons for severely lightening up then were that exchange traded gold funds such as Gold-Trust (GTU) had gone to significant premia over net asset value, the pricing appeared extended, and there was lots of excitement about gold on such websites as Zero Hedge.

Now, GTU and the more newly-launched "PHYS" gold ETF are at relatively low premia to NAV and for some time now, there has been little excited talk about gold on Zero Hedge. Compared to December 3, 2009, the metal is much closer to its 200 day moving average and is up year-on-year much less. So I am not inclined to sell any gold. If the comparator investment is a 5-year Treasury yielding almost certainly less than consumer prices will increase, how likely is it that at some point within the next 5 years, gold's price will allow gold-related investments to be sold at a profit that exceeds the return from that 5-year note? I think the probability is very high.

This series of articles is not going to discuss different ways to invest in gold. That will be addressed in the future.

In addition to gold vehicles, I have identified one other commodity in which I have invested, and three other currencies. The commodity is silver, and the currencies are those of Norway, New Zealand and Brazil. The other chart shown above is an exchange-traded fund that provides the return equal to money market rates available in Brazil (very roughly 10%) minus fund expenses, with full currency risk vs. the dollar. Not shown is a similar ETF for the New Zealand dollar, "BNZ".

In contrast, the only way I know to invest from America in the Norwegian kroner is by purchasing Norwegian sovereign bonds through a full-service broker.

Norway is in good part an oil-backed country, so I view its kroner as a form of a commodity currency; New Zealand has a large commodity role given how many sheep and cattle it contains per (human) capita; and Brazil is a special case with a strong chart pattern for BZF.


In Part II, I will discuss silver on its own merits and in relation to gold. Discussion of the above-mentioned countries and their currencies will follow.


Copyright (C) Long Lake LLC 2010

Price Increases Coming

Reuters is providing advance notice that goods made in China are going to become a good deal more expensive soon; and this is expected to occur without an upward revaluation of China's currency vs. the U. S. dollar. From the article:


"Apparel prices are going to go up. It's as simple as that," said Perry Ellis Chief Executive George Feldenkreis, who said a rise of up to 10 percent will be seen next year. "The American consumer will have to accept it."

China looks to be raising its prices of manufactured good to the developed world. While this article is specific to apparel, it's hard to see that the same type of price rises will not be general from China.

The massive expansion of credit that occurred in past years in both China and the U. S. is beginning to bite, even while the American economy remains weak. The silver lining for this country is that imports represent a relatively small part of the overall consumer cost structure. Nonetheless, those economists who are predicting an actual and somewhat chronic fall in the general price level in America to justify very aggressive low yield targets on long-term federal securities have just been provided with a real-world counterexample.

Copyright (C) Long Lake LLC 2010

Markets Churn as Deflationists May Be Overstating Their Case

Even David Rosenberg is buying into the austerity meme. In today's note, he discusses response to bear markets and recessions and says:

So it’s an open question as to where the exogenous positive shock is going to come from this time around, especially with policy rates already at zero and fiscal policymakers more bent on austerity rather than stimulus.

Remember that he is talking about the U. S. But he has it wrong. All we have is some resistance against continuation of the massive deficits, by far the largest peacetime deficits the U. S. has ever run. Properly accounting for the costs of Fannie Mae and Freddie Mac, the deficit exceeds that of Greece, I believe. This ignores the politically contentious future liabilities of Social Security and Medicare/Medicaid/Obamacare. There is no consensus for austerity. In World War II, there was virtually no production of any consumer automobile for the duration of the war. Now that's austerity. The average American uses perhaps 25 times as much oil per capita as the average citizen of India. Austerity? With the obesity epidemic raging? Hardly!

Meanwhile, Barry Ritholtz reprinted an updated graph of ECRI's confidential Long Leading Indicator (click on graph to enlarge), which so far as have been released, has in the past few decades turned down significantly before a recession has come on. It has not done so in a pronounced or pervasive manner, and ECRI predicts no recession to begin in 2010 based on large part on this fact. The shorter index, the publicly released Weekly Leading Index, has in fact turned down sharply.

Since there is now so much concern about a new recession, it's a better time than a few months ago to think of a new up-cycle in the economy, or at least some stability. It would appear that a growth slowdown is baked in the cake, and that the powers that be will likely "stimulate" some more if a recession appeared again, which would then likely propel buying interest in gold and growth vehicles. So the game goes on . . .

So we have, as usual, cross-currents, which the powers-that-be have analyzed more thoroughly than you or I can. So how can one out-think the market? First, it helps to be able to look around you and ignore the hype and understand one's objectives and the goals of the powers that be.

The powers that be want you to trade a lot, so volatility is in their interest. They want price inflation for various reasons. One response is to own assets that defeat those purposes.

