The future looks dim for a world that is a ball of confusion

My first interest rate/economic forecast class of the year is only three weeks away and will be held on Tuesday March 24th and is sure to sell out. The class will be held from 6-9pm and seating is very limited. Registration details: http://www.earlywarningwire.com/PDF/interestrateclass2009.pdfCan you afford not to attend? Did your financial advisor warn you two years ago of the credit crises, economic contraction and deflation? Did you use stop losses to exit from stock and mutual fund positions? Are your investments in a state of “frozen shock” and hope is your only strategy? How many newsletters leave all of their past issues on their site and encourage readers to review? 2009 will be a very difficult year as jobs disappear and asset values continue to plunge but assuming that you can’t change your strategy will insure a dismal financial future. Three hours on March 24th will change how you see the remainder of the year; do you have the courage to hear the truth?

The picture above clearly shows the situation the world faces today with the overwhelming presence of deflation represented by the sumo wrestler versus the much smaller U.S. government and consumer trying so hard to push back. What so many believed was just another ordinary business has turned into the most severe contraction since the 1930’s and more similar to the long depression of the 1870’s. Every economic statistic is worse than the previous release and one of the problems that we have now that didn’t exist in the 30’s is the never ending optimism from the pundits on business television. Hope is an expensive strategy that has made investors believe the bottom is near instead of using stop losses to exit positions that have now all but ruined many people’s retirement plans. The U.S. stock market has fallen 55% since the top on October 9, 2007 and the primary topic discussed in the media is what to buy for the next rebound. These networks are more concerned with their ratings than helping investors cut their losses and worry that if they suggest investors go to 100% cash (always a good strategy in a bear market) they would lose viewers. Because we only see the future from our own past experiences it is not surprising that so many are “frozen” and have rationalized that losing in company is better than winning alone but in a few years the financial pain from a lack of decisive action will hopefully prevent these people from making the same mistake again. There will be rallies that have everyone convinced the worst is over but the reality is that it will be years (2013) before we hit bottom and many more before we can begin a sustainable recovery. It took decades to build up the leverage that has caused the problems and the unwinding will be a longer process than many want to endure. The stock market today pierced the 50% retracement point for the advance that began in July 1932 and ended in October 2007. An intermediate term rally is overdue and investors should use it to sell positions and not try and hold on until a breakeven point is reached. Bear markets always give investors opportunities to head for the exits but the rallies are accompanied by those “experts” who tell us to remain seated for a ride back to the promised land of profits.

Ball of Confusion

Markets can handle bad news as long as it is clear and concise but confusion is the big enemy and sellers appear quickly when the sky becomes cloudy. Deflation has taken over the world economic landscape and investors are slowly realizing that debt and leverage accelerate the decline in asset values. Banks are reluctant to lend despite having funds supplied by the federal government for loans because the underlying collateral continues to decline in value. If you loan someone 70% of the value of a house or building and the value goes down by 30% you have very little margin for error. Unfortunately the private sector caused much of the current credit crises and now must rely on government assistance. The government’s biggest asset is its ability to print an unlimited amount of money but its biggest liability is in the execution of effective strategies that will help business get back on its feet. It can lower tax rates for business as an incentive to take the risk that is needed to create jobs and profits that will be required for an economic rebound. The message coming out of Washington last week that a balanced budget and higher taxes are coming soon has the stock market in a total state of confusion. On the one hand the government is trying to help with bail out money but increasing taxes and limiting deductions creates a message that has investors confused and reminds me of the 1970 hit song by the Temptations called “Ball of Confusion.” Many of the verses could easily be written today. “Vote for me and I’ll set you free. Politicians say more taxes will solve everything. Where the world is headed, nobody knows. Fear in the air, tension everywhere, Unemployment rising fast. People all over the world shouting ‘end the war,’ ball of confusion, oh yeah, that’s what the world is today.” Investors and consumers are confused as the economy heads south with prices falling and my theme for 2009 remains that the rich will get poorer and the poor will get richer. If taxes are raised in a deflationary environment the incentive to take risk will be extinguished and the U.S. economy will suffer a decade or more of annual declines in activity with very little if any growth in wealth. I wonder if that is not the new President’s intention as he seems to be focused more on creating a safety net for those suffering and very little on what is needed to create the engine of growth needed to create private sector jobs. Could we be looking at a lost decade similar to what Japan saw in the 1990’s?

Important speeches that are must reading for all readers

Monday, FDIC Chairman Sheila Bair addressed a Washington audience of International Bankers and gave insight into where the government is headed in terms of more possible bank bailouts. The key quotes were: “I don’t see the U.S. government operating a large institution (Citibank?) for an extended period of time. I would be surprised if the FDIC had to step in as conservator or receiver of a large, systemically important institution. (Takeover by another bank?) The main hurdle is that there’s no clear process for resolving a large financial holding company with multiple affiliates. We have a process for dealing with large banks, but not financial conglomerates. There is a very real question of whether our current funding mechanism is adequate to deal with the failure of a very large institution.” She concluded her remarks with a truth that everyone must realize and the sooner the better. “If you’re looking for a quick fix, you’re not going to get one. It’s going to take time and patience.” Americans have not been a very patient society with its buy it now and pay for it later attitude. This has ended and the head of the FDIC told us it is going to take a long time to fix the broken banking system. Although the President believes the problem can be fixed through more bank lending he will learn that the real problem is declining asset values for the assets that make up the collateral for the loans. In the end the government is going to have to guarantee the banks against losses or they won’t loan enough to get the economy growing again.

The other important speech given on Monday was by the Comptroller of the Currency John Dugan who was warning the nation three years of the impending credit crises. He criticized banks for decreasing loan loss reserves as the economy recorded record profits. These reserves are supposed to act as a counter cyclical force for banks but because this recession/depression is not cyclical but secular the banks and examiners weren’t prepared for the turndown in prices and increase in delinquencies by borrowers. Banks are now using very conservative assumptions in their underwriting process for new loans. This is another reason why it is doubtful we will see an increase in lending anytime soon. Borrowers have also begun to change spending habits as incomes decrease and fear for their jobs increases every month that the unemployment rate sets new highs. The savings rate rose to 5% in January after spending many years near or below zero. Consumers realize their world has changed and we must wait for investors to see the world is not as they need it to be (inflation) but the way it will be for at least the next 10 years.

Interest rates

Long-term interest rates continue to hold in their 2.50-3.00% range (10-year Treasury) but as inflation expectations decline it will be easier for these rates to go back to lows seen earlier this year. The Fed remains the buyer of last resort in the Treasury market but would rather wait on the sidelines hoping that investors realize inflation is not a worry for many years and that positive Treasury rates with negative inflation (deflation) create a very high “real” rate of return. The dollar continues strong against all currencies except the Japanese yen and foreign central banks continue to see the U.S. as the safest place for funds and receive a decent return (including currency appreciation).

Bottom Line

The world has changed and the real question is have you changed with it? The bear market in stocks needs a breather but has already done enough destruction that most investors will hide in the safety of CD’s and Treasury bills for the next ten years. Opportunities do exist but they are centered around assets that rise in value during a deflationary period and real estate is NOT one of the chosen few.