Friday, June 27, 2008

This Stock Market is Similar to 1933

I've seen some commentary recently about how bad the market is, comparing it to the previous worst start to a year, 1933. That sounds ominous since everyone knows that 1933 was in the middle of the Great Depression. Unfortunately for the gloom and doom crowd, 1933 also proved to be the bottom of a bear market and stocks subsequently returned 195% over the next 3 years. History never repeats exactly, but it just goes to show that, even in the depths of the Great Depression, the stock market was still able to pull off a pretty impressive bull market.

We have come through this in better shape than most investors because of our exposure to commodities, but we aren't immune to stock market declines. We hold larger positions in commodities than most advisors but the majority of our assets are still in stocks. The key though is to get through this bear market without taking a big loss. And so far we've been able to do that. Hang in there; if you can get a nearly 200% rise in the market during a depression, surely we can get a rally too.

Marc Faber: Buy Gold

Marc Faber has been right about a lot of things when it comes to investing. He was way ahead of the curve on the credit problems and called the commodity bull about the same time as Jim Rogers. In this interview on CNBC, he rips the Fed and recommends gold:

The Fed has been "misleading" investors on wanting a strong dollar, Faber said, as it kept lowering the interest rates. "When it comes to action, they show no concern about inflation."

He also blamed the central bank for forcing investors to abandon safe deposits in banks for riskier strategies by keeping rates so low.

"The Federal Reserve is the greatest speculator—they force people to speculate," he said.

"I think they should have stopped cutting rates at say 4 percent … you could stop cutting rates and pursue a tight monetary policy. You can take other measures, mop up liquidity," Faber added.

There's a video of the entire interview at the title link.

Best Evidence Yet of an Oil Bubble

Paul Krugman's editorial on oil speculators is actually technically correct, but when he says that the price of oil is supported by fundamentals, well that is to me prima facie evidence of a bubble. Krugman's track record since he started writing for the NYT is terrible and betting against him would have been very profitable.

He does have one good line though:

Many economists scoffed: Mr. Masters was making the bizarre claim that betting on a higher price of oil — for that is what it means to buy a futures contract — is equivalent to actually burning the stuff.

He's right about that one. Futures contracts are nothing but bets about the future price of the underlying commodity. As Hanke points out in the post below, there are other reasons why the price is rising; the placing of bets has no effect on supply and demand.

Required Reading for Politicians

Steve Hanke explains how the oil market functions and why prices are high. He also provides a way for politicians to do something useful about high prices rather than just hold hearings. First, he explains the role of the dollar:

For example, if the greenback had held its January 2001 value against the euro, oil would have traded at about $76 a barrel in May 2008. This is almost $50 below the price that crude oil was trading at in May 2008. Accordingly, the decline of the dollar’s value accounted for a whopping 51% of the $97 a barrel increase in the price of oil from May 2003-2008.

That's why a rate hike by the Fed to shore up the dollar would have also gone a long way toward puncturing the oil bubble.

Hanke then goes through an explanation of contango and backwardation and the resulting commodity interest rate:

If the price of a commodity for future delivery exceeds the spot (or cash) price, the market is in contango, and the commodity interest rate is negative. A lender of a commodity has no incentive to lend to the spot market because he would be in effect selling low and buying high. The reverse occurs when the spot price exceeds the futures price and the market is in backwardation. Commodity interest rates are positive. In this case, it pays those who hold commodities to loan them to the spot market.

Finally, Hanke gives some advice on how to bring prices down:

Instead of hoarding the SPR, the government should sell outof- the-money (at strike prices that exceed the current spot price) call options on the SPR. This would allow the purchasers to buy oil at the strike price until the option contracts expired. It would transform what is in effect a dead resource into a live one. It would provide the country with a huge inventory of oil, generate revenue to defray some of the government’s stockpiling costs, smooth out crude oil price fluctuations, and push down spot prices relative to prices for the oil to be delivered in the future. In consequence, commodity interest rates would become very negative as inventories would be abundant.

A stronger dollar and market-based release rules for SPR would provide relief from sky-high crude oil prices.

The solution is elegantly simple and has the advantage of being correct. Every politician should be required to read this article.

The Money Magazine Indicator

Money magazine is the Time or Newsweek of the investment world. By the time an investment fad makes it to Money, it is probably nearing a top. A recent example would be their stories about real estate in June of 2005. Now, Money has a story on inflation and how to protect your assets, including an allocation to commodities (HT: Tim Iacono at TMTGM):

One way to beat inflation is to own the stuff that's going up in price. Between 1973 and 1981, when inflation averaged 9%, the Goldman Sachs Commodity Index, which tracks oil, metals and food futures, averaged a 13% annual return. In just the past five years, commodity-driven mutual funds have gained an annual average of 30% vs. 10% for Standard & Poor's 500-stock index.

As Tim points out, the allocation is small, so maybe this isn't the story that marks a top in commodities. It would be a clearer sign if commodities were featured on the cover of the magazine, but this is certainly not a good sign for commodity investors. Tim was very good at calling the bubble in housing and the rise in commodities but, hey Tim, you can't have it both ways. Back in 2005, you used the real estate mention in Money as a sign of a bubble. This time you use the Money indicator to reinforce your argument to own commodities. If it meant a real estate bubble in 2005, why isn't this a sign of a bubble in commodities?

Thursday, June 26, 2008

Bernanke Blew It

I wonder if Ben Bernanke will ask for do overs on the FOMC meeting yesterday. Whatever reaction he expected from the inaction and statement of continuing belief in the future moderation of inflation (a belief that at this point is akin to the belief in unicorns) I'm guessing it wasn't a near 400 point sell off in the stock market, a dollar mugging, a $30+ spike in gold and a record close in the price of crude. And I wonder if Richard Fisher is telling his fellow FOMCers I told you so today. Fisher dissented for a hike in rates, apparently the sole remaining sane member of the panel.

The stock market is going down for a variety of reasons, from idiotic talk about banning speculation in oil markets (don't the morons in Congress know that oil speculators can short oil too?) to the never ending list of taxes Obama plans to raise, but the Fed head in the sand routine about the dollar and inflation just pushed things over the edge today. Public policy, whether from the coin clippers at the Fed or the do anything to get re-elected reconstituted populists of Congress, has I think reached a nadir of superficiality.

Would it really make any difference whatsoever to the economy if the Fed funds rate were 2.25% rather than 2%? While they certainly don't need any help in their never ending search for bankruptcy court, I suspect the banks would have weathered the storm of a symbolic hike in rates. They aren't lending anyway; what difference does it make? The Fed had an opportunity to lend actual support to the dollar rather than the empty rhetoric of the Ben and Hank show and they blew it. A symbolic rate hike and some timely intervention in the currency market could have done wonders for the dollar with the added benefit of deflating the oil bubble. It was so obvious that like the bugaloo, it plumb evaded them (to quote that other famous Buffet, Jimmy).

So what now? Has the Fed ever convened an emergency meeting to raise interest rates? The next meeting isn't until August and at the current rate of rise, oil will be more precious than a room full of babies and puppies by then. In a recent commentary I said if the price of oil didn't fall soon, I'd have to change my outlook for the economy. That point is rapidly approaching. The sad thing is it didn't have to be this way. The economy is not great but the market is working as it should. Housing prices are falling back to reality and while it's not a good time to be in the mortgage business, the rest of the economy is still chugging, if a few cylinders shy of a V-8. Letting the housing correction run its course would have been painful but a lot less damaging than this hair of the dog treatment that the Fed has administered.

Bernanke has managed to find the inverse sweet spot of the economy - too much inflation and not enough growth. Congress has blamed everyone from oil companies to speculators (and the newly discovered "index" speculators) to the tooth fairy for high oil prices while the architect of this economic conflagration fiddles away with interest rates 2% below the vastly understated official inflation rate. A mirror might also be a useful tool in Congress' investigative tool box. The price of oil will not be reduced by continuing a 27 year concerted effort not to find any more. Paying farmers to convert tortillas to gas is having the predictable effect on tortilla prices too.

Senator Obama called for a new "stimulus" package today and while I never want to discourage a politician from sending my money back, this economy will not be healed by another trip to the mall. The Fed cannot manufacture a recovery by manipulating the interest rate lever when consumers don't want to borrow and banks don't want to lend. If cheap credit isn't the answer to a problem caused by cheap credit, maybe, just maybe we should try something else. If you're in a hole the size of the Grand Canyon, for the love of God, stop digging and start filling.

Wednesday, June 25, 2008

FOMC Policy Statement

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Recent information indicates that overall economic activity continues to expand, partly reflecting some firming in household spending. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters.

The Committee expects inflation to moderate later this year and next year. However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time. Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred an increase in the target for the federal funds rate at this meeting.

Click here for Complete Update

Durable Goods Orders

Orders for durable goods were unchanged in May, as orders for airplanes and defense goods offset weaker demand for machinery and metals. Economists were expecting a decline of 1.0% for the month. It is the second straight monthly decline, but, considering orders remain unchanged since January, some economists were quickly questioning if the U.S. economy would experience a recession.

