True to form, even the mainstream press is starting to take notice, long after the trend has been well established. Ambrose Evans Pritchard dedicated a piece yesterday to the collapse in M3 growth, something that hasn’t been seen in the US since the Great Depression. Monetarists the world around are frightened about this trend, and with good reason. US interest rates are already essentially zero. The massive monetary and fiscal stimulus has been epic in nature. And all this has still not prevented the actual textbook deflationary trend we now find ourselves in.

“It’s frightening,” said Professor Tim Congdon from International Monetary Research. “The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly,” he said.

The major reason for this is that the banking system has severely curtailed its lending activities, which are largely (but not entirely) responsible for the growth in the money supply thanks to the money multiplier. One must ask how this is possible since essentially the banks have the Taxpayer Put in place where the US taxpayer is immediately hooked for any significant failure. For decades we have had an economy that relied on credit for its survival and now, like a drug addict in rehab, that credit is being limited. The result was fairly predictable.

Given the massive debts in our system, there are two obvious choices. First, hyperinflate away the debt. However, that ultimately ends in the destruction of the currency and the end of the current fiat age. Secondly, we could default through deflation/devaluation, and try to, in effect, reset the system much like what happened in the 1930’s. The major difference between then and now is the relative financial position of both the nation and individuals. Both are considerably weakened as we approach this next phase in America’s existence.

I’ve argued for the coordinated default/devaluation outcome for some time now. The collapse of M3 growth is one of the biggest factors on this side of the argument. The second is history. The US already has a rich experience in fiat money, dating back to before Lexington and Concord. We also have a rich history of defaults thanks to the over-issuance of fiat money. Granted, the defaults consisted of ceasing to redeem paper money for specie (Gold/Silver), but a default is a default.

We are clearly out of control in terms of our debts, both internal and external, and don’t seem the least bit concerned about real generational or fiscal reform beyond traditional Washington lip service. The Fed has been largely ineffective at doing anything but fattening bank cash flows by squeezing savers and allowing banks to collect generous margins on the performing consumer loans they do have. The bailout money sits in bank coffers, withheld from an economy that now depends on loans for its very survival.

Larry Summers, President Barack Obama’s top economic adviser, has asked Congress to “grit its teeth” and approve a fresh fiscal boost of $200bn to keep growth on track. “We are nearly 8m jobs short of normal employment. For millions of Americans the economic emergency grinds on,” he said.

I wrote many moons ago that once the parade of stimulus started that it would never end. Summers’ statement is tantamount to admission of the failure of his own Keynesian thinking. He is now acknowledging that in order to ‘grow’, we need stimulus (debt). Every once in a while the truth does come out.

Given these undisputable facts, it is really hard to conjure up a scenario where we can have any type of broad, well-grounded economic recovery. The various economic reports I dissect on a weekly basis bear this out. However, the bottom line as we solemnly observe Memorial Day weekend is M3. Where it goes, so goes America. Such is the way of things in a fiat money system.

]]> http://www.sutton-associates.net/blog/2010/05/27/the-consequences-of-m3/feed/ 1 http://www.sutton-associates.net/blog/2010/05/22/liberty-talk-radio-interview/ http://www.sutton-associates.net/blog/2010/05/22/liberty-talk-radio-interview/#comments Sat, 22 May 2010 13:14:17 +0000 TwoCentsEditor http://www.sutton-associates.net/blog/?p=380

Andy spent an hour with Joe Cristiano on Liberty Talk Radio discussing the global financial crisis, the problems in the Eurozone, and some of the different scenarios for our financial markets moving forward. To listen, Click Here

In yet another example of the failure of globalization, or regionalization as it were, the Euro is poised on the precipice of disintegration. Ironically, it will not be the overprinting and resultant hyperinflationary spiral that kills the Euro, but dead weight in the form of various Eurozone welfare states. Germany and some of the other quasi-responsible members simply cannot carry their own burdens and those of Greece, Spain et al. The $1 Trillion rescue fund created in haste this past weekend was intended to inspire confidence in the dying behemoth. Instead, the sheer magnitude of the bailout has done the exact opposite. The Euro-Dollar pair has now sunk below pre-bailout levels and there is a good deal of doubt as to whether rescue recipients will be willing or able to hold up their end of the bargain. I pointed this out in last week’s piece. The temporary euphoria created by a trillion dollars of palliative paper is already gone. This is something that was alluded to in these pages years ago; the law of diminishing returns applies to stimulus and bailouts. As the periods of crisis occur in a more frequent fashion, the effectiveness of Keynesian monetary policy falls commensurately.

That aside, there are several other points that must be addressed as we examine the latest Tower of Babel in the global macroeconomic arena.

