So California is Issuing IOU's?

By Jeff Diamond - So California is issuing IOU’s… And Bank of America, Wells Fargo, and others are accepting them as cash? It has been far too long since anyone has asked the question as to what qualifies as money these days. The Federal Reserve is creating dollars out of thin air at record speed, and the Federal government is spending stimulus and TARP money faster than anyone can count. If the old saying of “as goes California, so goes the nation” holds true, then we’re going to see a new kind of money printing in addition to to what the Federal Reserve and the U.S. Treasury have hidden up their sleeves.

Personally, I am very concerned about how all this is going to play out. At every level of government the only answer to our problems that politicians and bureaucrats seem capable of offering is to print money and issue more debt. Of course, FASB did its part by rejiggering accounting rules so that banks could hang onto their toxic assets and claim that they are still worth 100 cents on the dollar (bravo!)

If real estate hadn’t become so over-inflated (and over-built), then I would be telling everyone I knew to get out of stocks and bonds and to grab up as much “real” assets as possible… Unfortunately, real estate has become the epicenter of this financial implosion thanks to too many years of low rates, easy credit, massive leverage, and speculation. So, that’s hardly going to provide shelter in the storm.

Clearly, our government is hoping that their massive new money printing will avert deflation and bring on inflation. The rally in the stock market off the March 9 low is a good start, but since the economy is still clearly sucking wind, the government cannot remove their foot from the fiscal or monetary throttle. Increasingly, I hear more calls for a second round of economic stimulus in addition to the extraordinary measures already undertaken by the Fed. So here’s the trick… How do they do this without crashing the dollar and/or the bond market? Both are creaking more loudly all the time!

It seems that whenever the stock market rallies, the dollar weakens and bonds sell off. When the stock market falls, then we see the dollar rally and bonds hold firm. Seemingly, there is no formula for a steady currency and rising stocks and bonds… Clearly, our government is happy to throw the dollar under the bus, but while that has helped to rally stocks while also plugging holes in the financial system, the recent harsh sell-off in bonds helped to undermine the rally in stocks.

The answer is that our government cannot and should not be trying to save everyone and everything. Money printing, low rates, and debt got us into this mess in the first place, so why should that now get us out? Let’s just hope that all of these extraordinary measures don’t break what’s still working and that a new crisis isn’t the catalyst that ushers in real change.

New Bloggers

I am often asked to make more frequent postings to this blog. Although I would love to do so, I don't always have the time. Therefore, I have invited a few individuals whose opinions I greatly respect to post their views and comments to my blog. Obviously, I won't always agree with them and neither will you, but they are smart investors and serious thinkers.

Sam Ro is an equity analyst in my group at Forbes. He is fully involved with the entire process of picking stocks and researching companies for recommendation in the Forbes Growth Investor and Special Situation Survey investment newsletters. Just a few weeks ago Sam sat for the Level III exam of the Chartered Financial Analyst program. He has a degree in Religion from Boston University.

Taesik Yoon is a senior equity analyst and has been working closely with me at Forbes for 10 years. He has proven to be an excellent stock picker. He serves as associate editor of the Forbes Growth Investor and he is also fully engaged with the Special Situation Survey letter. Tae earned the CFA designation four years ago. He graduated from New York University with a degree in Marketing and International Business.

Jeffrey Diamond does not work at Forbes, but he joins our blog with a great deal of pertinent experience. He left Wall Street in 1995 after spending 12 years in fixed income sales at Credit Suisse First Boston and Bear Stearns. During that time he worked in both Tokyo and New York. Jeff has a B.A. from Columbia College (a.k.a., Columbia University of the City of New York) and has been managing money privately since 2000. He is an avid watcher of the economy and markets and has a true knack for seeing beyond the obvious.

I am looking forward to reading their comments. I have no doubt you will find them interesting and provocative.

Bernanke Not Likely to be Reappointed

What would you think if your boss said you are doing a "fine" job? Fine is satisfactory. It's not bad, but it's not good either. Fine means you should be doing better. Fine means your job is in jeopardy. Fine means you should be thinking about shopping your resume.

If you have a contract, you probably won't be fired and you probably won't be asked to resign. But when your term expires, you probably won't be asked to stay on. After all, there are plenty of other people out there who could do a fine job, too.

This is Ben Bernanke's predicament. President Obama, a man who is extremely careful with his words, recently said the Fed Chairman is doing a "fine" job. Earlier today, after Bernanke was grilled by Congress about what he did or did not say to Ken Lewis regarding the Bank of America acquisition of Merrill Lynch, the White House said it has "confidence" in Bernanke. Sounds like another lukewarm endorsement.

I think Bernanke is cooked, which is too bad. I think Bernanke did an excellent job of responding to the economic crisis. Bernanke will complete his term, which expires in January, but it is becoming increasingly clear that he will not be reappointed. It looks like Obama wants his own man at the Fed--namely Larry Summers. Summers probably wanted to be Treasury Secretary, but Tim Geithner got that job. I think Summers now wants the Fed chairmanship, and I think Obama wants to give it to him.

Buffett on CNBC

CNBC interviewed Warren Buffett today. He gave Ben Bernanke a strong endorsement. There has been much speculation lately about whether or not Mr. Bernanke should be reappointed as Fed chairman. President Obama was asked that question yesterday in a press conference and he merely said Bernanke was doing a "fine" job.

Obama's lukewarm endorsement has many wondering if he would rather appoint Larry Summers to the position. The biggest risk to Bernanke is the allegation that he somehow coerced Ken Lewis of Bank of America to go through with the Merrill Lynch acquisition despite concerns about Merrill's health. What worse, Bernanke has been accused of keeping Lewis from disclosing his concerns to his shareholders.

