What China Is Doing With Its Money

A few weeks back, I provided the video of an Australian investigative program on the ghost cities of China. If that wasn't enough to concern investors about China's "growth" miracle, perhaps this will. Here are a few (yes, there's more here and here*) photos of the corporate headquarters recently built for state owned Harbin Pharmaceutical.

And these are the guys whom investors are relying on to provide capital for the Eurozone and save the world economy with middle class demand. Ghost cities and corporate palaces. Good luck with that.

*Note: For some reason, this second link no longer works.

The Italian Opera

First, the Greek tragedy. Now, the Italian opera.

As the global deleveraging crisis continues to wreck havoc on the Eurozone and interest rates for one of its largest economies hits record levels (see chart), it is advisable to understand the multiple dimensions of this financial and economic opera.

In his blog posting yesterday, Nobel Laureate Paul Krugman notes, “…Italy is not a shadow bank; its debt has on average a roughly 7-year maturity, so high interest rates take time to filter into higher debt service. As a matter of arithmetic, this could go on for a while, maybe even a couple of years, without necessarily pushing the country into default.”

However, as Mr. K also notes, “...rates can go even higher; banks can come under pressure; and bank depositors can vote with their feet.” And therein lies the real trouble – a run on the bank, in this case, a sovereign. As the FT noted recently, “The biggest US money market funds cut their exposure to European banks to another record low last month, amid continuing uncertainty over the fate of the region’s debt crisis.”

As money flows away from risky areas and into safe havens like the US dollar denominated assets, stress fractures in the global financial and economic fabric continue to break apart thereby producing a cascading effect upon all and an obsessive focus on who’s next.

Bottom line: This opera won't end until the fat lady sings. Unfortunately, I don't hear her even warming up.

And don’t think the Chinese are so dumb nor so economically secure (you can’t built ghost cities forever) that they will send boatloads of bailout cash to sinking ships around the world. Turandot falls in love only once.

But, hey, none of this really matters to the bottom up boys and girls who are no doubt emboldened by the actions of their leader, Warren Buffet, who went on a spending spree in the third quarter.

Mangia!

Here is The Economist cover image that I referenced in yesterday's foxbusiness.com interview: the Eurozone leaders being lowered into a sea of trouble (mostly of their own doing) with a pasta colander serving as their boat.

One of the points made in yesterday's interview was the near certainty that a recession is on its way (if it's not already there) for the Eurozone. Today's Eurozone manufacturing data only reinforces that view. What is more ominous, however, is the prospect that the best case scenario for the Eurozone appears to be recession. The worst case? Don't ask.

Bottoms Up!

Giving the devil his due, the bottom-up crowd has won this round, as earnings results are not disappointing as economists did for the third quarter. Therefore, in light of the recent market action, it seems more than productive to understand the nature of this important (but not dominant) segment of the market.

Most investors are bottom-up oriented. They buy and sell stocks with a passing reference to the sector and style tilt their portfolios produce. Like many sports teams, portfolios are populated with the best ideas. Sectors and styles are a by-product. Individual company earnings results, performance metrics (such as profit margins, growth rates, etc.), and valuation levels determine the buy/sell/hold decisions made. From that comes the action taken.

This situation is largely due to tradition and training: traditional among individual investors, training among the professional crowd (the CFA program, for example). It is what the financial media obsesses on while providing limited, yet sorely needed, education on what constitutes good portfolio management.

As one of the two essential elements that drive stock prices up or down (the other being financial market liquidity), earnings results can dominate the moment, as they appear to have done thus far this month. When good earnings results motivate investors to act positively, the momos (the real power in today’s market) join the party, as they are indifferent to the reasons that drive investors and are far more interested in an excuse to act. As long as money is abundant (financial market liquidity), the upside bias exists. Which brings us back to earnings results.

As long as companies deliver positive earnings results and financial market liquidity remains ample, the bottom-up crew can move markets (aided and abetted by the momos, of course) to a significant degree. Should earnings falter, however, then the dual impact of declining results and diminution of financial market liquidity (in the form of redemptions and withdrawals) can produce a negative feedback loop to the real economy (Soros’ “reflexivity”). Yet, more importantly, within this investing approach lie the seeds of its own destruction.

Bottom-up investing is aided and abetted by ivy tower fantasies about efficient markets, assisted with high-sounding phrases like “price discovery” and “capital asset pricing models”, and supported by economic methodologies that are anchored in traditional metric analyses. Such traditional economic methodologies do, however, come with two significant blind spots: the inability to forecast with any degree of accuracy and consistency (certainly commensurate with a practice that fancies itself as a “science”) and an inability to do global macro analysis particularly well.

The first point is self evident and saturated with historical fact. For example, one need only look at today’s consumer confidence miss to see just how off the mark these “social scientists” can be. The second point was made most evident in the debacle known as the Great Recession. Moreover, the inability to do global macro well also comes with an inability to incorporate contagion’s speed and source (real and/or financial economy).

This is a big part of how the world works in Wall Street. It is the dynamic reality that exists in the surreal world of finance. It is the state of denial that many who play the investing game occupy. And it is why it is so essential to step back and smell the global macro rose, which right now has a decidedly foul odor to it.

But, hey! “Who cares?”, say the bottom-up boys and girls. "Earnings are good and that’s all that matters to me."

Quotable Quotes: Richard Koo and Martin Wolf

Today, I am reinstating a popular blog service that I provided several years ago: Quotable Quotes.

In the past, I would seek out interesting and often humorous quotes from the very well known to those of lesser fame. In this updated version, I will include comments and other relevant data that are appropriate to the current economic, political, and market times.

The first installment (below) begins with a letter sent to and published in The Economist from noted economist Richard Koo. The emphasis (bold and italics) is added by me to accentuate key points that struck me as especially useful in understanding key elements in the investment decision-making process.