National Sovereignty Ceded

While anyone looking at the debt picture could tell that Greece (like so many others) was in trouble almost since its acceptance into the Eurozone, its problems burst into the international media in early 2010. One of the first things that many people noted was the major difference between the Greek government and that of America. Greece was hamstrung in that it did not have its own national bank; it relied on the ECB. While I am not a fan of national or central banks absent a strict Gold standard, this total absence of flexibility accelerated the Greek crisis in months, rather than years. Greece had given up its national identity to join the Club. And for a time it worked. The people of Greece enjoyed lavish social benefits and a carefree lifestyle. As an IMF official recently said, however, and I am paraphrasing: “The party is over”.
Other dominoes are set to fall as well since every other country in the Club has essentially the same problem: they cannot pay their bills, and have no way to wiggle out of it. While in the strictest of terms, this is not a bad thing; it outlines the categorical failure of international trading and currency blocs in the long run. There are always members of any cohort who will try to ride the coattails of someone else. It is human nature and it will not change. From that standpoint, the breakup of the Club was ordained from the day of its inception.

The mere existence of these multinational blocs also fosters a temporary sense of false security, as member nations don’t mind their own fiscal indiscretions because they have the perception that they’ll be picked up by the rest. And they usually are initially, so why change? This is precisely why the Greek people (and now the Spaniards too) are resorting to riots and national strikes. Old habits die hard.

At the bottom of the mess, however, is the loss of national identity. While we look at them as Greeks and Germans, they have in a way come to view themselves as Europeans – citizens of Europe. As Ben Franklin so eloquently put it, new nations come into the world like illegitimate children; half compromised, half improvised. In the case of the EU, we’ve already seen the compromise. Now the improvisation has begun in earnest.

Destruction from Within

Much in the same way the EU is being destroyed by the profligate spending and lackadaisical approach to fiscal matters of a few members, the United States is in a similar position of being devoured from within. This is where it gets very dicey, and I am bound to step on a lot of toes here, but it needs to be said. We know that roughly half of Americans pay nothing in the way of Federal income tax. While I don’t have exact numbers for the 50 states, I cannot imagine that the situation is much different there. This means that, like the EU, America has roughly half of its population riding the coattails of the other half. I am sure that in many cases there are good and noble reasons why this is the case, but I’m trying to address this from a structural macroeconomic standpoint rather than drilling down to specific reasons why people aren’t paying. Frankly, for the purposes of this discussion, it doesn’t even matter. In this way, America is a microcosm of the Eurozone. And we’re not alone. Great Britain is in the same boat. The bills cannot be paid. There is no way to squeeze enough money from the paying 50% to take care of their benefits let alone those of the other 50%.

Much like the EU, America has a central bank, which advocates Keynesian policies such as deficit spending and unfettered monetary creation. Save for one brief stint of interest rate austerity in the early 80’s, America has never wavered. And before we sing the praises of Mr. Volcker, we must consider that his actions most likely were taken to perpetuate the broken system as a whole as opposed to representing some blanket metamorphosis of economic thinking.

The single biggest difference here is that the members of the Club still have the ability to vote others off the island, and/or leave themselves. There is a point certain where the people of Germany, for example will no longer tolerate the abrogation of their economic and financial sovereignty and will either compel Ms. Merkel to take appropriate action or will replace her with someone who will. Hence all the talk of the breakup of the Eurozone. The die was cast on January 1, 1999 when the Euro officially became an international unit of account.

Race to Gold – the Endgame of Paper

All the gloom and doom aside, there is an out for those countries and individuals who fear the breakup of the Eurozone, dollar standard default, national bankruptcy, and the types of cataclysmic financial events that our behavior causes us to flirt with. It is shining right now, making new all-time highs as I pen this commentary. It is soaring even as the dollar races higher thanks almost entirely to the fall of the Euro. The mini liquidation last week in global markets was unable to shake it, so unlike the Lehman days in 2008. People around the globe are racing to Gold as the ultimate safe haven. Where the US Dollar is a proxy on the flaws of the Euro, so is Gold the ultimate proxy on the fallacy of stable paper currencies in a Keynesian world. Where paper currencies represent control, Gold represents freedom and a standard weight and measure.

This is probably one area where many here in America fail to understand the connection between our wallets and the first round of the Eurozone bailout. Thanks to our contributions to fund the IMF, and the resumption of various Fed emergency swap programs, the American taxpayer is on the hook for more of the European rescue fund than anyone who seeks to maintain their position in politics or finance is willing to admit. The burdens of lesser paper currencies are shifting to the already compromised US Dollar and the American taxpayer. There is nowhere else to turn except honest money. Truly, the buck will stop there.

One of the biggest ways our premium newsletter has benefitted its subscribers over the past few years is comprehensive analysis of the macroeconomic, monetary, and precious metals environments. In May’s issue, which will be released on 5/15, we cover the conventional wisdom surrounding sovereign debt loads, propose some alternate metrics, and look at the latest jobs figures. For more information, click here.

The ‘Strong Dollar’ is Back?

