The Fed playbook for 2009

My last and most important class of the year will be held on Wednesday, November 19th from 6-9pm. I will discuss the best and safest places for your hard earned $$$ and give a detailed forecast for interest rates and the economy in 2009. Can you really afford not to be there?

I have spent more than 40 years studying Federal Reserve monetary policy and carefully monitoring the remarks of Federal Reserve Chairmen. We are at an extraordinary juncture in economic history that demands correct decisions be made for the survival of this country (and much of the world). Our current Fed Chairman, Ben Bernanke, is clearly the world’s expert on the Great Depression and it is no coincidence that he is leading us through this very difficult time but what is unique is that he spent years writing about what would be needed when we entered another crises similar to the 1930’s. I have been fortunate and lucky to have forecast (see archives) much of what has taken place in the real estate and credit markets this past two years. Rarely does a team get the opportunity to view the opponent’s playbook BEFORE the game begins but that is exactly what we have today as all of Bernanke’s writings are easily accessible on the internet.

I urge all readers to take the time to read and re-read a speech Ben gave on November 21, 2002 titled “Deflation: Making Sure it doesn’t happen here.” It’s only 12 pages but pay special attention to page six where he begins by asking the question: What should the Fed do if its overnight funds rate falls to zero? With this week’s 50 basis point cut to 1.00% it is only a matter of a few months before we land at 0.00% and the focus shifts to long-term rates. Lower interest rates usually stimulate loan demand but not if price levels are declining in a Deflationary environment. When asset prices are falling any level of positive interest rates is too high and creates high “real” interest rates which discourage borrowing. Bernanke suggests two ways to lower long-term interest rates, with an announcement that rates will remain at zero for a number of years thus changing investor expectations to the new lower level. The second method involves the Fed creating a rate ceiling for long maturity Treasury bonds which would create demand whenever market rates came near this new level. The Fed did maintain a ceiling of 2.5% on long-term Treasury bonds for almost a decade in the 1940’s. Finally he suggests that if the previous two methods did not stimulate demand the Fed could purchase securities (mortgages, etc) in the market place which would surely drive prices higher and yields lower. He is the exact opposite of our former Fed chairman (Greenspan) who went out of his way to conceal his plans and felt that surprising the financial markets resulted in better execution for the Fed. Ben’s strategy is to inform in advance market participants and have them better prepared for the coming uncertain times. He is well aware that investors only see the future from their own experiences and because he did not experience the Great Depression he did the next best thing and studied it for many years. His papers were written at a time when the last thought on everyone’s mind was a repeat of the 1930’s and his conclusions are well thought out and should prevent a lengthy setback for the U.S. economy. This is the playbook for the next 12+ months of Fed policy and is much simpler to read and understand than listening to the “always bullish” experts on business television shows. The buy and hold forever theory of stock investing has allowed many investors to lose 30-40% of their hard earned portfolio dollars this year and all because their advisors don’t believe in stop losses. Every investor must take responsibility and not assume everything will always be ok.

Long-term interest rates

The U.S. 10-year Treasury closed this week at 3.96% as sellers exited “flight to quality” positions entered earlier this month and began to nibble at stocks afraid they would miss the next big rally. The key inflation component fell to 83 basis points and with Deflationary CPI numbers on the way should fall close to zero in the next few months. As long as this key Fed indicator remains below 1.00% we should see foreign buying of long-term Treasuries anytime the 10-year rises above the 4.00% level. The Fed’s next mission will be to manufacture lower long-term rates and if necessary will enter the marketplace next year with purchases. (see above). Homeowners will not see relief until house prices stabilize (2010) but can be helped immediately by lower long-term interest rates.

TIPS

A few times each year I use the term “back up the truck” because it is an expression that implies great certainty and no one can be 100% sure of any investment idea (always use stop losses). Early this year (see archives) I strongly urged readers to bet on a widening U.S. yield curve (2yr-10yr) and it rose from 108 basis points in early January to today’s level of 240 bp. This was an easy call as it was obvious the Fed would ease short-term rates throughout the year. I also forecast a much weaker British Pound this year and it has fallen over 20%. It’s time for another back up the truck call and it involves U.S. government TIPS (Treasury Inflation Protected Securities). Due to rising fears of a U.S. default on its debt the 10-year TIPS notes have seen their yield rise to 3.13% a level not seen in many years. These notes also pay an annual amount of interest equal to the inflation rate and are usually purchased as a hedge against future inflation. They should ONLY be purchased in retirement accounts and NEVER leveraged but are a fantastic purchase despite the fact I don’t see any inflation for the next few years. Their yield is usually tied to expectations of future growth in the U.S. economy but a rising default premium make them a must for everyone’s IRA, 401k, pension or profit sharing plan or other retirement vehicle. It’s time to back up the truck again….

