Economic Update

In the past two months, the signs of a global economic slowdown have become evident to all who have an objective view of the world. What many people considered impossible four months ago—deflation—is now at the forefront of many investors’ minds. Though a contrarian must become alarmed when the mainstream starts to use deflation to describe the economy, the consensus still expects the economy to grow in the coming quarters—but at a reduced rate. I argue that a long deleveraging cycle is taking place after the largest expansion of credit in history. And we are only in the fourth inning of a nine-inning game. Buckle up: we are in for a very rough ride.

Market:
The market made its bounce, and is now resuming its decline. I stand by my belief that what we witnessed from March 9 2009 until April 23 2010 was an echo bubble, inflated by the largest Keynesian infusion of cash that history has seen. Now that the “medicine” is wearing off, the market is realizing that Lord Keynes was wrong and one cannot cure an addiction to drugs with more drugs. The result is a stock market that will move much lower.
The latest rally on low volume leads many to speculate that these are simply the algorithmic high-frequency trading machines making money by trading between themselves. Scott Peterson, who wrote the book, Quants, on the mortgage-backed security market, has said that the same people and institutions that created so much destruction with mortgage-backed securities, are now intimately involved in the high-frequency trading. This story bears watching.
From a value perspective, the market is expensive when one looks at the macroeconomic headwinds facing the world. This opinion runs contrary to the majority of “Wall Street.” Unfortunately, when the pundits opine future stock prices, they often use earnings as their evidence of a market that is undervalued. However, as pointed out in the following paragraph by Comstock Partners (CP), the “analysts” are often wrong.

“This is what we stated in the article back in May 2008, “Look at the numbers. Reported earnings for the S&P 500 for 2007 were just over $66. The operating earnings for 2007 were $84.54. The estimated numbers for 2008 are about $69 for reported earnings and about $90 for operating earnings. By the way, these estimates have just recently been revised downward drastically, due to the slowdown in the U.S. economy.” Imagine what they were before they were revised DOWNWARD DRASTICALLY. The actual numbers came in at $14.88 for reported earnings vs. the estimate of $69, and $49.51 for operating earnings vs. the estimate of $90 (see actual earnings in the attached chart). This means that with just 7 months to go in 2008 the earnings were off the $69 estimate by $54, and off the $90 estimate by $40. This goes to show how absurd it was and still is to use forward earnings-and imagine if we used the estimates before they were revised downward drastically.”

What CP believes is a better judge of valuation in a market:

“Our favorite means of determining a fair valuation is to smooth the reported earnings over a 9 year period of time by taking the 9 year average and grow the average for 4.5 years (one half the 9 years) at 6% (where earnings have grown historically) to arrive at the $64 of smoothed earnings. Using the smoothed earnings of $64 you arrive at the overvalued level of 17 times. We also believe that this market will not bottom out until it reaches 10 times or lower the smoothed earnings. Although this may sound implausible, we note that the S&P 500 sold at a P/E of 10 or under smoothed earnings in 17 of the past 60 years.”

One must remember that the money that was infused into the system in 2008 and 2009 is now reflected in companys’ earnings. Moreover, all of the analysts calling for a V-shaped recovery use the rationale that this was an inventory recession and not a massive balance sheet recession which demands that companies and consumers must deleverage for years before true economic expansion can begin. Therefore, to use earnings as the argument for buying stocks is nothing but vacuous commentary by the minions of the powers-that-be.

Jobs:
There is no real job growth in America. Real growth comes from the private entrepreneur, who has an idea, creates a product or a service to fill a market demand and in turn creates jobs, which grow the economy. Unfortunately, the majority of policy makers are Keynesians who believe that they can control market forces and keep deflation at bay until the private sector demand comes back. The question one must pose to Keynes’s disciples is: when are private-sector jobs coming back? And how large can budget deficits become before bond vigilantes strike America like they have the club med nations in Europe?
Starting in August 2009 we heard from many pundits that “jobs are a lagging indicator,” and that anyone looking to jobs as an indicator of economic health was going to miss the rally in equities. Today, some twelve months later, the same pundits continue their bullish commentary, but omit that famous Wall Street verbiage that jobs are a “lagging indicator.” This change in tune is due to the fact that jobs are a coincident indicator, meaning they do not lag nor do they lead an economic recovery, but instead they change when the economy changes. In our present situation, that means the jobless rate is set to move much higher than 9.5%.
[Note: this 9.5% is a false number due to the flawed models of the government. A more true number is the U6 which stands at 16.4%. Free-market economists like John Williams of Shadow Stats put the rate at 21.7%]
The following chart is one that has been posted on many sites, but I believe it is worth posting again for those who have not seen it.