Orders for core capital equipment, equipment businesses invest in to expand or update their productive capacity, fell 0.8% in May after a downwardly revised 3.1% increase in April. Core capital equipment orders, which exclude aircraft and non-defense goods, are the best monthly indicator of capital expenditures.

Orders for machinery dropped 5.3%, reversing April's 5.1% gain. Orders for primary metals fell 1.3%, while orders for fabricated metals increased by 0.1%.

Orders for transportation goods rose 2.6%, including a 10.3% rise in civilian aircraft orders. Orders for electrical equipment rose 1.5% after a double-digit gain in April.

See Full Report.

Monday, June 23, 2008

Guess Who Said This

"Well, housing prices are falling and many banks have bad loans and if prices fall much further the borrowers won't have the money to pay the loans back."

Click on the title of the post to find the answer.

Thursday, June 19, 2008

Cure for High Oil Prices

The cure for high oil prices is......high oil prices. This story from the IHT is about the boom in buidling offshore drilling rigs. Day rates have risen dramatically due to current shortages so ship builders are scrambling to build new drilling ships:

As President George W. Bush considers repealing a ban on drilling off most of the coast of the United States, a shortage of ships used for such drilling promises to impede any rapid turnaround in oil exploration.

Slow growth in oil supplies, at a time of soaring demand, has been a major factor in the spike in oil and gasoline prices. In recent years, a global shortage of drill ships has created a critical bottleneck, frustrating energy company executives and constraining their ability to exploit known reserves or find new ones.

Two decades of underinvestment due to low oil prices is having profound effects, but with prices this high, the investment is flowing now. There's plenty of oil in the world and oil companies are finding it. It is only a matter of time until supply catches up with demand.

As a result, explorers are scouring ever-more remote corners of the globe in their hunt for hydrocarbons. That quest has unlocked petroleum reserves offshore from Africa and Brazil, and opened up promising exploration regions in the South China Sea, offshore India, or around the coast of Australia. But those sites will remain largely off limits until the new drill ships arrive.

5 years from now, we'll be reading stories about the worldwide glut of oil. History does indeed repeat itself - especially in the commodity business. High prices are followed by increased production which leads to glut and lower prices. That's what happened the last time we had this problem and it will happen again:

The last such boom in orders came in the late 1970s and early 1980s, when exploration rose after the 1970s oil shocks. In the 1990s, low oil prices and overflowing oil supplies meant that oil companies drastically cut back on exploration.

Wednesday, June 18, 2008

Doddering Dodd

Senator Chris Dodd is the chairman of the Senate Banking Committee. He's also a "friend of Mozilo" who got a special rate on his home loan. I can't figure out for the life of me why the CEO of a mortgage company would want to provide a cut rate mortgage to the chairman of the Senate Banking Committee and apparently neither can Dodd:

And apparently the chairman of the Senate Banking Committee has no need to know current mortgage rates.

Update: Dodd may be more of an idiot than I thought (from the NYT):

WASHINGTON — Senator Christopher J. Dodd of Connecticut said Tuesday that he was aware that Countrywide Financial Corporation had assigned him to a V.I.P. program in 2003 when he refinanced mortgages on his homes in Connecticut and Washington but that he and his wife “assumed” that “it was more of a courtesy thing.”

Mr. Dodd insisted that they did not get favorable pricing.

As the Senate prepared to take up legislation intended to rescue homeowners at the brink of foreclosure, Mr. Dodd, a Democrat and chairman of the banking committee, defended himself against suggestions that he had received preferential treatment from Countrywide. At a tense news conference, he flatly denied seeking or receiving any discount from the lender.

But his concession that he never inquired or even wondered whether his special status with Countrywide might be related to his position as a senator prompted a barrage of new questions about the terms of his mortgages and about exactly what he knew and when he knew it.

“Somebody told you you were in a V.I.P. program,” a reporter said, “And you didn’t think you were getting ... ”

Mr. Dodd cut off the reporter and finished the question himself. “A special deal on a loan?” the senator asked. “No.”

Is he really that dumb?

Collective Madness

Victor Davis Hanson at the Corner:

There is something pathetic about Americans begging the House of Saud to produce another 300,000-500,000 barrels of oil per day, while in mindless fashion repeating the mantra, “We can’t drill our way out of this problem” — as if anyone suggested absolute oil independence was the goal rather than more supply to deflate tight conditions that encourage speculation. Americans, who invented the oil industry, are beginning to resemble H.G. Wells’ Eloi in our refined paralysis.

Exploration and oil production are an issue that is absolutely explosive for Democrats, given their perennial resistance to ANWR, coastal and deep ocean drilling, tar sands, shale, liquid coal, and nuclear. And the irony is that their opposition to drilling — dismissing each potential find or field with the reductionist “it would be only 500,000 barrels,” “a mere million barrels,” or “just a few cents off a gallon of gas” — is classically illiberal to the point of either callousness or abject madness.

The excuse I keep hearing about why we shouldn't drill is that the oil wouldn't be available for "ten years" which I guess means we shouldn't bother. Frankly, I'm skeptical of the ten year guesstimates but even if it is, so what? The alternative that is touted is to "invest" in alternative fuel research, but how long will it be before that research yields competitive results? Could it be 10 years? Or longer? Or never? I don't know and neither does anyone else, so if the logic of not drilling holds we shouldn't do the research either, right? Why not, drill for more oil and use the proceeds from lease sales to fund alternative fuel research? Doesn't it make more sense to pursue two paths rather than pinning all our hopes (and dollars) on one?

More from VDH:

The Environment: Given the demands of two billion users in China and India, the world is going to go after oil, whether we like it or not. U.S. oil companies and American environmental legislation are the most ecologically friendly in the world. Each time we refuse to pump a barrel of oil, someone else in this fungible market will — and with far less concern for the health of planet Earth. Again, there is something appalling in de facto saying to others — “Drill off your coasts and in your fragile deserts and beside your lakes so I can fuel my Lexus SUV and Volvo — and cherish the comforting thought I would never do that in my ANWR.”

Cuba is leasing blocks off the coast of Florida right now. Who do you think will do a better job of protecting the environment - Hugo Chavez' PDVSA or an American company operating under our rules?

Financial Sanity: U.S. exporters are doing brilliantly, with help from a weak dollar, but our efforts to produce and sell abroad are increasingly all for naught, given the enormous cost of imported oil. Each time we invest American know-how and expertise in selling abroad a skip-loader or bushel of wheat or new software program that once explained our national wealth, we simply buy another barrel of foreign oil at $140 that often costs the far-less-adept less than $5 to pump. In contrast, the tens of billions we would save by even shaving 3 to 4 million barrels per day from our imported appetites would radically redefine both our trade balances and the dollar.

Politicians all think they can cure the trade deficit by brow beating the Chinese into letting their currency rise against the US dollar. Unfortunately, the Chinese have been letting their currency rise and the trade deficit is not getting any better. That's because a large part of our trade deficit is due to the increasing bill for importing oil. If politicians really believe the trade deficit is a problem (which, from an economic perspective it's really not), they should be doing something about reducing our imports of oil. I guess its easier to blame someone else for our self generated problems.

Food versus Fuel: I don’t understand in moral terms how worrying about the terrain in 2,000 acres in a multimillion-acre Alaska trumps diverting one-fifth to one-fourth of our corn acreage away from animal and human foods to produce transportation fuel. People worldwide are in dire straits, given rising food prices, while we, in anti-humanistic fashion, complain about the view from Santa Barbara or a herd on the tundra.

Making ethanol at the expense of hungry people is just wrong. If ethanol is part of the solution, then get rid of the tariff on ethanol. Sugar cane produced ethanol is more efficient than corn based anyway. Of course, politicians can't harvest campaign contributions from Brazilian sugar farmers, so this won't happen.

True Progessivism

That's the title of a post at Cafe Hayek. Don Boudreaux:

According to today's Wall Street Journal, Barack Obama alleges that "Globalization and technology and automation all weaken the position of workers." If this presidential wannabe is correct, then some of the world's most prosperous workers must be the people in that newly discovered tribe in Brazil -- persons with absolutely no contact with the global economy or with modern technology.

Less extreme cases, of course, include persons not so cut off from the world as these Brazilian tribes. Sub-Saharan Africans should be more prosperous than eastern Europeans, who, in turn, should be more prosperous than Americans and western Europeans.

Of course, if the facts don't follow this pattern, then I guess that Sen. Obama will soon publicly apologize for either misspeaking or admit that his thesis is flawed.

I won't be holding my breath for apologies from the Senator. The statement does make some interesting points. Globalization and technology do have similar effects on the labor market. It is certainly true that technology is responsible for the vast majority of manufacturing jobs that have been "lost" over the last 30 year rather than free trade (globalization). Productivity has risen dramatically in that time and returns on capital have risen. So in some sense Senator Obama is correct that these market forces weaken the position of workers. There are fewer jobs in manufacturing to go around.

On the other hand those who are the most productive attain higher wages. The proper question for Senator Obama is why we should not want our economy to become more efficient. Those workers who are no longer employed in manufacturing may find more rewarding jobs in other fields. In a sense those workers have been freed from repetitive physical jobs to pursue jobs requiring more brain than brawn. That should be seen as a good thing. Furthermore, the higher return on capital means that there will now be capital available to fund other businesses that will produce more jobs. Higher productivity and increased trade are good for the economy, but workers need to be more versatile and flexible. The ability to adapt is highly rewarded in a dynamic economy.

