January 31, 2004


What's below started out as an e-mail reply to an essay by a colleague. The essay took the position that deficits don't matter, not very much anyway. For some reason, this touched a nerve with me. And I composed and fired off the response below. I've edited it a bit. But it's still a little cruder and heavy handed that I'd normally publish. However, I think the crux of it is right. If you've got comments, fire away. regards, Dan Deficits don’t matter? Or do they? The first issue you need to clear up when answering this question is if “deficit” refers to total U.S. debt (public/household/corporate) as % of GDP or just Federal debt. Households and corporations borrow in the open market. And although rates are manipulated by the Fed, the risk they take is their own, i.e. bankruptcy. Bankruptcy laws have changes and made it easier for people or corporations to go bankrupt without really paying the price. It might be a good idea to bring back debtor's prisons. But still, at least in non-public borrowing there's a price to be paid for being a bad credit risk, either in bankruptcy itself, or having to pay higher interest rates. You get kicked out of business and it becomes harder for you to waste someone else's capital again. The market spots a failure. The point being that the household/corporate debt as a percentage of GDP is less important, in my mind, because it reflects choices people willingly make with their own money (or with shareholder money). In each case, the borrower is held accountable by the market place. Shareholders punish stocks that waste capital (eventually). They sell them and move on to more efficient enterprises that don’t waste their money but multiply it. And I suspect at the household level, homeowners who borrowed cheap to buy too much house will soon owe more than they own. All of which is fine. No one holds a gun to your head and tells you to buy a house or Amazon.com and 900 times earnings. It’s simple risk and reward, resolved by market forces. Government borrowing is different. The government doesn't borrow money to create income-producing assets or make capital investment (home ownership). We’ll exclude for now the subject of government investment in basic infrastructure. For purposes of this discussion, let’s say that, for the most part, the government borrows to simply redistribute income, to make transfer payments. It does not create wealth. Because the government pays off its bonds with tax revenues (which it collects at the barrel of a gun) it's able to borrow at much lower interest rates than the private sector. And it's also able to run regular deficits as a percentage of its income because the income itself is...virtually guaranteed. No one "chooses" government services. The government imply collects its revenues through confiscation, a nice business if you can get it (or if you command the army and the police.) This has an obvious effect: it encourages even more government borrowing to distribute more money to get more votes to spend more money on the people who voted you in. It's nothing new. Neither is it sustainable. At what point does it become unsustainable? I suppose a government could borrow over 100% of GDP if there were people willing to own the bonds. But my main argument here is that an economy in which government borrowing becomes an increasingly large portion of GDP is one that's creating less wealth than it could. The economy grows less fast than it might. That means fewer tax revenues, fewer jobs, and fewer growing incomes. This takes its toll over time, but you see its net effect in socialist Europe. The pie gets smaller. ( It doesn't, "Make the pie higher," as Bush once said.) Worst of all, government deficits are addictive to shameess pandering politicians. Take your pick from either side of the aisle. Which brings me to point number two... Discretionary vs. Non-discretionary Spending: No Way Out Over 70% of 2004's $2 trillion in federal spending is non-discretionary. It's spending mandated by law, including Social Security, Medicare and Medicaid, and interest on the debt. There are fixed, legislated growth rates in non-discretionary spending, that can only be reduced by an act of political will (not likely). Barring a political magnetic pole reversal, federal spending is only going to keep growing. And if spending grows faster than income...deficits will only get larger. And by the way, the Medicare prescription drug benefit grew in cost by another $143 billion since November. It's now going to cost over $500 billion over ten years...or nearly 6% of GDP. Optimists suggest we can (a) grow our way out of it or (b) cut discretionary spending. Maybe. But defense and homeland security make up the bulk of discretionary federal spending. And the President has budgeted for 7% INcreases on both those next year, not decresases. Plus, that doesn't even include an extra $40 to $50 billion to pay for continuing operations in Iraq and Afghanistan. Those aren't included in the budget submitted, although at $407 billion and 4% of GDP, its still an impressive increase in an area where we're told we could save money. Bottom line: the war on terror, like the cold war and like world war two, is a blank check to increase discretionary spending. And since the war has no definable ending...the increases are seemingly infinite. If discretionary spending ain't going down, and non-discretionary spending CAN"t go down, there's only one choice left: MEGA GROWTH in TAX REVENUES (hint, hard to achieve by cutting taxes) But what about growing out of our deficits? A federal deficit of 5% of GDP doesn't seem so bad, historically speaking. Why not 10%? 15% 20%? Again, the point is that this is not simply a mathematical question of sustainability, but one of how wealth is created. I'd say that when the available savings of the world (since the U.S. economy is not creating a lot of savings for its own pool of investment capital) go increasingly to simple income redistribution programs and not to new investment or job creation...the long-term ability of the economy to create capital and wealth is hollowed out. The world is paying for American retirement and healthcare and getting less than 5% for the privilege. How long will that last? Government borrowing diverts savings away from productive investment and towards simple wealth redistribution. Over time, capital formation slows down...and so does business investment...as has happened here in Europe. My third and final, and most serious bone of contention is moral. The more content we are with regular government deficits, the less responsible we become for ourselves. Borrowing increases actual indebtedness...but it increases dependence, too. People get used to expecting things to be paid for and provided by the government. Once created and funded, how many government programs have gone away? Very few, if any. They develop a constituency of bureaucrats who need them for jobs or of tax payers who reap the booty of the wealth distribution. The whole exercise in representative government then becomes a shameless debasing game of looking out for your piece of the loot at the expense of your neighbors and friends...and your children and grandchildren. At root this is an argument that public debt (debt taken out in the name of the people and not by an individual or corporate risk taker) quickly becomes a shallow political ploy to win elections. This becomes corrosive to private morality. As an example, take the heat waves in France this past summer. Fifteen thousand people who survived the depression and World War two died in their homes or unattended in hospital beds from the heat. Their doctors, neighbors, and children were at the beach, on vacation, confident that the tax dollars they spent were taking care of their loved ones. When Chirac gave his speech to the nation addressing the human catastrophe, he said that no one person was to blame, but that all of France was to blame. That's pretty convenient. All of France means not me and not you but all of us. So let's just do better next time. Maybe in their private moments the children and neighbors of these people DO blame themselves for subcontracting their responsibility to take care of their elders to the government. And then again, maybe they DON'T. Maybe the cumulative affect of letting the government become the moral middleman is that you don't care about anyone but yourself anymore. You care about your job, your leisure time, your life. You work less, have fewer children, and stop believing in God or anything more than yourself. It may be a stretch...but I think it all starts the moment we accept that spending more than we earn--as a nation, through our government-- is morally tolerable. If it's not good for a private household to do it, not good economically and not good morally, why would it be better for the government to do it? Non-discretionary spending is busting the budget. Seventy percent of government spending is non-discretionary promises to pay for things the government does now, but which used to be done by families, churches, or the private sector. We have locked in these promises and have closed the discussion of whether we ought tom or can afford to keep making them. This view also suggests that we shouldn't treat our economics as mere mathematics. Economics used to be called moral philosophy. The study of the choices people made with their money couldn't be separated from whether the choices themselves were "good." The market judges "good" by whether the good or service you provide makes things better for people. If it does, you get rewarded for your risk. If it doesn't, generally, you fail. Debt isn't immoral per se. But taking on debt you have no intention of repaying is. And doing in the name of the "State" or the "people" may give you the political cover you need to explain away your recklessness. You disguise it as concern for the "public good" or for "society." But morally speaking, when you sanction it, you're contributing to the impoverishment of your economy and the debasement of your own morality.

