A Moment Of Reflection

This blog is devoted mostly to economics and investment theories. However, I wish to digress slightly for a moment and talk about the future in less economic terms, but more sociological and historical terms. You see, I believe the world is at an inflection point. The tide it is a changing, but it is not yet set in stone how it will change. Make no doubt, a revolution is at hand. I've already seen the beginnings with the Rally To End The Fed.

Revolutions are a result of the corruption of powers centralized in the hands of too few at the expense of the hands of many. Indeed, 1% of this empire controls the majority of this power and wealth, yet citizens rarely question why, preferring the comfort and security of their 50" LCD purchased on credit at tricky 0% APY....an illusion of prosperity.

Our founding fathers recognized these evils. George Washington, Thomas Jefferson, Ben Franklin, Andrew Jackson; all these men were quite wealthy, but they put their lives on the line as the equivalents of terrorists in the pursuit of life, liberty and happiness. This spirit has long gone and in its place has come centralized power, aka the federal government.

Courage and awareness is the only remedy. Unfortunately Americans have had cozy lives the past 60 or so years. There is a naivete inherent in Americans today as they've taken the bribe of false prosperity for so long. The seven deadly sins are catching up with us and unless education and awareness is spread, power and wealth will only continue to be transferred to the few.

Fortunately, media outlet is shifting. The internet has given a voice to all and is the ultimate knowledge portal. In fact, it is the perfect breeding ground for the kind of grassroots movement that has historically united the masses to form the waves of secular change. The transformation is never easy and involves sacrifice and hardship, but that's coming regardless. The centralized powers have gone to far this time.

I give you now a list of imbalances inherent in are system.

1. The Federal Reserve System - A private banking institution responsible for the corruption of currency through interest rate intervention and market distortion that causes the "boom & bust cycle"
2. The Federal Government - Responsible for the adoption of the Fed, which enables massive public works at the expense of the people via tax and the hidden tax aka inflation. Foreign meddling and empire uilding has now created America into a monster, our reputation shattered.
   
3. Fractional Reserve lending - The current banking system that acts like an upside down pyramid, whereby the Federal Reserve enables commercial banks to lend out 10x's demand deposits, creating money out of thin air. When economists speak of inflation, this is the real source.
   
4. Consumerism 1 - The blame can go around on this one. Pioneered by economist John Maynard keynes and pro-government, this has become the prevailing viewpoint of how our economy should be run today. Spending is the mantra, ruin is the result.
5. Consumerism 2 - Consumers themselves can take much of the blame here. We wanted to believe our false prosperity was real and could last forever without having to think. However, spending on credit only kicks the can down the road. The behavior consumerism instills is appalling if you sit back and reflect on it. The "I want it now" generation. Yet we never stop and think about the impoverished and starving in third world nations that despise Americans. Instead, we just turn on another ignoramus reality tv show over a couple Big Macs.
   

If revolution is coming at starts at the bottom as a result of the top. Reality is catching up with Americans, slowly but surely. The message is being spread. Public figures like Ron Paul and Peter Schiff are gaining supporters. Organizations like End The Fed are forming and disgust with bail outs will reach all time highs once the Automakers destiny is met. That will be the straw that breaks the camels backs. The US automakers are symbolic. If they fail despite government support then mistrust will grow rapidly in the Federal Government and their desire to be central planners.

This revolution doesn't have to be ugly, it can be a positive movement with all the sytems and communications we have in place. Finally, I urge all to read Confessions of an Economic Hitman. The story told by this ex-government agent of espionage is truly incredible and eye opening. Below are 2 parts of a radio interview:

Continuing Trend - Thrift

Ah yes, the return of thrift, nowadays only known to us through "back in my days" speeches from our elders and brushed aside in the wake of the "new paradigm". That is, until reality catches up to you and reversion to the mean finally awakens you to the fact that history actually has some precedence. In the wake of credit contraction and consumer awareness to managing a budget responsibly should take notice of The Return of Layaway:

You'd have to be TV-free to have missed Kmart's commercials over the past month touting the company's layaway program. Starting in October, the low-price retailer made a big push to get layaway noticed -- although Kmart has had layaway for 40 years. So why now?