A recession has arrived, is a depression on the way?

Thursday’s GDP report of a 0.3% third quarter decline confirms what everyone already knew, we are in a recession (declining economic activity) and with credit almost impossible to obtain the Fed is desperately trying to prevent a repeat of the Great Depression. Friday (11/07) the monthly jobs number will be released and it should be ugly with a decline of over 200,000 jobs in October and an unemployment rate of 6.3% (on its way to 8.0%). California is on its way to 10.0% and soon every state and local government will be sending delegations to Washington D.C. begging for a handout/bailout similar to the ones given brokerage firms, insurance companies, banks, auto manufacturers and others. How can Washington turn cities and states down when they have funded everyone else (except Lehman, Bear Stearns, Wachovia and WAMU)? What you allow, you encourage and with a new administration it will be hard to resist the cry for help by so many in need. The stock market appears to have stabilized for now and might be close to a trading rally but with liquidity low and rampant bullishness by those still long (and praying) it is not for those that don’t employ stop losses.

2009 will present tremendous opportunities for those in cash but sadly the majority is leveraged with no ability to borrow for new investments. The few that weren’t afraid to win alone are ready for the next adventure while those that don’t mind losing in company at least have their friends to hold their hand with excuses that no one could have forecast this disaster because we only see the future from our own past experiences.

DEFLATION – Are you really prepared?

This has been a week of mass destruction for the majority of worldwide investors as retirees, average workers and even the wealthy are waking up to the fact that a good portion of their wealth has disappeared in the last 60 days. After reviewing dozens of readers’ portfolios this week I am struck by the lack of stop losses used by money managers and investors. Did these “experts” really believe that the credit crises wouldn’t impact asset values? The sad truth is that all but a few see the future from their own experiences and now give the excuse to clients that “nobody saw this coming” and somehow that justifies their complete lack of risk controls. The only bull market in the world is now one of FEAR and has everyone completely frozen and unable to move as they try to find solace in the fact that people would rather lose in company than win alone. One of my favorite expressions is that if you don’t know where you are going, any road will get you there but it is usually used with the homeless clients that my charity, Food on Foot, sees each week. Do you or your financial advisor have a plan for the next 12 months or it is one of hope and faith? Watching business television shows I am constantly amazed when I hear someone say “I don’t have a loss until I sell.” I heard the same thing from holders of Fannie Mae, Freddie Mac, Bear Stearns, WAMU, etc. as their stock prices plummeted and then finally fell to ground zero. What was particularly painful was watching portfolio managers tell a TV audience they were adding to losing positions because the fundamentals hadn’t changed, the stock was selling at less than book value or the dividend yield was attractive. These managers believed in these strategies because they like everyone else only see the future from their own experiences. Did these “experts” have their own money at risk or were they playing roulette with the retirement savings of hourly workers? The game of investing has changed for the next decade as many failed to heed my warnings of the past two years that history did repeat but not from the 70’s or 80’s but the early 1930’s. The biggest lesson learned in the past few months is that the financial world is like a baseball game where 18 are on the field and 56,000 are in the stands. The problem is that your financial advisor is in the stands with you instead of being on the field seeing the play before those in the stands. Isn’t it about time you trusted those hard earned $$$ to someone who has risk controls in place and won’t use the excuse “no one saw this coming”? I am NOT a financial advisor or broker but can refer you to qualified experts and I do NOT take a fee for the referral. If you want me to review your portfolio or have questions send me an email.