January 30, 2004

Quote of the Day: Scientficially Fraudulent Keynesian Mathematics

Hat tip to Andrew Sullivan for posting this quote from Greg Ransom at Prestopundit.com (emphasis added is mine). "There is not even the smallest thing "conservative" about tax cuts and spending increases as far as the eye can see. Republicans who pretend otherwise are selling a "free lunch" that wastes wealth, decapitalizes the country and burdens the next generation with a massive negative compound interest problem. All that is being done is a con job on public in which the people are fooled into thinking they and the country are wealthier than they really are -- and that government goodies are a costless "free lunch". Well, there is no free lunch. "The classic "unseen" cost of this "free lunch" shell game is the cost which will be born by later generations who will be burdened with the massive weight of government debt, rather than advantaged by the wealth stream made possibly by private sector capital goods investment. And again, this cost is far, far more massive than any Peter Pan big government Republican can ever imagine -- (and God help us if they attempt to use their scientifically fraudulent Keynesian mathematics, or, worse, the fantasy mathematics of "supply side" economics. It ain't 1962 folks, and it ain't even 1982).

The Put/Call Ratio

Thought I'd post this subscriber question about the put/call ratio. It doesn't measure options prices, but it does measure the ratio between put buyers and call buyers...and as the subscriber points out...is also a useful measure of sentiment. Hi Dan, Although the VIX is showing little fear in the market right now, the Index put call ratio seems a little out of whack to me. The following is from the CBOE market summary for today. CBOE Market Summary for 01/27/2004 Total Put/Call Ratio : 0.87 Index Put/Call Ratio : 2.26 Equity Put/Call Ratio: 0.64 So it looks like "investors" are using the indexes to hedge rather than the equities directly. What's your take on this? Sounds right to me. Investors, and institutions, are making fewer bullish/bearish bets on single securities and making more on entire markets. At extremes of over or undervaluation, like we have now, this makes sense to me. Unless you can spot an obvious case of under or over valuation in a single security....the risk doesn't justify the reward. Incidentally, the put/call ratio declined yesterday, according to CBOE. But the bulk of the decline was in index puts. Lots of folks taking a bearish position Weds. Fewer yesterday. But still more put buyers than call buyers. Total Put/Call Ratio: 0.80 Index Put/Call Ratio: 1.82 Equity Put/Call Ratio: 0.64

Lord Rees-Mogg on the Middle Class Revolt

LRM doesn't actually use the word revolt in the article below. But I will. Bush seems to think that everyone will be happy with the tax cuts and ignore the spending boom. But spending worries people. It worries people as an abstract idea, the idea of a "national deficit." This has always baffled me that tax payers feel accountable for the government's irresponsible spending. But they seem too, at least in an ideal way. But spending worries people because they know it has to come from somewhere. And that somewhere is taxes. The more Bush spends, the more inconceivable it is to me that he'll be able to keep popular support for tax cuts. People intuitively know (even if they don't want to believe) that you can't have something for nothing. Bush is turning out to be the President who couldn't say no to anyone or anything. He hasn't vetoed a single bill or resolution from Congress. He's never met a tax cut he didn't like, or a spending increase he couldn't live with. And that's not even talking about foreign wars.... On to LRM.... Fewer Jobs For Life by William Rees-Mogg The next General Election in Britain will probably come in May or June of 2005, and we are already in a pre-election atmosphere. Though we do not have the long primary process of the United States, the political mood is similar in both countries. At this stage no-one, including the politicians, is feeling at all certain about the outcome. The precedents suggest a comfortable second term election for President Bush in November, and a relatively comfortable third term for Tony Blair in the following May, but in both countries the polls suggest that the voters have not yet made up their minds. In both countries, the decisive factors seem likely to be the economy and the social services of health and education. Even in the United States, Iraq is only seen as the most important issue by about 10 per cent of the population. I have not seen a similar poll in Britain, but I would guess that it would be even lower. What I do detect over here, and in many of the speeches of the primary campaign in the U.S., is a growing feeling that the middle class is suffering an economic squeeze, and is resenting it. I get a similar impression in the other European countries. Obviously this is bad news for incumbents, if my sense of middle class discontent is correct. By definition, the middle class is the majority, the people whose earnings come close to the average, the mass of population which comes near to the middle in any economic chart. Senator Kerry, who is at present doing very well in the primaries, with wins in Iowa and New Hampshire, makes a strong point. "In an economy that grew 8 per cent last quarter, the average American got to bring home an extra 3 cents for every hour of work. That's the slowest wage growth in 40 years." Lehman Brothers Global Economics forecast suggests that, "the unemployment rate may be stubbornly sticky in the coming months," despite increased optimism about job prospects. A subsection of the middle class seems to be affected particularly badly, the teenagers, or young graduates, looking for jobs. My youngest daughter is in her middle twenties. She finds that many of her friends, graduating with good degrees, have not yet found satisfactory jobs. Since January 1989, American teenagers have reduced participation in the work force by nearly 16 per cent. It has become notoriously more difficult for British or American students to find jobs which will help them to pay their way through College. As middle class parents worry about jobless children, this puts further pressure on the middle aged group. In conversation, many middle class people in both countries, and probably throughout the modern professional and industrial world, express similar worries. They feel that the poor get the benefits, the rich get the money, and the middle class pay the taxes. Again, this has become a standard campaign theme for Democrats in all the primaries. It is an issue which unite Kerry, Dean, Edwards and Clark. It is used to attack the top end of President George W. Bush's tax cuts. A generation of indusreorganizationsation has changed the job structure of the modern middle class. On average, middle class incomes are higher, but they are less secure. There are far fewer jobs for life. The ordinary middle class career has to be much more entrepreneurial, assuming several shifts of employment, unable to rely on the security of the company pension. These socio-economic issues present the same problems in all modern countries. There is no quick economic fix for them. The middle class squeeze means that voters are likely to feel less comfortable at any given level of national prosperity. That means that the middle class is less secure -- but it also means that politicians are less secure as well. William Rees-Mogg 30 January 2004