The second is an excerpt from Martin Wolf's most recent economic commentary. I encourage all to read his complete commentary (link provided, FT subscription required).

I trust you will find this reading well worth your time.

August 20, 2011

A different kind of crisis

SIR – The title of your leader on the debt crisis was well chosen (“Turning Japanese”, July 30th), but you missed the point. The Japanese problem of the past 20 years, together with the American and European problems of today, boils down to one fact: the economics profession has never considered a recession that could be caused by the private sector minimizing debt in order to repair balance sheets after a debt-financed bubble in asset prices. As a result, the profession has no clue as to what is the right thing to do.

In this rare type of recession, monetary policy is useless because people with negative equity will not borrow, no matter what the interest rate. Nor will there be many lenders when banks have such huge problems with their balance sheets.

In this environment, therefore, government must borrow and spend the savings generated by the deleveraging in the private sector in order to keep the economy from entering a deflationary spiral. But as John Maynard Keynes noted, it is almost impossible to maintain fiscal stimulus in a democracy during peacetime. It is this difficulty that prolongs this type of recession; it took Japan ten years to climb out of the policy mistake of premature fiscal consolidation in 1997.

The drama in Washington and other capitals is almost the exact replay of that confused policy debate in Japan. And the drama will continue until the public realizes that this is a different disease requiring different treatment.

Richard Koo

Chief economist

Nomura Research Institute

Tokyo

August 30, 2011

Struggling with a great contraction

Mr Obama wishes to be president of a country that does not exist. In his fantasy US, politicians bury differences in bipartisan harmony. In fact, he faces an opposition that would prefer their country to fail than their president to succeed. Ms Merkel, similarly, seeks a non-existent middle way between the German desire for its partners to abide by its disciplines and their inability to do any such thing.

Martin Wolf
Chief economics commentator
Financial Times

President Hillary Clinton

Given the near certainty that in the short run the new economic philosophy being adopted by most western economies, Expansionary Austerity, will result in a major economic contraction, there very likely will come a time in the not too distant future when enough US voters in 2012 will turn to someone else to help rescue the US (and, therefore, global) economy. In this regard, two names come to mind: Michael Bloomberg and Hillary Clinton.

Both have the business credentials to help the troubled economic climate ahead. Mayor Mike, for all the obvious reasons (turning $10 million into $10 billion speaks for itself). And Hillary because of the economic success of the Clinton years. Of the two, the edge has got to go to Mrs. Clinton.

Hillary Clinton has the tenacity and, now, the individual track record to mount a formidable attack on the President Gandhi. And when Bill Clinton injected himself into the recent debt ceiling fiasco by stating that he would invoke the 14th amendment and make the courts stop him (as opposed to President Gandhi, who relies on lawyers and experts to guide him virtually every step of the way), he showed what leadership looks like (a quality sorely lacking in the White House these days).

Consider it: Hillary in the White House and Bill at Treasury. One with the diplomatic and legislative bona fides, the other with strong economic credentials. A real two-fer, if there ever was one.

Obviously, there are many obstacles that stand in the way of a second Clinton presidency, most notably getting the nomination. But there may come a point over the next 6 months when fear rises to such a level that the unthinkable today becomes the best course of action. And at such a point, a draft movement would be all the impetus needed to start the process.

Not My Job: The Economic Consequences of Advocacy

"Never underestimate the power of a few committed people to change the world. Indeed, it is the only thing that ever has."
Margaret Meade

Today's NY Times' article "Big Business Leaves Deficit to Politicians" affords me this opportunity to comment on something I have been wanting to touch on for some time: the economic consequences of advocacy.

In regards to the main topic of the Times article - the US federal deficit, the article references that big business is "part of the problem", that big business "...consistently lobbies for a higher deficit. The roundtable defends corporate tax loopholes and even argues for new ones." This is true. But the article fails to go to the reason behind the actions taken by business - it's not their job.

Business (big and small) do not act for the collective good because it is not their job. A company may be headquartered in a country and even do most of their business in that country. Moreover, the senior management of the company may be lifelong citizens of that country, served in the military of the country, and be as patriotic as the next guy. However, when it comes to business, where one's heart is not where one's pocketbook is.

Their job, specifically senior management, is to advocate for their business. They are compensated according to how well their business does regardless of the consequences in a larger context. And this means pursuing any and all means necessary (and, one assumes legal and even moral) to achieve their financially driven goals: earnings and growing at a rate of return in excess of their cost of capital.

This advocacy approach is rooted in two areas:

1 - The big shareholders rule. A CEO will not keep his/her job very long if they are not advocating for their enterprise as aggressively as possible. Activist shareholders see to it that the CEO feet is kept firmly to this fire.

2 - The ideology of acting in one's best interest results in the collective being best served. According to this thinking, this is the way the world works and works best. All other approaches are fraught with conflicting efforts and outcomes (think laissez-faire versus socialism).

Acting in one's best interest also includes advocating in all related corporate realms - which includes the political and regulatory environments.

In sum, it is unfair to criticize senior management for doing their job, as there is no motivation for senior management to do anything other than act in their own (business and personal) selfish best interest. To do otherwise is, at a minimum, career suicide*.

As for the consequences to the larger economic environment that such an approach might have, the answer is not clear cut one way or the other and is, frankly, an area where the economics profession would be well served to provide some opinions and guidance. What does seem clear, however, is that without counterbalancing forces at work (representing other socioeconomic interests), the focused power of the advocacy of one constituency in a position of competitive advantage acting in their own selfish interests can easily distort and possibly ruin the greater good.

*And, in the minds of some, business and economic suicide.

Ben Opens The Kimono

If one took the time to sit and listen carefully, the Bernanke press conference was an excellent opportunity to understand not only the decisions made but the economic philosophy underlying them. For that, Bernanke should be applauded. Transparency is almost always a good thing.