If one takes into consideration the massive stimulus that has been implemented by the minions in Washington DC, it is appalling how little effect the cash has had for main street families.
One segment of the job market that has received little press is the youth market. These individuals, who represent the next generation, have dealt with a summer of joblessness not seen in over 60 years. This does not bode well for longer-term prosperity, as these individuals might go through their years of schooling (including university) having never actually worked a real job. Moreover, if one looks at recent studies that compare behavioral differences of the generations, it becomes evident that the narcissism of young people today is extremely high.
One of the most salient points of these studies is how Generation Xers—that grew up with video games, internet, soccer moms, etc—do not want to take a job that will sacrifice their social life. Compound this fact with the lack of job opportunities and one must wonder what the next engine of wealth will be. “Poverty is a great motivator:” Carmela Soprano.




Big Banks:
Since the summer of 2009 JP Morgan (JPM) & Goldman Sachs (GS) have been telling people to buy stocks, because we are in a V-shaped recovery and stock prices are undervalued. Their general market reports (GS has a 1350 target for the S&P, while JPM has a 1325, by year’s end) are nothing short of Goebbelsian propaganda. For example, GS from October 08 through February 2009 were buying tons of equities, while at the same time telling clients to “prepare for the worst.” Good video on GS: http://www.youtube.com/watch?v=e2GvuOVcCB8
In August 2009 GS started to jump on the “emerging markets” bandwagon and were touting fabulous returns that were to be found in Asia. Funny how August 2009 was the top of the Chinese market, since then, it is down almost 35%. Famous short seller John Chanos warned people in a January 2010 speech that GS and other “big banks” were doing this, but not one reporter in the mainstream press has developed the subject further.
From the larger macroeconomic view, these banks are destroying the economy by the egregious method of not realizing the toxic assets on their balance sheets. Courtesy of the U.S. government’s changing mark-to-market accounting, the institutions can value assets at bubble prices, which allow their earnings to look good relative to their stock price. This keeps the malinvestment in the system and allows bankers to reap major bonuses.
In addition, the US has a horrific problem with smaller banks that do not have the massive trading-wings like the big boys. These banks are continuing to default, but instead of liquidating in bankruptcy, the FDIC is coming in and assuming their liabilities. Unfortunately, with 109 banks taken over so far in 2010 at a cost of $18.9 Billion dollars, the FDIC has exceeded its allotted fund for 2010 of $15.3 Billion. In essence, this behavior is exactly what Japan did during their two lost decades. As professor Bill Black stated: “Japan’s equity market is down 75% in nominal terms and 85% in real terms” since their stock market peaked in 1989. Could the same lost decades be happening in the US? The answer will not be known for another ten years, but our situation looks similar.
With the consolidation in the industry, banks have become larger and control even more of the market place. I doubt very much that they have learned their lesson from 2008, and as David Einhorn said, their party will continue because the government has replenished their Kool-Aid supply.

Income:
Some people talk about how future unemployment could drop to the 3% range. Their rationale: the economy is recovering, housing would come back because it had fallen so much, and as baby boomers retire, they create a supply and demand imbalance. All of these factors are dependent upon working individuals’ income from their job, investments and homes. Unfortunately, evidence points to no such rebound for these facets of income.
For example, the Employee Benefit Research Institute found that ‘“early baby boomers” in particular, those between 56 and 62, have a 47% chance of not having enough money to fund their basic expenses in retirement.”’ Moreover, they concluded that 1 in 3 boomers will run out of money “twenty” years after they retire.
Therefore Americans will have to save more in the future than they have done in the past. Smells like a 8-10% savings rate is coming in the next ten years. The repercussions of such a high rate of savings are tremendously deflationary for our consumer driven economy.

Mr. Bond
With the volatility in the marketplace, bonds have performed very well for the income conscious investor. I personally do not own any because my portfolio is not of a large enough size for me to deem it consequential to hold the paper. However, I do pay very close attention to the yields, as they have a habit of predicting economic slowdowns.
The following chart shows how the drop in yield (as the demand for bonds goes up the yield goes down) coincides with a drop in the stock market. This has not always been the case but since 1999, it has held true.
I believe this is showing us, that the market is set to move drastically to the downside and all those equity bulls will be eating their words.

US Dollar:
Now that the dollar has fallen from 88 on the index to 80 and most of the investment community is bearish on its future (6% bulls in latest investor survey) I would expect the dollar to rally. (Update: rally has started, index above 82) Besides the aforementioned evidence, as people sell equities, the demand for cash will rise, therefore raising its value.
Inflation will come, but not today or tomorrow. [I was just at Office Max buying photo paper (which was buy one get one free) and they were selling school folders for 1 penny! Talk about deflation.]

