Financial Skeptic Bulletin, April 2007
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|"The purpose of studying economics is not to acquire a set of
ready-made answers to economic questions, but to learn how to avoid
being deceived by economists."
Joan Robinson, Cambridge University
My take on this whole situation?
The U.S. is certainly not in recession. But the ongoing problems in housing
are acting as a big drag on growth. Meanwhile, global economies
are going on their merry way without us and inflation remains above the Fed's
I've heard the "Stagflation-lite" label bandied about to describe
where we sit. I think that's right on target.
Guest's comment about unemployment is a bit off the mark. I
well recall that during the past Clintonoid Administration, rising unemployment
figures were hailed as meaning that inflation was being contained. This is one
of the many strange things that make me doubt the scientific basis of much that
passes for economic analysis. If wages for Joe and
Sally Sixpack rise, this is inflationary and hence evil. If corporate profits
(corporate wages) and/or management compensation rise, there is no inflation,
and this is wonderful. If interest rates rise for those imprudent
enough to actually try to save some of their money, this is bad since it indicates
that capital is not being put into productive immediate consumption. And if
stock and real estate prices rise, this is wonderful and not inflationary, unlike
the effects of increases in commodity and energy prices.
I suspect that much of this strange outlook is explained
by the old adage that he who pays the piper calls the tune.
Harry Truman claimed to be looking for a one-handed
economist. I would be happy to read one who was not a banking or corporate shill.
Professor Roubini seems to be independent enough to fill the
bill, unlike all to many of his fellow economists, and catches considerable
flak in the process of telling the truth as he sees it.
It looks like not only Iraq war and speculation propelled stocks.
The biggest buyer is the corporate sector itself. According to Tim Bond, of
Barclays Capital, American companies acquired (via takeovers and buy-backs)
some $602 billion of shares last year. In the fourth quarter, the pace
of purchases was running at an annualized rate of 6% of the entire market.
... ... ...
Mr Bond says this equity-buying splurge is almost exactly matched by
the corporate sector's financial deficit—in other words, companies are borrowing
money to buy back shares. This gearing up of the balance sheet is occurring
when profit margins are at their highest level since the 1950s. It looks like
... ... ...
If business conditions are getting more difficult, a bit of
financial engineering will help. Buying back shares with borrowed money boosts
earnings per share, so profit growth can continue to look healthy. That was
an important driver in the final stages of the 1990s bull market.
... ... ...
As Mr Roche puts it: “Credit derivatives are like good things
to the Catholic Church. If you have too much of them, they're a sin.” Nobody
will be sure how robust credit derivatives are until they have been tested in
a severe economic or financial downturn. And that is not something anyone should
A new president will still deal with housing slump -- expect it
to continue till 2008. The problems of the US housing market is a one huge problem
for the future president be it Obama, Hilary or Bloomberg.
Stricter lending standards will reduce demand for housing by
10% this year from where it would have been had credit remained loose, estimates
Thomas Lawler, a housing economist in Vienna, Va. He expects housing prices,
as measured by the national S&P/Case-Shiller index, to fall 7% in the fourth
quarter of 2007 from the year-earlier level.
Most of the wrong decisions investors make, behavioral research
has shown, stem from overconfidence....
Justin Fox wrote, long ago:
Is The Market Rational? No, say the experts. But neither are you--so don't go
thinking you can outsmart it. - December 9, 2002:
[T]he argument of modern behavioralists includes
a crucial observation that wasn't in Keynes--that professional investors are
now under so much pressure from their customers that they cannot make the kind
of long-term bets that might beat the market. If they do, as
was the case with a lot of value-oriented mutual funds in the late 1990s, they
can soon find themselves without any customers' money to invest. That gets us
to a world in which an investor with enough staying power and contrarian gumption
can beat the market, but the vast majority of mutual funds and hedge funds don't.
The modern gilded age is in full swing
With the modern gilded age in full swing,
hedge fund managers and their private equity
counterparts are comfortably seated atop
one of the most astounding piles of wealth
in American history. Their ascendancy has
been aided by an inflow of money from pension
funds and other big investors, robust markets
and fee-based compensation that can produce
staggering amounts of individual wealth.
look upon these masters of the new universe
as this generation’s robber barons, using
wealth to create wealth, often in secretive
ways, and leaving little that is tangible
in their wake. Others view
them as new-economy financiers, evoking
the likes of John D. Rockefeller or John
Pierpont Morgan as they provide liquidity
to the markets and broadly diversify risks
in the banking and financial systems.
