Stimulus, Growth and Recovery: The Debate Continues

There is growing intelligent dissent to the administration’s stimulus policy.  Critics argue that recent growth is the result of market principles.  Edward P. Lazear wrote Monday in the WSJ, that he forecasted a return to growth without stimulus spending.  He goes on to argue, along with others, that  housing programs have had questionable results.  Lazear said that Uncle Sam is fibbing about job growth as well, reporting job retention as if it where job creation.  John Irons of the Economic Policy Institute agrees.  The administration has an incentive to report positive unemployment numbers- the most popular, but also misunderstood indicator.

Unemployment is only part of the overall picture.  Other improving indicators reported this week tell us that the economy is turning around-but for whom? It depends on how you define growth.  A technical definition says that growth is positive GDP.  That means little to most people.  Real growth, theoretically, is an improvement in living standards for the entire country.  That’s why Main Street understands the unemployment rate.  Accordingly, the media use it as the sole judge for growth.  The problem is, as Lazear mentioned,  job growth is the final component of recovery- behind financial stability and GDP growth.  Unemployment lags years behind an actual recovery.   If unemployment is a lagging indicator, Lazear cannot empirically link failed stimulus policy to persistent unemployment.  He says that the administration is ignoring job losses while inflating job creation numbers.  Isn’t he doing the same thing by ignoring market stabilization and GDP growth? 

BEA Released GDP Data This Week 

According to the BEA, GDP is up for a number of reasons.  Look closely at the report.  Exports rose 14 percent over last quarter and consumer spending rose 3.4 percent.  Market Watch reported that positive numbers where in part due to stimulus spending, but as I argued in the past, these gains are only temporary.  The purpose of the stimulus is to stabilize the economy so that private markets can function again.  There is no wider conspiracy.  The government will roll back stimulus as soon as it sees the return of private investment.  There is evidence of this already: government spending actually slowed by 3.5 percent.

Not all the news was good.  Personal income fell and prices rose.  Hopefully this is a temporary trend based on slight price increases and high unemployment.  However, as long as export growth remains positive, I see no need to fear 70s style stagflation.  

Savings and Long-Term Growth

According to the old Solow Model, a country’s savings rate is positively related to long-term growth.  Today, personal savings is around five percent, that’s up from around one percent just four years ago.  This bodes well for long-term growth in the US.  And now is a great time to invest.  As private investment (including people’s savings) replaces public spending in the next few years, markets will rebound.  Private investment will power an upswing in the business cycle, spark growth and reduce unemployment. The sooner the government rolls back stimulus, the better.  In the mean time, citizens can take advantage of great opportunities in real estate and other deflated markets.  This transfer of savings from a stock to a flow will jump-start the economy in way no stimulus could.  It would take tens of trillions of dollars in government spending to match the power of private investors.

Thomas J. Powell

Explaining Derivatives to Michael Moore

            Documentarian Michael Moore’s latest project, Capitalism: A Love Story aimed at highlighting a number of flaws concerning the economic system upon which our country is built. In his film, Moore infiltrates Wall Street and Washington D.C. to “explore the root causes of the global economic meltdown.” In one scene, he attempts to make a citizens arrest of the AIG board of directors. In another, he drives an armored car to Merrill Lynch and attempts, kind of, to collect $10 billion on behalf of the American people. While searching for answers in high-profile places, Moore asks financial professionals to explain complex terms, such as derivatives. In an attempt to provide this answer for Mr. Moore, I thought I would revisit a scenario I created last year. The following is a fictional example. It never happened, except for in my head.

            There is and always has been stiff competition between Las Vegas casinos. Located miles from the strip, Sin and Tonic Casino relies on clever ideas from their owner, Dale, to increase profits. In the summer of 2005, Dale decided to unveil a ‘Play Now, Pay Later’ program to his loyal customers. Dale’s customers, most of whom rarely left the casino because they had no home or job to maintain, were allowed to gamble and drink while management kept tabs on how much money they were each blowing through.

            The customers told all of their friends down by the river about Sin and Tonic’s new program and soon the casino was always filled to record numbers for the property.

            Dale decided to lower the payouts on all of his table games and slot machines and also increase the price of alcoholic beverages. But, because his customers were not required to pay right away, no one seemed to complain. Dale’s sales blew through the roof and caught the attention of local banks. One bank referred to Dale’s customers’ debts as “valuable” and offered to increase Dale’s borrowing limit.

            With Dale’s customers’ debts as collateral, the bank turned the debts into securities known as Sin-a-Bonds. Soon, the Sin-a-Bonds were being traded on security markets nationwide. Investors across the country, and soon across the entire world, never knew the AAA-rated Sin-a-Bonds were, in reality, the debts of homeless gambling addicts.

