Financial Jenga

By Jeff Diamond - So, the improbable stock rally of 2009 continues… Kudos go to the Federal Reserve and their global cohorts. They have implemented all kinds of previously unimaginable liquidity facilities and other monetary props so as to once again levitate global stock markets. The rally has been parabolic in nature, and alas, unsustainable in the long run. In the meantime, however, the financial media is closing ranks in order to spread Ben Bernanke’s and Wall Street’s message far and wide: “The recession is over!” The only problem is that the recession may be ending for the ivory tower economists who devour government economic statistics with little doubt to their accuracy, but for the rest of us who live in the real world all we can see is the economic ruin left by the bursting of the last central bank induced bubble(s)…

If we set aside the smoke and mirrors of Ben Bernanke’s green shoots for a moment, then it is apparent that credit is still contracting, retail sales are still weakening, global trade is still declining, real estate foreclosures are still rising (though not as much as they should since banks are reluctant to swallow the costs and admit the losses associated with foreclosure these days), and sadly, unemployment is still worsening… All this is occurring in the face of the largest global fiscal and monetary money-pump in the history of mankind.

The recent history of cheap money and bubbles seems completely lost on central bankers. Their only answer to one burst bubble is to create a new bubble that is even bigger than the last. I must admit that I lack the imagination (and the chutzpah) to ever succeed at the current game of central banking. Back when Greenspan was chairman, he started off modestly when he engineered the bailout of Long Term Capital, but then cranked things up when his Y2K money pump induced the dotcom bubble. I didn’t foresee the real estate and credit bubble that he was going to foment back in 2002 as the stock market was bottoming in October . It wasn’t long, however, before I realized that the securitization markets were removing risk (supposedly) from lenders and freeing them to pursue business with little concern for the borrowers’ ability to ever repay. What baffles me is central bankers’ complete inability to foresee the consequences of their reckless behavior. So, here we stand in 2009 as the Jackson Hole powwow concludes with these same men patting themselves on the back for acting decisively in averting financial meltdown over the last 12 months while refusing to admit their role in creating it in the first place.

Again, I did not foresee a new global initiative among these men to once again bail themselves out with something even bigger than the housing and credit bubbles. Not only do we have the central bankers creating money at warp speed and shoveling it into what should be failed financial institutions, but we have deficit spending by politicians around the world hellbent on saving their own behinds from the wrath of their economically displaced constituents. But, a funny thing happened on the way to economic recovery. All this newly minted money was highjacked by the same gang of market operators who brought us the last asset bubbles in stocks, bonds, real estate, commodities, artwork, etc., etc… No wonder the real economy isn’t recovering!

So, just in case a central banker or high government official cares, let me say this as clearly as possible… We cannot print and deficit spend ourselves to prosperity. So why would anyone think that zero percent interest rates, government monetization of debt, “too big to fail” bailouts, and government stimulus might work this time? I do not know when the current rally will collapse. It may continue for weeks or months to come. Heck, maybe it could continue longer! It will, however, end in tears just as the last one and the one before that ended, because it is not based on a healthy, wealth-producing economy, but rather a game of financial Jenga that grows ever taller even while the building blocks are disappearing from the foundation.

Update 8/25: It's official... President Obama does not blame central bankers for the current financial crisis. Otherwise, why else would he nominate Ben Bernanke, one of the main architects of easy money since 2002, for a second term as Chairman of the Federal Reserve? It's the safe move politically for the President today, but I guess we'll just have to see how it plays out...

Cash For the Credit-Worthy

By Sam Ro - Cash for clunkers will not generate major incremental sales for automakers like Ford (F). Some of the 489,000 cars sold under the program were made by consumers who were already in the market to upgrade their vehicles. Some represent future sales that have been pulled forward. This sentiment is shared by J.D. Power and Associates, who recently boosted their 2009 auto sales forecast by 300,000 units, but cut their 2010 forecast by 100,000 units. This reflects a net gain of 200,000 over a two year period, during which 21.8 million cars are expected to be sold.

However, on a per dollar basis, cash for clunkers will be more effective in stimulating the economy than the 2008 tax rebate checks. While much of the tax rebates went toward paying down debt, the clunker cash is more likely to go back into the economy through personal consumption.

Consider those who are participating in cash for clunkers. If Jane Smith qualified for a $4,500 rebate and purchased a $15,000 Toyota Corolla, she has to make a $10,500 financial outlay. This is not a small amount of money. She is likely to take out an auto loan, which is only available to the credit-worthy. Furthermore, if she were in a tight financial situation, she would probably stick with her clunker, which is in driveable condition.

Jane is a confident consumer who won’t save that $4,500. She will spend it on a big screen TV, a family vacation, or a fancy dinner--all good for the economy right now.

This isn’t the only government program that rewards credit-worthy consumers who are likely to spend before saving. There’s also the $8,000 first-time homebuyer tax credit. The Wall Street Journal recently reported on a pending cash for appliance program. Again, this program will not provide a major long-run incremental sales boost to Whirlpool (WHR) and Electrolux (ELUXY). It just puts extra cash in the pockets of the customer, who can spend it on something else.

Obviously, I’m not happy that my tax dollars are going to people who don’t need it. But when it comes to economic stimulus, I prefer programs that reward the credit-worthy and encourage them to spend over programs that bailout the debt-laden.

It Ain't Over 'til It's Over

By Vahan Janjigian - A growing number of economists apparently believe the recession is over. According to the Wall Street Journal, 27 of 47 economists surveyed say the recession, which began in December 2007, has already ended. Another 11 economists say the recession will end by September.

Well, Thursday's retail sales figures threw some cold water on that idea. At the very least, if the recession has ended, the retail sales numbers suggest a double-dip is in the works.

The consensus expectation was for a 0.8% rise in retail sales in July. Turns out, however, that sales fell 0.1%. They fell 0.6% if you take out autos sales, which got an artificial boost from the "cash for clunkers" program. That program is merely bringing future sales forward. It is not going to create a long-lasting increase in auto sales.

Of course, some retailers are doing better than others. Wal-Mart (WMT), where it seems most of America now shops, is doing better than others. Yet even Wal-Mart is struggling with second-quarter U.S. sales falling 1.2%.

High-end retailers that are trying to hold the line on pricing are really getting hammered. For example, Abercrombie & Fitch (ANF) reported a 30% drop in same-store sales for the second quarter. Some of its competitors are doing better, but only because they are willing to discount their merchandise.

U.S. GDP is heavily dependent on consumer spending. Just as stock prices are often pressured by investor sentiment, consumer spending is strongly influenced by psychology. Some economists and government officials seem to think that consumers will believe the recession is over if we just tell them its over. Then they will start spending again and the recession really will be over. In other words, we will have a self-fulfilling prophecy. However, at this point, declaring the recession over is simply premature.

Employment Report Is Less Bad, But It's Not Rosy

By Vahan Janjigian - This morning's better-than-expected labor report was welcome news. Although non-farm payrolls continue to fall, job losses of 247,000 were better than expected. July marks the fourth month in a row that payrolls have fallen by less than 600,000. The employment picture is still ugly, but at least it's moving in the right direction.

Yet the strength of the recent rally in stocks already prices in a big improvement in the economy. While today's labor report is encouraging, it only provides further evidence that things are not getting better; they are simply getting worse at a slower rate.

According to the labor report, there are now 796,000 discouraged workers in the economy. These are people who have simply given up looking for work because they believe no work is available for them. That's more than twice as many as a year ago. This partly explains why the official unemployment rate fell from 9.5% in June to 9.4% in July. When people lose hope and stop looking for work, they are no longer counted as unemployed.

Do Blue Dogs Democrats Drink Beer?

The following commentary is from the August issue of the Forbes Growth Investor, which was released to subscribers on August 3.

By Vahan Janjigian - Is the recession over? With Q2 GDP falling just 1%, many economists are asking themselves this question. There is a general sense that the economy hit bottom during the second quarter and is already on the mend. While some corporations have been reporting better-than-expected results, the evidence for an economic recovery is not entirely convincing.

