The BLS' Ugly Internals, The Fed's Increasingly Ugly QE2

by John Mauldin:


To ease or not to ease? That is the question we will take up this week. And if we do get another round of quantitative easing (QE2), will it make any difference? As I asked last week, what if they threw an inflation party and no one came? We will take as our launching pad today's unemployment numbers, which serve to demonstrate just why the Fed may in fact be ready for some monetary shock and awe.

Teachers Don't Count?

As the jobs report came out a number of headlines trumpeted the "strong" private-sector job growth of 64,000 jobs, trying to soften the overall loss of 95,000 jobs. If you exclude the loss of census workers, the job losses were "only" 18,000. However, for the first time since December of last year, we lost jobs in a month. That is not the right direction.
"Moreover, when you adjust for the slide in the participation rate this cycle, the byproduct of a record number of discouraged workers withdrawing from their job search, the unemployment rate is actually closer to 12% than the 9.6% official posted rate in September, which masks the massive degree of labour market slack in the system. This is underscored by the broad U6 jobless rate measure, which spiked to a five-month high of 17.1% from 16.7% in August." (David Rosenberg)
Let's go to Table A-1 in the BLS website. You find that the total number of "civilian noninstitutional population" has risen by exactly 2 million over the last year to 238,322,000. That is the number of people over 16 available to work. But the actual civilian labor force has only risen by 541,000. Over the last 12 months we have added only about 344,000 jobs, according to the data from the Establishment survey, or just about a month's worth in the good old days.
Here's an interesting note I picked up while looking at employment data by age and education (with seven kids, these things are important to me!). There is a cohort that has seen its employment level rise. That would be men and women over 65. The total number of people over 65 who are employed has risen by 318,000 over the last year, accounting for nearly all the job growth (although one bit of data is from the establishment survey and the other is from the household survey, but that should be close enough for government work).
Think about that. Almost all the job growth has come from those who have reached "retirement age" (whatever that is) continuing to work or going back to work. The unemployment rate for young people 16-19 is 26%. The unemployment rate for black youth is an appalling 49%. (This is not an abstract piece of data. I have two adopted black sons, so this figure means something in the Mauldin household.) Next time you go into malls, Barnes and Nobles, fast food places, notice again the work force. These are the jobs that traditionally went to those starting out.
As my friend Bill Dunkelberg, chief economist of the National Federation of Independent Business, wrote yesterday:
"Officially, the recession ended in June, 2009 according to the National Bureau of Economic Research, historical arbiters of recession and recovery dates. But in July, 2009, Congress raised the minimum wage by over 10% and 580,000 teen jobs were lost in the second half of the year even as GDP posted growth of 4% (annual rate). This was more than double the losses in the first half of the year when GDP declined at a 4% rate and fewer workers were needed. This was one of many policies implemented or proposed by Congress that made no sense as a measure to blunt the impact of the recession. The minimum wage determines the minimum value an unskilled worker must add to a business to justify employment. Congress has made this hurdle higher and more teens find they cannot get over it. This is just one of many barriers to hiring that are institutionalized in our economy, for example restrictions in the stimulus legislation that required union labor on projects."
Let's hear it for unintended consequences.

The Rise of the Temporary Worker

17,000 jobs in the latest survey were from new temporary jobs. I caught this graph from uber data slicer and dicer Greg Weldon (www.weldononline.com). Notice that part-time workers "for economic reasons" is the highest on record at 9.4 million. My take on this is that part-time workers are no longer a leading indicator but simply a manifestation of the new reality that employers don't want to take on the burden of a full-time employee who may not be needed or who comes with costly benefits under the new regulatory and health-care regimes.

State and local governments shed 39,000 jobs, the largest percentagewise loss since 1982. Those jobs mean something, and as state and local governments lose their stimulus money they will continue to shed jobs as they are forced to work with less revenue. Even after many places have raised taxes, revenues are down 3%. The consumption that government workers contribute to final consumer demand is just as important as that resulting from private jobs.
20% of personal income is now coming from the US government, and wages are flat. If you take into account the tax that is rising energy prices, that means many workers are falling behind the disposable-income curve.
Where Will the Jobs Come From?
Back to Dunk from the NFIB: "The percent of owners with unfilled (hard to fill) openings remained at 11% of all firms, historically a weak showing. Over the next three months, 13 percent plan to reduce employment (up 3 points), and 8 percent plan to create new jobs (unchanged), yielding a seasonally adjusted net -3 percent of owners planning to create new jobs, 4 points worse than August. The urge (based on economic factors) to create new jobs is clearly missing in the current economy and expectations for future business conditions are not supportive of job creation. Plans to create new jobs have lagged other recovery periods significantly.

"Overall, the job creation picture is still bleak. Weak sales and uncertainty about the future continue to hold back any commitments to growth, hiring or capital spending. Economic policies enacted or proposed continue to fail to address the most important players in the economy - the consumer. The President promised to continue to push his agenda for higher energy costs, few believe the health care bill will actually help them, and there is huge uncertainty about a VAT tax and the fate of the "Bush tax cuts". Deficits are at "trauma" level, incomprehensible to the average citizen. No relief, just promises that the consumer sector will be asked to pay more of their income to support government spending. This has left consumer and business owner sentiment in the "dumpster", unwilling to spend or hire."
The employment surveys mentioned above are basically completed by the middle of the month. But yesterday a Gallup poll suggested that unemployment may be headed back to over 10%, and that the latter half of September was weaker than the first half. From the release:
"The rate of those 'underemployed' - mostly part-time workers - increased slightly to 18.8 percent, suggesting that the number of workers employed part-time but seeking full-time work is declining as the unemployment rate increases. Gallup explains 'this may reflect a reduced company demand for new part-time employees.'
"This rate is likely to not be reflected by federal numbers to be released Friday, Gallup says, because the government numbers are based on conditions around the middle of September.
"Nevertheless, Gallup says the trend shows continuing high unemployment which does not help the economy, and could hurt retail sales during the holiday season.
"Gallup concludes by saying, 'The jobs picture could be deteriorating more rapidly than the government's job release suggests.'"
OK, the job picture is terrible. GDP is clearly slowing down. Consumer spending and retails sales are abysmal. Consumer credit creation is visibly falling, down for seven months in a row. Housing construction is not coming back any time soon. Commercial real estate is sick, with mall vacancy rates at almost 10%. Inflation (except in commodity and energy prices) is under 1%. The approximately 3% GDP growth we have seen the last four quarters was almost 2/3 inventory rebuilding, not a sustainable growth source.
It is pretty clear there will not be much more coming from the US government in the way of new stimulus. If you're a Keynesian and in charge of the Fed or Treasury (which is the case), what are you to do?