The Fed and short-term interest rates

Does anyone care about Fed policy anymore? The overnight Fed Funds rate is at 1.50% and will soon be lowered to 1.00% and then 0.00% as the Fed makes it clear that the credit contraction is NOT about interest rates. The two-day FOMC meeting that takes place on Tuesday and Wednesday (10-28 & 10-29) should be the most interesting in at least 25 years as the Fed is faced with the problem of how to stop runaway DE-flation. Normally deflation is the lowering of prices (airline tickets, electronics, food, etc). Very few times in history have we seen asset deflation of more than just stock, bond and commodity prices. Home values continue to decline and commercial property (especially office and retail) are in the early stages of a long bear market that will have a devastating effect on the wealth of property owners due to the fact they are leveraged. The ability to qualify for a loan is now tougher not only because of tightened underwriting standards but borrowers no longer have the reserves needed to make payments in case income levels drop. It’s called a negative feed back loop where one price decline leads to another and then forced sales create lower prices and the loop begins again and again. In the late 1970’s runaway inflation forced then Fed Chairman Volcker to raise short-term interest rates to record high levels (above the inflation rate) which made borrowers pay a high “real” cost for their funds. This stopped inflation cold and by the mid-1980’s rates and inflation were slumping back to manageable levels. Fighting DE-flation is much more dangerous because it is not possible for nominal rates to fall to negative levels. The easiest way to stimulate demand is to force interest rates to a level UNDER the inflation rate thus giving borrowers an incentive to invest on leverage. If inflation is negative an interest rate of greater than zero is too high and holding cash becomes the only alternative for investors attempting to preserve wealth. Holding cash does nothing to stimulate demand but does increase the nation’s savings rate which is at historic lows. The only alternative for the government is massive investment and intervention in markets which has been happening in the past few weeks. Lines will soon be forming in Washington, D.C. from state and local governments, businesses needing help (autos) and anyone else who believes they need a helping hand. What we allow, we encourage and it was no surprise today that insurance companies announced they will be receiving some of the government bailout money.

In 2004 Ben Bernanke wrote an 86-page paper on DE-flation and needed government policies if we were to enter a similar period in future economic history. The title is “Monetary policy alternatives at zero interest rates” and is a must read for anyone who wants to move from their seat in the stands to a position on the playing field. The key paragraph states three policy alternatives for the Fed when the overnight rate is at zero (soon). The first is using communication policies to shape public expectations about the future course of interest rates and the Fed has been doing this for most of the year. The second move is for the Fed to increase the size of its balance sheet and recently we have seen a massive increase from under a trillion to almost two trillion. The final step involves the DIRECT purchase of long-term bonds as a means of reducing long-term interest rates. This has not occurred in over 50 years but I fully expect the Fed to begin to buy long-term bonds and/or mortgages soon as long as the inflation component of the 10 year remains near 1.00%. Today this key measure of investor expectations fell to a new low of 71 basis points and should soon fall to zero or less as the world begins to fully understand that DE-flation is a problem that may take years to solve.

When is the end?

Like a fourth grader who wants to know when his family is going home from a long road trip investors are quickly becoming anxious for a return to the good old times and the safe place called home. Change is extremely difficult and real estate, stock and commodity investors have learned to embrace inflation and the advantages of leverage to increase profits when prices are rising everywhere. We are now in an environment that most have never experienced and as a result very few know how to profit from and survive through. You MUST change your way of thinking immediately and stop listening to those that mean well but are caught in the storm where all but a few lose in company. Shell shocked is the first phase followed by numbness and the final phase of wealth loss and depression become the norm. Just because you made a good living in the mortgage or real estate business does not mean it will repeat anytime soon. When someone is giving you advice you must ask “WHY?” instead of believing that everything they say must be true because you feel you know so little. Most of life is common sense and the next four years will bring us a new president that may regret his decision to run for office as he will be handcuffed by events he had little to do with and can’t change the momentum of the hurricane called DE-flation. Very few will survive financially but the choice is yours if you are brave enough to leave your seat in the stands and enter the field of play. How much more pain do you need before you are ready?

Patience is needed for a society that is in financial trouble because they only see the future from their past experiences

Are you satisfied with your investment results for this year? Are you happy losing in company? Do you have the courage to win alone when all of your friends and co-workers are losing much of their retirement assets?

Only four days remaining – Tuesday, October 21st at 7pm I will be giving a FREE one hour class on the economy, interest rates and the safest place for your hard earned savings for the next 12 months. Advance reservations are required (sjg69@att.net) and seating is very limited. The location will be the Olympic Collection in West LA at the corner of Sawtelle and Olympic Blvd. Can you afford not to attend this class? I will teach you how to be one of the 18 on the field that are winning instead of the 56,000 in the stands that always lose.