These include owning shares in financially strong companies at attractive prices, understanding that stocks as a whole are probably overvalued, but also paying heed to Jeremy Grantham, who agrees that both large-cap and small-cap U. S. stocks are about as poor investments as are U. S. long-term bonds, but that "high quality" U. S. stocks are about the best investments on a 7-year time frame amongst all his listed asset classes (GMO, free subscription).

Here are some dividend-payers that meet the DoctoRx criteria of being high quality, based on Value Line data, and that are doing well operationally. These are Tractor Supply (TSCO), Apple, TJX; and for gold-oriented investors, Newmont (NEM). Who knows, but perhaps all of these can be buy-and-hold investments that prospectively can beat buy and hold of similar quality bonds or cash.

Now that Treasury yields are at Japan level, cash is approaching trash. But anyone who shops knows that prices are rising, except for things that people own and for which buyers usually need large loans, namely houses.

Yours truly is not an investment advisor, and the above is not investment advice. For full disclosure, I bought TSCO today and after hours, it issued a major earnings and sales upside statement. So the stock is up a good deal after hours. If it is not up a great deal tomorrow, I may buy more. Based simply on the "value line" of Value Line, it is easy to see 50% price upside for TSCO within a year, similar to that which I can see as reasonable for AAPL.

Copyright (C) Long Lake LLC 2010

Inflationary Pressures Building

The NY Fed has released its latest Empire State Manufacturing Survey. Here are the portions of greatest interest to me:

In response to a series of supplementary questions on prices, manufacturers estimated that the prices they paid for inputs rose by a little less than 6 percent, on average, over the past twelve months, while the median increase was a more subdued 3.0 percent (see Supplemental Reports tab). (The median and average increases differed so sharply because a few respondents reported price increases of 25 percent or more; these large increases boosted the average but had no effect on the median.) The median increase anticipated for the next twelve months was 4.0 percent, while the average expected rise was 4.6 percent. In assessing past changes in their selling prices, firms reported an average price increase of 2.9 percent and a median increase of 2.0 percent. Looking ahead to the next twelve months, firms predicted a 2.9 percent average increase in selling prices and a 3.0 percent median increase. Most of the price increases reported in this month’s survey were moderately higher than those reported in an identical survey conducted in May 2009. . .

Pricing pressures continued in May. The prices paid index inched up 3 points from last month’s elevated level, reaching 44.7, with 46 percent of respondents reporting that prices had risen over the month, and 1 percent reporting that prices had fallen. The prices received index, at 5.3, remained near the levels of the past several months.

As has been the case for quite some time, margin pressures on manufacturers have been intensifying. Stagflation is here. Meanwhile the U. S. government is spending vastly more than its income. This is creating a false sense of prosperity. If borrowing rates were to go to 5%, which is less than the average rise in input costs seen by the manufacturers in the above survey, what would happen to Federal debt service? How far are the Feds from the debt trap in which borrowing exists merely to service the debt?

Trying to put a "correct" price-earnings ratio on a stock market with this sort of existential threat to a government in what are more or less ordinary times -- no major war, plague, widespread drought, etc. -- is impossible. It is also necessary to look at real assets minus liabilities and then consider that AIG went under (more or less) despite a robust balance sheet. Neither the stock market nor the pricing of Federal securities has a margin of safety. The prices may rise but are speculative.

At least if one owns gold and silver, one owns durable assets that historically have always had a value, which has not been the case for paper "money".

Copyright (C) Long Lake LLC 2010

Bloomberg Announces that Inflation is Dead After Ten Year Treasury Yields Have Fallen 80 Basis Points in Almost No Time

Uh oh. Bloomberg.com has caught on to the drop in Treasury yields in the catchily titled article Strippers Declare Inflation Dead in Zero-Coupon Bond Revival.

Investment banks increased the securities -- created by separating the interest and principal payments of a bond and selling them at a discount -- by 4.4 percent to $179.4 billion from December through April, according to Treasury Department data. It’s the first time that the market expanded for five straight months since 2006.

The best time to buy straw hats is when summer is already leaving. This train has left the station. Price increases may be low. The idea that "inflation" is "dead" is idiotic. More than that, it is impossible. Deadness is a permanent condition precluding life. Not only are price increases still present, they only left briefly, at the bottom of a horrible economic downturn.

The powers that be globally are fighting an anti-deflation fight. Just as 30+ years ago it was reasonable to bet that Volcker would win his anti-inflation fight, it is reasonable that the Fed will get its wish.

Copyright (C) Long Lake LLC 2010

Prices Surging in Britain Likely Foreshadow the Same in the U. S.

Bloomberg.com reports that U.K. March Inflation Accelerates More Than Forecast. Here are some details:

Consumer prices climbed 3.4 percent from a year earlier, compared with a 3 percent increase in February, the Office for National Statistics said in London today. . . On the month, prices increased 0.6 percent. . .