The only plausible role for government in this equation is to assist the transition of the workers displaced. And frankly, I think that is debatable. What we shouldn't do is handicap the entire economy because a minority of workers are not able to make the transition in a more competitive environment.

Tuesday, June 17, 2008

Weak Dollar Attracting Investment

The bad consequences of a weak dollar are well known. But there are good consequences as well. The US needs to attract foreign investment and a weak dollar makes US investments look attractive to foreigners. Many bemoan this fact thinking that it matters if it is foreigners rather than Americans doing the investing. I don't worry about that much; the source of the investment is less important than the fact that the investments are made. Yesterday, the US reported big inflows to US securities:

WASHINGTON -- Foreign demand for long-term U.S. securities jumped in April, partly due to greater interest in Treasury notes and bonds, according to a Treasury Department report released Monday.

Net foreign acquisition of long-maturity U.S. securities totaled $102.8 billion in April, following purchases of $53.3 billion the month before, the Treasury report showed. Foreign net purchases of U.S. Treasury notes and bonds totaled $80.3 billion in April, up from $53.6 billion in March.

"The bottom line from this report is that overseas demand for U.S. long-term securities remained strong in April and in the first quarter of 2008, notwithstanding downward pressure on the U.S. dollar and extremely turbulent conditions in world financial markets," Brian Bethune, chief U.S. financial economist at Global Insight, said in a research note. "This indeed is positive news overall."

This is probably due to the fact that the dollar seems to have stablilized. Once foreigners become convinced that the dollar has stopped falling, they will be more comfortable investing here. Hopefully, we have reached that point.

The Obama Tax Grab

Senator Obama gave an interview today to the WSJ about his economic plans. I'll post something later about the whole plan, such as it is, but this part caught my eye:

Sen. Obama has proposed a variety of measures that would raise taxes on individuals at the top end and provide tax relief to middle- and lower-income households. Under his plans, those in the middle would see their after-tax income increase by 2.4%, or $1,042, according to a nonpartisan analysis by the Washington-based Tax Policy Center. Americans with incomes above $2.8 million would see their after-tax income decrease by 11.5%.

Because he doesn't define middle class, it's hard to say exactly what this means in dollars. Is it a direct transfer from one class of Americans to another? How much of the money raised from the wealthy does he just redistribute and how much stays in DC to get spent by politicians? Apparently, a lot gets left in Washington because his spending plans can be called anything but limited. This is just old style centralized industrial planning. Why do politicians think they know better than the rest of us mere mortals where our hard earned dollars should be invested? Why do voters keep falling for government schemes that have already been tried and have already failed?

Update: And if you believe that part about a tax cut for the middle class, I've got some land for sale just west of here. He'll get the middle class with the behind the back cap and trade system. He expects cap and trade to realize $100 billion a year. Where does he imagine that money comes from? The evil corporations will just pass it along to consumers. The bottom line is whether you believe the fantasy that it comes from the evil corporations or not, it must come from somewhere. It is still $100 billion a year coming out of the private sector and getting sucked into the hands of politicians. He's not getting that kind of scratch just from the wealthy....

Update II:

To "capture some of the nation's economic growth," he said in the interview, "and reinvest it in things we know have to be done like science, technology, research and fixing our energy policy, then that is actually going to spur productivity."

Capture some of the nation's economic growth? At least fishermen practice catch and release....

Update III:

Sen. Obama also proposes eliminating capital-gains taxes on start-up companies, though he backs higher capital-gains rates overall. He hasn't defined precisely what he means by a "start-up." Wasn't he concerned that tax lawyers would simply form "start-ups" for existing companies looking for a new tax break?

"There are always folks who are interested in gaming the system, and obviously one of the things you have to do with tax policy generally is to pin down definitions so they're not twisted beyond recognition," he said. But he argued, "Companies that are starting off...should be allowed to accumulate capital, reinvest profits, if there are any, to the point that they stabilize."

What happens after they've accumulated capital, reinvested profits and stabilized? Then they won't be allowed to accumulate capital or reinvest profits? Does he believe that once companies "stabilize" they shouldn't be allowed to grow? Why would we enact a policy that punishes anyone who works hard or gets lucky enough to succeed? Who is going to accumulate capital, reinvest profits and then give the spoils to government? How is that fair? The investor takes the risk and the polticians get the reward?

Monday, June 16, 2008

Florida Offshore Drilling

Petrobras is able to drill off the Florida coast, why can't US companies?

HAVANA, Cuba (Reuters): Brazilian state oil company Petrobras is studying a block in deep Cuban waters for possible exploration as part of broader cooperation with the Caribbean island, a top advisor to the company said on Friday.

"We are planning to cooperate not only in exploration and production, but lubricants, refining and training," Andre Ghirardi told Reuters in Havana at a one-day meeting of Brazilian and Cuban businessmen.

"We are working on the possibility of exploring a block in the Gulf of Mexico, but negotiations have not ended, they are advancing," he said.

Interest in Cuba's Gulf of Mexico blocks has picked up as oil prices soar.

Seven foreign companies have signed exploration agreements with Cuban state oil company CUPET for 28 of the 59 blocks available in the deep Gulf of Mexico waters of Cuba's economic exclusion zone fronting the United States.

And just imagine how much longer it will take to rid Cuba of communists if they do actually find that much oil....

Countrywide Corruption

It has recently been revealed that Countrywide Mortgage had a special loan program for the so called "Friends of Angelo". Angelo Mozilo was the CEO of countrywide and his group of friends included several politicians, two CEOs of Fannie Mae and a plethora of well connected individuals. Mozilo waived points and reduced the rates on mortgages for his group of "friends". This is raising ethical questions and rightly so (from the WSJ):

The Countrywide Financial sweetheart loan scandal continues to grow, spreading to Senators and other Beltway potentates. We are about to find out if Congress's passion for investigating business ethics extends to conflicts of interest and cash that involve fellow Members.

Take Senator Kent Conrad, the North Dakota Democrat whose office issued a Friday statement saying that "I never met Angelo Mozilo." What he did not say then but admitted under later questioning by a Journal reporter is that, although he may not have had a face-to-face meeting with the Countrywide CEO, Mr. Conrad had called Mr. Mozilo and asked for a loan. The result was a discounted loan on his million-dollar beach house and a separate commercial loan of a type that residential lender Countrywide did not even offer to other customers, regardless of the rate.

Conrad is being cute when he says he never met Mozilo; surely speaking with him on the phone would qualify as "meeting" him. More disturbing though is the relationship Countrywide had with Fannie Mae:

In the week since the Journal revealed this program, the key questions have become clear: What did Countrywide CEO Angelo Mozilo receive – or think he would receive – in return for the friendly loans to politicians? And what did Mr. Mozilo get – or think he would get – in return for sweetheart loans to Fannie Mae CEOs Jim Johnson and Franklin Raines? Mr. Conrad says he called Mr. Mozilo at the suggestion of Mr. Johnson, a leading and long-time member of the Democratic Beltway establishment.

The relationship between Countrywide and Fannie Mae goes to the heart of the mortgage crisis. Fannie makes its money by borrowing vast sums at low rates (thanks to an implied taxpayer guarantee on its loans) and then using that cash to buy loans from mortgage originators like Countrywide. Fannie then holds the mortgages and earns interest on them, or pools them into securities for sale to investors.

Fannie has been buying more home loans from Countrywide than from anyone else. In its most recent 10-K report filed with the Securities and Exchange Commission in February, the company reports: "Our top customer, Countrywide Financial Corporation (through its subsidiaries), accounted for approximately 28% of our single-family business volume in 2007, compared with 26% in 2006."

A Fannie spokesman tell us that "for competitive and proprietary reasons, we can't provide information about the terms we agree to with specific lenders," and adds, "We don't have lender-specific performance data available." Count us among the skeptics that Fannie hasn't bothered to check how well Countrywide's loans perform compared to those of other lenders vying to do business with the government-sponsored giant. But then again, we don't know what terms Countrywide's competitors offer on loans to Fannie CEOs.

Those wondering why Bank of America continues to move forward on its planned purchase of the controversial Countrywide might consider that BofA, despite its huge brand name and resources, has been able to capture only 4% of Fannie's single-family business on its own. Clearly, there's something about Angelo.

It matters if Fannie Mae favored Countrywide over other lenders because taxpayers have provided Fannie Mae(and Freddie Mac) an advantage over their competitors through the implicit taxpayer guarantee. In other words, if Fannie Mae bought a bunch of bum loans from Countrywide, we could be on the hook for the losses. This is exactly why we should get rid of these hybrid public/private organizations. Politicians in the boardroom is a recipe for trouble.

I don't know what to think about the loans to Senators. They are citizens too and should be able to get a mortgage, but how do we police it so they don't get preferential treatment? I don't have an answer to that, but it would seem we need to find one.