Corporations that beat their earnings estimates did so largely because of cost cuts, not because of higher revenues. In fact, in many cases the year-over-year revenue declines were simply frightening. While some CEOs claim to see signs of stabilization in their markets, almost no one is saying that things are getting better.

The decline in GDP was better than expected, but only because net exports and government spending contributed 1.38 and 1.12 percentage points, respectively, to growth. Ordinarily, a contribution to growth from net exports would be good news. However, exports did not rise in the second quarter. They fell. Net exports rose only because imports fell even more. This slowing of international trade is due to the weakening dollar as well as to consumers saving a greater share of their income. In fact, personal consumption expenditures, the largest component of GDP, fell 1.2% as the personal savings rate surged to 5.2%. As for government spending, there is no comfort in the fact that its role in the economy is growing. Even so-called Blue Dog Democrats are beginning to ask if this makes sense.

Measured in 2005 dollars, second quarter seasonally adjusted real GDP was $12.892 trillion, down almost 4% from its peak exactly a year ago. You have to go back almost four years to find a lower figure. If economic growth hits the top end of projections made by Federal Reserve economists, it will take well over a year to get back to where we were one year ago. Ironically, while those Fed economists have become slightly more bullish about growth, they have become considerably more bearish about employment. They now expect the unemployment rate to peak at 9.8-10.1% this year, an estimate that could easily prove conservative. Even by 2011, they don’t see it dipping below 8.4%.

Although rising unemployment puts a housing recovery at risk, the housing market may have already bottomed. Both existing and new home sales have climbed three months in a row and inventories have fallen. More importantly, prices are beginning to firm. The S&P/Case-Shiller Home Price indexes posted month-over-month gains for the first time since mid-2006. Because the most recent figures are for May, there is real hope that things are even better now than the data suggest.

The bulls got what they were looking for—evidence that the worst is over. They reacted by pushing stock prices to their highest levels since last October. I doubt the euphoria can last. Corporations can’t produce earnings by cutting costs forever. Eventually, they will need revenue growth. With consumers still cutting back on their purchases, the 46% rally in the S&P 500 from its March 9 low seems premature. Stocks are already pricing in a strong economic recovery. Evidence contradicting this thesis will likely cause a significant sell-off.

Cash for Clunkers Makes No Sense

By Vahan Janjigian - Although I hate taxes, I like the fact that taxes affect behavior. In general, if you want less of something, tax it. If you want more, provide a tax subsidy.

Americans used to smoke a whole lot of cigarettes. Today, they smoke less than they used to. No doubt, some gave it up for health reasons. Others, however, decided it costs too much. We have taxed the hell out of tobacco products and we got less smoking as a result. That's good news for health, but bad news for politicians who thought higher taxes would create more revenue.

On the other hand, many of our politicians decided long ago that home ownership was a good thing. They wanted to encourage people to buy more homes. So they decided to allow home buyers to deduct the interest payments on their mortgage payments. Those who don't own homes are subsidizing those who do. Things worked as planned and we got more ownership as a result--maybe more than was optimal.

Now our politicians want us to buy cars. So they came up with the "cash for clunkers" idea. Trade in your old car for a new one now and the government (read taxpayers) will pay a good part of the cost. So today's car sales figures should be no surprise. Stocks like Ford took a big jump.

Unfortunately, the sales jump will not last. All we are doing with this program is bringing future sales forward. The more cars we buy now, the fewer cars we will buy later. Auto stocks that surged today will likely give up at least some of their gains tomorrow.

The Emperor's New 787 Dreamliner

By Sam Ro - Boeing’s 787 Dreamliner was originally scheduled to fly in September 2007. Just a few days before the maiden flight, management announced what would be the beginning of a 2+ year delay. That’s long even by airline standards. In its five or six announcements—it’s hard to keep count—management blamed everything from a shortage of fasteners to incomplete software to a labor strike.

The latest delay was announced on June 23, 2009. Management said, “first flight of the 787 Dreamliner will be postponed due to a need to reinforce an area within the side-of-body section of the aircraft.” I’m not an aerospace engineer, so I won’t say how I really feel about that. Regarding first flight and aircraft deliveries, they said, “It will be several weeks before the new schedule is available.”

Several weeks later on July 22, 2009, Boeing announced their Q2 financial results. Regarding the 787, they said “The company expects to complete its assessment of the schedule and financial implications during the third quarter.” Not only have they delayed first flight, they have also delayed the new schedule for first flight. They also added that they recently completed “low-speed taxi tests on the first flight test aircraft.” I guess you learn to walk before you run…or fly. Again, I’m not an aerospace engineer.

At this point, I have lost confidence in management and I am only 99% sure that the Dreamliner will eventually get off the ground. While I think it would be risky to bet against BA stock at current levels, I would not recommend you buy it either. If that 1% disaster comes true, shares will take a Black Swan-style swan dive

Another Reason Why a Buy/Hold Strategy is the Way to Go, Part 2

By Taesik Yoon – In a post last Friday I wrote about a white paper written by Sal L. Arnuk and Joseph Saluzzi of Themis Trading LLC that discussed specific trading strategies designed at “exploiting new market dynamics” and how this has negatively affected real investors.

My coworker Sam (another contributor here) sent me a link to a front page article on today’s New York Times titled Stock Traders Find Speed Pays, in Milliseconds.

Click HERE for a link to the article.

The article essentially deals with the same topic--how traders are able to profit from high-frequency/high speed trading due to incentives, loopholes, and speed advantage in order placement. However, it’s more reader friendly. It also provides a very detailed real world example of how such a trading strategy led to higher prices being paid by regular (i.e. slower) investors for shares of Broadcom, a semiconductor company, on July 15.

As I noted in my prior post, the best way to minimize the impact of such strategies is to follow a simple BUY/HOLD strategy. Even in the example presented in the article, the exploitation in Broadcom’s stock price was within the range of $26.20 and $26.40 per share. For portfolio managers attempting to get the best execution for large blocks of share purchases, this probably will lead to inflated prices paid. But for an investor willing to hold long-term, paying $26.20 or $26.40 doesn’t make much of a difference if you expect the stock to be at $40 in a couple of years.

Of course, no one wants to pay more than they have to. Nor should they. But until these practices are curbed, the risk that you may pay higher prices on stock purchases does exist. Let’s just hope that these strategies don’t result in the persistence of (or worse yet, growth in) artificially inflated stock prices over longer periods. The last thing we need is the development of another bubble.

What? No Green Shoots?

By Jeff Diamond - On Tuesday, in response to Rep. Bachus' question on the poor condition of the commercial real estate market, Fed Chair Ben Bernanke said, "As the recession’s gotten worse in the last six months or so, we’re seeing increased vacancy, declining rents, falling prices -- and so, more pressure on commercial real estate."

Let's recap... In a moment of unscripted candor, Ben Bernanke said that the recession has worsened over the last six months! Despite all his spin about green shoots and stabilization, he very matter of factly stated that things are continuing to worsen. He went on to say that our government is considering measures to help out commercial real estate in the future. Is there any sector of the U.S. economy that will be allowed to correct? Does everything pose a systemic risk? I continue to be amazed at what lengths the Fed and the Treasury will go to prevent markets from imposing discipline or penalties on poor risk decisions.

If you listen carefully, however, you can occasionally glean the truth even from Bernanke... The economy is still worsening. It's a matter of fact. No one questioned Bernanke's description, since we all know it's true. Green shoots are a lie, a very convenient lie, but a lie that our government considers necessary. They need to provide the rationale for more ill-considered risk-taking among investors. That's the only hope they've got to whip this recession that has "worsened over the last six months."

Exit Strategy?

By Jeff Diamond - The Fed's exit strategy to its unprecedented monetary easing and money printing depend on the economy and our financial markets returning to normal. A happily expanding GDP, a receding of the credit crisis, a reduction in the massive levels of debt in both the public and private sectors, and several other dream-like occurrences. Now, let's consider the likelihood of that versus the likelihood of another crisis developing... Which do you think will happen first?

