Buffett’s op-ed piece in NYT

August 19, 2009

Op-Ed Contributor

The Greenback Effect

By WARREN E. BUFFETT

Omaha

IN nature, every action has consequences, a phenomenon called the butterfly effect. These consequences, moreover, are not necessarily proportional. For example, doubling the carbon dioxide we belch into the atmosphere may far more than double the subsequent problems for society. Realizing this, the world properly worries about greenhouse emissions.

The butterfly effect reaches into the financial world as well. Here, the United States is spewing a potentially damaging substance into our economy — greenback emissions.

To be sure, we’ve been doing this for a reason I resoundingly applaud. Last fall, our financial system stood on the brink of a collapse that threatened a depression. The crisis required our government to display wisdom, courage and decisiveness. Fortunately, the Federal Reserve and key economic officials in both the Bush and Obama administrations responded more than ably to the need.

They made mistakes, of course. How could it have been otherwise when supposedly indestructible pillars of our economic structure were tumbling all around them? A meltdown, though, was avoided, with a gusher of federal money playing an essential role in the rescue.

The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.

To understand this threat, we need to look at where we stand historically. If we leave aside the war-impacted years of 1942 to 1946, the largest annual deficit the United States has incurred since 1920 was 6 percent of gross domestic product. This fiscal year, though, the deficit will rise to about 13 percent of G.D.P., more than twice the non-wartime record. In dollars, that equates to a staggering $1.8 trillion. Fiscally, we are in uncharted territory.

Because of this gigantic deficit, our country’s “net debt” (that is, the amount held publicly) is mushrooming. During this fiscal year, it will increase more than one percentage point per month, climbing to about 56 percent of G.D.P. from 41 percent. Admittedly, other countries, like Japan and Italy, have far higher ratios and no one can know the precise level of net debt to G.D.P. at which the United States will lose its reputation for financial integrity. But a few more years like this one and we will find out.

An increase in federal debt can be financed in three ways: borrowing from foreigners, borrowing from our own citizens or, through a roundabout process, printing money. Let’s look at the prospects for each individually — and in combination.

The current account deficit — dollars that we force-feed to the rest of the world and that must then be invested — will be $400 billion or so this year. Assume, in a relatively benign scenario, that all of this is directed by the recipients — China leads the list — to purchases of United States debt. Never mind that this all-Treasuries allocation is no sure thing: some countries may decide that purchasing American stocks, real estate or entire companies makes more sense than soaking up dollar-denominated bonds. Rumblings to that effect have recently increased.

Then take the second element of the scenario — borrowing from our own citizens. Assume that Americans save $500 billion, far above what they’ve saved recently but perhaps consistent with the changing national mood. Finally, assume that these citizens opt to put all their savings into United States Treasuries (partly through intermediaries like banks).

Even with these heroic assumptions, the Treasury will be obliged to find another $900 billion to finance the remainder of the $1.8 trillion of debt it is issuing. Washington’s printing presses will need to work overtime.

Slowing them down will require extraordinary political will. With government expenditures now running 185 percent of receipts, truly major changes in both taxes and outlays will be required. A revived economy can’t come close to bridging that sort of gap.

Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes. In fact, John Maynard Keynes long ago laid out a road map for political survival amid an economic disaster of just this sort: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens…. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

I want to emphasize that there is nothing evil or destructive in an increase in debt that is proportional to an increase in income or assets. As the resources of individuals, corporations and countries grow, each can handle more debt. The United States remains by far the most prosperous country on earth, and its debt-carrying capacity will grow in the future just as it has in the past.

But it was a wise man who said, “All I want to know is where I’m going to die so I’ll never go there.” We don’t want our country to evolve into the banana-republic economy described by Keynes.

Our immediate problem is to get our country back on its feet and flourishing — “whatever it takes” still makes sense. Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.

Nice story on Real Estate

Peter Linneman on Real Estate: The Storm Is Over, the Wreckage Remains Published : August 19, 2009 in Knowledge@Wharton

Although some upbeat economic news in recent weeks might indicate the beginning of the end of the recession, there’s still plenty of “wreckage” to deal with, says Wharton real estate professor Peter D. Linneman. Nowhere is this more apparent than in the housing and commercial property sectors, which have taken one of their worst beatings ever. Linneman refutes the argument that the U. S. government should do more to prop up the weakest parts of the economy, like the troubled real estate industry. In an interview with Knowledge@Wharton, he also draws on policy missteps of the past to caution the Obama administration to tread carefully and avoid “trying to cure things they can’t cure,” while contending that the U. S. might have more in common with countries like Venezuela, Russia and Japan than most observers think.

An edited transcript of the conversation follows.

Knowledge@Wharton: Could we start by taking stock of the real estate market — both housing and commercial. What does it look like to you today and for the rest of the year?

Peter D. Linneman: Let’s take housing first…. Single-family has clearly bottomed. It is the untold story. Single-family housing starts have bottomed and will slowly pick up, [and] single-family housing prices in almost every market have bottomed. For the last four months, single-family housing prices at multiple listing services — namely what real people are selling their homes at instead of foreclosure sales — have been up in almost every market except Las Vegas. So that part is positive, absent further economic collapse driven by Washington.

The multi-family side has fallen off a cliff. Multi-family starts are about a quarter of their historic norm. They’re down 75% in about seven months as a run rate and they’ll stay down because of the shortage of available construction capital. It’s not such a horrible thing because there’s a fair amount of vacancy. What’s happened is that as the economy has lost jobs, people have doubled up. They stay with their parents — [say] young graduates, immigrants stay with their cousins and brothers. That will continue until the economy improves, which probably won’t be until late this year and into next — again, if Washington can just keep calm. Therefore, the lack of construction going on is a good thing in the sense that it means you can eat up excess inventory. It’s not good if you’re in the construction business, but as a general matter it’s good. I see the multi-family [sector] taking longer to pick back up. It won’t pick back up, I think, until next year based on my analyses.

If you ask, is the storm over? The storm is over. What’s left is cleaning up the wreckage from the storm. People have a hard time distinguishing the storm and the wreckage. [There is a]big difference though. When that hurricane is still hitting you, it’s still creating more damage. Now what you’re dealing with on the housing side is all of these people who bought speculative homes. They thought prices would only go up. They thought they’d flip them in six months. There was nobody to flip them to, so of course, they foreclosed. They had no money in it. They didn’t lose anything. That’s probably over half a million homes.

So the wreckage is still being dealt with — [by] the people who were speculators, the people who bought 97%-loan homes even if they were living in them and [the people in] greater Ohio. Greater Ohio is, say, Ohio and 50 miles [just outside] of the Ohio border — that’s in a real recession. It’s been in a real recession for seven years. That’s a different issue than the rest of the country faces.

Unfortunately, the government is trying to cure things it can’t cure. The government is trying to [give] what is not theirs to give. Salvation is not theirs to give, but they’re trying to give salvation. If you had no money in your home, and you thought you would flip it in six months for 100% profit — and then prices fell 20% — salvation [for that business decision] is not the government’s to give. They shouldn’t do it. And the more they try to do it, the more harm than good they’re doing.

Knowledge@Wharton: When you say the storm is over and what’s left is the cleanup, is that just in the U.S. or do you see the same thing internationally?

Linneman: That’s fairly true everywhere. The difference is on the commercial side. It’s true everywhere with the minor exception of China and Brazil, and the very minor exception of India. And when I say that [I mean conditions are] good for Brazil, China and possibly India.

Knowledge@Wharton: How do you see the differences between the way the financial crisis affected the housing market and the commercial market?

Linneman: In one sense, it’s totally different; in another, it’s not. The way [the commercial market] is different [was that] it wasn’t subprime. The Fed kept interest rates at effectively 1% for four years while inflation was running at 2.5%. It guaranteed that anybody who put their money short and safe, lost money for four years. Well, people aren’t going to sit around and lose money for four years. People piled into long and risky.

The common element is what was long and risky. Subprime was long and risky. Certain types of commercial real estate were long and risky. Condominium developments were long and risky, not just in the U.S.: Developments in [India] were long and risky. Leveraged buyouts of operating companies were long and risky. The common element was long and risky [assets], not real estate.

If you look across the world, anything that was long and risky has been crushed because the government went from forcing people artificially to demand long and risky to quite the opposite. It forced them to demand short and safe. When that happened, the supply of long and risky had not changed dramatically. Demand changed dramatically, from being artificially high to [becoming] artificially low. The government also encouraged [buyers] with low interest rates … [making it enticing to borrow] short and float.

