Notes on my scorecard

Daily subscribers receive my thoughts five nights a week but weekly readers need to be kept up to date when opportunities arise or events warrant a comment. I have spent the past forty years (18 hours a day) observing, analyzing and forecasting economic and market events so nothing that has occurred in the past two years is a surprise or something I haven’t seen before. Old age brings very few advantages in life but if your memory doesn’t fail past experiences do give one an edge when preparing for future events.

I keep a daily diary of important events that occur each day and it is frequently reviewed when I am attempting to forecast market reactions to economic events. All serious investors keep a daily or weekly log of their thoughts with the reasons for every decision along with the results. Investing is just like a business and yet so many investors don’t get rid of what isn’t working and add more of what is profitable.

U.S. stock market

The March lows have held despite massive investor pessimism and the recent rally has gone further than expected because money managers have been forced to come off the sidelines for fear of missing another significant move. Last year these managers were able to convince many clients that losing “only” 30% was ok because the overall market was down 40% but relative performance is an excuse and doesn’t pay for food and shelter. Paying a fee to have someone lose money is not what most investors want or expect but justify as long as everyone else lost $$. Losing in company is sometimes more comfortable than being the only winner. The stock market anticipates corporate earnings and future economic growth and the spring decline had created expectations that were close to depression levels. With massive injections of capital by the Federal Reserve and Treasury the patient was revived but remains in no shape to leave the intensive care unit despite the optimistic forecasts of always bullish analysts that see the future more from their need to be positive than the reality of what won’t change for at least four years. GDP may bounce back with a small positive gain the in third or fourth quarter but using that as a base for the end of the recession may be too big an assumption and another setback is due next year. Much of the earnings surprises that propelled stocks higher in July have come from a reduction in costs NOT an increase in revenues and there is only so much a company can cut unless labor costs are going to decrease and that is doubtful considering the federal minimum wage increase that became effective today.

For those that are having withdrawal pains from missing the recent S&P run-up remember to always use stop losses (no exceptions) and only buy on two day pullbacks. The S&P could easily reach 1000 or more as cash chases the rally focused more on fear than strong future economic fundamentals. With unemployment above 10% and some states at record highs there is only so much a state or local government can do to create permanent jobs. The ultimate stimulus must come from a reduction in tax rates or new tax credits that incentivize corporations to invest money in new ventures that will create new and lasting jobs. Currently corporations are paying down debt and work hours trying to stay in business and while that may give a short-term boost to earnings in the long run a focus on survival will not bring the risk taking that is needed for corporations to grow. Normally when an economy rebounds workers are hired back by companies that reduced their workforce but this time we have seen hours cut instead of layoffs and that will delay new hires as current workers are given more hours. It will be many years before we see any relief in the unemployment rate. It’s also important to remember that population growth adds new workers every year (college and high school graduates) and they are now competing for jobs against people with experience and who most likely will be hired back first which would drive down wage levels except for the fact the government has a minimum wage floor. Everyone is anticipating the end of the current recession but the U.S. economy is not binary and if we are not falling it does NOT mean we are rising and I see many years of slow to non-existent growth where the government is forced to keep the patient from regressing but definitely not showing any progress. The new reality for this country is a slow grind with no return to the risk taking, high growth asset bubbles we saw in the last twenty years. The big question is how long it will take the average person to change their lifestyle, spending and savings habits.

Interest rates

This week Fed head Bernanke gave his semi-annual testimony before the House and Senate concerning monetary policy. He is the most visible Fed Chair in history and penned a commentary earlier this week in the Wall Street Journal and then will close the week with an appearance on Jim Lehrer’s PBS show on Sunday night from Kansas City. He made it clear this week the Fed’s zero interest rate policy (short-term rates) is in no danger of ending and investors should expect low borrowing rates for the foreseeable future. The Fed has spent much of the year buying hundreds of billions of mortgage backed securities and Treasury notes to help keep rates lower so it is highly improbable they would allow rates to rise and cut off demand for credit that is almost non-existent today. The supply of credit (except from the government) continues to contract and long-term rates should continue their seasonal pattern of falling in the second half of the year. Inflation fears rising from the bloated Federal Reserve balance sheet are misplaced as the money printed has been sent to the banks only to be returned to the Fed for safekeeping. According to the Fed’s H.3 report (http://www.federalreserve.gov/releases/h3/Current/h3.pdf) the $55 billion increase in the monetary base for the week ending July 15th was matched by an almost identical $56 billion increase in excess reserves held by banks at the Fed. Until we see the Fed’s money creation used for lending instead of saving the inflationary consequences will be zero.

Gold

Although my forecast is for little if any inflation over the next few years, gold appears to be an appropriate insurance policy for a small amount of investor funds. A move above $1000 could easily trigger panic demand from investors underinvested in the yellow metal but volatility is high and a stop loss under $900 should be in place. The Fed and Treasury’s only chance for a significant economic rebound may come from a weaker dollar and foreign demand for U.S. goods and services. If the dollar is allowed to depreciate it could stimulate demand as long as inflation expectations remain muted. It’s a tricky move because experts have been forecasting the demise of the U.S. dollar for decades and many have only losses to show for their efforts. It is also a strategy that may be used by other countries facing weak domestic demand and a rush to depreciate many world currencies could trigger unintended consequences for many trading partners.