You don’t have to agree with the decisions made. However, knowing the thought process that leads to the decisions will help much more than whether his voice sounded shaky (which, if you listen to his testimony to Congress, it always does) or if he appeared to be sitting behind a piano (I actually love that comment. The imagery of Ben crooning a tune is priceless. Thanks, to Matt Phillips at WSJ).

In a manner similar to what St. Louis Fed President James Bullard discussed at the NYSSA luncheon I moderated last fall, Bernanke lays out the thinking behind the decisions. Therefore, here are a few observations:

• First quarter slowdown is transitory. Economic pace will pick up over time. Accordingly, the US economy should achieve a sustainable expansion. Continued improvement is expected. (Key words "over time". Lots of wiggle room.)

• Concern re inflation and its impact on jobs. Inflation (and any deviation away from stable, low inflation, which, of course includes deflation, for that matter) will inhibit job growth and must be guarded against.

• Related to this is the issue of long-term unemployment, which the Fed can virtually nothing about beyond seeking to help the current conditions and, thereby, help facilitate a virtuous circle of jobs creation. The long-term unemployment problem is one for the political process and other areas of the US economy.

• The Fed holds a “stock view”, which is actually Soros' "Reflexivity" – the feedback loop from the financial markets to the real economy and back and forth over and over. In this regard, QE (1 and 2) worked because “easing financial conditions leads to better economic conditions.” This is exactly the same philosophy and view expressed by St. Louis Fed President James Bullard at the New York Society of Security Analysts luncheon I moderated last fall.

• As for the potential of more QE, Mr. Bernanke took that off the table when he noted that in the Fed’s view the tradeoffs of more easing versus the risks of inflation and inflationary expectations are not favorable. (Perhaps for the reasons John Hussman has been fretting about.)

• Fiscal cuts (austerity) at the state and local level are not a major concern and, therefore, no plans to respond monetarily. The Fed is ready to react but no worries right now. (Not sure how this squares with the previous point.)

• The first step that signaled the end of monetary easing is occurring at the end of June, when QE2 ends. The second step that will signal the end of Fed easing is when the Fed stops reinvesting the US Treasuries and the mortgage back securities it has on its bloated balance sheet. This will, in effect, lower the size of its balance sheet.

• Rogoff and Reinhardt have shown that recoveries following financial crises tend to be slower and less robust. Bernanke believes this is true, as the problems tend to be in the credit markets and housing. He also, believes, however, that the reason for the post credit crises below average recoveries is that policy responses were not adequate. In his and the Fed’s board view, the aggressive and extraordinary actions undertaken by the Fed should help lead to a better economic outcome for the US. That said, he did acknowledge that the US economy growth (and employment, for that matter) thus far has been sub par but, as noted above, the Fed expects “recovery continues to be moderate but the pace will pick up over time.”

So what can we take away from this press conference that is of meaningful investment value? Two main items come to mind:

1 – The Fed is driven to maintain stability at the price level. They are very concerned about inflation (for the employment related reasons noted above). They are, however, deathly afraid of deflation. A Goldilocks approach to inflation is the only porridge that will do. And that is a very difficult thing to accomplish indefinitely.

2 – In the current environment and now that, in the Fed's view, the deflationary dragon has been slain, inflation and job creation are joined at the hip. Rising inflation will impact job creation and must be avoided at all costs.

Everything described above assumes an private sector led sustainable economic expansion lies ahead, which takes us to my third and most important point:

3 - No one asked the one question that I would have asked (and the one I have been asking for months now), What if the US economy does not achieve the escape velocity of a private sector led sustainable economic expansion?

What will the Fed do? What can the Fed do?

How will the markets, the economy (US and global), the geo and socio political environment react to another round of monetary easing? Why would QE 3, 4, or 5 work when 1 and 2 produced such transitory (and some would argue negative) effects?

If the Fed is right and a private sector led sustainable economic expansion does emerge, then the outlook will improve but to what extent remains to be seen. If not, then what?

Is there a plan B? A plan C?

Bottom line: What Bernanke did is a terrific thing. Transparency is almost always an excellent thing. Moreover, I truly believe he is sincere, knowledgeable, hard working, and has little in the way of political agenda (unlike Geithner). That said, being a good guy is not enough if the actions taken lead to a bad outcome.

Herbert Hoover was a good guy and look at how that turned out.

U.A.E. To The Rescue

How is the US going to square the circle of involvement in Libya but not in the far more strategically important Bahrain? While the thrust of the following WSJ article is in one direction (why the United Arab Emirates (U.A.E.) is not engaged militarily in Libya), the real value lies in the fact that the U.A.E. has provided a way for the US to avoid the hypocrisy of involvement in Libya but not Bahrain: blame it on Iran.

From today's WSJ:

Former U.A.E. Official Blames U.S., EU for Libyan Pullout
By NOUR MALAS

"ABU DHABI—The United Arab Emirates was prepared to deploy 24 aircraft to help enforce a no-fly zone over Libya but decided not to participate in the allied effort because of U.S. and European policies towards Bahrain, the former commander-in-chief of the U.A.E. Air Force said Tuesday.

"The U.A.E. was willing, and there were preparations, to deploy a significant number of aircraft for the no-fly zone, but a re-prioritization—specifically the European and U.S. positions on Bahrain—did not satisfy the Gulf states to this end," said Maj. General Khalid Al Buainnain.

The U.A.E. had been prepared to deploy two squadrons of 12 aircraft each to Libya, Mr. Buainnain, said on the sidelines of a conference in Abu Dhabi.

Mr. Buainnain said the U.S. and Europe had failed to appreciate the extent of Iran's interference in the Gulf countries, and had misread the protests in Bahrain as a spill over of calls for democratic change sweeping through the region.