You had this odd situation where you were encouraged to invest long but borrow short. It was a disaster that had to end. Anything that was long and risky had the same impact. That’s what’s been lost in the shuffle. People are looking at the symptoms rather than the cause. The cause was low interest rates forcing people to go long and risky. Better to lose money later with a risk than for sure now. It turns out now is the settling up for when you went long and risky.

There’s no similarity between a home [loan] and a commercial real estate [loan]. Commercial real estate has a cash flow behind it. It has tenants behind it, everybody from the U.S. government to a venture capital firm. [Residential] homes have you and me [asking], do we want to stay here? [There is] no cash flow. By the way, the leverage was much higher on the single-family side at the margin. People forget that 20% of all homeowners have no mortgage — no mortgage — in the United States…. Only 5% of all Americans are not current with a mortgage, 33% of Americans rent, 20% have no mortgage and 5% aren’t paying [their mortgage].

There’s an undue focus on a small amount of things, but it’s a very noteworthy amount of things. In that way, they’re similar. The dynamics though are very different in terms of the cash flows, the nature of the mortgages and [the loan] structures.

Knowledge@Wharton: Coming back to the role of the government, you said earlier that it shouldn’t try to do what it can’t do. What is the right strategy for the government now?

Linneman: My view is that [what] government [officials] should have done but didn’t [was to] admit that they are also human beings. Milton Friedman was an old professor of mine and he used to say that when you listen to people talk about the government, if you change the word government to omnipotent deity, the meaning of most sentences would be unchanged. You hear people say the government should help delinquent borrowers. What they really are saying is an omnipotent deity should come in and save them and so forth. They’re just human beings. They have no more information than we do. They have no more expertise than we do. They have powers of mandatory behavior, which are dangerous because I make mistakes everyday at my job. For all we know, this tape is not working. Well, if this tape is not working and it’s just us, it affects two of us. If we’ve committed a similar mistake and we’re in charge of the government, it affects 300 million people.

What they [the government] need to do is admit they’re human, and that they do not have answers. The phrase I’ve used throughout all this is, first, do no harm. If you take a life safety course, the first thing they teach you is to do nothing until you completely understand the situation. We’ve had a government that for the last year has — under both the Bush administration with Paulson and the Obama administration with Geithner — leaped, then looked. They leap to grand solutions, whether it’s TARP or TALF … then two days later they say, “Well, we’re not going to do it that way and by the way we’re changing. “[From] somebody who follows this closely, all [I see that] they’ve done is obliterate rules.

The thing that distinguishes us from Zimbabwe, and distinguishes us from Russia and Venezuela, is that prior to September 1, 2008, you had a fair idea that if a company couldn’t pay its debts, it would go into bankruptcy and the process would work out. You had a fair idea that if a bank couldn’t collect its loans, it would be taken over by the FDIC and liquidated…. Now they’re talking about oil. Will we regulate oil prices? And just on and on, so that you have no certainty at all.

What was the best way to raise money prior to September 1 last year? You went to Wall Street. You made a pitch to investors and you tried to convince them. What’s the best way to make money today? Lose a lot of money and then go to Washington with your political power and try to raise money. That can’t be good because I don’t know who is politically powerful enough. So they’ve ruined the playing field. People do not play games if they don’t know the rules. That’s why Zimbabwe, Venezuela and Russia have weaker economies — nobody knows the rules. I don’t even have to like the rules. You and I play games all the time that we think have stupid rules. But as long as we know the rules, we’ll play.

We changed from the most predictable rules in the world to [a] Russia-Venezuela [approach]. If you don’t believe it, suppose I told you the Duma in Russia conducted hearings for two weeks on whether to subsidize, to the tune of tens of billions of dollars, a couple of companies? After two weeks they said no. The next day Putin said yes. You’d say, “Well, that’s Russia. And that’s why I don’t invest in Russia. “

That’s literally what happened in November to the auto industry. Congress conducted hearings. They said no. Twelve hours later, the Secretary of the Treasury said, “We’ll do it anyway. “

I’m not picking on Democrats or Republicans. Unfortunately, this has crossed the party line. What they really need to do is — less. Unfortunately, that is not what they’re good at.

Knowledge@Wharton: Let’s look back about 20 years [when] the savings and loan debacle happened. The government agency called in the Resolution Trust Corporation, or RTC, to solve, at that time, what looked like a big mess, and Wall Street, securitization and real estate investment trusts [REITS] emerged as a solution. As this scenario plays out with real estate finance, and housing and commercial real estate, where do you see the sources of capital [coming from] and what will the landscape look like?

Linneman: There is a great similarity between what happened then and [what is] happening now…. One, human nature. Human nature then said things only go up and we believed our own [lies]. One of the things that happens at the end of every cycle, by the way, is that human nature takes over, so it’s not the first time human nature has taken over. In all of history utopist go around saying, “I’m going to change human nature. “You’re not going to change human nature. You’re not going to regulate human nature out of existence. Madoff is not the first guy to steal. Wars have been going on since the dawn of man. Murder has been going on. And so have economic ups and downs because of the hubris of people. That was a bust of hubris.

The difference was the government then said, “We are going to live by the rules. If you’re not solvent, we’re going to shut you down. “Did they make some mistakes with hindsight of shutting down a few people who were solvent? Yes. And the courts later resolved that. There were so many of them that were insolvent, they had to liquidate them and set up a special agency.

Instead of doing that this time, the government has said, “We can decide how to keep people alive. “Instead of shutting down the insolvent, they’ve kept the insolvent [institutions] alive and pumped in billions of dollars. Think about it. There’s only so much money and capital in the system. If you give money to insolvent people, all you’re guaranteeing is that the solvent aren’t getting the money. There’s only so much. My analogy is that if you give blood transfusions to the dead, they’re not only not going to get up and dance the jig, but there won’t be any blood to give to those who are still alive and could benefit from it. That was the big mistake we made this time.

You mentioned securitization. Securitization came to the rescue of Latin American debt if you think about it. Back with the Brady bonds, it came to the rescue of the S&L crisis — namely, we’ll package stuff up both in terms of debt and equity. The equity side has proven pretty successful. Yes, the stock prices fell. Hey, stock prices of everything fell. REITS stock prices fell more than the prices of other stocks for one simple reason — that in normal times, they have a beta of about 0.5. They aren’t perfectly correlated. Therefore, people are willing to pay a premium for something that’s not perfectly correlated. When people rush for the fire escape, everything is perfectly correlated. Not only does it go down as much as everything else, no longer are you getting a premium for the fact it doesn’t. It actually has to fall more. The flip side is going to be … it will go back up more until the next time we rush to the fire escape. And we will rush to the fire escape again within the next ten years because we’re human.

How will capital sources come? They will be equity, not debt. It will, in the near term, be a massive debt-for-equity swap. People say we’re over-levered…. At the face value of the debt we are, but not at the current market valuation. It’s a little like saying I put $100 million into my stocks. Of course, they’re worth $20 million today and you’re still saying, “No, they’re worth $100 million. “No they aren’t. They’re worth $20 million. In the same sense, if you look at the market value of the debt, whether you trace it through the banks, through what’s traded or through [commercial mortgage-backed securities or residential mortgage-backed securities], we’re not over-levered.

What we are is over-face valued, which means — because debt is a contract — you’ve got a lot of contracts that have to be worked out. Whereas equity says no workouts; it’s just down. It’s great for lawyers, bad for everybody else. Where will the money come from? It will come from public capital markets first. The REITS are the best position to take advantage of this because they’re around, they’re loaded, they’re low leverage, they’re transparent and they’re name brands. The private equity funds will take advantage of it. It’s more difficult because they’ve told investors that they are going to get 20% to 25% returns. It’s very hard to make a pro forma show a 20% to 25% return on a cash stream — any cash stream — without a lot of leverage. So the absence of leverage means you can get 12, 15, 18% on paper, but not [in the 20% range]. And that’s a challenge for private equity. In fact, any time you can do a pro forma and generate a 20%, you will never do it. Any time you can’t do a pro forma that generates 20%, you might be able to do it because it means capital is scarce.

What you’ll see is a lot of equitization though. You’ll probably see some private equity funds go public, for example, [and] use that money to pay down debt … and restructure in that way….

You are going to see banks sell assets. It’s going to go a lot slower than people think because this time the U.S. government is acting much more like Japan did in the early 1990s, which was very slow to shut down the insolvent [Japanese banks]. We are giving blood to the dead, rather than giving blood to the living. If we do that, they have less incentive to [sell] assets, create a market and move on.

Knowledge@Wharton: What will real estate look like and what should it look like in the future?