“We have upward pressures from commodity prices and we have yet to see full impact of past weakness of sterling filtering through,” Nick Kounis, chief European economist at Fortis Bank Nederland NV in Amsterdam and a former U.K. Treasury official, said in a telephone interview. “We’re going to see above target inflation persisting in coming months and our base case is for the Bank of England to raise its rate in August.” . . .

Inflation accelerated due to higher prices for gas, fuel, air transport and food, the statistics office said. Transport costs rose 11.3 percent in March from a year earlier, the most since the series began in 1997. Overall inflation has exceeded the central bank’s 2 percent target for the last four months. . .

Core inflation, which excludes costs of energy, food, alcohol and tobacco, unexpectedly accelerated to 3 percent in March from 2.9 percent in February.

The U. S. has been following the same policies following the same sort of housing-centric financial bust as the U. K. The U. S. leading economic indicators were reported yesterday to be at a record, and up more than anticipated. Fed and Federal economic policies remain pro-growth. Why should we not expect the same sort of price increases here that Britain is now seeing?

To that end, gold is rebounding on schedule from its options expiration swan dive two trading days ago. Growth precious metals such as silver and platinum are up more than gold on a percentage basis. Over a full boom-bust cycle, structurally gold is signaling that it will end up stronger than those metals, which are already up much more from their 2008 lows than is gold. Short-to-intermediate term, however, gold:silver and gold:platinum ratios on a 5-10 years trading basis favor silver and gold.

In the 2009 book "Animal Spirits" by Akerlof and Shiller (Democrats), these noted economists continue to promote the benefits of price illusion in keeping the proletariat content. In other words, a wage increase of 2% with general price increases of 4% is supposed to be better accepted by the great unwashed than a wage decrease of 1% and a general price increase of 1%.

This is of course absolutely true for debtors when the principal is unadjusted for inflation. The problem of course is the floating interest rate and the general need of U. S. debtors to stay in debt; thus in effect the principal tends to float as well.

The main point though is that government policy is favoring inflation from a variety of directions. Interest rate increases are coming. The longer they are delayed, the more the precious metals have a tailwind.

Copyright (C) Long Lake LLC 2010

Even the Tough Talkers on the Fed Are Inflationists

In reporting Fed Governor (Kansas City Fed) Thomas Hoenig's speech today, Bloomberg.com restates the obvious: Hoenig Says Fed’s Objectives Threatened by U.S. Debt.

Well, duh!

“It is a fact that the current outlook for fiscal policy poses a threat to the Federal Reserve’s ability to achieve its dual objectives of price stability and maximum sustainable long- term growth, and therefore is a threat to its independence as well,” Hoenig said today in a speech in Washington. . . .

Hoenig criticized a comment published last week from Olivier Blanchard, the International Monetary Fund’s chief economist, that central banks should increase their targets for inflation.

“While this may sound like a reasonable theory from a credible economist, my concern is that it rationalizes solutions to short-term problems that too often take an economy down the wrong path,” Hoenig said.

Governor Hoenig believes in a slower rate of debasement of the currency than some, such as Drs. Blanchard or Krugman, that's all.

But it's all a matter of degree; how best to shear the sheep(le). Dr. Hoenig is just less of a money-printer than is Dr. Blanchard. But as the title of the article suggests, the Fed has no choice, like it or not, but to cooperate in whatever deficit financing the powers that be decree. If money printing AKA quantitative easing is required, Dr. Hoenig is with the program.

Meanwhile, gold went from strength to strength today, though at the end of the day, the retail vehicle GTU mildly outperformed GLD even though GTU is at a generous premium to NAV of 7.5% and thus reflects small investor optimism. More importantly, gold has been more consistent than stocks during this period of credit shenanigans. Closing prices from the ends of 2007, 2008 and 2009 and then today's close for GLD are (in USD):

82.46, 86.52, 107.31, 109.66.

For the SPY ETF that tracks the S&P 500, the same numbers are:

146.21, 88.97, 111.44, 109.74.

Stocks, which should be stabilized via dividends and being able to roll with inflation/deflation, have been far more volatile than gold, although gold scares the average investor more.

The debt monster is coming to eat us up.

If the Fed stopped enabling the Feds, they couldn't run giant deficits without end.

Meanwhile, Gallup continues to show essentially no job creation that is visible to average workers--in the 26th month since the official beginning of the Great Recession/depression.

Deficits have ceased to stimulate. Polls show that the public "gets it". Does the Fed?

I think not.

Interim rallies associated with money printing and post-depression natural rebounds, it will take some really good fortune such as an end to foreign wars and some hot new truly useful technologies (cheap distributable green energy sources, etc.) to fundamentally help matters heal here. We can hope for the best while dealing with that that is.

