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ACID TEST ON YEAR-OLD VIEWS

In August of 2003, a series of articles entitled “Ass-Backward Economics” summarized my entire position, published in part I, part II, part III, and part IV. The irreverent banner was indicative of my disdain for economic directives, which have been backwards, ever since Greenspan departed from responsible banking policy. Economic policies and direction are pure folly. It took ten minutes for me to explain to Kurt Richebächer one afternoon on his porch, what was meant by the title. We had a good laugh during my demonstrated twisted walk with a leading backside, perhaps my best side. He had invited me on a visit to his home in France, based on the contents of that article series. A quick review might be worthwhile, in order to see where we stand, how my views were right on, and where they were off, perhaps even why. In review, little is off. This essay is the first of two installments, since in all ten fallacious beliefs and policies were listed in the original work, along with a preface of Gresham’s Law and two original corollaries.

Any analyst worth his salt occasionally reviews past work for a validity check with reality. This excludes Wall Street analysts, who would be too embarrassed. It excludes most economists, who would merely offer extenuating circumstances, which overwhelmed their simplistic views, burdened by vested interests. Many backward policies have served as principal planks in ongoing directives, some of which stand amazingly without challenge. Most are designed to perpetuate a system, which has grown wholly indefensible. Their advent began when Chairman Greenspan strayed off the rational path in 1996. At that point, corporate profits faltered, productivity faltered, household debt grew, household savings vanished, foreign dependence grew, and our real economy began to disintegrate. The USA has since moved into a higher reverse gear, step by step. Most of my positions remain sound.

Many fresh new perceptions can be found in my HAT TRICK LETTER newsletter issues. Our misguided leaders have embarked on new strange directions, which are identified, complete with grand but thoroughly rationalized stresses. Furthermore, additional forecasts can be followed from my analysis in the pursuit of hefty investment profits in the mining and energy fields, which have begun to materialize. We are at the doorstep of serious change in the winds. The gating factors are identified to my readers more fully.

We have maintained a very wrong path since 1996. Many recall the myopic chairman’s speech warning of irrational exuberance. He should have heeded his own urgent warnings. A policy change was seminal and critical in 1995 and 1996. The Fed used to manage the money supply with tempered control based upon growth of the economy and its population. Nine years ago, we departed from that prudent path. In this new age, money supply has been permitted to grow almost without bound or discipline as long as no detrimental effects were observable in the consumer price index. This was insanity, and was total heresy in the historical guidelines of any sane central banker. The United States created great monetary expansion, and exported the inflation to Asia primarily. Asia overbuilt their manufacturing base, employed fractional banking to put at least $10 to use for every $1 in “hot money” held in their banks. A valid argument can be made that we inflated at home, and in the immediate, paid our bills to Asia with inflated money. As their production rose, our imports accelerated. The USDollar enjoyed a bull market, which translated into all imports falling in price. However, our national foreign dependence advanced in its destructive magnificence. Our inflation actually caused lower prices. We locked in a delayed reaction on realized consumer price inflation, which is the final step soon to be seen domestically. The mania continued up to 2000, fully supported by mythological mumbo jumbo rationalization, when the bust began. All economic policy has been screwball since the bust, in a desperate attempt to flood the system with liquidity so as to avoid a collapse. Heresy continues to be promoted as policy bound in wisdom.

Some backward beliefs and policies (with what was said over a year ago in italics):

Gresham’s Law: “bad money displaces good money” (timeless axiom)

This continues to be true, as the USDollar retrenchment all year long continues to pressure gold. Something unusual is in progress. Even though the DXY index on the US$ is nowhere near its January lows with an 85 handle, gold has pushed past $420. Perhaps liquidity floods assist gold as well? Methinks the Asians are totally awash in surplus US$-denominated securities, and have broadened their accumulation of gold, unwilling to invest further large amounts in US TBonds. Bad money may have limited displacement potential in the future of Asian coffers.