Volatility Insurance

Rounding up my posts on the VIX, the good news is that you’ll soon be able to use it to hedge market risk. First though, I should explain what the VIX actually is and what it tells us. The VIX is an indicator that measures the market’s expectations for near term-volatility (within the next 30 days). It does this by looking at options prices on the S&P 500. I won’t try and explain the whole calculation (for you options pricing junkies, you can find it at http://www.cboe.com/micro/vix/vixwhite.pdf ) When markets are placid, options prices are cheaper. When markets aren’t placid, options prices go up (you pay a premium for the right to buy or sell something when the direction of its price is unclear.) You can see from the chart below that as the world gets uncertain, options prices (and the VIX) go up. The main point is that the VIX measures fear. It’s often called “The Fear Gage.” And what you can tell from my chart earlier (and the one above), is that bull markets in fear lead to bear markets in stocks. If that’s all the VIX was useful for, it would be very useful indeed. You’d have a great way to call market tops and bottoms. But in a few months, you’ll be able to do more than that. CBOE has applied for a listing for the VIX to trade on the new CBOE Futures Exchange. You’ll be able to trade the VIX. Unfortunately, it will be on the futures market. So you’ll be trading options on futures (something my friend Sue Rutsen at Fox Investments does very well.) But aside from trading options on futures rather than a straight up option, adding the VIX to your toolbox is a good idea if you have a big bullish bet in the market. A call on the VIX is essentially a bet that volatility will increase and that, if the historical relationship holds, stocks will fall. So, by owning VIX calls…you own a kind of bear-market insurance. There are other ways to do this of course, like through long-dated put options on the indexes. But what’s nice about the VIX is that it’s so directly correlated to the S&P. So a S&P bull can own VIX calls and be reasonably confident that a fall in the S&P will be hedged by a rise in the VIX. I’d recommend using the VIX as a way to make directional bets, i.e. the VIX is going to rise or fall. Right now, it’s a simple bet. The VIX is coming off historic lows. It’s got a lot of up to go. I’d buy calls. None of this makes the market less risky. But what’s interesting about a listing for the VIX is that it puts pretty sophisticated hedging at the fingertips of retail investors like you and me. You can take a few simple positions in a Rydex fund, in the VIX, or in broad market index puts, and at least take out, at a pretty cheap price, an insurance policy on your buy-and-hold positions. Insurance probably isn’t the right word, because no one is going to give you your money back if you lose it being long stocks. But now, you can make money on market declines, and you can do it relatively cheaply. That’s progress.

Correlating the VIX and Returns

What does it mean to say the VIX and market returns are correlated? Take a look at the chart below. It's a bit clumsy. But you can see is that, generally, a rise in the volatility means a fall in the Nasdaq ( the index I've compared the VIX to here). When investors have a heightened sense of risk, stocks sell off. Conversely, when investors are lazy and complacent (as they were earlier this week), stocks drift higher. What's notable about this picture is that even historically low levels of complacency about risk haven't been enough to drive the Nasdaq anywhere close to it's pre-crash high. It has, however, been enough for the Dow to recover to where it was nearly four years ago. On Jan. 28 of '00 the Dow traded at 10,940...yesterday it closed at 10,510.

Patience Breeds Panic

You have to wonder about the fundamental strength of a market that gets rocked by a change in words, from "considerable period" to "patience." If nothing else, Greenspan roused the market from its lethargy. Check out the VIX below...which jumped off its 7-year lows and promptly crossed above its 50-day moving average. (Note: this is the "new" VIX from the CBOE. It's calculated based on all the options traded on the $SPX. The old index (VXO on bigcharts.com) calculated volatility based on just eight at-the-money options...more on this in another post.) As I showed in the January issue...a rising VIX is usually very bad for stock prices. And even though bond prices were under pressure yesterday, I believe this dynamic of a rising VIX and falling stock prices will be bond bullish. We'll see...

January 29, 2004

India in, Russia Out?