Copyright (C) Long Lake LLC 2010

Pak-Ghanistan Update: Spies Everywhere; and Market Comments

The investigative reported Gerald Posner has reported bad news about the bombing in Khost, Afghanistan that recently killed seven CIA agents in the article, Did Pakistani Spies Help CIA Bomber?:

Early evidence in the December 30 bombing that killed seven CIA agents suggests a link to Pakistan, two senior Afghan sources, including an official at their spy agency, told The Daily Beast. The pair said that U.S. has already taken a chemical fingerprint of the bomb used by a Jordanian double agent in the attack, and that it matches an explosive type used by their Pakistan equivalents, the Directorate for Inter-Services Intelligence, or ISI.

The bomb’s provenance was an immediate concern after the attack, which took place in a remote base in eastern Afghanistan called Camp Chapman, because of its compact power. Most suicide attacks involve a bulky vest or belt. “It is not possible that the Jordanian double agent received that type of explosive without the help of ISI,” a senior government aide to President Hamid Karzai told me.

This underscores how confusing the local politics are. In Afghanistan, who might be the native "freedom fighters" vs. imported foreign jihadists or mercenaries is impossible for us to know. And after all, the U. S. brought in its own types of mercenaries in the form of the French in our war of independence.

The more complex and global al-Qaeda gets, the more the U. S. assets and efforts get stretched. Unlike in 2001, this is occurring at a time of tremendous stress on the U. S. economy and governmental finances. Make no mistake, no matter what the preliminary December jobs numbers turn out to be today (and recall there are two surveys reported together, the establishment and household surveys), there is now an underlying pro-inflation bias in our economy for years to come that will be bad for bondholders, good for gold and bad for the real economy. Would the al-Qaeda movement survive both bin Laden and Zawahiri leaving the scene one way or the other? I dunno, but we need to prepare for war without end.

As an aside, the Israeli-based generic company Teva (actually 30% of its business is from branded products) announced yesterday at a company meeting in New York that its 5-year goal is 14% compounded growth in sales and profits. Its Value Line chart shows massive underperformance relative to the general stock market in 2009, despite having an up year to record highs. I thus went back into the stock. It is global, defensive, raises the dividend, has successfully completed transition to a new CEO, and could be taken over by a global pharmaceutical giant. Unfortunately for its downside, it has more or less no tangible net worth, having grown in large part by acquisitions, so I couldn't sleep at night with much of my own "tangible" net worth in the stock, but in most scenarios, I expect that the company will likely meet or exceed its expectations and that its P/E is quite reasonable at about 12.5X projected 2010 earnings. Thus a mid-case scenario is for 15% total return counting dividends on a 5 year buy and hold strategy. Of interest is that this exceeds by central expectation for gold prices, which with a huge capability for variability I target at 7% per year, as that is a long-term rate of nominal GDP growth. (Interestingly, GLD as of now GLD will open right around $110, which is the equilibrium price I suggested a month ago when I called a short-term top in gold prices. I believe that long-term buy-and-holders can enter here, though the price premium in the ETF in GTU is a bit disconcerting and reflects just a bit more optimism than I prefer to see. Also interesting is that GLD and SPY are roughly tracking each other in what I view as a potential long-term equilibrium relationship as well.)

Copyright (C) Long Lake LLC 2010

Monday Evening Review

Your humble blogger has been 4+ busy catching up on the torrent of commentary on the macro situation, as well as evaluating specifics. Here are a few observations.

Technically, the S&P 500 (ETF = SPY) looks as if it has broken bullishly to the upside from the rounded dome it was forming off of last March's low, a chart formation which the best of the large banks (JPM and WFC) remains in. The leading stocks are techs with their own breakouts, such as ORCL and IBM which were highlighted here recently; certain specialty companies such as TEVA and BUCY; and a number of others. A number of stocks are in record territory. The stock market is acting very much as it did after the horrendous 1974 bottom(s), though then the problem was rampant price increases and shortages, and now the problem is wage cuts and commodity price increases without shortages. In 1976, stock prices hit new nominal highs, but the underlying economic problems led to years of real declines in stock prices, only bottoming 6 years later adjusted for inflation. The same thing could well be happening now, though as of today, the risk of price declines remains, perhaps just as unthinkable as 21% interest rates and sustained double digit inflation appeared in 1976.

The weekend remarks by Fed Chairman Bernanke suggesting no tightening any time soon (many think 2011 is the earliest) may have added to short-covering in the precious metals to send gold up over 2% and silver up 4% today. Fundamentally, the decision of the Fed and the Treasury to backstop all Fannie/Freddie losses may have added to the resolve of the gold bulls to buy and hold gold until fiscal responsibility returns a la Mr. Volcker 30 years ago.