My Gresham’s Sector Corollary: “Industry sectors nourished by bad money and debt will displace the productive sectors anchored by real money” (Aug 2003)

The strain at General Motors, Ford, and Chrysler drives this corollary point home. GM and Ford recent quarterly statements highlight the dominance of their mortgage and car finance operations. Car sales are a necessary front for their lending business, as great pressure exists from pensioners and their health costs. Dozens of carmaker plants are scheduled for closure in the current and upcoming future years. Other stories in the news have been the closure of Maytag in the home appliance business. Mortgage lending, home appraisal, realtor, the home construction business, and home remodeling (see Home Depot and Lowe’s) have been beneficiaries to this sick trend. Detroit carmakers are the losers, as market share loss dictates plant closures.

My Gresham’s Debt Corollary: “assets closely associated with heavily indebted businesses are vulnerable to liquidation or impairment in value” (Aug 2003)

My view has not proved right when the assets have one leg in speculative arenas. Take KMart for instance. They exited bankruptcy last year, closed many stores, and restructured. They are now perceived as a Big Box real estate owner. Home Depot, Sears, and other chains have not only eyed their properties, but bid and purchased several. Their stores proved perfect in size and footprint. The KMart stock price has quadrupled this year alone, with little profitable operation improvement. However, the same cannot be said for abandoned assets owned by Maytag, machine tools businesses, and Detroit carmakers. Those assets are surely impaired and will sell for a song. Real bargains might be seized if certain equipment can be deployed efficiently. Given the stress to the entire manufacturing sector, difficulty in turning a profit will be a common thread in similar businesses.

Fallacy a) The US Economy is in danger of falling into deflation, so the Fed must accelerate the monetary pumping operations. Wrong diagnosis, wrong cure, feeble attempt to cover its tracks… The structure of the US Economy is now deeply dislocated, out of balance. The current price deflation is a structural phenomenon. Greenspan has diagnosed it as a monetary problem, unleashing vast money supplies in its treatment…The end result will be arterial aneurisms from the excessive blood supply that the economic body cannot properly handle… We are soon to see even lower product prices and even higher commodity prices, just when the housing sector falters. (Aug 2003)

The manufacturing sector has fallen by 1% more of GDP in the last year. In a 13 county area of western Pennsylvania, from 2002 through late months of 2003, over 120 thousand mfg jobs were lost. The state of Ohio registered over 200 thousand lost jobs. The several jobs reports in recent months have shown either a drop or a very slight gain in mfg jobs. The structural problems have greatly worsened. Evidence is so clear of greater structural damage, with aggressively growing trade gaps. New jobs are widely reported to be lower paying, without fringe benefits like health insurance. Commodity prices continue to make new highs, with copper and crude oil the most notable. Gasoline prices have finally caused public alarm. Cement prices are higher, but more importantly its shortage has halted large projects in Florida. Some steel products have tripled in price, matched by certain lumber products. Meanwhile, the residential housing market continues to inflate in coastal urban areas, and elsewhere. In numerous locales housing has stalled, as unsold new home inventory has logged higher. The foreseen faltering in housing prices is isolated, and not yet systemic.

Fallacy b) Lower interest rates are stimulating the economy and will eventually kickstart growth. Nonsense, the exact opposite is true in an environment burdened by overcapacity, although completely unnoticed… Low rates create a collectivist climate whereby the weak, the inept, the clumsy are given reprieve, all in the name of preserving jobs. As a result, low rates forestall an economic recovery… Pent-up demand is sorely absent, a requisite ingredient in order to reap the advantage of attractive rates… Mfg is at a historic overcapacity now, with only 75% capacity utilization… In the year 2001, roughly $1100 billion was earned in interest income [while] only half that figure, roughly $600 billion was paid out as costs to service [debts]. (Aug 2003)

To be sure, many large US firms have rolled over bonds and reduced their borrowing costs, as greater fools stepped up to purchase overpriced securities. Unfortunately, the “walking dead” have done the same. General Motors perpetrated a massive fraud by selling their pension exposure as collateralized debt obligations (CDO) when they are technically insolvent, i.e. bankrupt. Their debts are 8 times their market capitalization. Hundreds of other companies are quite weak, and would possibly benefit from the wonders of bankruptcy restructure. Instead, those companies maintain a high cost structure and will not grow, or will grow anemically. Banks and bond holders would be the losers. The car industry continues its insanity with zero percent deals and large cash rebates for new car sales. Reports have surfaced that underwater balances of existing loans from the trade-in cars have routinely been rolled into the new loans. Car finance has reached new depths. No pent-up demand exists whatsoever. Detroit experimented in past months with withdrawn promotions, only to put them right back on when sales slumped badly. Other major vendors like Circuit City, Home Depot, and large appliance dealers have begun extraordinarily easy finance terms. This trend toward easy money is deepening.

