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.