As the economy's tailspin continues, Kmart figures customers will want a prudent way to pay. Layaway lets you select the stuff you want now (while it's in stock) and pay for it over time. By the time you take your purchase home, it's paid off, which means one less credit-card surprise come January.

In a recent PersonalShopper.com survey, almost half of the respondents said they're not looking forward to holiday shopping because they're afraid they can't give the gifts they want without maxing out their credit cards.

Layaway forces shopping discipline. Says Ludwig Bstieler, associate professor of marketing at the University of New Hampshire's Whittemore School of Business and Economics: "There is a segment of consumers who have a hard time paying their bills. In times like these, that group grows larger, and layaway offers them a way to purchase something without going beyond their means."

Tom Aiello, a spokesman for Kmart and Sears, agreed, but says that the cash-strapped aren't the only customers seeking other options. "There's this whole movement of frugalistas," he says. "It's suddenly hip to be frugal."

A comeback

This month, Sears brought back an expanded layaway program -- it covers most store items -- that the company had axed in 1989. The program is just a trial, though -- it will run only through Christmas for now, and it does not affect the company's fine-jewelry layaway program.

You can also do layaway online. Web sites set up layaway programs for merchandise they buy through partner e-tailers. Once you're paid the bill in full -- payments can be deducted from your checking account -- the item is shipped to you.

Because layaway programs are expensive to administer and represent only a small fraction of business for the stores that offer them, Bstieler says we shouldn't look for more to come. Unlike the days of the Great Depression, when all the major department stores had layaway programs, credit is still king and the demand for instant gratification is high.

Instant gratification will be a thing of the past at year end 09' and next year layaway will be much more popular. This will not save the retailers though, but is a welcome step to financial responsibility. Regarding the holiday shopping season:

U.S. Retail Sales Drop As Auto, Fuel Purchases Slump:

Dec. 12 (Bloomberg) -- U.S. retail sales fell in November for a record fifth consecutive month, led by slumps at auto dealers and service stations that overshadowed gains at electronic and department stores.

The 1.8 percent decrease was smaller than forecast and extended the longest string of declines since records began in 1992, the Commerce Department said today in Washington. Sales at service stations dropped by a record 15 percent as fuel costs plummeted.

...

Excluding autos, purchases dropped 1.6 percent, also less than anticipated.

Retailers are discounting heavily to lure consumers in, margins will be squeezed and more layoffs will come as a result. Fuel pump sales plummeting in the face of dramatically dropping fuel prices is never a good sign.

U.S. Consumer Sentiment Index Unexpectadly Improves:

Dec. 12 (Bloomberg) -- Confidence among U.S. consumers unexpectedly improved this month from the lowest level in 28 years, reflecting a record drop in gasoline prices that gave temporary relief to household budgets.

The Reuters/University of Michigan preliminary index of consumer sentiment rose to 59.1 from 55.3 in November. The reading exceeded every forecast in a Bloomberg survey of economists.

...

The U.S. lost the most jobs in 34 years in November and the unemployment rate rose to the highest level since 1993, the Labor Department reported last week. The 533,000 drop in jobs brought the cumulative losses this year to 1.91 million.

Difficult to Spend

In addition to job losses, Americans have to contend with declining home values and stricter lending standards, making it difficult for them to spend. U.S. household wealth fell in the third quarter by $2.81 trillion, the most on record, Federal Reserve figures showed yesterday.