Manufacturing capacity utilization has not recovered materially, up to 77.3% in August. Much of it simply obsolete, never to go back online. Labor renders much of it irrelevant in a global economy. Retirees complain broadly about severe income losses. At least three stories personally have been recounted to me on their loss and its impact on their lives. All priority is directed toward the young and middle aged, who rely on low interest rates and new debt creation. Its addiction has been written about in previous essays. Little appreciation seems to exist for the plight of the retired workers.

Fallacy c) Real estate is in the midst of a great bull market, has held up economic growth, and is providing valuable equity for continued household consumption. Bull cookies, a new bigger bubble will cause bigger future problems when it runs its course… Why is it that rates are at 40-year lows, but both mortgage delinquencies and defaults are also at 40-year highs?... I believe the initial cracks in the residential real estate sectors have already shown themselves, along its foundation of mortgage finance. Not one, but three top executives at Freddy Mac were urged to resign, a euphemism for release and firing… David Chapman recognizes a looming mortgage crisis, on the scale of the 1989-90 Savings & Loan washout, or the 1998 Long Term Capital Management wipeout… For now their gambles have paid off, but when conditions reverse with higher rates or worsening labor markets, those gambles will bite hard. (Aug 2003)

The Federal Housing Authority provides insurance against default for mortgages either held by Government Sponsored Enterprises, or spun off as part of mortgage backed securities. A recent figure was reported at 10% default. Not much has changed in the great mortgage inflation and fraud story. A year ago, Freddy Mac officials issued grossly under-stated profits, as they sidelined them for future use, like a hedge fund piggy bank. A news release last week reported that Freddy will no longer act as a broker dealer in the multi-trillion dollar mortgage bond market. They will return to their original role of acting as intermediary between mortgage lenders and buyers of pooled mortgage bonds. They will thus remove themselves from the derivative casino. My personal take is that Freddy was permitted to return home from the casino after the USGovt assumed their monstrous hedge book, overrun by acidic losses.

Fanny Mae has bigger problems, which have only begun to surface. The ultimate damage, without governmental intervention and monetization to repair and to sanitize their hedge books, could conceivably bring down both the domestic housing sector and the US Economy. My name for this insane hedge fund is Short Term Capital Management, in mocked terms reminiscent of the LTCM implosion from 1998. It is not a coincidence that JPMorgan exited the news, only to show no ill effects from its monstrous hedge book on recent earnings statements, after two separate bond revolts. The summer 2003 and spring 2004 bond events probably killed JPMorgan. It is in Fed receivership. Talk about offloaded risk! The same changes probably killed Fanny and Freddy, the obscenely obese compulsive gamblers on the housing veranda who are being crushed by a falling roof.

Fallacy d) The USDollar’s recent decline in value has adequately addressed the imbalances in world trade, affording our corporations the opportunity to compete on a more level field. No way, not even close, the USDollar correction has not yet begun… Together, Japan and China weigh in at $200 billion in trade surpluses versus the USA alone… Where have we seen more than minimal shifts in Asian currencies in dollar terms? Nowhere… The yen has risen less than 10% versus the dollar in the past three years… Their [China] pricing advantage inside the USA is constant from the yuan’s pegged exchange rate to the USDollar, the recent source of political conflict… Such is life for economic ships in the sea of floating currencies since the abandonment of the Bretton Woods anchor to gold. Shifts in currencies act much like giant invisible tsunamis, crashing onto commercial shores. (Aug 2003)

