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Politics As Usual

November 1, 2010


Good morning. A very quiet finish to the market last week as the nation prepares to go to the polls this coming Tuesday. Someday someone will explain to me (officially) why elections are not held on a Sunday like in Europe, but I guess the unofficial reason that those in power really do not want big turnouts will suffice. This election, at least in Illinois, has been particularly nasty, with a lot of outside money entering the state (a lot due to the absurd Supreme Court ruling last year) that is virtually untraceable as to its real source. My unofficial non-scientific survey has the ads roughly 90% negative, with virtually no mention of any real new ideas capable of solving the governmental box we are in. I guess the numbers are too big for people to even talk about, much less comprehend. In this column, to the people I know are reading, it is at least worthwhile trying to outline the scale of the problem, almost $14T in debt on the national level, hugely in debt on day to day operations in the state with an even worse mess on unfounded future obligations, same picture in other states and a lot of municipalities. Maybe that is the reason; no real change this Tuesday despite the expected changes in the House, that the VIX was up over 11% last week to close at 21.2.

Why is it impossible to write a financial column these days without devoting most of it to politics? It is simply because the overwhelming issues of Economic policy, dollar racing up and down affecting exports and imports on almost a daily basis, Federal Reserve Policy going from one where deflation was a possibility to one where inflation is almost a certainty (all in a couple of months), are sort of superceding the old standby of looking for undervalued stocks and buying them. You have only to look at the incredible inflow into longer term government bonds in the last year or two, with virtually no knowledge on the part of investors of the risks in those investments, to be worried about that potential bomb.

I am actually writing this on Sunday morning. On my way here I had the pleasure of listening to both the Republican and Democratic candidates for one of the House seats in the western suburbs, and found it interesting. In this case the Democrat is the incumbent and the race is very close. As expected the Republican talked about size of government, deficits being too high, regulation out of control, all of which I think everyone would agree with. The Democrat talked about the total degradation of the manufacturing base starting in the early 2000’s, the almost total collapse of the economy in 2007-2008, the fact that government intervention was surely warranted at the time, and that a lot of the programs put in place in the crisis did have some benefit, again all things that make some sense. In a nutshell that is really the economic discourse (when you can get away from the attack ads) that has been driving the campaigns. The issue, however, that neither side has any desire to discuss is “What now, really!” The deficit is running around $100+B per month, roughly half of which we borrow from overseas. So even if you consider the amount we (our government) borrows internally to be somewhat of a wash in regards to creating demand (I could argue that the money we spend overseas that is not repatriated is not a wash but let’s be simple) it still leaves $50B per month being driven into the economy (or about 4-5% of all spending). Neither side has a clue, or wants to talk about, this money. The Dems say (if you read between the lines) that it was necessary at the time, and maybe most agree, but never address the issue that it is certainly unsustainable for any length of time. Yet they appear to have no exit strategy, and even seem somewhat willing to ad to the monthly carnage. Even the most Keynesian among them must see a $20T national debt in 5-6 years as a problem with no fix (if it takes that long).

The other side says we should just stop spending, deficits are an issue, and again I agree. Under their (Republicans) watch, and some before them, we have lost over one third of our manufacturing jobs. Have they really thought out what would happen if we stopped all those programs tomorrow? We have a growth rate of barely 2% with the government spending artificially 4-5% of the demand each month. It is the same sort of lack of thought by the GOP that made their run in office a disaster. So here we are, most people with a brain cell would agree that we couldn’t go on like this, yet we can’t just stop without consequences that might be very damaging. I believe the term conundrum applies. The real issue, in my mind, is that neither side of the group of “statesman” running have come to grips with the depth of the problem we have, both think a topically applied ointment from their list of standard fixes will suffice. I can’t disagree more.

Somewhere in my voluminous files (mess) I have an article that talks about our government’s (both sides of the aisle) habit through the decades of basically putting off most real problems until the underlying growth that, with few exceptions, the U.S. has always enjoyed (then if the timing was right you took credit for if you were in office) bails them out. Examples would surely be the huge unemployment after WWII that was eventually eaten up by the tremendous growth of all those new families. Another might be the Resolution Trust; one of the most mis-managed and outright crooked federal undertakings of all time, yet bailed out by the tremendous growth of the 1990’s. The one time that just the passage of time failed us was the Great Depression; there had been such an erosion of the income base that the growth could never really catch momentum. It took a world war. I believe there can be a solution now, but it would take an almost simultaneous enactment of probably ten policies that neither side could get past the lobbying hacks that are really controlling this country. I would be happy to divulge my list, but then again, if no one pays huge for it no one thinks it would be any good.

So how do we trade it? Check out this article I read last week (actually sent to me from a Stocks and Jocks listener) entitled “The Task of Depression is Margin Compression.” It is a fascinating article that deals with certain things common to all Depressions (as everyone, I think, knows I was a student of the Great Depression in grad school, but am astounded by the vast amounts I have continued to learn recently). This article goes into the particulars of the unevenness of the suffering of business and people during economic depressions; specifically the costs of raw materials remain high in relation to finished goods. That means that the margins of those businesses using raw materials and the wages of those working there get squeezed, possibly to the point of extinction. In other words, his point would be that, say, in the Great Depression, some auto companies would find that they could only sell cars if they could price them down 40%, but the cost of steel and rubber night only be down 15%, causing the problem to be even worse. Aren’t we seeing that now? Last weeks’ earnings showed a lot better picture for like a Cliffs Natural Resources than an Archelor-Mittal, or maybe for someone growing corn than a cereal company. I think we need to zero in on those companies having some measure of monopoly pricing power, like maybe the rails, or IBM, or maybe the chemicals like DD or POT, or stick with the providers of the resources. Obviously the problem is that the trade could be very crowded, U.S. steel is already way off its highs while companies like Archer Daniels and Potash have already had huge runs. We have seen some slight mitigation in the volatility increasing as we go out in time, and maybe that may flatten more after Tuesday. If it does we are still interested in adding to peoples’ positions in the XLE, I just refuse to initiate positions where the volatility of the puts we buy is 20% higher than that of the calls we sell. I think we will get some real opportunity this week, and am a little suspicious that any celebration we see with Republicans taking the House might be a good time to lean a little short. We will see.