Financial Reform:
Simply put: a worthless bill from Congress that will change nothing at all.
It is amazing the amount of propaganda that the large banks have been producing. The articles I read about the reform in Europe are very similar to the ones in the US. How the restrictions will hurt bank profits, tighten lending, and derail the “recovery.” Fortunately for the banks, their slaves in Washington DC are following orders well and have passed a financial reform bill that will allow them to continue partying like “it’s 1999.” Here is a list of restrictions that should have been put on such a bill and were not. Courtesy of Mish Shedlock:

• Glass-Steagall: Paul Volcker supported provisions that were hopelessly watered down, so much so that they can accomplish nothing.
• Derivatives Reform: Banks successfully lobbied for derivative exceptions big enough to drive the planet Jupiter through. They succeeded. Derivatives reform is meaningless.
• Too Big To Fail: The reform bill did absolutely nothing to rein in the widely recognized "too big to fail" policies of the Fed.
• Preventing the Last Crisis: There is not a single thing in the bill that can possibly be construed to have prevented the last crisis.
• Preventing the Next Crisis: There is not a single thing in the bill that can possibly do anything to prevent the next crisis.



The Fed:
Much has been made about the Federal Reserve’s policies, but their influence in waning. Their recent policy announcement that they will roll over their Treasury holdings and continue to buy bonds, exemplifies the notion that they have absolutely no exit strategy. Banana Ben will continue to try to fight deflation the only way he knows how—buying bonds, which is essentially printing money. This strategy will produce inflation in the future, but the massive deflationary forces of the moment are too great for the Fed to control. Any major policy decisions, like rescuing more NYC banks, will be met with upheaval by the American people who find more massive government spending unpalatable at this point. In short, the Fed has shot their wad, and is now out of ammunition.

My Portfolio:
Gold and Silver bullion holdings continue to perform well, though a short-term decline could occur as people liquidate assets in the near-term.
Short positions in SDS and SH have performed nicely. I closed the SDS for a 9% profit. (Update: put SDS back on). I continue to hold the SH position, as an inverse index fund—making money when the market goes down. I may buy more
I have taken a hit with some of the smaller, volatile mining stocks, but the little game of arbitrage has paid off. Sabina Gold announced a large gold discovery and the stock jetted up from $1.20-$3.30 over the past few months. This company comprised 6% of my portfolio before its rise.
Golden Goliath, another junior mining company I have held for a long time, appears to be making strides in the right direction. They own a huge parcel of land in Mexico, which was a major Spanish mining center in the 18th and 19th centuries. The company owns the property outright; therefore their burn rate is only $60,000 a month. The drill results continue to point in a positive direction, with an upcoming 43-101 (mineral estimate) to be released shortly. The stock has been trading +/- 20cents, which is the same amount is cost me to buy shares in 2005. Given the fact they have diluted modestly and have discovered many new mineral veins, it looks undervalued. Moreover, 23.2% of their stock is owned by large miner Agnico-Eagle and by Sprott Asset management. These are long-term share holders who believe in the feasibility of the project. However, the stock is extremely volatile due to their light trading volume; it was up 21% on one day recently only to be followed by a decline of 12%. Perhaps the best thing GNG.V has going for it is the lack of analyst coverage. In my experience, when analysts cover a lightly traded stock, they become overvalued and then plunge quickly when the analysts call their buddies and tell them to sell. See Farallon NYSE: FAN.
I am sitting in roughly 38% cash with 12% short and 50% in mining companies. The later have led to an increase in my overall value by 8.4% since my last writing.

Conclusion:
We have started the next contraction of economic growth. What we saw in 2008 was a financial panic. What we will find over the next few months are the flaws in our system that cannot be cured quickly. What many people cannot fathom today is a stock market below 6000 on the Dow and 600 on the S&P. In my opinion, these are very real possibilities. One must remember that if the market breaches those levels, investors who have seen very little growth from their buy-and-hold strategy over the past 12 years and lived through the panic of 2008, will become extremely nervous and likely will hit the all-out sell button on their portfolios. At this point the prudent will leverage-up and buy, allowing the panicked individual to move into cash at exactly the wrong time.



Upcoming:

--California’s Budget
--Discussion on Health Care
--The Greatest bubble of all: Washington DC
--Stock Update





Just a little extra:
The following chart does not need any explanation. Though I do not know as much about the sector down under, all of the objective commentary I read points to some major problems.