In an effort to get out ahead of the rush of year-end summaries, commentaries, and reviews, we’re going to try something a little bit different this year and leave 20 days of 2009 on the table. The themes discussed at the outset of 2009 were all longer-term in nature anyway, and it is unlikely that anything major will happen to unsettle those themes during the last few days of the year. Incidentally, a buffalo nickel goes to the first person to email in if I happen to be wrong on that last assertion. So without further delay...

Theme #1 for 2009 - The blowout federal deficit

On Thursday, a poll was released that only 21% of Americans support giving Helicopter Ben Bernanke a second term as chairman of the US Fed. This compared to 41% thinking that someone else should be given the job. I must say this is quite an improvement. I wonder if Rasmussen would have been able to say 2 years ago that 21% of Americans even knew who Bernanke was? If nothing else, the financial crisis and economic debacle of the past two years have certainly shone some much needed but unwanted light on the Fed and its clandestine activities. As much as I disapprove of Bernanke’s policies and his handling of virtually every aspect of what has gone on, I’ll be the first to admit that Big Ben isn’t the problem. No, it isn’t him or Greenspan, or Volcker. It’s the institution itself that is the problem.

Mandate #1 – Price Stability

It nearly slipped through the cracks this week as mediastocracy marveled at the apparent lack of inflation as the PPI and CPI reports hit the wires. However, just beneath the surface, the financial and economic metamorphosis continues unabated. I am talking about Qatar and its very successful bond sale.

This tiny emirate nation-state is 164th in total landmass, 159th in population, and 123rd in population density. Oddly enough, Qatar is 65th globally in terms of GDP, but is number two in per capita GDP (on a purchasing power parity basis) at over $86,000 per annum. They are second only to Lichtenstein.

The past two weeks have brought two massive paradigm shifts to a Gold market that has been morphing literally on a daily basis for the past few months. During this time, the pundits and purveyors of misinformation and tripe have done their best to ‘student body left’ Gold back into obscurity as an ancient, barbaric relic. They certainly get an ‘A’ for effort. Now that Gold has made its debut above $1100 an ounce, they’ve switched their tactic and are now calling it a bubble. We’ll deal with why this cannot be the case in a bit.

For the past 9 years now, students of history and common sense have been literally shouting from the rooftops that Gold was the place to be as the monetary tradewinds shifted back in 2000 and the fiat inflationary cycle began to go parabolic. While the multi-trillion dollar deficits might be a surprise to many, for those who understand how these things work, it is just a mundane repetition of history and yet another confirmation that man cannot alter the laws of economics or his own intrinsic predilection to ignore events past.

The result really wasn’t all that surprising. The reaction wasn’t either. On Thursday morning the Commerce Department released its advance GDP reading and proclaimed the end of the recession by asserting the American economy ‘grew’ at an annualized rate of 3.5% in the third quarter. A previous commentary already pointed out the fact that government borrowing shouldn’t be counted in GDP calculations anyway, so I’ll not repeat that exercise. Certainly there isn’t much to say on this topic that hasn’t already been said. However, there are some salient points that have been glossed over that are worth mentioning.

Cost vs. Price

Perhaps one of the most preposterous statements made during the ongoing financial crisis was by Ben Bernanke when he stated that we would have a ‘jobless recovery’. Certainly this is not a new term, but that doesn’t change the fact that in concept, the idea that a real recovery can occur with rising unemployment seems pretty ludicrous. Again, the devil is in the details and it all comes back to how you define your terminology and ask “A recovery for whom?”

A number of months ago, I pointed out the somewhat flawed rationale of using GDP itself as a gauge of economic growth since government spending is a portion of that measurement. Normally, this wouldn’t be a huge problem, but when the government tries to in essence become the economy by spending exorbitant amounts of borrowed money, then GDP loses its usefulness as a measure of genuine economic growth. I willingly admit that it is exceedingly difficult to argue against government spending to a construction worker who is able to remain employed because of a road project paid for with stimulus borrowing. However, we all need to be concerned with the undeniable fact that more and more of our national well-being is becoming dependent on the hazardous practice of reckless borrowing and debt monetization.

I have been asked countless times in the past month why it is that share markets seem to have a difficult time navigating the autumn months. Obviously, there is a healthy amount of fear regarding the next 29 days, as the memories of last year are still firmly intact. Yesterday’s 203-point drop in the Dow Jones Industrials Average has done nothing more than rekindle those sour memories. While the question ‘Why October?’ is largely rhetorical in nature, we can certainly take a look at history for some potential causes for the blowups.