This "unexpected" rise is temporary and job losses are going to soar. Sentiment is still dreadfully low by all historic means. The official unemployment rate is at 6.7%, but is more realistically in line with the U-6 number at 12.5%. Besides the obvious job cuts that will continue there are serious State Level Concerns & Fed Intervention coming. Finally,

U.S. Consumers Seen Facing "Liquidity Squeeze":

“The entire mortgage market hit a wall,” Whitney wrote, adding that home loans probably fell last quarter. There hasn’t been a drop since the second quarter of 1982, according to the Federal Reserve data cited in the chart. The Fed will release third-quarter figures later this month.

Whitney also projected that banks will reduce unused credit- card lines by 45 percent during the next 18 months. That works out to $2.13 trillion, based on the total credit lines available from all lenders insured by the Federal Deposit Insurance Corp. as of June 30, according to the report.

I respect the opinions of Meredith Whitney highly as she has been right on top of everything in this economic disaster, so take heed of her predictions. The days of abundant amenities for ordinary consumers have met their end. The days of savings and production have just started.

From an investors point of view, I look forward to a return to a production based economy with a large scale back in services. This means in the future screen for stocks of companies that build things, aka infrastructure. Regardless of a massive Obama infrastructure project, there are estimates of over $1 trillion in infrastructure repair needs. Look to the energy sector, more specifically clean energy, although I wouldn't discount oil and gas because these are mature cash rich companies the world will depend on for years to come. utilities and natural resource companies, these are business that provide us with things we need, not crap consumers can cut from their budgets in the blink of an eye and are the areas where additional production is needed and therefore jobs as well.

Don't look for opportunities immediately; these predictions are years in the making and the road will be tough. Instead comb the field for opportunities and wait to strike like a cobra after governments finally quit meddling and return to more free market principles, hopefully.

State Level Concerns & Fed Intervention

In June I proposed that if you Think Things Are Bad Now, Wait Til The States Cut Back.

That share is gigantic. At $1.8 trillion annually in a $14 trillion economy, the states and municipalities spend almost twice as much as the federal government, including the cost of the Iraq war. When librarians, lifeguards, teachers, transit workers, road repair crews and health care workers disappear, or airport and school construction is halted, the economy trembles. None of that, or very little, has happened so far, not even in California, despite a significant decline in tax revenue.

This is now becoming a reality and catching on in the mainstream media. So far, it's limited as California grabs headlines, so publicly it hasn't gained the recognition it needs yet to truly spread fear. But just wait, shortly the reality will be panic as State Budget Troubles Worsen:

States are facing a great fiscal crisis. At least 43 states faced or are facing shortfalls in their budgets for this and/or next year. States are currently at the mid-point of their fiscal year — which started July 1 in most states — and are in the process of preparing their budgets for the next year. The outlook for state budgets remains grim.

Over half the states had already cut spending, used reserves, or raised revenues in order to adopt a balanced budget for the current fiscal year — which started July 1 in most states. Now, their budgets have fallen out of balance again. New gaps have opened up in the budgets of at least 37 states plus the District of Columbia after they struggled to close the largest budget shortfalls seen since the recession of 2001. And these problems are expected to continue into next year.

Current estimates are that mid-year gaps total $31.2 billion — 7.2 percent of these states’ budgets — but they will almost certainly widen as the continuing economic turmoil causes revenues to come in below estimates in more states.

The 37 states facing mid-year fiscal year 2009 shortfalls are Alabama, Arizona, California, Colorado, Connecticut, Delaware, Florida, Georgia, Hawaii, Idaho, Illinois, Kansas, Kentucky, Maine, Maryland, Massachusetts, Minnesota, Mississippi, Missouri, Nevada, New Hampshire, New Jersey, New Mexico, New York, North Carolina, Ohio, Oregon, Pennsylvania, Rhode Island, South Carolina, South Dakota, Tennessee, Utah, Vermont, Virginia, Washington, and Wisconsin. In addition, the District of Columbia faces a budget shortfall. These budget gaps are in addition to the shortfalls that these and other states faced as they adopted their budgets for the current fiscal year.[1] At that time, 29 states faced a total of more than $48 billion in combined shortfalls.[2]