This should also be a cautionary tale for all those hoping that a politician can "change" D.C. Politicians are human and as such are susceptible to the perks of office. Their party affiliation doesn't seem to matter much if at all. Democrats and Republicans alike sought out Angelo for loans at preferential rates. And he provided them no doubt because he thought there was something to be gained. As long as government employees have the ability to deliver favors to people like Mozilo, we will have corruption (or at least the appearance of it). The key to reducing corruption is to limit the power of government. Simplify the tax code and politicians won't be able to craft loopholes for campaign contributors. Reduce regulations and businesses will not be tempted to coerce regulators. It is simply impossible to have big, centralized government and low levels of corruption.

A Silver Lining

A few weeks ago, I noticed an article (I think it was in the WSJ, but I can't remember now) about a Chinese company that was expanding - in South Carolina. The costs associated with the expansion were comparable even with higher labor costs. Land and transportation costs were cheaper in S.C. than China. That is a major shift that I don't think most people recognize. Now, here's another article from the WSJ about manufacturing jobs returning to the US specifically because of transportation costs:

The rising cost of shipping everything from industrial-pump parts to lawn-mower batteries to living-room sofas is forcing some manufacturers to bring production back to North America and freeze plans to send even more work overseas.

The fall in the dollar and the subsequent rise in energy costs is having some positive effects. This is how markets work. The fall in the dollar, which is a direct result of poor US growth, will make US investments attractive relative to foreign countries. And that investment will mean higher future growth.

The cost of doing business in China in particular has grown steadily as workers there demand higher wages and the government enforces tougher environmental and other controls. China's currency has also appreciated against the dollar -- though not as much as some critics contend it should -- increasing the cost of its products in the U.S.

Edward Zaninelli, vice president of trans-Pacific westbound trade at Orient Overseas Container Lines in San Ramon, Calif., a major shipping line, says he's heard from customers who are moving production back to the U.S., including a maker of steel pans for car engines.

"I believe a decent amount of production could come back into the States within five years, not everything," he says. "But it won't be because of transport costs -- it'll be because other production costs have gone up and companies have realized they can have better control over their production when it's closer to home."

It's not just tranportation costs that are driving this trend and explains why the Chinese are so reluctant to let their currency rise against the dollar. The Chinese are in a race to develop the rural interior of the country before their cost advantage disappears. Right now the coastal areas are booming but the rural areas are still very poor. The Chinese government needs to use the capital produced by the coastal areas to develop the rural areas and avoid political unrest. The faster the currency appreciates, the less time they have to make that transition.

There are detrimental effects of the falling dollar but there are also some advantages. It is the advantages that are keeping the economy from falling off a cliff right now.

Fleckenstein is Bearish, Blah,Blah,Blah

Bill Fleckenstein is bearish about the market and the economy. That is not exactly news since Fleckenstein has been bearish since I started in the business and he makes his living as a short seller. Fleckenstein always makes some good points in his commentaries and his view of the Fed is not that different than mine, but his permanent bearishness is getting old. Here's an excerpt from his latest commentary:

Given that backdrop, I believe the chance of Bernanke raising interest rates is essentially zero. I think the Fed's next move will be to ease rates, though I don't know if that will be three months or six months from now.

What I do know is that Bernanke is not really serious about containing inflation, as is obvious by how far the Fed has let it climb. He cares only about avoiding a downturn. So, when it looks like push has come to shove, Bernanke will ease again.

Push is coming to shove, and there's nothing he can do to stop that.

Certainly, Bill is in the minority in the view that the Fed will ease again. I like to take the contarian view too, but sometimes the majority is right. I don't expect the Fed to cut again; doing so after all the recent rhetoric to the contrary would do great damage to their credibility. And that is more important than the GDP growth rate.

Saturday, June 14, 2008

Housing Crisis

I don't want to minimize the effects of the housing crisis - I feel your pain - but this does get to the heart of the matter (HT Adam Smith):

(2008-06-13) — The U.S. housing crisis reached fever pitch this month, with potential foreclosures up 48 percent compared with May 2007.

The devastation of receiving foreclosure notices has now swept through a full 2/10ths of one percent of American homes. About 1/10th of one percent of owners may lose their homes. For some of those people, it’s actually their primary residence in jeopardy, rather than a second home, rental property or vacation condo.

Oil Specs Beware

I dont' believe oil prices are high because of a lack of supply but this may spook some of the speculators:

Saudi Arabia, the world’s biggest oil exporter, is planning to increase its output next month by about a half-million barrels a day, according to analysts and oil traders who have been briefed by Saudi officials.

Friday, June 13, 2008

Consumer Price Index

The US consumer price index gained significantly in May, as today's monthly report showcased a worrisome 0.6% increase. The report was above the 0.5% expected by economists. Core CPI, which excludes energy and food prices because of their volatile nature, increased 0.2%. That was inline with expectations. Year-over-year, consumer prices have increased 4.2%. Core CPI gained 2.3% in the same period.

The monthly gain was largely attributed to an increase in consumer energy prices. Energy prices in the US rose 4.4%, the biggest gain since November. Gasoline prices also rose, at a seasonally-adjusted 5.7% for the month.

Report Details

Food prices ticked 0.3% higher, with beef prices up 1.5%, while dairy, pork and fruit prices fell.

Prices for bread and cereal rose 1.6%.

Apparel prices fell 0.3% and are down 0.6% in the past year.

Prices for medical care increased 0.2% and have risen just 1.8% on an annualized basis over the past three months. Drug prices fell 0.7%.

New vehicle prices fell 0.1%, while air fares soared 3.2%, the biggest gain in six years.

Recreation prices rose 0.1%, while education and communication prices grew 0.4%.

See Full Report.

Kostigen's Ethical Confusion

Thomas Kostigen writes a column for Marketwatch called Thomas Kostigen's Ethics Monitor. I've never seen the column before, but I ran across his latest article called Moore or Less. In the article, Kostigen attempts to make the case that the US auto industry is unethical. Or at least I think that is what he's trying to do. His logic (or rather the lack of logic) in the article makes it difficult to understand exactly what it is he thinks they've done that was unethical. He starts by praising Michael Moore but apprently he watched Roger and Me with the sound off because he completely misses the point:

Michael Moore's 1989 film "Roger & Me" took General Motors' management -- specifically its chief executive at the time, Roger Smith -- to task for not seeming to care about the ramifications of its operations and actions on people, namely its Flint, Mich., employees.

Moore may now be getting his due as GM and other U.S. automakers slip on the increasing price of oil. The gas-guzzling cars and SUVs that U.S. automakers rode to profits a decade ago are shackling them to consumer consternation of high-energy prices.

There may be a moment of schadenfreude in the current environment of gas prices piercing automakers' profits. But there is a grander lesson for businesses: Listen to your critics; they may just have a point.

As I remember Roger and Me, Moore's intent was to get GM to stop closing unprofitable plants and laying off excess workers. So why would Moore be feeling a sense of schadenfreude at the demise of GM? Wouldn't that mean even more union workers laid off? Does Kostigen think it is good for GM workers that GM is having finacial difficulty? What point did Moore have? If GM had followed Moore's advice they would be in even worse shape than they are now. How would that serve the goal of preserving auto industry jobs?

Kostigen then quotes something called Ethical Magazine:

Ethical Corp magazine this month opines, "With last week's announcement, the interfaith investor coalition which wants GM to make a vapid climate change commitment comparable to the one it recently wrung from Ford may have had its job done for it by consumers, who have seen red at the petrol pump, if not green. Investment managers should be at least as worried by the scale of GM's $3.3 billion first-quarter '08 loss, and at the prospect of GM losing market leadership in its home market as well as globally to Toyota. Hope that GM can supply more rational products would be bolstered by a better climate for profit."

The rationale for more fuel-efficient products has been in place for decades; automakers just chose to ignore it. The big automakers have highly educated and skilled economists on their staffs. There is no way they didn't see the current oil price surge coming and figure that into production and products. So it would be interesting to see and read these predictions now and have management explain its ignorance.

The quote from Ethical Magazine would seem to indicate they have some kind of green agenda. I have no idea what kind of agreement was reached with Ford about the environment but it would seem to have something to do with building more fuel efficient or "green" cars since they intimate that the rise in gas prices is forcing a change in auto purchasing trends. Kostigen also seems to think that GM has some pretty special economists on staff with crystal balls that tell them future energy prices. And there is an apparent conspiracy to keep the evidence of their predictions secret. If GM had these special economists with the ability to predict future gas prices why does Kostigen think they didn't act on that information? Was there an evil cabal at GM seeking bankruptcy so they could punish more union workers?

I did a little investigation and analysis myself and found that the world will need to increase its oil supply by 70% by 2050 just to meet demand, according to the International Energy Agency. Yet, as any one who reads the daily newspaper can tell you there are no new major supplies of oil. Basic supply-demand theory shows then that with less or the same supply and increased demand prices will rise. And that's just back-of-the-napkin figuring. Imagine the sophisticated modeling and scenarios the car companies utilize.

Where did Kostigen get that 70% increase in demand? He didn't provide a link and I'm not going to chase it down this late at night, but the ability to predict oil demand that far out is fanciful. As for their being no new supplies of oil, well that is just plain ignorance. There have been major discoveries just this year off the coast of Brazil and there are ample supplies in the US that are kept off limits by politicians. Kostigen should have found one of those special GM economists to write the economic portion of his article.