Linneman: What it will look like in the future is pretty obvious — ups and downs, with more up than down. Probably 60% to 70% up and 30% down — but the downs being right when you think they’re impossible to occur and the ups occurring just when you think they’ll never occur. As I was saying to some friends at a gathering that I host, of major real estate people, if you go back to 1997, before the Russian ruble crisis, nobody saw the extent of the collapse. Some people saw there was weakness, but nobody saw the extent. At the bottom post-Russian ruble crisis, nobody saw the height of dot-com, which was two years later in terms of valuation and froth. At the height of the dot-com, nobody saw that two years later you’d be in the depths of 9/11. You may have seen a down, but not the depths. In the depths of post 9/11, nobody saw 2005 being as strong as it was. As you sat in 2005, nobody saw the first quarter of 2007 being as frothy as it was. In the first quarter of 2007, no one saw the depths we’re in now.

Why do you believe any of us when we sit here and say anything, because even those of us who have been pretty good at predicting, have only predicted direction and generally missed magnitude? I predicted a recession five years ago and every quarter thereafter for 2009. So great. I was right. I predicted flat GDP and a 1.5 million job losses. I was only off by 4.5 million jobs and I was only off by 6% of GDP. Other than that, I was a genius, right? The point being, even those of us who got directions right, missed magnitude.

We need to have some humility and understanding. We’re going to be very wrong about the next two years. The next two years are going to see a lot of asset price appreciation, particularly related to real estate. You’re going to see better economic performance than people are foreseeing. If you look at past recessions, that’s always turned out to be the case.

The real estate industry [is] probably going to have a great four years for public companies, including companies that aren’t … [yet] public. You’re going to see a number of private equity funds struggle, some [just] to stay in existence because they are heavier debt. Let’s face it. Anybody who used debt is caught up in that negotiation game. And if all your energies are caught in the negotiation, you’re not in the create-new-value game. You only have so much time and energy.

What you’re going to see is those who had low debt, which are going to be a few families but mostly public companies, are going to see their timeAnd private funds, and the heavily leveraged, will have the opposite [experience].

Will securitization arise? Some version of it, yes. Do I know exactly what version? No. There’s probably some 35-year-old out there who is figuring out the new answer that will be the end of history. And then five years later, [it will turn out that] it’s not the end of history. One of the advantages of being old is you realize, every solution creates its own problem.

But [the solution] did solve a problem at the moment. I’ll deal with the [new] problem five years from now. I’ll be happy to deal with the problem of five years from now if I can just solve the problem today. If you think about life, that’s how we go through life as. I solved the problem of today. Are you working on the article of five years from now? [Or do you think,] “Hey, I got enough problems just getting the articles of today together.” Sort of similar, right?

What you’ll see though is that securitization is not going to go away. People are saying, “We should do this regulation or we should not allow this or not allow that. “Trust me. If you read the literature that people — intelligent people doing thoughtful analysis — wrote as securitization was occurring, not just in real estate, it said, “Look at all the problems it’s solving. Yes, it does have a few drawbacks, but… “Well, as things gain momentum, the “buts” come to dominate the benefits. In the beginning, it’s easy to get the benefits to dominate the “buts. “As we push things and we start believing our own [public relations] and our hubris sets in, we push the margins….

There is a myth [that] securitization created this problem. It’s not true. What created the problem was bad risk analysis, whether it was bad risk analysis on the equity side or bad risk analysis on the debt side. A loan to somebody to flip an apartment when there are 50 apartments that [are ready to move into] and there are 500 [apartments] being delivered in a year — if you give 100% loan on that, that’s a bad loan because it was badly underwritten, whether it’s securitized or held as private loan, or even if it’s bought with 100% equity. It’s bad risk analysis. Fifty are needed. And 500 are being built. That’s ten years’ worth. If you’re pouring money into that, that’s bad….

Bad risk analysis generally goes with either the end of a cycle — when we start believing ourselves — or bad policy. The bad policy was the 1% interest rate, which made things look better than they should have as an alternative.

By the way, do I think the Fed will never make another monetary policy mistake? It was an honest mistake. It certainly wasn’t a dishonest mistake. Of course, they’re going to make more mistakes because they’re just human beings. So securitization isn’t what is wrong. Japan, in the 1980s, made the greatest number of insane loans with the worst risk analysis and the worst documentation in modern history. None of them were securitized. They were all held on balance sheets…. The packaging of it influences it at the margin. But bad decisions are bad decisions, no matter how you package them.

Knowledge@Wharton: The argument that some people might have is that with securitization you don’t have to hold the risk. You can move it to somebody else.

Linneman: The old joke was — this is in the old loan world when you didn’t securitize — I make the loan and then if it doesn’t work, I pretend it’s good until either I get promoted or retire. Right? That was it. So the institution in some sense held it. But when you get to where the rubber meets the road, it’s human beings. And human beings have the incentive to not take the responsibility for their own mistakes. We have the human being dimension to take all the responsibility for any success we’re remotely [close to], including success we have nothing to do with. Failure [has] no parents and success [has] a thousand fathers. These are old sayings for a reason. When [these loans] were held as whole loans, or when they were done as equity, dot-com had relatively little debt, was some of the worst risk analysis ever. Hundreds of billions of dollars [were] wasted on bad risk analysis.

By the way, if we had done it as debt rather than equity, would it have been any smarter if we’d have held them as whole loans rather than equity. Dumb is dumb as [far as] risk analysis [goes]. And the packaging can influence [the risk profile], but it’s secondary. The truth is, you saw relatively few people with 100% of their own money making really dumb decisions — in any of these. What you always see is a lot of people, with other people’s money [making bad decisions], and an incentive structure [to further encourage those decisions].

Because we’re human beings with flawed integrity and the ability to tell ourselves we’re doing the right things even when we’re not, one of our greatest abilities is deluding ourselves. I look in the mirror every morning and I see John Wayne at his best. It gets me through the day. You see the storybook here. We all delude [ourselves]. People are focusing on the package it [these loans] came in. I’ve got bad incentives whether I’m holding the loans on and I’m trying to get my bonus that year or I’m trying to sell them and get my bonus. It may be more transparent one way over the other.

Securitization made the problem visible about two years earlier than it did in Japan when it was private, and than it did in the S&Ls when it was behind closed doors. I shudder to think how big the mistakes would have grown to if they had have been behind closed doors instead of securitized.

Knowledge@Wharton: What are the main lessons that we should learn from this experience?

Linneman: Great lessons. One: Whenever there’s more money being offered to you than you can imagine, it will be followed by a period where nobody’s going to offer you money. Another lesson:Don’t match long assets with short liabilities. These aren’t rocket-science lessons, but they are lessons.

Third:Debt has risk. Normally, and too often, people only think debt has a price, but not a risk. A lot of people say, “Debt is cheaper than equity. “Do you understand how many people paid as the cost of their debt — not the interest rate — they paid all their equity. I put in 20% equity on a purchase. The interest rate was 4%. It ended up costing me one year of 4% interest and 20%. It cost me 100% of my equity…. The biggest risk of debt is not that the interest rate goes up. The biggest risk of debt has always been — I wrote this in my book years ago — [that] they don’t want to give you money when your debt is due…. This is not the first time it’s happened. It’s interesting. I’m 58 and in the last 31 years I counted five times when economic events that supposedly only happen once every 100 years have occurred. Must have been a good 31 years, you know? .

This stuff happens and it happens because we’re human. That’s the last lesson. We are human. And they’re talking about more regulations. We don’t need more regulations. We just need to enforce the regulations we have. We have regulations that date back to the 1930s that say no federally insured depository can exist unless it can demonstrate safety and soundness. And we pay regulators — we have paid regulators — to enforce that. I think they missed. Now, I’m not even blaming them. Remember, the burden of proof is you don’t get a government insured deposit license unless you can demonstrate safety and soundness. It’s pretty obvious they weren’t safe and sound. The law was there and I’m not even faulting human beings. Again, they’re human beings on the regulating side as well.

The notion that you can regulate people into good behavior — we’ve got more regulations. It reminds me of the tragedies of gun control. Every time somebody walks into a McDonald’s, a post office or a school and kills … people with a handgun, you know that the next day there will be cries for more gun control. Every state in the country has probably 14 inches of gun control laws because every time [new legislators are voted into office], they pass an addition. What we need to do is to enforce the gun control laws, which say children, criminals and mentally unstable should not have access to them. All those laws already exist. Forget more regulation. Just enforce the ones we already have. All that more regulation can do … is make it harder to enforce, because I am going to have to spend a year figuring out what they mean. Now instead of 14 inches, I have 28 inches of regulation and I can’t pay attention to all of them.