For the past several weeks, the proclamations of a ‘strong dollar’ have been floating around the airwaves. Commentators will point at the rising USDollar Index and mistakenly assume that everyone wants our currency because our economy is recovering so nicely. What they fail to understand and/or convey is how the index is calculated. The index is nothing more than a weighting of the value of various currencies versus the Dollar. The Euro is currently 57.1% of the index and is in freefall thanks to out of control sovereign debt. Our policymakers should be taking notes on the developments in Europe. At any rate, since currencies are traded in pairs, when one half of the pair falls, the other rises. This recent surge in the US Dollar index, while good for us in terms of the cost of European imports has nothing to do with the strength of our currency. I’ve said this time and time again. We have to hope for bad things to happen to the rest of the world to keep the Dollar afloat. The true barometer of the strength of a currency is the cost of Gold in that currency. Even as the Dollar index has risen over the past several months, Gold priced in Dollars has risen right along with it. Gold is sniffing out exactly the points made above. People are fearful of paper currencies, and while they dump the Euro in favor of the Dollar in the short run, they are also loading up on Gold, the ultimate money.

The reality shown above is not a one or two day event, but a three month trend, which is intact even in a period of extreme market distress. Many people will try to draw parallels between 2008 and the present. By that logic, they argue that Gold should be falling since we’re flirting with another period of all-out liquidation. However, 2008 was largely a liquidity crisis whereas today we are facing that plus the bankruptcy of roughly 20 nations and the possible disintegration of at least one currency along with it. Yes, the sovereign debt crisis is that bad. Granted, the emerging divergence between the equity markets and Gold (shown below) is in its infancy, but it is a very important development and needs to be pointed out now.

Will Greece Pay Up?

On the front burner and driving the current hysteria is the situation in Greece. While the EU has come together to bailout the embattled nation, there are legitimate fears that:

a) The bailout isn’t big enough and is merely a band-aid. Apparently folks have been paying attention to the bailout of the US financial system.

b) The EU won’t be willing (or able) to extend the bailout

c) The people of Greece will not accept austerity measures

d) The people of Greece will dismiss their standing government in favor of one who will continue the current welfare state.

e) Greece will not pay back its neighbors for the bailout

I would contend that all of these are legitimate concerns. Several days of intense rioting and national strike by the people of Greece are making it very clear that at this point they have no intention of being under the thumb of austerity. This is what happens when you create a welfare state. Again, our policymakers should be taking notes. The country can’t pay back what it already owes, hence the ‘need’ for a bailout. How is a reasonable person to accept the notion that somehow Greece will now be able to pay back the money already owed plus another $146 billion in bailout loans?

Yanking the carpet out from under a welfare state is going to have monumentous social implications. The people of Greece are likely to dispatch their current government in favor of one who will take a disposition similar to that of Iceland and tell the lenders of the bailout money and the country’s creditors in general to take a real long walk off a short pier.

It would be bad enough if this problem stopped at the Greek borders, but unfortunately, it is nearly systemic in Europe, and in fact extends across the Atlantic as well.

Freddie Mac Continues to Bleed

In a harsh reminder of the perpetual state of bailout that the US has entered, Freddie Mac announced earlier this week that it will need another $10.6 Billion from the Treasury by the end of June to cover first quarter losses of $6.7 Billion. This wil run Freddie’s tab to well over $50 Billion with no end in sight.

Back in 2008, the USGovernment pledged to guarantee that both Freddie and Fannie Mae maintain a positive net worth. This has led to periodic infusions of cash into what is now admitted to be a black hole at both companies. What is most concerning about these actions is that there is little or nothing being done to end the reliance on bailouts. At the root of this problem lies the reality that people, for various reasons, cannot pay their mortgages. For many it is because of job losses. If we’re going to borrow and throw money down a black hole, it would have made a lot more sense to use the $50 Billion to build some factories that would employ workers who would produce goods made in the US. That would have put people to work and at the same time would have helped us ease our reliance on foreigners. Instead, we throw the money away, choosing to perpetuate a broken system.

April Jobs Report

As of this writing, the April jobs numbers are available. The economy ‘added’ 290,000 jobs in April, with generous upward revisions to both February and March. What is disconcerting about this report is the fact that we now know that roughly 600,000 new census workers are in place, yet these folks don’t appear to be attributed to the government’s portion of the non-farm payroll. BLS is claiming that of the 573,000 jobs created so far this year that 483,000 were created in the private sector. Yet looking at the Federal Government’s workforce over the past few months there hasn’t been much of an increase at all. So either government is trimming the sails in other areas or the census workers aren’t being counted as government employees, but are instead being credited to the private sector. A recent Gallup survey seems to bear out this discrepancy in that it concluded that government hiring was outpacing private sector job creation. While we don’t yet have the birth/death adjustment to April’s numbers, it is clear that something is amiss. The headline and U-6 unemployment rates rose to 9.9% and 17.1% respectively. State and Local government workforces continued to shrink in April, outlining the dire circumstances that continue to face many geographic areas.

With the cost of insurance on European bank bonds surging to a pre-Lehman high, it is apparent that at the very least, there is again a severe ripple in the credit system, this time at a sovereign level. Given debt levels around the globe it is quite likely that damage control will take precedent over containment.