“You had railroads in the 19th century,
which led to the opening up of the steel
industry and huge fortunes being made,”
said Stephen Brown, a professor at the Stern
School of Business of New York University.
“Now we’re seeing changes in financial technology
leading to new fortunes being made and new
dynasties created.” But as hedge funds and
their private equity brethren begin to emerge
more onto the public stage — playing increasingly
bigger roles in art and cultural circles,
tiptoeing into the Washington lobbying game,
and even selling shares of their own firms
to the public — all aspects of their activities, their
own compensation in particular, are raising
“There is some question as to what the
hell they are doing that is worth” that
kind of money, said J. Bradford DeLong,
an economist at the University of California,
Berkeley. “The answer is damned mysterious.”...
Those who invest in a bubble at its peak are great public benefactors:
they help to fight inflation...
invest in a bubble at its peak are great
public benefactors. They
give away all their money, and we get the
organizations, the producers' durable equipment,
the inventions and innovations, and the
structures that their money paid for. On
top of that the rest of us build the economic
growth of the post-bubble generation.
But there are no testimonials or plaques
to these great philanthropists--the investors
in Insull's utility empire in 1929
or in Cisco
in late 1999. They are unknown
to the rest of us.
Daniel Gross (2007), Pop: Why
Bubbles Are Great for the Economy
(New York: Collins: 0061151548)
The Short View
By John Authers
Published: April 26 2007 03:00 | Last updated: April 26 2007 03:00
Needed: one bucket of cold water. The Dow Jones Industrial Average, the world's
best-known stock market benchmark, passed 13,000 for the first time early yesterday.
It was a symptom of the air of optimism in Wall Street. But ultimately a landmark
for the Dow signifies little or nothing.
This column has addressed the Dow's technical limitations before. It is weighted
by share price, not market value, so the biggest companies do not have the biggest
impact. A third of the 1,000 index points by which the Dow has increased since
it passed 12,000 last October came from just four companies - Altria, Boeing,
Honeywell and ExxonMobil.
It is not even a true benchmark for "mega-cap" large companies. These are under-performing
but you need the Russell Top 50 index, up only 1.6 per cent this year, compared
with a 4.2 per cent rise in the Dow, to tell you this.
Its defenders point out that the Dow continues to be correlated closely with
the S&P 500, by far the most important index in terms of the money linked to
it. But that acknowledges the importance of the S&P, which needs to grow only
2.7 per cent to set its first record high since 2000 - a much more important
Ironically, another Dow Jones benchmark set up at the same time as the Industrials
may be more interesting. The 20-stock Transportation Average is also at a record
high. It is up 14 per cent for the year - 10 percentage points better than the
Transport stocks are highly exposed to the global economy, and a joint high
for Industrials and Transportation is traditionally viewed as a very bullish
indicator. It at least suggests that if there is a risk at present, it is of
overheating, not a slowdown. That, maybe, is of some interest.
Copyright The Financial Times Limited 2007
Written by Ryan Darwish
on 2007-04-26 13:56:40
Taking out the volatile aircraft orders here is what the series
looks like, as % change from prior year:
It was as high as +9.3% at the top, back in July 2006.
Re: durable goods orders
I have a couple of charts up showing the progression of such orders, minus the
volatile aircraft series. Not hot.
They can be found at:
Reader response from Wednesday's Currency Currents showing
the S&P Index relative valuation to the US$ Index:
I think you are not looking at the coupling of the S&P and the dollar correctly.
The question "are stocks too high or is the dollar index too low" cannot be
If the dollar drops in value, being a fiat currency, things that have real intrinsic
value must rise in dollar terms - this is seen with
oil or gold. Since the S&P has risen as the dollar falls, it
only proves that stocks have an intrinsic value independent of the currency
they are traded in. IBM still has the same value whether purchased in terms
of euros, yen or dollars, so as the dollar falls it would still be in demand
from investors with a more valuable currency.
A more interesting graph would be the S&P change
in relation to gold or a basket of commodities (since individual commodities
would be subject to more volatility). My guess without doing
the work is that it has risen, but not to the extent shouted by the newswires.
Maybe, after these adjustments of true valuation, the stock market is not at
an all-time high, or not as high as we would like to think. From EK
Thank you, Ed! They were great points. So we have included the S&P 500 Index
divided by the gold weekly chart below for your review. And Ed is exactly right.
