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A Victim of Circumstance

October 18, 2010

Good morning. It was a very interesting week for the market last week, with stocks and bonds heading in different directions. The SPY was up one percent on the week to finish at 117.7, the highest close since May 3 of this year, and within striking distance of the years’ top print of 122.12 on April 26. The move in the SPY this week paled in comparison to the continued love being directed at the likes of AAPL (up 7%), GOOG (up 12.1%) and AMZN (up 6%). It continues to amaze me how this generation of investors continues to place such fundamental premiums on the stocks of companies that are fashionable and in the news. The flip side of what would otherwise have been a solid week for investors was the late week collapse in the long-term bond market. The TLT (20+ year bond ETF) was down 3.8% on the week and the 30-year bond future fell 3 8/32 (2.5%) to close at a rate of 4% (up from 3.75%). From what we have been reporting for a while now more retail investment dollars have been invested recently in bond funds than stock funds, so last week, given the relative moves in stocks versus bonds, was probably a down week for the majority of investors. The VIX continues to decline, down 8% to close at 19.03, even though the cost of protection continues to go up the further out in time you look. The market is showing reasonable confidence that there are no land mines in the near-term, not so confident going forward.

So what do we make of all this? I am very concerned about the rapid drop in bond prices evidenced on Thursday and Friday of last week. The recent stated goal of our (in my opinion very misguided) Federal Reserve to re-introduce inflation into the economy (supposedly to counter non-existent deflation) has had the effect of racing commodity prices higher and pressuring the dollar lower still, although that effect has been muted some by expected similar moves on the part of other governments. What is obvious to all amongst us is that the value of the Washington (or Franklin if you are so blessed) in your pocket has been going lower. So when you stop in to buy gas, or buy gold, or go to Europe on vacation, or maybe even see your stocks rise, all you are really seeing is the value of your dollar fall. The price of oil, gold, corn, etc, has gone up very little recently (if at all) if you had been lucky enough to have Euro’s in your pocket than our beloved dollar. Yet we have an election coming up, with amazing feelings on each side, and I see virtually no discussion of any of these issues and how to resolve them. Without going into too much nauseating detail one only had to watch the ridiculous debate between our (one of them) soon to be senior statesman, Gianulious or Kirk, and all you heard was some blather about one can’t get his war record straight and the others only real job was in his dad’s bank that blew up. What do you think that debate would have sounded like if a few of us were asking the questions? A few blank stares from the debaters maybe, as we asked some real questions and demanded real answers?

So what has suddenly afflicted our Federal Reserve? Why have they settled into this new policy, seemingly out of nowhere? I have always said there are three levels of fibbers (bull-bleeper’s to be exact) in this world. One is the person that once in awhile lets an untruth slip in the interest of keeping peace, like saying to your wife or significant other that you were 10 minute late due to traffic and not the phone call discussing the latest trade in fantasy football (not good but used sparingly can dodge an argument). The second is the person that just lets one fly by habit, they know they will be late if they make the call about the fantasy football trade but are so immune to telling the whopper that it is OK. By this point the wife or significant other knows it is BS, but they keep the secret and now you are the stooge. The third is the most ominous; you start to believe your own BS to the point where you lose the ability to differentiate. Like I have said on the radio, you become like some of the south side plumbers. You are scheduled to come over and fix a toilet, and do not show, but upon questioning you go into this “I was right there, I was heading to your place, caught this train, had another client call with water running on her head, could get to her by turning around on the train, was an emergency, etc.” In his mind he almost did fix your toilet, he was clearly (as Curley Howard of the Three Stooges would say) “A victim of circumstance.” I think the Federal government has reached this stage. They have messed with these inflation numbers so much that they are almost useless, and they know it, but still throw them out to you like they mean something.

