March 3, 2014

If You Build It, They Won’t Come: Opinion

Posted in business, Capital, cost of living, Economic Growth, Economy, Federal Reserve, generation, government, income gap, industrial economy, Inflation, investment advisor, investment banking, investments, job market, labor force, Labor Market, large business, medicare/medicaid, National Federation of Independent Business's, revenue, Robert Barone, small business, social media, social security, taxes, Unemployment, wages, Wall Street at 8:31 PM by Robert Barone

It is not the strongest of the species that survives, nor the most intelligent, but the one most responsive to change.– Charles Darwin

I am often asked: “When do you think the economy will return to normal?”

My response: If by “normal” you mean what we had from the 1980s to 2008 — the “if you build it, they will come” economy — the answer is, not anytime in the foreseeable future.

The economic environment has permanently changed, and businesses that don’t adapt to the new environment will become extinct like dinosaurs. Think about Kodak and Polaroid. They were big, strong and probably smart, but they didn’t adapt.

Slower Growth

In the new business environment, economic growth will be much harder to achieve, the income gap will continue to grow and bigger and more intrusive governments at all levels will demand more revenue.

In mid-February, the Congressional Budget Office concluded that potential economic growth for at least the next 10 years will be much lower than what we have experienced for the last few decades. They attribute this to the health system known as Obamacare as well as disincentives to work.

A Growing Income Gap

The growing income gap is well documented. What’s not well documented are the causes.

There are two major ones starting with government policy. Federal Reserve money printing, for example, benefits the most affluent and Wall Street’s financial institutions. Government policy to under-report inflation (which began in earnest in 1994) reduces budget deficits by limiting payouts to Social Security and Medicare recipients and saves interest costs on the debt. But it has kept wage rates from keeping pace with inflation.

If inflation has been understated by just three percentage points per year since 1994, then wage earners, who have only received “cost of living” adjustments, have lost 55% of their purchasing power. No wonder both spouses have to work (some with two jobs) and still have a hard time making ends meet.

But, there is another factor at play here. In the Industrial Revolution, innovation benefited all workers. It wasn’t hard for workers with little formal education to learn how to operate machine tools, and they could master skills needed in the new industrial economy.

But, that is not true today. In fact, the National Federation of Independent Business’s surveys have for some time now shown an increasing trend that businesses cannot find the skills they need. As a result, jobs go unfilled. The jobs that are available require skills only learned through and intensive educational process, such as majoring in engineering or computer science at a university.

These are the folks who are getting the high paying jobs. Those with few or no skills must take much lower-paying service type or minimum wage jobs. In the latest unemployment survey, the unemployment rate among college graduates was 3.3%, for those with high school degrees it was 7.3%, and for those with less than a high school diploma, it was 11.1%. Thus, it appears that the nature of the new technology revolution is also contributing to the income gap.

Other Endemic Factors

For the past five years, multinational corporations have been hoarding cash. Capital expenditures are at their lowest growth levels in six decades. Perhaps these large businesses have recognized that growth will be slow and that revenue growth will be a function of acquisitions.

Finally, new laws, regulation and taxation strangle small businesses — the recognized driver of economic growth for the past 60 years. The stranglehold that regulators have on community banks that restricted lending to small businesses is just one example.

Unfortunately, instead of recognizing that government policies have both slowed the economy and widened the income gap, politicians are likely to use these as wedge issues. So it appears that more regulations and increased taxation on small businesses and higher income earners is certain.

The Survival Mentality

In such a tough, low growth environment, businesses must be more innovative. For instance, 80 million Millennials (those between 15 and 35 years old) will soon have more spending power than any other generation in history. The common characteristic of this generation is they make spending decisions only after consulting social media (friends, Web sites, comments from strangers).

Businesses have to recognize this and play in that space. This generation also has different attitudes toward such things as cars. They are more interested in convenience and access than ownership. In addition, the recognition that the more highly educated are likely to have the disposable income may dictate marketing strategy.

In conclusion, don’t expect a return of the “if you build it, they will come” economy. Without an approach that is fundamentally different from what has been the norm for the past 30 years, many businesses will become extinct.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Contact Robert Barone or the professionals at UVA (Joshua Barone and Andrea Knapp) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

February 24, 2014

What’s Inflation? It Depends on the Definition

Posted in asset inflation, Banking, Big Banks, CPI, Federal Reserve, Inflation, investment advisor, investment banking, Markets, Nevada, Quantitative Easing, Real Estate, Robert Barone, Wall Street at 8:55 PM by Robert Barone

One of today’s economic myths is that the money that the Federal Reserve has created through its quantitative easing programs has not found its way into the money supply, and, as a result, no significant inflation has occurred.

The theory is that QE has only resulted in bank reserve creation, but little new money. Money and Banking 101 takes students through the “money multiplier” concept, where $1 of excess reserves can turn into $10 of new money if reserve requirements are 10%. Because there has been little net new bank lending since the Great Recession, the conclusion has been that there has been little money growth, and, therefore, minuscule inflation.

Those who tout this theory simply don’t understand how the money creation process works. In addition, inflation isn’t just measured by the narrowly defined and downwardly biased Consumer Price Index. Inflation means prices are rising, and, as I show below, we have plenty of that.

Money Creation

To show how the process actually works, assume that Citizen X buys $100,000 of securities from Citizen Y, and pays for it with a check drawn on X’s account at Bank XX. Citizen Y deposits the check in Bank YY. In this example, no new money has been created. An existing deposit at Bank XX was transferred to Bank YY.

Now assume that the Fed is the buyer of the $100,000 asset from Citizen Y. When Y deposits the check into his or her account at Bank YY, reserves in the banking system do rise by $100,000 as Bank YY ends up with a new deposit at the Fed.

But, also note that Citizen Y now has $100,000 in a deposit at Bank YY, a deposit that did not exist in the banking system prior to the transaction. Going back to Money and Banking 101, while the $100,000 may not be “multiplied” into $1,000,000 because the banks aren’t lending, the first step — the creation of $100,000 — did, indeed, occur.

The explosion in the assets on the Fed’s balance sheet of more than $3.3 trillion since the beginning of the QE process has resulted in the creation of at least that much new money. Using a back-of-the-envelope calculation, the change in currency in circulation as well as demand and savings deposits at commercial banks since the start of QE has been about $4.2 trillion. Net loan growth at those institutions has been about $1.1 trillion.The $3.1 trillion difference is, as expected, close to the growth of the Fed’s balance sheet.