The Ride of the Keynesian Cowboys

The Fed is basically down to one bullet in its policy gun. It cannot lower rates beyond zero, although it can pull down longer-term rates if it so chooses. But lower rates so far have not been the answer to creating jobs and inflation. All less-subtle instruments of monetary policy have been tried. The final option is massive quantitative easing, the monetization of US government debt. As the saying goes, if all you have is a hammer, all the world looks like a nail. And after the last FOMC meeting, the markets have openly embraced quantitative easing. And for good reason: that is the talk coming from the leadership of the Fed.
Since my friend Greg Weldon has so thoughtfully collected some of the more salient parts of some recent Fed speeches, let's turn the next few paragraphs over to him.
"We note the following quotes, starting with the would-be-hero, maybe-headed-for-monetary-hell, Fed Chairman, Ben Boom-Boom Bernanke himself ...
... "'I do think that additional purchases, although we do not have precise numbers for how big the effects are, I do think they have the ability to ease financial conditions.'
"Next we note commentary that sparked Monday's extension lower in US Treasury Note yields, from New York Fed President William Dudley:
"'Fed action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long.'
"Indeed, the Fed will keep pumping, until it sees the proverbial whites-of-their-eyes, as it relates to inflation, and job growth.
"More from Dudley ...
... "'The outlook for US job growth and inflation is unacceptable. We have tools that can provide additional stimulus at costs that do not appear to be prohibitive.'
"Indeed, when we first used the word 'deflation' in the Money Monitor, back in the nineties, and into the first part of the last decade, people scoffed, as this was a word equated to 'monetary blasphemy'... and I might have been 'charged' as a 'heretic' for suggesting that, someday, the Fed would PURSUE INFLATION as a POLICY GOAL.
"Now, the New York Fed President openly states that subdued inflation is ...
... 'UNACCEPTABLE'!!!!
"Welcome to the new world order, where deflation is openly discussed, and inflation is, in fact, pursued by the Federal Reserve, as a policy goal."
Greg goes on to quote Chicago Fed president Charles Evans as favoring easing, and you can bet vice-chair Janet Yellen is on board.
But there are voices that question the need for QE2. From the Bill King Report:
"Hoenig Opposes Further Fed Easing, Warns About Prices
"Kansas City Federal Reserve Bank President Thomas Hoenig said the central bank shouldn't expand its balance sheet by purchasing more Treasury securities in an effort to spur economic growth... The Kansas City Fed official repeated his view that the Fed should raise its short-term target rate to 1 percent, then pause to assess the economy's recovery. He also rejected the idea of raising the Fed's informal inflation target above 2 percent because of concern over the possibility of falling prices.
"'I have to tell you it horrifies me,' Hoenig said, responding to an audience question. "It assumes you can fine-tune things like interest rates." 'I have never agreed to' an informal inflation target, he said. 'Two percent inflation over a generation is a big impact.'"http://www.moneynews.com/StreetTalk/HoenigOpposesFurtherFed/2010/10/07/id/372979
And then we have a speech from Dallas Fed president Richard Fisher that he gave yesterday at the Minneapolis Economics Club. I highly recommend you take a few minutes to read it in its entirety. It is well-written and thoughtful. We need more men like him on the Fed. (http://www.dallasfed.org/news/speeches/fisher/2010/fs101007.cfm)
Let me give you a few paragraphs (all emphasis mine!):
"... In my darkest moments I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places. Far too many of the large corporations I survey that are committing to fixed investment report that the most effective way to deploy cheap money raised in the current bond markets or in the form of loans from banks, beyond buying in stock or expanding dividends, is to invest it abroad where taxes are lower and governments are more eager to please. This would not be of concern if foreign direct investment in the U.S. were offsetting this impulse. This year, however, net direct investment in the U.S. has been running at a pace that would exceed minus $200 billion, meaning outflows of foreign direct investment are exceeding inflows by a healthy margin. We will have to watch the data as it unfolds to see if this is momentary fillip or evidence of a broader trend. But I wonder: If others cotton to the view that the Fed is eager to "open the spigots," might this not add to the uncertainty already created by the fiscal incontinence of Congress and the regulatory and rule-making 'excesses' about which businesses now complain?
"... In performing a cost/benefit analysis of a possible QE2, we will need to bear in mind that one cost that has already been incurred in the process of running an easy money policy has been to drive down the returns earned by savers, especially those who do not have the means or sophistication or the demographic profile to place their money at risk further out in the yield curve or who are wary of the inherent risk of stocks. A great many baby boomers or older cohorts who played by the rules, saved their money and have migrated over time, as prudent investment counselors advise, to short- to intermediate-dated, fixed-income instruments, are earning extremely low nominal and real returns on their savings. Further reductions in rates earned on savings will hardly endear the Fed to this portion of the population. Moreover, driving down bond yields might force increased pension contributions from corporations and state and local governments, decreasing the deployment of monies toward job maintenance in the public sector.
"My reaction to reading that article [what Fisher called that eye-popping headline in yesterday's Wall Street Journal: "Central Banks Open Spigot"] was that it raises the specter of competitive quantitative easing. Such a race would be something of a one-off from competitive devaluation of currencies, a beggar-thy-neighbor phenomenon that always ends in tears. It implies that central banks should carry the load for stymied fiscal authorities - or worse, give in to them - rather than stick within their traditional monetary mandates and let legislative authorities deal with the fiscal mess they have created. It infers that lurking out in the future is a slippery slope of quantitative easing reaching beyond just buying government bonds (and in our case, mortgage-backed securities). It is one thing to stabilize the commercial paper market in a systematic way. Going beyond investment-grade paper, however, opens the door to pressure on a central bank to back financial instruments benefiting specific economic sectors. This inevitably leads to irritation or lobbying for similar treatment from economic sectors not blessed by similar monetary largess.
"In his recent book titled Fault Lines, Raghuram Rajan reminds us that, 'More always seems better to the impatient politician [policymaker]. But any instrument of government policy has its limitations, and what works in small doses can become a nightmare when scaled up, especially when scaled up quickly.... Furthermore, the private sector's objectives are not the government's objectives, and all too often, policies are set without taking this disparity into account. Serious unintended consequences can result.'"
Hear. Oh, hear!
Can Fisher and Hoenig stand athwart the Keynesian tide at the Fed and get it to stop? Or for that matter, can the growing chorus of noted economists and analysts who openly question the need or wisdom of a QE2?
I doubt it. The Keynesian Cowboys are saddling their QE horses and they intend to ride. They have no idea what the end result will be. This is all a guess based on pure theory and models (like the broken money multiplier). And I really question whether the result they hope for is worth the risk of the unintended consequences (more later). As I wrote a few weeks ago:
"If it is because they don't have enough capital, then adding liquidity to the system will not help that. If it is because they don't feel they have creditworthy customers, do we really want banks to lower their standards? Isn't that what got us into trouble last time? If it is because businesses don't want to borrow all that much because of the uncertain times, will easy money make that any better? As someone said, 'I don't need more credit, I just need more customers.'"
How much of an impact would $2 trillion in QE give us? Not much, according to former Fed governor Larry Meyer, who, according to Morgan Stanley, "... maintains a large-scale macro-econometric model of the US economy that is widely used in the private sector and in public policy-making circles. These types of models are good for running 'what if?' simulations. Meyer estimates that a $2 trillion asset purchase program would: 1) lower Treasury yields by 50bp; 2) increase GDP growth by 0.3pp in 2011 and 0.4pp in 2012; and 3) lower the unemployment rate by 0.3pp by the end of 2011 and 0.5pp by the end of 2012. However, Meyer admits that these may be 'high-end estimates'.
"Some probability of a resumption of asset purchases is already priced in, and thus a full 50bp response in Treasuries is unlikely. Moreover, a model such as Meyer's is based on normal historical relationships and therefore assumes that the typical transmission mechanisms are working. For example, a drop in Treasury yields would lower borrowing costs for consumers and businesses, helping to stimulate consumption, business investment and housing. But there is good reason to believe that the transmission mechanism is at least partially broken at present, and thus the pass-through benefit to the economy associated with a small decline in Treasury yields (relative to current levels) would likely be infinitesimal." (Morgan Stanley)
It is clear, at least from the speeches I read, that if the economy continues to sputter and looks like it may fall into recession, that the need to DO SOMETHING will overwhelm all caution. Not trying the last tool in the box if the economy is rolling over is just not something that will be considered by those of the Keynesian persuasion. Never mind that Congress is getting ready to raise taxes (and has already done so in the case of Obamacare, to the tune of almost 1% of GDP!); in the face of a slowing economy, the Fed is going to step in and try to do something.
Let me be clear. We do NOT have a monetary problem. And whatever solutions we need are not monetary. This is on Congress and the Administration. The Fed needs to step aside.