Let's take a look at another geopolitical development of 2004...the marginalization of Russia and the elevation of India. The bulk of the post below is about Russia. I'll save India for later. But in short order, elevating the importance of India on the geopolitical stage appears to help the Bush administration in a number of important ways: 1) It makes it likelier that in concession for U.S. support in getting a permanent seat on the Security Council, India will work with Musharraf to find an agreement on Kashmir. 2) Growing stronger ties with India puts a counterweight to growing Chinese influence in South West Asia. 3) India is a growing voice of support and partner with Israel on the world stage. Ariel Sharon went to India in September. It was the first visit to India by an Israeli prime minister. One month later India signed a one billion-dollar deal to buy the Phalcon military radar system from Israel. Early this month, Israel and India announced a plan to set up a joint panel to boost bilateral trade. Israel has even signed on to an Indian-led unmanned mission to the moon in the next five years. Could India be a credible broker of peace in Israeli-Palestinian conflict? Stranger things have happened....meanwhile...back to Iraq...and oil. I mentioned yesterday that the list of who was on the oil take from Saddam Hussein is finally being published by an Iraqi newspaper, Al-Mada. The article was translated by the Mideast Media Research Institute (MEMRI). You can find the translation here or by going to http://www.memri.org/bin/latestnews.cgi?ID=IA16004 . It's also worth keeping in mind that plenty of people on this list deny that they were on the take. Sounds like a good story for the New York Times or someone with a lot of resources to take up. Of course you might find out, as I said over a year ago, that for some people, the war really WAS about oil, the kind they were getting to say nice things about Saddam. MEMRI also publishes these useful disclaimers: First, MEMRI is not responsible for the accuracy of the details with regard to the names listed or the amount of oil granted. Second, all names listed in the original were in Arabic. Some of those are transliterated into English phonetically, and may not be precise. Third, denials by those whose names appear in this dispatch are footnoted. Fourth, the issuing of vouchers by Saddam's regime may have served two primary purposes: A: Payments in the form of bribes to individuals and organizations for their support of the regime. B: Vouchers may have been issued to pay for goods and services that fell under U.N. Security Council sanctions and could not be financed under the "Oil for Food" program. Goods may have included military equipment or military parts, luxury automobiles that Saddam distributed as gifts inside and outside Iraq, and general luxury goods for the benefit of high-ranking officials in the Ba'ath party and government. Fifth, the voucher recipients sold the vouchers to oil traders, who then collected the oil against the vouchers from the Kirkuk-Banias (Syria) pipeline terminal, which was operating in contravention of the Security Council sanctions. The pipeline carried 200,000 barrels per day of Iraqi oil, which benefited Syria greatly. " Dislclaimers aside, the folks who come out looking the worst from the whole article are...certain Russians. This can't be good timing for Putin, who just got dressed down by that diplomatic firebrnd, Colin Powell. The Russian paper Izvestia published a Powell essay in which, among other things, he said, "Key aspects of civil society — free media and political party development, for example — have not yet sustained an independent presence." Now, couple that with a reply Dick Cheney made to a question after his speech in Davos this week, according to Jay Nordlinger from National Review, who covered the event. Cheney was asked about the future of the U.N. His response, according to Nordligner: the U.N. was made for the world of 1945, and, 60 years on, the world looks somewhat different. Perhaps the U.N. needs to take that into account, in its structure. Translation, it makes a lot more sense to have say, Brazil and India as permanent members of the Security Council than say, France and Russia. France and Russia "punch above their weight" on the world stage for different reasons. The French have diplomatic influence in the EU and in Africa. And there multipolar vision of the world obviously has resonance in some world capitals. The Russians have oil...and those pesky nuclear weapons. Under a second Bush term, will we see Cheney, Powell, Rice et. al move to marginalize Russia as a world player? Can they afford to do that? And what effect will all this subtle poormouthing of the Russian state have on the Russian stock market? It can't be good.... Russia is one of the countries I hope to visit on my upcoming trip...so I can separate the media hype from the reality on the ground. In the meantime, here is the list of Russians receiving oil from Saddam's Iraq...according to Al-Mada. "Russia: The Russian state itself received 1,366,000,000 barrels. The list also included the following: "Companies belonging to the Liberal Democratic Party received 79.8 million barrels - the list notes the name of party president Vladimir Zhirinovsky. The Russian Communist Party received 1 million barrels. The Lukoil company received 63 million barrels. The Russneft company received 35.5 million barrels. Vladimir Putin's Peace and Unity Party received 34 million barrels - the list notes the name of party chairwoman Saji Umalatova. "The Gazprom company received 26 million barrels. The Soyuzneftgaz company received 25.5 million barrels - the list notes the name Shafrannik. The Moscow Oil Company received 25.1 million barrels. The Onako company received 22.2 million barrels. The Sidanco company received 21.2 million barrels. The Russian Association for Solidarity with Iraq received 12.5 million barrels. The Ural Invest company received 8.5 million barrels. Russneft Gazexport received 12.5 million barrels. The Transneft company received 9 million barrels. The Sibneft company received 8.1 million barrels. The Stroyneftgaz company received 6 million barrels. "The Russian Committee for Solidarity with the People of Iraq received 6.5 million barrels - the list notes the name of committee chairman Rudasev. The Russian Orthodox Church received 5 million barrels. The Moscow Science Academy received 3.5 million barrels. The Chechnya Administration received 2 million barrels. The National Democratic Party received 2 million barrels. The Nordwest group received 2 million barrels. The Yukos company received 2 million barrels. "One Russian company which phonetically reads as Zarabsneft received 174.5 million barrels. Vouchers were also granted to the Russian foreign ministry, one under the name of Al-Fayko for 1 million barrels, and one to Yetumin for 30.1 million barrels. The Mashinoimport Company received 1 million barrels. The Slavneft Company received 1 million barrels. The Caspian Invest Company (Kalika) received 1 million barrels. The Tatneft Tatarstan company received 1 million barrels. The Surgutneft company received 1 million barrels. Siberia's oil and gas company received 1 million barrels. "In addition, the son of the former Russian Ambassador to Iraq received 19.7 million barrels. Nikolay Ryjkov, a former prime minister of the USSR, received 13 million barrels. The Russian President's office director received 5 million barrels.

Chart of the Day

From the Mortgage Bankers Association...the solid line is the MBA Index of Mortgage Loan Applications (left axis). The wavy line, total mortgage industry employment (right axis.) One has already fallen considerably...the other may not be far behind...although if you're in the foreclosure business....business should be very good.

Doom for Home Sales?