Probably the most misleading of conclusions is to simply point at the national debt and declare America to be bankrupt. While there is no denying that America is in big trouble with its national debt that will not be what causes bankruptcy. Think of it on a micro scale – a family. Family X has $120,000 per year in revenues and $150,000 in expenses. Let’s say for the sake of simplicity that the family replicates these figures for 4 years. At the end of the 4 years, Family X’s debt (not counting interest payments) will be 100% of its revenues. Is Family X bankrupt? Absolutely not. Truth told, this family could continue to run these annual deficits as long as someone is willing to give them $30,000 in loans each year, dismissing debt service payments for simplicity.

For some reason when it comes to looking at Sovereign debt and debt ratios, the number always used as a benchmark is GDP. I am uncomfortable using GDP in creating a quantitative measurement of solvency since GDP is not some cash account from which public debt may be paid off. GDP is a rather convoluted measure of output, not an expense account. Since the Federal government has assumed this debt on behalf of you and I (a whole OTHER issue), they (we) are responsible for paying it back. Therefore, since the government is on the hook, we need to be looking at the government’s revenues, not GDP when making judgments on the veracity of the government’s financial position.

In fiscal year 2009, the US Government had revenues of $2.198 Trillion. This was a decrease of $463 Billion from FY 2008 according to the Treasury’s Financial Report of the US Government report. The outstanding debt as of this writing is $12.87 Trillion making the debt/revenue ration 5.85. This is a whole lot worse (and much more accurate) than saying that debt is 90% of GDP. As bad as it is having an outstanding debt that is roughly 600% of revenue, it doesn’t even begin to address the issue of bankruptcy.

Marginal Utility of Debt Turns Negative

The underlying graphic has been seen in many different places, and with good reason. One of the biggest justifications of borrowing money in any situation is to cause growth. What has become apparent, however, over the past 5 decades is that the utility at the margin has diminished. What this means is that our ‘bang for the buck’ has disappeared. For example, back in 1966, a dollar of debt resulted in nearly $.90 in GDP growth. Today, adding a dollar of debt results in an over $.40 contraction in GDP. While this doesn’t have a direct bearing on national bankruptcy per se, what it is telling us is that our borrowing addiction is now cannibalizing economic growth. Small wonder. However, since economic output has a direct bearing on government revenues vis a vis tax receipts, the broken debt function will sit like an albatross upon our backs as we try to negotiate this brave new world.

We see evidence of the recognition of this reality in Washington as policymakers of varying stripes try to justify a value-added tax to close the gap and give the impression that we are, in fact, serious about austerity. No, this isn’t a joke. As usual, our government is making more colossal mistakes. Of course, real austerity would mean cutting government spending, but it should be clear to all that we will get nothing of the sort; from either bunch.

So, What Exactly is it that Constitutes Bankruptcy?

According to the Kotlikoff-Auerbach model, which is a variant of Irving Fisher’s Two Period Life Cycle Model work circa 1930, the current fiscal gap is approximately $185 Trillion. That number is a week old. Back in July of 2006, the fiscal gap stood at $65.9 Trillion. Anyone see a problem here? This gap analysis includes the full complement of social insurance programs including the new healthcare plan, military spending on wars for global empire, other domestic entitlements, and pretty much anything else you can think of that the Federal government might be involved in. The model looks at future revenues and outlays well into the future using current law and policy and uses the Net Present Value equation to bring the future amounts into present dollars.

To what extent will the Federal government be able to take the output of producers in the economy and dedicate it towards payment of these bills? We were cutting it very close when the number stood at $65.9 Trillion 4 years ago. Instead of addressing it then, we chose to do nothing. $185 Trillion is an unfathomable amount of money, especially for a government that takes in around 1/90 of that each year in tax revenue. And it is a lot for a country, whose total assets don’t even amount to 1/3 of our tab. Simply raising taxes won’t do it. The more marginal tax rates rise, the less incentive there will be to produce in following the old economic wisdom that you always get less of what you tax and more of what you subsidize. The historical landscape is littered with examples of how raising marginal tax rates actually causes tax revenues to decrease. So much for the idea of the VAT saving the day. Taking corporate profits won’t do it either. Raise taxes on corporations and they’ll lay off more employees, raise finished goods prices, and consumption will fall in proportion. So that isn’t going to work either.

An Undesirable Solution

The only real solution to this mess would be to essentially kill off Social Security, Medicare, and Medicaid benefits beyond what those programs actually take in each year on a cash basis. Going hand in hand would be the assumption that the contribution rates of these programs would remain the same. Pay 85% of benefits based on what the forecast is for the program’s revenue for a year, then give recipients a ‘catch-up’ payment at the end of year based what was actually taken in. Then start the next year with a clean slate. No unfunded liabilities. Period. At the same time, government would be turned into a flying gas can, being allowed to spend on only the barest of essentials.

Can you see the myriad of problems that lie in such a course of action? Forget the fact that it would be political suicide for anyone to propose this, which is the only reason I can get away with it – I’m not running for office. The culling of government would result in massive unemployment, with essentially no way to pay the benefits. The same would be true for private sector unemployment. The program cuts in social insurance would put most families over the edge since so many people rely on them. Ostensibly, we have no savings as a nation, with more than 4 in 10 having less than $10,000 set aside for retirement or any type of life emergency. In short, too many people rely on these programs making the social insurance Ponzi scheme too big to fail. At the same time, the sheer magnitude of these programs makes them too big to save.