Madoff is not a matter of market failure. Madoff is a matter of regulatory failure — over four administrations. The guy was a thief. Do we need new laws against thieves? There have been laws against thieves as [long] as mankind [has had laws]. Yet there are always thieves. The issue is having the will to enforce what you have. It’s rare that we’re passing a law that is truly improving on the fundamentals of the Ten Commandments or the Koran or whatever. They figured it out then. Don’t lie. Don’t steal. Let’s just have it real simple. What we need is a dedicated enforcement effort that takes it seriously. That’s difficult to do because it takes a human will that’s generally not there. We’re not inventing anything new. We’re just reliving. One hundred years from now this will all just be history. It’s just like reading about World War I. It happened over there, a whole bunch of people got hurt and some died. It was a great tragedy. But it will just be history. We’re just living history and it’s just going to keep repeating itself in variations. At least that’s my view.

Marc Faber Comments from August Newsletter

Marc Faber just released an excellent analysis of current market conditions through his newsletter service. The gist of it is the following: 1) the rally in equities is reaching a near term top, but after a correction equities could continue to rally, 2) strength in equities has nothing to do with any improvement in economic conditions and everything to do with money printing and zero interest rates, 3) equities may continue to rally for a while longer after a correction exactly because the economy is not recovering and even more money will be printed and spent by the government in a futile attempt to create economic growth, 4) gold and other hard assets are still good but may not outperform in the short run, 5) high quality equities and corporate bonds are much better than long term government bonds or cash, 6) Asian equities are much better than other equities, 7) all of this is in the context of a long term US bear market that will take many more years to run its course (i.e. think Japan in the 1990’s).

Bill Gross’ August Commentary

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2009/Investment+Outlook+August+2009+Gross+Investment+Potion.htm Investment Outlook

Bill Gross | August 2009

Investment Potions

I took my troubles down to Madame Rue You know that gypsy with the gold-capped tooth She’s got a pad down on 34th and Vine Sellin’ little bottles of – Love Potion #9                                         – Love Potion #9, Circa 1959  I’ve never known any gold-capped tooth money managers, but without squinting very hard there is undoubtedly a strong resemblance between all of us “managers” and the infamous Madame Rue selling Potion #9. Instead of love, though, we sell “hope,” but very few are able to seal the deal with performance anywhere close to compensating for the generous fees we command. Hope has a legitimate price, of course, even if its promises are never fulfilled. It is the reason we put a five spot into the collection plate on Sunday mornings and why we risk a 25-dollar chip at the blackjack table. In the former case we usually rationalize it as “insurance,” and with the latter as “entertainment.” Whatever – I’ve already alienated all of you with strong faith in the hereafter or the ones who actually believe they’re going to win on their next trip to Las Vegas. But my point is that those who sell investment “potions” must wrap their product with an extra large ribbon because history is not on their side. Common sense would dictate that the industry as a whole cannot outperform the market because they are the market, and long-term statistics revealing negative alpha for the class of active managers confirms it. Yet, what a price investors are willing to pay! A recent Barron’s article pointed out that stock funds extract an average 99 basis points or virtually 1% a year in fees from an investor’s portfolio. Bond managers are more benevolent (or less pretentious) at 75 basis points, and many money market funds manage to subsist at a miserly 38. Still, those 38 basis points are as deceptive as the pea that disappears beneath the shell of a street-side con game. Since money market funds barely earn 38 basis points these days, much of the return winds up in the hands of investment managers. A mighty expensive potion indeed. While some index and ETF proponents avoid this extreme absurdity with lower fees, roughly 90% of the $1.5 trillion in 401(k) and other defined contribution assets in mutual funds are in actively managed offerings with expenses close to 1%. Paying for those potions during an era of asset appreciation with double-digit returns may have been tolerable, but if investment returns gravitate close to 6% as envisaged in PIMCO’s “new normal,” then 15% of your income will be extracted based on the beguiling promise of Madame Rue. The solution, of course, is to compare long-term performance with fees and approach 34th & Vine with informed confidence, as opposed to Pollyannaish hope that you’ll get your money’s worth. Down the hatch and good luck! Investors looking for love potions or successful investment strategies in this new normal economy dominated by deleveraging and reregulation must focus on some very macro-oriented ingredients as opposed to typical news-dominated minutiae. The latest quarterly earnings report from Goldman Sachs may be an indicator that the financial sector is getting some color in its cheeks, but it doesn’t really let you know what needs to happen in order for the real economy to stabilize as well. My last month’s Investment Outlook commentary on the significance of wage and employment trends remains the key focus. Common sense tells us that consumer spending growth comes from highly employed, well-compensated labor, and we are far-far from even approaching that elemental condition. The fact is that near double-digit unemployment has resulted from numerous business models that are now broken: autos, home construction, commercial real estate development, finance, and retail sales. Construction of a new Humpty Dumpty capitalistic “oeuf” will be a herculean task. Potion hunters, however, should also understand the following macro concept that will dominate the indefinite future, one which I will humbly try to explain in the next few pages in 500 words or less: Reflating nominal GDP by inflating asset prices is the fundamental, yet infrequently acknowledged, goal of policymakers. If they can do that, then employment and economic stability may ultimately follow. To explain: A country’s GDP or Gross Domestic Product is really just an annual total of the goods and services that have been produced by its existing stock of investment (capital in the form of plant, equipment, software and certain intangibles) and labor (people working). Over the last 15 years or so in the U.S. that annual production (GDP) has increased in nominal (real growth and inflation) terms of 5-7% as shown in Chart 1.  Not every year, certainly not in boom or recessionary years, but pretty steadily over longer timeframes, and consistently enough to signal to capitalists that 5% was the number they could count on to justify employment hiring, investment spending plans, and which would serve as well as a close proxy for the return on capital that they should expect. Nominal GDP is in fact a decent proxy for a national economy’s return on capital. If each and every year we grew by 5%, then that would be sort of like a stock whose earnings grew by the same amount. Companies and investors then would be able to estimate the present value of those cash flows, and price investment and related assets accordingly – a capital asset pricing model or CAPM based on nominal GDP expectations. While objectively hard to prove, logic dictates that that is exactly what has happened over the past several decades. Businesses expanded with a developing certainty that demand, expenses, and return on the economy’s capital would mimic this 5% consistency. Debt was issued with yields that reflected the ability to service those payments through 5% growth in both real and inflationary terms, and stocks were issued and priced as well with the same foundation. Pension obligations and similar liabilities were legitimized on comparable logic, as were government spending programs forecasting tax revenues and benefits. Both real economy and financial markets then, were geared to and, in fact, mesmerized by this 5%, GDP/CAPM, “model.” Now, however, things have changed, and it is apparent that there is massive overcapacity in the U.S. and indeed the global economy. As reflexive delevering has unveiled the ugly stepsister of the “great 5% moderation,” nominal GDP has not only sunk below 5%, but turned at least temporarily negative. If allowed to continue – and this is my critical point – a portion of the U.S. production capacity and labor market will have to be permanently laid off. Nominal GDP has to grow close to 5% in order for the economy’s long-term balance to be maintained. Otherwise, employment levels become unsustainable, retail shopping centers unserviceable, automobile production facilities unprofitable, and the economy itself heads towards a new normal where unemployment averages 8 instead of 5%, housing starts total 1.5 instead of 2 million, and domestic auto sales 12, instead of 16 million annual units. Critically in the readjustment process, debts are haircutted via corporate defaults and home foreclosures, and equity P/Es are cut based upon increased risk and substantially lower growth expectations. A virtuous circle of expansion turns into a vicious cycle of recession or low-growth stagnation. Label it what you will, but a modern capitalistic economy based on levered financing and asset appreciation cannot thrive if its “return on capital” or nominal GDP suffers such a significant shock. Policymakers/government to the rescue –we hope. 0% interest rates, quantitative easing, $1.5 trillion deficits, trillions more in FDIC or explicit government guarantees, a trillion plus in MBS and Treasury bond purchases, TALF, TARP – I could, but I need not go on. Can they do it? In other words, can they successfully reflate to 5% nominal GDP and recreate an “old” normal economy? Not likely. The substitution of government-backed vs. private-leverage is one strong argument against the possibility. Despite the attractive financing rates incorporated with the TALF, TLGP and other government-subsidized financing programs, they come with quality constraints (larger collateral haircuts and mortgage down payments, to name a few) that inhibit the “new normal” lenders from approaching the standards of the 5% nominal-based shadow banking system. Just last week, President Obama proposed new “transaction fees” for “far out transactions” undertaken by financial companies. “If you guys want to do them,” he said, “put something into the kitty.” In turn, there are internal Washington Beltway/external Main Street USA, politically imposed limits which will thwart policy expansion beyond the current stasis. Most of the politicos and even ordinary citizens are screaming for limits on monetary/fiscal expansion: “No TARP II! 1.5 trillion dollar deficits are enough! The Fed must have an exit plan!” etc. If there are such future political constraints or caps (both domestically and from abroad), then one should recognize that most of the ammunition has been spent stabilizing the financial system, and very little directed towards the real economy in terms of job loss prevention. Where is the political will or wallet now to grant corporate tax breaks for private sector job creation or to even hire new government workers, aside from a minor positive push with military enlistment? In brief, the “new normal” nominal GDP, the future return on our stock of labor and capital investment, will likely be centered closer to 3%, for at least a few years once a recovery is in place beginning in this year’s second half. Diminished capitalistic risk taking and constrained policymaker releveraging will lead to that likely conclusion. Investment conclusions? A 3% nominal GDP “new normal” means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalistic model. High risk bonds, commercial real estate, and even lower quality municipal bonds may suffer more than cyclical defaults if not government supported. Stock P/Es will rest at lower historical norms, and higher stock prices will ultimately depend on tangible earnings growth in the form of increased dividends, not green shoots hope. An investor should remember that a journey to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end. There is no investment potion for this new environment other than steady income-producing bond and equity investments in companies with strong balance sheets and high dividend yields, as well as selectively chosen emerging market commitments where nominal GDP growth prospects are tilted upward as opposed to gravitating to new lower norms. Madame Rue has met her match. William H. Gross Managing Director