Let Us Count the Unintended Consequences

Is there a chance that it could work? The short answer is, "Yes, but I doubt it." The whole purpose of QE2 is to try and get consumers and businesses spending. For a Keynesian, it is all about stimulating final consumer demand. That is tough in a world coming out of a credit crisis, where consumers are wanting to deleverage.
But what if they push a few trillion into the economy and it shows up in the stock market? Or the market just feels good that "Daddy" is doing something and runs up on its own? Can that change consumer sentiment? Will we feel like spending more? Could that be the catalyst? Maybe, but I doubt it. But you can bet your last trillion they are going to try.
It is doubtful that any QE2 that is enough to really do something in the way of reflating assets will be good for the dollar. Now, cynics might say that is the point, as a falling dollar is supposed to help our exports (and for my international readers, I get it that this is at the expense of other countries). Do we really want to open the first salvo in a race to the currency bottom? If the Fed does it, it gets legitimized everywhere.
(By the way, as I noted a few weeks ago, my call for parity for the euro and the pound is temporarily on hold. Stay tuned. We will get back to it.)
But QE2 also drives up commodity costs. Rising oil prices have the same effect on spending as a tax increase. As do rising food costs, etc.
How does one control inflation by printing money on the order of 10% or more of GDP? Is 3% ok? Do you really want to get to 4% and then have to start taking off the stimulus to get inflation under control, and push us back into recession?
You don't get inflation without a rise in interest rates. What about the increased costs of financing an ever-rising government debt? And aren't higher rates what the Fed is fighting? Talk about confusing the market.
Does the Fed really want us to get our animal spirits back up and go back in and borrow more money? Isn't too much leverage what got us into this problem to begin with? Does the Fed really want to persuade us to go out and buy mispriced assets? Should we buy stocks now in hopes that QE2 somehow finds a transmission mechanism and keeps us from recession? If it doesn't work, then all those buyers will get their heads handed to them, making matters even worse.
What if, as I think likely, the QE money simply makes a round trip back to the Fed balance sheet? Do we go for QE3? At the Barefoot Economic Summit I just attended (see more below), one very well-connected economist said he would start getting interested about QE when it approached $6 trillion. That is the number he thinks would be needed to actually have an effect. It raised a few eyebrows when he told that to David Faber on CNBC.
If the money makes a round trip back to the Fed, the markets will get spooked. All kinds of markets.
The only way I think they do not pursue QE is if the economic data in the next few months suggests the economy is beginning to heal itself. That will make the next few months worth of data more critical than usual. The stock market seems convinced that QE2 will be good for the economy and the markets, and thus bad news will be perversely considered good.
Sadly, if we go down that path I think this is going to end in tears. There are just too many unintended consequences that can reach up and bite us in our collective derrieres. I am not sanguine about 2011. I dearly, truly hope I am wrong. For your sake, gentle reader, and for my seven kids.

This Is Either a Bubble or Budding Hyperinflation!

Sugar and cotton today skyrocketed. Sugar is now priced higher than at the peak of the 2008 commodity bubble, and cotton is very close to that level. Cotton has been limit up two days in a row!

NYBOT CCI Commodity Index daily, intraday

NYBOT CCI Commodity Index monthly - the prior peak was the 2008 commodity bubble!

Sugar daily -- 30% higher than the 2008 bubble!

Sugar weekly

Cotton daily

Cotton weekly

Grains All Limit Up

Corn, soybeans, soybean oil, soybean meal, wheat, and oats all opened limit up today. I have never seen this occur before!

Sugar, Cotton Reverse, Move Higher

Sugar - moves powerfully higher - intraday

Sugar - daily

Cotton - limit up intraday

Cotton - limit up daily

Mixed Markets, Key Reversals?

by Matt Bradbard:
Today could mark a key reversal for several markets, including but not limited to the US dollar, metals and energies. Oil reversed from these same levels in August… will history repeat itself? In recent blogs we hinted at this, and on confirmation tomorrow Crude will likely move back to the 50 day MA; in November at $77.70. If that is the case, we’ve seen an interim top in the distillates as well; that would drag heating oil and RBOB 12-15 cents lower. A bearish AGA report prompted natural gas to lose 4.4-6.25% depending on the month. Some clients have thrown in the towel; others will likely be out in the coming sessions if we do not move north from here. I feel we’re close to a bottom, being the sentiment is so bearish, but as the saying goes, markets can be irrational more than most investors can remain solvent. What really irks me is that Goldman is forecasting a 20-25% advance in natural gas in the coming months and clients will likely get out at the bottom. Unfortunately sometimes that is the way the cookie crumbles. We will advise clients to re-establish positions once an interim bottom is established.
The next leg in indices will be determined by the NFP tomorrow. We’ve positioned several clients short the S&P via November put spreads.
We're seeing a failed rally in cocoa; as we’ve voiced, our downside target is 2600. Sugar rallied 6.88% today; if a new high is not reached we will be looking to add to clients' short positions. Same story in cotton: if the recent high acts as resistance we will be looking for bearish plays. Although we would have liked a larger rally aggressive traders could be short coffee with stops above $1.7850 in the December contract. Lean hogs traded to a three month low today though pared losses by the close. If we can find some buying interest around these levels we may start probing longs for clients. We would recommend booking profits on ALL remaining shorts.
Could today be day 1 of the correction in metals? Gold will close just over $30 off its highs, silver nearly $1 and copper just over one dime. It is way too premature to celebrate, but our more aggressive clients are positioned short gold and silver thinking a sizable correction is around the bend. Targets in December gold are $1295, 1278, 1256, 1235 and December silver $21.23, 21.00, 20.40, 19.75.
USDA is out tomorrow before the grain open. We’ve positioned some clients slightly long July 11′ corn. We feel both soybeans and corn will benefit from the fight for acreage and we will have buy objectives and price targets in the days to come.
The dollar lifted its ugly head today to close positive and looking at a candlestick chart a doji star on good volumes. The ECB and BoE left rates alone today at 1.0% and 0.50% respectively. Our featured play in forex remains shorts in the Loonie expecting .9550.

Simmering Currency Wars

by Patrice Hill at Washington Times:

While the United States has been fussing at China for gaining an advantage in trade by depressing the value of its currency, other nations — while agreeing about China — are increasingly focused on the falling dollar and concern that the U.S. may be doing the same thing.
Treasury Secretary Timothy F. Geithner on Wednesday stepped up U.S. demands that China stop closely controlling the value of its currency and allow it to rise against the dollar, suggesting that the Asian giant may be violating its pledge last year to move toward freer exchange rates with other Group of 20 economic powers.
"We have moved aggressively to do our part to help bring the world out of crisis," said Mr. Geithner, noting Congress' enactment of strict new regulatory reforms on Wall Street this summer, and a big drop in the U.S. trade deficit since 2008 as a result of greater savings and less spending by U.S. consumers.
While not mentioning China specifically in his speech to the Brookings Institution, Mr. Geithner pointed to what he described as other "major economies" with chronic large trade surpluses and undervalued currencies, in an unmistakable reference to the Asian giant.
European nations echoed Mr. Geithner's criticism in a separate forum with Chinese Premier Wen Jiabao in Brussels, and called on China to allow more rapid appreciation of its currency, the yuan or renminbi. That prompted a strong rebuke from the Chinese leader.
"Do not work to pressurize us on the renminbi rate," he said. "Yes, we are going to proceed with the reforms," but he suggested the bigger problem for the world economy was the recent large drop in the U.S. dollar, which is the world's main reserve currency.
Mr. Wen warned of dire consequences if China were to abandon its gradual currency reform and allow a rapid rise of the yuan.
"Many of our exporting companies would have to close down, migrant workers would have to return to their villages," he said. "If China saw social and economic turbulence, that would be a disaster for the world."
But the United States. received strong backing in its dispute with China from an important quarter — the International Monetary Fund. In a report Wednesday, the IMF urged China and other Asian nations with large trade surpluses to stop devaluing their currencies, rely less on exports for growth and encourage more consumer and business spending at home.
While the IMF expects the world economy to keep growing this year — led by double-digit growth in China and other developing countries — it warned that the resumption of distorted trade patterns that prevailed before the recession could undermine the economy once again.
The recovery is "neither strong nor balanced and runs the risk of not being sustained," said Olivier Blanchard, the IMF's chief economist. He added that the threat of a downward deflationary spiral in the United States, Japan and other developed nations remains viable.
Renewed economic weakness in the United States this summer — and the Federal Reserve's vow to fight a relapse into recession with even looser money policies — set off a rapid drop in the dollar against other free-floating currencies. Since August, the dollar has lost 8 percent of its value against the euro, and is down by 5 percent against major world currencies.
The dollar's rapid decline has provoked a chain reaction in other countries, ranging from a decision by Australia not to raise interest rates this week to a forceful intervention in currency markets to support the dollar by Japan and a dramatic move by the Bank of Japan to slash interest rates to zero this week.
Because the U.S. dollar is the world's dominant currency, it is taking center stage along with the spat with China at the run-up to an IMF meeting in Washington this weekend as well as a G-20 meeting planned in Seoul next month.
Brazil's finance minister created ripples in financial circles by suggesting last week that the decline of the dollar was setting off an "international currency war." Brazil itself has imposed taxes on hot money coming across its border in an attempt to stem the rapid rise of its own currency, the real.
With the U.S. and most other nations vowing to offset weakness in their own economies by trying to increase exports, some analysts fear that the kind of competitive devaluations that erupted during the Great Depression could be in the offing.
"Beggar thy neighbor is back," said Harm Bandholz, economist at Unicredit Markets. He said the U.S., Japan and United Kingdom are all deliberately weakening their currencies to try to gain an advantage in trade. The Obama administration has set the goal of doubling U.S. exports in five years.
But Raghav Subbarao, analyst at Barclays Capital, says he doesn't see a currency war on the horizon just yet, though he expects the G-20 meeting to be especially tense as nations sound off about their currency grievances..
"It would clearly be impossible for every country to follow a policy of competitive devaluations simultaneously," he said, but the temptation is there because the U.S. and other developed nations seem to have reached the limits of using fiscal and monetary policies to try to stimulate their economies.
With interest rate already at or near zero, "governments are increasingly turning to exchange rate policy as a means to maintain or improve their competitive positions," he said. That means the risks of a currency war, "although quite low, are increasing," he said.