For example, when home prices were increasing rapidly they did not want to include those rapid increases verbatim in the inflation numbers, so designed some sort of funky number that implied what it would cost for you to rent your own house, interesting. There was always the adjustment that says if the price of the car went up 10%, but it could be attributed to technical “advancements” it really did not go up at all (tough if you walk in to the dealership only able to afford last years price). They also introduced some sort of adjustment a few years ago, I believe, that says if the cost of an item goes up too strongly people will begin to substitute. For example, if beef were to double, you would assume that people would switch to pork or chicken, so you would adjust the price of beef doubling downward, interesting again (or BS). The actual CPI calculation comes down to two main things, the first is the price of the item itself, and the second is the weighting it is given in the calculation, and there is the rub (in my opinion). I think, and would love to be able to fund a couple of Doctoral Thesis on the subject, that the weighting becomes so important and skewed for certain people that the index as a whole almost becomes useless.

For example, I think most would agree the cost of college (and elementary and high school for that matter), the cost of health care, and the cost of prescription drugs have totally outstripped any reasonable number contained in the Consumer Price numbers. So for the person faced with paying for a college education of $200,000 after tax over four years, or the person paying half of their paycheck for insurance, or the seniors paying a big percentage of their social security for prescription drugs, the rest of the CPI almost does not matter. None of these people (except maybe for the family that pays the $200,000 tuition easily) cares a whit about the price of a high end men’s suit staying even, or lobster coming down, they are out of that loop. A person making $36,000 per year could pay half their take home pay for health insurance, for them the rest of the CPI (other than the rent they can barely afford) is but a concept. There will be no new car, no new suit, and no restaurant meal, for them the CPI is infinite, as one piece of it went from zero (if they were covered at a previous job) to over $1,000 per month. Same thing with the seniors paying increased drug costs (as our slimy drug firms headquarter in Bermuda to avoid taxes and hide behind patent protection given them by us). No new Buick this year, the money went over the drug store counter, who cares if the price of the Buick is actually down 1%.

So where is the solution? I suppose it is possible that we could get in such a bad way that the leaders we elect would be forced into shaping up (not likely). Remember the saying that most acts of heroism were really acts of blind desperation; maybe statesmanship is the same. Maybe Roosevelt was made by the times and the challenges he faced, same thing with Washington and Wilson, and maybe we have a few leaders already in place that are ready to grow with the challenges ahead. Just does not seem to be the ones I listen to. Reid, Palin, Roosevelt, what’s the difference? Yikes! I see no one with any kind of courage whatsoever. I see a President who started with a mandate of change that has changed little; in fact he has done more damage to those he supposedly sought to help than the man he replaced. He has totally underestimated, maybe too busy patting himself on he back, the influence in the bureaucracy of special interests on the bills he has passed. The supposed ground breaking legislation on Financial Regulation will end up being a godsend for those few remaining large institutions it was supposed to regulate, and it will be virtually impossible for any smaller firms to grow to that status and compete. Is he overwhelmed by the detail so he cannot see, know very well what he is acting as nothing more than the agent of those he supposedly is against, too trusting of the help, or totally clueless? I do not know, but the danger is real. Everyone small will be regulated almost to the point of extinction, and the big people will easily be able to deal with it and pass on the cost.

So how do we trade it? We were pretty active last week, and had a pretty good week. I think we need to be mindful that the dollar is dropping in relation to virtually everything else, but maybe we have reached the tipping point there for a while. The last time the dollar reached 140 Euro it paused and strengthened, as we are starting to see some European countries rethinking their policies that relate to the strong Euro. I do not think they will stand by and watch their companies lose this devaluation battle. We have already seen the Bank of Japan intervene on behalf of the yen. So I think the dollar pauses here for a bit, maybe to see what the reaction will be in other countries. The recent down move in bonds I think is real, and everyone needs to do an inventory of their bond portfolio. The movements last week may be a little too much in the short term, but I see a 5% thirty-year rate a lot sooner than a 3% rate. We will continue to be bearish bonds. As for stocks, we are looking to stocks left behind with good numbers and dividends (INTC this week) and the XLE if we get a pullback of any amount, again all protected in case the market were to relapse from the whole mess around it. There will be some opportunity here, let’s just be that tough combination of both patient for the chance, then aggressive when we see it.