The USDollar decline continued to a January climax, but since then has stalled in a major way in recent months. No progress has been made in repairing the trade gaps. In fact, they are much worse. The last two trade gaps were a mind-boggling $55.2 billion in June, followed by $50.15 billion in July. Just when the January gap of $45.2 billion trade gap registered a record hard to surpass, new records are set in subsequent months. The Chinese trade surplus has increased by roughly 25% in the last year. The Japanese yen has actually given back its gains won by January, evidence of the titanic struggle. At odds are their exporters who want a low currency exchange rate versus those who purchase foreign oil to power their economy, and the interests of foreign investors in Nikkei stocks. Exporters have the greater political pull, so it seems. The euro offers the least resistance to central bank and FOREX trader attempts to seek balanced remedy. Thus the slosh of currencies strains the euro exchange rate periodically, only to realize the futility of doing so when the problematic imbalances demand a solution. The trade gap with the European Union has grown over 30% in the last year, despite a similar rise of more than 30% in the euro currency. Correction to imbalances is nowhere. We have seen frustration within the G-7 finance ministers, who seem increasingly helpless to direct true remedy. Their newest tack is silence on important issues.

Fallacy e) We must encourage continued consumer spending, by whatever means, in order to sustain the economy at a healthy growth level. Sure, if toxic debt and lethal trade hemorrhage are worth continuing… An imbalance exists characterized by consumption far in excess of production across the nation… To exhort households to step up and keep the engine running seems ridiculous, since additional debt extensions are clearly required… I object to the spirit of the stimulus package, which states an intention to sustain consumption regarded as essential to the economy. The design is flawed… Employing such ideals, our investment society would hold in higher esteem a household couch potato who downs a pizza, a six-pack of beer, while ordering unneeded video games on extended credit than we would a man who joins his wife on that same couch for a snuggle, a favorite show, and an early lights out to prepare for the next day of work, eagerly awaiting the vacation they save for. (Aug 2003)

The insanity of consumption prevails in our economy. US households will spend $3 billion in Halloween outfits this season, an exclamation point on useless futile spending. Zero percent deals are as widespread as ever, for the purchase of cars, furniture, and home electronics. The deal has spread to cabinetry and materials for home remodeling projects, even to home jacuzzis. Furniture can be bought with frontloaded finance. Every month a new item is offered by vendors with liberal supplied finance terms. The list goes on. Our national obsession with shopping has become so entrenched as to be intimately linked with emotional depression, both as cause and effect. Our economic policy makers perpetuate pure unadulterated drivel, that evermore consumption spending can lift our economy out of a recession. This is complete nonsense, but it continues to fill the conference rooms and airwaves.

Whether from tax rebates or tax refunds, the effects are glaring. Retail sales figures slowed markedly this past summer, precisely when IRS tax refunds had wound down to nearly nothing. At the same time, observers trained their eyes at rising long-term interest rates. Home equity raids via refinanced mortgaged had been temporarily interrupted. Car manufacturers experiment with reduced sales promotions, only to reinstate them after flagging sales. New cars routinely are offered for sale with both cash back and nil interest rates. The used car market has been decimated in the process. Shopping malls continue to spring up along the trails of my travels. Work centers are replaced by shopping centers, in a stark microcosm example of how debt has displaced wealth.

CONCLUSION

The so-called economic recovery is being ridden on the backs of households, who are in the worst fiscal shape of all economic partakers. They are running the largest net deficits in 76 years. Consumer debt has risen 13.8% in the first two quarters of this year, after more gargantuan increases in the past two years. Even as interest rates descended to historic lows in 2001, the household financial obligation rose. The ratio of disposal income devoted to debt service actually rose as rates declined in accommodation, which speaks volumes as to new toxic debt taken on as burden. In the last year, that ratio stood roughly at the same high level as in the year 2001. The trade gap marches inexorably higher, quarter by quarter, to remain lethal. In the last year, my analytic refrain has been that the increase to money supply roughly equals the increase to household debt, which roughly equals the increase to the Chinese trade surplus. So most new money goes to debt, and heads through retail spending to China. We continue to pull Asian economies. Our toxic debt and lethal trade gaps continue to provide nourishment for Asian investment. This is not progress, but rather pure insanity, a clear confirmation of ass-backwardness.