Stocks/Industries to buy during every part of economic cycle

From realmoney.com and S&P

The Fed’s Farewell?

op ed in WSJ today from Bernake:

 

 

• OPINION
• JULY 21, 2009, 8:13 A.M. ET

The Fed’s Exit Strategy

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By BEN BERNANKE

The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

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Chad Crowe

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.

To some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of our short-term lending facilities, and ultimately to their wind down. Indeed, short-term credit extended by the Fed to financial institutions and other market participants has already fallen to less than $600 billion as of mid-July from about $1.5 trillion at the end of 2008. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Fed mature or are prepaid. However, reserves likely would remain quite high for several years unless additional policies are undertaken.

Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.

Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.

Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.

Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank’s liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates.

 

Despite this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began to pay interest on reserves. This pattern partly reflected temporary factors, such as banks’ inexperience with the new system.

However, this pattern appears also to have resulted from the fact that some large lenders in the federal-funds market, notably government-sponsored enterprises such as Fannie Mae and Freddie Mac, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks.

Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal-funds rate and the rate the Fed pays on reserves. If that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets—the second means of tightening monetary policy. Here are four options for doing this.

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

—Mr. Bernanke is chairman of the Federal Reserve.

WSJ article today on the economy and how it may be worse than we think….Dah!

From wsj.com:

The Economy Is Even Worse Than You Think

The average length of unemployment is higher than it’s been since government began tracking the data in 1948.

By MORTIMER ZUCKERMAN

The recent unemployment numbers have undermined confidence that we might be nearing the bottom of the recession. What we can see on the surface is disconcerting enough, but the inside numbers are just as bad.

The Bureau of Labor Statistics preliminary estimate for job losses for June is 467,000, which means 7.2 million people have lost their jobs since the start of the recession. The cumulative job losses over the last six months have been greater than for any other half year period since World War II, including the military demobilization after the war. The job losses are also now equal to the net job gains over the previous nine years, making this the only recession since the Great Depression to wipe out all job growth from the previous expansion.

Here are 10 reasons we are in even more trouble than the 9.5% unemployment rate indicates:

David Klein

- June’s total assumed 185,000 people at work who probably were not. The government could not identify them; it made an assumption about trends. But many of the mythical jobs are in industries that have absolutely no job creation, e.g., finance. When the official numbers are adjusted over the next several months, June will look worse.

- More companies are asking employees to take unpaid leave. These people don’t count on the unemployment roll.

- No fewer than 1.4 million people wanted or were available for work in the last 12 months but were not counted. Why? Because they hadn’t searched for work in the four weeks preceding the survey.

- The number of workers taking part-time jobs due to the slack economy, a kind of stealth underemployment, has doubled in this recession to about nine million, or 5.8% of the work force. Add those whose hours have been cut to those who cannot find a full-time job and the total unemployed rises to 16.5%, putting the number of involuntarily idle in the range of 25 million.

- The average work week for rank-and-file employees in the private sector, roughly 80% of the work force, slipped to 33 hours. That’s 48 minutes a week less than before the recession began, the lowest level since the government began tracking such data 45 years ago. Full-time workers are being downgraded to part time as businesses slash labor costs to remain above water, and factories are operating at only 65% of capacity. If Americans were still clocking those extra 48 minutes a week now, the same aggregate amount of work would get done with 3.3 million fewer employees, which means that if it were not for the shorter work week the jobless rate would be 11.7%, not 9.5% (which far exceeds the 8% rate projected by the Obama administration).

- The average length of official unemployment increased to 24.5 weeks, the longest since government began tracking this data in 1948. The number of long-term unemployed (i.e., for 27 weeks or more) has now jumped to 4.4 million, an all-time high.

- The average worker saw no wage gains in June, with average compensation running flat at $18.53 an hour.

- The goods producing sector is losing the most jobs — 223,000 in the last report alone.

- The prospects for job creation are equally distressing. The likelihood is that when economic activity picks up, employers will first choose to increase hours for existing workers and bring part-time workers back to full time. Many unemployed workers looking for jobs once the recovery begins will discover that jobs as good as the ones they lost are almost impossible to find because many layoffs have been permanent. Instead of shrinking operations, companies have shut down whole business units or made sweeping structural changes in the way they conduct business. General Motors and Chrysler, closed hundreds of dealerships and reduced brands. Citigroup and Bank of America cut tens of thousands of positions and exited many parts of the world of finance.

Job losses may last well into 2010 to hit an unemployment peak close to 11%. That unemployment rate may be sustained for an extended period.

Can we find comfort in the fact that employment has long been considered a lagging indicator? It is conventionally seen as having limited predictive power since employment reflects decisions taken earlier in the business cycle. But today is different. Unemployment has doubled to 9.5% from 4.8% in only 16 months, a rate so fast it may influence future economic behavior and outlook.

How could this happen when Washington has thrown trillions of dollars into the pot, including the famous $787 billion in stimulus spending that was supposed to yield $1.50 in growth for every dollar spent? For a start, too much of the money went to transfer payments such as Medicaid, jobless benefits and the like that do nothing for jobs and growth. The spending that creates new jobs is new spending, particularly on infrastructure. It amounts to less than 10% of the stimulus package today.

About 40% of U.S. workers believe the recession will continue for another full year, and their pessimism is justified. As paychecks shrink and disappear, consumers are more hesitant to spend and won’t lead the economy out of the doldrums quickly enough.

It may have made him unpopular in parts of the Obama administration, but Vice President Joe Biden was right when he said a week ago that the administration misread how bad the economy was and how effective the stimulus would be. It was supposed to be about jobs but it wasn’t. The Recovery Act was a single piece of legislation but it included thousands of funding schemes for tens of thousands of projects, and those programs are stuck in the bureaucracy as the government releases the funds with typical inefficiency.

Another $150 billion, which was allocated to state coffers to continue programs like Medicaid, did not add new jobs; hundreds of billions were set aside for tax cuts and for new benefits for the poor and the unemployed, and they did not add new jobs. Now state budgets are drowning in red ink as jobless claims and Medicaid bills climb.

Next year state budgets will have depleted their initial rescue dollars. Absent another rescue plan, they will have no choice but to slash spending, raise taxes, or both. State and local governments, representing about 15% of the economy, are beginning the worst contraction in postwar history amid a deficit of $166 billion for fiscal 2010, according to the Center on Budget and Policy Priorities, and a gap of $350 billion in fiscal 2011.

Households overburdened with historic levels of debt will also be saving more. The savings rate has already jumped to almost 7% of after-tax income from 0% in 2007, and it is still going up. Every dollar of saving comes out of consumption. Since consumer spending is the economy’s main driver, we are going to have a weak consumer sector and many businesses simply won’t have the means or the need to hire employees. After the 1990-91 recessions, consumers went out and bought houses, cars and other expensive goods. This time, the combination of a weak job picture and a severe credit crunch means that people won’t be able to get the financing for big expenditures, and those who can borrow will be reluctant to do so. The paycheck has returned as the primary source of spending.