Fundamentally, the question of American bankruptcy (or any for that matter) becomes the simple matter of looking at the bills that need to be paid and determining if they can in fact be paid. They certainly can’t be paid with revenues; we know that. We are already borrowing heavily and there is no indication that will change. Getting back to the earlier example of Family X, conventional analysis keeps telling us that some time uncertain, such a system arrives a point where there is simply not enough money in the system for external lenders to perpetuate it.

Points to Ponder

For all intents and purposes that has already in fact happened and the Fed is currently monetizing roughly 80% of Treasury auctions and bribing banks NOT to lend to the public by paying them interest on the reserves they keep at the Fed. This is all done to avoid what would normally turn into a hyperinflationary explosion. The bills cannot be paid. America is bankrupt. And we’re not alone. This is one of the reasons I wrote two weeks ago that we’re going to likely see a coordinated devaluation of currencies and then default as central banks slam the door on monetary creation. The monetary aggregates are already showing signs of this. It will not be pretty. At the same time expect more cuts in programs like Medicare, Medicaid, and Social Security. The money will simply not exist to pay all the promised benefits. It will be an in situ default.

There will be those who will say that the above thesis is baloney and that it will be hyperinflation forever and ever. We are so much smarter than we were back in the 1930’s and we should have never allowed that nasty deflationary collapse to occur. However, the debt bubble that exists today on a global scale is several orders of magnitude larger than what existed back then and believe me, banks and governments knew back in the 1930’s about over-issuing paper currencies.

Our national history is littered with these little experiences of wanton money creation. They never ended well. However, looking at it through that lens, the 1930’s allowed the banking elite to ‘reset’ the system and squeeze another 70+ years out of an already broken monetary model. However, the only reason we made it this far is because the first 30 or so of those years we were giving away the national treasure in the form of our Gold to foreigners for the right be the consumers of the world. History doesn’t always repeat, but it sure does rhyme. I certainly don’t have a crystal ball (or inside info for that matter), but to me, the above thesis makes a good deal of sense especially given the untenable financial position we find ourselves in.

We already have what amounts to the sovereign debt equivalent of a commercial signal failure in the case of Greece, and it doesn’t take much thought to come up with the conclusion that nobody wants to step up and bail out an entire country and start the avalanche. It may well end up being that the default occurs for no other reason than it is the path that provides the least resistance.

Inflation

There are two camps and they argue bitterly. One claims that prices rise because of supply and demand factors (which is partially true) and as a function of a healthy economy, which is patently false. The other side argues correctly that prices rise because the supply of money and/or credit has increased – effectively monetizing demand, which pushes up price levels. Some analysts have argued that there is no inflation because the price of electronics always seems to drop. In the second half of 2008 they argued that there was no inflation because petroleum prices were falling. They made the tragic mistake of substituting a single good for the concept of ‘general price level’.

It is categorically impossible for general price levels to increase in the long run without a commensurate increase in the supply of money and credit. It is important here to make the distinction between short and long run. In the short run, an increase in general prices can be absorbed without a growth in the money supply because it could, in theory, be sustained by devouring savings. But in practice, generally speaking, that isn’t how things work. People tend not to expand spending unless they feel comfortable that money and (particularly) credit are readily available. The housing bubble of the early 21st century is a prime example.

Bubbles

Out of fear of destroying a very easy point, I am going to let the three charts shown below along with a very brief narrative speak for themselves. Then you decide what fueled the housing bubble, and drove up house prices along with general price levels.

As can easily be seen in the above chart, 30-year mortgage rates dropped steadily from 1981 through the present. Not surprisingly, low rates and readily available credit led to a massive price expansion by monetizing demand.

Clearly the expansion in money had to come from somewhere to fuel lower mortgage rates and the expansion in home prices. The chart below, with brackets for the 1990-2007 period shows exactly where it came from. M3 in the US nearly tripled during that 17-year period.

Deflation??

One thing that should be utterly frightening is the recent freefall of M3 growth. Most folks understand that inflation has been responsible for the vast majority of our economic ‘growth’ over the past century. Inflation fueled the dotcom and real estate bubbles. In short, our economy is set up to run in an inflationary environment. Unfortunately, there is a predictable end to this scheme. At some point, the monetary environment devolves into hyperinflation, then a deflationary collapse. We certainly haven’t experienced hyperinflation yet in the US, and we know the Fed can win a battle with deflation because it can create as much money as is necessary to overwhelm deflationary forces. The current Chairman didn’t get his nickname because he used to fly puddle jumpers. So we’re left to ask: what exactly is going on here?