Not helping our prospects for avoiding another October surprise is the fact that almost nothing has been done to rectify the underlying problems facing the U.S. economy. Plenty has been spent to bailout various enterprises, but until a healthy, unsubsidized demand for goods and services exists at the consumer level, we will continue to spin our wheels. A fantastic example is the cash for clunkers program. The massive infusion of subsidies did manage to increase auto sales, but now that the program has ended, we’re heading right back to where we were before. This is evidenced by Ford’s U.S. auto sales immediately dropping 5.1% after the program was terminated.

While all the hubbub here in the US has centered around abominations such as Cash for Clunkers, tax credits for buying homes, and the other machinations directed at returning the US to the blissful year of 2005, other portions of the world have taken notice and have been conducting some activities of their own. They have been locking down ever-growing stockpiles of critical basic materials needed to run their economies. These strategic moves have certainly not been done in secret, but given how we spend our intellectual energies here in America, they might as well have been. Leading the pack has been China, but there have certainly been others.

Venezuela’s $16 Billion Oil Deal

Last October was a pretty brutal time to be in the prognostication business. I had just called Gold the opportunity of a lifetime at the end of August at a price of around $800/ounce. By the time late October came around, the price had fallen to around $725 and the catcalls had begun in earnest. The Keynesian Kakistocracy was out in full force, hurling insults so rich and humorous that I felt compelled to write some of them down. Now a year later it is time to do another quick review and probably set myself up for yet another barrage of hate mail if the price of Gold doesn’t immediately set a course for Mars.

Yes, we are one year removed from that column and Gold is up 25% in dollar terms at nearly $1000/ounce. Detractors will quickly point out Gold’s inability to land and stick above the $1000 level. In return, I will point at the Dollar’s failed rally to 90 as measured by the USDX. Detractors will point to a lack of interest and dividends from investing in Gold. I will point out that Gold is not an investment; it is money. However, for those who insist on comparing Gold to stocks, I will point out that in the year since the last article, Gold is up 25% while the Dow Jones Industrials are down 19%. Detractors will point out the new bull market in stocks. I’ll counter with the fact that stocks are merely in the middle of a countertrend rally within a bear market while Gold’s correction last year was a countertrend move within a bull market. Detractors will point to the save-haven status of the Dollar during times of economic distress. I’ll counter with the fact that Congress has ensured that the Dollar will die of nearly two trillion cuts – in FY 2009 alone. Must we really continue this?

Last week’s essay centered on the fact that America has borrowed nearly $12 trillion yet achieved very little, if any real economic growth in the last half century. If that wasn’t alarming enough, this week’s effort should suffice to turn some heads. While last week we used the broadest monetary aggregate M3 to discount GDP, this week we’re going to take a look at velocity of circulation in the M2 aggregate and translate that into some logical conclusions. Politicians, the Conference Board and nearly every alphabet soup media outlet known to man are trying to talk this economy out of recession. We already know that talk is cheap, but I have a distinct suspicion that we’re soon going to find out exactly how cheap it really is.

But why pick on M2? The reason here is simple. The Conference Board’s index of leading economic indicators (LEI) assigns M2 a whopping weight of 35.8%. So just creating money automatically means good things will happen? Here we get yet another insight into one of the many flaws of Keynesian economic theory. Average weekly hours in manufacturing is the second largest component of the index or LEI and is assigned a 25.49% weight. It should be immediately obvious that significant changes in M2 could easily overshadow diverging movements by other components of the Index. The full chart is displayed below, from the Conference Board’s website:

Apparently, a bazooka wasn’t enough. Last summer, that is what then-Treasury Secretary Henry Paulson asked for when he made his case for sweeping financial powers. Instead, Congress gave him a nuke, and apparently that wasn’t enough either. Making the jump from completely absurd to the absolutely ridiculous, Timothy Geithner became the latest in a long line of Treasury Chiefs to run to Congress to ask for an increase in the nation’s debt ceiling.

The fact that he is asking for the increase should not be a surprise to anyone given the massive deficits already racked up over the past 18 months. What would be laughable if it weren’t so serious, however, were the comments made in his request letter to Congress.

It doesn’t take long these days to find an economic bull that’s for sure. Whether you turn on the television, radio, or pick up a newspaper, they’re everywhere. The most popular phrase to date has obviously been Bernanke’s ‘Green Shoots’ comment made several months ago. Boy, have we gotten some mileage out of that one.

San Francisco Fed President Janet Yellen became the latest to don the well-worn 3D glasses early last week at the Oregon and Idaho Banker’s Association convention. The following are some of her comments:

The clichés are plentiful and well known. Putting all of one’s eggs in a single basket is probably the most popular example. One of the biggest manifestations is when an investor looks at their portfolio and realizes that it is grossly underperforming a particular market index or that the same portfolio has performed much worse than a given benchmark. Even if you’ve done everything right and selected the right themes, industries, and firms, if you get the portfolio mix wrong, you can still have problems. This is one of headaches that mutual funds are generally supposed to relieve investors of, but for a litany of reasons, it doesn’t seem to always work out that way. In truth, every individual portfolio is a mutual fund of sorts, and so the same rules apply.