This process is nowhere near complete and, until it is, the economy will barely grow if it does at all, and it may well oscillate between sluggish growth and modest decline for the next several years until the rebalancing of excessive debt has been completed. Until then, the economy will be deprived of adequate profits and cash flow, and businesses will not start to hire nor race to make capital expenditures when they have vast idle capacity.

No wonder poll after poll shows a steady erosion of confidence in the stimulus. So what kind of second-act stimulus should we look for? Something that might have a real multiplier effect, not a congressional wish list of pet programs. It is critical that the Obama administration not play politics with the issue. The time to get ready for a serious infrastructure program is now. It’s a shame Washington didn’t get it right the first time.

Mr. Zuckerman is chairman and editor in chief of U.S. News & World Report.

More From Dr. Doom-Forbes.com

Doctor Doom
Brown Manure, Not Green Shoots
Nouriel Roubini, 07.09.09, 12:00 AM ET

 

 

The June employment report suggests that the alleged green shoots are mostly yellow weeds that may eventually turn into brown manure. The employment report shows that conditions in the labor market continue to be extremely weak, with job losses in June of over 460,000. With the current rate of job losses, it is very clear that the unemployment rate could reach 10% by later this summer–around August or September–and will be closer to 10.5%, if not 11%, by year-end. I expect the unemployment rate is going to peak at around 11% at some point in 2010, well above historical standards for even severe recessions.

It’s clear that even if the recession were to be over anytime soon–and it’s not going to be over before the end of the year–job losses are going to continue for at least another year and a half. Historically, during the last two recessions, job losses continued for at least a year and a half after the recession was over. During the 2001 recession, the recession was over in November 2001, and job losses continued through August 2003 for a cumulative loss of jobs of over 5 million; this time we are already seeing more than 6 million job losses and the recession is not over.

The details of the unemployment report are even worse than the headline. Not only are there large job losses right now, but as a way of sharing the pain, firms are inducing workers to reduce hours and hourly wages. Therefore, when we’re looking at the effect of the labor market on labor income, we should consider that the total value of labor income is the product of jobs, hours and average hourly wages–and that all three elements are falling right now. So the effect on labor income is much more significant than job losses alone.

The details also suggest that other aspects of the labor markets are worsening. If you include discouraged workers and partially employed workers, the unemployment rate is already above 16%. If you consider also that temporary jobs are falling now quite sharply, labor market conditions are becoming worse and the average duration of unemployment now is at an all-time high. So people not only are losing jobs, but they’re finding it harder to find new jobs. So every element of the labor market is worsening.

The unemployment rate rose only marginally from 9.4% to 9.5%, but that’s because so many people are discouraged that they exited the labor force voluntarily and therefore are not counted in the official unemployment rate.

The other element of the report that must be considered is that, for the summer, the Bureau of Labor Statistics (BLS) is still adding between 150,000 and 200,000 jobs based on the birth/death model. We know the distortions of the birth/death model–that in a recession jobs created within firms are much smaller than those created by firms that are dying. So that’s distorting downward the number of job losses. Based on the initial claims for unemployment benefits, it’s more likely that the job losses are closer to 600,000 per month rather than the figures officially reported.

These job losses are going to have a significant effect on consumer confidence and consumption in the months ahead. We’ve also seen extreme weakness in consumption. There was a boost in retail sales and real personal consumption-spending in January and February, sparked by sales following the holiday season, but the numbers from April, May and now June are extremely weak in real terms. In April and May you saw a significant increase in real personal income only because of tax rebates and unemployment benefits. In April, there was a sharp fall in real personal spending, and in May the increase was only marginal in real terms.

This suggests that most of the tax rebates are being saved rather than consumed. The same thing happened last year: With a $100 billion tax rebate, only thirty cents on the dollar were spent while seventy cents were saved. Last year, people expected the tax rebate to stimulate consumption through September. Instead, there was an increase in April, May and June, with the increase fizzling out by July.

This year it’s even worse. We have another $100 billion in tax rebates in the pipeline. But the numbers suggest that in April, real consumption fell. And in May it was practically flat. So this year households are even more worried than they were last year about jobs, income, credit cards and mortgages. Most likely only around 20 cents on the dollar–rather than 30 cents last year–of that increase in income is going to be spent. In any case, that increase in income is just temporary and is going to fizzle out by the summer. So you can expect a significant further reduction in consumption in the fall after the effects of the tax rebates fade.

The other important aspect of the labor market is that if the unemployment rate is going to peak around 11% next year, the expected losses for banks on their loans and securities are going to be much higher than the ones estimated in the recent stress tests. You plug an unemployment rate of 11% in any model of loan losses and recovery rates and you get very ugly losses for subprime, near-prime, prime, home equity loan lines, credit cards, auto loans, student loans, leverage loans and commercial loans–much bigger numbers than what the stress tests projected.

In the stress tests, the average unemployment rate next year was assumed to be 10.3% in the most adverse scenario. We’ll be already at 10.3% by the fall or the winter of this year, and certainly well above that and close to 11% at some point next year.

So these very weak conditions in the labor market suggest problems for the U.S. consumer, but also increasing problems for the banking system as these sharp increases in job losses lead to further delinquencies on loans and securities and lower than expected recovery rates.

The latest figures on mortgage delinquencies and foreclosures suggest a spike not only in subprime and near-prime delinquencies, but now also on prime mortgages. So the problems of the economy are significantly affecting the banking system. Even if for a couple of other quarters banks are going to use the new Financial Accounting Standards Board (FASB) rules and under-provisioning for loan losses to report better-than-expected results, by Q4, with unemployment rates above 10%, that short-term accounting fudge will have a significant impact on reported earnings. And this will show the underlying weakness in the economy. So banks may fudge it for a couple of other quarters, but eventually the effects of very sharp unemployment rates and still sharply falling home prices are going to drag down earnings and have a sharp effect on losses and capital needs of the banks and the entire financial system.

Essentially, the results today suggested that there are not as many green shoots. These green shoots, as I’ve argued, are mostly yellow weeds that may even turn into brown manure if a double-dip, W-shaped recession occurs in 2010-11. And it’s not just the employment situation. Real consumption and retail sales remain weak. Industrial production remains weak. The housing market, in terms of price adjustment, remains weak, even if the quantities–demand and supply–may be closer to bottoming out. Indeed, the inventory of unsold new homes is so large that you could stop producing new homes for almost a year to get rid of that inventory. Moreover, about 50% of existing home sales are distressed sales (short sales and foreclosed homes).

The labor market conditions may have a significant effect on how long it takes for the housing market to bottom out. It’s already estimated that by the end of this year, there will be about 8.4 million people with a mortgage who have lost jobs, and therefore have little income. Therefore, the number of people who will have difficulties servicing their mortgages is going to rise very sharply.

Home prices have already fallen from their peak by about 30%. Based on my analysis, they are going to fall by at least 40% from their peak, and more likely 45%, before they bottom out. They are still falling at an annualized rate of over 18%. That fall of at least 40%-45% percent of home prices from their peak is going to imply that about half of all households that have a mortgage–about 25 million of the 51 million that have mortgages–are going to be underwater with negative equity and will have a significant incentive to walk away from their homes.

The job market report is essentially the tip of the iceberg. It’s a significant signal of the weaknesses in the economy. It affects consumer confidence. It affects labor income. It affects consumption. It affects the willingness of firms to start increasing production. It has significant consequences of the housing market. And it has significant consequences, of course, on the banking system.

Overall, it’s an extremely weak report and suggests that weakness in the labor markets is going to continue, and that the recession is more likely to continue through the end of the year and the beginning of next year. It also suggests that recovery will be anemic, subpar, below trend. We are still estimating that U.S. growth next year is going to be 1% above the 2009 level, well below a potential growth rate of 3%. This is because there is little deleveraging of households, corporate firms and financial institutions while there is a massive re-leveraging of the public sector with sharply rising deficits and debts as many of the private losses have been socialized.

There are also signs that there may be forces leading to a double-dip recession sometime toward the second half of next year or toward 2011. If oil prices rise too much, too fast, too soon, that’s going to have a negative effect on trade and real disposable income in oil-importing countries (U.S., Europe, Japan, China, etc.).

Also, concerns about unsustainable budget deficits are high and are going to remain high, with growth anemic and unemployment rising. These deficits are already pushing long-term interest rates higher as investors worry about medium- to long-term stability. If these budget deficits are going to continue to be monetized, eventually, toward the end of next year, you are going to have a sharp increase in expected inflation–after three years of deflationary pressures–that’s going to push interest rates even higher.

For the time being, of course, there are massive deflationary pressures in the economy: the slack in the goods markets, with demand falling relative to supply-and-excess capacity. The rising slack in labor markets, which are controlling wages and labor costs and pushing them down, implies that deflationary pressures are going to be dominant this year and next year.