My personal prediction is for fireworks (i.e. severe selloff) to occur in either the Treasury market or the U.S. dollar. I will not recap the horrendous fundamentals that make this a possibility, since they are so widely described elsewhere...

So, I predict that the best laid exit strategies for the Fed will not come to be. Just as they were forced to take extraordinary actions to prevent a meltdown of the financial system, they will have to respond to a market spike in interest rates and/or a freefall in the U.S. dollar. That will preempt their plans for an orderly return to "normal."

We can listen to Ben Bernanke wax poetic today and tomorrow in front of his Congressional audience, but I think it's a waste of time. Whatever plans he outlines today will not come to pass in the manner that he is going to describe...

Another Reason Why a Buy/Hold Strategy is the Way to Go

By Taesik Yoon - A friend at work gave me a white paper written by Sal L. Arnuk and Joseph Saluzzi from Themis Trading LLC, an independent brokerage firm, titled Toxic Equity Trading Order Flow on Wall Street.

I had seen Mr. Saluzzi a few times before on Bloomberg TV speaking about the overvaluation of the equity markets and the rampant manipulation of stock prices by program trading. The paper expands on the latter by outlining the specific “toxic” trading strategies traders employ by “exploiting new market dynamics” and how this has negatively affected real investors.

Click HERE for a link to the PDF.

The strategies outlined and examples given provide a very good understanding of how these market exploitations work. And unlike so many other critical articles I’ve read in the past, the authors provide two clear recommendations as to what can be done (from regulatory standpoint) to stem these types of trading practices.

I agree that these practices occur. They highlight the fact that some financial institutions will do anything to make a profit—even at the expense of their own clients. And I’ll admit that while generating profits by inducing false price movements is not a new concept, being able to profit by simply buying the right to place your server in the NYSE or NASDAQ server room certainly is. (Though in this age of ever evolving technology I really should know better.)

As for the impact on the individual investor, it probably does result in some investors paying a slightly inflated price on their stock trading transactions. But over the longer-run, what are a few pennies?

If anything, this is just another reason why following a BUY/HOLD strategy is the way to go. I’ve long been a proponent of this simple investing method. If my analysis concludes that a particular stock is worth $30.00 per share in two years, then does it really matter whether I buy it at $20.01 or $20.03 today?

Of course, if these strategies somehow result in the artificial inflation in equity values over longer periods then it could jeopardize any investing strategy, including BUY/HOLD. But as someone who has seen this strategy work time and time again during his ten years of buying and selling stocks, I’ll take my chances.

S&P 500's Stealth Earnings Growth

By Sam Ro - How could analysts expect S&P 500 earnings to grow from $49 in 2008 to $55 in 2009 and to $74 in 2010? One explanation is turnover on the index.

Let's consider the impact of General Motors. According to data compiled by S&P's Howard Silverblatt on June 2, the S&P 500's consumer discretionary sector earnings were expected to fall 75.6% year-over-year in Q2. This was due to the massive loss estimated for GM. But now that GM has been removed from the S&P 500, Q2 consumer discretionary earnings are expected to jump 36.6% year-over-year. It's clear how changing a constituent can have a material impact on the index's earnings estimates and valuations.

And GM isn't the only money loser that got booted from the index in the last year or so. Lehman Brothers, Freddie Mac, and Fannie Mae bled money for the S&P 500 in 2008, but they're not in the index today. This could at least partially explain the expectation for 300% year-over-year earnings growth in the S&P 500's financials sector in Q2.

Stocks Will Give up Their Recent Gains

By Vahan Janjigian - What should we make of the 7% rally in the major market indexes over the past four days? In my opinion, not much. Stocks will likely give up those gains, and possibly more, in short order.

On the plus side, we saw an upbeat report from Intel. And today, the market rallied on news that Nouriel Roubini, one of the biggest bears on or off Wall Street, thinks the worse is over. But don't get your hopes up. Turns out Dell, one of Intel's biggest customers accounting for 18% of Intel's net revenue in 2008, is not so optimistic. As for Roubini, he quickly refuted comments attributed to him saying they were taken out of context. He hasn't changed his outlook at all.

Google's earnings announcement, which came after the market closed, was much better than expected. However, the sell-off in the stock in after hours trading is a clear indication that this market has rallied too far too fast.

IBM Has Got a Magic Potion

By Jeff Diamond - IBM beat estimates! What a surprise... Not! I haven't been counting, but Bloomberg just announced that this was the 17th quarter in a row that IBM has "surprised" to the upside! Sweet! I wonder how they surprised this time? Did they cut their pension contribution again? Maybe a few acquisitions or a lowered tax rate? Oh, or maybe a favorable FX conversion? IBM has got more tricks up its sleeve than a Las Vegas magician.

Nothing much has changed on Wall Street. Enjoy the rally while it lasts, but as we have seen in the past these games have mostly lead to tears, and no one ever sees it coming!

July 17th UPDATE - So, riddle me this: How does earnings-per-share at IBM rise 18 percent year-over-year while revenues fall 13 percent during the same period??? I don't know the answer, but with the stock closing up over 4 percent on the day the market doesn't seem to mind. Clearly, IBM does possess a very powerful potion!

What Comes to Mind

By Jeff Diamond - All I can think when watching the Paulson hearing is that so much of this mess would have been self-correcting if our government had not bailed out all the bad players. AIG and some banks would have failed. Our government could have used that $700 billion TARP money to bail out the non-risk seeking depositors and policy holders. The surviving banks (and investment banks) would have gotten religion and reeled in excessive behavior while having had a less competitive playing field in front of them for the future. Boards of directors at all sorts of public companies would have become more activist to protect shareholders, and many CEO's would have been replaced by the boards (rather than all this questioning of the former Treasury Sec'y as to why the government didn't replace more CEO's.)

As it stands our government is doing everything within its power to maintain the status quo and put back the "broken" system that allowed this crisis to develop in the first place. Capitalism has been circumvented, and many of the correction mechanisms within a capitalist system have not been allowed to work.

In my opinion, our system is still sick. We are not well positioned for more than a temporary recovery. The cancer is still there. The government has essentially covered up the symptoms but not done anything to cure the patient. In fact, it is standing in its way of healing.

Higher Tax Rates Do Not Result in Higher Tax Revenues

By Vahan Janjigian - It is absolutely mind boggling how people continue to confuse higher tax rates with higher tax revenues. Numerous pundits continue to argue that we need to raise tax rates to fund the growing budget deficit. But raising tax rates is one sure way of making sure the budget deficit grows even larger.

There are only two ways to shrink a deficit: 1) Spend less money. 2) Generate more revenue. Spending less money is a great idea, but given all the promises the government has made to various constituents, this is not likely to happen in the near future. Therefore, we must raise more revenue, but that will not happen by raising tax rates.

Higher tax rates are a recipe for reduced employment and slower economic growth (or a more severe recession). Time and time again, we have seen how tax rate cuts have spurred employment, economic growth, and tax revenues. Budget deficits during such lower tax rate/higher tax revenue eras are the result of uncontrolled spending, not the result of less revenue.

Politicians should be clear and honest. Tell us we need more tax revenue, not higher tax rates. Then lower tax rates to make sure we get the revenue we need.

Morgan Stanley and the Future of Research

By Sam Ro - The Financial Times recently reported Morgan Stanley tapped a 15 year old summer intern for some insight into "How Teenagers Consume Media." The introduction reads, "Without claiming representation or statistical accuracy, his piece provides one of the clearest and most thought provoking insights we have seen."

So, as the requirement to provide independent third party research expires in the next few weeks (Global Research Analyst Settlement), is this a preview of research to come? It's cheap (Hello, cost savings!), it has no statistical basis (Nassim Taleb would be proud), and it's independent (How corrupt could a teenager be?).

Of course, I don't really expect research departments to be taken over by high school kids. However, I do expect to see an increasing use of unconventional research. Surely, statistical study will reveal that conventional research has made you very little, if any, money in recent years.

Enough Already!