The article is in depth and has some very cool graphs. I encourage you to read the article in full as it is a serious eye opener, but I must highlight one more part:

Based on past experience and the depth of this recession it appears likely that all but a handful of states will face shortfalls in fiscal year 2010 and these deficits will end up totaling over $100 billion.[4]

Yowsers! First, let me say that the amount of job loss as a result of this will be sad and tremendous. Second, though it may sound cold, the sooner these budget shortfall expectations are met and adjusted for the sooner society as a whole can realign their own plans and adjust. Right now there is only a linger of uncertainty in the air. The fact is that states are (were) levering up just as much as banks and our government is and was therefore distorting the market. As they cut back the sooner private land and capital can be reallocated more efficiently. There's no easy solution, years of mal-investment on enormous scales ends in difficult (to say the least) corrections. Heli-Ben and Handy Hank might have you think otherwise, but wait, speaking of them.....Bernanke: Fed's Hands Tied In Aiding States:

The central bank’s hands are legally tied when it comes to directly helping U.S. states and municipalities overcome financial challenges, Federal Reserve Chairman Ben Bernanke said in a letter sent recently to a key U.S. lawmaker and obtained by Dow Jones Newswires. (Read the letter.)

“The Federal Reserve Act provides the Federal Reserve with only limited ability to purchase directly the obligations of states and municipalities,” Bernanke said in the letter to Rep. Paul Kanjorski (D., Penn.). “In addition, the Federal Reserve generally has little or no authority to lend directly to a state or municipal government.”

That said, local governments might be better off talking to U.S. Congress and Treasury Department officials about ways they can obtain direct aid, Bernanke said. He listed federal grants, loans and guarantees as possible options.

This hasn't stopped Heli-Ben before, what's changed? What's changed is that pressure on Big Ben to address the issue of states hasn't reached critical mass yet as the effects of state cut backs are still in the preliminary stages of setting in. Just give it time, I suspect the states will be eating a strict diet of alphabet soup in the future with tax payers eating the pavement. The mere fact that this issue is being raised with the Fed chairman is a good indicator that officials are wising up to the problem and that programs are on the way. Please see Mish's Fed Uncertainty Principle for more on this. I could be wrong, but then again Ben sets the precedence.

Retail Investors At A Crossroad

Indeed, retail investors should be asking themselves a series of important questions:

• Why am I paying my financial professional to invest in losing mutual funds?
• Why am I paying additional fees into a mutual fund if it has not delivered the long term results I was expecting?
• Is "buy and hold" a viable strategy?

These are the most important questions I can think of, but new considerations are welcome in comments. This is not the first time I've covered this topic, let's revisit A Sea Of Funds:

Over the 25 years from 1980 to 2005, the S&P 500 index returned an average of 12.3% a year. Over the same period, the average equity mutual fund returned 10% and the average mutual-fund investor (thanks to his regrettable tendency to buy the hottest funds at the top of the market) earned just 7.3%, five percentage points below the index.

That data is old, just ponder on how that has changed since. In fact, let's find out just how well some of the top mutual funds have done. First, we'll look at a staple fund in the investing community from Fidelity, a supposedly moderate fund, the Fidelity Advisor - Equity Income Fund-A (FEIAX). A brief summary:

Investment Objective

Seeks a yield from dividend and interest income which exceeds the composite dividend yield on securities comprising the Standard & Poor's 500 Index. In addition, consistent with the primary objective of obtaining dividend and interest income, the fund will consider the potential for achieving capital appreciation.

Strategy

Normally investing at least 80% of assets in equity securities. Normally investing primarily in income-producing equity securities, which tends to lead to investments in large cap "value" stocks.

Right off of the bat I have a problem, the fund managers are constrained into investing most of their assets into stocks, 80%. Stocks at any given time, may be inferior to other asset classes, case in point would be in 2000 when valuations were through the roof and any investor who bought into "buy and hold" at that time would have gotten crushed.