Make no mistake: Automakers have failed us. They sold us products they knew or must have known would be financial monkeys on our backs. If your entire business raison d'etre relies on gas prices, don't you think you'd take dire oil supply information like this and do something with it? Or better to turn a blind eye and keep on selling in the face of it?

People, mostly middle- and lower-income Americans are feeling the prices at the pumps the most. It eats into our wallets at a much higher percentage of income than for wealthier people. The average income of an SUV owner is between $50,000 and $75,000 per year, according to an ABC News poll. And that doesn't include the mass of lower-income people who own trucks and cars with poor miles-per-gallon ratings.
Automakers should be ashamed. They've given Moore et al something to celebrate, but at our, the consumer, cost. And when those causes of celebration manifest in people driving less, doing without, and causing financial hardship, something in the system has fallen down.

Automakers had their chances to give us what would be good for us now. But they chose to give us what was good for them then. Sadly this is the making for yet another documentary for Michael Moore.

It's always somebody else's fault isn't it? It's GM's fault that consumers wanted trucks and SUVs. All those poor people now saddled with the vehicle of their choice. Damn that GM. And again why would Moore celebrate the downfall of GM when his goal was to preserve jobs for union members? The system has failed if people have to drive less and when there is financial hardship? Isn't it just possible that people with financial problems are to blame for their own failures? And talk about a general misunderstanding of business - GM should have sold us only cars that were "good for us"? What the hell does that mean? Can Kostigen actually believe that companies can profit by selling products that consumers don't want? How does that work?

Health-care industry take note.

What does that mean? Take note of what? Does he mean that the healthcare industry should make us do what's good for us? I have no idea. Is this entire article written in some kind of code? Was this written by Jack Handey?

Thursday, June 12, 2008

Nobel Economists Discuss the Economy

Excerpts from the Milken Global Conference economic roundtable:

Ed Phelps: Our friends in the financial sector have given capitalism a black eye. Suddenly capitalism is held in less awe around the world. That is a very serious impact.

Phelps is right that capitalism has a black eye right now, but I disagree with who delivered the blow. It should be central banking that gets the black eye not capitalism.

Milken: Another Nobel Laureate, Joseph Stiglitz, has said recently that the U.S. is facing one the worst downturns since the Great Depression. Does anyone agree with that?

Becker: The unemployment rate in the U.S. now is 5.1 percent. Unemployment was 25 percent in the Great Depression. We are so far from that, it is ridiculous. We won't even get close. Things may get worse than at present. But at the outside, the only issue is whether unemployment might rise somewhere between 6 and 9 percent.

Phelps: I'm surprised at how slow unemployment has been rising. So far, this downturn barely qualifies as an official recession, let alone a Great Depression.

Scholes: It is erroneous to compare this to the Great Depression. But there is more unraveling to come. We have to worry about effects on the housing market and where it is going to end. Will the housing shock lead to consumption fallout, which leads to more unemployment and further consumption fallout?

Stiglitz just shows his political colors when he makes comments like that. He's a liberal economist with an agenda. That the current economic slowdown is akin to the Great Depression is nonsense on steroids.

Models or Engineers?

There are a limited number of H1-B visas available to foreign workers each year. Here's the Wikipedia entry about H1-B visas:

The H-1B is a non-immigrant visa in the United States under the Immigration & Nationality Act, section 101(a)(15)(H). It allows U.S. employers to employ foreign guest workers skilled in specialty occupations if a U.S. citizen or resident is not available. [1]

The regulations define a “specialty occupation” as requiring theoretical and practical application of a body of highly specialized knowledge in a field of human endeavor including, but not limited to, architecture, engineering, mathematics, physical sciences, social sciences, medicine and health, education, law, accounting, business specialties, theology, and the arts, and requiring the attainment of a bachelor’s degree or its equivalent as a minimum. Likewise, the foreign worker must possess at least a bachelor’s degree or its equivalent and state licensure, if required to practice in that field. H-1B work-authorization is strictly limited to employment by the sponsoring employer.

Rep. Anthony Weiner (D-NY) has introduced a bill to create 1000 new visa slots models. Apparently, models are included in the HB-1 visa slots due to an immigration bill from 1991. How they could possibly meet the requirement listed above is beyond me, but at least if this passes, there will be more HB-1 visas for people that are actually worthy.

It's time we introduced some common sense into the immigration debate. Foreigners come here to get educated as engineers and other technical careers and then are forced to return to their home countries to work due to a lack of HB-1 visas. Doesn't it make more sense to let them stay and work here so our economy benefits?

More on Regulation

Megan McArdle has a followup post on financial regulation (here's the original post). As usual she makes some good points:

But assuming arguendo that the regulators are every bit as smart and well-trained as the analysts they regulate. This is adequate only for certain kinds of regulation: the kind where the goals of the regulators are fundamentally different from those of the regulated.

If they could get away with it, some companies would lie in their advertising or sell adulterated goods; we want regulators to catch them at it. Companies have an incentive to present an inaccurate picture of their financial well being to investors; that's what auditors are for. Depositors in an FDIC-insured bank have no incentive to check on whether the bank is sound, so we put regulators in charge of doing it for us.

But what happened in the markets was not a case of fraud. It was a case of the systemic mispricing of credit risk. More importantly, it was a case of the systemic mispricing of credit risk on the buy side: Bear Stearns didn't fail because it had originated too many dodgy securities, but because it had bought too many. The banks have just as much incentive to price risk correctly as the regulators do--probably more, actually, because the regulators are unlikely to get fired if they miss one. It's hard to make a clear case for managerial moral hazard as a result of the Bear Stearns bailout--they all lost their jobs.

I'm coming to the conclusion that the only additional regulation that makes sense is an enhanced capital requirement for these investment banks. Anything else would seem to be too heavy handed and would likely have unintended consequences.

Unintended Consequences

Far from being an environmental panacea, ethanol is turning out to be an ecological disaster. There is no free lunch and ethanol is just one more example of the unintended consequences of interfering with the market:

From his Cessna a mile above the southern Amazon, John Carter looks down on the destruction of the world's greatest ecological jewel. He watches men converting rain forest into cattle pastures and soybean fields with bulldozers and chains. He sees fires wiping out such gigantic swaths of jungle that scientists now debate the "savannization" of the Amazon. Brazil just announced that deforestation is on track to double this year; Carter, a Texas cowboy with all the subtlety of a chainsaw, says it's going to get worse fast. "It gives me goose bumps," says Carter, who founded a nonprofit to promote sustainable ranching on the Amazon frontier. "It's like witnessing a rape."

This is the dirty little secret of ethanol production. It turns out that if you raise the price of agricultural products, people will try to produce more of them. Imagine that....

This land rush is being accelerated by an unlikely source: biofuels. An explosion in demand for farm-grown fuels has raised global crop prices to record highs, which is spurring a dramatic expansion of Brazilian agriculture, which is invading the Amazon at an increasingly alarming rate.

Propelled by mounting anxieties over soaring oil costs and climate change, biofuels have become the vanguard of the green-tech revolution, the trendy way for politicians and corporations to show they're serious about finding alternative sources of energy and in the process slowing global warming. The U.S. quintupled its production of ethanol--ethyl alcohol, a fuel distilled from plant matter--in the past decade, and Washington has just mandated another fivefold increase in renewable fuels over the next decade. Europe has similarly aggressive biofuel mandates and subsidies, and Brazil's filling stations no longer even offer plain gasoline. Worldwide investment in biofuels rose from $5 billion in 1995 to $38 billion in 2005 and is expected to top $100 billion by 2010, thanks to investors like Richard Branson and George Soros, GE and BP, Ford and Shell, Cargill and the Carlyle Group. Renewable fuels has become one of those motherhood-and-apple-pie catchphrases, as unobjectionable as the troops or the middle class.

How long will we continue this folly?

Not the 70s

Many people are comparing the current economic environment to that of the stagflationary 70s. As I have pointed out in my commentaries and blog posts, this comparison is overwrought at best. Steve Chapman at Reason agrees:

Critics insist that the Fed has surrendered on inflation, pumping money out in a desperate attempt to prevent a full-fledged downturn. Exhibit A in the charge is the weakness of the dollar. Bernanke's detractors say he's let the greenback sink, which in turn has pushed up the price of oil and doomed us to the sort of inflation we haven't seen in a long time.

But the theory and the evidence find themselves at odds. The dollar has actually been stable over the last three months, both against the Euro and against other currencies. Three months ago, however, the price of oil was below $100, and lately, it's been above $130. A dollar that's not declining can't explain why oil prices are rising.

If the dollar were steadily losing value, another commodity should also be soaring in price—namely gold, the traditional haven for the inflation-wary. In fact, gold, which came within sight of $1,000 per ounce back in March, has been trading well below $900.

I pointed out the divergence between gold and oil in a post below. These divergences don't tend to last long and I suspect that this will be resolved by a fall in the price of oil, especially if the dollar continues it's recent action.

The US economy has proven very resilient in the face of signficant headwinds. This is typical of the economic slowdowns of the last 20 years and is very different than the 70s. I am not a fan of the Federal Reserve but they are doing a much better job than their 70s counterparts.