Types of Risk

Last time we discussed the concept of valuation for some different types of investments and the formation of themes that can be used to help zero in on potential areas for focus. This week we’ll take a look at some ways of breaking down industries and sectors, sizing companies, then connecting the dots between economic themes and investment needs.

If you go to the NYSE website, you will be able to find what is called an Industry Classification Breakdown or ICB. There are ten major industries with varying numbers of supersectors, sectors, and subsectors under each major heading.

In an age of green shoots, fluff, and spin, it is probably worthwhile to put our feet on the ground every so often and take a look at some old fashioned ways that we might value a project, a firm, or capital stock. Too many times over the past 15 years in particular, investors have been lured into various valuation traps. Probably the most noteworthy was the dotcom era of the late 1990’s and the first part of the 21st century. Not a great start to a new millennium. And so the trend has been that each time the investing public deviates from the ‘old fashioned’ rules of finance and analysis, there is always a good whipping waiting just around the bend.

Unfortunately, turning on the television won’t do much in the way of helping one to find answers in this regard. Much like the medical community, the financial and investing world is littered with incomprehensible jargon, which can be downright boring at best, and impossible to follow at worst.

Despite the calm appearance on the economic waters of late, there is quite a bit of turbulence building beneath the surface on a multitude of fronts. Several developments have emerged that fly directly in the face of the idea that we’re headed for a green shoots recovery. Even more surprising, when you take a deeper look at these issues, some rather remarkable inconsistencies emerge in that the methods being used in some critical areas virtually guarantee that they will not be successful. We’ll take a look at two of these areas, but first, let’s discuss maneuvering room.

Compressing the timeline – less time for proactivity

In a mid-February editorial we took a look at some factors that were beginning to confirm one of our proprietary indicators that pointed to a bottoming in consumer prices in December 2008. Writing such an article at the time was a big risk since it flew in the face of a trend that had been firmly in place for the past half-year. The price of nearly everything was falling – or so it seemed. For those who understand and appreciate the function of money supply in the determination of prices, the article made perfect sense. However, for those who believe that economic growth or the absence thereof determines prices, there was a great deal of consternation regarding our assertions.

Nearly three months have passed since then and almost every piece of data that has come across this desk has validated the claims made back in February. Just aside of the factors we mentioned in the February article, which were the CRB Index, Gold, and West Texas Intermediate Crude, there is another major indicator of this phenomenon and that is the stock market. From the 3/6/2009 bottom through today, the Dow Jones Wilshire 5000 Index raced from 6935 to 9342; an increase of 34.71%. More importantly though, lets look at it in terms of dollars. The value of the Wilshire 5000, which is one of the broadest measures of US market capitalization increased by $2.407 Trillion during that relatively short period of time.

If you take a short walk down memory lane, it will not take you very long to find the carcass of New Century Financial along the side of the road back in March 2007. It would be a full 12 months before the word recession would be mentioned in the US mainstream media and stock markets would roar into their all-time highs six months after the disintegration of New Century. Much of the early portion of the credit crisis as it was called focused on mortgages and after that, mortgage-backed securities. Wow, haven’t heard that term in a while, have we?

Much of the scuttlebutt at the time centered around the ratings which were assigned to these mortgage bonds and people started asking questions about how all of these Triple-A rated bonds could suddenly be worthless and why bonds with this high of a rating were paying historic spreads above and beyond US government debt of the same maturities (which are also rated Triple-A).

While it may seem rather inappropriate to talk about hedging strategies while the markets are retracing at least a portion of 2008’s devastating plunge, common sense continues to support the position that the worst is yet to come. Granted, focus has shifted to ‘less bad’ economic data and the anointing of government spending as the elixir that will return the American economy to prosperity. Yes, that whole “We’re going to spend our way to prosperity” mantra is once again in play. Make no mistake about it; what we are witnessing right now will be viewed years from now as the biggest sucker's rally in history – so far.

That said, now is the time to start talking about protecting portfolios from the next move down. The techniques below were used either individually or in tandem to drastically limit losses in our client portfolios during the 2008 liquidation. Some of these strategies have been sold to the investing public as ten feet tall and bulletproof, but don’t work out too well unless the intricacies are understood. And still others are exceedingly complicated to execute and rely on a preponderance of difficult predictive successes to be beneficial.

This week’s surprise Consumer Confidence report gives us yet another reason to take a step back and survey the landscape. Much of the recent focus has deservedly been on unemployment while little focus has been given to other aspects of the consumer and more importantly, the overall state of the consumer’s mind.

Clearly there are several enigmas manifesting themselves in both confidence and spending patterns. This week we’ll take a closer look at some of these issues, and probably generate quite a bit of debate as well.