I'd be remiss to not comment on the home sales report yesterday. It's not the starting gun for a free fall in home building stocks or in mortgage activity. But it may be more like a rolling start. The good news, if you're looking to flip your house and buy a new one, is that 2003 was a record year. New home sales were up 11% and over 1 million units were sold. The bad news is that December sales were down 5%. Inventories--supply of new homes--were up too. There were 374,000 new homes in the market in December...about 4.3 months supply given current sales rates. That's the highest inventory level since 1989...suggesting that supplies are growing just as demand as falling...the classic signs of a "capacity build out." Of course the key in all of this is sales rates. Homebuilders are going to keep building if they think buyers will keep buying. And buyers probably WILL keep buying...as long as money is cheap. And on THAT score, the fact that mortgage requests were down last week--demand for new loans--isn't good news for homebuilders. The higher rates grow, the lower demand for new homes will be. You can't read too much into week-over-week changes in mortgage demand. The big question is what demand will look like two or three years out...and that will affect both individual home buyers and the GSEs, who make their living buying up new mortgages. The MBA published it's Macroeconomic and Housing Finance Outlook for 2004-2006 l ast week. Here were some of its conclusions (emphasis added is mine): +"Mortgage interest rates will follow Treasuries but will not rise as far as Treasuries because the drop-off in refinance volume brings an increase in competition, thus narrowing spreads. The Federal Reserve will remain on the sidelines until late 2004. Mortgage rates will likely end 2004 in the 6.3 to 6.5 percent range with an increase to slightly over 7 percent by year-end 2005." + "Mortgage origination volume, which hit an all-time record in 2003 at $3.8 trillion, will decline to $1.9 trillion in 2004 which will be the 5th largest year on record. Volumes will register slight decline to $1.7 trillion in 2005 and another $1.7 trillion in 2006." +"The volume of loans originated for home purchases will increase annually across the three-year forecast period. The refinance share of originations will fall from 66 percent in 2003 to 34 percent in 2004, to 22 percent in 2005 and to 19 percent in 2006." These forecasts prompt some obvious questions... 1) If mortgage rates rise to 7% by 2005, what effect will it have on recent buyers? And if rising rates slow down the pace of new buyers, will home prices fall...leaving many new buyers owning homes whose mortgage value exceeds its market value? 2) If mortgage originantion falls by 50% in 2004, as the MBA projects, how will it affect the financing of Fannie Mae and Freddie Mac? 3) If refinancings as a percentage of originations fall by 50% this year, will a huge prop to consumer spending be kicked out from under the barely recovering economy? I'm not aiming to answer all these questions at once, or even today. We just don't know how it all will play out...and how vulnerable Americans are to falling home values. But I think we'll find out soon... And in the meantime...the important investment implication is that a marginal increase in interest rates is going to lead to much slower growth in mortgage activity and new home buying. Even if this didn't signal that something was broke in the homebuilding market, it would still be bad news for homebuilders. It means the cheap money that's driven demand is a thing of the past. And that inventories of supply (new homes) are likely to get larger. You saw a foretaste of what that does to homebuilding stocks early this month. And you saw more of it yesterday, when the Philly Homebuilding Index (HGX) fell 3.5% on the slower December sales news. Home prices might not collapse all at once. But stocks of homebuilders, which are thinking of the future, might very well do just that.

A Word's As Good as a Hike

The Fed has spoken, but nothing has changed. There's only one line in the Fed's short statement from yesterday that matters. Here it is: "With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation. " This last line was different from the FOMC's December 9th statement that read: "However, with inflation quite low and resource use slack, the Committee believes that policy accommodation can be maintained for a considerable period." The market took this to mean that the Fed has moved away from its long-term accommodative stance, and opened the door to raising rates as early as this year, IF the economy heats up and inflation in consumer prices makes an appearance. Stocks fell. Bonds fell. Gold was up. And so was the dollar. But nothing has really changed. The Fed sees no inflation in consumer prices. The labor market is sluggish. Home sales were down 5% in December. The Mortgage Bankers Association reported that its weekly measure of mortgage activity fell by 5.2% last week as mortgage rates crept back up. Taken altogether, there's no macro case for raising rates any time soon. In fact, the only good explanation for the policy change is that the Fed wants to support the dollar in words without actually changing its monetary policy at all. This would be a relief to the Europeans and the Japanese, and might reduce trader's expectations for something momentous to come out of the upcoming G-8 meeting. If the dollar is stronger going into the meeting, the urgency to DO SOMETHING about a weak dollar is diminished. And of course, all this is accomplished, as I said, without making any change at all to the cheap money policy. So what's the immediate forecast for stocks, bonds, and the dollar, based on the Fed's new language? Stocks are still pricey. And the more lukewarm the eco news, the lower they could go. Bonds were spooked by the Fed's language. But in my view, the Fed's resolve to actually raise rates (much less a pretext for doing so) is sorely lacking. As stocks weaken, bond prices will go back up. And you may even see yields fall back below 4%. As for the dollar, a lot depends on how much pain its decline is causing foreign investors who own U.S. stocks...and foreign exporters. But even more depends on the fact that the U.S. government has no plans to reduce its deficit in the near future. And the current account deficit shows no signs of improvement either. The dollar is weak and getting weaker because the U.S. twin-deficits are large and getting larger. This is the fundamental tension in the currency markets that cannot be avoided. The dollar is weak because it deserves to be weak. And unless the Fed really truly means to raise rates to strengthen the dollar (something the Fed won't do until the labor market, or inflation picks up), the dollar is going to fall, no matter how "patient" the Fed is. If you're hunting for yield, Australia and the U.K. are two great places to find it. Interest rates are higher than, and may go even higher in the short-term.

January 28, 2004

A Toast to 70!

Loic, from the next room, has brought in a bottle of champagne for me to finish. I'm going to oblige him (it's only one glass). And after all, it IS Wednesday... We shall toast to the fact that my publisher has just told me that Strategic Investment has readers in over 70 countries. If you're reading this, then you're in one of them. Thank you for your support! Sante, as the French say!

Free Money: the Real Fed Funds Rate

The "real" fed funds rate is the funds rate adjusted for inflation by subtracting growth in CPI from the yield on the funds rate. As I've mentioned before, CPI isn't moving because inflation is showing up in raw materials and financial assets, not in finished consumer goods. The funds rate is the rate banks charge each other to loan money overnight. The Fed can't "force" banks to loan money. But it can make it easy for them to do so. And, by effectively lowering the return on holding cash...the Fed encourages getting rid of cash into something that throws off more than a negative yield....something like say...a stock...or even a house...or two. The chart below is taken from a Cleveland Fed Report called, "Dude, Where's My Country." I'm not making that up. It's more formal name is "Economic Trends: January, 2004." You can find it here or by going to http://www.clevelandfed.org/Research/index.htm Cash, Looking Like Trash

Maybe Bin Laden Doesn't Matter After All

The U.S. said last week that al Qaeda is 70% out of commission. Yet with attempts on Musharraf's life in Pakistan...and this story below from the Straits Times...Bin Laden's dreamed for rebellion against the West may be taking root in just those countries he had hoped...especially in Saudi Arabia. Rebellion brewing in Saudi city - JAN 26, 2004: "SAKAKA (Saudi Arabia) - The tiny city of Sakaka in the remote al-Jouf province that borders Iraq may seem an unlikely setting for the beginning of a revolution against the ruling al-Saud family. But one does not have to spend too long here to realise that this is what is happening. Al-Jouf has witnessed an extraordinary level of political violence in recent months. The deputy governor, say local residents, was assassinated. Also shot down was the police chief, executed by a group of men who forced their way into his home. Even before these bloody incidents, the region's top Syariah Court judge was shot down as he drove to work early one morning. "

Cheney Out, Rudy In?

