Bob Carlson

I’ve long been a fan of closing the Securities & Exchange Commission and replacing it with a completely remade securities regulator. It’s not enough to put new blood among the commissioners and hope for a change. The problems with the SEC are embedded in its institutional culture, regulations, and employees. William Cohan, a former investment banker and now author, writes that there’s new evidence that on its own should be enough to close the SEC. It seems the SEC’s been routinely destroying documents related to alleged wrongdoing that it decided not to investigate.

The SEC has missed almost every major scandal, fraud, and misdeed in the financial markets for decades. When it finally takes action, it’s often too late and too little. It missed penny stock scams, Enron and other accounting frauds of the 1990s, the Internet bubble, everything related to the subprime and hyperleveraging crisis, and much more. Worse, it imposes high costs and restrictions on law-abiding people and businesses it regulated, fully aware that these costs do nothing to make the markets safer or more efficient. I agree with Cohan. Close it.

PIMCO’s Bill Gross is out with another of his monthly investment commentaries. In this one he takes a big picture look at the three main players in the global economy and markets: Europe, the U.S., and the emerging economies, especially China. He focuses on the tensions within the European Union, within the U.S., and between the U.S. and China. It’s a lively, clever, well-written summary of points we addressed in past issues of Retirement Watch. Gross seems to admit being surprised that Treasury yields could fall as low as they have, but cautions that they’ve discounted a lot of bad news at this level and can’t produce good results for either borrowers or lenders. He favors investing in a few strong countries outside the U.S. and considering high-yield global stocks, though he warns there could be more downside to the stocks.

What to do when a love affair goes bad? How should you invest when Euroland is at each other’s throat, when a thinly disguised battle between labor and capital freezes policy action in the United States, when a mercantilistic partnership between developed and developing nations produces more questions than answers, more losers than winners? Increase the odds for a divorce, we’d suggest, which in investment markets means focusing on the return of your capital as opposed to the return on your capital. Of the three rocky relationships, Euroland has the most immediacy. Mohamed El-Erian is increasingly of the persuasion that one or more of the outer periphery (Greece, Ireland and Portugal) may be forced to vacate the premises. If so, technically destabilizing liquidity concerns may affect all peripheral bond markets unless the ECB counters the rush for the exits with an enlarged daily checkbook.

That’s what the U.S. is paying to investors who purchase treasury bonds today. The interest they earn is less than the current inflation rate. The result is a real yield (the nominal yield minus inflation) that is less than zero. People are paying the treasury to use their money. Washington Post columnist Ezra Klein says this is an opportunity for the government to refinance its debt and borrow a lot of money cheaply. That might or might not be a good idea. I’ll let policy makers decide how much they want to borrow and how to invest/spend it.

But this shows how weak the economy is and how little confidence people have in the future. They’re looking for safety at any price. You can see that in treasury bond yields and also in gold. We anticipated this a few months back and added long-term treasury bonds and gold to our portfolios in Retirement Watch. I’m watching closely for when it’s time to exit the treasury bond position with our profits intact, but we’re not there yet. Today’s consumer confidence numbers show people still are gloomy about the future and expecting the economy to slow.

Here are a few items I spotted over the weekend that might interest you:

“Why Gold May Take a Breather” in Barron’s (subscription might be required) presented reasons why gold’s price is too high and is likely to slide soon, perhaps by as much as one third. I’ve been issuing warnings since gold’s recent parabolic rise, which usually precedes a decline. But gold should stay about where it is as long as there are major concerns about currencies and debt in Europe and the U.S.

I support that cause, but what we sound-money advocates would prefer to see must be distinguished from what is likely to happen. The roaring bull market in gold seems ripe for a downside correction—assuming it didn’t already begin with the $100-plus selloff from Monday’s high.

According to the metals-consulting firm CPM Group, if gold were bought only for its industrial and ornamental uses—the attributes that make it a commodity—its price would run about $600 an ounce today. The last time gold saw $600 was nearly five years ago (see chart below), so other factors must have propelled the price to highs of more than triple that level. The main factor has been net buying by investors, aided by the advent of exchange-traded funds that make it easy to acquire the metal.

One of our go-anywhere funds makes the news. Barron’s did a profile of manager Steven Romick of FPA Crescent, which is in our hedge fund portfolio. In the interview, Romick said he’s been buying stocks as they declined the last few weeks. But he wasn’t loading the portfolio with them and is cautious about the U.S. economy and its political process.