Asset Inflation

So, why haven’t we had inflation if the money supply has grown so much? Well, we actually have had inflation. The only place we don’t find it is in the Bureau of Labor Statistics’ CPI calculation.

But, rather than dwelling on this single measure, consider that the form that inflation — rising prices — takes very much depends on what Citizen Y does with the newly created money, and what those who receive the money from Y do with it. More concretely, the Fed purchases from the large Wall Street institutions. So, it is likely that we will find inflation if we followed the path of the newly created money from those institutions.

As I have been discussing, about 25% of the newly created money over the past five years has gone into net new lending. Where did the rest of it go? It is a pretty sure bet that, given that these are Wall Street banks, much of it went into the equity and real estate markets. Equity prices as measured by the S&P 500 have risen by 150% over the five-year period, and by 29.6% in 2013 alone. Meanwhile, real estate prices as measured by the Case-Shiller 20-City Composite rose 13.7% last year.

It is also a pretty sure bet that the newly created money found its way into the emerging markets, where interest rates have been higher and the Fed’s promise of low U.S. rates for a long period of time (known as the “carry-trade”) significantly reduced the risk of the trade.

The latest 12-month official data show that inflation in Brazil is 5.6%, in India 8.8%, in Indonesia 8.2% and in Turkey 7.8%. Of course, we are all aware that the currencies of these countries have been crushed over the past six weeks, as hedge funds and other large investors have, en masse, withdrawn their funds as the prospect of a Fed tapering has become reality, along with expected rising rates.

Despite the so-called taper, the Fed continues to create a huge amount of money each month. Currently it’s $65 billion. This money has to find a home. It appears to be more than coincidental that, despite a 5.75% mini-correction in the equity market in January, prices have once again continued their upward trek.

Conclusion

More than $3 trillion of new money has been created by the Fed. It is sloshing around and causing prices to rise in equities, real estate and, until recently, in emerging markets. The money now coming out of the EMs will find another investment, causing those asset prices to rise.

We have inflation: asset inflation. The Fed continues to create money which finds its way into the financial markets. Is it any wonder why Wall Street loves QE and hangs on every word from the Fed? If history is any guide, asset inflation will continue as long as the Fed is printing. Just think what could happen to the money supply and inflation if the banks actually start to lend again.

And what might happen to asset prices if the Fed ever started to tighten?

 

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Contact Robert Barone or the professionals at UVA (Joshua Barone and Andrea Knapp) are available to discuss client investment needs.  Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

February 12, 2014

US Economy: Stealth Inflationary Pressures Are Not Yet Priced Into Markets

Posted in Banking, Capital, CBO, Congressional budget office, deflation, Economic Growth, Economy, emerging markets, establishment survey, Europe, Finance, GDP, Inflation, investment advisor, investment banking, investments, job market, labor force, Labor Market, obamacare, payroll tax reductions, Robert Barone, small business, Unemployment at 5:18 PM by Robert Barone

In countries where central banks are printing money, such as the US, UK, eurozone, and Japan, deflation is the fear. On the other hand, inflation is high in countries where central banks have followed more traditional policies, like Brazil (official inflation 5.9%), India (11.5%), Indonesia (8.4%), and Turkey (7.4%). One explanation is the carry trade. Because the central banks of the developed world promised low rates for the long term, the liquidity created by those central banks found its way into the economies of the emerging markets (EM) (read: borrow at low interest rates, invest at high ones). Unfortunately, most of those funds did not find their way into capital investment in those markets, but was instead used for consumption, which has played havoc with EM trade balances. When the demand side (usually measured by GDP) outstrips the supply side (potential GDP), inflation occurs. Now that the bubble in EM countries, caused by excess liquidity in the developed world, is starting to burst — investors no longer believe the carry trade will last much longer — what will become of all of that liquidity?

On February 4, the Congressional Budget Office (CBO), a supposed non-partisan government agency, released a shocking report, “The Budget and Economic Outlook: 2014 to 2024,” projecting that over the next 10 years the Affordable Care Act, commonly referred to as Obamacare, would reduce future employment rolls by more than 2.3 million. Overlooked in that report is the CBO’s projection that “potential” GDP in the US will be much slower over the next 10-year period than it has averaged since 1950; this in an age of innovation where rapid change is considered normal. The CBO says that “changes in people’s economic incentives caused by federal tax and spending policies set in current law are expected to reduce the number of hours worked…” and “that estimate largely reflects changes in labor hours worked owing to the ACA [Affordable Care Act].”

In the US, if the current gap between real GDP and potential GDP closes (and the so-called “slack” in the economy disappears as the CBO projects it will), then, just like in the EMs, any growth on the demand side of GDP above potential GDP, ends up, by definition, as inflation.

There are a many measures that indicate that the economy is much closer to its potential than is generally assumed. One such measure is the fact that, despite record levels of cash flow (used mainly for stock buybacks or dividends), for the past five years, corporations have not reinvested in their plant and equipment. According to David Rosenberg (Gluskin-Sheff), the average age of the capital stock in the US is almost 22 years, an average not seen since 1958. Given the fact that the cost of capital is near an all-time low, there is something holding back such investment. Rosenberg speculates that it is likely found in overregulation and the uncertainty regarding tax policy. An old and aging capital stock implies a much lower growth rate of potential GDP than in the past when the capital stock was younger.

The second issue is the labor force. While the December and January Establishment Survey disappointed the markets (December’s survey reported 75,000 jobs added; January saw a gain of 113,000), nobody is talking about the Household Survey. This is the survey from which the “official” unemployment rate is calculated. While more volatile that the Establishment Survey, the Household Survey showed gains of 143,000 jobs in December and a whopping 638,000 in January. When combined with other surveys (NFIB) which show that 23% of small businesses have at least one open position that they cannot fill (a six-year high according to Rosenberg), and that there is a sustained uptrend in voluntary quits, it would appear that the Establishment Survey is the outlier and that the labor market is quite tight.

If, indeed, the CBO is correct and potential GDP growth will slow over the next 10 years due to Obamacare, a tight labor market in conjunction with old capital stock will only exacerbate that situation. Since the financial crisis, the unemployment rate has fallen from 10.0% in October ’09 to 6.6% in January ’14, a 3.4 percentage point decline. During that period of time, the annual GDP growth rate has been about 2.4%. After the recession of the ’90s, to get the unemployment rate to fall 3.4 percentage points (from 7.8% to 4.4%), it took an annualized GDP growth rate of 3.7%. The lower GDP growth required to reduce the unemployment rate implies that the gap between actual and potential GDP is either small or nonexistent.