By the way, the Intelligence Bulletins you're used to seeing in the monthly issue haven't disappeared. They're just being remodeled. Instead of publishing them just once a month...I plan on publishing them a lot more often...several times a week...when they're more relevant to the markets and more timely. Stay tuned...and in the meantime...I'm going to include more frequent discussion of what's going in the political world...today...the Vice President. He's got a bad heart, a crooked smile, and a mean streak. Paul O'Neill compared him to the Praetorian Guard that guarded--and controlled--Rome's weaker emperors. Democrats hate him. And the media won't let go of the Halliburton story. What exactly does Dick Cheney have going for him? He hasn't reigned in the President on spending. He's not popular with the practical realist friends of George Bush's father (Scowcroft and Baker). And he's not nearly as telegenic as John Edwards or John Kerry. The problem is, there aren't too many known-commodity conservatives Bush could replace Cheney with that would be "acceptable" to the bedrock right of his party. The current crop of Republicans with national recognition are all far more liberal than Cheney (George Pataki and Rudy Giuliani.) Newt Gingrich and Bill Bennett are conservative...but have as much, if not more baggage, than Cheney. Condolleza Rice isn't ready for prime time. And Colin Powell won't win many friends at National Review. Who's left that secures Bush's base but doesn't alarm the electorate? For conservatives, the cupboard is pretty bare, which is surprising, given that Republicans have been in power in Washington for the last two years. In fact, the Bush presidency is turning out to like Reagan's third term only in terms of deficit spending. Nearly everywhere else...Bush is looking a lot more like Bill Clinton than Ronald Reagan.

Pakistan by October, Bin Laden by November

Blogger Dan Drezner quotes from a Chicago Tribune article that reports the U.S. is preparing for a military offensive in Pakistan before the election. Or at the very least, the Dept. of Defense is under orders to...give the President options. While the media talks about John Edwards' folksy rhetorical style and John Kerry's dignified hairdo, the U.S. has come close to suffering a major strategic blow in Pakistan. Twice in the last two months, terrorists have tried to kill Pakistan's President Pervez Musharraf. Even if you don't wholly buy into the "War on Terror" Pakistan DOES have the bomb...and a lot of angry terrorists. They're angry that Musharraf has cooperated with the U.S. WOT. My contact in the Army, who spent nine months in Afghanistan as part of an anti-terror unit, tells me that the U.S. already operates in Pakistani territory...chasing down Taliban remnants who cross back and forth over the border into Afghanistan. But straying across the border for a few days while the Pakistani's look the other way is completely different than conducting a major operation in the border region between Afghanistan and Pakistan with the full support of the Pakistani government. It's a huge gamble for Musharraf. But then again, he must be feeling like it's a better gamble than waiting around to be killed by his own countrymen (or bin Laden's sympathizers). Musharraf is acting like a man who can't afford to hedge his bets anymore. He's laying his money down with the West. At the World Economic Forum in Davos, Musharraf admitted that Pakistani scientists had sold nuclear secrets...to Europeans. In fact, it's an interesting sub-story that's naturally gotten very little press in Europe. Pakistan's daily, The News, reported this week that the father of Pakistan's nuclear program, A.Q. Khan had "direct ties with international black market dealers who sold non-peaceful nuclear technology and hardware to Iran and Libya. Tha paper also says the good Dr. is "reported to have offered similar deals to Syria and former Iraqi dictator, Saddam Hussein." Musharraf made the mea culpa in public, and then asked the obvious question. He said Pakistan was willing to share the blame for the proliferation of nuclear technology...but why was there no uproar in Europe that in was European middle-men who put the Pakistani doctor in touch with interested buyers? It's a pretty good question. In the meantime, it looks to me like he's given the Bush administration a convenient excuse to shift the focus away from the fact that Iraq has no WMDs and TO the fact that Pakistan does...and is besieged by dangerous Islamists...whom its courageous President has graciously invited us to help him destroy, in the name of regional security, nuclear non-proliferation, at the war on terror (three for three and a clean political sweep.) Oh yeah...and then there's bin Laden...Bush could be thinking that (a) conducting a joint operation with a willing partner is a lot easier than say, taking down Syria by November, (b) it sure would be nice to catch bin Laden before the election, and (c) just in case the transition of power in Iraq is neither peaceful nor entirely successful, this would be one way to "maintain America's focus in the wider war on terror" or, perhaps, divert attention away from one major strategic move by initiating another. Here's what the Trib article said: "The Bush administration, deeply concerned about recent assassination attempts against Pakistan President Pervez Musharraf and a resurgence of Taliban forces in neighboring Afghanistan, is preparing a U.S. military offensive that would reach inside Pakistan with the goal of destroying Osama bin Laden's Al Qaeda network, military sources said. "U.S. Central Command is assembling a team of military intelligence officers that would be posted in Pakistan ahead of the operation, according to sources familiar with details of the plan and internal military communications. The sources spoke on the condition they not be identified. As now envisioned, the offensive would involve Special Operations forces, Army Rangers and Army ground troops, sources said. A Navy aircraft carrier would be deployed in the Arabian Sea. "Referred to in internal Pentagon messages as the 'spring offensive,' the operation would be driven by certain undisclosed events in Pakistan and across the region, sources said. A source familiar with details of the plan said this is 'not like a contingency plan for North Korea, something that sits on a shelf. This planning is like planning for Iraq. They want this plan to be executable, now.'"