By Jeff Diamond - I’m getting tired of Tim Geithner, Ben Bernanke, Barney Frank, Larry Summers, and President Obama making false promises about what our government can accomplish with all of this intervention. The intervention spans markets, private enterprise, government, and even the judicial system (as they make end runs around bankruptcy law and contract law, etc.)

When in the world are they going to admit that we’ve got problems that the government can’t fix? When are they going to allow some of the “too big to fail” institutions to fail? You know it’s coming. They know it’s coming (or at least they should!) Bad risk-takers should fail. That’s the way capitalism works, and if you intervene on the downside, then don’t expect capitalism to work to the upside either. Sure, we might get bouts of improved economic activity, but don’t expect a lasting recovery. Just look at Japan. We are looking a lot more like them all the time. They started intervening back in the early 1990’s and look how far that has gotten them.

Bubbles form when capital is misallocated, and they burst when that misallocation leads to unsustainable price levels. Admittedly, the bursting is no fun. It’s damn painful. So, I understand the desire and willingness of politicians to step in to alleviate the pain (and I have no doubt that we would be in the same position if George W. Bush were still President and Henry Paulson in the Treasury.) The problem is by not allowing the markets and the economy to “clear,” our government just delays the day of reckoning.

The topic of stimulus package II keeps resurfacing since there is general dissatisfaction with the continuing malaise. Now, I guess I should distinguish between bailouts and stimulus. I am vaguely sympathetic to a well-structured stimulus plan. The problem is that the stimulus money isn’t getting spent on stimulus. The biggest share of Stimulus Package I was given to the states who are using it to support their bloated and unsupportable state budgets. Revenues have fallen off a cliff in most states around the country and they aren’t going to bounce back big enough and quick enough to avoid painful cutbacks. Just look at California, even with the stimulus money from the federal government they can’t make ends meet! Federal, state, and local governments are attempting to provide too many services and benefits that they cannot (and never could) afford.

So, when is the greatest capitalist society in the history of the world ever going to allow capitalism to work? The first step is allowing the bad actors to fail and suffer their due (and that includes the states.) Yes, asset prices will fall and people will lose more jobs, but it will happen anyway. Just pick your timeframe… One or two years of pain? Or, one or two decades? If you picked the latter, then I hope you are prepared for all sorts of unintended consequences. We are already seeing the bad actors that the government has propped up undercut their competition who didn’t need a bailout. The explosion in government debt is going to lead to something bad. I’d guess higher interest rates and a weak currency, but who knows? And who knows what the unintended consequences of the unintended consequences will be, but in general, I’d guess that they won’t be pleasant.

So, this grand experiment in government intervention needs to grind to a halt. Let’s take our medicine and get on with it! The average American isn’t getting much out of all this anyway. I can see how the “too big to fail” crowd with all of its lobbying money is getting something, but it’s hardly trickling down. In fact, banks are rushing to cut credit lines, raise minimum payments and interest rates even on its customers in good standing. If the government wants to offer incentives for investment so that money flows rather than being hoarded, then maybe you can convince me, but enough of the money printing and exploding debt. That’s going to lead to nothing but trouble.

The Madoff Affair on PBS

By Vahan Janjigian - Last night I took time to watch The Madoff Affair, a video production by Frontline that aired on PBS not too long ago. The entire investment industry has been following events related to the world's largest stock fraud ever since news of it first broke in December 2008.

The Frontline production does an excellent job of covering Bernie Madoff's career from the time he graduated from Hofstra University in 1960 to his conviction. His fraud began soon after he married his high school sweetheart and took an office in her father's accounting firm. Madoff first started a market-making operation, which he grew by paying for order flow.

However, he also started an investment advisory business without registering with the SEC. He did what he knew how to do very well: He paid for investments. In fact, he paid big bucks to so-called feeder funds to send him their clients' money. Amazingly, these feeders did virtually no due diligence on Madoff.

As all Ponzi schemes are prone to do, Madoff's fraud blew up when the long bull run in equities ended and stocks started falling fast. His clients started asking for their money back; not because they were unhappy with his performance, but because they needed their money to cover loses in their other investments. Of course, what they didn't realize at the time was that their money was gone and Madoff's outstanding performance was nothing but fiction.

One of the most tragic events of the Madoff fraud was the suicide of Thierry Magon de la Villehuchet. He was a money manager from France who had invested everything with Madoff. He killed himself shortly after Madoff's fraud became public. Frontline interviews Villehuchet's brother who calls the suicide honorable.

I urge you to watch the video if you would like a more complete understanding of how Madoff earned the trust of investors and got away with his fraud for so long.

The Blame Game

By Taesik Yoon - One of the things that has bothered me most in the aftermath of the financial mess that we are still digging ourselves out of is the blame game that so many seem to be playing. Sure, there is plenty of blame to go around and plenty of participants to share in that blame. However, to wholly place blame on any single one of these players is both narrow minded and a sorry attempt to absolve others of their share of responsibility.

The latest ire of these finger pointers comes in the form of a recent, now widely-circulated, article written in the latest issue of Rolling Stone magazine by contributing editor Matt Taibbi.

Here’s a link to the article: The Great American Bubble Machine

In it the author trashes Goldman Sachs. He blames the financial institution and the reach of its not-so-invisible hand (through company alums that have managed to infiltrate key positions in our government) for engineering “every major market manipulation since the Great Depression.”

In reality, the article focuses more on the present decade—specifically on how Goldman’s “unprecedented reach and power have enabled it to turn all of America into a giant pump-and-dump scam” beginning with the tech/dotcom bubble, moving on to the housing bubble, then the bubble in commodity prices. It even highlights how Goldman rigged the federal bailout.

My problem with the article has little to do with the facts presented. Generally, I found it to be well-researched. The specific examples of how Goldman profited from these bubbles both legally and illegally were compelling and enlightening.

But Mr. Taibbi was not above distorting the truth to make a stronger argument for his thesis. For example, he notes that Goldman converted from an investment bank to a bank holding company specifically so it could participate in the taxpayer-backed TARP funding. The author is right that Goldman received $10 billion in TARP funds. However, what he conveniently omits is the fact that Goldman never wanted (or likely even needed) these funds. It has also been among the most vocal at wanting to pay the funds back as soon as possible. In mid-June, it did just that, repurchasing $10 billion in preferred shares from the government, as well as paying an additional $425 million in dividends, which is expected to reduce second quarter earnings by 77 cents.

In other words, Goldman not only gave back the taxpayer money it borrowed less than three quarters after borrowing it, it also paid an additional $425 million to taxpayers. If the company was as brazen as the article suggests or if the money provided was, as he states, “…10 billion free dollars in a paper bag to buy lunch,” then why pay it back so soon or at all?

What makes this particular omission so egregious is the fact that a key reason why Goldman wanted to payback TARP funds so quickly was because of all the restrictions on compensation set forth in it. This, in fact, is completely consistent with Mr. Taibbi’s argument that Goldman is all about greed and paying fat bonuses. The only reason I can see for leaving this out is because it would invalidate his more important argument that the funds were provided to Goldman by its chummy government buddies without impunity. This sort of data mining is dangerous. It serves the exact same purpose he claims Goldman is guilty of: duping the uninformed.

And speaking of the general public, Taibbi does not note their participation in this mess. I, on the other hand, am not as kind. In the end, it all comes down to supply and demand. For example, with regard to the housing bubble, he notes how Goldman’s influence helped lead to a regulatory environment which allowed the CDO market to explode. But that only represents the supply side. You still need mortgage demand to drive the CDO market. This demand is driven by consumers. If we would have been more disciplined there would have been no pool of sub-prime loans to package together as CDOs. Whether or not financial institutions or government agencies helped perpetuate an environment of easy credit and mortgage lending practices, it was ultimately up to the consumer to decide to take that credit or leave it.

This is not to shift the blame entirely on individuals, but rather to highlight just how easy it would be to do so. Nor am I trying to absolve Goldman of wrong doing. There is no denying the company profited immensely from each one of the bubbles Mr. Taibbi lists at the expense of the American public. Additionally, there is no way to defend some of the unscrupulous tactics Goldman used to generate profits during these bubbles.