The aging of the capital stock, lack of new investment, and the tightening labor market indicate that resources are in short supply, which means that there is a strong probability that any semblance of robust economic growth will be accompanied by inflation. Adding to such pressure is the liquidity sloshing around the EM world. If it finds its way home, as appears to be happening, unless much of it goes into new capital formation (which is unlikely given the current regulatory and tax regimes), we are likely to see growing inflationary pressures much sooner than is currently priced into the financial markets.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Contact Robert Barone or the professionals at UVA (Joshua Barone and Andrea Knapp) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

January 27, 2014

What’s the Safest Way to Hedge Against Inflation With Gold?

Posted in Ben Bernanke, Big Banks, Economy, Europe, Foreign, gold, investment advisor, investment banking, investments at 11:02 PM by Robert Barone

Until inflation becomes recognized, the investor holding gold as a hedge must have both patience and the ability to hold for an extended period.

Historically, the price of gold protected the purchasing power of the currency invested in it, as the price rose in some reasonable correlation with existing or expected inflation of that currency. But today, the price of gold is set in a speculative market where traders and hedge fund managers make bets, and little or no attention is paid to gold’s traditional role. (See the first part of this article, Why Gold Prices Dropped in 2013.)   According to John Hathaway of Tocqueville.com, in 2010, the physical gold market consisted of 121 million ounces. With a growth rate of about 1.5% per year, there are currently about 127 million ounces in existence, as of Hathaway’s writing. Using futures and options data, and OTC clearing data from the London Bullion Market Association, Hathaway calculates that the paper gold market is 92 times that of the underlying physical market. If each investor in a paper gold ounce believes it is backed by an ounce of physical gold, then each physical gold ounce must have been loaned or hypothecated, on average, 92 times. If everyone decided that they wanted physical possession, which of the 92 paper gold ounce owners really owns the physical metal?
That, of course, explains why it took so long (17 months) for the London banks to deliver the physical gold that Hugo Chavez’s Venezuela demanded. They either didn’t have it and had to purchase it in the open market, or they had to unwind trades where the gold was loaned or pledged as collateral, or both. As for the seven years that it will take for the US Fed to deliver Germany its gold, the only conclusion can be that the web of hypothecation must be long and complex.

Let’s now consider the characteristics of the London financial markets, where gold’s price is fixed twice each day. Nearly every well-known financial calamity over the past 20 years has originated from London offices of major financial corporations. That’s because in the UK, financial institutions have little regulatory oversight. Just think about JPMorgan’s (NYSE:JPM) $6+ billion 2012 loss from its London trading office. We learned from the MF Global (OTCMKTS:MFGLQ) fiasco that client assets can be hypothecated and re-hypothecated an infinite number of times, and that there are no customer protection rules. If you have been wondering what happened to Jon Corzine’s (MF Global’s CEO) clients’ funds, you now have a pretty good idea.

Recently, we’ve seen major UK financial institutions pay hefty fines for manipulating certain commodity prices and for fixing the price of LIBOR, a short-term rate that plays a key role in the world’s financial markets. Apparently, the illegal activity had been going on for years. There are five London banks that control the two daily London gold price fixes. Given the known shenanigans of the London banks regarding LIBOR and other commodities, and the infinite re-hypothecation allowed, how much confidence should we have that the daily gold price-fixing is impartial, that in a crisis or panic the hypothecations can be unwound with every paper claim on gold made whole, or, in fact, that some of the underlying gold even exists in the vaults? As Hathaway says, “It would be hard to imagine that the culture of [London] did not extend to gold.”

There has been a great deal of political angst by Bernanke and Co. over the demand by some members of Congress for a Fed audit, and great political maneuvering to avoid it. Some commentators, like John Williams (Shadowstats.com), believe that the Fed and government officials disdain rising gold prices because that suggests that the government and the Fed are not doing their jobs in maintaining price stability. Hence, Williams believes that heavy selling in 2013 was an orchestrated government intervention. In his January 8, 2014 issue of Hyperinflation 2014 – The End Game Begins, Williams says, “A number of times, very large sell-orders from one customer were placed in the global markets before the open of US trading. For someone looking to move out of gold, orderly sales would make the most sense in terms of getting the best prices. Instead, these actions were designed to pummel the gold markets, and they did.”

Remember what happened to credit default swaps, issued by AIG (NYSE:AIG), just five years ago? Remember what happened to AAA-rated mortgage-backed securities that turned out to have a lot of sub-prime loans? Could something like that happen to the paper gold market?

If it’s discovered that some of the underlying gold has disappeared from the vaults, or in a panic the competing hypothecations for the underlying gold ounces tie up the assets in a long-term court battle, or, as in the case of General Motor’s (NYSE:GM) senior secured bondholders and some depositors in Cypriot banks, it becomes politically correct to single out a class to bear losses, some holders of paper gold could be out of luck. It might be very painful one day to wake up to find that the paper gold investment you thought you had turns out to have not been collateralized.

So, what should gold investors do?

First, understand the difference between hedging and speculating. If it is your intent to hedge against an inflation that you believe will inevitably come due to current worldwide monetary- and fiscal-policy excesses, then the systematic purchase of gold, like mutual fund dollar-cost averaging, is a good practice.

In what form should you hold your precious metal assets? What about the ETFs traded on the exchanges? If you want to keep the gold in your brokerage account, there are some funds or ETFs that say that they hold bullion in a vault and do not hypothecate it. You need to do careful research to make sure this is the case and know if the paper you hold is convertible into the underlying asset. Gold mining stocks are another way, since the gold is there in the ground. Unfortunately, the typical gold mining company continuously dilutes shareholders with new rounds of equity offerings as they continue their search for the “mother lode.” So, research here is also essential.

The safest way, of course, is to hold the gold yourself, i.e., take physical possession and put it into a safety deposit box or in your own safe.  Many Americans are doing this, but the Chinese and Asians are way out ahead in this area. To do this you need to find a reputable gold or coin shop that will sell to you for a reasonable commission, say 3-4%.

Today’s gold investors must also understand that the price of gold is currently a 100% function of hedge fund speculation. In the future, as inflation becomes recognized, this may change, but until it does, the investor holding gold as a hedge must have both patience and the ability to hold for an extended period — oh yes, and the ironclad belief that the laws of economics haven’t changed, i.e., that “this time is different” is a lot of bunk.