More Soverreign Debt Downgrdes

Fitch has finally downgraded Ireland from AA- to A+, with a negative outlook

More Bank Bailoluts Coming?

And I thought the recession was over and we were in recovery!

Stocks Sag

On a day when the Fed injects only $2.1 billion in the stock market, representing a paltry 1/3 of the total volume, stocks can't hold their own weight.

America's Middle Class Halts Spending

Middle-class Americans made their deepest spending cuts in more than two decades, slashing spending on such discretionary items as restaurant meals and alcohol during the recession.
Households in the middle fifth of the population sliced their average annual spending to $41,150 in 2009, the Labor Department said Tuesday in its annual spending breakdown. That was down 3.1% from 2007 and 3.5% from 2008, the steepest one-year drop since records began in 1984. The drop came even as those households' after-tax income remained relatively stable over the two years, at an average $45,199.

Geithner Heats Up Election-Year Trade War Rhetoric

Is there a worse currency manipulator on the planet than the Fed? Just look at the USD! It's devaluation is a direct consequence of Fed policy, both in its artificial suppression of market interest rates and its quantitative easing!

WSJ:

WASHINGTON—China's undervalued currency is triggering an international currency war that risks undermining the global economic recovery, U.S. Treasury Secretary Timothy Geithner said Wednesday.
"When large economies with undervalued exchange rates act to keep the currency from appreciating, that encourages other countries to do the same, and this sets off a dangerous dynamic," Mr. Geithner said.
He addressed two issues—exchange rates and fiscal strategies—expected to take center stage in ministerial meetings around the International Monetary Fund's annual gathering this week and ahead of the Group of 20 summits in coming weeks.
Mr. Geithner said more countries face stronger pressure over time to resist market forces pushing up the value of their currencies. The collective impact, the treasury secretary said, causes inflation and asset bubbles in emerging economies or else depressed consumption growth.
The U.S. House of Representatives has passed legislation that would slap tariffs on Chinese imports, while the head of the European Central Bank warned that the strong euro was threatening already anemic growth there.

ADP Shows Private Sector Unexpectedly Shed Jobs

This was the worst ADP jobs report in 7 months!

NEW YORK (Reuters) - Private employers unexpectedly cut 39,000 jobs in September after an upwardly revised gain of 10,000 in August, a report by a payrolls processor showed on Wednesday.
The August figure was originally reported as a loss of 10,000.
The median of estimates from 38 economists surveyed by Reuters for the ADP Employer Services report, jointly developed with Macroeconomic Advisers LLC, was for a rise of 24,000 private-sector jobs in September.
The ADP figures come ahead of the government's much more comprehensive labor market report on Friday, which includes both public and private sector employment.
That report is expected to show overall nonfarm payrolls were unchanged in September, based on a Reuters poll of analysts, but a rise in private payrolls of 75,000.
Economists often refer to the ADP report to fine-tune their expectations for the payrolls numbers, though it is not always accurate in predicting the outcome.

Fed Building a Dollar Disaster

Fed Buying Physical Gold by Proxy

by Rob Kirby from Financial Sense:

A couple of weeks ago, I pitched an idea to some associates of mine who are involved in SERIOUS [tonnage] PRECIOUS METALS procurement – physical metal only – let’s just say HUGE money.  I asked them if they would be interested in purchasing an “option” – cash up front - for the exclusive rights [first right of refusal on off-take] of a gold producer [miner] for a set number of ounces for 3 – 5 years “at the market” – using LBMA pricing [a.m. / p.m. fixes] in the future.  The answer I got back from my associates was “show us a terms sheet, we definitely have interest”.
So, I spoke to a friend who is very close to an intermediate producer who is in the mode of raising money right now.  I had them ask the producer if they would have interest – the producer said, “YES, we are interested - but just to let you know – J.P. Morgan has been asking us if we would sell them the same option”.  So, while gold producers have shuttered their “gold hedge books” – the Bullion Banks are ‘synthetically’ trying to keep physical output captive – I would suggest FOR THE EXPRESSED REASON THAT THEY SELL EVERY PHYSICAL OUNCE AT LEAST 100 TIMES OVER.
Gold is going to get EXTREMELY scarce in the future folks.  Big money interests are now cutting off [or bidding for / gaining exclusive access to] the traditional bullion supply chain “at the pit”.
The shorts of ‘paper gold’ at J.P. Morgan [the Fed in drag] are selling the daylights out of the paper market and simultaneously buying exclusive rights to producers’ future production so they can try to fudge their way through an unmitigated fraud and settle a big enough chunk of their bad bets to keep this ‘systemically ruinous’ precious metals ponzi-scheme alive.

Price of Gold and Interest Rates Are Joined at the Hip

The academic research that outlines the inter-relatedness of gold and interest rates is succinctly laid out in a 2001 treatise, Gibson's Paradox Revisited, by Reg Howe.  From this one can deduct that ANY rigging of the gold price must go hand-in-hand with simultaneous rigging of interest rates.
Folks would do well to realize how neatly emerging details of Fed surrogate Morgan’s  ‘stealth’ activity in the bullion market dovetails with their obscene, obsequious activity elsewhere in their derivatives book – particularly their JUMBO TRILLIONS sized interest rate swap positions.

Stealth activity on the part of the Fed – utilizing proxy institutions to generate limitless artificial demand for any and all U.S. Government Debt – effectively gives the Fed control of the long end of the interest rate curve [the bond market].
From a timing perspective, it is also noteworthy that gold price rigging – long maintained by GATA – is alleged to have begun in earnest during the Clinton Administration with the appointment of Robert Rubin as U.S. Treasury Secretary [along with understudy Lawrence Summers] in Jan. 1995.  Coincidentally [or perhaps not?] we can trace the genesis of the “explosion” in the use of derivatives [mostly interest rate] to that exact same time frame.  In fact, if we follow the time line in ‘reverse’ – the growth in the use of derivatives appears like a trail of bread crumbs – right back to the time when Professor Lawrence Summers, under the tutelage of Sir Robert of Rubin, brought his academic alchemy to Washington:

Does anyone with a pulse really believe that ANY Bank Holding Company in the U.S. would be permitted to have a derivatives position in excess of 75 TRILLION [five times the size of U.S. GDP] if they were not ‘in bed’ with the FED????
If you except the premise that, “J.P. Morgan “is” the Fed”, then, “IT’S REALLY THE FED WHO IS BUYING GOLD” and they [unfortunately, this means “America”] likely have NONE LEFT to sell.
NOTHING could be more bullish for the price of gold going forward.
Everyone needs to get it through their heads; these criminals are NOT IN IT for profits.  The survival of our “BROKEN FIAT MONEY SYSTEM” “IS” their only goal.

Conclusions: 

Officialdom will never admit it and it will NEVER be reported in the mainstream financial news but our financial system has NEVER been in a more precarious state. A banking crisis of unparalleled proportions is coming – probably soon – the exact timing is still sketchy.
Got physical precious metal yet?

Pray for True Justice

(Sept. 14) -- As arguments begin Tuesday in a Florida District Court where 20 state attorneys general and the National Federation of Independent Business are challenging the constitutionality of the health care law, the American people can be forgiven for feeling a bit ill at ease about the direction their country is going. James Madison would feel the same way.

Madison's vision of limited government was integral to the creation of the U.S. Constitution and its ratification, and he thought the limited nature of the federal government was so clear from the text of the Constitution itself that even the Bill of Rights should have been unnecessary.