But Goldman certainty was not the only one to employ such tactics. Indeed, investment banks are like drug dealers. Only instead of selling crack or heroin, they sell a much more potent intoxicant—the promise of wealth and quick riches—all while doing their best to mask the risk inherent. And I would agree that Goldman was probably the biggest dealer on the street. But there is no doubt in my mind that if you could not buy from it, there would plenty of others more than willing to take your money. In other words, these bubbles would have occurred with or without Goldman’s involvement. The problem for Goldman was that it was among the last dealers standing after the raid and that makes it an easy target.

Mr. Taibbi ends by stating, “This is the world we live in now. And in this world, some of us have to play by the rules, while others get a note from the principal excusing them from homework until the end of time… It’s gangster state, running on gangster economics… And maybe we can’t stop it, but we should at least know where it’s going.”

This to me is the ultimate cop-out. It essentially boils down to saying here’s the problem. Unfortunately, I can provide no solutions—not even one; the reality of the situation is that there is not much we can do about it.

Well, I’ve got one solution for him and anyone else who shares his view: buy Goldman Sachs’ stock. After all, if Mr. Taibbi is correct in his assessment, then Goldman’s stock is what we in the industry refer to as an arbitrage (risk-free) opportunity. By his account, Goldman already owns all the air it needs to inflate the cap-n-trade bubble he is so certain will be the next to take place. Therefore, Goldman should be the biggest beneficiary. As an owner of Goldman shares, so should you.

July 1 Commentary From FGI

The following commentary appeared in the July issue of the Forbes Growth Investor, which was made available to subscribers on July 1.

By Vahan Janjigian - June was a bad month for celebrities. Ed McMahon, Farrah Fawcett, Michael Jackson, and Billy Mays all passed away. June was also a bad month for Federal Reserve Chairman Ben Bernanke; although he presumably is still in good health.

I have blamed the Fed in the past for many of the bubbles our economy experienced in recent years. Its easy monetary policy caused the technology bubble of the late 1990s, the housing bubble that peaked in 2006, and the commodities bubble that followed shortly thereafter. Nonetheless, I would also argue that Ben Bernanke has done an admirable job of responding to the financial crisis that began shortly after he took over as Fed chairman. Under Bernanke’s leadership, the Fed responded quickly and decisively by slashing interest rates and increasing the money supply. While these actions increase the risk of inflation and threaten to erode further the value of the U.S. dollar, I believe they were necessary to restore confidence and prevent a total collapse of the financial system.

However, Bernanke now finds himself in political hot water. Congress recently grilled him amid allegations that he coerced Bank of America CEO Ken Lewis to consummate the Merrill Lynch acquisition against his better judgment. Bernanke even stands accused of urging Lewis not to disclose the poor state of Merrill’s health to his shareholders. Democrats and Republicans attacked him with equal ferocity.

As I explain on my blog, I believe Bernanke’s days as Fed chairman are numbered. President Barack Obama appears reluctant to give him a strong endorsement. Obama recently said Bernanke is doing a “fine” job. When questioned during a press conference, he refused to say if he would reappoint Bernanke as chairman. Soon after Bernanke’s grilling in Congress, the White House issued a tepid statement saying it had “confidence” in Bernanke. As the nearby cartoon illustrates, when praise from your boss is this impassive, it’s time to shop your resume. Besides, I believe Larry Summers is hungry for Bernanke’s job and I believe Obama would like to give it to him.

As for the economy, I still see no evidence that things are getting better. At best, they are still getting worse, but at a slower pace. According to the S&P/Case-Shiller Index, housing prices fell 18% year-over-year in April. The good news, if you can call it that, is that prices are no longer falling at an accelerating rate on a nationwide basis. Unfortunately, price declines are accelerating in some key markets, which until recently had been holding up well. These include Charlotte and New York.

In addition, according to the Conference Board, after three consecutive monthly gains, the Consumer Confidence Index fell more than five points in May. Consumers became more pessimistic about their present situation. They also grew more wary about their near-term outlook for jobs and income. This is not what hard-hit retailers were hoping to hear.

Overall, I continue to believe there is a significant risk for a near-term sell-off in equities. Keep some cash on hand to take advantage of the sell-off when it occurs.

Preview of Q2 Earnings Season

By Sam Ro - Based on my reading of Q1 earnings announcements, I think corporate managers may have been a little too optimistic in their expectations for economic recovery. Below is some language I expect to hear during the Q2 earnings announcement season.

(Company XYZ) Reports Second Quarter Results
Q2 net revenue was weaker than we had initially anticipated. April and May were inline with our projections. However, demand fell significantly in June. Year-over-year comparisons were particularly challenging due to last year’s stimulus checks. Top line weakness was partially offset by favorable currency movements since the beginning of the year (i.e. the weaker dollar).

Net income was in the low end of our previous guidance due to weak volume. However, the operating profit margin benefited from cost saving restructuring initiatives, which included idling factories and laying off employees. Thanks to significant reductions in capital expenditures, the company had significant free cash flows which were used to repurchase shares. Adjusted for restructuring charges, earnings per share was in the high end of our guidance.

“Our company has performed well in this challenging macroeconomic situation,” said the CEO. “We continue to take actions to right-size our operations in response to the evolving demand environment. We believe we will be in a stronger competitive position when the recession ends.”

“Because economic conditions continue to deteriorate, we believed it was prudent to revise downward our full year earnings guidance range. We continue to see further deterioration in consumer confidence due to weak employment conditions and higher-than-expected gasoline prices. Raw material and energy costs are higher than we had initially budgeted, which is pressuring our gross profit margins. Projected weakness should be partially offset by the benefits of a weaker dollar.”

We look forward to speaking to you again in three months.

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 in 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.

Have Consumers Misplaced Their Confidence?

The headlines were full of bad news today, yet stocks rallied strongly anyway. North Korea tested a nuclear bomb, GM moved a little closer to bankruptcy, and housing prices continued to plummet. However, investors decided to pay more attention to the consumer confidence number.

According to the Conference Board, the Consumer Confidence Index jumped from 40.8 in April to 54.9 in May. This index, which is based on a survey of 5,000 households, had a cutoff date of May 19.

Given the recent and very strong rally in stocks, it is no surprise that confidence climbed. After all, the S&P 500 was 34% higher on May 19 than it was at its March 9 low. A rally of this magnitude would make even the most pessimistic consumer a little more confident.

One notable change was the big increase in the percentage of respondents who are expecting an improvement in the labor market in the near future. This is somewhat surprising since unemployment commonly continues to rise for several months after recessions end. Furthermore, most economists are forecasting very anemic growth in the U.S. for several years to come. Demand for goods and services could remain weak for a long time as consumers and businesses focus on shoring up their balance sheets.

GDP growth of just 1-2% will not do much to help the labor market. As a result, the unemployment rate could remain above 8% for quite some time. That's not the kind of outcome that will help boost consumer confidence.

VIX Falls as Stocks Rally

There has been a lot of talk lately about the Volatility Index commonly called the VIX. Investors often look at the VIX to determine how much fear there is in the markets. For a prolonged period, 2004-2006, the VIX traded at very low levels. For most of those years, it traded well below 20, suggesting not only that investors had little fear of risk, but also that they were complacent. However, the VIX started rising in 2007. It peaked in late 2008 above 80 as the financial crisis made front-page news.

Recent talk of the VIX has focused on its rapid decline. It is now below 30, yet still well above the 2004-2006 levels. This suggests investors have become less fearful of putting money at risk, but they are still far from being complacent.

The VIX is actually the instantaneous standard deviation from the Black-Scholes Option Pricing Model. Traders sometimes use this model to identify overvalued or undervalued options. The model relies on several variables, one of which is the underlying stock's instantaneous standard deviation. This variable is almost impossible to measure. However, if all the other variables are known, the standard deviation can be backed out of the Black-Scholes equation. In the case of the VIX, the underlying stock is actually the S&P 500 Index.