 

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

December 30, 2013

8 U.S. business predictions for 2014

Posted in Auto Industry, business, Economic Growth, Economy, Finance, GDP, gold, government, Housing Market, Inflation, interest rates, investment advisor, investment banking, Labor Market, Manufacturing, Robert Barone, Unemployment, Wall Street at 8:45 PM by Robert Barone

The holiday season is the traditional time of year to prognosticate about the upcoming year. But, before I start, I want to make a distinction between short-term and long-term forecasts.

Long-term trends are just that, and they unfold slowly. And, while I have great concerns about the long-term consequences of inflation, the dollar’s role as the world’s reserve currency, the bloated Fed balance sheet and resulting excess bank reserves, and the freight train of unfunded liabilities which will impact the debt and deficit, because these are long-term issues and simply don’t appear overnight, I do not believe there is anything contradictory about being optimistic about the short-term.

With that caveat, here are my predictions for 2014:

1. Real GDP will grow faster in 2014 (3.5%): The “fiscal drag” that caused headwinds for the economy has now passed with the signing of the first budget in four years in mid-December. Since 2009, governments at all levels have been shedding jobs. But, that has now all changed. The November jobs reports show that employment at all levels of government has turned positive.

No matter your view of the desirability of this for the long-term, in the short-term, those employees receive paychecks and consume goods and services. I predict the real gross domestic product growth rate will be more than 3.5 percent in 2014.

2. Manufacturing and trade are healthy and will get better in 2014: The Institute for Supply Management’s indexes, both manufacturing and non-manufacturing, are as high or higher than they were in the ’05-’06 boom. In November, industrial production finally exceeded its ’07 prior peak level.

Auto sales today are as frothy as they were in the pre-recession boom, and auto sales in the holiday buying period are destined to surprise to the upside. Online sales in the weekend before Christmas overwhelmed both UPS and FedEx, causing many gifts to be delivered on the 26th.

3. Housing, while not near its old bubble peak, has turned the corner: Part of the reason the economy is not overheating is housing. While November’s housing starts surprised to the upside, they still only represent 53 percent of their bubble peak. Nevertheless, because new home construction has been in the doldrums for the past six years, the resurgence evident in the economy has pushed the median price of homes to the point where many homeowners, who were underwater just a couple of years ago, can now show positive home equity on their balance sheets

While interest rates have risen and may be a cause for concern for housing, they are still very low by historic standards, and we have a Fed that, on Dec. 18, recommitted to keeping them down for a period much longer than the market ever anticipated.

4. The unemployment rate will end 2014 somewhere near 6%: Because the popular unemployment index is a lot higher today than it was in the ’05-’06 boom (7 percent vs. 5 percent), the popular media assumes that the labor markets are still loose. But, demographics and incentives to work have changed over the past seven years.

The labor sub-indicators imply much tighter labor conditions than the traditional unemployment index would lead one to believe. Recent data for nonfarm payrolls are equivalent to their monthly numbers in ’05-’06. Weekly new jobless claims are in a steep downtrend. The sub-indexes for layoffs and discharges are lower than they were in ’05-’06. And hard-to-fill-position and job-opening subindexes are in definite uptrends and are approaching ’05-’06 levels. As a result, expect a steady decline in the unemployment rate in 2014.

5. Investment in new plant & equipment will rise in 2014: For the past 5 years, large-cap corporations have hoarded cash and have not reinvested in their businesses. As a result, because equipment and technology is older, labor productivity has stagnated. This is one reason for the strong labor market. In 2014, I predict there will be an upturn in the reinvestment cycle. Beneficiaries will be technology companies and banks.

6. Inflation will be higher in 2014, both “officially” and in reality: While every individual player in the financial markets knows that everyday prices are rising, each espouses the Fed’s deflation theme, perhaps only to play along hoping the Fed will continue printing money.

Are we to believe that the jump of retail sales in October of 0.6 percent followed by 0.7 percent in November were all without price increases as the Bureau of Labor Statistics says? The “official” consumer price index says that airline fares have not increased despite the 18 percent growth of airline revenues in 2013 (bag check fees, etc.)? Should we believe that double-digit revenue growth rates at restaurants are volume-only and we are just eating more? I don’t know what the actual rate of inflation is, but it sure feels like it is higher than 5 percent. In 2014, it will be even higher than that.

7. Equity markets will rise in 2014: The fiscal headwinds are behind us; industrial production and sales are strong; housing is healing, the rise in home prices have generally raised consumer confidence; there appears to be the beginning of an upturn in the capital investment cycle; and, most important, the labor markets are strong. Any equity market corrections should be bought. Meanwhile, longer-duration bonds should be avoided unless there is an accompanying hedge instrument.

8. Gold — it should rise in 2014, but this is a tricky market: Every indicator points to a rise in the price of gold, especially since all of the world’s major central banks are printing money at record rates. But, contrary to logic, the price of gold has fallen in 2013 by nearly 30 percent.

The reason behind this lies with leverage and hypothecation — getting a loan using collateral — in the gold market. Once again, Wall Street has discovered that money could be made by leveraging; and the paper gold market is about 100 times larger than the physical market. When you have that kind of leverage, collusion, price fixing, or just plain panic can quickly move markets.

As inflation is recognized, the price of gold (both physical and paper) should rise. In a healthy economic year, as I predict for 2014, a collapse in the paper gold market is unlikely, and perhaps the price of gold will rise in response to rapidly expanding fiat money. But beware. The only safe gold is what you can hold in your hand.

December 27, 2013

Part II: The Long-Term Outlook – Even a Strong Economy Doesn’t Change the Ultimate Outcome

Posted in business, debt, Economic Growth, Economy, Europe, Finance, Foreign, Inflation, investment advisor, investment banking, investments, Markets, National Deblt, Robert Barone at 4:46 PM by Robert Barone

If you’ve read Part I of this year end outlook, you know that it is our view that the underlying private sector is healthy and, except for the fact that the real rate of inflation is much faster than the ‘official’ rate, we could well have a short period of prosperity.

Unfortunately, our long-term outlook is not as sanguine as our short-term view.  The eventual recognition of the inflation issue, the dollar’s role as the world’s reserve currency, the bloated Fed balance sheet and the resulting excess bank reserves, and the freight train of unfunded liabilities and its impact on the debt and deficit are issues that have large negative long-term consequences.  Remember, the long-term unfolds slowly, and we don’t expect that we will wake up one day to find that all has changed.  Still, the changes discussed below could very well take place over the next decade, and investors need to be prepared.