In terms of gold, the S&P 500 Index isn't anywhere near its old highs …
Reader response on a dollar bounce, liquidity crunch and top in stocks:
But for us the level of risk has risen considerably more.
I am therefore calling this to be the secondary top (in stocks). It will be
followed by a violent move down. The hypothesis remains the same.
We are heading toward a liquidity crunch. I expect US treasury and the US dollar
to rally. The yen will outperform all other currencies.
Not in favor of gold temporarily.
I am a major bull on NatGas, 30yr Treasury, sugar and yen. We rarely advocate
shorting. The last time we did was in 1990 at the top of the Japan mkt.
For us this is unusual but we are going to start
recommending being short the mkt.
I had this funny feeling at the top of the Japanese mkt. I am, however, able
to measure risk with my tools that I did not have back then. I believe a <>
is about to reprice the whole structure of the derivatives mkt.
The repercussions are not measureable because the
size of the market over 400 trillion today has never been tested. Some surprises
are coming. By the way, I rode the euro up along with gold and
both are sold here. Why? If it is a liquidity crunch then we have better buys
a bit later. The anecdotal evidence is building up. People never change.
Cheers from sunny Montreal. From YL
We tend to agree with YL. One of our major concerns, too, is the derivatives
market. Many hedge funds will say it's not that big of a deal - their derivatives
portfolios have been "stress-tested" by the quants. But have we really seen
a market test since hundreds of trillions have been layered on in the last few
years? We noticed that it's not just us worried about this stuff. ECB president
Tritchet made some comments on Thursday (Financial Times) about the lack of
transparency in the derivatives market. He also agreed that yes, derivatives
do spread risk, but they don't eliminate it. And that's the bottom line.
These numbers imply that the ratio of residential mortgages
to GDP increased 50% over the last 15 years, a trend that may have some good
economic explanations though it could not continue indefinitely. But mortgage-backed
securities issued by Fannie Mae and Freddie Mac doubled as a fraction of GDP,
while the ratio of mortgages retained by the GSEs to GDP quintupled. If the
growth in the latter two have indeed been fueled by a
implicit government guarantee, that raises the possibility that much of
this growth would not be justified by economic fundamentals, but may instead
have contributed to a socially undesirable level of systemic financial risk.
from the Wayback Machine web.archive.org
Fannie Mae website FAQ on CREDIT RISK:
Are you taking on more credit risk when you reach into the subprime
market? How will you manage that?
[RESPONSE] To meet its mission
and HUD-mandated housing goals, Fannie Mae does intend to take more
credit risk in the future, but on a limited and controlled basis.
Using our knowledge of how factors relating to a borrower's property
or their wealth and income position interact with their credit history,
the company intends to begin offering credit guarantees on a segment
of the subprime market in a way that broadens our participation
while managing our credit risk.
But less than a year earlier:
Are you taking on more credit risk when you reach into the subprime
market? How will you manage that?
[RESPONSE] Most of the subprime (or "credit impaired") loans
that we have purchased for our portfolio have credit enhancements
that take the credit risk up to the "Triple-A" level. As a consequence,
we have very little credit risk on subprime loans in portfolio.
We have so far taken very little credit risk in subprime loans.
We do intend to take more in the future, but on a limited and controlled
basis. Using our knowledge of how factors related to a borrower's
property or their wealth and income position interact with their
credit history, we intend to begin offering credit guarantees on
a segment of the credit-impaired market -- the so-called "A-minus"
segment -- which have the best loan quality. We will use our underwriting
technology to protect ourselves against losses.
JDH at April 10, 2007 04:55 AM
Being a former accountant, I find the $701B retained
portfolio -- which will certainly be at risk as home
sales and prices continue to move downward, and ultimately
impacting wherewithal to repay mortgages -- offset by
only $28B in equity to be quite 'climatic.'
will be moving to reorganization quite quickly.
It's going to be an ugly,
This leads me to a second question. How does the increasing
dependence upon bond inflows -- even if sourced from the official
sector and quasi-state entities -- inform our thoughts on how
the adjustment to a smaller current account deficit? Some answers
Freund and Warnock's careful examination of 26 current account
reversals in developed economies over the 1980-2003 period:
"...Deficits associated with
greater bond inflows do appear to be followed by larger
increases in interest rates -- perhaps because
the bond inflows kept interest rates abnormally low --
and a sharper decrease in equity
... ... ...