If you read John Hussman's latest letter, Timothy Geithner Meets Vladimir Lenin, which reviews his prior thinking and which I recommend, you may have your faith in the U. S. government tested assuming you have a modicum of faith before you read it. Dr. Hussman is looking for about 7% annualized inflation over the next decade, though not beginning immediately. His reasoning is powerful but does NOT tell you not to own intermediate terms bonds now.

Meanwhile, David Rosenberg has returned from a trip to Israel and elsewhere, a bloodied bear but unbowed. He returns with a (free) subscription only lengthy argument for economic weakness being the predominant condition in this country, is bullish on gold vs. our dollar, and argues for deflation being the current major problem.

The Discover Small Business Watch is out for December. Consistent with November's survey and the NFIB November survey, business remains poor and worsening for its respondents:

The number of small business owners who think the economy is getting worse was down to 49 percent from 53 percent in November; while 24 percent of small business owners see the economy staying the same, up from 16 percent in November; 25 percent see the economy getting better, down from 28 percent in November; and 2 percent are not sure.

22 percent see conditions for their own businesses getting better in the next six months, an improvement from 19 percent in November; but still in contrast to the 52 percent who see conditions getting worse, 24 percent who see things staying the same, and 3 percent who aren't sure.

35 percent rate the current economy as fair, up from 30 percent in November; while 61 percent rate it as poor, and 4 percent rate it as good or excellent.

18 percent of owners say they will increase spending on business development activities such as advertising, inventories and capital expenditures in the next six months, 26 percent will make no changes, 51 percent plan to decrease spending, and 5 percent are not sure.

51 percent of owners have experienced cash flow issues in the past 90 days, down one percentage point from last month; 45 percent of owners have not experienced cash flow issues, and 4 percent aren't sure.

Finally, Gallup.com's polling continues to find that its respondents are seeing no net hiring at the companies at which they work. This parameter remains about as bad as it has been over the past 13 months.

To summarize, cheap short term money appears to be used to speculate in the financial markets, but not enough economic activity is really happening to be consistent with a strong, solid economy.

Who knows what the powers that be will do, but my bet is that they will continue to do what they have been doing, which is to utilize the power of the government to benefit Big Finance at the expense of the rest of us.

Where are Big Financiers putting their winnings? If you think most of it is going into 3.8% 10 year Treasuries, think again. Some, of course, will do so. I'm still thinking Swiss gold vaults that have run out of storage space.
Is gold overbought? Technically, not any longer. Is it overpriced? With unlimited U. S. dollars having gone to or having been pledged to go to bail out bondholders and stockholders of private companies, and with gold's cost of production said to be $800/ounce, it is hard to argue that it is too high in terms of dollars. Yet most Americans own little or no gold and those investors who do have in general at most 5% of their net worth in it. Yet most American investors own lots of stock even though the insiders in public companies haven't been on the buy side for about a year.

Copyright (C) Long Lake LLC 2010

America as Amerika in Pakistan

Because of the potential financial ramifications, this blog has been reporting and commenting from time to time on events in "Pak-ghanistan". In an otherwise unremarkable article on more Predator drone killings of militant, the Karachi-based "Nation" newspaper ran the accompanying editorially loaded graphic showing a Predator drone as an angel of death. "The Nation" may be the country's leading English-language newspaper and thus reflects and intensifies the unpopularity of our country in Pakistan.

You may have read about the homicide bomber killing civilians of a pro-government town yesterday, with the count now over 100 dead. You may also have read about the U. N. beginning to pull out of Pakistan.

To this veteran of peaceful protests against America's military actions in Viet Nam, these and other events in this region are disquieting. The most technologically sophisticated power on earth is raining death on what the Pakistanis appear to regard as hillbillies who, prior to U. S. involvement in the region, were left alone to do their thing.

In a sense, Pakistan is to our war in Afghanistan as Cambodia was to our war in Viet Nam. That one ended tragically for the Cambodians as well as for us. Today, the U. S. is probably more disliked both in Pakistan and Afghanistran than it was in South Viet Nam or Cambodia, and we have allied ourselves with distasteful regimes in both countries whose virtues may simply be that they are less distasteful than their opposition.

This sounds like a chancy situation that may have a variety of macro results, ranging from an inflationary U. S. escalation in the region to some sort of quick resolution followed by pull-out to more indecisive war slowly bleeding all involved. Most scenarios are not friendly either to the U. S. economy or the price of Federal debt.