The VIX tends to rise when the market sells off, but it falls when the market rallies. In other words, it is a better measure of downside volatility than overall volatility. Furthermore, the VIX is not a reliable forecaster. The market does not rally simply because the VIX falls. In fact, it is more accurate to say that the VIX falls as the market rallies.

Finding Religion in Your Jeans

On March 25, I recommended buying True Religion Apparel (TRLG) in the Forbes Growth Investor investment newsletter. The stock was selling for $11.60 at the time. On May 8, a few days after the company released first quarter results, I told subscribers to sell. The stock closed that day at $21.97.

While the stock is not obviously overvalued, it's no longer a screaming buy. The company reported a 19% year-over-year increase in sales. That's impressive in a recession, but it's also a considerably lower growth rate than TRLG posted in recent periods. Furthermore, the company's largest segment, U.S. Wholesale, saw an 11% decline. In addition, the operating profit margin fell 70 basis points and net income climbed by only 9.8%, well below the increase in revenues.

Yet with $76.5 million in cash and no debt, TRLG is a very healthy company. Even in this severe recession, the company has had no problem convincing fanatically devoted customers to purchase its overpriced jeans. During the first quarter, TRLG commanded an average price of $262 for a pair of ladies' jeans in its full-priced stores. Perhaps more amazingly, it got $287 for each pair of men's jeans. More than 40% of its sales now come from the men's category.

TRLG is trying to increase the number of branded stores and is pushing for growth in the more profitable Consumer Direct and International segments. However, if it hits the high end of management's guidance, full-year revenues will be up only a modest 10%. EPS will be down slightly. I believe management is being deliberately conservative with its projections. Nonetheless, unless the recession ends quickly and more consumers develop an urge for high-priced jeans, growth at this company will likely continue moderating.

First Quarter GDP Likely Fell by More Than 6.1%

In the May issue of the Forbes Growth Investor, I wrote about the dramatic decline in international trade. Today, we were given more evidence of this. The "U.S. International Trade in Goods and Services" report for March was released this morning. Not surprisingly, due to the recession, we saw fewer imports and exports. However, imports fell by less than exports. Imports were down $1.6 billion to $151.2 billion in March from $152.8 billion in February. Exports dropped $3 billion to $123.6 billion in March from $126.6 billion in February.

The Advance estimate for first quarter GDP was -6.1%, but that report showed a bigger decline in imports than exports. As a result, net exports added 1.99 percentage points to the first quarter GDP report. The Preliminary estimate for first quarter GDP comes out on May 29. This is a more accurate estimate because it is based on more complete data. Unfortunately, today's trade data indicates that the contribution from net exports was less than shown in the Advance estimate. As a result, GDP in the first quarter likely fell by more than 6.1%.

We Remain Skeptical Despite Strong Results

The recent market rally prompted us to close out some positions in the Forbes Special Situation Survey. In the last few days, we pocketed gains of 38% in 2.5 months on Chicago Bridge & Iron (CBI) and 35% in 6 months on Goodrich Corp. (GR). In March, we closed out EnerSys (ENS) for a 123% gain in 4 months and Western Digital Corp. (WDC) for a 46% gain in 3 months. However, today, we took a 64% loss on Coventry Health Care (CVH) in 28 months. These sells have reduced the number of open positions in our recommended portfolio to 13.

According to the Hulbert Financial Digest, our recommended portfolio has gained 7.2% on an annualized basis (excluding dividends) over the past 3 years. That ranks us #4 overall out of 183 investment newsletters. Our 5-year record comes out to 10.1% on an annualized basis, good enough for #5 overall. Year-to-date, Hulbert has us showing a 16.1% gain.

One reason we have pared back our holdings is because we are somewhat skeptical of the recent rally. While things are getting worse at a slower rate, they are still getting worse. We believe there is more bad news to come. Investors may react by selling aggressively when that happens.

Unions Destroy Shareholder Wealth

Just as Ben Bernanke gives us some hope that the economic recession may be coming to an end, here's something new to worry about.

A working paper published by the National Bureau of Economic Research (the same organization charged with declaring the start and end of U.S. recessions) and summarized by Linda Gorman concludes that unions destroy shareholder wealth. In "Long-Run Impacts of Unions on Firms: New Evidence From Financial Markets, 1961-1999," authors David Lee and Alexandre Mas find that a union victory costs the owners of the company an average of $40,500 per worker.

Union advocates often argue that unionization does not result in a loss of profits. Indeed, the authors of this paper provide evidence that unionization has little impact on profits and return on assets. Unfortunately, they also find that growth at companies where unions win organization elections falls short of growth at companies where unions lose. In other words, unionization may not decrease profits, but it does put an end to the growth of profits.

Because the stock market is a discounting mechanism, investors anticipate this end to growth and sell the shares. The loss in equity value begins when the union wins an election to organize and continues for 15 months. The net result is large negative returns of 10-14%. It also turns out that the greater the margin of the union's victory, the greater the loss in shareholder wealth. This could also explain why unions are sometimes reluctant to take ownership stakes in organized companies.

With a new administration in Washington strongly backed by the unions, it's a good bet that organized labor will expand its reach in coming years. The authors of this paper estimate that a doubling of unionization will cause equity values to fall about 4.3%. This should give the administration something to ponder as it tries to save General Motors and Chrysler.

Short Term Bearish; Long Term Bullish

The following commentary is from the May issue of the Forbes Growth Investor.

The S&P 500 is up almost 30% from its March 9 low. This has some investors wondering if we are now in a new bull market. Whatever you choose to call it, we remain skeptical and warn you not to become complacent. After all, it is not as if all the problems in the economy have suddenly gone away. On the contrary, they are growing worse. The only difference is they are now getting worse at a slower rate.

Take the latest S&P/Case-Shiller report on housing prices. The 20-city index documented an 18.63% decline in housing prices from February 2008 to February 2009. However, that was a little better than the 19.03% decline from January to January. In other words, things are getting worse, but at a slower rate.

The GDP report for the first quarter of 2009 also was interesting. The 2.2% rise in personal consumption expenditures was certainly welcome news, but it was not enough to offset big declines in inventories and fixed investment. Furthermore, international trade is falling off a cliff. Exports fell 30%, which came on top of a 24% decline in the fourth quarter of 2008. Imports plunged 34%. They were down 17.5% in the fourth quarter. Overall, the economy contracted 6.1%, but that was somewhat better than the 6.3% contraction in the fourth quarter of 2008. In other words, things are getting worse, but at a slower rate.

The Federal Reserve added fuel to the stock market’s rally when its Open Market Committee released a statement saying,“… the economy has continued to contract, though the pace of contraction appears to be somewhat slower.” You guessed right:Things are getting worse, but at a slower rate.

Of course, things cannot get better until they first start getting worse at a slower rate. Therefore, investors are not wrong to cheer. A bit of a rally in stocks is fully justified. However, a 30% rally in just a month-and-a-half seems extreme. We continue to believe long-term investors should think more about buying than selling. Anyone with an investment horizon of five years or longer is not likely to regret buying stocks today. Nonetheless, we also expect a meaningful sell-off in stocks in the short term. Earnings season will soon come to an end. Given the strength of the recent rally, profit takers will be tempted to take some money off the table. This kind of activity could easily drive the Dow lower by about 500 points or so. Be prepared to buy more of your favorite stocks when that happens.

Gimme Credit

What ever happened to the concept of personal responsibility? I seem to remember a time when people actually blamed themselves for their own bad decisions. If they got caught speeding or even if they lost some money in the market, they simply said, "It's my own damn fault!" Today, however, that's the last thing on their mind. If things don't go the way they hoped, they immediately try to find someone else to blame. Sometimes, of course, they are right to do so. Yet all too often, their loss really is their own damn fault.

The problem is that even irresponsible people get to vote. Which explains why politicians are so eager to listen to them. For example, politicians are now falling all over themselves to blame the banks for charging too much interest on credit card purchases. The consensus opinion--at least among some in the political class--seems to be that consumers were somehow duped by the banks. That it wasn't made clear to these innocent consumers that someday they would have to pay back the money they borrowed--with interest no less!