So far, the Fed has managed to keep inflation in check, and it's done so without strangling the economy. These may not be the days of wine and roses, but the 1970s never had it so good.

Initial Jobless Claims

The number of people filing for first time unemployment benefits rose sharply in the week ending June 7th, according to the Labor Department. Claims jumped by 25,000, to 384,000. Economists were expecting 365,000 new claims for the week.

Having witnessed extremely volatile measurements in the past few weeks, it is wise to consider the four-week moving average of initial claims, which smooths out one-time factors such as bad weather or holidays. The four-week moving average was also higher, by 2,500 in the latest week, up to 371,500. A year ago, the four-week average stood at 305,000.

See Full Report.

Retail Sales

With the help of Uncle Sam and his $50 billion in rebate checks thus far, retail sales managed to beat expectations for the month of May, gaining 1.0%, after an upwardly revised April. Excluding automobile purchases, sales were up 1.2%, the largest increase in six months. Economists were expecting a 0.6% gain in total sales and a 0.8% gain ex-auto.

In the past year, retail sales are up 2.5%, while sales excluding autos are up 4.9%. The figures are not adjusted for price changes.

Report Details

Motor vehicle sales rose 0.3% in May and were down 7% in the past year.

Sales at furniture stores rose 0.4%, the biggest increase in 10 months.

Sales at electronics and appliance stores rose 0.7%.

Sales at building supply and garden stores rose 2.4%, the second straight increase over 2%.

Sales at general merchandise stores rose 1.2%, including a 0.8% increase at department stores. It was the largest increase at general merchandise stores in 14 months.

Sales at nonstore retailers rose 1.6%, as high gas costs encouraged more consumers to shop online or through catalogs.

Excluding the 2.6% rise in gas station sales, sales still increased 0.8%, the biggest gain in a year.

See Full Report.

Gold and Oil

Gold and oil tend to be highly correlated but recently the two commodities have diverged. This has happened before of course, but over time, the two commodities have a positive correlation.

So, will oil fall or will gold rise? My guess is the former.

Wednesday, June 11, 2008

Federal Reserve Beige Book

Reports from the Federal Reserve Districts suggest that economic activity remained generally weak in late April and May. Three Districts described economic activity as softer, weaker, or lower, with an additional four Districts reporting slower, sluggish, or modest economic growth. The remaining five Districts of Philadelphia, Cleveland, Atlanta, St. Louis, and San Francisco described activity as stable or little changed in recent weeks.

Consumer spending slowed since the last report as incomes were pinched by rising energy and food prices. Higher energy prices also appeared to damp domestic tourism. Reports on nonfinancial services varied across Districts and industries. Manufacturing activity was generally soft in recent weeks, with weak demand for housing-related and some other products but with increasing demand for exports. Residential real estate markets remained weak across most Districts. Commercial real estate conditions varied across Districts, as did reports on nonresidential construction activity. Lending activity also varied across Districts and market segments, though tighter credit standards were reported for most loan categories. Districts reporting on the agriculture and energy sectors noted improved crop conditions and increased drilling and extraction activity.

Reports of higher input costs were widespread. Manufacturing contacts in several Districts noted some ability to pass along higher costs to customers. Retailers reported mixed results with respect to raising final goods prices. In most Districts, wage pressures were reported as moderate or limited for all but a few skilled-labor positions, as hiring activity remained spotty in most Districts.

See Full Report.

Tuesday, June 10, 2008

More Financial Market Regulation?

Now that investment banks are borrowing from the Fed via the TSLF, many are calling for increased regulation of these companies. Austan Goolsbee, an economic advisor to Barack Obama recently said:

"If you can borrow money from the U.S. taxpayer at a moment of crisis, that is a very sacred insurance policy underwritten by the U.S. taxpayer," said Mr. Goolsbee in an interview last week with Dow Jones Newswires. "We have the right to oversee anyone who is accessing that insurance policy."...

The problem, as we found out with Sarbanes/Oxley, is that the manner of the regulation matters a great deal. From Megan McArdle:

When I try to get people to specify, beyond those four rather anodyne suggestions, we should do, there's a lot of hemming and hawing. Even the left-wing think tankers sort of look at their shoes and whisper "We need a better regulator". At which point even the left-wing journalists in the audience start asking "Where are we going to find regulators who understand this better than the guys at Goldman Sachs--and are willing to work for, say, a GS-13 salary?" The only people who confidently state that they have a surefire master plan to fix the problem are, not to put too fine a point on it, morons with very limited understanding of financial markets. These people generally start by talking about how the Bear Stearns crisis can really be traced back to the repeal of Glass-Steagall, then almost immediately reveal that they know nothing of Glass-Steagall other than its name.

I have tried all sorts of ways to ask these questions. Nor am I engaged in "libertarian gotcha"; though the game is hours of fun, I am not actually against better or even more regulation of investment banks*. I just want to know what sort of regulation we are going to have; I am against doing something for the sake of doing something.

Which financial instruments should be illegal, I ask, but few are willing to name one. How should we arrange the orderly winding-down of an investment bank with complicated business lines and massive counterparty exposure? Rueful shrugs. What business lines should investment banks be forced to divest? Ummm . . . . Should we limit the percentage of a market that one bank can control, at the risk of lowering liquidity in ordinary times? Welllllllllll . . . Should banks have broader distribution of their capital across business lines, or fewer business lines, and is either even possible to arrange without financial disaster . . . good question. Do we give the regulator broad powers, to make them more flexible, or narrow powers, to make them more accountable? Let me think about that . . .

I tend to agree that if the investment banks have access to the discount window, they should be regulated more tightly. But if we tie them up with too much regulation, we are limiting access to capital which could have much wider implications for the economy. I don't have an answer to this one, but I fear that whatever Congress comes up with will be much more onerous than necessary.

Inverse Wealth Effect

There's been a lot of press about the "wealth effect". Supposedly, if people feel wealthier, such as when house prices rise, they spend more. More recently, we've heard a lot about the inverse wealth effect. As people feel poorer, such as when house prices fall, they spend less. This is certainly true to some degree, but what is the real impact?

Yet the idea of a wealth effect doesn't stand up to economic data. The stock market boom in the late 1990s helped increase the wealth of Americans, but it didn't produce a significant change in consumption, according to David Backus, a professor of economics and finance at New York University. Before the stock market reversed itself, "you didn't see a big increase in consumption," says Backus. "And when it did reverse itself, you didn't see a big decrease."

Just another example of a popular notion that turns out to be wrong. Beware of simple explanations for complex topics.

We Are Not Running Out of Oil

John Bartelson, who smokes Marlboro Lights through fingers blackened with tractor grease, may look like an average wheat farmer. He isn't. He's one of North Dakota's new oil barons.

Every month, he gets a check for tens of thousands of dollars from Houston company EOG Resources, which drilled two oil wells on his land last year. He says the day his first royalty check arrived was one to remember.

"I smiled to beat hell, and I went to town and had a beer," Bartelson, 65, says.

His new wealth springs from the Bakken formation, a sprawling deposit of high-quality crude beneath the durum wheat fields of North Dakota, Montana and southern Saskatchewan and Manitoba. The Bakken may give the U.S. — the world's biggest importer of oil — a new domestic energy source.

Unlike the tar from Canada's oil sands, Bakken crude needs little refining. Swirl some of it in a Mason jar and it leaves a thin, honey-colored film along the sides. It's light — almost like gasoline — and sweet, meaning it's low in sulfur.

Best of all, the Bakken could be huge. The U.S. Geological Survey's Leigh Price, a Denver geochemist who died in 2000, estimated that the Bakken might hold 413 billion barrels. If so, it would dwarf Saudi Arabia's Ghawar, the world's biggest field, which has produced about 55 billion barrels.

High oil prices are the cure for high oil prices. The laws of supply and demand have not been repealed.

Senate Admits Defeat

This is one of the most significant stories to come out of Washington in a long time:

Year after year, decade upon decade, the U.S. Senate's network of restaurants has lost staggering amounts of money -- more than $18 million since 1993, according to one report, and an estimated $2 million this year alone, according to another.

The financial condition of the world's most exclusive dining hall and its affiliated Capitol Hill restaurants, cafeterias and coffee shops has become so dire that, without a $250,000 subsidy from taxpayers, the Senate won't make payroll next month.

Our leaders can't even run their food service efficiently and yet still they persist in claiming that they can fix what ails the economy. Maybe admitting defeat in this simple task will convince them to forego any attempts to address other, more complex concerns.

The House privatized their food operation and the contractor makes a profit while the Senate operation, run by the government, requires constant subsidies. Maybe we should privatize more government functions.

Moral Failings

I sent the following letter to the editor of the NYT today in response to this Op-Ed by David Brooks:

David Brooks, like many Americans, sees the explosion of debt over the last 30 years as a moral issue. This is apparently one instance where it is considered acceptable to blame the victim rather than the perpetrator.