Copyright (C) Long Lake LLC 2010

JFK Adviser Compares Afghanistan to Viet Nam

This financially-oriented blog has focused on the Pak-ghanistan war(s) because of my belief that escalation there could lead to as much inflation at home as the guns-and-butter strategy of LBJ led to with his escalation in Viet Nam. An informative, interesting and brief post has appeared by John F. Kennedy's closest adviser, Theodore Sorenson, titled America's Next Unwinnable War. I recommend it is a good read from a variety of standpoints.

Mr. Sorenson makes the case that Afghanistan is close to being Barack Obama's equivalent of Lyndon Johnson's Viet Nam.

The U. S. historically has only had significant inflation during major wars or in the aftermath of the few losing ones, such as Viet Nam.

With the entire force of government and its creation the Fed committed to steadily destroying the real purchasing power of the dollar you have in your wallet, gold cannot lose nominal value in the very long run unless they fail miserably in that goal; but gold can be a poor investment nonetheless.

If the U. S. ramps up much further in Afghanistan, and continues to bribe/coerce Pakistan to do the same internally, look for domestic price increases to exceed expectations.

Copyright (C) Long Lake LLC 2009

A Military Man Argues for Ramping Down in Afghanistan, Though Not to Zero

This blog has mentioned the potential inflationary implications of a serious ramp-up in the U. S. military effort in Afghanistan. I have pointed out how all important inflationary periods since 1900 have coincided with U. S. wars or their aftermath. (Perhaps the end of the Carter era was an exception, though I would say that the inflation of the late 1970s can be traced to the Vietnam War and a guns and butter policy, with pro-inflationary Fed policies and strange U. S. support for the oil price increases of the mid-1970s adding fuel to the flame.

In any case, the President's hand-picked commander in Afghanistan, General McChrystal, wants more troops.
A powerful rebuttal to this strategy from Ralph Peters, appears in today's New York Post; click HERE to read it. Here's a part of this brief piece:

Meanwhile, we've forgotten why we went to Afghanistan in the first place. (Hint: It wasn't to make nice with toothless tribesmen.) Here's a simple way to conceptualize our problem: A pack of murderous gangsters holes up in a fleabag motel. The feds raid the joint, killing or busting most of them. But some of the deadly ringleaders get away.

Should the G-men pursue the kingpins, or hang around to renovate the motel? Common sense says: Go after the gangsters. They're the problem, not the run-down bunkhouse.

It's especially interesting to find an anti-war point of view from someone who is often associated with the opposite.

The President, having stressed the great importance of some form of success in Afghanistan in August, is reportedly unsure of whether to authorize more troops there. From an economic and financial standpoint, at least for the immediate future, matters will be stabler in the U. S. if he reverses course and listens to Colonel Peters. And if the decision is to ramp up the military effort further, the economy needs it to please be funded properly-- meaning not with debt--as the Democrats used to complain about the Iraq War just a few years ago.

(This post is not spefically agreeing with Col. Peters, as EBR tries not to make sweeping comments about large geopolitical issues involved in this issue, as its focus is on economic and financial issues, with occasional exceptions for DoctoRx to comment on health care.)

Copyright (C) Long Lake LLC 2009

Trends Reversing and Implications Thereof

The content on Jesse's Cafe Americain has been informative lately. Not surprisingly, the personal income chart mirrors another one also from www.contraryinvestor.com, on retail sales.

These long downtrends will be in force until they are not. One would at the least expect a snapback, given the extreme nature of the recent declines.

This expected snapback is to a large extent priced into retail stock prices, which now sell with low dividend yields and generally high price to book and price to earnings ratios. Not that the stocks will not rise; I have no idea about Mr. Market's mood or the short or long-term "fundamentals".

Looking back to the left hand side of these charts, one sees that as the years went by, a rising trend of personal income had sharp setbacks. The dominant fear throughout much of that time was literally of a return to the deflationary depression years of the 1930s. A quarter of a century after the worst of the 1932-33 stock and economic cycle is now known to have passed, Benjamin Graham, who mentored Warren Buffett at Columbia and was one of the truly great investors of the 20th century, was able to find numerous NYSE stocks selling for less than cash on hand. This at a time when a multi-year bull market had been in force! It is much easier in hindsight now to have "bought" those dips in income than at the time.

Based on today's data on capacity utilization and industrial production, it would appear that these have hit bottom for the nonce. Paradoxically, the greatest investment opportunity from a risk and reward perspective could be in the major asset class that has performed the worst this year and that one might think suffers from the bottoming of the production cycle: longer term Treasury bonds.

They are both despised and "under-owned" by the public. Even bears such as Robert Prechter advise people to sell stocks and buy ultra-liquid very short-term debt instruments (T-bills), not bonds. Yet a cyclical industrial recovery and an upturn in personal income (or at least a cessation of the decline) means less contra-cyclical government spending, and thus a (relative!) shortage of bonds to a market that has been absorbing unprecedented supply.

