Taking Off The Rose Tinted Glasses

Good morning. We had a very solid rally on Friday of over 1.5% in the SPY that was almost able to turn what had been a very negative week to the positive. As it was, the SPY finished “only” down .6% on the week and finished at 106.86. Friday’s close puts the SPY down 4.2% from the closing price of last year of 111.44. The VIX was actually down 4% on the week, closing at 24.45. What are the “reasons” for Friday’s rally? I think most would say it was some combination of finally an economic number better than expectations (Friday’s second quarter GDP estimate came in at up 1.6% vs. the predicted 1.4%) and maybe a short-term oversold condition in the market. The numbers preceding Friday had been nothing short of abysmal, both in the housing and manufacturing sectors, as well as in the job numbers. When you start talking of the possibility of a double dip recession, decreasing numbers of GDP growth reaching the 1.6% range do not leave a whole lot of room between those levels and negative.

What is the problem, why do we seem to be sinking again? I would suspect that a lot of people’s small and non-scientific surveys (like mine) of the economy would indicate that some sort of a slowdown has happened this summer, and that view would seem to have been confirmed by the recent macro numbers. The question is why? In my opinion it has to do with a general inability or unwillingness to understand the depths of the problems we are facing. That is causing a slew of programs to be put forth that sort of push the problem down the road, and have their own backlash (higher deficits) if they do not “work.” Of course that brings on an ocean of negative campaigning and almost hate mongering politically from the other side, to cover the fact that they nave no solutions either. Let me give one example. Recently a Bill was passed, and I believe it is the second one aimed at this issue, that would help states and municipalities maintain teacher, police, and fireperson employment roughly where it is. Obviously, everyone has heard, and been sort of insulted by, the state and local government habit of essentially threatening the citizens with lay-offs in those areas of government that people need the most. You will never hear some Mayor or Governor (for sure in Illinois) say “If we are not able to raise taxes we will have to cut limousine allowances for aldermen or pensions for former part time legislators.” It is always, “”If we do not raise taxes, we have no choice but to not pick up the garbage and fire the policeman in your neighborhood.” The politicians are slimy, but not dumb.

The problem comes down to one of assumptions and assessing the problem. If the economy has developed some serious long-term imbalances (like ours has) the short-term fix probably will not work. In this instance you can see any number of studies that say in the last 20 years the total compensation (salary, benefits, and pensions) of the public sector employees has grown faster than those in the private sector. It is not about some liberal (and I can be critical of liberals as I am accused of being one) saying, “Oh my God! Teachers have the responsibility of educating our next generation, or Fireman are all heroes and look how dangerous that job can be.” We know all that, it comes down to balance and ability to pay. In most states and municipalities there needs to be a serious conversation, union or not, maybe in Bankruptcy Court or not, with the public sector (and I will include Washington) as to what compensation can be paid. If the economy picks up steam we can always happily pay a bonus down the line. What I am getting to is that the administration, maybe with bad advice, has decided that the economic problems are only short-term and not a long-term imbalance at all. With that view, their solution is to borrow from the future, send money to the states and cities, and maintain the current compensation in these areas. It really could work if this was just a “regular” normal slowdown in the business cycle. I have never thought this was a “regular” business cycle event, and I think any program like this just props something up for a while. My guess is we will have to have the conversations, and they probably will happen in Bankruptcy Court, and all the short-term money thrown at the problem will be totally wasted. Waste is not stimulus, despite what the President’s Economic Team thinks.

Look at the housing mess! The 20 year fiasco that keeps on giving, and I would estimate is only half as bad as it is going to get. And yes, the downslide has been easily predictable to anyone who cares to take off the rose tinted glasses and look. We had a system of housing financing, mainly S&L’s. It was vulnerable (since you had short- term borrowing supporting long-term lending) to sharp increases in rates. That happened in the late 70’s and early 80’s, destroying the industry. It was replaced with a scattered system of mortgage brokers giving out loans without a whole lot of supervision, a Federal system of guaranteeing loans they barely looked at, and the combination of those loans into securities bought by people having no idea what was in the packages. Now there has been a sharp drop in housing prices affecting everyone, even those with the strongest loans and the biggest down payments, as the price declines have been dramatic and a lot of owners have the added burden of now no job. The good news is that financing rates have also dropped dramatically, so one of the “fixes” if anyone had a brain, would be to get as many people as possible refinanced at the new rate. That is not happening to any great degree, because now we are all of a sudden real careful about our loans. If the formerly $400,000 house now appraises for $260,000, and the person initially put down $80,000, and actually still may be making his payments, we tell him that his house does not appraise high enough, meaning he cannot qualify for a 4.5% loan even though he has not missed a payment at 6%. I someone putting stupid pills in the water someplace?