But eventually, large budget deficits and their monetization are going to lead–toward the end of next year and in 2011–to an increase in expected inflation that may lead to a further increase in 10-year treasuries and other long-term government bond yields, and thus mortgage and private-market rates. Together with higher oil prices driven up by this wall of liquidity rather than fundamentals alone, this could be the double whammy that could push the economy into a double-dip or W-shaped recession by late 2010 or 2011.

So the outlook for the U.S. and global economy remains extremely weak ahead. The recent rally in global equities, commodities and credit may soon fizzle out as an onslaught of worse-than-expected macro, earnings and financial news take a toll on this rally, which has gotten way ahead of improvement in actual macro data.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics (RGE), is a weekly columnist for Forbes. Read more of his columns here.

The Case for a Summer SnoozeFest in Stocks from Doug Kass

The Case for a Summer Snooze Fest for Equities
7/9/2009 8:05 AM EDT

realmoney.com

Here is an update of my current market view.

 

 

“He falls asleep in the woods one day
Spent twenty years of his life that way
Rip Van Winkle, Rip Van Winkle, sleep, sleep sleep.”The Devotions, “Rip Van Winkle”

Since I have been out for a few days of meaningful and persistent downside pressure, let’s frame the market expectations that have led up to my current outlook for stocks over the balance of the summer and into the fall.

Like Shakespeare’s Polonius, I adopted a neutral view of U.S. equities in late May in a column entitled “Neither a Bull nor a Bear Be.”

As stocks continued to rise, I argued in early June on CNBC’s “The Kudlow Report” that, while I remained confident that a generational low would not likely be breached for years (if not forever), equity valuations had nonetheless more than discounted the second derivative improvement in the economy, and stocks were running ahead of the real economy.

In addition, I further opined a month ago:

• More tangible signs of economic traction are necessary before the markets move higher. 
• The trajectory of economic growth will be shallow and will likely disappoint the equity markets during the second half of 2009. 
• Massive cost cutting has resulted in better-than-expected first-quarter 2009 profits, but it holds a downside as significant employee layoffs (and a still-weakened consumer) threaten the seeds of domestic economic growth over the intermediate term. 
• Savings rates will remain high, and personal consumption expenditures will remain low for an extended period of time. 
• The specter of rising taxes and higher interest rates in late 2009/early 2010 will likely impact an already fragile recovery in the economy and in the markets — a double-dip is due then. 
• Near term the market looked increasingly exposed and the upside was certainly capped.

In mid June, as stocks moved to 2009 highs, I stressed that the markets were getting stretched ever more by investors and traders who worshiped at the altar of price momentum. I further suggested that, while the economy was getting “less worse,” stocks were increasingly vulnerable and ahead of the real economy.

I went on record that a decline of between 5% and 10% was imminent.

As stocks began to slip during the following week, in “Will There Be a Cure for the Summertime Blues?” I offered the view that, following the selloff, a sideways correction or a deep correction held a combined probability of 65% and that a continued rally held only about a 35% chance.

Thus far, the market action in July has been abysmal and has generally confirmed my forecasts. At Wednesday’s mid-afternoon low, the S&P 500 had fallen by about 8.5% from it’s yearly high, at the upper end of my mid-June forecast of a drop of between 5% and 10%.

Just as I wrote that it was wrong to buy following the strength of three weeks ago, I believe it to be wrong to sell the recent weakness as I see emerging value developing in a growing set of stocks. Most technicians, following the recent drop, have turned more bearish, and I suspect that the sentiment surveys and short interest will follow the technicians. As well, we are quickly moving into oversold territory. All of these factors can be interpreted as contrarian and as more positive signals.

However, as I mentioned to Sir Larry Kudlow a month ago, just as there is limited causality between advancing stock prices and an improving economy, a declining stock market does not necessarily suggest an immediate deterioration or disappointment in economic activity.

Indeed, despite the disappointing jobs report last week, which appears to be the proximate cause for July’s market schmeissing, I see light at the end of the economic tunnel.

I still see a production boom caused by the replenishment of inventories (from a very low base).

I still see stabilization in residential real estate as affordability records multi-decade highs and as the relationship between home ownership grows substantially more compelling than renting.

I still see the domestic economy in (but shortly moving out of) the final phase of deteriorating unemployment reports as the massive fiscal and monetary stimulation plans begin to take hold in the last half of 2009.

And, as reflected in my previous writings (see below), I still believe the odds favor my scenario of a sideways correction following the recent overbought drop, which lays the groundwork for another tradable (but final) leg higher.

 

Looking beyond the near term, I would emphasize that I view the two correction scenarios as bolstering the market outlook during the fall-winter period. Both scenarios would serve to build up skepticism, shake up complacency and make it difficult for many investors to have the nerve to get back in…. A subsequent rally out of these two scenarios would be fueled by investors chasing strength as even in bear market rallies (1938-1939), there is typically more than one leg higher. By contrast, a continued rally would expose the markets to a more serious correction.– Doug Kass, “Will There Be a Cure for the Summertime Blues?” (June 22, 2009)

 

Stated simply, I see the current correction as a normal reaction to a seismic rally from the unprecedented and compressed levels of early March.

 

My Updated and Current Market View

Consistent with my expectations of a sideways correction, the world’s stock markets appear to be poised to go to sleep for the balance of the summer.

Over the course of the next two months, I expect the S&P 500 to trade in a relatively narrow range of between 850 and 925.

Here’s why I find that there are few catalysts that would move the market in any meaningful direction from current levels (as I pay homage to my much-loved summers at Camp Chipinaw in Swan Lake, N.Y.):

• Hello, Mudda. Hello, Fadda. Second-quarter earnings will produce little in the way of surprises. While being nothing to write home about (like Alan Sherman’s letter to his mudda and fadda!), corporate profits should continue the trend of the previous quarter, exhibiting tepid top-line sales growth, but profits will be buoyed by drastic cost cutting. 
• Here I Am at Camp Granada. Market participation should be especially light. Not only is it summertime, but the wounds of 2007-2008 must be allowed to heal. Long weekends (taking off Fridays) will likely grow longer (as many will also take off Thursdays or Mondays). 
• Camp Is Very Entertaining, and They Say We’ll Have Some Fun if It Stops Raining. Macroeconomic statistics should continue to stabilize, but the progress should not meaningfully deviate from consensus expectations. Housing will be aided by lower pricing, a continued improvement in affordability and in a reduction in the cost of home ownership relative to renting. The replenishment of manufacturing inventories will stoke modest third-quarter GDP growth but will be muted by a large output gap. Employment statistics will get “less worse,” but, again, the recovery will be modest in scope and settling of the double-dip debate will linger. All in all, the principal signs of economic activity that I expect to be reported in July through September will not be enough to produce an upside surprise but neither will it be too little to generate meaningful downside momentum in equities. 
• And the Head Coach Wants No Sissies, So He Reads to Us From Something Called Ulysses. With little in the way of substantive change in economic growth expectations, commodities, too, should be on snooze mode. 
• All the Counselors Hate the Waiters, and the Lake Has Alligators. Political initiatives should be modest in July and August as our leaders take leave of Washington, D.C., and also vacation. 
• You Remember Jeffery Hardy? They’re About to Organize a Searching Party. I expect little in the way of hedge fund or mutual fund flows (inflows or outflows) to generate a material change in the supply and demand for stocks, and with fixed-income prices (and yields) exhibiting limited fluctuation, the reallocation of pension plans into stocks and out of bonds will likely ebb in the months ahead. 
• Let Me Come Home if You Miss Me. I Would Even Let Aunt Bertha Hug and Kiss Me. With valuation arguably at an historical mid range, P/E multiples seem to be reasonably fair and not subject to a major move in either direction. 
• Playing Baseball, Gee, That’s Betta. Mudda, Fadda, Kindly Disregard This Letta. It’s hard to see a meaningful swing in sentiment under the aforementioned muddle-along economic setting that contains few surprises.

Won’t be long till summer time is through
(Summer time is through)
Not for us now
Every now and then, we hear our song
(Every now and then, we hear our song)
We’ve been having fun all summer long
We’ve been having fun all summer long.– The Beach Boys, “All Summer Long”

In summary, last weekend’s Independence Day celebration might have already marked the end of the market’s summer fireworks and of the market’s decline, as the corporate profit and economic pictures (along with other factors) will likely remain cloudy, inconclusive and absent any surprises. Also contributing to the possible snooze fest are reasonable valuations (against normalized profits), midrange sentiment conditions and the absence of meaningful fund inflows or outflows. (If my forecast of a market chill and slumber are met as an 850-to-925 base is built in the S&P 500, selling option premium might be the most productive investment strategy during the summer of 2009).