So imagine his response if the Congress of 1789 had proposed a law like the Patient Protection and Affordable Care Act -- i.e., Obamacare. Nowhere does the Constitution grant the power to force individuals to buy a product.

One constitutional provision, the Commerce Clause, allows the federal government "to regulate commerce ... among the several States." But regulating the health of the citizenry had always been the role of state, not federal government, and the notion that medical care would be considered interstate commerce would have been shocking to Madison's contemporaries since in almost all cases the doctor and his patient live in the same state.

But the government -- and the way we view the Commerce Clause -- isn't what it used to be.

The landmark case of Wickard v. Filburn was decided in 1942 and has dramatically expanded the application of the Commerce Clause. In Wickard, the federal government wanted to apply its agricultural regulations to Roscoe Filburn, an Ohio farmer who was growing wheat for personal use on his own farm. He wasn't selling it, so it never entered commerce. And it certainly didn't cross state lines as it went from his field to his own table. Nonetheless, the Supreme Court determined that his wheat production had an incidental effect on the national market for wheat since Filburn and those like him would then not be buying their wheat in interstate commerce.

Wickard v. Filburn was crucial in clearing the way for the pathbreaking expansions of government in the New Deal. Now that our government is engaging in a renewed expansion into the lives of the American citizen, that case is becoming relevant yet again and is central to the government's case defending Obamacare against federal lawsuits brought by more than 20 states.

It claims the impact of health and health care costs on the national economy can be felt through their effect on governments and individuals who subsidize coverage for the uninsured, the costs to the economy of poorer health and shorter lifespan, and the rate of personal bankruptcies.

This argument has shocking implications for the notion of limited government, because the same reasoning could be used to expand government even further beyond its already bloated state.

As Sen. Tom Coburn, R-Okla., queried during Senate Judiciary Committee hearings on Elena Kagan's nomination to the Supreme Court, what would prevent Congress from claiming even something as novel and intrusive as mandating individuals to consume a certain quota of fruits and vegetables affected interstate commerce?

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After all, doesn't bad nutrition lead to more costs for the governments and taxpayers who subsidize health care, result in sickness and early death, and possibly contribute to the health care costs that themselves can trigger bankruptcy?

Indeed, is there any action that Congress could not argue has some effect on the economy, and if on the local economy then, by extension, on the national economy? But the health care law goes even further than that, because Congress has chosen to regulate not only actions, but inaction -- the failure to buy or provide qualifying health insurance.

Congress had no scruples in passing a bill whose constitutional basis was paper thin. President Barack Obama was proud to sign it. Now only the federal courts stand between our burgeoning federal government and the Constitution's model of limited government.

Carrie Severino is counsel and policy director for the Judicial Crisis Network and a former law clerk for U.S. Supreme Court Justice Clarence Thomas.

Gold Still Higher Following More Japan QE

Past 10-Year Returns Are Poor Predictors of Future Returns

by Bill Hester, Phd. at Hussman Funds:

Can the process of forecasting long-term stock market returns be simplified to include just one step – calculating the prior decade's return? This is one of the arguments that analysts are currently using to convince investors that the coming decade will offer above-average returns. It's important to take a closer look at the argument because it's become widely discussed and reported. A strategist at a major investment bank argued recently that poor 10-year trailing returns is reason enough to expect lofty returns over the next decade. A similar argument was recently made in Barron's, and by various mutual fund companies.

Some of the research is structurally flawed. One piece examines the 50 worst 10-year returns since 1871 to construct a sample to calculate subsequent 10-year returns. The study used monthly data, so many of the observations clustered within a single year. 11 of those "worst" returns occurred during the past decade. Of the remaining 39 months for which the subsequent 10-year stretch of returns is known, 32 of them occurred around 1920, so the study is heavily influenced by a single period. The implicit argument is that the next decade will look much like the Roaring 1920's.

But even using a broader set of periods with poor trailing returns, the average return during the decade that followed has typically been slightly above average. In fact, some of the individual periods have provided strong returns, especially when they marked the beginning of secular bull markets, like in 1942 and the early 1980's. The graph below shows the 10-year rolling total return of stocks since 1929.

Looking at the graph, it is clear that 10-year returns for the market have varied a great deal, creating long "secular" periods of above-average and below-average returns. There are just few periods where 10-year trailing returns fell to very low levels – after the stock market crash of the early 1930's, in the early 1940's, and again during the late 1970's and the early 1980's (on an inflation-adjusted basis, the 10-year returns during these last two periods were also negative). A cyclical bull market followed the low returns of 1933, and secular bull markets followed the low returns of the early 1940's and early 1980's. When looking at the data below, we'll include the 100 worst months of 10-year trailing total returns beginning in 1929. This group of months will capture the bulk of the periods just mentioned.

The Drivers of Returns

Once the observation is made that long periods of negative trailing returns have been followed by strong subsequent returns, it's logical to ask whether there are other characteristics that those strong decades shared. To that end, it makes sense to begin with the fundamental underpinnings of stock prices: growth and valuations.

The valuation argument is relatively straight forward. On a cyclically adjusted earnings basis (where profits are averaged over the prior decade), the average cyclically adjusted P/E ratio following periods of poor long-term returns was 12. That compares with the long-term average of 16 using the entire historical period, or 14 if you exclude the Bubble Years surrounding the year 2000. Either way, not surprisingly, valuations tended to be quite low and below average following decades of poor stock performance. The cyclically adjusted P/E ratio is graphed below, with the red line showing the long-term average following poor long-term returns.

At the low in 2009, the CAPE was close to the average level of prior periods that followed poor 10-year returns. But the current argument being made by analysts is not about investing at last year's low. It is about investing at current levels of valuation. And here, the graph shows that today's CAPE of over 21 sits far above the levels that typically lead to strong long-term returns.

To drive earnings over the long-term, economic growth matters too. Here the gap between today's characteristics and prior periods widens further. In the 10-year periods that followed low return decades, the US economy grew at an average nominal rate of 10.5 percent a year (using annual GDP data through 1946 and quarterly data thereafter). So, clearly the economy has eventually grown rapidly following periods where stocks suffered poor long-term returns. This makes sense. It was a long, hard slog from the depths of the depression until full recovery. It took until 1941 for output to climb above 1929's level of GDP. But once it did, the economy grew quickly, both during the build-up to the War and during its aftermath. The economy also grew quickly coming out the early 1980's recession, after a long stretch of mediocre economic performance and poor stock market returns.

This data suggests that we should modify the assumption that poor past returns, in and of themselves, reliably lead to strong subsequent long-term returns. It is more accurate to argue that following poor 10-year returns, provided that valuations are depressed based on normalized earnings and the economy is likely to grow at double digits rates of nominal growth - investors can probably anticipate higher subsequent long-term returns.

There are a couple of arguments that put that latter assumption into question today. One is the secular downshift of nominal economic growth that has occurred during the last two-and-half decades. The graph below plots the rolling 10-year change in nominal GDP. Although a long-term drop in inflation explains part of the decline, the inflation-adjusted also data shows a downshift. Ned Davis typically shows this chart to his subscribers along with one that depicts the increased levels of debt in the economy, making the case that higher levels of debt have been producing lower levels of GDP growth. Another reason for this downshift is that according to Commerce Department data, demographics and other factors have caused the growth rate of "potential GDP" to slow persistently in recent decades. Regardless of the cause, the graph does show that in order to attain high rates of nominal GDP growth from current trends, very high levels of inflation would likely be needed. And historically, abrupt shifts from low levels of inflation to high levels of inflation have delivered investors poor returns.

Estimating Long-Term GDP Growth

There are a couple of ways that we can obtain an estimate of GDP growth over the next decade. One is from combining estimates from economists and bond investors. The Livingston Survey, which is collected by the Philadelphia Federal Reserve Bank, periodically asks economists for their 10-year forecast for GDP growth. The most recent survey showed that economists expect the economy to grow at an average rate of 2.80 percent a year over the next decade, adjusted for inflation. The current spread between 10-Yr nominal Treasury bonds and 10-Yr Treasury inflation-protected bonds is currently about 1.8 percent. That gives us an estimate for nominal GDP to grow at about 4.6 percent a year over the next decade.