 The best news of the week is that all financial markets are closed until Sunday evening (Far East) and Monday morning (U.S.). The Federal government finally took step #2 that I forecast months ago and injected permanent capital into 9 of the largest U.S. banks. They have recognized the problem and implemented a solution but are now faced with the more daunting problem of how to force banks to lend money. When the next administration and Congress realize next year that bank lending is not increasing due to the fear of borrower default the final step will be offered to banks. Loan guarantees (similar to the SBA program) will allow banks to lend money to homeowners, commercial real estate investors and corporations without the normal risk associated with lending. Because banks only see the future from their past experiences they would much rather use new capital injections to pay down current high interest debt or purchase government bonds and earn risk free profits. Why should banks take a risk on borrower non-payment when the economy is sinking fast and DEFLATION is reducing the value of the underlying collateral?

Long-term interest rates have increased sharply in the past two weeks despite massive liquidity injections by the Fed into money markets. I have read many “experts” tell us that inflation expectations are rising due to the fear that the explosion in the Fed’s balance sheet will eventually be used to purchase goods and services and drive prices higher. If that was true wouldn’t we be seeing an increase in the inflation component in Treasury notes and bonds? The 10-year U.S. Treasury closed today at 3.93% with an inflation component of 1.07% and a real rate of 2.86%. This compares to a nominal rate of 3.45% on October 6th with an inflation component of 1.28% and a real rate of 2.17%. Long-term rates have risen due to a perceived risk by investors that the U.S. government will default on its debt. The five-year Treasury has an inflation component of only 0.30% with a real rate of 2.52%. Investors are much more worried about the health of the U.S. than its inflation rate. Thursday’s CPI (retail inflation) rate was 0.00% and the next 12 months will see an actual decline in prices giving us the first real DEFLATION since the early 1930’s. This will allow long-term rates to stay relatively low (but much higher than short-term rates) as lenders see very high real rates of return (nominal rate less inflation). The problem is that this is exactly the opposite of what will stimulate borrowing and spending. For the past 10 years people bought homes for the main reason that they feared prices would be higher next year and with cheap financing available today was the best day to buy. Inflation was embedded in everyone’s mind and reinforced by prices that were rising every year. DEFLATION is a period of declining prices and since no one has ever experienced this they don’t expect it or know how to react when it occurs. We can only prepare for something we have experienced. If you witnessed declining home prices for a few years you would be very hesitant to purchase a home for fear its price would be lower next year and in the future. Since these purchases are mostly made on leverage lower prices will wipe out equity and produce margin calls from lenders.
 

The Fed

In good times the Federal Reserve raises short-term interest rates to stop the flow of credit and rising prices. This has the effect of increasing the real cost of borrowing (borrowing rate less inflation) and normally the economy slows down, rates fall and demand is restimulated and the cycle repeats over and over. DEFLATION is much more dangerous because once prices begin to fall and inflation goes negative it is impossible for the Fed to lower rates enough to cause positive real rates for borrowers. Why would anyone borrow money at a rate ABOVE the rate the inflation? Especially if they believed the price of the purchased asset would be lower next year. This is exactly the problem the Fed is faced with today and why it must lower the overnight Fed funds rate as soon as possible to 0.00%. The next FOMC meeting will be held on October 28-29 and an announcement of action at 11:15am on 10/29 but has it has shown in the past 18 months it can make a change at any time. Fed head Bernanke will testify before the House Budget Committee on Monday October 17th at 7am but markets are no longer hanging on his every word as it has become obvious he is only reacting to the latest crises and has no idea when or if it will end. A rare admission of confusion was admitted by Vice Chairman Kohn on Wednesday when he stated: “But recent events have few if any precedents, and thus we can have even less confidence than usual in our economic forecasts.” The world financial markets need confident leaders that can lead the way out during uncertain times. When they are confused it drives all markets lower as investors become more worried about the return of capital more than the return on capital.

The next BIG problem

With declining prices comes lower tax receipts and many state and local governments will find themselves on the verge of bankruptcy next year. I’m sure they will be headed to Washington seeking a bail-out with reasoning that their existence is more important than banks. Car companies will also be seeking a hand-out and any other industry that has hit hard times. What you allow, you encourage is one of my favorite sayings and it will apply in 2009 as the line at the Treasury window becomes a long and winding road.