"What's going on in Bahrain is much beyond our Western allies [ability] to understand," he said. "It is a complete conspiracy of the Iranians in the region...The European and U.S. positions are unable to imagine the extent of Iranian intervention in Bahrain."

"It's a matter of political disagreement—not a matter of resources—between the Gulf states and the Europe and U.S.," Mr. Buainnain said. "The position of the Europeans, especially the United States, towards Bahrain—really, this is something that is very scary, and it's not encouraging," he said.

Mr. Buannain didn't specify which policies the U.A.E. objected to. But the U.S. warned against the use of violence during the recent crackdown on protesters in Bahrain, and urged both sides to reach a negotiated solution.

On Sunday, Qatar became the first Arab nation to join international action against Libya's Col. Moammar Gadhafi, saying it was sending fighter jets to Libya to help enforce the U.N. resolution calling for an international military intervention to impose a no-fly zone over the country.

There has been speculation that the U.A.E. would send military assistance as well, though late Monday the country said it is playing a purely humanitarian role in Libya by delivering aid supplies. The U.A.E.'s role is "strictly confined to the delivery of humanitarian assistance," according to a statement carried on the state news agency.

The U.A.E had taken a leading role in the calls for action in Libya, hosting a meeting of the Gulf Cooperation Council in Abu Dhabi on March 7 at which the six-member bloc of Gulf Arab nations urged the international community to enforce a no-fly zone.

The U.A.E. Ministry of Foreign Affairs didn't immediately return requests for comment Tuesday.

Bahrain's Sunni ruling family has for more than a month battled protests led by its largely-Shiite opposition, leading King Hamad bin Isa Al Khalifa to declare a three-months state of emergency amid rising sectarian tensions on the Gulf island kingdom.

Last week, Saudi Arabia and other GCC states including the U.A.E., sent security forces to Bahrain to help quell the ongoing protests. Soon after the Gulf troops arrived, Bahrain launched a violent crackdown on the antigovernment protesters, clearing them from the capital's financial district and the Pearl roundabout, imposing a curfew and banning all public gatherings.

On Monday, Bahrain's King Hamad said a foreign plot against his state had been foiled—presumed to be a reference to Iran—and thanked troops brought in from neighboring Saudi Arabia and the U.A.E. to help keep security. Iran has condemned the arrival of foreign troops in Bahrain.

Mr. Buainnain said the U.A.E considered Bahrain's security "an extension" of its own security, and sees it as a top priority. He also said Bahrain risked turning into a third center of Shiite extremism in the Arab world, in addition to the presence of Hezbollah in Lebanon and the Houthi group in Yemen.

His comments follow warnings by GCC Secretary General Abdel Rahman bin Hamad Al Attiyah Monday, at the same conference, that the Gulf states reject any foreign intervention in their affairs, including by Iran.

Mr. Buainnain, a former U.A.E. fighter pilot who rose to head the air force, retired in 2006. He is now president of the Dubai-based security think-tank, the Institute for Near East and Gulf Military Analysis."

*Note: bold and italics emphasis added above

Nero Would Be Proud

From Today's FT:

Inside Obama’s not-at-war room
By Robert Shrimsley
Published: March 16 2011 21:49 | Last updated: March 16 2011 21:49
The leader of the free world is debating Libyan intervention with his closest advisers.

Obama: So what are we going to do to support the Arab democrats?

Which ones.

The ones in Libya. They are taking a shellacking.

Actually, Mr President, our intelligence has classified it as a hammering; Secretary Gates is not ready to upgrade it to a shellacking.

When will he be ready to do that?

After they’ve been crushed, sir.

Shouldn’t we be helping democrats against a brutal dictatorship?

Are we sure they are democrats, Mr President?

Second aide: Didn’t we do this meeting last month?

That was Egypt. . . or Tunisia.

Obama: Well, that seemed to work out; what did we do then?

We positioned ourself carefully behind the curve and immediately backed whatever had happened the day before. It was cost-effective and it worked, sir. Your strategy of protracted hesitation has paid dividends in a number of theatres.

David Plouffe prefers to call it the evaluate-and-decide strategy.

I apologise Mr President, I thought that was our Afghan strategy. I understood we’d moved on to an “evaluate and then evaluate some more” strategy here.

The forces in Benghazi may only have a few days left.

Yes Sir, the Secretary hopes this problem will be off your desk by Friday.

So don’t we need to act now? What about a no-fly zone.

Secretary Gates is strongly in favour of a no-fly zone, Mr President. He says all talk of intervention must be shot down immediately. He advises we do all we can to assist the rebels short of actually helping them.

I have spoken out many times on the need for Gaddafi to go.

Yes Mr President, Secretary Gates has long felt that your words can speak louder than our actions. He added that should you wish to make an inspiring speech on the matter, he’d very much like to be there.

Obama: What are the risks of intervening in Libya?

The risk is that we face another Iraq where we are dragged into a foreign war from which we cannot extricate ourselves. What’s more, there’s also strong evidence that democrats would not support it.

Really, which democrats?

The ones in New Hampshire, Sir. There is also the issue of double standards Mr President. Can we be seen to support rebels in one place while acquiescing in their suppression somewhere else.

We must back hope against fear; fright against might; the oppressed against the oppressors.

Is that everywhere, Sir, or on a case by case basis?

Which case did you have in mind?

Libya.

Yes.

Bahrain?

I see your point.

As you know Mr President, the Saudis have already gone in to quell the protests in Bahrain. They will not let the Crown Prince fall.

That doesn’t sound good. What influence can we bring to bear?

We’ve told the Saudis to use restraint, Sir.

What does that mean?

They’ll try not to kill anyone on camera and restrict brutal crackdowns to the hours of darkness.