Now let's see how this fund has performed:

As of Month-end 11/30/2008 - Load Adjusted

1 Yr: -44.72% 3 Yr: -12.26% 5 Yr: -3.03% 10 Yr: 0.13% Life: 8.80%

It's benchmark is the Russell 3000 Value Index:

1 Yr: -37.95% 3 Yr: -8.65% 5 Yr: 0.09% 10 Yr: 1.85%

Fund managers are compensated to perform relatively better than their competing index, in this case the index has outperformed across the board (Russell 3000 Life performance was not given). Is any compensation at all justifies for this outright lousy performance?

Fees:

For this abysmal performance you pay a maximum up front sales charge of 5.75%. Additionally, annual expenses are 0.99%. Your financial adviser may charge you additional fees beyond this, although this is a generalized example and results may differ.

Holdings:

As of 10/31/2008 99.7% of the portfolio was invested in equities and the remainder in cash. Even more absurd is that from a year ago (10/31/2007 - 10/31/2008) the fund increased its position in financials from 24.80% of its portfolio to 31%!

Hedge Funds

I'm going to switch focus now to Hedge Funds, another outlet for retail investors that has become popular in recent years. Hedge funds are supposed to earn "absolute returns" meaning positive returns in any market. I agree with this line of thinking and strive to earn the same in my own portfolio management, however there are some flaws:

• 2/20 model - Charging a 2% management fee and 20% of capital apreciation is absurd!
• Withdrawal timetables and pooled accounts. The timetables create panic among nervous investors which is then exacerbated by the fact that accounts are pooled (in some cases). If accounts were held in separate accounts forced redemptions would not be a serious problem.
  
• Lack of transparency - thanks to a supreme court ruling overturning hedge fund regulation by the SEC as investment advisers, the hedge fund industry remains clouded in mystery and unaccountable for risk appetites of their investors.
  

Again, these are just a few of the problems I see, comments are welcome.

So how have hedge funds stacked up performance wise versus their mutual fund peers?

From the Credit Suisse/ Tremont Hedge Fund Index:

Equity Market Neutral Strategy: Oct 08': -1.83% Sept 08': -1.4% YTD 08': -0.19%

Long/Short Equity Strategy: Oct 08': -7.13% Sept 08': -7.81% YTD 08': -19.46%

I could not find a methodology for these hedge fund strategies, but I believe them to be in line with an absolute return policy. Neither have performed well but certainly much much better than their mutual fund peers. Government meddling in short equity restrictions have undoubtedly affected those returns.

Conclusion:

Retail investors must start demanding more from their financial advisers, especially as they witness baby boomer retirement accounts evaporate. If your financial adviser is advocating the use of mutual funds and the typical "buy and hold" methodology, then please for your own sake grill him for details and analytical reasoning and proof that his strategy will benefit you. Pay attention to his compensation and make sure it is reasonable. Ask for past performance of the portfolios he/she has managed in the past. Inquire into his economic knowledge and outlook and judge if he's just not trying to sell you and sugarcoat reality, after all, the majority of advisers out there are series 7 holding representatives, which means they usually earn from commissions based on sales volume.

Finally, in my first shameless promotion of myself, I must officially introduce that I own and manage a registered investment adviser firm - Liberty Analytics, LLC. If you are interested in hearing more of what I have to offer and are tired of your current adviser's results, I am open to new business and please refer to my website.

Handy Hanky's Treasury & Heli-Ben's Chopper Shop

This article is just to hilarious to not share....enjoy!


Yes, Handy Hanky is here to wheel and deal, but it wouldn't be possible without his good buddy helicopter Ben. In the move towards quantitative easing, Heli-Ben & Handy Hanky will now ensure you can get affordable housing and refinancing no matter what your credit (or possibly employment) situation is as Borrower's Rush To Refinance:

...