Historically, T-bond yields bottom well after a recession/depression ends. The post-Great D low in bond yields was in 1940 or after. The prior 21st Century T-bond low came over a year-and-a-half after the shallow recession ended in 2001. Not that the 30-year T-bond makes sense anywhere the 2.5% it hit last December, but the 10-year is different. It would not be prudent to put all one's money in such a debt instrument given the inflation risks, but consider the following analogy. The great bridge player Marty Bergen says that the bridge point system in which an ace rates 4 points, a king 3 points, a queen two points, etc. underrates the value of the ace.

Similarly, even the fine economists such as David Rosenberg who recommend corporate bonds based on their spread over Treasuries miss the point in their public analysis. U. S. Treasuries are, like it or not, special. All the other bonds must be judged on their absolute yield and riskiness and not on the yield difference over Treasuries.

From a technical basis, the long decline in corporate bond yields has ended. The bull market for Treasury debt remains intact. The CPI is reported to have dropped 2% y-o-y as of July, the sharpest drop since 1950. Thus the instantaneous "real" yield on a 10-year Treasury is 5.5%.

Markets exist in part to surprise the greatest number of people. Can Treasuries (TLT on the NYSE and zero-coupon bonds OTC) truly be vehicles for capital gains as well as safe income?

Time will tell.

Copyright (C) Long Lake LLC 2009

Financial Markets Duel With Reality

We have a busy post this morning. First, from Zero Hedge. Note that the italicized part is from the COP report itself, and the non-italicized part is Tyler Durden's commentary:

August COP Oversight Report: $658 Billion In Total Level 3 Assets, Small Banks Need "To Raise Significantly More Capital"

Submitted by Tyler Durden on 08/11/2009 08:27 -0500

The Congressional Oversight Panel has released its August report which contains some much more dire language about the prospects of the U.S. banking system than did the joke that was the Stress Test, especially in the small/middle bank sector.

The Panel‘s analysis of troubled whole loans suggests they pose a threat to the financial health of smaller banks ($600 million to $100 billion group). Using the same assumptions, it looks as if banks in the $600 million to $100 billion group will need to raise significantly more capital, as the estimated losses will outstrip the projected revenue and reserves. Under the "starting point" scenario, this second group of banks will need to raise $12-14 billion in capital to offset their losses, while in the "starting point + 20% scenario", non-stress-tested banks are expected to have to raise $21 billion in capital to offset their losses. The capital shortfall for those relatively smaller banks is primarily due to the lack of reserves, which on average account for only 25 percent of the expected loan losses.

Another useful data point is the disclosure on the total Level 3 Asset Exposure at March 31, 2009. Compliments of the FASB, over $650 billion in "assets" are being marked-to-model, and most likely overestimate the true worth of these assets by about 50%. That's $300 billion in hot air on the banks' balance sheets.

DoctoRx here now. Moving along . . .

Jonathan Weil has an informative Bloomberg.com writeup on this topic, which includes complex financial institutions of any size, in Next Bubble to Burst Is Banks’ Big Loan Values. It begins with a "teaser":

It’s amazing what a little sunshine can accomplish.

Check out the footnotes to Regions Financial Corp.’s latest quarterly report, and you’ll see a remarkable disclosure. There, in an easy-to-read chart, the company divulged that the loans on its books as of June 30 were worth $22.8 billion less than what its balance sheet said. The Birmingham, Alabama-based bank’s shareholder equity, by comparison, was just $18.7 billion.

So, if it weren’t for the inflated loan values, Regions’ equity would be less than zero. Meanwhile, the government continues to classify Regions as “well capitalized.”

The report is concise and interesting.

Meanwhile, the discordance between facts "on the ground" as we are shown them and the abstractions of stock traders continues, as Bloomberg.com also reports Global Confidence Increases on Signs Recession Is Nearing End and Stock Bulls Increase as Survey Shows Most Optimism in Two Years. The latter has a quote that points out that the professionals are aware of the momentum nature of this rally:

“The more stocks go up, the more optimism there will be,” said Alberto Espelosin, who helps manage about $10 billion at Zaragoza, Spain-based Ibercaja Gestion and was among 1,375 participants in the survey.

He is likely referring to the public.

Finally, back to the real world, there is the world's largest retailer, Wal-Mart, which just reported a challenged quarter, with same-store sales declining year-on-year and coming in below the company's own predictions. Also from Bloomberg.com:

Sales at U.S. stores open at least a year fell 1.2 percent after the retailer had forecast them to remain little changed or rise as much as 3 percent. The cost of sales declined 2.5 percent to $75.2 million.

As of now, the price inflation is in equities, not in the real world.