Quote of the Day, Japan's "large affect" on gold

This story from Reuters qualifies as the quote of the day and the story of the day. The respite in the forex markets, where the dollar's decline isn't wholly disorderly, is allowing investors--including central banks--to rethink how many dollar denominated assets they want to own. "Fewer" will surely be the conclusion. But what other kind of currency reserves will foreign central banks own if they own fewer dollars? Wel...dare I suggest gold? Or should I let the Japanese Finance Minister do that for me? You'll note that he suggest gold cautiously...lest he have a "large effect" on gold markets. But that's precisely what's going to happen anyway, sooner or later. As a trader though, the Fin Min probably doesn't want to cause a run on gold. Then he'd have to pay more for it. If Japanese monetary authorities are treating the current gold lull as a chance to add gold as a reserve currency...that should be some comfort to you if you're worried about your gold stocks falling. Now is a great time to quietly accumulate... "TOKYO, Jan 28 (Reuters) - Japanese Finance Minister Sadakazu Tanigaki said on Wednesday he wanted to carefully consider whether to change the weighting of gold in Japan's foreign reserves. "Tanigaki told a parliamentary committee he thought it necessary to take a standpoint of diversifying assets in Japan's foreign reserves, which are mostly made up of dollar-denominated assets. "Asked about gold, he said he would think about it carefully. 'There are various discussions about the positioning of gold in foreign reserves, even among...currency authorities,' Tanigaki said. 'If I say something too simply, I think there could be a large effect on gold markets...so I would like to consider it carefully,' he said. "

On the Oil Take in Saddam's Iraq

The day is certain to be dominated by the housing numbers and the Fed's announcement...that interest rates are going to stay low. But that doesn't mean there isn't a lot going on geopolitically. For instance, you probably won't hear much about this...but Le Monde...the big French daily...republished a story from the Arab press about who Saddam Hussein was bribing with oil. You can find the whole article here. An excerpt below. Please note, this is a google translation of the story...so it isn't perfect...but it sure is revealing. "For France, not less than eleven names are published with the quantity of oil barrels which were allocated to them. Among them, written with a sometimes approximate orthography and including/understanding some uncertainties on the first names or headings of companies and associations, appear the company Adax, Patrick Maugein de Traficor or Travicor, Michel Grimard, the association of friendship arabo-Frenchwoman, Charles Pasqua, Elias El-Ferzeli or Ghazarli of Lebanese origin, Claude Kaspereit, Bernard Mérimée (former ambassador from France to Rome and UNO), Bernard Desmaret and De Souza. "12 million barrels would in particular have been allocated to Charles Pasqua, four other Mr. Kaspereit and three with Mr. Mérimée while Patrick Maugein would have profited from 25 million barrels. No other precision is given. The documents come from the SOMO (State Oil Marketing Organization), company of marketing of oil attached to the ministry for oil. A LETTER OF THE SOMO "George Gallaway, former Labour deputy with the Communes, appears in good place in the list. Its name is mentioned in six contracts and the newspaper publishes a letter of the SOMO on December 31, 1999, signed by Saddam Zbin, cousin of Saddam Hussein which managed this company and in which it asks for the ministry for oil of grant contracts to him. Apparently, this British member of Parliament was particularly well treated. But it is not only. "In this very long list appears also Khaled, the son of Egyptian president Nasser, the son of the Syrian Minister for defense, the son of the president of Lebanon, Emile Lahoud, the girl of the president indonésien Sukarno, Megawati, today Prime Minister, the Russian orthodoxe church and the Russian Communist Party. "The Russian ultranationalist Vladimir Jirinovski, it, particularly are also well parcelled out (79,2 million barrels). Swiss companies, Italian nationals, Jordanian deputies, Egyptian politicians, the Popular Front of release of Palestine (FPLP), the Palestine Liberation Organization (PLO) are quoted. The list is not exhaustive. "Among the quoted countries appear inter alia: South Africa, Algeria, Saudi Arabia, Australia, Bahreïn, Bielorussia, Brazil, Bulgaria, Canada, China, Cyprus, Spain, Libya, Malaysia, Morocco, Nigeria, Oman, Panama, the Philippines, Qatar, Romania, Turkey, Ukraine, Yemen and Yugoslavia. "These disclosures caused in the close countries, either of the made indignant reactions, the ones calling upon slandering or the political plot, or of the justifications according to which they were legal businesses carried out in due form. As far as the knowledge can, the selected people received attributions for a certain volume of barrels which were then resold at companies. The interested parties touched in the passing a commission of which the percentage is not known.

January 27, 2004

Ryland Leads, HGX Follows

If you want to know what I think will happen to homebuilding stocks in general, look at what happened to Ryland in particular. Double Top, Triple Top, Correction Double Top, Triple Top...And?

Homes Boom Again

The housing market just keeps surging forward. Yesterday, the National Association of Realtors (NAR) said that December existing home sales rose by nearly 7%. And for the year, sales of existing homes made a new record. 6.1 million existing homes were sold in 2003, beating 2002’s mark of 5.56 million. Prices also rose at 7.5%, the fastest rate since 1980 (11.7%). And from what the NAR says…demand for housing is robust. In fact, NAR’s David Lereah says that, “the reason we have such strong price appreciation is because we’ve got lean inventories.” By inventories, he’s referring to the supply existing homes. And by NAR’s count, inventories fell 7.3% in December. That leaves 4.3 months supply at the current sales rate. Based on those numbers, there’s no reason to think housing prices couldn’t keep going up…and that home sales will stay strong in 2004. Supply, it seems, is barely keeping up with demand. And tomorrow, we’ll find probably find out that new home sales were up in December too. Most economists surveyed by Reuters are expecting December’s numbers to come in over 1 million units. All of this is pretty convincing…if you don’t look beyond the surface. The surface argument is simple and compelling. Housing demand is strong. In fact, supply can hardly keep up with it. Home prices are rising and rates are low. The boom will continue, driven by new buyers, refinancing at low rates, and demographics (esp. boomers buying second homes.) Underneath the surface, though, is an economic reality: housing activity is strong because money is cheap. It all hinges on low interest rates. I won’t recap all the details I’ve gone through over the last few weeks. But the kernel of my observation is that the housing market is not being driven by normal, sustainable, affordable growth. It’s being driven by a credit binge…where the newest buyers are the biggest credit risks. In other words, if you just looked at the supply dynamic, you might be convinced everything is fine. But the closer you look at demand, you see that it’s been artificially stimulated. And that can’t last forever.