We can also obtain an estimate of the likely growth rate of the economy by relying on historical precedent. A paper that was presented at the Kansas City Fed's most recent economic policy symposium can help. The paper – ‘After the Fall' – was written by Carmen and Vincent Reinhart – and it discusses common economic outcomes following major credit crises. The work is an extension of This Time is Different, Carmen Reinhart's collaboration with Ken Rogoff on the periods leading up to and immediately following credit crises. In the paper the Reinhart's extend the window of the research and ask the question: what are the long-term effects on inflation, unemployment, and GDP growth following severe credit crises?

Their findings are sobering. For developed countries, around a standard severe credit crisis – those that were generally country specific – the unemployment rate averaged 2.7 percent in the decade prior to the beginning of the crisis. In the decade that followed, the jobless rate averaged nearly 8 percent. Stunningly, in all five advanced economies and in four out of five emerging economies they studied, the unemployment rate has failed to decline below the levels reached prior to each crisis (even though most of crises in developed economies occurred 20 years ago).

Their data on GDP growth following credit crises was equally uninspiring. For developed countries, GDP growth was typically 1 percentage point lower than the decade prior to the peak. Developed economies grew at an average real rate of 3.1 percent in the decade prior to each crisis, and at 2.1 percent in the subsequent decade. The outcome was even worse for periods that followed severe credit crises which were global in nature. The Reinhart's put the decade of the 1930's and the 10-year period following the 1973 oil shock into this group. Here the rate of economic growth in the decade that followed these global credit crises was cut by half. Developed economies grew at an average of just 1.8 percent a year following global credit crises.

The Reinhart's research also sheds some light on the tendencies of inflation following a collapse in credit. While they note the well documented periods following the 1929 stock market crash (severe deflation) and the 1973 oil shock (high rates of inflation), they also draw a distinction between these periods and the standard (but still severe) credit crises. For developed countries, inflation averaged 6.5 percent in the decade prior to each crisis and 2.2 percent in the decade that followed. Crises in emerging countries showed similar patterns. Inflation in these countries averaged 5.9 percent in the decade leading up to the crisis and 3.6 percent in the decade that followed. As the Reinhart's point out, “this is all the more remarkable considering that the emerging market countries all sustained massive devaluations/depreciations in their currencies at the height of the economic turmoil.”

Within this framework, we can construct an estimate for GDP growth over the next decade. In the 10-year period up to the peak of the 2008 credit crises, real GDP growth averaged 3.1 percent a year. Based on the Reinhart's research, it is reasonable to expect the economy to grow at somewhere between 1.5 percent and 2 percent over the next decade. Inflation averaged 2.5 percent leading up to the crises. That's low by historical standards, so a rough estimate based on their work might be about 2 percent. So, if the economy takes a decade to recover – which is standard for post credit crisis periods – then the US economy would be expected to grow at a 3.5 percent to 4 percent nominal rate over the next seven or eight years.

Following the worst 10-year returns for the S&P 500, the average cyclically-adjusted P/E was just 12, GDP growth over the following decade average 10.5%, earnings growth averaged 8.63%, and the S&P 500 return over the following decade averaged 11.33. Presently, the cyclically adjusted P/E is above 21, while the prospects for earnings growth are depressed, both based on potential GDP and on the typical aftermath of a credit crisis. It is worth remembering that investors in the Japanese stock market have had rolling negative 10-year returns since 1997.

The argument that above-average long-term returns typically follow periods of poor past long-term returns is not wrong, it's just incomplete. The more complete argument is above-average long-term returns can be expected to follow long periods of low or negative, provided that they end with low P/E multiples on smoothed earnings and precede a period where the economy can be expected to enjoy robust growth. Today, valuations are at levels that have normally been followed by 10-year returns that are well below average. At the same time, based on a template from more than a dozen prior credit crises, the argument that the economy will grow strongly over the coming decade finds little support.

John Hussman: Economic Deterioration Continues

October 3, 2010 Economic Measures Continue to Slow

John P. Hussman, Ph.D.
All rights reserved and actively enforced.
Reprint Policy
The latest evidence from a variety of economic measures continues to suggest deterioration in U.S. economic activity. Probably the best way to characterize the latest round of data from the ISM and other surveys is that the data is coming in a bit less negative than we've anticipated, but continues to deteriorate in a manner that is consistent with stagnant economic activity.

To obtain a broad indication of economic performance, we averaged eight different measures reported by the ISM and the Federal Reserve. These included the ISM National, Chicago, Cincinnati and Milwaukee surveys, as well as the Federal Reserve's Empire Manufacturing, Philadelphia, Richmond and Dallas surveys. The chart below shows the average standardized value of the overall indices, as well as the new orders and backlogs components (a standardized value subtracts the mean and divides by the standard deviation of a given series, so all of the variables are essentially Z scores).

Closer inspection shows that all of these measures dropped below zero last month. That said, these measures are not as negative as what we observe from the ECRI Weekly Leading Index. Taken by itself, this data implies tepid economic growth, but not outright contraction.

Still, with the S&P 500 at a Shiller P/E over 21, and our own measures indicating an estimated 10-year total return for the S&P 500 in the low 5% area, it is clear that investors have priced in a much more robust recovery than we are likely to observe. Our long-term total return estimates are consistent the historical norms based on Shiller P/Es - since 1940, Shiller P/E values above 21 have been associated with annual total returns for the S&P 500 averaging 5.3% over the following 7 years and 4.9% annually over the following decade.

The activity indices presented above are closely correlated with GDP growth. On that note, second quarter GDP growth was revised last week to 1.7% annualized, which was up slightly from the first revision of 1.6% growth, but down from the initial estimate of 2.4%. Based on what we observe in other data, third quarter GDP is likely to reflect continued tepid growth, though the overall activity indices did not decline enough to suggest that the economy contracted in the third quarter. Unfortunately, if we look historically at 6-month periods where real GDP achieved positive growth, but less than about 2.5% annualized and slower than the prior 6 month span, the S&P 500 has historically achieved zero total return, on average, during those periods. Slow, positive economic growth is only helpful for the market, on average, when that growth represents an acceleration.

Dividend payout ratios and operating earnings growth

A note on valuation. A number of observers have suggested that the low level of dividend payouts as a fraction of operating earnings is indicative of strong prospects for reinvestment, which is then extrapolated into assumptions for high rates of future earnings growth. Unfortunately, this argument is problematic on two counts.

First, forward operating earnings are not realized cash flows. As I've noted frequently over the years, forward operating earnings represent analyst estimates of the next year's earnings excluding a whole range of chargeoffs and "extraordinary expenses" as if they do not exist. While operating earnings provide a smoother measure of business performance, they don't provide a good measure of the cash flows that are actually deliverable to shareholders.

Losses that are booked as "extraordinary" are still losses, and represent the results of bad investments and a consumption of amounts that were previously reported as earnings. Similarly, the portion of earnings used for share buybacks is often expended simply to offset dilution from grants of stock to employees and corporate insiders, and again do not reflect cash that is deliverable to shareholders. In recent years, based on the widening gap between reported operating earnings on one hand, and the sum of dividends and increments to book value on the other, a great deal of what is reported as earnings ends up evaporating as extraordinary losses and share compensation.

The second problem with the low level of dividend payouts, relative to forward operating earnings, is that there is no historical evidence whatsoever that low payouts are accompanied by higher growth in future operating earnings. To the contrary, when dividends are low relative to forward operating earnings, it is a signal that operating earnings are temporarily elevated - typically because of transitory profit margins. As a result, subsequent growth in forward earnings is actually slower than normal over the following decade.

Dividend policy is set in a very forward-looking manner. Since dividend cuts generally result in very negative events for corporations, dividend payments are set to a level that management believes it can sustain. Relative to current forward operating earnings, indicated dividend payments are near the lowest level on record. If anything, investors should take this as a signal that managements do not expect present levels of earnings to be sustained at a level that is sufficient to justify higher payouts.

In contrast, high dividend payouts (as a ratio of forward operating earnings) typically reflect temporarily depressed operating earnings, and short-term margin compression. Accordingly, elevated payouts tend to be followed by above average growth in operating earnings over the following decade. The tendency for dividend payouts to lead operating earnings growth is depicted below (see Long Term Evidence on the Fed Model and Forward Operating P/E Ratios for details on forward operating earnings prior to 1979). Suffice it to say that the low level of payouts today most likely reflects elevated and unsustainable operating margins.