I think the answer lies in the fact that there are roughly 20 countries right now that are on the verge of bankruptcy and an outright default – the US and UK among them. The US clearly isn’t the only nation in hot water with debt. Greece is a pitifully minute example of what is really a systemic problem for much of the West. In my opinion, we are likely moving towards a coordinated outright default, which will involve the devaluation of currencies followed by central banks capping money growth, which in turn will trigger a second deflationary depression. Most people realize that we now have a fiscal gap of around $100 Trillion just in the US alone. It cannot be filled via conventional means consisting of tax increases and program cuts. I and many others wrote years ago that we needed to address those issues right then or lose our chance. We didn’t do it. There are two choices now: hyperinflation or default. While the collapse in M3 growth does not yet constitute de facto proof that we’re headed for the default scenario, it is certainly something that has to be considered. The good news in that scenario is that cash money would be worth more because it would be in short supply. The bad news is that there won’t be enough of it to maintain our current standard of living – especially in a situation where there is a concurrent devaluation.

Gold

Many will be wondering how I can be an advocate of Gold and Silver in such an environment? The benefits of precious metals are well documented in the case of hyperinflation, but not so much so in the case of deflation. It is a pretty simple and logical conclusion that if there is a shortage of cash, then the presence of cash ‘substitutes’ will be very beneficial. This is especially true in local commerce as in the 1930’s when many areas saw the widespread use of ‘co-ops’ or local trading blocs. The rationale for holding precious metals will be different than if we experience hyperinflation, and their use would be different as well, but I think it is foolish to assume that they’d be a detriment in either case.

Hopefully everyone reading this understands the importance of watching the monetary aggregates for clues as to what is coming down the road. Thanks to nowandfutures.com for providing the continuation of the M3 series depicted in the chart above. Ultimately, our monetary destiny now lies in the hands of global banking interests. We will proceed down the path that best serves them, not our national interest. Congress abdicated its responsibility for our money, as outlined in Article 1, Section 8 of the US Constitution, when it passed the Federal Reserve Act back in 1913. The best thing this Congress could do with the rest of its time is craft and pass legislation to repeal that Act in its entirety.

This tax day, April 15th, we’ll be releasing the next issue of The Centsible Investor. Our focus this month will be on the President’s Working Group on Financial Markets, aka the Plunge Team. We’ll also examine the prospects for $100 oil and analyze a company that makes its money selling electrical generation, process automation, and a vast array of other products to industries ranging from petroleum exploration and pharmaceuticals to automobile manufacturers. Don’t miss it! Click Here for more information.

All joking aside, we’ve again reached the point of absurdity on so many fronts that instead of focusing in on a single topic, it is time to dedicate an entire issue to scanning the landscape in an attempt to make sense of the ludicrous.

Bureau of Labor Statistics – Ring #1

The monthly unemployment numbers were released last Friday by BLS and you could almost hear the clinking of the champagne glasses from the studio in the belly of the NASDAQ. Yes, the US only lost 36,000 jobs in February; good times must be just around the corner! Such a sham was this report that I actually dedicated an entire podcast to debunking it. The bottom line is that the jobs deficit for the month of February was around 350,000 jobs – nearly 10 times what BLS reported. This takes into account the 97,000 jobs mysteriously created by the birth/death model (completely unsubstantiated), the fact that our economy needs to create roughly 145,000 jobs each month just to break even in terms of population growth and new entrants to the work force, and finally the fact that most of the ‘new’ jobs created were temp jobs, a whole bunch of which were for the upcoming census.

Perhaps the most alarming part of this report was the revelation that 31,000 state and local government workers lost their jobs last month. These are the jobs most people make fun of, but would love to have because they’ve always been considered to be a job for life with a great pension. The paradigm is changing folks. Either recognize and deal with it or become cannon fodder for the new economic realities that are emerging. The days of borrow and spend are over; at least for the consumer. As you’ll see in the next section, the US Government apparently thinks it has an exemption from the laws of economics – and common sense.

The US Treasury – Ring #2

In the second ring, we have the US Treasury and its burgeoning FY2010 shortfall. So bad was FY2009’s shortfall that the report that outlines our actual financial position was delayed nearly 2 full months, FINALLY being released back on 2/26 to an absolutely comatose response from the belly of the NASDAQ. February’s outlay was massive, totally $220.9 billion. Much of it was blamed on stimulus spending, tax credits, and TARP outlays of $2.3 Billion (Yes, they’re still handing out TARP money). The media cooed about the Fed’s contribution to the US Treasury, but says nothing about the fact that every dollar in our system is loaned to us by those same loan sharks at interest. Ah, the conveniences of selective reporting. To date, the Treasury’s gap stands at a whopping $651.5 billion, which is around $65 billion ahead of last year’s record pace. If they maintain this pace for another seven months, we’ll have a cash basis shortfall for FY2010 of $1.563 trillion – around $132 billion more than FY2009.