            Leading brokerage firms were selling loads of Sin-a-Bonds and their prices continued to escalate at a surprising rate. Everything was fine until pesky risk managers started poking around and demanding the gamblers to start making payments on their debts. On a busy Saturday night at Sin and Tonic, Dale informed his customers that payments needed to start being made that Monday. The remainder of Saturday night and all day Sunday, Sin and Tonic was filled to capacity.
            On Monday morning Dale and his employees were witness to the first day without customers in the casino’s history. Not one of the customers came in to make payments on their debts and the ones that stumbled around drunk in the parking lot claimed they “hadn’t got no money.” Dale told the bank he could not pay back any of the money they lent him and he quickly decided to claim bankruptcy.

            Sin-a-bonds dropped to near-worthless levels and investors lost their money. Plus, the bank that issued the Sin-a-Bonds saw its capital depleted and they were consequently unable to offer any more loans. The bank laid off all of its employees and closed.

            Dale was unable to pay any of his bills and all the companies that granted him payment extensions had to take massive losses, as Dale was their largest customer. The carpet cleaning service was forced to downsize, the vending companies were left with handfuls of damaged machines that no one else was interested in and alcohol suppliers were left with large inventories that could not possibly be consumed without Dale’s heavy-drinking clientele.

            The brokerage firms that sold the Sin-a-Bonds were in heavy distress. Eventually, the government stepped in to save them by creating a bailout package that was funded by taxpayers from states where gambling is prohibited.

            Dale retired from the casino business and is now rumored to be heavily involved in politics.

 

Absolute Returns Absolutely

            An increasing number of investment firms looking to capitalize on the fears of their investors have started offering “absolute return” funds that boast the ability to always produce returns. Investment advisors are pushing mutual funds that are designed to produce positive returns no matter how badly the stock market is performing. The idea has been around for decades, but now major financial companies such as Goldman Sachs, Dreyfus and Putnam have all launched similar absolute-return funds.  In response to the growing group of clients who want to be able to rely on their portfolio’s positive performance, investment firms have started heavily marketing absolute-return funds. But, are these funds worth all the hype?

            Similar to hedge funds, absolute-return funds focus on making money in all market conditions. By taking long positions in stocks and balancing them with short positions of similar value and in similar assets, absolute-return funds aim to produce returns slightly higher than Treasury bills.  In a dropping market, gains on the short positions are meant to offset losses on the long positions. In a rising market, the long positions are supposed to outperform the shorts; therefore producing modest returns for passive investors. If the sheer makeup of an absolute-return fund is not producing, fund managers also attempt to achieve their target by employing a number of different strategies. For instance, short-selling can help offset market falls and derivatives can shield from undesired volatility.  

            Generally, the techniques used by absolute-return fund managers to stabilize your portfolio’s ride are the sort of diversification practices you can do yourself, without having to pay hefty annual fees. In a recent Reno Gazette Journal article, Registered Investment Adviser Robert Barone recommended the following three steps in order to achieve consistent positive returns:

            First, reduce the allocation to equities in your portfolio to the 30-to-40 percent range. Remember to hold equity positions in companies with sound business practices and low levels of debt.

            Second, increase the allocation to fixed income to the 40-to-50 percent range, but keep the maturities relatively short (no more than three or four years to maturity).

            Third, because of weak dollar policies, increase the normal allocation to commodities to the 10-to-20 percent range.

            The discussion of investment strategies in this article should not be considered an offer to buy or sell any investment. As always, consult an investment professional to assist you in meeting your investment goals.

 

A Broken CIT Will Trip up Small Businesses

            On October 1^st CIT announced the launch of a plan which will aim to enhance its capital and improve its liquidity. According to the official press release, the restructuring plan is designed to “ensure continued financing support for small business and middle market clients.” After being denied financial support from the Treasury in July, CIT was forced to create a restructuring plan in order to attempt to sidestep bankruptcy court. But, because of concerns with CIT’s financial stability, the FDIC has forbidden the company from increasing its deposits, which severely limits the restructuring tools in its belt.

            The target of the restructuring plan is to slice CIT’s $31 billion dollar debt load down to about $25 billion. But, some experts have argued that the amount is not nearly enough to persuade the FDIC to again allow CIT to accept deposits. CIT is offering voluntary exchange offers for certain unsecured notes. Current holders of an “existing debt security would receive a pro rata portion of each of five series of newly issued secured notes, with maturities ranging from four to eight years, and/or shares of newly issued voting preferred stock.”

            The future success of CIT relies on a significant increase in capital. The restrictions imposed by regulators and the troubling credit freeze have created enormous obstacles for CIT. Financial companies, like CIT, without direct access to Federal Reserve emergency loans rely on funding from short-term debt markets. But, with these markets already shriveled, the possibility of finding new debt buyers has all but disappeared.