It’s tougher to diversify. That’s the message in an article on The Huffington Post. The article points out that this week almost all stocks have been moving up and down together, with a corelation of 0.83, where 1.0 is perfect correlation between individual stocks and the index. Correlations between all assets have been rising. It’s largely because politics and politicians are now major players in the economy and investment markets.

“When you have overriding political considerations hanging over the market, all stocks are going to respond in kind,” said Andrew Lo, a professor of finance at the MIT Sloan School of Management.

“It’s not just stocks. It’s actually all asset classes,” said Lo, who is also the chairman and chief investment strategist of a hedge fund. “The U.S. dollar relative to other currencies, gold, oil and hedge fund returns have now all become very highly correlated.”

Investors continue to flee high yield bonds. Though the bonds usually have a high correlation with stocks, they didn’t participate in  last week’s recovery in stocks, says Bespoke Investment Group. The spread in high yield bonds over treasuries is at the same level it reached in December 2009. It’s likely a sign that investors fear a recession and rising defaults.

We’ve taken a position in our portfolios that will profit from an increase in the value of the Chinese currency. The Chinese government keeps its currency pegged to the dollar, allowing it to rise at a slow, steady rate. This peg is at an artificially low value, designed to boost Chinese exports to the U.S. But the peg is causing domestic problems in China, because economic conditions are very different in the two countries. The use has too much debt and is deleveraging. It has an easy monetary policy and low interest rates to offset some of the effects of deleveraging. But China doesn’t have a lot of debt and is growing rapidly. Because its currency policy means it’s importing the U.S. monetary policy, China is facing bubbles, emerging bubbles, and rising inflation.

Harvard professor Martin Feldstein agrees that China is likely to increase its currency’s value in the future at a more rapid rate than people are anticipating.

A more rapid increase of the renminbi-dollar exchange rate would shrink China’s exports and increase its imports. It would also allow other Asian countries to let their currencies rise or expand their exports at the expense of Chinese producers. That might please China’s neighbors, but it would not appeal to Chinese producers. Why, then, might the Chinese authorities deliberately allow the renminbi to rise more rapidly?

There are two fundamental reasons why the Chinese government might choose such a policy: reducing its portfolio risk and containing domestic inflation.

You should read the entire article. It’s a strong support for our investment position.

Why were so many economic forecasts wrong? Why did all the stimulus measures fail to stimulate the U.S. economy and get it back on track? Vincent Reinhard is an economist often overshadowed these days by his wife, Carmen Reinhart and co-author of This Time It’s Different. But his latest paper for the American Enterprise Institute answers these questions. He argues, as I have in the pages of Retirement Watch, that this is not a typical economic cycle. After an economy undergoes a severe financial crisis, the following years are very different from those following a typical cyclical recession. The recovery takes much longer after a crisis. A lot of mending needs to be done. And the policies that will help the healing are very different. Following the standard policies could make the recovery take longer.

Mean reversion is a pretty good bet to describe typical post-World War II recoveries. But we are not living through a typical cycle. Rather, the United States experienced a wrenching financial crisis, and recoveries from those are lengthy and the subsequent economic expansions are tepid.[3] The paper “After the Fall” looked at the fifteen worst financial crises of the second half of the twentieth century, a sample that includes advanced and emerging-market economies, and focused on economic outcomes in the decade before and after the crises. The median experience of real GDP growth in these countries is plotted as the solid line in figure 3a. (To read the chart, note that the time series for each country has been shifted so year zero marks the onset of the financial crisis.) As is evident, a financial crisis is followed by a severe recession and initially subpar recovery. On average, as indicated by the dashed lines, real GDP growth slows about 1.5 percentage points in the decade after the crisis relative to the one before. With output first contracting and then recovering only hesitantly, the unemployment rate rises and stays stubbornly high. Indeed, in ten out of fifteen cases studied, the unemployment rate does not return to its precrisis low for the entire decade after the fall.

None of the efforts by policy makers designed to improve the economy have been helpful, because they diagnosed the problem wrong.They’re trying the same policy measures that are helpful in a typical credit-starved recession. We’re not in that economic environment. We’re in an overleveraged economy, with households being especially overleveraged. Many in the investment world have diagnosed the problem correctly, but it hasn’t made its way to the insulated folks in Washington. There’s some hope that the message might be getting through Ezra Klein is a mostly-liberal political reporter for The Washington Post I don’t usually read or quote. Today he posted an incisive column titled, “It’s the Household Debt, Stupid.” He summarizes the problem concisely in a way that even career bureaucrats and politicians can understand:

That means that in this crisis, indebted households can’t spend, which means businesses can’t spend, which means that unless government steps into the breach in a massive way or until households work through their debt burden, we can’t recover. In the 1982 recession, households could spend, and so when the Federal Reserve lowered interest rates and made spending attractive, we accelerated out of the recession.