I simply can't buy this argument. I have been using credit cards for at least a few decades. I have been receiving solicitations for even more credit cards for almost as long. I cannot remember one instance when an offer for a card did not clearly state the interest rate I would be charged. I cannot remember one time that I was not notified by the issuer of a card I already owned that it was planning to raise the interest rate. I cannot remember one credit card bill I ever received that did not clearly state the finance charge.

So just exactly how have the banks deceived us? It doesn't take a rocket scientist to avoid paying interest on a credit card. There are at least three ways that come to mind: 1) Don't use the credit card. 2) Use the credit card, but don't buy more than you can afford; and make sure you pay off the balance within the grace period. 3) Buy more than you can afford at this very moment, but only if you are certain that you have enough cash flow coming in before the grace period ends.

There is a very simple rule of thumb in the credit markets. The higher the risk of the borrower, the higher the interest rate charged. This is exactly why BB rated companies pay higher interest rates to borrow money than do AAA rated companies. And this is why banks will issue credit cards to high risk borrowers, but only at higher rates than they charge borrowers with good credit scores.

It seems what the politicians really want is for the banks to lend money for free. Even if this is good public policy, it makes no sense to a business trying to earn a profit. Let's not forget, however, that the government is now running many of our financial institutions. Profits have taken a back seat to public policy. This is the inevitable result of nationalization. Yet if the government forces the credit card companies to reduce the interest rates they charge, there will be less credit available to the very borrowers the government is trying to protect. On second thought, maybe that's not such a bad thing after all.

Protecting Taxpayers' Money

I want to call your attention to an op-ed written in yesterday's Wall Street Journal by Ari Fleischer, former press secretary for President George W. Bush. Fleischer makes a point I've made on this blog, in my book, and in my newsletter. Only he articulates it much better than I do. He says everyone should pay their fair share in taxes. There are simply too many Americans who pay absolutely no income tax at all, yet they have a sense of entitlement.

The government is trying to get more money out of the so-called rich. But the rich are already overtaxed. The top 1% pay about 40% of the income taxes. Keep that in mind the next time you hear someone like Barney Frank claim he is trying to protect taxpayers' money.

April Issue of FGI

The following commentary is from the April issue of the Forbes Growth Investor.

The United States was once a bastion of capitalism, but a comment I sometimes hear from recent immigrants is very telling. They ask,“Why are some Americans trying to turn this country toward socialism?”

The government now owns large stakes in major U.S. corporations. It created a task force to make strategic decisions for the automobile industry. It fired the CEO of General Motors. After pouring billions of dollars into that company, it finally admits that bankruptcy might be an option. A capitalistic economy would have recognized this long ago. With Americans buying only nine million cars per year, the industry has too much capacity. The least efficient companies and plants must be shut down. While I hate to see anyone lose their job, I have to wonder if it wouldn’t have been cheaper to pay laid off GM autoworkers to retool their skills for a new job than to keep pouring money into a failing business.

Then there is the uproar over the AIG bonuses. Excessive executive compensation has been a point of contention for years—and rightly so. As I mention in my book, Even Buffett Isn't Perfect, in the 1970s the typical CEO made about 25 times what the average worker at his company made. By 2000 this multiple reached almost 400. My long held personal opinion is that anyone who makes more money than I do is grossly overpaid. Yet, if you have noticed, I haven’t quit my job. That should tell you that I must be at least somewhat satisfied with what I’m making.

It is not surprising that the average Joe gets all worked up when he hears about multimillion dollar bonuses in the executive suite. No doubt he works hard too, but no one has ever offered to pay him anything close to that kind of money. So the outrage over the AIG bonuses is perfectly understandable. The real shame, however, is the behavior exhibited by some of our politicians. After forcing out the former CEO, the government asked Ed Liddy to come out of retirement to save the company. He did not seek the job. The government even passed legislation authorizing the payment of those controversial bonuses. Then when elected officials realized their constituents were upset, they gave Liddy a public tongue lashing. The man who is getting paid just $1 per year to do the government’s bidding sat there and looked contrite with hardly a word of objection. He should have pulled a Johnny Paycheck. He should have stood up and said, "Take this job and shove it! I ain’t workin’ here no more."

Of course, if taxpayers had not bailed out AIG, the company would no longer exist and bonuses would not have been paid. However, the government chose to bail it out, and as one AIG employee who recently published his letter of resignation in the New York Times pointed out, employees were promised on several occasions that they would receive the bonuses if they stayed. Some gave up opportunities elsewhere because of those promises. Now with a gun pointed at their head, they are "voluntarily" returning the bonuses. With a multitrillion dollar budget deficit and trillions more in debt, taxpayers can at least take solace in the fact that politicians did everything possible to get back those bonuses.

When Tax Simplification Can be a Bad Thing

According to a Bloomberg report, President Obama asked Paul Volcker and the Economic Recovery Advisory Board for a proposal by December 4 to overhaul the tax code.

I almost jumped for joy, but tempered my excitement when I read the details. An overhaul of the tax code is clearly needed, but we don't want one that makes matters worse. Spokesman Tom Gavin said the board has a mandate "to simplify the tax code, protect progressivity in the revenue base, close tax loopholes and find ways to reduce tax evasion and ... corporate welfare."

The tax code is unnecessarily complicated. I am all in favor of simplifying it. It takes the average taxpayer much too long to file a return. In fact, the code has become so complicated that more and more taxpayers have to turn to professionals for help. But simplification must be done in a fair way. Economists used to joke that Bill Clinton wanted to simplify the tax code when he was president. Under the fictitious Clinton plan a tax return would have only two lines: 1. How much money did you make? 2. Send it in. This is the kind of simplification we definitely do not need.

However, we do need to make paying taxes easy and painless. There is no reason why Americans should spend a full weekend or more filing a return. One quick fix is to eliminate all deductions in exchange for significantly lower tax rates. Take the mortgage interest deduction for instance. This deduction exists only because the home building industry has convinced Congress that using the tax code to promote home ownership is a good thing. Unfortunately, this tax subsidy contributed to the housing bubble. Consumers make choices. Whether they choose to buy a house, a car, or more clothing, the rest of us should not be subsidizing that decision.

Of course, I am also in favor of reducing tax evasion. Everyone should pay their "fair" share. However, it is not the stereotypical rich who are evading taxes. Tax evasion is most pervasive among those who work on a cash basis. It is not difficult for them to under report their income. And let us not forget about people engaged in the illegal drug trade. One study estimated that 10 years ago Americans spent $65 billion on illegal drugs. All of it went untaxed.

As for protecting progressivity of the tax code, this is a worrisome sign. While I agree that taxes are a necessity and that those who make more should pay more, a progressive tax code is specifically designed to punish people for doing well. It may be too much to hope that a Democratic administration would understand this, but a tax code that is too progressive reduces the incentive to work hard. At a time when we need to encourage the most productive members of our society to start businesses and employ more people, the last thing we should do is threaten to tax them at higher rates if they succeed.

Geithner's Stock Rises on PPIP

A government program has to have a catchy name. So it was that Treasury Secretary Timothy Geithner introduced the Public-Private Investment Program. This is the latest plan to save the banks and free up credit. According to this plan, the government will work in partnership with the private sector to buy up so-called toxic assets from the banks. The hope is that by removing these assets from the banks' balance sheets, banks will be more willing to lend.

The first thing you should notice is who gets top billing in the name of the plan. It is not called the Private-Public Investment Program for a reason. The government wants to make sure taxpayers come first.

The next thing you should ask is will the program work as planned? This program assumes that banks are not lending because of these toxic assets. It fails to consider the possibility that maybe businesses don't want to borrow. In general, businesses borrow money when they want to expand. When demand is strong and they are growing, they have to finance that growth. But when there is a recession and demand is weak, there is no point in expanding so there is no need for financing. Of course, this is a bit of a Catch-22. The recession won't end until businesses borrow and invest. But businesses won't invest until they are convinced the recession is coming to an end.