Let’s consider for a second all the money that has been spent on stimulus and other projects. Let’s consider the trillions spent bailing out banks. Finally, let’s overlay all that spending with the grossly awful jobs report from last Friday and the months preceding it. How can anyone in their right mind call the stimulus anything but an abysmal failure? The problem is that the government cannot create jobs. Simple. Yes, the government can pay people to perform services. They can pay for a guy to fill potholes. (Send someone to Pennsylvania while you’re at it please; I’ve seen some potholes here that are bigger than these new ‘mini’ cars everyone seems to want.) Once the potholes are filled, then what? Once the bridge is built, then what? Once the census is finished, then what? It all comes down to sustainability. None of the money that is being spent in ‘stimulus’ is being spent on anything that can sustain itself. It cannot pay for itself. How is an $8000 housing tax credit going to pay for itself? The consumer will take the $8000, spend it and create a temporary boost. Then what? This is why I’ve said for many months now that additional stimulus would be needed. And it will need to continue ad infinitum unless our policymakers wise up and start implementing policies that would foster genuine growth, provide for a return of manufacturing to the US, and create sustainable economic growth. Unfortunately, that just isn’t in the ringmasters’ plan. The new tactic in Washington is to devise stimulus packages, but call them anything but, as if somehow changing the name really makes a difference.

The Commerce Department – Ring #3

Not to be outdone we have the Commerce Department, and more specifically the Census Bureau, in the third ring. This morning’s release of retail sales data will no doubt serve to thoroughly confuse anyone who pays attention to such matters. Granted, it is extremely hard to reconcile, but one must look just in the opening statement of the release to get a window into what is really going on here. Repetition notwithstanding, it must be noted (again) that retail sales are reported in nominal terms. From this morning’s release:

“The US Census Bureau announced today that advance estimates of US retail and food services sales for February, adjusted for seasonal variation and holiday and trading day difference, but not for price changes, were $355.5 billion…”

It would be much more useful, albeit challenging to accomplish, if these numbers were reported in units as opposed to dollars. But we can do some reasonable discounting on our own. The ‘headline’ retail sales number was up .3%. Ignore for a second that the media takes sales ex-autos when that shows a bigger gain or smaller loss. Basically, whichever number is better is the one they’ll focus on. While we don’t yet have February’s CPI, let’s assume the headline is .2%-.3%, which is pretty much in line with what has been reported over the past half year. That pretty much wipes out the headline gain. Our internal metric was .55% for February, which when applied to the headline number would take it to a .25% contraction.

Of course, you’ll never hear this from the belly of the NASDAQ. You’ll be lead to believe that all is well, consumers are tripping over each other to spend money, and that a return to the boom times of 2005 can only be a few short months around the corner. While that would be nice, it would be extremely irresponsible to predict such an occurrence based on the evidence that now lies before us.

Some potentially useful tidbits of information from the report are presented below. It must be noted that these useful bits of information can be gleaned from each month’s report for monitoring purposes.

- Seasonal Adjustments added $38 billion or 12.28% to February’s total.

- Removing the seasonal adjustments, retail sales fell in February from $321.8 billion to $316.7 billion; a change of $5.1 billion or 1.59%

- Gasoline station sales are up 26.4% in the last year.

- The 3.7% jump in electronic and appliance stores comes in concurrence with several states doing ‘cash for appliances’ type programs. See Iowa as an example. The state gave away nearly $200 million in funds to such a program. While that may not sound like a lot, it accounts for nearly all of February’s gain for the sector. And that is just Iowa. I realize this is highly anecdotal in nature, but these are the types of things that can skew reporting and promulgate false assumptions so I’m bringing it up.

- The data for MARTS (Monthly Retail and Food Services Survey) is gathered by sending surveys to 5000 businesses. The responding firms’ data accounts for nearly 65% of the national monthly sales estimates.

- The estimates use the 90% confidence level. If the range established by the use of this level includes zero, then the change is not statistically significant. The headline number was .3% with a range of ±.5%, meaning that zero lies in the range, and therefore this month’s retail sales change from last month is not statistically significant. The December 2009 – January 2010 change of .1% with a range of ±.3% was also not statistically significant. Put simply, retail sales are just as likely to have been flat or even negative as they were to gain .3%.

Obviously the points above are enough to cast serious doubt on the veracity of consumer spending. When one overlays the jobs situation, relatively stagnant incomes, and other factors over top of this, it would seem fairly likely that this report represents something of an outlier. It is also instructive to note the role that borrowed government spending plays in skewing the numbers as in the case of cash for clunkers last year, homebuyer tax credits, and now cash for appliances. Also not commonly known is that Medicare spending also counts as part of retail sales. So if Medicare pays for a knee replacement for your uncle, that counts as retail sales and is parlayed as consumer spending.

Sorry Ringling Brothers, but the government-media complex, which puts out and then appropriately spins the numbers and information has stolen your title of “Greatest Show on Earth”; and they’ve done it hands down.

This month’s issue of the Centsible Investor will be released on Monday, March 15th. It will contain an in-depth analysis of the recent Treasury report on the financial condition of the US, a look at current trends in gasoline production and consumption in light of predictions of $3.50/gallon gas this summer, and a comprehensive study of a rather successful petroleum transportation operation. Plus, we’ll do our usual cutting-edge analysis of the major stock indexes and plot the course for the markets over the next few weeks. For more information, Click Here

We have chronicled the damage that Bernanke’s pursuit of QE and near-zero rates have done to savers. Mainly, we’ve focused on short-term implications for those investors who rely on their savings to create income for immediate consumption. But what about the folks who are looking at the pie charts and the promises of over a millions dollars in retirement income? Ah, the powers of compounding. Yes, I have in front of me the literature from 2 national financial service firms that strongly suggest that you too can retire a millionaire for as little as $60/week. Of course there are no guarantees, but the details and assumptions to this rosy scenario on steroids are buried in fine print that you’d need an electron microscope to read.