The European periphery countries are at the center of today’s financial angst and the concern over another possible financial contagion. That’s why hte good news from Ireland, one of the peripherals, should be getting more attention. Today, the yields on debt from most of the other PIIGS countries rose. But Ireland’s looking to be in better shape. It’s still not complete, but it is far enough along to attract the attention of the Financial Times. The FT says events in Ireland provide hope that the debt problems in the rest of the periphery can be solved without first undergoing a lot of pain.

As a result of all this growth is starting to re-emerge, even though domestic demand is still contracting. As expansion accelerates, it will generate jobs only slowly. But with the speed and slope of correction in competitiveness that is under way, the feed-through to domestic demand and job creation will come. And over the next few years a socially more sustainable balance to the recovery will also end up swelling the tax base more strongly than the present pattern of export-led growth. For the pressured taxpayer, there is a glimmer at the end of the tunnel.

We are highly conscious of the contagion risks posed to Ireland by further bond market or banking shocks elsewhere in the eurozone, or by any setback in world trade. And no one can ignore the political challenge of keeping Ireland ahead of the Troika’s targets. It also has to be stressed that we are assuming firm persistence in the course of fiscal consolidation. This said, we do believe that Ireland’s macroeconomic fundamentals provide the most important defence there can be against all forms of shock.

The prominent Morgan Stanley strategist pushes back against economic and market bulls. He says the economy is weak, as it always is after a major financial crisis, and will have a problem if there’s another shock. He says the first quantitative easing worked, but the second quantitative easing failed. The jobless situation is no better and might be worse, and caused pops in stock and commodity prices. Household balance sheets need to be repaired, and policies are not being directed at that. The whole video is worth watching. You also might be interested in his view of what government should do now.

Consumers want to pay down their debt. their debt to income ratio exploded to 130%. It’s come down to 115%. It’s a movement in the right direction, but the norm in the last 30 years of the 20th century was 75%. It’s a long way to go. The same thing is true with the savings rate. It’s up to five. The norm was closer to 8%.

Ben  Bernanke has said the Fed’s QE efforts were successful. Supporters of QE focus on two points. The economy stopped its free fall toward a deep depression. Also, stocks and other risky assets gained in value. The idea was that this would create a “wealth effect” that would cause consumers to resume their spending and borrowing. There’s another view, of course. That view is that QE merely prevented the corrections that needed to occur and introduced a number of distortions into the economy that might make it harder for the economy to mend. Consider these comments from John Hussman:

Without question, one of the notions buoying Wall Street optimism here is the hope that the Fed will pull another rabbit out of its hat by initiating QE3. That’s a nice sentiment, but it does overlook one minor detail. QE2 didn’t work.

Actually, that’s not quite fair. The Federal Reserve was indeed successful at provoking a speculative frenzy in the financial markets, which has now been completely wiped out. The Fed was also successful in leveraging its balance sheet by more than 55-to-1 (more than Bear Stearns, Lehman, Fannie Mae, Freddie Mac, or even Long-Term Capital Management ever achieved), and driving the monetary base to more than 18 cents for every dollar of GDP – a level that requires short-term interest rates to remain below about 3 basis points in order to maintain price stability ( see Charles Plosser and the 50% Contraction in the Fed’s Balance Sheet ). The Fed was indeed successful in provoking a wave of commodity hoarding that affected global supplies and injured the poorest of the poor – particularly in developing countries. The Fed was successful in setting off a very predictable decline in the value of the U.S. dollar. The Fed was successful in punishing savers and the risk averse, and driving investors to reach for yield in risky investments that they would normally avoid were it not for the absence of yield. The Fed was successful in provoking those with strong balance sheets to pay down existing higher interest-rate debt, and in creating an incentive for those with weak balance sheets to issue more of it at low rates, resulting in a simultaneous deterioration of credit quality and compensation for risk in the financial system. The Fed was successful at boosting the trading profits of the banks that serve as primary dealers, by announcing precisely which securities it would be buying prior to Treasury auctions, and buying them on the open market a few days later from the dealers that acquired them. The Fed was successful in creating a portfolio of low yielding securities that will be almost impossible to disgorge without capital losses unless the Fed holds them to maturity. On proper reflection, the list of the Fed’s successes from QE2 is nothing short of stunning.

It is beyond comprehension why anyone would wish for more of this recklessness.