You should also ask if the banks even want to sell all those toxic assets in the first place. After all, they have already marked them down. They may prefer to wait until the markets improve so they can benefit by marking them back up. Of course, there is a price for everything and banks will sell at the right price. But the public-private partners will want to buy at as low a price as possible. A little arm-twisting by the government may be necessary to convince the banks to sell.

Nonetheless, Secretary Geithner's new plan is the best plan we have seen to date. The market certainly liked it and rallied strongly in response. Geithner has been criticized for talking in generalities and providing no specifics about how he will respond to the financial crisis. This time, he gave us specifics. Those who were shorting Geithner and calling for his resignation got a little burned. Today his stock went up at least a few points.

Is the U.S. a Developed or an Emerging Country?

Ian Bremmer and Sean West have an op-ed in today's Wall Street Journal called AIG and 'Political Risk.' I urge you to read it. While some people are upset that AIG employees got any bonuses at all, others are equally upset that the government has stepped in and threatened to take them away. The authors argue that the outrage by Congress and the Obama administration over the bonuses is a result of nothing more than political expendiency. It scores populist points. However, it also raises the risk for investors and does nothing to resolve the financial crisis.

Bremmer has been warning for several months now that Congressional actions represent the most important political risk investors face this year. I know Bremmer well so I sent him an email congratulating him on the article and expressing remorse that the U.S. suddenly seems hellbent on turning toward socialism. He replied by saying that what is going on is right up his alley because he has been studying emerging markets for twenty years. So there we have it. The world's most developed nation is behaving more like an emerging country.

Fed's Actions Induce Rally

Stocks surged immediately following the Fed's press release today. In perhaps its boldest action to date, the Fed said it would significantly increase the size of its balance sheet by buying up to $750 billion of mortgage-backed securities, up to $100 billion more of agency debt, and up to $300 billion of longer-term Treasury securities. In other words, it will flood the market with money.

The Fed has come under criticism is recent weeks for tightening the money supply. Steve Forbes, for example, recently pointed out that despite lowering short term interest rates, the Fed's balance sheet has actually shrunk by almost $400 billion since December. Today's decision reverses this trend.

Despite today's actions, investors know that the economy will not improve until housing prices stop falling. What the Fed announced today should support housing prices by reducing mortgage rates, but that may not be enough to generate sufficient demand. After all, housing inventories are still too high, and mortgage rates are just one component of the cost of buying. As I've discussed on this blog many times before, property taxes represent a major cost of owning a home and there is nothing being done to address this problem.

I continue to believe this is an excellent time for long-term investors to be buying equities. Those who are willing to wait five to ten years should not hesitate to get in now. Nonetheless, I also think there is a reasonable chance we will see another significant selloff in stocks in the near term. If we are lucky, the recession will be over by yearend. However, there is more bad news to come. With corporate profits falling and unemployment rising, we are still a long way from being out of the woods.

Leon Charney Report

I come across a lot of smart people. Leon Charney is one of them. Charney is a New York attorney who played a significant role in the Camp David Accords, which were signed during the Carter administration. Charney is also an astute investor who appears on the Forbes Billionaires list.

Unlike most other investors, Charney actually managed to hold on to his wealth this past year. He also has a popular PBS television show that airs in the New York City area. I have been a guest on his program a number of times. We filmed an episode on March 5, which aired on March 8. I am honored that an investor of his calibre even cares about my opinion. Click here to watch this episode of the Leon Charney Report.

Explaining Mark-to-Market Accounting

A good friend forwarded this humorous explanation of mark-to-market accounting. It was produced by John Carney and can be found at businessinsider.com:

You have two cows.

You write down on a piece of paper that the cows are worth $100 each.

You notice the cows are on fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the fire.

Your cows are dead from fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the dead cows.

You notice that you aren't getting as much milk as expected, so you adjust the model and mark the cows down to $98. You are confident, however, that the dislocated stream of milk revenue will quickly revert to expectations.

You need to borrow some money so you ask investors for a loan against the cows. The investors tell you the cows are dead, and you already owe them $200 dollars you borrowed to buy them in the first place. You show them the paper that says the cows are worth $98 each.

They light your paper on fire.

You ask the government to buy the dead cows at $98 each.

The government holds meetings all weekend and finally comes up with a plan to inject $45 dollars into your cattle ranch. In exchange, the government gets a right to milk generated from the cows at some point in the future. It expects you'll buy a new cow with the $45.

You have two dead cows, $45 and $200 in debt to your investors. You have no plans to buy new cows.

That is very entertaining, but here is a more realistic view of mark-to-market accounting:

Suppose it is not your cows that catch on fire and die, but your neighbor's cows. Your neighbor tries to sell his dead cows, but no one wants to buy them.

Since you own the same kind of cows, mark-to-market accounting forces you to value your cows at zero because no one is willing to buy your neighbor's cows.

Even though your cows are still alive, still producing milk, and still helping you generate positive cash flows, you have to pretend they are worthless.

This is why mark-to-market accounting needs to be fixed.

Cash is Trash

It is nice to see a violent rally in the stock market for a change. It is also nice to hear that Citigroup may not be as sick as everyone thought. At last look, the stock was up about 35% for the day. Of course, for a penny stock, that does not mean much in absolute terms. Nonetheless, it is encouraging to think that one of the most important financial institutions in the country is actually going to survive the recession.

FAS 157 (mark-to-market accounting) has made many of our financial institutions look sicker than they actually are. Even those that are cash-flow positive look like they are losing money on paper. This has scared investors and helped drive stock prices down. In fact, Warren Buffett recently said, "The investment world has gone from underpricing risk to overpricing it." In the end, those companies that manage to survive will come out stronger; and those investors brave enough to take advantage of the turmoil will come out richer.

Despite today's good news, the recession is real and will continue for many more months. Credit spreads are still too high, consumers are still not spending, and corporations are still laying people off. Undoubtedly, stocks will remain volatile and we could see another selloff. Yet, I believe the risk of holding cash outweighs the risk of being long for anyone who has an investment horizon of five years or more.

Those who are interested can view these videos I taped for the MoneyShow on February 6:

Economy--No Progress Yet

Any Energy Plays?

Buffett Makes Mistakes, Too

President's Unemployment Forecast Much Too Rosy

In looking over President Obama's proposed budget for fiscal year 2010, I found Table S-8 Comparison of Economic Assumptions particularly interesting. As the name implies, this table compares economic assumptions under the proposed budget to the Congressional Budget Office's assumptions and to the Blue Chip forecasts. What really stuck out to me were the forecasts for the unemployment rate.

The Blue Chip consensus forecast is for the unemployment rate to peak at 8.7% in 2010. The Congressional Budget Office predicts it will peak at 9.0% in 2010. However, the president's budget predicts the unemployment rate will peak at 8.1% this year and then fall to 7.9% in 2010.

Admittedly, the Congressional Budget Office ignores the possibly beneficial impact of the American Recovery and Reinvestment Act. Even so, the president's forecast seems much too optimistic, especially since he is also proposing to raise taxes on the people who do most of the investing in this country.

The government cannot create jobs nearly as efficiently as businesses can. However, by raising taxes on the investment class, the president is virtually guaranteeing that more people will find themselves out of work.

The unemployment rate was 7.6% in January. Tomorrow morning, the Bureau of Labor Statistics will report the unemployment rate for February. The consensus estimate is 7.9%. I have been warning since last September that the unemployment rate would reach 8-9% by June. I think the average for 2009 could exceed 8.5%. This is considerably higher than the president's forecast. Unfortunately, I think it is also much more realistic.

Why Financial Education is Important

One of our equity analysts forwarded this multiple choice question he found on CNBC's website. It asks, "After breaking 7,000, where's the Dow headed next?" The three choices are 5,000, 6,000, and 8,000. Amazingly, about one-third of the respondents answered 5,000. Which brings up an interesting question. How can the Dow go to 5,000 next without going to 6,000 first? Perhaps this group of respondents are the same people who created mortgage-backed derivative securities.