Copyright (C) Long Lake LLC 2009

Proof of Expanding War in Afghanistan

From the Washington Post: Analysts Expect Long-Term, Costly U.S. Campaign in Afghanistan

As the Obama administration expands U.S. involvement in Afghanistan, military experts are warning that the United States is taking on security and political commitments that will last at least a decade and a cost that will probably eclipse that of the Iraq war. (emph. added)

After presenting some statistics, the article gets to the other point: get ready:

Military experts insist that the additional resources are necessary. But many, including some advising McChrystal, say they fear the public has not been made aware of the significant commitments that come with Washington's new policies.

"We will need a large combat presence for many years to come, and we will probably need a large financial commitment longer than that," said Stephen Biddle, a senior fellow for defense policy at the Council on Foreign Relations and a member of the "strategic assessment" team advising McChrystal.

This will be inflationary.

Team Obama is now trying to persuade the Congress and public on the merits of the following huge projects:

Cap and trade;
Health care (health insurance) "reform";
Limitless war in Afghanistan;
F-reform (F = financial or the F-word, take your pick);
Stimulating the economy.

Not to mention smaller bore stuff such as prosecuting CIA operatives for alleged criminal acts, doing away with Guantanamo, etc.

And then you recall that various "stimulus" projects are stalled because a buy-American provision in the "stimulus" bill means that a unique GE filter made in Canada cannot be purchased, and you understand that for any project, the devil truly is in the details.

Copyright (C) Long Lake LLC 2009

Bank of England Loves Inflation

This is a bit scary from the Bank of England today:

In the light of the Committee’s latest Inflation Report projections and in order to keep inflation on track to meet the 2% inflation target over the medium term, the Committee judged that maintaining Bank Rate at 0.5% was appropriate. In the light of that outlook, the Committee also agreed that it should extend its programme of purchases of government and corporate debt to a total of £175 billion, financed by the issuance of central bank reserves. The Committee expects the announced programme to take another three months to complete. The scale of the programme will be kept under review.

The Committee noted that the increase in the scale of the programme would necessitate an increase in the range of maturities of government debt that the Bank was willing to purchase. That is explained in an accompanying market notice.

It's news to me that the BofE, and therefore likely the Fed, is so committed to non-deflation that it will print money--debasing the currency-- at a time when inflation was 1.8% (per the statement). Does anyone really think that in a large complex economy such as Britain's, it is possible to measure the inflation rate with such great precision? Worse, what's wrong with letting savers actually have a positive return on their savings?

The Bank of England should stop manipulating interest rates to pump up the credit bubble again, and so should the Fed.

Copyright (C) Long Lake LLC 2009

What Are We Doing in Afghanistan? (And How Will the Answer Affect Your Investments?)

The increasingly expensive effort in Afghanistan could spin into a Vietnam-style mess, which is why a financial web site is paying attention to it. History suggests that if the U. S. stays at peace, the economy will trend upwards without inflation. A little war will be insignificant to the giant U. S. economy, but another Iraq-style war will be meaningful. It will distort production to armaments and raise the inflation level while crowding out important spending, such as on health care. Consider U. S. increasing counter-narcotics efforts in Afghanistan from the L. A. Times, which begins:

The U.S. government is deploying dozens of Drug Enforcement Administration agents to Afghanistan in a new kind of "surge," targeting trafficking networks that officials say are increasingly fueling the Taliban insurgency and corrupting the Afghan government.

The move to dramatically expand a second front is seen as the latest acknowledgment in Washington that security in Afghanistan cannot be won with military force alone. . .

The Obama Administration should directly inform the American people what its strategy and objectives are in Afghanistan. What would prevent an escalation from mimicking LBJ's in 1965, though he posed as the peace candidate in the 1964 election? It's a large leap from preventing another 9/11 - the original reason to send troops to Afghanistan in 2001 or capturing UBL- from intervening in the drug trade in one of the poorest countries in Asia. We need to know the exit strategy, what an acceptable result is, what the U. S. does if the pitiful Kabul "government" does not step up to the plate, and the like.

The future of your investments will turn on matters that are not now on the front page. Everyone and his/her brother/sister "knows" that the "recession" has either ended (Merrill Lynch and others) or is ending soon (ECRI and almost everyone else) or soon enough (Roubini). You cannot make a dime investing thusly. If you believe that all these guys are wrong and the economy will keep shrinking well into next year, you can make a fortune shorting stocks and not getting jerked out of your bear positions on the up-move(s). I propose that a less risky way to conserve and increase your net worth is to follow the issues that are not on the front burner.
Watch the Af-Pak region. The more it looks like a quagmire into which the U. S. gets sucked, the more you should sell all Treasury securities other than shot-term bills and instead buy gold, oil and the other stuff that worked when Viet Nam and Iraq were hot enough to matter. If things go our way, then tend to invest in the opposite direction.

Copyright (C) Long Lake LLC 2009