Get comfortable, we are long way from the bottom

The U.S. economy remains in the ICU and after many operations will be resting in the economic hospital for at least the next four years. It is unrealistic to expect someone to bounce back from as much trauma as we have seen (will continue in 2009) this year and yet the most common question I receive each day is” Have we hit bottom?” with the assumption we will rebound a few months later. Time is only your ally in an inflationary environment when everyone makes money despite their lack of due diligence and hard work. 99% of profits are made on the long side (buying) because prices generally rise over time. But when prices decline year after year the only asset that rises in value is cash and most of America is deeply in debt. On April 7, 2008 I wrote: “We have begun a MAJOR de-leveraging in this country where credit becomes a precious commodity and increased savings drives consumer spending lower. The days of living beyond your means have ended and the high-speed train (U.S. economy) is slowing down to a much safer speed as it prepares to endure the most difficult economic period in over 75 years.” We all knew it was coming but convinced ourselves that like the game of musical chairs we would be able to secure the last chair in the game. It never happens that way because we really are more secure when we lose in company than make the preparations to win alone. Did you have stop losses in all of your investments? Why not? Because your broker said this would never happen and now tells you “This is the worst I have ever seen it.” Or my favorite “you lost less than the market averages”….losing less still means you lost part of your hard earned $$$…do you know when you will have lost enough to change??? Or is it more of going along with the crowd?

Patience is needed by everyone as expectations for future recovery are overly optimistic. The business TV channels continue to interview so called “experts” and ask for recommendations for the long side of the stock market. Bear markets are rare but they all have the same characteristic of lasting longer than anyone expects and destroying the majority of investors’ wealth. Rallies bring hope of a break even or trading profits but the reality that the world is not what we need it to be…are you ready to change your way of thinking even if all of your friends, family, advisors are stuck seeing the future from their own experiences?

I hope you will choose to spend an hour with me on Tuesday (10/21) and begin the process of change.

If you don’t know where you are going, any road will get you there…

Tuesday, October 21st at 7pm I will be giving a FREE one hour class on the economy, interest rates and the safest place for your hard earned savings for the next 12 months. Advance reservations are required (sjg69@att.net) and seating is very limited. The location will be the Olympic Collection in West LA at the corner of Sawtelle and Olympic Blvd.

On November 20, 2007 I wrote “This time is different and it is going to be more painful than you can imagine”. “We are nearing the end of the first phase of what history will see as the demolition of hundreds of billions of dollars of real estate and mortgage equity in the U.S. economy. A true bear market is not something we have seen for over 80 years and it is long-lasting, painful and doesn’t end until the masses have left the scene of the massacre.” Did you protect yourself? Doubtful, as the vast majority of Americans faced with a future they have never witnessed freeze and use hope as a survival strategy. Did you have stop losses on all of your investments? Or did short-term investments become long-term holds (and hope) due to unexpected price declines? My theme for 2008 has been that 99% of investors would rather lose in company than win alone. Losing becomes justifiable if everyone else is also losing their life savings with comments like: “No one saw this coming, who could have known, this is the worst I have ever seen, or my favorite….I refuse to be anything but optimistic.” We rely on support systems (friends, TV, newspaper) that tell us what we want to hear because if they confirm our worst fears it places us in a position so uncomfortable we flee. The question is are you brave enough to embrace a future that has not been seen in your lifetime and make necessary changes that will protect your wealth. It is much more difficult than it sounds and very few will be standing when this economic collapse hits bottom in a few years. The cost of inaction is huge and the pain enormous but most people are followers and will do anything not to change their behavior.

On January 7th of this year my issue was titled: A year of uncertainty and I gave three best bets that offered low risk but unlimited upside potential. #3 was that the commercial real estate market would begin a severe bear market as the securitized financing market would not return and the government would not have an agency (similar to Fannie & Freddie) that could fill in the financing void. As the economy fell into the most severe contraction since the depression values would fall and vacancies rise. We are in the early part of this decline and 2009/10 will see massive problems for those that invested in shopping centers, industrial buildings and office buildings. Apartment buildings will suffer the least because people must have a place to live. (My charity Food on Foot is seeing a dramatic increase in the number of people we serve each week).