So what is the next leg down, and it is so clear it is right in front of everyone’s face. These homeowners, even the good ones trying to pay and willing to take the hit on their bad timed home purchase, say “The hell with it!” They (probably with advice of counsel) pay off their credit cards, buy a new car, and hunker down for the year or so it takes for them to get booted out of the house. Of course, now all the original mortgage brokers are gone, and all the lucrative servicing is in a few spots that are undermanned and enamored with phone systems designed to block any access. Once they do finally move or get thrown out, the supposed “servicer” who is supposed to actually care for the property, does not. The power gets shut off, the pipes explode, and the place is now a mess. Someday it does sell, when the servicer finally finds whoever actually has this particular mortgage buried in some “basket,” and will sell it for about 40-50% less than what the “market” value should be. Now this “comp” enters the appraisal pool and begins to affect the original person trying to refinance his house, and now the appraisal on his place is even less, and the circling the drain of the whole area continues. Not to mention many homeowners have a house or houses on their formerly pristine block boarded up and abandoned, with all the problems that situation can bring. How big is this problem getting? My brother Dan tells me that he saw a figure that the electric utility in Chicago has 17,000 less customers that last year. That is an astounding number, and I have to believe that most of them are just abandoned houses where people walked and the “servicer” is not maintaining the property, to everyone’s dis-service.

OK, so what does any of this have to do with investing? It surely affects the markets if the general wealth level of potential buyers of stocks either is not rising, or actually falling. The financial “wealth” of a family is pretty easy to determine. It is the combination of the earning power of those working combined with the “assets” owned. For the most part (forgetting for a minute those having gold bars, rare paintings, or old cars) those assets mean value of property and investments in the market and other places. Right now the earning power for most is static at best, and we still have 16 million people either out of work or looking for a full time job. The market has not really moved in 11 years, and the values of real estate, depending on when you bought, is either down dramatically or back where it was many years ago (and hopefully you did not refinance based on prices near the top and spend the money). The only real bright spot has been the bond market, as decreasing interest rates have cause huge gains there.

Those that have hedged themselves, like those in the PIP program, have managed to weather the storm and are ready to invest in whatever looks good. Coupled with that, there have been some short-term opportunities in the market that we have been able to exploit. The problem is finding something that looks good. Despite Friday’s rally, the market looks a little sick. The bright spots of earnings and cash holdings of large companies are indeed bright spots, for them, but do not seem to be translating into higher stock prices or dividends for us. Politically things are a mess, and the supposed drive for jobs is but a fairy tale. Today I could not help but notice how the United/Continental merger was approved with the sole concern of them having to lease a few gates at Newark to Southwest Air. How many jobs will that cost us, and how many will the resultant increase in airfares cost us. Where do we get these people we elect?

I think we need to stay the course on the market, stay hedged, put a little more money to work if the market, especially the XLE and XLF, continue to decline, and look to be short these long term bonds. As for seasonal trades, I have been talking to some people that do a lot of research in that area, we may be looking to find a cheap way to go long AMZN and short PCLN. So far, I have not found an easy way to do either, but will continue looking.

Before I sign off, I’d like to let you know that we have another In-Office Protected Index Program®  Seminar on the calendar – for Saturday, October 2nd, 2010 from 9:00am – 12:00pm. My brother Dan and I will explain the strategies of our managed money program and will field questions from you in a no-pressure complimentary session. We will have coffee and a continental breakfast waiting for you and you will have the opportunity to meet some of the friendly PTI staff. So, if you are wondering what to do about your 401K or your IRA or Trust – we may have an alternative for you. View details and register here! Seating is limited and spaces fill quickly so be sure to register.