Quote of the Day

"French lawmakers, who are the heirs of those who voted for the Declaration of the Rights of Man and the Citizen, have no reason to listen to the speech of a head of state who will speak in hackneyed phrases." Lionnel Lucca, French lawmaker, on today's speech by Chinese President Hu Jintao to the French Parliament

January 26, 2004

Discounting the Election

One of the reasons the VIX is so lowly is that no one thinks much of anything will happen between now and the election. In other words, there won't be a change in the dollar policy (i.e. the U.S. monetary authorities will let the dollar slide and force others to do something about it.) or in interest rate policy--low rates, after all, being the engine of the housing boom. This begs the question of what would happen AFTER the election...and if markets discount the future...won't they discount what's going to happen after the election BEFORE the election? THAT depends on how certain you are which things would definitely happen after the election. And of course, no one can be sure that, for example, interest rates WILL rise after the election, taking some of the currency pressure off Europe and Asia. It's one thing to buy the rumor and sell the news. It's another thing to try and guess what the rumor will be and trade it ahead of time. The further you get ahead of the present in your prognostications, the more speculative your forecasts become. After awhile, it's just educated guessing, at best. But...if everyone is certain rates will rise after the election...a truly efficient market, reflecting the opinions of all the actors, would price the rate increase before it actually happened...i.e. before the election. Wouldn't it? Unfortunately, the future is so murky right now...that no one seems comfortable taking a strong position on the future of interest rates. Thus the complacency. Incidentally, one good way to take advantage of the complacency is to buy puts on IIX.

Risks, Chart of the Day

For all the risks in the global economy (more below) investors are historically complacent. Just how complacent? Take a look at the chart below, comparing the CBOE Volatility Index (VIX) with the Inter@ctive Week Internet Index (IIX). Pretty clear. The less investors care about risk (VIX), the more Internet stocks they buy (IIX). What kind of risk is being taken here? Here are the top five holdings of IIX and their respective p/e ratios. 1. Qualcomm (QCOM) -- p/e of 49 2. Broadcom (BRCM) -- no earnings, but it's losing about $9.90/share 3. eBay (EBAY) -- p/e of 99 4. Juniper (JNPR) -- p/e of 188 5. Symantec (SYMC) -- p/e of 39 But aside from simple market/value risk...there's plenty of Marco risk. Stephen Roach had an excellent report from the World Economic Forum at Davos. The outsourcing issue is beginning to rankle a lot of people...mostly because it's starting to cost high-paying white collar jobs as well as high-paying manufacturing jobs. He also makes the point that globalization is a destructive as well as a creative process. The upside for Americans, the rest of the world is producing astonishingly cheap goods for us to consume. The downside, Americans who used to make their living making this goods or providing these services are out of a job. The net result is a return to protectionism...which our fearless political idiot leaders in Washington have no shame in returning to right away. As the campaign heats up this spring and summer...don't be surprised if the candidates try to outdo each other on ways to save American jobs, the American farm, and the American worker. Globalization is generally good for us, except when it's not. From Roach (emphasis added is mine): "The fifth theme I took away from Davos this year is the most worrisome of the lot, the mounting risk of a protectionist endgame. Former senior policy makers were especially worried about the ramifications of the rapid emergence of China and India. One argued that the pace of change, to say nothing of the scale and scope of such development, shatters any semblance of globalization's status quo. Another stressed the precedent of agriculture as an example of how badly the modern world has bungled secular declines in core economic activities; the fear is that today's protectionist web of farm subsidies could well be a harbinger of what's to come in the aftermath of the secular decline in manufacturing. Needless to say, pressures on services would only exacerbate this risk. "Concerns over mounting protectionist sentiment in the US Congress were especially evident in Davos. Japan and the US have led the way in China bashing, and there is fear that Europe is about to follow suit. History does not speak well of the world's ability to cope with large entrants in the arena of global commerce. The darkest fears of Davos pertained to the lessons of such episodes in history and how they may apply to a world that is now attempting to cope with the rapid emergence of China and India, nations that collectively account for more than 35% of the world's population. Trade liberalization, the mainstay of globalization, cannot be taken for granted in this climate. "Yes, there was an improved tone in Davos this year. But it came off of easy comparisons, a world that a year ago was weak economically and on the brink of a serious war. A rebound in the global economy and world financial markets has certainly tempered any residue of angst -- at least for the time being. Moreover, there was a nearly unanimous view that nothing bad could happen to this US-centric world between now and the November 2 American presidential election. At the same time, there was a palpable sense of unease as to what might then follow in the post-election climate. This tug-of-war between a constructive near-term outlook and the ever-mounting strains of globalization was the essence of this year's debate at Davos. "

Pressure Builds on GSEs

Two interesting excerpts from an FT article on Freddie Mac. I mentioned last week that Freddie's current regulator is trying to curb FRE's ability to expand its balance sheet until the company comes clean on last year's accounting picture. The FT reports that the Office of Federal Housing Enterprise Oversight (the office that produced the report on the GSEs and systemic risk) told the Senate last week that Freddie Mac, "remains exposed to "substantial management and operations risk." OFHEO has proposed that Freddie hold up to 30% more capital. The other itriguing revelation...is that Mark Brickell, the former J.P. Morgan managing director and derivatives expert, withdrew his nomination to become the director of the OFHEO and supervise the GSEs. The regulatory pressure is heating up in GSE-land...

Bird Flu

In the age of media hype, stories are often more interesting for what they could become than what they really are. But this Bird Flu in Asia should at least be a reminder that pandemics are a staple of history. The Spanish Flu killed more people in five short months in 1918 and 1919 than were killed in the four years of the Great War. It also infected a fifth of the world's population, nearly 30% of Americans...and killed over 670,000 Americans. Estimates vary over the global death toll. But between 20 and 40 million were killed. Could it happen again? Antibiotics are much more pervasive now than they were then. But the flu mutates as well. And scares like the bird flu are grim reminders. Needless to say, this would be fairly disruptive for global markets...in Asia in particular where the poultry industry must surely be in dire straits. London Free Press: News Section - Deadly bird flu confirmed in Indonesia: "Asia is on a region-wide health alert, with governments slaughtering millions of chickens to contain outbreaks in Thailand, Vietnam, Cambodia, South Korea, Japan and Taiwan. "Vietnam has slaughtered more than three million chickens, while Thailand has exterminated about nine million. Yesterday, the Thai government enlisted hundreds of soldiers and 60 prisoners to help with the mass cull. Scientists believe people get the disease through contact with sick birds, raising concerns it might mutate and link with regular influenza to create a form that could be transmitted from person to person, fostering the next human flu pandemic. "