The 2nd best bet for the year was against the British Pound. It was trading at 1.97 and the forecast was for a move to 1.80 which occurred recently and the Pound now trades at 1.70. It was clear the UK was going to follow the U.S. with housing problems and the Bank of England’s high overnight rates were the wrong policy as inflation would soon plunge and force the BOE to ease. This week the overnight rate was cut by 50 basis points and will surely be cut again soon.

The #1 best bet for the year was an investment for a lifetime and was based on continued Fed easing and the yield curve to widen dramatically. The spread between the 2-year and 10-year Treasury notes was 108 basis points on January 7th. Early this year I used a term “back up the truck” in an attempt to move everyone into this opportunity and today the spread has widened to 228 basis points with the 2-year at 1.58% and the 10-year at 3.86%. The curve will stay positive for years as the Fed is not even close to thinking about tightening monetary policy and short rates must stay low so that banks can fund themselves and make back some of their capital that was lost in the past 21 months.

Hopefully you have followed my forecasts this year and made lots of money but if you haven’t isn’t it time you asked yourself why not? Was it because I was so far away from the mainstream predictions? Was it because no one else agreed with me? Do you need to have all of your friends and advisors agree before you make a decision on an investment? During this time of incredible financial panic it is imperative all readers do an assessment of their investment philosophy and most importantly analyze why they don’t use stop losses and/or surround themselves with advisors that would push them to limit their risk and fight the tendency to freeze. Real estate investors are learning a hard lesson that the market doesn’t care about your purchase price and that you only have a loss if you sell is a sure way to financial ruin. Since we only see the future from our own experiences this year’s financial collapse will push 99% of investors to a “I’ll never invest in the stocks real estate, commodities, etc. ever again” mode and again “freeze” when they should be making plans for the future and trying to learn from their mistakes. The biggest mistake is the hardest to overcome: Realizing that if you don’t know where you are going, any road will get you there.

The Golden Rules

Print these out and place them on your refrigerator door so you see them every day.

#1 – Never enter an investment without knowing in advance your exit point on the upside and downside. You must know in advance how much you will risk and “I will watch it” is not an acceptable answer.

#2 Never add to a losing position, If you are losing $$$ you are wrong and there is no reason to believe things will change. I am amazed at the big money managers that bought millions of shares of Fannie & Freddie as prices continued to decline using the excuse that the fundamentals were still strong and the government would never allow them to go under. These “experts” were correct; the government did bail out Fannie & Freddie but not before common shareholders were wiped out!

#3 Add to winning positions which is usually the opposite of what investors want to do which is take profits and allow losses to grow.

#4 The market doesn’t care about your purchase price, if you buy a stock at $100 and it begins to decline waiting for it to go back to $100 will usually give you bigger losses as we have seen this year. Become an expert at stop losses by trading and trading and trading and then taking losses, practice does make perfect but everyone needs more practices taking SMALL losses.

#5 Stop believing the past will repeat, real estate agents, mortgage brokers, homeowners saw the hurricane coming but refused to change because “real estate is always a good buy, every time in the past I bought a few years later I had a profit, and the best of all time…I don’t know any other business I could make this kind of $$$.” What makes you believe you will ever make this kind of $$$ again?

#6 Finally, the best lesson of all…always ask why? when someone gives you an investment idea. For the past three years every time someone would tell me they wanted to buy a house, building, stock, etc. I would ask why? And the answers were always the same. My real estate agent said it’s a good time to buy (have you ever heard a real estate agent say it was a bad time to buy?), my friend made $$ doing this, (was he lucky or smart?) As Warren Buffett always says: “A rising tide will float all boats”. Analyzing why you made $$$ is the most important thing you can do and must be done with everything. The excuse of “I have never seen this before” is unacceptable from a stock broker, portfolio manager, real estate agent because it doesn’t do anything to get back your losses. Billions of dollars have been lost this year in real estate, stocks and other markets and most could have been avoided with simple stop losses and risk levels set in advance. People believe what they need to believe to get through the day and you need to surround yourself with advisors that aren’t afraid to take small losses, think outside the box and most importantly are not afraid to win alone. Life is like a baseball game where 18 are on the field and 56,000 are in the stands. Which group are you in?