That seems a measured approach. We must be careful about the signal we send to our ruling friends and allies in the region. They need to know we will not desert them in their hours of need; that America is a true and loyal friend. They need to know that we will not cut and run at the first whiff of trouble.

No Sir.

We want them to know that we only cut and run when trouble hits at least its second or third whiff.

Yes Mr President.

OK, now what am I going to do about the Europeans. David Cameron is leaving lots of messages with my secretary. I’ll have to get back to him sooner or later.

The Brits are pressing for a no-fly zone over Libya.

That’s pretty easy to do when you’ve abolished the Royal Air Force What’s he planning to police it with, a British Airways 737? Thank you for joining us on this routine patrol; we will be circling Benghazi for a few hours. Insurgents are invited to help themselves to snacks and drinks from our trolleys.

The French are also demanding actual intervention, Mr President.

We’re being out-hawked by the French?

We think it’s empty rhetoric, Sir.

I’m being outgunned on rhetoric?

The (Fed) King's Speech

Lionel Logue: [as George "Berty" is lighting up a cigarette] Please don't do that.
King George VI: I'm sorry?
Lionel Logue: I believe sucking smoke into your lungs will kill you.
King George VI: My physicians say it relaxes the throat.
Lionel Logue: They're idiots.
King George VI: They've all been knighted.
Lionel Logue: Makes it official then.

“We have seen increasing evidence that a self sustaining recovery in consumer and business spending may be taking hold.”
Fed Chairman Ben Bernanke
Congressional testimony, March 2011

There are two major issues equity investors are currently struggling with. The first is the obvious one: the price of oil. The second is one that I raised months ago at each and every Market Forecast event (10 of them) that I conducted throughout the US: will the US economy reach what economists call “escape velocity” and achieve a sustainable, private sector-led economic expansion WITHOUT the aid of government stimuli? Apparently, our esteemed Fed chairman has answered that question. Let’s hope he’s right.

Let’s hope that:

• The US consumer is capable of spending beyond his/her means, a fact that becomes that has been made all the more difficult as middle income wages have stagnated for decades, that the ability to borrow is now limited to non revolving (as in autos) credit versus other sources, such as revolving (credit card) and home equity withdrawals (see Monday’s Consumer Credit report for the latest installment of this reality), and that the need to continue to repair their balance sheet (deleverage, a/k/a save more, spend less) is combined with the need to prepare for a world of reduced government support (cuts to Social Security and Medicare, for example) looms on the horizon.
• US based corporations decide it’s time to unleash their nearly $2 trillion cash horde on capex projects in the low growth/high cost US and not in the high growth/low cost emerging markets.
• High growth/low cost emerging market governments allow US based companies in to the detriment of their domestic companies, not to mention their emergent, large, multinational competitors.
• Cut backs at the state and local level don't more than offset a prospective hiring and wage increase binge by US companies.
• The US dollar doesn’t crater to new all-time lows thereby driving up longer-term interest rates.
• The unrest and turmoil in North Africa doesn’t leap frog over the Suez Canal into the oil rich, Western friendly despotic kingdoms of the Middle East thereby driving oil prices to record levels.
• The structure of the markets doesn’t produce a financial crisis courtesy some financially engineered Frankenstein ("It's alive!") product, service, or process that few truly understand.

This partial list of concerns is the tip of the iceberg. The full list is a long one. But that’s what bull markets driven by tons of liquidity and constructive earnings results* are supposed to look past. Or, so it's said.

Investment Strategy Implications

Stock market dogma states that a bull market climbs a wall of worry. However, when that wall has lots of grease on it and given the interconnected, interdependent, rapid transmission nature of our globalized world, any slip can turn into a self-reinforcing downward tumble in a very short period of time.

Hope is not a strategy but in the end it may be what this bull market largely rests on.

* The one truly bright spot, that may have run its course with its cutting, management and technology efficiency benefits. Is there more blood that can be wrung from the cost cutting efficiency stone?

Note: Many of the above points were expressed yesterday when I appeared on foxbusiness.com. To view the interview on my media blog click here.

Seeing Is Not Believing

Confused over this morning’s initial US stock market reaction to the poor employment data? Don’t be. Here’s why:

In the eyes of the cyclical bulls (who currently rule today’s market thinking, with the underperforming momentum lemming hedge funds in tow), the poor employment numbers are a twin win for the following two reasons:

1 – The Fed’s dual mandate includes the goal of full employment. Accordingly, QE2 is headed the economy’s way. This ensures another flood of money thrown at the problem, much (most?) of which will bleed its way into the financial assets.

2 – Today's employment data is the last report before next month's mid term election. Anything that damages the reviled party in power, the Democrats, enhances the chances of a Republican win next month. Gridlock will ensue, something the cyclical bulls believe is good for the economy and markets.

From a corporate profits perspective, third quarter results will be just fine – at to slightly above consensus expectations. This will provide the expectational foundation for future earnings results at consensus expectations at a minimum, which puts the 12 month forward operating earnings outlook for the S&P 500 at or above $84.

With an above average P/E of 17, the future fair value of the S&P 500 is 1428, or 1286 in today’s market.

Seeing Is Not Believing

Other than 3Q10 earnings results, I do not subscribe to any of the above views as presented but offer them as the rationale for this morning’s initial stock market action. That said, the technical analysis deterioration noted over the past weeks (see blog postings below) is unchanged. Unless reversed, a 3 to 5% stock market pullback is likely.

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The Real Problem With Obama

Let me cut to the chase: It’s not about Mr. Obama’s capacity to show emotion beyond a clenched jaw that is missing. It’s about his capacity to lead. Just because someone has the title of leader doesn’t mean he/she is a leader.

In his media book tour for “The Promise”, author Jonathan Alter notes how impressed he was with Obama’s ability to manage the job – to synthesize the information and make an informed decision. This is no doubt due to his God given abilities. But it is also no doubt due to his educational training.

