January, Tuesday 03, 2012

DOW + 201 = 12418
SPX + 21 = 1278
NAS +44 = 2649
10 YR YLD +.09 = 1.96%
OIL +4.22 = 103.05
GOLD +37.20 = 1604.60
SILV +1.85 = 29.81 (biggest % gain in 3 years)
PLAT + 32.00 = 1435.00

Here is the basic question for investing in 2012: will we see a turnaround? Will we see economic growth or is the economy so inherently damaged that you should fear it and possibly short it?

The Federal Reserve has been driving the bus, so let’s start there. The Fed has been active in Quantitative Easing. This means the Fed has been adding tremendous amounts of money into the financial system by selling treasuries directly from the government to the big banks at auction.  The Fed then purchases the treasuries from the big banks, also known as primary institutions, and pays the banks by crediting their accounts. The big banks get paid for holding the treasuries in reserve. And the big banks now have new “cash” for their banking activities. You have to think the Fed intervention had something to do with treasury bonds posting one of their biggest annual gains last year.

Further, the Fed has a ZIRP Policy, or Zero Interest Rate Policy. The Fed has held interest rates to the big banks at near zero for the past 3 years, and they announced today they will communicate any intention to change the ZIRP – there will be no surprise interest rate hikes, but eventually there must surely be an interest rate hike. This Zero rate policy cuts into profitability of traditional lending; so it is much easier to park excesses in reserves, and let the Fed pay a risk-free profit to the bankers. It’s a good gig if you can get it – money for nothing. For bankers that want to pump up profits (and bonuses) they can take some of the newly created cash and they can trade in the financial markets; this pushes up prices on stocks, bonds, and commodities. The problem is that it doesn’t do much to get the economy growing.

John Bogle, the founder of Vanguard, and the creator of the S&P 500 Index mutual fund, says the financial industry is no longer involved in growing the economy: “It's something we think of as providing capital for new businesses, that will enable people to finance new companies or add to the capital of existing companies. We do that to the tune of about $200 billion a year in financing through Wall Street, or through the financial system. And yet we do some $40 trillion worth of trading every year. I'm selling my investment to you, and you're buying it from me, and it creates no value for society. Indeed, it subtracts value, because the guy in the middle gets his piece.”

And while all this “banking activity” really amounts to nothing more than gambling; it does not help grow the economy, it does push prices higher. The official inflation rate is 3.4% over the past year. You have to understand that this is not the same methodology to determine inflation that was used in decades past. When prices get too high for certain items, the government stops counting. Regardless, 3.4% is a pretty high inflation rate, especially when you consider that 8.6% of the population is unemployed, 16% are underemployed, wages are contracting, and personal savings have dried up. You might expect inflation during times when the economy has started to show signs of strong growth. So, either the economy has started to grow, or we’re moving into a nasty scenario of slow to no growth with increasing inflation.

The Fed’s policies discourage savings. The personal savings rate is so low that there will likely be shortfalls for many people considering retirement, and the personal savings rate does not contribute to pent-up demand – the converse is true; we have been learning how to make do with less.

Demand is needed to grow the economy, and demand is not likely to return without a significant improvement in unemployment. We still have a problem with jobs, or more specifically, the lack of jobs. The country added 1.4 to 1.5 new jobs last year. Too bad the working age population went up by 1.7 million people.

And somehow the unemployment rate dropped from 9.8% to around 8.6% officially – just a reminder, when the Fed first announced stress tests for the banks a couple of years ago, they used 8% unemployment as a worst case scenario. The U6 unemployment rate is almost 16%, and a more accurate rate of underemployed and marginally employed and potential workers who have just given up or moved underground puts the unemployment number around 23%. On top of the weak labor market, wages stopped growing, they contracted last year; on an inflation-adjusted basis, wages have contracted over the past 10 years.

It’s a wonder we still buy anything in this country; less surprising is that we use credit to finance our consumer purchases. Consumers are re-levering. Consumer credit is at its highest level in more than 2 years. This is consumer credit, the high priced financing, not the kind of rates the big banks pay; rather it’s the kind of rates the big banks charge. Nothing ratchets down demand faster than not having money, and financing consumer purchases has a short shelf life.

Meanwhile, the Fed is trying to resuscitate the housing market by purchasing mortgage-backed securities, maintaining a Zero interest Rate Policy, and buying long-term treasuries. They are trying to re-inflate the housing market based on flooding the market with cheap money, not by increasing the demand for owning a home; that demand only comes from people with jobs and a sense of job security. Without demand, any attempts to re-inflate the housing market is artificial – we’ve already seen that bubble pop, and we shouldn’t be surprised that artificial stimulus hasn’t been enough to lift housing – which closed out 2011 at its lowest levels since the peak.

So, where does that leave us?

Interest rates will go up at some point but for now the Fed will try to keep rates as low as possible for as long as possible. The Fed’s efforts to combat economic contraction are inflationary; they must walk a fine line between stimulating the economy and just inflating the economy. Also, the labor picture has significant structural flaws. We have shipped manufacturing jobs offshore. We replaced manufacturing jobs with financial services and real estate connected jobs, and then we lost those to the bubbles. We have to come up with some better ideas for jobs – something with productive purpose.