The next important move will require some modest patience as summer is over in only two months or so. Fortunately, as The Beach Boys crooned, “It won’t be long till summertime is through,” the fall holds promise for the stock market. Sooner than later, as Alan Sherman sang, “Wait a minute, it’s stopped hailing, guys are swimming, guys are sailing.”

My baseline expectation is that the expected summer snooze fest could be followed by a meaningful, maybe even an explosive and certainly playable up leg that, from my perch, should be sold into in anticipation of the first half of 2010’s double-dip and within the context of an extended period (in years, not months) of inconsistent and lumpy growth that will be difficult for both corporate managers and investment managers to navigate as the nontraditional headwinds gain strength and impact.

Bill Gross’s June Commentary

Investment Outlook

Bill Gross | July 2009

“Bon” or “Non” Appétit?

“Kill the umpire,” the fan cried to open the 1996 baseball season in Cincinnati, and eight pitches later, the man behind the plate, John McSherry, was dead, all 320 pounds of him screaming for more and more oxygen to feed his spastic heart. He’d been killed by a billion molecules of sink-clogging, Drano-resistant cholesterol that fed on his coronary artery and sucked up his life’s blood like a vampire in the heat of the night. The next day Howard Stern had characteristically railed that the antidote was obvious. It was the same for all fat people: “DON’T EAT,” he howled. As if the ump hadn’t known. The fact was, he couldn’t stop. He loved the taste of food – every sugary, fat-ladened, carbohydrated morsel. The first bite was a special ecstasy, as was the last, and everything in between. The man, it seemed, was a Cuisinart with four limbs. Franz Kafka wove a tale 100 years earlier that was a mirror image of McSherry’s tragedy. His “A Hunger Artist” described a professional faster – a sideshow freak in 19th century Europe who attracted attention and spare coins by withering away inside a wooden cage. The gapers marveled at his shriveled skeleton, stuck their hands through the bars to nudge his boney ribs, and awed at his resolve to starve himself to the precipice of self-extinction. “I always wanted you to admire my fasting,” confessed the hunger artist, “but you shouldn’t have. The fact is, I have to fast, I can’t help it. I couldn’t find the food I liked. If I had found it, believe me, I would have made no fuss and stuffed myself like you or anyone else.” The juxtaposition: one man who couldn’t stop and another one who couldn’t start – eating, that is. Their stories, though, are really not about food, but life itself – what compels us to do what we do, what forces us to act or not to act, what makes us who we are: is personal behavior really beyond our control? Shakespeare would retort that the fault lies not in our stars, but in ourselves. On the other hand, who are we other than this amorphous, gelatinous blob of moving flesh and bone molded primarily without our input, first by DNA, and then by environment into the living person we know as ourselves? Are we all just walking Cuisinarts, or better yet, mobile computers with a consciousness? Modern science has progressed to the point of asking, “Can machines think?” and if they can, it might well ask the corollary, “Are people machines?” The fact is that sophisticated modern machines can do just about anything a human being can do. The difference between “us” and “them” may only be our consciousness. We are “aware” whereas they are not. But if true, who wants to be a machine that simply knows it’s a machine? Who wants to walk the Earth as a preprogrammed robot with no input or free will? Unless the John McSherrys of the world can stop eating and the hunger artists can start, we might as well just turn out the lights. Our economy’s lights, if not switched off in a rehash of the 1930s Depression, have certainly been dimmed in a 21st century version likely to be labeled the Great Recession. Much like John McSherry, U.S. and many global consumers gorged themselves on Big Macs of all varieties: burgers to be sure, but also McHouses, McHummers, and McFlatscreens, all financed with excessive amounts of McCredit created under the mistaken assumption that the asset prices securitizing them could never go down. What a colossal McStake that turned out to be. Now, however, with financial markets seemingly calmed and an inventory-based recovery in store for the balance of 2009, there is a developing optimism that we can go back to the lifestyle of yesteryear. PIMCO’s driving thesis however, if not a juxtaposition, is succinctly described as a “new normal” where growth is slower, profit margins are narrower, and asset returns are smaller than in decades past based upon the delevering and reregulating of the global economy, which in turn should substantially inhibit the “gorging” of goods and services that we grew used to in decades past. Forecasts based on econometric models inevitably miss these secular/structural breaks in historical patterns because it is impossible to quantify human behavior, and long-term trends involving risk-taking and in turn derisking are decidedly human in their origin. Bell-shaped curves with Gaussian/random distributions fail to anticipate that human beings do not make decisions by chance or independently of each other, but in many cases in reaction to one another. Humanity’s personal and social computers appear to be programmed that way. And so, instead of “normal” distributions, economists and investors must learn to be on the lookout for “black swans,” and if not, then certainly “fat tails,” which differ from the measurement of natural phenomena accepted in science. “New normals,” flatter-shaped bell curves, and structural shifts in previously accepted standards become not only possible, but probable as human nature reacts to itself and its prior behavior. The efficient market hypothesis was always dead from the get-go, but academic tenure and Nobel prizes were food for the unwilling or perhaps unthinking. PIMCO and yours truly are not masters of the antithesis, a subjective approach which might derisively be called “crystal ball gazing,” but we try to focus on what might be legitimate changes in the way economies and financial markets are affected by seemingly irrational or “non-normal” behavior and events. The supersizing of financial leverage and consumer spending in concert with the politicizing of deregulation describes in fifteen words our most recent brush with irrational behavior and inefficient markets. Greed will come again. But for now, the trend is the other way and it promises to persist for a generation at a minimum. The fact is that American consumers have suffered a collapse in wealth of at least $15 trillion since early 2007. Global estimates are less reliable, but certainly in multiples of that figure. And when potential spenders feel less rich by that much, the only model one can use to forecast the future is a commonsensical one that predicts higher savings, lower consumption, and an economic growth rate that staggers forward at a new normal closer to 2 as opposed to 3½%. There’s no magic in that number, and no model to back it up, just a lot of commonsense that says this is how people and economic societies behave when stressed and stretched to a near breaking point. I was impressed this weekend by an article in the Op-Ed section of The New York Times by staff writer Bob Herbert. “No Recovery in Sight” was the heading and his opening sentence asked, “How do you put together a consumer economy that works when the consumers are out of work?” That is really all one needs to ask when divining our economy’s future fortune. Unless an optimist can prescribe how to put Humpty Dumpty back together again and shuffle him/her back to work then there can be no return to an “old normal.” As unemployment approaches 10%, what is less well publicized is that the number of “underutilized” workers in the U.S. has increased dramatically from 15 to 30 million. Those without jobs, as well as those individuals who only work part-time and have become discouraged and stopped looking, total 30 MILLION people. The number is staggering. Commonsensically, one has to know that many or most of these are untrained for the demands of a green-oriented, goods-producing future economy. Imagine a welding rod in the hands of an investment banker or mortgage broker and you’ll understand the implications quicker than any economist using an econometric model. What this all means to you as an investor is near obvious as well. Unsurprisingly, what still can be modeled is the direct correlation of real profit growth to real economic growth, assuming a constant division of the “pie” between profits, labor and government. If long-term economic growth declines by 1½% then profit growth will as well. This, after settling at perhaps half of absolute peak profit levels of 2007, because of the rise of savings rates from 0 to 8% or higher. But to add to the woes of the investor class, one has only to observe that their share of the pie is shrinking. What does the General Motors example tell us all about the rebalancing of power between the investor class and the proletariat? What do trillion-dollar deficits and the recent reinitiation of PAYGO government programs tell you about the future of corporate tax rates? They’re headed higher. Do you really think that a national health care program can be paid for with cost-cutting as opposed to tax hikes at insurance companies and benefit-paying corporations throughout all sectors of the American economy? The new normal will not be investor-friendly unless your forecasting dial is turned to “Pollyanna” or your intelligence quotient is significantly less than 100. Investors who stuffed themselves on a constant diet of asset appreciation for the past quarter-century will now be enclosed in a cage featuring government-mandated, consumer-oriented fasting. “Non Appétit,” not Bon Appétit, will become the apt description for the American consumer, and significant parts of the global economy, including the U.S. Because this is so, short-term policy rates will be kept low for longer than cyclical norms, and the outlook for risk assets – stocks, high yield bonds, and commercial and residential real estate will involve just that – risk. Investors should stress secure income offered by bonds and stable dividend-paying equities. Consumer Cuisinart consumption is a relic of the past. William H. Gross Managing Director