On the latitude for a constructive investment stance

Based on the data that we've observed in recent months, my view remains that a fresh downturn in the economy remains a not only a possibility but a likelihood. Little of the economic improvement we've observed since 2009 appears intrinsic, but instead appears driven by enormous government interventions that are now trailing off. Still, while I believe that there is a second shoe that has not dropped, I recognize that the full force of government policy is to obscure, stimulate, intervene and borrow in every effort to kick that can down the road. I believe that the unaddressed and unresolved problems relating to debt service, employment conditions and housing are too large for this to be successful, but as we move through the remainder of this year - as I've said throughout 2010 - we are gradually assigning greater probability to the "post-1940" dataset. Accordingly, there are developments that could potentially move us to a more constructive position. We don't observe those at present, but an improvement in economic evidence and a clearing of overbought conditions, leaving market internals intact, would be one configuration that might warrant less defensiveness.

How constructive is "constructive"? Without an improvement in valuation levels, a constructive investment exposure for us here would likely be limited to a removal of perhaps 20% of our hedges, because the improvement in expected return and reduction in expected risk will not be dramatic unless valuations retreat sharply. That said, we occasionally observe conditions that warrant placing about 1-2% of assets into call options, which would allow a subsequent market advance to soften our hedges without actually removing the put option side of our defenses.

A better configuration would include a significant retreat in valuations and a massive, if uncomfortable, amount of debt restructuring. Those two events would be the best way to put the recent (and probably ongoing) debt crisis behind us, and could easily allow us to completely lift our hedges for an extended period of time in anticipation of an unobstructed recovery.

To some extent, I view current market conditions as something of a "Ponzi game" in that valuations appear neither sustainable nor likely to produce acceptably high long-term returns, and speculators increasingly rely on finding a greater fool. As the mathematician John Allen Paulos has observed, "people generally worry only about what happens one or two steps ahead and anticipate being able to get out before a collapse... In countless situations people prepare exclusively for near-term outcomes and don't look very far ahead. They myopically discount the future at an absurdly steep rate." Undoubtedly, we have periodically missed returns due to our aversion to risks that rely on the ability to find a "greater fool" in order to get out safely. But it is important to recognize that speculative risks are not a source of durable long-term returns. At a Shiller P/E of 21 and a historical peak-to-peak S&P 500 earnings growth rate of 6%, a simple reversion to the historical (non-bubble) Shiller norm of 14 would require seven years of earnings growth and yet zero growth in prices. Stocks are not cheap here.

Meanwhile, the U.S. financial system appears to be a nicely painted dam, behind which a massive pool of delinquent debt is obscured. A significant correction in valuations and resolution of the growing backlog of delinquent debt may finally restore strong "investment merit" to the U.S. stock market, but only after a greater amount of pain and adjustment than most investors seem to anticipate.

In general, we want to take risk in proportion to the improvement we observe in the return that we expect per unit of that risk, primarily based on long-term historical evidence about what has occurred in similar conditions. For now, we remain defensive.

Market Climate

As of last week, the Market Climate for stocks was characterized by rich valuations, elevated (but not extreme) bullish sentiment, generally positive but overbought price trends, and continued negative economic pressures. Overall, our measures suggest an overvalued, overbought, overbullish condition, but with shorter term factors struggling between emerging economic weakness and overbought conditions on the negative side, and speculative trend following on the positive side. For our part, the current set of conditions is associated with an unfavorable return/risk profile, so the Strategic Growth Fund and the Strategic International Equity Fund remain well hedged.

In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and positive yield pressures. The Strategic Total Return Fund continues to carry a portfolio duration of just over 4 years, mostly in straight Treasury securities. We've clipped a small portion of our precious metals holdings on strength in order to hold our exposure to roughly 10% of assets, but the overall Market Climate remains favorable in that sector for now. The Fund continues to hold about 5% of assets in foreign currencies and about 2% of assets in utility shares.

Gold-Dollar Recurring Theme

Gold has reached another new all-time high, and the Dollar has reached another low overnight.

Gold

Dollar

Gold Prices to Continue Rising?

NEW YORK (TheStreet) -- Spot gold prices were dipping in the red Monday afternoon due to profit taking, which kicked in after the yellow metal hit about $1,320 on Friday.
"People saw it all weekend long," EverBank president Chuck Butler said of the Friday price level. This profit taking "just makes a lot of sense." According to a coin dealer Butler spoke to recently, there's been an increase in individual selling of gold recently to pay bills -- electricity bills for instance. Butler noted that this selling is sparse compared to the panic selling seen a several years ago, when gold tumbled from $1,000 to $900 to $800.
Looking further into the future, Butler believes that gold can be pushed beyond $1,300 -- even to $1,500 in a year. Although the Fed has already indicated that it's open to more quantitative easing owing to very low inflation levels -- and much of this announcement has already been priced into the current spot gold prices -- "I think the Fed will surprise" with how big they're going to make the size of the additional quantitative easing, which will put further downward pressure on the dollar and "spur even more gold buying," Butler said.
Butler added that the S&P Agriculture Index has been at a two-year high, indicating higher inflation and more buying of gold and silver as an inflation hedge. The Australian Commodity Index, Butler continued, is equal to 2008 levels right now, indicating a "huge" boom in commodity prices, which "has a lot to do with the push we've seen with gold and silver recently."
Silver prices, he said, could advance to $50 in a year. Silver is used as both an investment and industrial metal.
In terms of the recent price action of silver, Butler thinks that "it has risen quite nicely in the last couple weeks on the coattails of gold," though without any "real emphasis" on silver vs. gold: "we've seen it in equal amounts ... when gold sold off, so did silver."

New York spot gold prices were falling by $3.90, or 0.3%, to $1,314.70 an ounce Monday afternoon.

New York spot silver prices were lower by 10 cents, or 0.5%, at $21.99.

New York spot platinum prices were losing $6, or 0.4%, at $1,669 an ounce, while its sister metal was slipping.
New York spot palladium prices were surrendering $16, or 2.8%, at $557 an ounce.

A handful of mining stocks and precious metals ETFs ended Monday's trading session in negative territory. Mining stocks offer another form of exposure to precious metals.
North American Palladium(PAL) closed at $4.24, down 4.9%, while Stillwater Mining Company(SWC) finished at $16.24, down 4.4%. Barrick Gold(ABX) ended at $45.98, down 2.2%.
SPDR Gold Trust ETF(GLD) fell 0.4% to $128.46 and ETFS Physical Palladium Shares( PALL ) tumbled by 2.2% to $55.90.

Phases of a Bubble Cycle

Doug Kass: Quantitative Wheezing!

Ten days ago, during my guest-hosting stint on CNBC's "Squawk Box," Appaloosa's David Tepper made some very optimistic comments about the U.S. stock market and on the domestic economy. In part, based on those remarks, equities embarked on a sharp run up that began that Friday morning and has continued to date.

Sometimes it's just that easy.... What did the Fed just tell me? What did they say? They want economic growth. And they said, We want economic growth, and we don't even care -- not only do we not care if there's inflation but we want a little more inflation. Have they ever said that before?... They want the market up. So, what am I-I'm gonna say, No, Fed, I disagree with you?... Either the economy is going to get better by itself in the next three months. And what assets are gonna do well? You can guess the assets that are gonna do well. Stocks!... Or the economy's not gonna pick up in the next three months, and the Fed is going to come in with QE. And then what's gonna do well? Everything!... Let's see. So what I got-I got two different situations. One, the economy gets better by itself.... The other situation is the Fed comes in with money.... You gotta love a put.... I gotta buy; I can't take the chance of not being a little bit longer now.... That does not mean that I'm going balls to the walls.... That's how easy it is right now. -- David Tepper, "Squawk Box" comments

Let me begin by make one thing clear: We can admire our icons, but we can question and be in disagreement with them:

• I worshipped at the altar of Tiger Woods' golf game, but he moved down many pegs after the disclosure of his many trysts.
• I worshiped at the chess altar of Bobby Fischer, but his idiosyncratic behavior turned me off to him and to chess.
• I worship at the baseball altar of anything having to do with the New York Yankees, but I disagreed with the manner in which Brian Cashman and George Steinbrenner appeared to treat former manager Joe Torre, when he was asked to take a pay cut following the 2007 season.
• I worship at the altar of Quentin Tarantino's movie productions. While most of his body of work can be viewed as pure genius, I hated Kill Bill (both volumes).
• I worship at the altar of Julia Roberts' acting prowess, but her recent performance in Eat, Pray, Love (more like Sit, Watch, Groan!) was sententious, patronizing and saccharine.
• I worship at the music altar of the Grateful Dead, but I have attended numerous Dead concerts in which Jerry Garcia was so stoned his voice was unrecognizable.
• I worship at the political altar of President Obama, but, at times, I have been critical of his policy and lack of focus regarding the need for a transformative jobs program.
• I worship at the consumer advocacy altar of (my ex boss) Ralph Nader, but he never knew when to get off the stage and cost Vice President Al Gore the Presidency.
• I worship at the investment altar of Warren Buffett, but I shorted Berkshire Hathaway's (BRK.A) shares in early 2008, based on the belief that his portfolio was too skewed toward financials (an industry that that had lost their "moat" feature), and I disagreed with the timeliness of his derivative short of the S&P 500.
• Similarly, I continue to worship at the hedge fund altar of Appaloosa's David Tepper, but this morning I want to question the conclusion he made during his "Squawk Box" appearance that, if the economy fails to recover up to expectations, the Federal Reserve will embark on a successful QE 2 that will dutifully bring a rally in the U.S. stock market.

Shock and Awe (QE 1) to Shucks and Aw (QE 2)?

• interest rates are already low
• absence of global cooperation in reflating
• weak confidence and uncertainty of policy
• bank loan demand and credit extension weak
• bank reserves are already plentiful
• increased suffering by the savers class
• QE 2 fails to address structural unemployment issue
• long-term costs considerable

Fed officials are clueless about how quantitative easing is supposed to impact the economy. They aren't even sure if it has any effect on the economy.... The Bank of Japan tried quantitative easing to revive their economy and avert deflation, but it didn't work.... Bernanke knew back in 1988 that quantitative easing doesn't work [Bernanke and Blinder research]. Yet, in recent years, he has been one of the biggest proponents of the notion that if all else fails to revive economic growth and avert deflation, QE will work.
-- Ed Yardeni

The economic signs continue to point to the need for more quantitative easing. (This view is generally agreed to by bulls and bears alike.) What is not agreed to is the likely effect of QE 2, especially when compared to the first round of quantitative easing.
Will David Tepper be accurate, or will the "shock and awe" of QE 1 be replaced by "shucks and aw" in QE 2, having very little incremental benefit? (See Ed Yardeni's comments above.)
Last week, Credit Suisse's Andrew Garthwaite captures the consensus that QE 2 will be implemented in November/December and that it will be successful for the following reasons:

• By driving down real bond yields (which helps government funding arithmetic, lowers the savings ratio and pushes up DCF valuations of assets);
• Through the funds flow effect: it gives asset allocators money, which they partly invest in other assets;
• Via the currency: a weaker dollar forces other central banks to adopt QE (Japan, U.K. and maybe eventually after a stronger euro the ECB). This, of course, will eventually lead to a revaluation of emerging-market currencies (which is what most policy makers in the developed worlds desire) as GEM countries have an inflation backdrop that will not permit them to participate in QE. (They either have to accept an asset bubble or currency revaluation, probably a bit of both);
• Through psychology: the lower the bond yields, the more fiscal tightening is postponed (as we have now seen with the likely renewal of the Bush tax cuts).

I previously chimed in that there is little doubt that QE 2 will have some positive influence but questioned the degree of its impact:

• It will pull the U.S. dollar still lower, serving to improve our exports and slow down our imports and resulting in a more balanced trade deficit.
• The yield curve will likely flatten further -- in theory, serving to encourage banks to lend.
• The consumer will continue to benefit by a further drop in mortgage rates as debt service ratios improve. Refinancing activity will also increase; a pickup in consumer spending could follow.
• Even though housing will continue to be haunted by an unsold shadow inventory, lower mortgage rates raise the odds that the residential real estate markets stabilize sooner and, with less pressure on home prices, that consumer confidence might recover quicker.
• Real interest rates will drop further, so risk assets should theoretically gain in price.

The times, they appear to be a-changin', and the effect of QE 2 -- its ability to move the needle -- despite David Tepper's assurances, remains uncertain. Back then, QE 1 was instituted at a very depressed level of worldwide economic activity, during a period when market participants were fearful of a financial collapse. Balance sheets were unstable, and funding was problematic. There was unanimity of opinion (over here and over there) that our financial institutions needed to be backstopped, and they were by central bankers in a synchronized and coordinated global fashion.
Everyone was "all in."
Today, our financial markets are stabilized, credit and spreads and risk markets are in far better shape, and our stock market is up violently from the March 2009 lows.
We needed (and got) stability two years ago, but today we need growth.
Today we have a broken domestic money multiplier, we suffer from structural unemployment, interest rates are already at zero (and our savers' class continues to suffer from policy), lackluster credit demand is lackluster, our domestic banks hold large excess reserves but are reluctant to extend credit in the face of economic, and regulatory uncertainty and the housing market (price and activity) is losing some of its historical correlation to interest rates (as it is haunted by a large shadow inventory of unsold homes). Also, with the ECB not playing ball with respect to a global coordination reflation program, not everyone is "all in" today for QE 2.
From my perch, it is growing increasingly hard to see QE 2 as a significant needle mover and as a successful/meaningful follow-up to QE 1, but it is easy to see some intermediate-term fallout.
Dr. Bobby Marcin offered a negative and extreme view of QE 2 recently:

[The Fed] has pulled out their one trick pony named All-Ease-All-The-Time. The Fed insists this trick is panacea for the economy.... [The Fed believes that] asset speculation creates wealth and economic prosperity. Bernanke believes currency debasement will create jobs, reflate housing, spike financial assets.... And, it will accomplish this by only gently nudging inflation up to 2%. What a joke.
The next QE performance will create trillions of paper dollars and create no jobs and minimal GDP growth and inflate no home prices. It might goose financial assets a bit temporarily, but that seems to be the ... end game.
QE 2, however, will crush the dollar, hurt pension funds and savers, spike inflation (especially in commodities) and distort market pricing signals. And if it persists, will force investors out on the risk curve and may initiate bubbles in bonds, stocks and commodities. Easy Al has relinquished the circus ring to Bubble Ben.
In an act of suspension of disbelief, the markets wants to applaud this pony trick. How foolish. Printing money and inflating asset prices creates no sustainable wealth or economic activity. It creates the illusion of wealth and fosters major economic imbalances. That's our problem today, yet the clowns running the circus don't understand that sentence.

Bobby's prose might appear inflammatory, but there are kernels of wisdom/truth contained in his rant. Rather than a consensus-like response that QE 2 will be successful economically and market-wise -- currently the U.S. stock market is having a benign response to a weakening dollar (as it did in 1987) but for how long?) -- I would offer some additional questions investors should be asking:

1. What will the costs of QE 2 be?
2. At some point, shouldn't increased monetary intervention by the Fed (and fiscal intervention by the government) cause market participants to lower the market multiple as opposed to increasing it?
3. Isn't QE 2 simply reducing the quality of earnings and, similar to Cash for Clunkers or the Homebuyer's Tax Credit, borrowing from future growth?
4. How does QE 2 resolve the single-most headwind to growth, structural unemployment?
5. At the very least, at what point have the prospects for QE 2 been priced in?

The above issues and the uncertain impact that QE 2 will have on our currency helps to explain the very public debate going on now among the Fed members that we have witnessed over the last week. And it also helps to explain why some of those members are encouraging an incremental policy, not a "shock-and-awe" QE 2 but a "shucks and aw" QE 2. As my idol and icon, Grandma Koufax, used to say to me, "Dougie, I will always love you, but sometimes I don't like some of the things you do."
In a similar vein, with respect to one of my icons/idols, Appaloosa's David Tepper, I must respectfully take some exception to the certainty of a salutary investment and economic consequence of QE 2 that Tepper displayed in his remarks on "Squawk Box" -- namely, that investors will win whether the economy strengthens or weakens and is followed up by QE 2.
Heads investors win, tails investors win?
At current stock prices, that is not a coin toss that I wish to bet on right now.