            With CIT operating in more than 50 countries, it is peculiar that the government did not deem CIT “too big too fail,” as it has a number of other institutions. The last company of this size that was denied a bailout was Lehman Brothers and its resulting bankruptcy filing tore the financial market to ribbons.

            For over a century CIT has been a huge player in providing loans to small and medium-sized businesses. The company has more than one million corporate borrowers; including popular businesses such as Dunkin’ Donuts and Dillards. If (or when) CIT collapses, the biggest problem will be the scores of small businesses that will find it even more difficult to find capital to fuel their ventures. As constantly noted, small businesses are crucial to our recovery. The credit freeze has already built a wall between businesses and available capital. The crumbling of CIT will only exacerbate the problem and highlight the importance of private capital in the marketplace. Without capital, our financial system cannot begin to encourage economic growth, and without growth a recovery is out of reach.

All My Best,

Thomas J. Powell

 

 

 

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Pulling the Unemployed off the Ropes and Into the Fight

As markets continue to produce signs of stabilization over the next quarter, it is unlikely that unemployment figures will show much improvement. With figures the highest they have been in more than 25 years, unemployment appears to have neared its peak. Lowering the rate to levels our economy can adequately support will prove to be a daunting task. But, with a little encouragement the corporate sector certainly has the power to handle it.
Last week, Federal Reserve Chairman Ben Bernanke was quoted by multiple major news sources after he told the Brookings Institute, “The recession is likely over at this point.” According to Bernanke, the economy appears to be growing, but not at a pace that will be sufficient for lowering the unemployment rate. Historically, economic upturns after recessions have been stamped with consumer demand. This time around, however, many Americans may not have the ability to help lead a recovery because they have been completely wiped out financially.
In order to spur consumer-led demand, the corporate sector will again have to make jobs readily available. The unemployed are not the kind of consumers that are needed to invigorate our economy and induce growth. We do not need to turn to an economics textbook to tell us that our broken economic cycle can be patched with more available jobs—this much we know.
Corporations large and small have been forced to adapt to this constricted economy and the majority of them were required to do so through downsizing. Now, company leaders are reluctant to increase their workforce until they are confident there is a significant increase in demand for their products and services. But, one strong possibility that could provide the encouragement needed to get company leaders hiring again is a temporary change in corporate tax policy.
A temporary tax break aimed at equaling the payroll costs of adding new employees would strip the risk for companies that are awaiting a full-blown recovery before they hire. Plus, according to a recent article published in The Wall Street Journal:
“The impact of a two-year program on the federal deficit would be relatively modest. Using a conservative set of assumptions, an $18 billion annual program, which represents 10% of estimated corporate tax receipts in the next fiscal year could create nearly 600,000 good-paying jobs …”

Before they commit to hiring, companies are waiting for consumers to spend. But, before consumers commit to spending, they are waiting for companies to hire. The cycle is stagnant and will remain so until one side is persuaded to change their behavior. A government-sponsored tax break for companies that agree to hire could be the first action taken during this recession that encourages our country’s government, companies and individuals to work together.

Capital River is Frozen; We Can Thaw it

Because of the severe impact of the recession, the stream of capital that once flooded our economy has been reduced to a trickle. The majority of the flow evaporated when banks were forced by the Fed to tighten their lending standards as delinquent loans polluted their books. Consequently, failing to restore the flow is making it extremely difficult for the Fed to take progressive measures toward recovery and has the potential to drop us back into another recession.
According to Bloomberg.com:
“The Fed’s second-quarter survey of senior loan officers, released Aug. 17, showed U.S. banks tightened standards on all types of loans and said they expect to maintain strict criteria on lending until at least the second half of 2010.”

With dropping values in commercial real estate, rising unemployment numbers and a seemingly unending onslaught of delinquent mortgages; banks are not lacking reasons to practice strict lending measures. Earlier this year, through a series of stress tests, the Fed found that 19 of the country’s largest banks needed $75 billion in new capital to protect themselves from mounting losses.
With all of my recent writings and blog postings concerning the benefits of getting our private capital back in the game, I am by no means hiding my agenda for restoring capital flow. The economy will only be repaired once the flow of capital is rejuvenated. It is much easier to lead capital tributaries back into the main stream if they are first flowing. Over the next couple of quarters, banks will continue to deleverage and work toward a balanced lending system. But, without raising more private capital, banks will not be able to establish a lending system that enables credit-worthy individuals and businesses to acquire reasonable loans; which puts an enormous restraint on economic progress.
Our economy is already positioned to attempt to force a jobless recovery, which will certainly create complications in sustaining a recovery. Trying to force a credit-less recovery will only exacerbate our struggles. Dragging our banks through a painful recovery without sufficient capital will only position them to break and lead us right back through more of the same. By identifying ways to put our private capital back into the equation we are positioning our financial system to rise from this recession stronger and more efficient. By investing in private enterprise, we are sparking long-term, mutually-beneficial relationships between capital-producing businesses and banks (while also earning gracious returns on our initial investments). Now is the time to put our private capital back to work.