Public policy is the source of our debt addiction. The tax code explicitly encourages debt accumulation. Corporate interest payments and mortgage interest are deductible while corporate dividends are taxed once as profit and later as income to the recipient. Monetary policy is distorted by the dual mandate to maintain economic growth as well as minimize inflation, at times mutually exclusive goals. The Federal Reserve since the elevation of Alan Greenspan to the Chairmanship in 1987 has consistently pushed the price of credit below natural levels to induce economic growth. When offered a chance to borrow ever devaluing dollars at artificially low interest rates, Americans responded as expected.

It is not the public that has lost its moral bearings. Americans are acting rationally and responding to the economic incentives provided by policymakers. No amount of cajoling will convince Americans to reduce their debt unless policies which encourage debt are changed. Returning our country to its roots of thrift, savings and investment will only be accomplished by changes in policy. As Mr. Brooks says, “There are dozens of things that could be done”. Blaming average Americans for our leaders’ moral failings is not among them.

With a Little Help From My Friends

From my latest market update:

It appears now as well that the mandarins of the Federal Reserve have finally discovered that a weak dollar may be complicating their policy making. Ben Bernanke delivered a speech recently where he acknowledged, finally, that the falling dollar was having an effect on inflation and pledged to make it part of their future deliberations. The dollar is part of the Treasury Department portfolio and previous Fed Chairmen have assiduously avoided speaking about the value of the dollar lest they step on the wrong toes. That Bernanke even mentioned the dollar tells me that he and Hank Paulson are of a single mind about the future course of the dollar. Don’t be surprised if you see a report soon about the Treasury buying dollars on the open market. Coordination between the Fed and the Treasury could cause a lot of heartburn for speculators who are almost universally short the dollar.

A lot of the effect from that speech was wiped out by Trichet's comments late last week. Today, there was an obvious coordinated message about the dollar coming from the administration, maybe for the first time. Bush talked about the dollar before leaving for Europe and again in an interview:

President Bush talked up the dollar's prowess Monday before leaving on a trip to Europe, saying "long-term strength" of the U.S. economy would be reflected in the currency. Later in the day he went even further, telling the Times of London in an interview that "we want the dollar to strengthen." Treasury Secretary Henry Paulson, meanwhile, refused to rule out intervening in the markets to prop up the flagging currency.

The comments boosted the dollar, which bought 106.30 yen, up from 105 yen Friday, and the euro fell to $1.5628 from $1.5769.

Later Treasury Secretary Paulson was asked about intervening in currency markets to support the dollar:

Mr. Paulson also bolstered the dollar when he said he wouldn't rule out another tool in the administration's limited arsenal: Intervening in the markets by coordinating with other countries to buy dollars in foreign-exchange markets. "I would never take intervention off the table or any policy tool off the table," Mr. Paulson said, replying to a question about intervention in an interview with CNBC. "I just can't speculate about what we will or won't do."

That may not seem significant but until now, the standard line about the value of the dollar from the administration has been that the market should determine the value.

Then tonight Ben Bernanke sounded fairly positive about the economic outlook in a speech about analyzing inflation:

Before turning to those issues, however, I would like to provide a brief update on the outlook for the economy and policy, beginning with the prospects for growth. Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly. Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so. Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy. However, the ongoing contraction in the housing market and continuing increases in energy prices suggest that growth risks remain to the downside.

To translate: The economy is not that bad and will likely improve from here. Don't expect any more rate cuts.

Bernanke then turned to inflation:

Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities. Thus far, the pass-through of high raw materials costs to the prices of most other products and to domestic labor costs has been limited, in part because of softening domestic demand. However, the continuation of this pattern is not guaranteed and future developments in this regard will bear close attention. Moreover, the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations. The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.

Translating again: Inflation is too damn high and its freaking me out a little. I hope it gets better but after watching crude bounce around in a nearly $20 range last week, frankly, I don't have a clue. And if it doesn't come down, we will raise rates.

The dollar was up signficantly against the Euro today; we'll have to see if there is any carryover buying tomorrow after Bernanke's speech tonight. It appears to me that Bernanke and Paulson are working together. If Paulson, who came from Goldman Sachs, is as savvy a trader as Rubin was, he wants to wait until he's got the dollar going in the right direction before intervening in the market. And if he can spark a rally by just talking, he may not have to intevene at all. I'm not sure just talking will be enough so I still expect to see the Treasury in the market buying dollars for euros at some point soon. If Paulson builds up that expectation and then doesn't follow through, the whole strategy could backfire.

Monday, June 09, 2008

Why You Need an Investment Advisor

Our firm is organized as a Registered Investment Advisor. We are not brokers and we don't sell investment products. We organized this way because we wanted to eliminate any conflicts of interest between our firm and our clients. As fee only investment advisors, we have to act in the best interests of our clients.

Brokerage firms do not function this way. When you go to Merrill Lynch, Morgan Stanley or UBS (or any other brokerage firm), you are dealing with a broker who gets paid to sell investment products. Yes, they sometimes act as investment advisors, but generally clients don't know what hat their broker is wearing. And that can cause some problems.

Individuals who go to these firms for investment advice need to understand that they are not the clients the firm values most. These firms make most of their profits from investment banking. Investment banking involves helping companies and governments raise money through the issuance of stocks, bonds and other financial instruments. Individuals who are clients of brokerage firms are the sales channel through which these products are sold. Interestingly, these firms have a fiduciary duty to their investment banking clients but not to the individuals who buy these financial instruments.

The point is that these firms know where their bread is buttered and have a greater interest in keeping the investment banking clients happy because that is where they make the majority of their profits.

The latest news about the auction rate securities market provides proof of how brokerage firms favor large investment banking clients over less profitable individual clients:

UBS Financial Services Inc. knew as early as December that a segment of the municipal bond business was in trouble, but the Wall Street firm kept selling the investments to some clients without warning them of the risk, according to documents reviewed by the Globe.

By February, the $330 billion auction-rate securities market had collapsed, locking out the nonprofits and municipalities that had used the market for years to issue inexpensive debt, as well as the investors who had purchased it. UBS brokers have said they were as surprised as anyone about the market's shutdown.

But on the other side of the firm, UBS was advising some large investment banking clients of the looming problems at least three months before all trading stopped, according to a letter to investors by one of those clients, a New Hampshire bond issuer.

So the investment banking side of UBS warned issuers about the possibility of failed auctions while the brokerage side that caters to individuals was selling the same securities to individuals and telling them they were safe, cash equivalent investments. The article linked above highlights an individual investor with $650,000 stuck in auction rate securities issued by a UBS investment banking client. The real client of UBS was the issuer, not the individual. To UBS, and the other brokerage firms, the individual investor is just a sales channel for the products they create for investment banking clients.

To get truly unbiased advice, investors have only one choice. Fee only planners (be sure they are really fee only) and RIAs are working for you. Brokerage firms are not. It's that simple.

Sweden's Central Bank Acknowledges Reality

The Swedish Central Bank today announced that they will no longer be using a measure of "core" inflation to set monetary policy. To my knowledge this is the first central bank in the world to acknowledge that depending on "core" inflation is a worthless exercise:

”Our target variable is the CPI. We want to be clear about this. Our strategy and our inflation target stand firm. Over the years, another measure of inflation, the CPIX, has played a prominent role alongside the CPI. The Riksbank has previously assumed that the CPI and the CPIX will converge in the long-term. We no longer believe that this will be the case. The CPIX will be phased out, but this will not have a tangible effect on future interest rate decisions.” These comments were made by Deputy Governor Barbro Wickman-Parak in a speech held at Swedbank today.

They are dumping the idea that core and overall inflation will converge in the long run. They've been running the central bank based on an indicator that they now acknowledge is flawed. Don't expect the Fed to follow suit anytime soon.

The Buffet Bet

Warren Buffet has made a bet with Protege Partners (with the winnings going to charity). Buffet's bet is that an S&P 500 index fund will beat the results of a Fund of Funds hedge fund, after fees over the next ten years.

I think Buffet will probably win the bet and we can only hope he's around to see it. Funds of Funds are known in the business as Funds of Fees for a reason.

Schumpeter on Politicians

Since we're posting quotes today, here are two more credited to Joseph Schumpeter (from Don Boudreaux at Cafe Hayek):

Politicians are like bad horsemen who are so preoccupied with keeping in the saddle that they can't bother about where they go.

A statesman is the criminal who works with phrases instead of with the burglar’s jimmy.

I've never seen these but apparently nothing has changed since the 1940s.

Quote of the Week

The Adam Smith Institute has a quote of the week on their blog. This week's is from Groucho Marx and seems to still apply:

Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly, and applying the wrong remedies. Groucho Marx

Eat Local?