The Dollar as the Reserve Currency

The dollar is currently the world’s reserve currency.  Most world trade takes place in dollars, even if no American entity is involved.  Because world trade has rapidly expanded over the past 20 years, more dollars have been needed than those required for the U.S. economy alone.  As a result, the U.S. has been able to run large deficits without any apparent significant impact on the dollar’s value relative to other major currencies.  Any other country that runs a large deficit relative to their GDP suffers significant currency devaluation.  Current policy in Japan is a prime example.  A weakening dollar has implications for the prices of hard assets.

In addition, the Fed’s policy of Quantitative Easing (essentially money printing) has disrupted emerging market economies.  Zero rates and money creation caused hedge fund managers to leverage at low rates and move large volumes of money offshore to emerging nations where interest rates were higher.  The initial fear of “taper” in May and June caused huge and sudden capital outflows from those countries resulting in massive economic dislocation in those markets.  In India, for example, the Rupee was pummeled as the hedge fund investors, fearing that interest rates were about to suddenly rise, all tried to unwind their Rupee investments at the same time.  And now that ‘taper’ has officially started and longer-term rates are expected to rise, these issues will continue.  Those countries have all taken defensive measures.  India, for example, imposed taxes on gold imports, which has impacted the gold markets but has reduced India’s balance of payments deficit.

As a result of such tone deafness on the part of the Fed, and because there now appears to be enough dollars in the world for the current level of trade, the international appetite for U.S. dollars is clearly on the wane.  Japan and China, the two largest holders of Treasury debt, have recently reduced purchases.  Most emerging market nations and large players like Russia and China have vocally called for an alternative to the dollar as the world’s reserve currency.  This movement is alive and well.

The Fed’s Balance Sheet

As the economy expands, the size of the Fed’s balance sheet and the level of excess bank reserves will become a problem.  There are $2.3 trillion of bank reserves in excess of what are ‘required’  under the law and regulations.  (Required reserves for the U.S. banking system are $.067 trillion; so, the system has 34x more reserves than it needs.)  Under ‘normal’ conditions, and the way the system was designed to work, if the economy got too hot, the Fed could sell a small amount of securities out of its portfolio which would reduce bank reserves to the point where banks would have to ‘borrow’ from the Fed.  Because bankers are hesitant to do that, and because the Fed could raise the ‘discount’ rate, the rate charged for the borrowings, the Fed could control new lending and thus the economic expansion.  This isn’t possible today as the Fed would have to sell $2.2 trillion to cause banks to have to borrow.  Such a volume of sales would likely cause a crisis in the financial system, or even collapse.  Today, the only way the Fed has to stop the banks from lending is to pay them not to lend – this is exactly the opposite of the intent of the original legislation and the opposite of how the Fed has worked for most of its 100 year history.

Furthermore, given the growing lack of confidence in the dollar as the world’s reserve currency, if fiscal budget deficits grow in the future, the Fed may end up as the major lender (i.e., lender of last resort) for the U.S. Treasury.  That simply means more money creation.

Unfunded Liabilities-

The U.S. Treasury officially recognizes $85 trillion as the amount of unfunded liabilities of the Federal Government.  Other professionals set this number near $120 trillion.  For comparison, the annual U.S. GDP is about $16 trillion.  The budget deficit reported in the media is a cash flow deficit (tax collections minus expenditures).  The budget deficit doesn’t include promises made for future payments (Medicare, Medicaid, Social Security, government pensions) which have been running between $4 and $5 trillion annually for the past few years.  These amounts simply get added to the ‘unfunded’ liability number.

As the population ages, these payments will have to be made, and the budget may become overwhelmed. (You see the relevance of the remark made above about the Fed being the lender of last resort for the Treasury.)   This is the heart of the debate about ‘entitlements’ that has been front and center for the past decade.

 Solutions (none of which you will like)

 Philipp Bagus is a fellow at the Ludwig von Mises Institute in Europe.  He is well known in Europe for his work on financial issues there.  In a recent paper, Bagus says that there are several possible ways out of the current money printing predicament.  Any one or a combination is possible.  We have put them in an order of most likely to least likely to be used:

  •  Inflation – this is the natural outcome of printing money;
  • Financial Repression – this is current Fed policy; savers and retirees bear a disproportionately large burden as inflation eats at their principle but there is no safe way to earn a positive real rate of return;
  • Pay Off Debt – this means much higher levels of taxation, and is definitely a real possibility.  In Europe, the International Monetary Fund (IMF) has proposed a one-time 10% wealth tax.  As the unfunded liabilities push up the federal deficit, expect such proposals in the U.S.;
  • Bail-In – In ’08-’09 we saw ‘bail-outs’ where the government saved GM, Chrysler, AIG and the Too Big to Fail banks by buying stock or otherwise recapitalizing them.  A ‘bail-in’ refers to the financial system.  Banks and other depositories have liabilities called deposits.  The depositors do not consider themselves ‘lenders.’  But, in a ‘bail-in,’ it is the depositors who lose.  Their deposits are ‘converted’ to equity in the bank.  When they try to sell their bank shares, they find that it will fetch only a fraction of the value of their deposits.  A variant of this is what happened in Cyprus in the spring of 2013.  Because of the distaste the public now has for ‘bail-outs,’ if there is another financial crisis, this is likely to be the method used;
  • Default on Entitlements – when we talk about ‘entitlement reform’ in the U.S., we really mean at least a partial default.  It is likely that some people simply won’t get what they were promised.  We put this low on the list because we have witnessed a political process that won’t deal with the issue;
  • Repudiate Debt – Because the government can simply print money to pay it debts, this is the least likely of all of the possibilities in the U.S.

The long-term issues are serious.  And not addressing them simply means a higher level of pain when addressing them is required.   Remember, these are long-term issues.  They are all not likely to occur at the same time, nor will they simply appear overnight.  The first signs of trouble will occur when markets begin to recognize that the ‘official’ inflation rate significantly understates reality, or that the inflation data become so overwhelming that they can no longer be masked.  Even then, markets may come to tolerate higher inflation, as after 100 years of fighting inflation, the Fed and the world’s major central banks have embraced it as a good thing.

Meanwhile, as set forth in Part I of this paper, the immediate outlook for the economy is upbeat.  Enjoy it while it lasts.

December 20, 2013

Robert Barone, Ph.D.