I commented on this and other issues on CNBC immediately after Buffett's interview. Click to watch: CNBC

The following commentary was recently sent to subscribers of the Forbes Special Situation Survey.

Although the Federal government now owns large chunks of formerly blue-chip companies, it seems investors have overcome their fear that capitalism is about to end. In fact, they now seem to believe that the worst of our financial and economic crisis is over. As a result, they are once again willing to put money at risk as evidenced by a number of factors. Spreads between yields on corporate bonds and Treasury securities have shrunk, the CBOE Volatility Index has declined significantly, and stock prices are up 40% from their March 9 lows. Yet despite this increased appetite for risk, we remain concerned that stocks will see another pullback. While there is plenty of evidence that the economy is deteriorating at a slower rate, we see nothing to suggest it is getting better.

First quarter earnings provided one catalyst for the stock market’s rally. Earnings were down from a year ago, but for the most part, they were better than expected. Many of the positive surprises were due to lower raw material and energy costs as well as layoffs and other aggressive cost cutting activities. More recently, however, commodity prices have been on an upswing. The Goldman Sachs Commodity Index, a composite of energy, metals, and agricultural goods, is up 41% from its recent low. The Energy Information Administration, which in January had forecasted an average price of $43.25 for a barrel of crude oil for 2009, recently upped its forecast to $58.70. With oil currently selling for more than $70 per barrel, it may have to revise its forecast again. This rapid rise in commodity prices will squeeze gross profit margins for many companies.

Furthermore, corporate layoffs have pushed the unemployment rate to 9.4%, its highest level since 1983. Yet those fortunate to remain employed are getting squeezed. A recent survey conducted by Challenger, Gray & Christmas indicates that 52% of companies have cut or frozen salaries. Many have eliminated benefits such as contributions to 401(k) plans. On top of this, the national average price of gasoline is up almost 60% since the start of the year. Less income and higher gasoline prices will reduce consumer spending, the most important component of GDP.

In addition, housing, where all the problems began, remains troubled. Sales may be stabilizing, but prices are still plunging. The government tried to help by forcing mortgage rates to below 5%. However, the long-end of the Treasury yield curve has suddenly jumped and so have mortgage rates. Higher mortgage rates will only prolong the housing crisis.

In short, the economy is still deteriorating. Yes, things may be getting worse at a slower rate, but they are still getting worse. We agree that a rally off the March 9 lows was fully justified. We also agree that even at current prices stocks are attractive from a long-term perspective. However, we also believe stocks have climbed too far too fast and a retest of the lows is inevitable. We are not suggesting you sell and get out of the market. Instead, take advantage of a pullback if it occurs to put more money into your favorite stocks.

Stocks Reverse After Selling Off

The Dow was down as much as 130 points today then suddenly reversed and closed even for the day. It's not clear why. Some traders said shorts began covering aggressively in the final hour. Others credited comments by economist Paul Krugman. Bloomberg reported that in a talk delivered at the London School of Economics Krugman predicted the recession would end by September.

I'm hearing more and more talk that the market has rallied too far too quickly. Many investors (including myself) have been expecting a near-term sell-off. Yet every time stocks start selling off, buyers jump right back in and push them back up again. Since I'm long, I'm not complaining. However, I still see enough problems in the economy to worry me. As of yet, I haven't seen anything that justifies a 35% rally in just three months.

Can the Rally Last?

Headlines in May were far from encouraging. The unemployment rate climbed to 8.9%, initial jobless claims topped 600,000 each and every week, new home sales continued to tumble, existing home prices plunged again, the decline in retail sales was worse than expected, and it became clear that GM would file for bankruptcy. In addition, Standard & Poor’s threatened to downgrade the United Kingdom’s AAA credit rating, which made some investors wonder if the same could happen to U.S. bonds.

Despite all this bad news, stocks climbed higher. The S&P 500 Index is up an amazing 36% from its March 9 low. Even the successful test of a nuclear weapon by North Korea could not dampen investors’ spirits. The accompanying cartoon nicely sums up the situation. The economy may be dying, but at least our portfolios are getting healthier.

To be fair, there were some tiny bits of good news last month as well. For example, existing home sales picked up a bit, and consumer confidence showed some improvement. Other than that, there wasn't much to celebrate. For the most part, this line of thinking explained the rally in stocks: "Things are getting worse, but they are getting worse at a slower rate!"

And what should we make of the sudden rise in interest rates and crude oil prices? The bulls say these are good signs. After all, higher long-term interest rates give us a healthy upward sloping yield curve, which makes it easier for banks to make money. And rising oil prices suggest the recession’s end is near. Investors may simply be betting that demand for oil, which is still down, will soon pick up.

I admit that I, too, have made similar arguments in the past. However, this time I am at least a little worried about these developments. I can't help but notice that a rally in gold prices and a significant weakening of the dollar against major currencies have accompanied the rise in interest rates and the increase in crude oil prices.

Perhaps our creditors are becoming genuinely concerned about the U.S. government's massive budget deficit. Perhaps higher interest rates are needed to entice creditors like China to keep lending us money. Perhaps investors are jumping into oil to hedge against the falling dollar. It seems we have seen this movie before.

Unfortunately, higher interest rates will result in more expensive mortgages. That's not a development that will facilitate a recovery in the housing market. And higher oil prices translate into higher prices for gasoline. That's not something overextended consumers facing falling incomes and rising taxes can easily handle.

The recent rally in stocks has been wonderful, but I don't take much comfort from the fact that things in the economy are getting worse at a slower rate. After all, they are stilling getting worse. I would like to be wrong about this, but I still expect a near-term sell-off in stocks. After such a strong rally in less than three months time, a sell-off would be a healthy outcome. It would provide a test of the market’s lows and give a second chance to all those investors who are still kicking themselves for holding back in March.