Mr. Obama is an excellently trained Harvard business manager. One of the attributes of a good manager is the ability to work for incremental improvements. Another is to be quite pragmatic. Mr. Obama has both qualities, so eloquently combined in Frank Rich’s commentary this past Sunday – incremental pragmatism. And therein lies the rub.

Being an excellent manager means espousing phrases like “don’t the perfect be the enemy of the good”. Stop and think about that phrase for a moment, then ask yourself if that is something that a leader would ever articulate as the centerpiece of his philosophy?

Perhaps a Chicago trained politician might hold such a core view. Certainly a well trained manager would. But a leader?

Then And Now

An earlier Harvard trained President once faced a crisis involving life and death global implications. Having learned his lesson in relying on the experts around him from a prior episode, this President bucked his experts and literally saved the world from a nuclear holocaust. In the process, a metamorphosis occurred in which the man became the leader he was destined to become. He became The President.

For this young man, it was lessons of The Bay of Pigs that taught him to vigorously question his experts and to chart an innovative solution both in process and outcome. He learned to lead. For the current young man occupying the White House, it is The Bay of Rigs that is testing his mettle.

Hopefully this latest crisis will enable Mr. Obama to find his gut, to transcend the moment, to articulate a world to be, to envision a man on the moon within this decade, to demand that Mr. Gorbachev tear down this wall, to reassure that we have nothing to fear but fear itself, to lead. Then, Mr. Obama may, just may, become President Obama.

A Stock Market Correction Hanging In The Balance

Stock market corrections, such as the one we are currently experiencing, are healthy processes by which excesses generated in the advance can be wrung out and rotational (sector) change can evolve. In the process, new leadership emerges thereby helping to elevate the renewed rally to higher levels. There is, however, another evolutionary factor that investors should be mindful of: a correction that could easily evolve into a transitional phase resulting in a market reversal.

One way this transitional phase can occur is when a market correction is succeeded by a failing rally which then morphs into a distributional range from which more market weakness is developed culminating in a market reversal. I referenced one such version of this in last week’s post (“37.17”). While this process is underway, those in favor of the preceding market trend (in this case, a bullish one) argue for a continuation of the preceding good times. In the process, further distributional market action occurs. And when the market decline begins in earnest, the market believers continue to dismiss the move.

Will this occur in the current market conditions? It is too early to say for certain, but for the moment the benefit of the doubt must be given to the bull case for the following reasons:

The fundamental argument for a resumption of the bull after the correction is anchored in optimistic earnings growth levels (S&P 500 operating earnings of $80 and $88 for 2010 and 2011, respectively) coming to pass AND for average to above average P/E ratios (15 to 18) being applied to such earnings. For both issues to occur, an economic slowdown in the US and Europe coupled with a only modest decline in China’s growth rate is one key ingredient*. A second ingredient is for little to no serious surprises in the geo political realm. This would include any exogenous shocks, such as a massive terrorism act. It would also include governments that are overly fractured due to the consequences of domestic politics (e.g. the US mid term elections).

A third ingredient would be for longer-term interest rates (5 and 10 years) to remain range bound and neither decline nor increase substantially as either move would imply deflation or inflation. Both will likely be most unacceptable to investors – the former for the implications of a collapsing pricing structure for businesses (not to mention the risks to monetary policy, among other risks), the latter for the implications of a higher cost of capital (among other factors, and not excluding the possibility of a stagflationary environment).

A fourth ingredient has to be the unforeseen and unintended consequences emanating from the final financial regulatory reform bill and/or overly aggressive action by the regulators. Since virtually no one can predict how far the financial tentacles reach from financial innovation products and processes into the real economy, this is a substantial unknown that goes far beyond just the financial services industry and must not produce yet another macro financial services industry surprise (that ends up negatively impacting the real economy).

In sum:

• Sustained economic growth (albeit at very low rates in developed economies)
• No geo political or exogenous shocks
• Stable longer-term interest rates
• No unintended consequences from the new regulatory regime

If any of the above four items fail to live up to expectations, the fundamental arguments for a resumption of the bull market must be reexamined.

Investment Strategy Implications

When it comes to stocks, it must be assumed that the old Yogi Berra adage, “It ain’t over ‘til it’s over”, applies. The above four items could deliver and the current market correction will be all she wrote. Markets get in gear again and higher highs are confirmed. However, if any of the above falls short, the fundamental justification for higher stock prices is in jeopardy.

From a market intelligence perspective, until there are clear signs of a market reversal (a Mega Trend reversal being the most significant), it is advisable to operate on the assumption that the correction will be just that – a correction – followed by a resumption of the trend in force. That said, investors are advised to be ever vigilant for signs of market deterioration and the aforementioned items as the fundamental story hangs in the balance. And that goes a long way toward explaining the contradictory and conflicting market action of late.

*China's growth must also evolve to a more demand driven model and away from fixed investment and exports, both of which are unsustainable for China and, importantly, the global growth story. Corporate profitability needs to remain at their current levels, something that appears to be quite achievable.

We’ve Seen This Movie Before

The dramatic news on Friday (re Goldman Sachs) has a more narrow impact (directly on Financials) and a far more limited impact on the broad market as the economic recovery and its sustainability are significantly more important to equity prices overall.

The limited broad market impact would be for Financials to begin to struggle and potentially produce a negative contribution to higher prices. However, the likely offset is a rotation away from Financials and into other sectors where less governmental activism exists. This is similar to what occurred with the Healthcare sector, as the debate became law. Healthcare stocks may have underperformed but the overall bull market remained intact. The same is very likely to occur going forward re Financials and the broad market.