Joshua Barone

Andrea Knapp Nolan

Dustin Goldade

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp  and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Part I: The Short-Term Outlook – A Strong and Accelerating Economy

Posted in Banking, business, Economic Growth, Economy, Federal Reserve, Finance, Housing Market, investment advisor, investment banking, investments, Markets, mortgage rates, Robert Barone at 4:41 PM by Robert Barone

Those who read our blogs know that over the past 6 months or so, we have turned positive on the underlying private sector of the U.S. economy.  We have had comments from several readers about this apparent change of heart, some of them almost in disbelief.  So, let us dispel any doubts.  There is a huge difference between the short-term and the long-term outlooks.  Let’s realize that long-term trends are just that, long-term, and that they take a long time to play out.  As you will see if you read through both parts of this year end outlook, our long-term views haven’t changed.  But, since the long-term doesn’t just suddenly appear, there really isn’t anything contradictory in being optimistic about the short-term.  As a result, we have divided this outlook up into its two logical parts, the short-term and the long-term.

Let’s start with the short-term.  First, at least through 2014 and probably 2015, the ‘fiscal drag’ that caused headwinds for the economy has now passed with the signing of the budget deal in mid-December.  In his December 18th press conference, Fed Chairman Bernanke indicated that four years after the trough of the ’01 recession, employees at all levels of government had grown by 400,000; but at the same point today, that number is -600,000, i.e., a difference of a million jobs.  Think of that when you think about ‘fiscal drag.’  The November jobs data shows that jobs at all levels of government have now turned positive.  No matter your view of the desirability of this, those employees receive paychecks and can consume goods and services.  So, from a short-term point of view, the ‘fiscal drag’ has ended, and, all other things being equal, this will actually spur the growth rate of real GDP.

Manufacturing and Trade

The institute for Supply Management’s (ISM) indexes, both manufacturing and non-manufacturing, are as high or higher than they were in the ’05-’06 boom period.  This is shown in the chart immediately below.

pic 1

Shown in the next chart is industrial production, which in November, finally exceeded its ’07 peak.

Pic 2

Now look below at the auto chart.  Sales are as frothy today as they were in the pre-recession boom.  Sales for the holiday buying period are destined to surprise to the upside.

Pic 3 

Housing

Part of the reason that the economy is not overheating is housing.  The chart clearly shows that housing starts are significantly lagging their ’05-’06 levels.  But, recognize that ’05-’06 was the height of the housing bubble.

Pic 4

November’s housing starts surprised to the upside.  But, they are still only 53% of their bubble peak.  Nevertheless, because new home construction has been in the doldrums for the past six years, the resurgence evident in the economy has pushed the median price of a new home north of what it was then.  In addition, the lack of construction has put the months’ supply of new homes at less than 3.  In the housing bubble, when everyone was in the market, the average level of supply was 4 months.  So, in some respects, the current housing market is hotter than it was at the height of the bubble.  And, while interest rates have risen and are a cause for concern, they are still very low by historic standards, and we have a Fed that on December 18th recommitted to keeping them down for a period much longer than the market had anticipated.

 Labor Markets

Because the popular unemployment index is a lot higher today than it was in the ’05-’06 boom (7% vs. 5%), the popular media assumes that the labor markets are still loose.  But, demographics and incentives to work have changed over the past seven years.  The labor sub-indicators imply a much tighter labor market than the traditional unemployment index would lead one to believe.  Recent new nonfarm payrolls are equivalent to their monthly gains of ’05-’06.  The weekly Initial Jobless Claims number for the week ending 11/30 was 298,000.  Except for one week this past September, you have to go all the way back to May ’07 to find a number that low.  The first chart below shows the definite downtrend in new and continuing jobless claims.

Pic 5

The next chart shows that layoffs and discharges are lower than they were in ’05-’06 and that both the “Job Openings” and “Jobs Hard to Fill” sub-indexes are in up trends and are approaching ’05-’06 levels.

Pic 6 

The Aggregates

So, while auto sales are booming, the labor markets are tight, and manufacturing and services are expanding at or near boom levels, why do the aggregates (Real GDP, for example) appear so depressed?  One explanation that we think has some credibility, is that there has been an expansion in the underground economy (barter; working for cash, etc.).  The ‘fiscal drag’ headwinds discussed earlier, have, no doubt, had a large impact on the sluggish growth in the aggregates.  On a positive note, the latest revisions to Q3 ’13 Real GDP show a growth rate of 4.1%, which, on its face, supports our short-term optimism.  And until mid-December, the markets had discounted this as resulting mainly from growth in unwanted inventories.  But Black Friday and Cyber Monday sales along with upbeat ongoing retail reports tell us something different, i.e., the inventory growth was not unwanted at all.  While the markets expect a 2% Real GDP growth for Q4 ’13, don’t be surprised if it is much higher.

Short-term Implications

The underlying data, at least for the next 6 to 12 months, point to a strengthening economy.  Certainly, a stock market correction is possible.  We haven’t had one for more than 2 years.  But, while possible, a significant downdraft like those of ’01 or ’09, don’t typically occur when the economy is accelerating (1987 is an exception) without an extraneous and unanticipated shock.  With the signing of the first budget deal in four years, and with the Fed clearing the air about tapering and actually extending its announced period of zero interest rates, almost all of the short-term worries appear to be behind us, except one.

 Inflation – The Potential Fly in the Ointment

The ‘official’ Consumer Price index (CPI) was flat in November, dominated, as it has been all autumn, by the fall back in gasoline prices.  Somehow, while we all know that everyday prices are rising at a significant pace, the markets have bought into the deflation theme.  Perhaps the belief is that if the markets play along with the Fed’s low inflation theme, the Fed will remain easier for longer.

In his December 16th blog, David Rosenberg (Gluskin-Sheff) has the following to say about inflation:

I have a tough time reconciling the ‘official’ inflation data with what’s happening in the real world… the .7% jump in retail sales in November on top of +.6% in October – these gains were all in volume terms?  No price increases at all?  Restaurants are now registering sales at a double-digit annual rate… No price increases here?  The BLS tells us in the CPI data that there is no pricing power in the airline industry and yet the sector is the best performing YTD within the equity markets…  global airline service fees have soared 18% in 2013… these [fees] are becoming an ever-greater share of the revenue pie and one must wonder if they are getting adequately captured in the CPI data.

Inflation could be the fly in the ointment for 2014.  As long as the markets play along with the Fed’s deflation theme, as we expect they will as long as they can, the economy and markets will do just fine (this doesn’t mean there won’t be a correction in the equity markets, as we haven’t had a meaningful one for two years).  But sooner, or later, something will have to be done about inflation.  We will close this Part I with a quote from Jim Rogers, the commodity guru (Barron’s, October 12, 2013):

The price of nearly everything is going up.  We have inflation in India, China, Norway, Australia – everywhere but the U.S. Bureau of Labor Statistics.  I’m telling you, they’re lying.