Summary

Nothing has changed from my earlier forecast of a painfully slow recovery from the past two year credit crises. A country not used to patience will learn painfully that government assistance can stabilize the patient but not give the needed medicine to leave the hospital and return to the ways of old. Government regulation and taxes will continue to rise and the incentives for business to take risk won’t return for at least four years. Investors that maintain a strategy of focusing on the return OF capital instead of the return ON capital will be in a better position to take advantage of the next economic upswing beginning in 2013.

The reality of DEFLATION has entered the thoughts of investors

Five nights a week at 10pm (Sunday-Thursday) I send an update with my thoughts about markets, the economy and interest rates. Below is the e-mail sent to all daily subscribers last night, if you wish to subscribe the cost is only $1 a day. 

The biggest news of the day comes from the $19 billion 10-year T-note auction that sent shorts scrambling to cover after massive losses. I have warned for two weeks that a major short squeeze was coming because the overnight repo rates were causing much pain for those betting on higher long rates. The 3-year repo rate today was MINUS 1.05% and the 10-year was MINUS 2.05%. We should see some relief on Thursday as many of these shorts are gone wondering how they could lose so much is such a short amount of time. The 10-year closed at 3.31% and the inflation component fell 10 basis points to 1.54%. Thursday is the final leg of this week’s auctions and $11 billion of 30-year bonds will need bids at 10am (PST). It’s doubtful the shorts will again wait to cover in the auction and we should see an uptick soon back to at least 3.50% in the 10-year. Today’s auction was truly extraordinary because the 10-year was trading at 3.425% at 10am when bids were due but the auction cleared at 3.365%. Billions of shorts who thought they covered in the auction were left without notes and it was a mad scramble within seconds of the auction results for notes at any price. The bid cover was 3.28 (bids versus winners) and the normal for a 10-year auction is 2.26 which again tells us that most of the shorts missed yet again. We are on our way to 3.00% in the 10-year with more shorts that need to be covered AND because the inflation component has fallen 50 basis points in the last month.

The Fed announced today the dates for their next note and bond purchases with one tomorrow (1-2 yr maturities), two next week and two the following week. The Fed has now bought over 60% of its $300 billion Treasuries and almost 40% of its $1.25 trillion mortgage backed securities. A month ago when the 10-year was at 4.00% everyone believed Fed purchases were inflationary but now these same traders are trying to find places to hide from what is obviously deflation.

The Fed reported consumer credit fell $3.2 billion in May after a revised record decline of $16.5 billion in April. Many experts are declaring an end to the consumer spending contraction but these figures are always revised and banks show no signs of increasing credit to anyone except those that don’t need to use it. Consumer credit has now fallen $62 billion since its peak in July 2008.

Most of the important news on Wednesday showed an acceleration in the DEFLATION that is now affecting new areas of the U.S. economy. A very sharp reader asked about food prices and the Arizona Farm Bureau reported that food prices fell 6.5% in the second quarter of this year.

Southwest Airlines announced one of the biggest fare sales in their history with one-way fares as low as $30 (trips up to 400 miles) and American and other airlines have begun to match as much as possible. Falling air fares in the summer when most people travel on vacation shows how many are not flying and is another example of DEFLATION. 

Less flyers means less revenue for airports and many are considering slot machines, corporate sponsorships and other Las Vegas type ideas to bolster their bottom line. http://www.tampabay.com/news/business/airlines/article1016490.ece

According to an analysis from Real Capital $108 billion U.S. commercial properties are now in default, foreclosure or bankruptcy up 100% from earlier this year. At the end of June 5,315 buildings were in financial distress and increase of more than 100% from January. 

Last night I wrote about apartment vacancy rates and rents falling and tonight Reis Inc. released rates for both strip and regional malls. Vacancies at U.S. strip malls hit 10% in the second quarter but more importantly effective rents fell 3.2% in the past 12 months. 7.9 million square feet was returned to the market last quarter and there are NO signs of bottoming especially since the consumer can’t obtain credit and is too afraid to spend.

Although the Fed and administration are telling anyone who will listen they want an increase in lending the Fed has quietly been adding personnel to it supervision and regulation group. They are projected to employ 2,876 in 2009 versus 2,674 in 2008. Banks are not only afraid to make loans against collateral that is declining in value but also because they know every loan will be examined more carefully and by more bank examiners than any time in history. This is why the Fed and almost anyone with assets is desperately hoping for a return of inflation. The only winners in a DEFLATIONARY era are those with no assets and a fixed income (minimum wage workers).

Final thought: What if consumers continue to increase savings AND pay down debt instead of spending? Wouldn’t that drive down prices and long-term interest rates to levels not seen in 60+ years? The poor would become rich and the rich would soon become poor. Would anyone in Washington be upset if that happened?

If you missed my last economic forecast/interest rate class or webinar we now have a CD-ROM of the June 17th webinar with all of the material presented for only a $100 donation to Food on Foot.