Concerns re an activist government (greater regulation, lower profit margins) appear to be somewhat overblown. The Obama administration's axiom – “Don’t let the perfect be the enemy of the good” – demonstrates both a pragmatic approach to issues and no intention of destroying whole industries and the companies within, the histrionics of the right wing opposition notwithstanding. The price that is being asked to be paid (in the form of greater/tighter/smarter regulation) appears to be a very reasonable one given the economic debacle that succeeded the more laissez-faire approach to regulation.

What may be some concern to investors is the masterful manner in which the Obama administration has finessed their opposition. In a series of events that can only be viewed a classic Clintonian, consider what occurred the past week:

• On Wednesday (April 15, 2010), President Obama meets with congressional leaders at the White House to discuss financial regulatory reform.
• Senate Republican minority leader Mitch McConnell (providing an outstanding example of Pavlovian behavior) steps out of the meeting (fresh from his recent sojourn to the titans of Wall Street) to declare that President Obama is on the wrong side of this issue.
• On Friday, the Securities and Exchange Commission charges Goldman Sachs with investor fraud.

At this point, someone needs to hand Senator McConnell a towel to wipe the egg off his face.

This week, more bank earnings results will be reported, including those from none other than Goldman Sachs (Tuesday, April 20th). The results are sure to further inflame the public outcry re bank bailouts and buttress the efforts of the Obama administration and the Democrats to push through financial regulatory reform.

The consequences of a victory in financial regulatory reform will have repercussions in this fall’s midterm elections. Moreover, it is the manner in which Obama handled the Republicans this time around that is yet to be fully digested by most investors (think Bill Clinton and his famous triangulation strategy). It does appear that the Obama administration (and President Obama, in particular) have relocated their political voice and have combined that with a governing style that needs to better appreciated by investors.

Investment Strategy Implications

Right now, what matters more to equities is the global cyclical recovery. The challenge will be whether the economic handoff (from government spending to sustainable private sector growth) can truly occur. That is a question that still remains to be answered. Despite the solid earnings results of 4Q09 and thus far from 1Q10, it is hard to determine whether growth can be sustained without the life support mechanisms put in place by governments around the world. And the growth in debt, the extraordinary and inventive governmental actions (quantitative easing, for example) and the generous amounts of liquidity cannot go on indefinitely.

The longer-term structural problems (e.g. debt levels, consumer demand in emerging economies, imbalanced domestic growth policies in key emerging economies (notably China), the currency straightjacket on weak economies within the Eurozone, among others) along with the aforementioned Obama’s emergent political skill wait in the wings and may become the rationale for the long overdue market correction. These fault lines are to be monitored closely for signs that they will become the focal point for investors. This is where market intelligence earns it pay*.

In the meantime, the excess liquidity and encouraging cyclical growth remain center stage for most investors. A clear case of the cyclical over the secular. Accordingly, there is little reason for investors to move to the sidelines and adopt anything more than a cautiously bullish position. There will come a time for a more aggressively conservative view. That time does not appear to be now.

*The absence of traditional investors is also a worrisome sign as trading continues to be dominated by the fast money crowd. More on this in a future posting.

Doing the Valuation Math

Now that my market forecast events have begun (with NYSSA's event last Thursday), it's time to do a little valuation math for the year ahead. So, based on the initial comments heard at last week's event and elsewhere, here you go:

18 times $80 (S&P 500 operating earnings for 2010) = 1440.
1440 minus a present value discount (12%) = 1267

This is the bulls’ case for why stocks should go higher this year – an above historical average P/E times a robust earnings growth for 2010 minus an historical average discount rate (bringing the future value back to the present*) equals a most profitable year.

The valuation debate is a paradox – simple yet complicated. Simple in that the formula is rather easy to compute. Complicated in that the social science known as investing involves numerous variables, many of which are highly subjective. For example, the P/E used in a valuation model is based on the views of the investor for the economic and market times of the moment and the near future. In the current case, the bulls would argue that an above average P/E is appropriate for the current and near future because history says so – low inflation + robust economic growth + strong corporate balance sheets = above average P/Es. Exactly what level above the historical average P/E (which happens to be 15) is the subjective wiggle room and a key area of the valuation debate. Then there is the earnings number.

$80 operating earnings for the S&P 500 for 2010 is the best case number I am hearing of late. Of course, this number is open for debate. The final two components that investors might want to ponder doing the valuation math involve the discount rate and the time period.

In the above illustration, I used the historical average return for large cap stocks, which has often (but not always) been 12%. Some would argue that 10% (or lower) is a more appropriate going forward expected return for stocks given the slow growth environment envisioned for the next several years for advanced developed economies. Then there is the time period one discounts the future value. In the above case, I use 12 months. Some might argue things are far to dynamic and a 6 month discounting time period is more appropriate.

Investment Strategy Implications

Wherever you fix the fair value of today’s market, the valuation math always needs to be done as it provides the return context for an asset. For what it’s worth, I think these times are extraordinary and do not warrant an above average P/E (which signifies a below average risk climate). Rather, I would argue the uncertainty factor for 2010 is considerably higher than the bulls believe, despite the prospects of a robust earnings period for the large cap, multinational companies that populate the S&P 500. Risks in areas broad (e.g. geo political, US domestic political, developed economies’ internally generated growth) and specific (e.g. sector specific issues such as those facing the financial services and healthcare industries, sustainability of Chinese growth, regulatory change) are abundant and should be ignored at one's financial peril.

All of this leads to the more prudent conclusion that an average P/E times a moderately higher earnings growth rate is appropriate. In other words,

15 times $74 = 1110
1080 minus 12% = 977

Therefore, at today’s price of 1140 the market is currently 14% overvalued.

Liquidity driven markets have a funny way of producing overvalued markets. And an even funnier way of producing justifications for just about any fantasy valuation levels one wants to concoct. At least for a while.