Eating locally grown food has been promoted as a way to reduce global warming. The argument is that food that is transported long distances results in unnecessary CO2 output. One argument against that is the productivity issue. Growing food in areas that are more fertile or suited to the crop in question may result in lower greenhouse gas emissions for the same amount of food even if you factor in transportation. Here's further evidence of that:

Christopher L. Weber* and H. Scott Matthews
Department of Civil and Environmental Engineering and Department of Engineering and Public Policy, Carnegie Mellon University, Pittsburgh, Pennsylvania 15213
Received for review November 28, 2007
Revised manuscript received March 4, 2008
Accepted March 14, 2008
Despite significant recent public concern and media attention to the environmental impacts of food, few studies in the United States have systematically compared the life-cycle greenhouse gas (GHG) emissions associated with food production against long-distance distribution, aka “food-miles.” We find that although food is transported long distances in general (1640 km delivery and 6760 km life-cycle supply chain on average) the GHG emissions associated with food are dominated by the production phase, contributing 83% of the average U.S. household’s 8.1 t CO2e/yr footprint for food consumption. Transportation as a whole represents only 11% of life-cycle GHG emissions, and final delivery from producer to retail contributes only 4%. Different food groups exhibit a large range in GHG-intensity; on average, red meat is around 150% more GHG-intensive than chicken or fish. Thus, we suggest that dietary shift can be a more effective means of lowering an average household’s food-related climate footprint than “buying local.” Shifting less than one day per week’s worth of calories from red meat and dairy products to chicken, fish, eggs, or a vegetable-based diet achieves more GHG reduction than buying all locally sourced food.

Shifting diet from red meat would seem a more effective way to reduce the GHG emissions associated with food. It certainly has other benefits as well.

Latest Market Update

I've posted a new market update at the website. You can view it by clicking on the link above. Here's an excerpt:

So, it’s Obama versus McCain. A year ago the “experts” told us that Rudy Giuliani and Hillary Clinton would be accepting their party’s nominations this summer. Rudy didn’t make it out of Florida. Clinton stuck around all the way to the last primary, but in the end discovered that her Back to the Future campaign had as much appeal as the movies of the same name. Democratic primary voters opted for “change” which apparently means young, good looking and not named Clinton.

So, once again the experts got it wrong. Predicting the future is impossible and the only way to improve your odds would appear to be choosing the opposite path of the pundits. And so it goes with economic predictions as well. Recession, which seemed a sure thing to the press and the vast majority of economists a few months ago, has still not arrived. The economy, stubborn thing that it is, refuses to roll over despite high oil prices, falling home prices, rising food prices, imploding bank balance sheets and the rhetoric of politicians intent on re-election.

To be fair to the pessimists, there is some debate over the accuracy of the economic statistics that are reported by the government. The tame inflation reported in the official statistics contrasts sharply with the disgusted looks on the faces of real people at the pump or checkout line. And if the inflation numbers are suspect, then the official GDP statistics don’t reflect reality, but rather some funhouse mirror version of the economy. I don’t disagree with this view; the economy is not growing nearly as much as anyone would like and likely less than the official numbers. On the other hand, we aren’t on the precipice of the Great Depression Part II (Buddy Can You Spare a $100) either.

I finished writing the update prior to the employment report and oil spike on Friday. I considered some revisions but in the end I decided that the thesis is still intact. The oil spike on Friday was driven by short covering; the selloff in the dollar in the wake of Trichet's comments had a direct impact on the oil market. The employment report, while not great, was not the disaster that some were talking about. Most of the rise in the unemployment rate was due to younger workers entering the workforce (teenagers looking for summer jobs or recent graduates). For teenagers who can't find jobs, they can probably thank Congress; the rise in the minimum wage is not a free lunch.

Oil is giving back some of last week's rally and the dollar is up today. Stocks have rebounded (at least as I write this we're still up) some. What we got last week was a lot of volatility without much movement in the end. Since last Wednesday, the Dow is down a little over 100 points.

Our portfolio models all include commodities and we have benefited from the boom. Our portfolios are up for the year even after Friday's sell off.

Weak Dollar

Judy Shelton has an important op-ed in the WSJ today about the consequences of a weak dollar. While domestically a weak dollar is associated primarily with inflation, there are consequences beyond our borders:

How disillusioning to discover that the leading proponents of open global trade – the ones who insist on a "level playing field" – think nothing of adopting policies that render our products overly expensive for their consumers, even as they proffer their goods around the world at inordinately discounted prices.

Now you know how members of the European Union feel these days.

As former New York Fed economist David King recently observed, the value of the U.S. dollar against the euro has fallen drastically in the last few years. In December 2002, one dollar was equal in value to one euro; today, it requires more than half again as many dollars to equal one euro. For American consumers, that means prices of imported European goods are more than half again higher than they would be had the dollar retained its value relative to the euro.

The weak dollar is also causing inflation outside the US in countries who have tied their currencies to the US dollar:

Ukraine is among the most besieged – and perhaps the most pivotal – of Europe's recent converts to democracy. The biggest threat to Ukraine's prospects for success, both politically and economically? Inflation, now soaring past 30%. Ukraine's hryvnia is pegged to the dollar; every cut in the U.S. fed-funds rate spawns huge dollar inflows that must be converted by Ukraine's central bank into the domestic currency, further exacerbating inflation.

Other countries are also importing US inflation. Many of the countries in the Middle East peg to the dollar. While China is the most prominent of dollar peggers in Asia, other countries are also tied to the sinking dollar.

Monetary policy is at the root of many of the economic problems we face. From wealth inequality to the housing bubble to the rising price of commodities, monetary policy has worked to exacerbate, if not directly cause, these problems. At a time when every politician seems to want to talk about reform, none (with the exception of Ron Paul) has even mentioned the one reform that would actually accomplish the goals we all share - monetary reform.

Pending Home Sales

The pending home sales index, an index tracking the level of sales contracts on previously owned homes, gained a surprising 6.3% in the month of April. Economists were expecting an unchanged reading. The index is at its highest level in six months, as prices continued to fall.

Regionally, pending home sales were up 8.3% in the West, 4.6% in the South, and 13.0% in the Midwest. Sales dropped 1.9% in the Northeast. Over the past year, pending home sales are down 13.1%.

See Full Report.

Friday, June 06, 2008

US Non-Farm Payrolls

In today's Labor Department report, nonfarm payrolls in the US fell by 49,000 in May, much less than the 60,000 job losses expected. In contrast, the unemployment rate surged by half a percentage point, to 5.5%, much more than expected. That is the largest increase in the unemployment rate in 22 years. Economists were expecting a 5.1% jobless rate.

Job losses were concentrated in construction, manufacturing, and retail. Construction jobs fell by 34,000, while factory jobs declined by 26,000. Retail positions contracted by 27,000.

Health care added 34,000 jobs, while the government added 17,000. Year to date, the economy has lost 324,000 jobs.

See Full Report.

Is Everybody Long Oil Yet?

There's panic buying in the oil pits today. None of the explanations for the move make much sense. Some have blamed the move on Claude Trichet, the ECB president, who is claimed to have hinted at raising rates next month. The dollar has sold off for two days on those comments. But what exactly did Trichet say that is so much different than past comments?

``It's not excluded that, after having carefully examined the situation, that we could decide to move our rates by a small amount at our next meeting,'' Trichet said at a press conference in Frankfurt after the ECB left its benchmark rate at 4 percent. ``I don't say it's certain. I said it's possible.''

Well that's clear as mud. Compare that statement to this one from January:

The ECB was "prepared to act pre-emptively so that second-round effects and upside risks to price stability over the medium term do not materialise," he stated, a clear warning it could raise interest rates in the future despite slumping economic activity.

Furthermore, the dollar is at just 157.7 as I write this which is better than the 160.5 the euro cost in April. And oil was less than 120 when the euro hit its high.

Another explanation are the comments from the Transport Minister in Israel that if Iran continues to develop nuclear weapons, Israel will attack. Again, not exactly news.

So why are oil prices spiking today? Because traders are buying it. Why are traders buying oil? Because the price is going up. Where does it end? Damned if I know....

Thursday, June 05, 2008

Initial Jobless Claims

The number of people filing for first time unemployment benefits fell sharply in the week ending May 31th, according to the Labor Department. Claims dropped 18,000, to 357,000. Economists were expecting 375,000 new claims for the week.

Having witnessed extremely volatile measurements in the past few weeks, it is wise to consider the four-week moving average of initial claims, which smooths out one-time factors such as bad weather or holidays. The four-week moving average was also lower, by 2,750 in the latest week, down to 368,500. A year ago, the four-week average stood at 305,000.

See Full Report.

Tuesday, June 03, 2008

Fed Finally Notices the Dollar

Ben Bernanke finally took notice of the dollar today in a speech in Barcelona, Spain:

collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in foreign exchange markets. The challenges that our economy has faced over the past year or so have generated some downward pressures on the foreign exchange value of the dollar, which have contributed to the unwelcome rise in import prices and consumer price inflation. We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations and will continue to formulate policy to guard against risks to both parts of our dual mandate, including the risk of an erosion in longer-term inflation expectations. Over time, the Federal Reserve's commitment to both price stability and maximum sustainable employment and the underlying strengths of the U.S. economy--including flexible markets and robust innovation and productivity--will be key factors ensuring that the dollar remains a strong and stable currency.

I actually think Bernanke has it backwards on the dollar. It is not the Federal Reserve's "commitment to both price stability and maximum sustainable employment and the underlying strengths of the U.S. economy" that will result in a stable dollar. It is a stable dollar which will contribute to price stability and sustainable employment. Nevertheless, it is nice to see Bernanke at least acknowledge that the dollar is an important part of their policy decisions. The market is responding to the speech by bidding up the dollar against most currencies.