Next, you have to consider exogenous events; such as Europe setting off a global financial meltdown. Austerity measures in Italy, Greece, Spain, and Portugal plunges all of Europe into a major recession. Spain and Portugal will follow Greece into an outright depression. There is a decent chance that some country leaves the Euro, or gets kicked out. This just makes the US economy look better by comparison.

Or maybe a geopolitical dust-up that affects the oil supply. That would be ugly, especially considering that in 2011, we had the highest average gas prices for the year in the history of the USSA.

There is certainly plenty to fear for 2012, and perhaps even enough to make you embrace the short side, but then you have to remember that the solutions being offered by the Fed may work – for a while; they’re not solutions, but they are effective Band-Aids. The markets are driven by liquidity – the bankers and brokers and fund managers and bond vigilantes just love it when the Fed throws free money at the markets. Just because the financial services industry is part of the problem, doesn’t mean we’ll see a collapse tomorrow. And there is a good chance the economy will shuffle along. It’s hard to call it a turnaround. There is an excellent chance the Fed will institute QE3 and the Fed will buy more toxic assets from the bankers, and continue to erode the finances of senior citizens, people who try to save a few dollars, people who eat food or use other commodities, like heating oil or gasoline.

The investment banks have an army of Wall Street strategists to try to buffalo you into believing the S&P 500 will go up 10% this year; so says Abby Joseph Cohen, and Byron Wein, and Kiplinger’s, and the cheerleaders at CNBC, ad nauseum – it’s the exact same prediction they’ve made every year for the past 12 years. Over the past 12 years, the S&P hasn’t done anything. The only thing I can think of that would cause a huge rally – a 10% to 15% rally on Wall Street, is if a few of the big name investment bankers were arrested for the greatest financial fraud in world history. Nothing would brighten the mood of the public more than a good tough prosecution. Don’t hold your breath.

There is a good chance the markets will whistle past the graveyard. There’s a chance – slim, but a chance. Don’t confuse a slim chance with a bull market. And don’t think it will be a cakewalk to short a market pumped full of liquidity.

Several Wall Street firms have recently published their gold price forecasts for 2012. Goldman Sachs predicts the price of gold will peak at $1,900 per ounce and average $1,810 per ounce in the coming year.
Gold prices will rally again in 2012 to reach $2,000 to $2,500 per ounce according to a commodities strategist at Bank of America Merrill Lynch.

UBS has reiterated its bullish outlook for gold and believes gold will average $2,050/oz in 2012. Barclays Capital says gold will average $2,000/oz in 2012 – which is 25% above today’s spot price. John Embry, of Sprott Asset Management, said the price of the yellow metal could possibly exceed $2,500 in the next 12 months.

 A private trade group said that U.S. manufacturing expanded last month at the fastest pace in six months. The Commerce Department also said that U.S. construction spending jumped in November on a spate of new projects for single-family homes and apartments.

It is now official; the USSA closed the books on 2011 with record high debt of $15,222,940,045,451.09. Seriously. Who calculated the 9 cents? The debt is now just a smidge above the GDP.

The situation with Iran – while serious, is probably not going to escalate much. If the Iranian government makes good on recent threats to stop oil shipments through the Strait of Hormuz, oil prices could jump by $20 or $30 dollars a barrel in a day or less, and the price of gasoline would jump by about $1 a gallon. And this would be one of those exogenous events that could plunge the economy into a fresh downturn. Iran just concluded a 10-day military exercise intended to prove to the West that it can choke off the flow of Persian Gulf oil whenever it wants. This is in response to economic sanctions that have been hurting the Iranians. They have effectively prevented Iranian access to main international banking networks, and this is problematic because oil is priced in dollars.

The oil markets are essentially ignoring the likelihood at the moment, but any increase in tensions will increase risk assessment and thereby pricing. One reason the markets haven’t reacted much to Iran’s latest rhetoric is that although it has threatened to close the Strait of Hormuz many times over the past 20 years, it has never followed through on the threat.

But a fresh wave of Western sanctions could hurt Iran’s economy enough to make Tehran much less cautious.

The latest sanctions, signed into law by U.S. President Obama on Saturday, will make it far more difficult for refiners to buy crude oil from Iran. And looming on the horizon is further action by the European Union, which next month will consider an embargo of Iranian oil.

If Iran can do enough to convince the world that it’s serious, it could scare the markets enough to cause crude oil prices to jump and insurance premiums to rise. That would punish the West without harming Iran’s economy. Even if Iran does not actually close the Strait, a continuing naval presence in its own territorial waters would put pressure on the traffic.

And here’s why it most likely won’t escalate beyond a little posturing. The truth is that Iran needs Western technology to prevent declining oilfield production. They also need Western refining capacity. Iran is the fourth largest exporter in the world when it comes to crude oil, but they have to import gasoline and heating oil. So, there’s a little price pressure on oil, but probably not $200 a barrel any time real soon.

Of course, Mark Twain once said: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

The man on the street's spend-ability has seen the worst five years' growth in half a century. For four decades, US real per capita disposable income has risen at ~20% a decade. For the average working man, that is a doubling of disposable income in a typical working life. The last 5 1/2 years, however, have seen no change whatsoever - the worst performance in at least half a century.