*Note: It is important to remember that on any given day stocks sell at a discount to their expected future value. Therefore, today’s price is always a discount to where stocks should be in the near future.

Divergences on the Horizon

To help visualize key aspects of the commentaries posted on this blog recently, the accompanying 2 charts illustrate important patterns that investors should keep a close watch on.

The first chart* covers the price action since the early March lows of this year for the three major US style categories – Mid (MDY), Small (IJR), and Micro (IWC) cap – and perhaps the single most important non US market, China (FXI). What is quite clear is that the higher risk categories have outperformed the lower risk, larger cap group S&P 500 – SPX) by a considerable margin. This is what is known in many circles as the beta trade: higher beta = better performance.

The second chart shows the beta trade continuing over the past three months, but not for all indices tracked. The beginnings of a meaningful divergence appears to be underway with China as price performance has begun to trail the four predominantly US indices.

Investment Strategy Implications

What you want to keep your eye on is any more substantial divergences between the big boys (SPX) and their lower quality/higher risk brethren and various global markets. As noted in last week’s commentaries, I expect such divergences to begin to emerge as earnings seasons unfolds and reveals an underwhelming performance by the higher risk US companies (represented by MDY, IJR, and IWC).

The wild card is the other index listed – China. I am in the camp that is more than a touch reluctant to drink the “China is great, no problem here” Kool-aid – a fact that the price action of the index may reveal in the coming months.

*click images to enlarge

Wanted: Gene Krantz

There’s this one moment in the movie Apollo 13 when mission control manager Gene (failure-is-not-an-option) Krantz, frustrated by the steady stream of bad news, asks his colleagues to identify what is working on the crippled spaceship. From that starting point, from that solutions oriented point of view the process of rescue begins for the mission and crew. Which brings us to the current economic malaise.

In the current climate of all misery and all doom, in a world where nothing seems to work and crooks and incompetents emerge daily, perhaps someone should take the lead and begin to ask the same type of questions and, with the same determination that Mr. Krantz had, apply it to the US and global economy and thereby begin the transformation process from what is wrong to what is right, what is working, and with something that resembles a failure-is-not-an-option attitude.

Frankly, I am sick of listening to the Dr. Doom’s of the world prescribe their vision that the only medicine the world economy needs is an even more bitter elixir. What happened to the can-do spirit of America? What happened to focusing on what is working? Where is that solutions oriented process that includes some out of the box thinking? Too much myopic, woe is us, bureaucratic thinking and not enough innovation, what’s working, and let’s fix and not fiddle around the edges.

This is not to say that problems should be ignored. Nor am I suggesting that the problems are easy to solve. But, give me a break, for as complex as CDS and CDOs might be, they can’t be more complex than the human genome. And they certainly cannot be more pressure cooked than saving three lives in a crippled spaceship.

Where’s Gene Krantz when you need him?

“Buy America” = Protectionism

If you are looking for one subject that will tilt an already precarious world economy toward a very bleak future, it is the "Buy America" provision of the stimulus bill currently under negotiation. For nothing in the stimulus bill – not the ill-advised earmark pork of the power starved liberal Democrats, not certain suspect components of the business tax cuts favored by Republicans, not the not-shovel-ready infrastructure spending – is more threatening to the global economy than the “Buy America” provision.

But don’t just take my word for it. Consider the warning from the EU today. Or British Prime Minister Brown when he “warned gravely against "deglobalisation" and denounced trade and financial protectionism.”

* What signal does “Buy America” send?
* How are other countries faced with economically-derived internal strife likely to respond?
* What are other countries that provide capital to the US likely to do?

While not exactly Smoot-Hawley, it is a big step toward closing the door on the prosperity that trade and globalization facilitates. Moreover, it generates more issues and problems precisely at a time when cooperation and communication matter most. And, in the process, how Mr. Obama handles this issue will speak volumes as to his governing style.

Investment Strategy Implications

At my first five Market Forecast events conducted thus far this year and on these pages*, I have raised the larger economic question, “What will be the economic philosophy that follows the death of laissez-faire, American-style cowboy capitalism?” Heaven help us if the answer includes protectionistic measures like “Buy America.”

*see Jan. 13 & 17 postings

Geithner’s Opening Blunder – China Bashing

As refreshing as the activist tone and tempo of the early days of the Obama administration may be, there is a developing uncertainty as to exactly what is the philosophy of the new administration? Take, for example, the nexus of foreign and economic policy and the comments made by recently confirmed Treasury Secretary Geithner.

What is Mr. Geithner trying to convey when he states that China is “manipulating” its currency? What is the strategy and gamesmanship behind rhetoric that can easily be construed as having a protectionist sound to it?

At a time when the threat of a global beggar-thy-neighbor mindset could develop between and among nations pressured by their citizens (leading to protectionist actions, such as the one the toy industry in India just instituted), it seems quite imprudent for a high US government official in a brand new administration whose philosophy is not quite fully disseminated to be making accusatory statements about one of the world’s most important countries.

The activist tone and tempo of the Obama administration is clearly designed to quickly seek the high ground in the battle to change the game of the political status quo. And who can blame the President. The economic stimulus package is a perfect example of the competing forces at work, with the result almost certainly being the equivalent of an economic camel – a horse designed by a committee. Therefore, getting a jump out of the starting gate does seem to be a rational tactic. However, as shown in business, the first mover advantage may not be sustainable, particularly when so many forces are aligned against change AND the advocates for change may not be completely prepared for all contingencies, including the inevitable unintended consequences.

Investment Strategy Implications

There’s a great moment in the acclaimed HBO series “John Adams” when Ben Franklin advises the volatile Mr. Adams against publicly attacking someone who disagrees with him. “He might think you are serious”, cautions Mr. Franklin. Perhaps the Treasury Secretary should heed such advice. Or, maybe the implied no-drama Obama administration is just a campaign slogan.