NEWS TIDBITS

The bond market was closed, in observance of Columbus Day. Stocks traded in light volume, as they lacked guidance from the larger bond market. The US Senate easily gave final congressional approval to a huge corporate tax bill that aims to end a trade fight with the European Union. It repeals $5 billion in US export tax subsidies that violate global trade rules. The $140 billion cost to the Treasury in new business tax breaks in the bill was offset by repealing the export subsidies, closing some corporate tax shelters, and other revenue raising measures. But critics said some of those measures were gimmicks that mask the bill's true cost. US machine tool demand in August rose sharply from a year earlier as manufacturers ratcheted up purchases amid signs the economy is improving, two industry trade groups report. The American Machine Tool Distributors Association (AMTDA) and the Association for Manufacturing Technology (AMT) said US machine tool demand stood at $225.52 million in August, up 54.2% from $146.27 million in August 2003. French and Chinese made agreements on over $1 billion in military hardware sales, following an air show. Volkswagen owns a 30% market share of cars owned inside China.

Crude oil prices hit record highs over $53.60 per barrel. The lingering impact of Hurricane Ivan, which hit Gulf oil producers nearly four weeks ago, has further tightened supply. About 475 thousand barrels per day of Gulf of Mexico oil production remains out of commission, one third of which is expected to be resumed by the end of this month. Nigeria also remained a worry after repeated threats to its production. Its unions began a 4-day general strike over fuel prices, although oil executives said there should not be an immediate impact on output, which accounts for about 3% of the world oil output. Norwegian oil rig workers plan to cut an additional 25 thousand barrels of oil per day as they broaden a 3-month strike. The strike has hit a total of 55 thousand barrels per day of Norway's three million bpd output. The general problem with labor strikes in the oil industry has to do with workers not sharing in higher energy prices earned by production owners. Gasoline prices rose an average of 7.8 cents nationally, to $1.99 per gallon. Dealers have seen half the price pressure that suppliers have recently endured, so some catch-up might be coming soon in gasoline price increases. As in, higher prices still.

Fanny Mae announced their new folly, a 40-year mortgage contract. It is planned for launch next year, and would enable monthly costs to come down slightly. They claim an even wider population would be permitted the privilege of home ownership. Does anyone realize Japan offered 100-year mortgages at their mindless housing peak? Perhaps Americans can look forward to passing along mortgages in last will and testaments, just like Japan did. Can the agency sell new products when the foundation of its old products might be in bankruptcy receivership, amidst ongoing earnings restatements?

"Superman" actor Christopher Reeve, who turned personal tragedy into a public crusade, died at age 52. From his wheelchair he became the nation's most recognizable spokesman for spinal cord research, then stem cell research. Reeve went into cardiac arrest at his New York home, then fell into a coma and died Sunday at a hospital surrounded by his family. He became a paraplegic after his 1995 horse riding accident. The irony is unmistakable. The pair of career ending injuries to Reeve and Bo Jackson (football, baseball, golf, race car driving, rock & roll guitarist) came at their peaks. The 1996 baseball MVP Chris Caminiti died of a heart attack. He made news years ago in revealing the wide steroid usage in major league baseball. New York Yankee pitcher Mariano Rivera might miss the entire remainder of post-season baseball. His nephew and father were electrocuted and died in a swimming pool accident at his home in Panama. The Boston RedSox, New York Yankees, and St.Louis Cardinals have secured berths in the next round of baseball playoffs. The Atlanta Braves and Houston Astros determine the last berth tonight. The New England Patriots set an NFL record with 19 consecutive pro football wins. Animation “Shark Tale” took the top movie box office spot with $31.7 million, followed by “Friday Night Lights” at $20.6M and “Ladder 49” at $13.3M.

TODAY’S MARKET

Today the Dow Jones Industrials wrapped up at 10,082 (+27), S&P at 1124 (+2.2), Nasdaq at 1929 (+8.8), TENS yield 4.133% (closed). Currencies closed with Euro at 124.13 (closed), JYen at 91.67 (closed), Can$ at 79.84 (closed). Metals finished with gold at 422.0 (-0.9), silver at 723.0 (unch), copper at 147.35 (+0.05). Energy ended with crude oil at 53.62 (+0.31), natural gas at 694.0 (-22.3), unleaded gasoline at 140.75 (-0.45). Prices are at major futures contracts.

Jim Willie CB

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