December 20, 2013

Robert Barone, Ph.D.

Joshua Barone

Andrea Knapp Nolan

Dustin Goldade

 

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

 

 

November 25, 2013

Stagflation: Debt Grows, GDP Slows

Posted in Economy, Inflation, investment advisor, investment banking, investments, recession, Robert Barone at 7:59 PM by Robert Barone

The markets are torn between polar opposite schools of thought. There are those who believe we are in a period of intense deflation, which will continue for some time, and there are those who believe that inflation is inevitable and, in fact, is already with us as consumers can attest.

Deflation

The Fed must be in the deflation camp. Why else would they continue to create $85 billion/month of new and unneeded bank reserves? Several recent academic papers have indicated that the major industrial economies of the world, representing more than 70% of the world’s GDP, are so indebted (U.S. Private & Public Debt/GDP: 360%, Europe: 450%, UK: 470%, Japan: 500%) that the world has entered into a period of debt disequilibrium and deleveraging. The annals of history indicate that such periods take an average of 20 years to resolve. Because the indebtedness has actually increased since the financial crisis and Great Recession, this deleveraging cycle may be even longer.

The deflationists believe that the world’s economies will continue to falter, and that no matter how much QE the Fed provides, it won’t translate into economic growth if there is no ability to consume due to excessive debt loads. In this scenario, the price of gold and other precious metals have likely seen their peaks and may fall even further from current levels.

Inflation

The second camp belongs to those who see inflation, not only potentially in the future, but currently hurting consumers. The CPI, as produced by the BLS, just isn’t realistic for most Americans. In the Oct. 12 issue of Barron’s, commodity guru Jim Rogers opined, “The price of nearly everything is going up. We have inflation in India, China, Norway, Australia — everywhere but the U.S. Bureau of Labor Statistics. I’m telling you they’re lying.”

In some of his recent daily blog posts, economist David Rosenberg (Gluskin-Sheff) indicated that if the rapid increase in home and auto prices over the past year were used directly in the CPI instead of the massaged data that is used, today’s CPI would be north of 4% instead of the 1.5% that BLS publishes. <story_page_break>

Furthermore, private sector economists who measure inflation, like John Williams of Shadow Government Statistics or Ed Butowsky, producer of the Chapwood Index, all point to real inflation as being much higher than BLS’s CPI.

But, besides the actual everyday inflation experience, the final issue in the inflation camp, and the one that I think carries the most weight, is the rapidly approaching freight train of unfunded liabilities of the U.S. federal government. There are monstrous (unspoken) additions each year to those liabilities. Add to these the lack of recognition and inability of government to address these numbers, which are almost too long to write on a page ($85,000,000,000,000 to $120,000,000,000,000). That’s $85 trillion to $120 trillion. Just for comparison, the annual GDP of the U.S. is about $16 trillion.

To date, the U.S. government has been able to issue trillions of dollars of debt ($17.5 trillion and growing rapidly) because the dollar is the world’s reserve currency and it is used in international transactions that have nothing to do with U.S. economic activity. Unfortunately, today there are now too many dollars in the system, and other world powers are both complaining and seeking alternatives. China now settles more than 12% of its foreign trade in its own currency, versus 3% in 2010. It is likely that foreign powers will soon begin to shun U.S. debt, leaving the Fed the only buyer of the large deficits that clearly lie ahead.

Stagflation

So, which side is correct — deflation or inflation? Unfortunately, both. There is too much debt, and the pace of economic growth has significantly deteriorated in each decade since the 1980s. Because both sides are correct, the result is “Stagflation,” a world of slow or negative economic growth accompanied by rising prices. If this is the case, the price of gold won’t stay down for long.

 

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.

Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

 

August 16, 2012

Today’s market not driven by fundamentals – so be careful

Posted in Banking, Economy, Europe, Federal Reserve, Finance, Foreign, investment banking, investments, Italy, Spain, Uncategorized tagged , , , , , , , , , at 8:45 PM by Robert Barone

The Past
 
The stock market always has been considered a “leading” They are “administered” by central banks (the Fed, the European Central Bank, the Peoples’ Bank of China, the Bank of Japan, etc.), which set and manipulate the rates. When interest rates are determined by other than market forces, you can be assured that scarce resources are inefficiently allocated. We need only look to the long period of administered artificially low rates under the Greenspan Fed to realize that such a policy was a major contributor to the housing bubble last decade.

Expectations

Given the recent collapse in basic, fundamental worldwide economic activity (consumption, orders, employment), one must be skeptical of an equity market that continues to, apparently, defy gravity. Investors, or more accurately, speculators, await the next Fed or ECB policy-easing move, not wanting to “miss” the inevitable market updraft that they hope occurs. (Of course, they could be hugely disappointed, as were the initial investors in Facebook!) Could it be that market expectations of such moves already have driven prices up, and the policy-easing moves themselves will be anticlimactic? In market parlance, this is known as “buy the rumor, sell the fact.”

Recent market reactions

Sooner or later, markets will come back to valuations based on the underlying fundamentals. This isn’t the first time that the markets have exhibited extreme sentiment. And it won’t be the last. So, let’s examine some of the recent “policy” issues and data releases in light of market sentiment.
 
• On July 26, ECB President Mario Draghi (“Super Mario”) said, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” adding later, “Believe me, it will be enough.” The market interpreted this as a pledge that the ECB would directly purchase the debt of Spain and Italy, thus reducing pressure on interest rates in those countries. The Dow Jones rose 3.2 percent during the next two days. On Aug. 2, when the ECB met and didn’t announce
anything major, the Dow sold off .7 percent, only to begin a rise again on Aug. 3 when the market realized that Spanish and Italian two-year rates, which is where those two countries are selling new debt, were now falling. Apparently, the markets now believe Super Mario’s words.
 
Nevertheless, no amount of liquidity can resolve the solvency problem that exists in Europe’s southern nations. No matter what these politicians do, short of an unlikely fiscal union, the euro will be pulled apart. The northern countries — Finland, Denmark, Germany — have attitudes toward work, debt, inflation and socialism that are diametrically opposed to the attitudes in the Mediterranean countries.
 
So, Europe likely is to remain in a recessionary/slow growth mode for the foreseeable future, and debt issues there will continue to impact capital markets worldwide.
 