The markets

With U.S. stocks down a few hundred Dow points today the federal government needs to declare a “market holiday” and close the stock exchange for at least Monday if not all of next week. Seven consecutive days of 1% or more declines in the S&P 500 haven’t been seen since 1897 and are only making consumer and investor psychology worse than it needs to be. The markets are losing faith in the financial system and our government leaders. The stock market was closed for four days after 9/11 and it had a beneficial effect on prices when the market reopened. Long-term interest rates are rising not because of a fear of future inflation but because foreign investors (and some in the U.S.) are fearful the government will default on its debt. Everyone is glued to the financial TV channels and it is becoming a “soap opera” but in this case it is a real catastrophe with dire consequences for the future. The stock market will recover in time but the U.S. economy is headed for 8-10% unemployment and the only one hiring in the next year will be the federal government. Society is used to quick fixes from our leaders but patience will be needed as the solution will take years. Please don’t fall into the trap we have seen this year where people say it hasn’t affected them yet so it won’t…..it will affect everyone and you MUST change your way of thinking, acting and decision making immediately or you will become one of the 56,000 that is losing everything. Are you brave enough to take the field and be one of the 18 that isn’t afraid to win alone?

I hope to see you at my FREE class on October 21st, can you afford to be anywhere else that evening?

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The Fed MUST lower the overnight funds rate to 0.00%

Daily subscribers received valuable market and economic information BEFORE the credit contraction became a daily headline in every newspaper in America. Can you really afford to be without this valuable tool each night at 10pm? To subscribe…

The picture above is from June 2006 when a power outage blacked out parts of Honolulu, Hawaii. The past 18 months have seen the most severe credit crisis since the early 1930’s and is very similar to a rolling blackout as most areas believe they will be unaffected until they lose power and are unprepared for the event. Yes, this mortgage/real estate mess was predictable (see archives) but it is so much easier to believe everything will be ok and then when it hits to act surprised and justify the results with thoughts that everyone else is in the same position and no one else saw this coming. Losing in company is comforting but doesn’t prevent your wealth from decreasing rapidly. The vast majority of real estate, stock, hedge fund and other investors are frozen at this time not having a clue what to do because they have never seen anything close to today’s events as hope is not a good strategy.

Congress finally passes the bailout bill

Monday the House stunned the financial world with its swift rejection of a $700 billion plan that would help remove toxic mortgages from bank balance sheets. U.S. stocks fell 777 Dow points but caused very little panic in Washington as the typical voter hasn’t been hit yet by the rolling credit blackout. With an election only four weeks away these publicity hungry politicians were center stage for the entire week that finally ended with today’s passage and signing by the President. The bad news for Washington is that the stock market declined sharply after news of the vote and if Dow 10,000 is taken out next week it will again create headlines that will be met with concern from voters across the country. The bill does increase the FDIC insurance limit to $250,000 per account and allows the Fed to pay interest on reserves from its member banks but a change in psychology may not come quick enough for those running for office in November. The really bad news is that it will take years to recapitalize the banks and many will not survive.

The Fed’s balance sheet is growing and growing and growing…

In the past week the Federal Reserve expanded its credit by $500 billion as it has become the lender of last resort to banks, brokerage firms and companies that need oxygen (credit) to continue daily operations. When the Fed began to increase its lending a few months ago financial markets were fearful of a rise in inflation expectations which drove gold and other commodity prices to yearly highs. As I wrote months ago DEFLATION is a bigger problem and all commodities except gold have fallen to lows for the year. We witnessed the same problem in Japan in the early 1990’s when the great Milton Friedman warned of hyper inflation due to a massive increase in the Japanese money supply. It never occurred because velocity slumped as borrowers couldn’t borrow from banks that refused to lend. Today we have a similar problem in the U.S. as banks lack the capital needed to fund loans and asset values are falling so fast the collateral needed for loans has disappeared. Once deflation begins it is very difficult to stop and Fed head Bernanke is well aware that money is needed in the short run to improve liquidity but in the long run he must find a way to increase bank capital on a permanent basis. The Fed MUST lower the overnight funds rate to 0.00% immediately which will increase bank profit margins AND should lower long-term borrowing costs for struggling businesses and homeowners.

Could the U.S. default on its debt?