The Federal Reserve announced last week that it would purchase up to $100 billion in direct debt of Fannie, Freddie and the Federal Home Loan Banks, along with up to $500 billion of mortgage-backed securities backed by Fannie, Freddie and Ginnie Mae.

The move caused mortgage rates to drop.

According to the MBA survey, rates on 30-year fixed-rate mortgages averaged 5.47% for the week ending Nov. 28, a shortened week due to the Thanksgiving holiday. The mortgage averaged 5.99% the previous week.

Fifteen-year fixed-rate mortgages averaged 5.13% last week, down from 5.78%. And one-year ARMs averaged 6.61% last week, down from 6.87%.

Applications to refinance an existing loan rose 203.3% last week, compared with the week before. Mortgage applications to purchase a home rose a seasonally adjusted 38.0%.

The four-week moving average for all loans was up 29.7%. Still, application volume last week was down 21.9% compared with the same week in 2007.

Refinance applications made up 69.1% of all activity, up from a 49.3% share the previous week. The adjustable-rate mortgage share was 1.4%, down from 3.0% the week before.

The MBA survey covers about half of all U.S. retail residential mortgage applications.

This is a dramatic and outright ballsy move. However, this does not solve the problem which is an over-extension of credit across all sectors of the economy. This move will save some foreclosures and possibly some write-downs, but it doesn't stop the job losses that will continue to soar, especially as expectations and market pyschology are at all time lows.

More importantly, the implications of extending these massive amounts of credit, which haven't made their way into the real economy on a large scale yet, are frightening. I have stated that deflation is the trend right now and there is still no escaping that. Deflation is not a bad thing, it's a cleansing period for the economy and a natural rebalancing is taking place. The greater the need for balance, the harder the deflation is to endure.

The Monetary base of the Fed has exploded courtesy of Heli-Ben & Handy Hanky, but as stated above, demand for money is at very high levels, which is translated into mainstream terms as "money hoarding". Again, the US has been in negative savings, another rebalancing need in the economy. Banks are holding their money at huge levels of excess reserves at the Fed and good ol' Heli-Ben hates it. He wants to encourage more misguided lending at any cost, hence his run at buying treasuries in his attempt to bring yields so low as to make it unprofitable for banks to hoard into "ultra-safe" treasuries and excess reserves at the Fed. This mass pyschology of consumers and banks demanding more money is like sprinting against a hurricane!

If Heli-Ben succeeds, then I will reverse my position on deflation. If banks actually do start lending again and continue to receive capital injections then watch out! Deflaion will not go away, its day of reckoning will just be pushed even further down the road. Instead what will happen is massive inflation and dollar devaluation. But this will be its own means to an end as public outcry will be at extreme levels and the end-game will lead to the eventual deflation that naturally needs to occur, but worse than needs to be. This is already in its very very early stage, as ironically public mistrust of government is growing at the same time big brother is stepping up to the plate to "save the economy" as never before.

These are just predictions and most likely Heli-Ben will not overcome the trillions of dollars in hard to understand derivative and credit instruments that are pushing his press back into oblivion. The massive amount of credit extended to investments that never should have been made has fully come home to roost.

Mark to Market Jibberish Continues

(click here to watch)

Once again, mark to market is a red herring instead of mal-investment. Listen to Rick Santelli, he gives Rich Berg a verbal murder of logic. Rich talks about running the country out of capital if values of securities continue to be marked down. Well, that is the problem.....credit capital is too plentiful and now an adjustment is occurring, trying to prop values up through accounting interference will only lead us to a Japanese like zombification for the next 20 years. If cash flows are richer than valuations suggest, then Lifting The Komono is the solution. Let it be known and let the market decide, if cash flows are rich, buyers will enter (at attractive values). Doing the oppositte will only infuriate the problem and extend its length of reckoning. Right now, we're sort of in limbo in between these two paralells, with mark to market but low transparency. The solution is not one or the other, but more transparency and market.