• On July 27, the Department of Commerce’s Bureau of Economic Analysis reported that the real GDP grew at an annual rate of 1.5 percent in the second quarter. (The measurement methodology of the price deflator is questionable as it biases the real GDP number significantly upward. While every other indicator of economic activity is declining, it doesn’t seem logical that this one is rising.)
 
The markets had expected a worse report, and breathed a sigh of relief, advancing 188 Dow points that day (1.5 percent). But, even a cursory analysis of the underlying data reveals that the private sector remains in stagnation. In the second quarter, nominal dollar GDP grew by $117.6 billion or by $1.29 billion/day. However, the federal government added $274.3 billion in new debt ($3.01 billion/day). Thus, it took $2.33 of new debt to increase GDP by $1. Would anyone in their right mind sign up for a loan of $233,000 if the lender was only going to fund $100,000?
 
• The Aug. 3 employment report was “stronger” than expected, according to the media, with the Establishment Survey showing new job growth of 163,000. (June’s 80,000 job growth was revised downward to 60,000.) The headline “unemployment rate” went up to 8.3 percent. It was widely reported that the rise of the unemployment rate was due to the fact that fewer people were discouraged and more people entered the labor force. After all, how else could the unemployment rate rise when 163,000 jobs were created? The answer is, after all these years, the media doesn’t know that the headline unemployment rate is calculated using a completely different survey. The Establishment Survey queries 141,000 businesses, while the Household Survey queries 60,000 households. The Establishment Survey adds in a residual factor of about 50,000 jobs per month, created out of nowhere, from what is known as the birth-death model (the BEA assumes 50,000 more new small businesses are created every month than are closed; this is clearly an historical artifact and doesn’t exist in today’s world, but it is still added to the data). The Household Survey actually showed a decline of 195,000 jobs (all of which were full-time jobs) in July, and because the labor force declined by 150,000, the unemployment rate went up. The labor market is nowhere near healthy.

Conclusions

As I said earlier, sooner or later, the markets will come back to what the fundamentals say. I don’t know when that will occur, perhaps after the elections, or maybe not until sometime in 2013, depending on who wins. As I said in a previous column, policy issues are important for markets. Clearly, today, policy appears to be not only the most important factor but the only factor.
 
Because sentiment on Wall Street can change in an instant, investors should remain very cautious. Depending on your own situation, perhaps some profit taking is now in order. Short duration bonds continue to look safe given current underlying economic conditions and likely policy moves.
 
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

August 2, 2012

Equities: Is a bear market inevitable in this economy?

Posted in debt, Economic Growth, Economy, Europe, Finance, government, investment banking, investments, payroll tax reductions, recession, Stocks, Uncategorized, Unemployment tagged , , , , , , , , , , , , , , , , , at 7:40 PM by Robert Barone

All of the data and the trends in the data indicate that it is possible that a recession might already have begun.

• Job creation has been dismal in the second quarter, with little hope for improvement soon; jobless claims are, once again, on the rise.

• Retail sales have fallen three months in a row; this has never occurred without an ensuing recession. What is of greater concern is that this has occurred while gasoline prices have been falling.

• While market pundits have cheered small gains in housing data, it is clear that housing is still bottom bouncing. Changes in foreclosure laws have caused supply constraints that have made it appear that home prices are rising again.

• Industrial production, the one bright spot in the economy, showed a decline in May before recovering somewhat in June.

• The drought has caused raw food and commodity prices to spike. These will soon translate into higher food and raw input costs. (Is anyone now questioning the wisdom of the congressional mandate to produce increasing quantities of ethanol from corn instead of sugar?)

 • Consumer confidence continues at levels below those seen in past recessions . Much of this is due to uncertainty surrounding fiscal policy and taxes.

• In the June Philadelphia Fed Survey, manufacturers were asked to list reasons for slowing production; 52 percent cited uncertain tax policy and government regulations.

• Real incomes are falling. The downward bias in the inflation numbers produced by the government inflates the reported GDP numbers. It has been my view that, as a result of the biased reporting, the recession never really ended, and real GDP is much lower than reported.

 Equity market up for year

 Nevertheless, despite all of the poor data, the equity markets have held up. At 1,338 (the closing level on July 25), the S&P 500 is still 6.4 percent higher than it was at the beginning of the year. This is strange, given that every other major market in the world is down 20 percent and in bear market territory. Here are a couple of possible explanations:

• The equity markets used to be a leading indicator of the economy. Severe market corrections (20 percent or more) usually meant recession was either imminent or already here. But, with the advent of computerized trading, the market now appears to be more of a coincident indicator. In late 2007, when the last recession began, the market was only off 5 percent from its October peak.

• Europe: There is such financial chaos in Europe that a flight to the dollar is continuing. Because higher quality bond yields are so low, some of the funds have found their way into the U.S. equity markets, thus keeping them buoyed.

Neither of these two reasons should give investors any confidence that U.S. markets can hold up. Besides the poor internal economic data within the U.S., worldwide data have been weak. In addition to the obvious problems in Europe, China is in a much slower growth mode, as is Japan, the rest of Asia, and even the commodity producers like Australia and Canada.

European soap opera
 
Europe is a whole other issue. American markets have benefited from their financial issues, but when panic and contagion show up over there, markets behave poorly over here. We have seen this time and again as the European drama (really a soap opera) has unfolded. It would be far better for the European politicians to come up with an
orderly plan for countries to exit the monetary union than to deny that the union isn’t in any danger of falling apart.

 

Solvable “fiscal cliff”

Finally, the approaching “fiscal cliff” in the U.S. is another wild card that could have a significant impact on capital markets. The good thing about the “fiscal cliff” is that it isn’t an outside force being imposed. The cliff is avoidable and completely under the control of Congress and the president.

With all of this going on, is a bear market inevitable? While I think that the confluence of events (worldwide economic slowdown, slowdown in the U.S., European financial chaos, “fiscal cliff”) make it likely, as I indicated in my last column, the application of “business friendly” policies could prevent it.

Until visibility into policy becomes clearer, investors should continue to be extremely cautious. They should remain liquid.

 Finally, the U.S. economy is so fragile that any external shock, like a financial implosion in Europe, is certain to have negative impacts on U.S. markets. Policy responses to economic slowdown or financial chaos (e.g., printing of money by the European Central Bank or QE3 by the Fed) are likely to have a positive impact on the value of precious metals and commodities. And the ongoing drought will definitely move food and commodity prices upward.

Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

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