Long-term interest rates are a function of future inflation expectations and a real rate of return. The U.S. Treasury 10-year note closed today at 3.60% with its inflation component at 1.44% (a five year low). As long as this rate remains below 2.00% foreign money will continue to flow to the U.S. Treasury market and drive nominal rates lower. BUT something very interesting has occurred in the past week which we haven’t seen in this country in 75 years. The 10-year rate is a little higher (30bp) than it should be due to a premium for the risk of a default on its debt by the U.S. government. Foreign and U.S. investors are more than a little concerned about the Fed/Treasury printing $$$ by the billions in an attempt to rescue “too big to fail” government agencies and U.S. corporations. The worry is NOT coming from future inflation expectations and that is why the inflation component of the 10-year continues to fall. This is why it is so important for the Fed to lower the Funds rate to 0.00% and show the world they fully understand the severity of the problem and recognize that investors are not worried about inflation but the risk of not seeing their principal returned when their U.S. bonds come due. Until markets stabilize (short selling should come back in three business days and is badly needed in the stock market) the risk premium for a default on U.S. bonds will be a head wind for the long end of the Treasury market.

Have you tried to find a job lately?

Although today’s jobs report showed the U.S. unemployment rate was unchanged at 6.1% it will soon be headed higher with a target of 8.0% or more in 2009. A fall of 159,000 jobs in September (after a seasonal adjustment of +42,000) is a strong pick up from the 73,000 loss in August and 67,000 in July. With population growth every month we should never see a decline in jobs but this credit crises is just beginning and the job market is now crowded with thousands of over-qualified people applying for minimum wage jobs. If you have a job opening at your company an ad on Craig’s List will bring 1000+ resumes in the first 24 hours. Temporary jobs fell 24,000 in August and the number of people willing to take part-time employment for economic reasons soared last month and is an excellent indicator of future rising unemployment.

When the big are having trouble, the small may not survive

The king of all investors, Warren Buffett stepped up this week and invested $3 billion in a new preferred stock with a 10% dividend issue by GE. He also was given warrants to purchase common stock at a below market price. Why does GE need to pay 10% to borrow money? The credit contraction has now crossed over from real estate and mortgages to well diversified businesses that rely on short-term funding from money markets and banks that is no longer available. Solid, profitable corporations are now faced with money markets that will only loan funds for a day at a time and at very high rates of interest.  AT&T was faced with these problems last week and the result is to try and access permanent capital (see above) and begin to consolidate operations and cut spending (jobs) to raise cash that will be needed for future operations. By the time the average worker is laid off and politicians realize it is affecting the average voter the unemployment rate will be much higher. Wall Street and big corporations are having a very difficult time explaining (in English) how this credit crises will affect the general workforce and until they find a better way to communicate the tug of war will continue over how to solve the biggest economic problem this country has faced since the Great Depression.

The week ahead

Could we finally see a week with no bank failures? Stock market rally? Lower long-term mortgage rates? Today’s announcement from Wells Fargo that they have a signed merger agreement with Wachovia has the FDIC is surely its heels and wondering who is in charge of the banking system. Market volatility is usually seen at major turning points and although my call last week on the stock market was clearly premature, an intermediate rally should begin soon led by major bank stocks that will be seen as “too big to fail” by the U.S. government. Long-term mortgage rates must come down for the economy to have any chance of recovery in 2009-2010. As former Fed Chairman Greenspan found out the hard way these rates are very difficult to influence as they are subject to long-term inflationary expectations. Investors should watch the inflation component of the 10-year on a daily basis as a barometer of investor’s appetite for long-term U.S. bonds. The dollar should remain strong for the remainder of the year which will create continued demand for U.S. debt and if inflation expectations remain under 2.00% we may see a fall in mortgage rates and that will have a positive effect on consumer’s wallets. Fed chief Bernanke will speak on Wednesday at 10:15am PST (10/07) in Washington on the economy and remind the world he will continue to open the Fed wallet for as long as necessary to reduce the strain in the money market. But he also knows the real problem is not liquidity but a lack of bank capital and until that is corrected there is NO chance of a bottom in real estate prices or a slumping economy. Credit is oxygen and without it the U.S. will tumble into the 2nd Great Depression in the last 78 years. To survive you must be willing to change your way of thinking and decision making and not be afraid to win alone as everyone else around you loses in company.