Without Our Capital, Banks Get the Axe

Our private capital plays an integral part in our local economies—which then all collectively have crucial roles in our country’s financial stability. Because banks have become over-reliant on easy credit, they are now struggling to keep their businesses running by raising capital the old fashioned way. Without our capital, our banks (and more importantly our communities) cannot function properly. Not able to fulfill their debt obligations, banks are closing their doors and falling under the control of the FDIC; which “estimates bank failures will cost the fund about $70 billion through 2013.”
Banks are necessary to ensure that money circulates in our communities. They distribute the money of their depositors to borrowers who have a worthwhile purpose for the money. The banks secure our savings and lend the money to companies or individuals. Banks provide a convenient location for borrowers to acquire funds. Without banks, companies would find it very difficult to borrow large sums of money.
While banks perform their role as intermediaries, they also essentially increase the supply of money. By accepting deposits from its customers and loaning the money to worthy borrowers, banks “create” money. Consider the following simple example. Imagine a customer deposits $20,000 into her bank account. Even though the bills are no longer in circulation, the amount of money in our country does not change as a result of the deposit. Allowing the money to simply sit in the bank’s safe would not earn the bank anything. Therefore, the bank lends $10,000 to an entrepreneur in return for an additional interest fee. The depositor still has a $20,000 credit in her account and the entrepreneur has $10,000, therefore the money supply has increased by $10,000. The entrepreneur purchases supplies with the money and creates a product that he sells for a profit. As long as banks have depositors, they are able play their crucial role of increasing the money supply by making funds available to those looking to find backing for their ventures.
The word “bank” itself is derived from the Italian word “banca,” which referred to the table on which coins were counted and exchanged in the middle ages. “Bancarotta,” from which the word “bankrupt” was derived, means “broken bank.” Originally, if a banker was unable to pay his debts, the authorities arrived to smash his table in half with an axe. Today, the FDIC seizes failed banks and seeks buyers for their branches, deposits and faulty loans—all, for some reason, without smashing anything with an axe.

All my best,

Thomas J. Powell

 

 

The Great Recession is not over

While Wall Street celebrates the apparent passing of systemic financial failure, there is a different reality on America’s streets. The Great Recession is not over. Millions of jobs have been lost, and most people’s incomes have fallen. So has America’s ability to consume and pay down debt. Because consumption is the most important component of GDP in America, without shoppers filling stores, production, income and job growth will remain weak.
A side effect of reduced incomes is falling prices. When consumers feel financially pinched, they become more frugal. Wariness to spend forces businesses to lower prices in an effort to entice shoppers. Rents, too, will continue to fall as massive home and commercial real estate supply compete for available renters.
For years, the answer to every income short fall was credit. Want some new $250 jeans – Charge it! Don’t have cash for the big ticket item? – Put it on an adjustable rate payment plan. Trillions of dollars were pulled out of homes as prices soared, with the money spent on improvements, trips, and a multitude of consumer goods. Now, this debt is coming due, and incomes are falling!
In short, the great boom of the last twenty years was a story of debt expansion. As long as credit kept growing, more money could be spent. Easy money created a multi decade spending boom, which created an illusion of affluence. But, the credit party is over. The only way out is to spend less and pay off debt. Unfortunately both society and our political process are in denial. History has shown that every debt bubble ends the same way – prices fall until existing incomes can support them. All of the debt spending in Washington only delays the inevitable deflationary pain, and that new debt weakens us as an international economic power.
To finish the story, lower income will, along with tight credit, push down a buyer’s ability to support high rents. Lower rents make real estate less enticing as an investment until the property prices fall far enough to align with the new lower rent levels. Here in Nevada, this saga continues.
On the bright side, many are rediscovering the simple things in life. Family and friends are more important than weekends in Las Vegas! Perhaps this reality check will bring us back to what made this country the greatest in the world, namely, hard work and entrepreneurship.
Matt Marcewicz
Robert Barone, Ph.D.
Robert Barone and Matt Marcewicz are Investment Advisor Representatives of Ancora West Advisors LLC an SEC Registered Investment Advisor. They are also a Registered Representatives of Ancora Securities, Inc. (Member FINRA/SIPC). Mr. Barone is a Principal of Ancora West Advisors and a Registered Principal of Ancora Securities.

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