Personally, my view is less sanguine than that presented
in the paper, but if the Freund-Warnock results extend
to the current US process of adjustment, we should expect the
impact to show up in bond and equity markets, with less noticeable
effects appearing in GDP and the exchange rate. It will be interesting
to see if the increased sensitivity of bond capital flows to
interest rates remarked upon in the IMF report further heightens
the interest rate effects -- especially
if the adjustment takes place against a backdrop of financial
turmoil in US capital markets (e.g., subprime market collapse).
Military spending are higher than at the peak of the Reagan
buildup and will keep both inflation and the economy growing.
President George W Bush's proposed increase of 10% for next
year will raise this figure to over half a trillion dollars, that is, $501.6
billion for fiscal year (FY) 2008. A proposed supplemental appropriation to
pay for the wars in Afghanistan and Iraq "brings proposed military spending
for FY 2008 to $647.2 billion, the highest level of military spending since
the end of World War II - higher than Vietnam, higher than Korea, higher than
the peak of the Reagan buildup". 
... ... ...
... Higgs concludes: "I propose that in considering future defense
budgetary costs, a well-founded rule of thumb is
to take the Pentagon's (always well publicized) basic budget total and double
it. You may overstate the truth, but if so, you'll not do so
by much." 
[Apr 19, 2007] For 2000-2007 Vanguard TIPS fund (VIPSX
) returns with cost averaging are equal to stable value fund assuming fixed 4.5%
That means that Vanguard TIPS func (VIPSX)
can be used as a proxy of stable value fund.
If we assume biweekly contribution of $500 TIPS and zero initial
investment then imitational model produces at the end of the period (April 2007)
$93478 for VIPSX and
$92683 for stable value fund.
[Apr 16, 2007] What rapidly rising price of gold means ?
Is this like Churchill said "beginning of the end" (in a sense
that it is a reflection of growing exposal of structural problems of the USA economics)
or just "end of the beginning" ?
[Apr 6, 2007] Has Fed lost control over U.S.
Jubak stated in December 2006 that, “The dollar’s tumble and Federal Reserve
Chairman Ben Bernanke’s attempts to placate overseas investors are the clearest
signs to date that the foreign investors who finance the huge U.S. trade deficit
have gained significant control over the U.S. economy. A few more weeks like that,
and it will be clear to everyone outside of Washington that the Fed has lost control
over U.S. interest rates.” The Fed has two mandates - to manage inflation expectations
and to spur economic growth. According to Jubak, a third one is being adopted.
“Yes, fighting inflation remains important to the Fed, and, yes, the Fed would prefer
not to tank the economy. But Feds have a tough choice: managing the dollar is more
important at this point than managing inflation or growth. That’s because the huge
piles of dollars sitting in the vaults of the central banks of China, Russia, Japan,
the OPEC countries and the European Union are large enough that they make overseas
bankers nervous. When you hold 700 billion U.S. dollars in reserve (out of
a total $1 trillion in foreign-exchange reserves), as the Chinese do, for example,
every penny decline in the value of the U.S. dollar makes you nervous.” in February
Axel Merk is Manager of the Merk
Hard Currency Fund joined the chore of "dollar demise" crowd.
The author seems to predict no recession but little growth...
The key idea: "The emerging market safety valve no longer
works to limit US inflation and, as a result, the US economy has to do more of its
own adjusting to ensure a satisfactory outcome for price stability."
But there has been also a lot of "subprime" allocation of capital
and risk across the past few years outside housing. Are those risks well contained
Let me make a few observations about the US economy. Inflation is rising. The
housing market is declining. The current account deficit is narrowing. And there
is a strong whiff of protectionism.
... ... ...
The emerging market safety valve no longer works
to limit US inflation and, as a result, the US economy has to do more of its
own adjusting to ensure a satisfactory outcome for price stability.
This is proving to be a painful process. The housing market continues to decline.
Problems in the sub-prime mortgage market are not going away. Profits are showing
signs of topping out. And capital spending, often seen to be a bulwark against
a softening housing market, is now declining.
... ... ...
The US is facing too low a growth rate.
Strong growth elsewhere in the world - combined with softer domestic demand
- may be lowering America's current account deficit,
but it's also leaving US inflation too high. If the US
can no longer determine its own economic destiny, it's all too easy for its
electorate - and its leaders - to blame others.
Stephen King is managing director of economics at HSBC
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