The obvious conclusion most people draw is that interest rates fluctuate and the phenomenon we’ve witnessed over the past year or so will be transient and eventually higher rates will cycle in and restore the cash flows of fixed income investors. After all, that is what has always happened before, right? Not so fast. There are a couple of reasons to believe this won’t happen anytime soon.

As the graphic below outlines, the Treasury Dept (including debt service) is the third largest line item in the actual FY 2009 budget, at over $700 billion. According to Treasury Direct, the interest paid on the national debt in FY2009 was around $383 Billion. This constitutes an average interest rate of just over 3.1%. Doing a little projecting, if the deficit runs at the estimated $1.5 trillion for FY 2010, the Treasury will need to pay out an additional $431 Billion to service the debt assuming the same 3.1% average interest rate. If early results mean anything though, the amount might be much higher. In the first four months of FY2010, the Treasury has already paid out $164 Billion in debt service, which is setting a pace for nearly $500 Billion. For FY2009, tax revenues were $2.211 Trillion and interest payments on the debt ate up 17% of tax receipts. If the current trend in FY2010 continues, debt service will gobble up around 22% of tax receipts by the time the fiscal year ends next September 30.

While 17% doesn’t sound too bad, think about paying nearly 1/5 of your net income every year to credit card companies. Not a real appetizing thought, but certainly this application of sanity couldn’t apply to the federal government.

The Problem

The problem here lies in the fact that the national debt is forecast to increase dramatically in the next 10 years. Estimates range anywhere from $18 to $23 Trillion depending on whose forecast you’d like to use. Let’s use $18 Trillion as our test case. At this level, assuming an average interest rate of 3.1%, debt service by 2019 will cost around $558 Billion per year. If tax revenues don’t change, debt service will eat up 25% of tax receipts. The conclusions that can be drawn from this simple analysis are pretty clear. If the government intends to provide the same levels of service on entitlement programs and maintain other government spending, the deficit will need to increase each year just to accommodate the additional debt service. This is called a spiral. It is akin to the family taking cash advances on a VISA to pay off Mastercard. I am sure there are many who will disagree with this rationale and call me all sorts of vile names for suggesting that we’re spending beyond our means and that somehow this really isn’t a good thing. Unfortunately, in reality, this situation is actually worse than the above paragraph indicates for a second, less publicized reason.

Artificial Interest Rates

Let’s start at the beginning here. Interest rates are payments given to lenders of capital for the privilege of using their money for a period of time. At a very minimum, the interest rate should ensure that the lender’s purchasing power doesn’t diminish due to making the loan. In other words, at the very least, interest rates must equal inflation. Such a situation is generally referred to as ‘free money’ since the lender isn’t actually being compensated for the loan in real terms.

When discussing the federal government and its inclination to spend beyond its means, interest rates are a very important topic at the US Treasury, as they should be. This is one of the reasons why government officials, Fed chairmen, and the absentee press generally try to temper inflationary expectations. If lenders expect inflation, then they’re going to want to see higher interest rates.

I have argued for several years now in this column that inflation in the US is grossly understated, and that it is done for both political expediency and out of absolute necessity, especially in an era of ballooning government debt. John Williams at shadowstats.com estimates (using previous BLS methodologies) that price inflation in the US is currently around 6% per annum. If we had free market interest rates, we would expect the yield curve to start somewhere around 7%, assuming John’s numbers are accurate, and there is no reason to believe that is not the case. It is very easy to see the implications this would have for debt service.

Let’s assume for a moment that under a free market interest rate environment, the US Government could achieve an average borrowing cost of 6.7%, allowing for a similar spread between price inflation and the mean interest rate as what we observe now. Debt service in FY2009 would have been $831 billion and devoured 38% of tax receipts. In 2019, using the same assumptions as previously mentioned, debt service would be $1.2 Trillion and eat up a whopping 55% of tax receipts. I understand there are many assumptions made here, many of which might fluctuate over the period, but the goal of the exercise is to make the simple point that the US cannot afford market interest rates.

It should now be easy to see why inflation is consistently understated, and why the FOMC and its minions are quick to temper inflationary expectations. While that might work to a limited extent when dealing with the general public, does anyone think for a minute that investors around the world don’t know what is going on here? Most of them are doing the exact same thing, albeit to a lesser extent, so you can bet they do.

In Conclusion

Many might look at the above analysis and wonder why it is any big deal. Keep the rates buried at near zero and we can keep getting ‘free money’, right? The problem is that mispriced capital leads to misallocation of the same. The gross misallocation of capital is one of the main ingredients of the ongoing financial crisis. It was willfully done by the Fed previously and it is being done again. These actions will virtually guarantee more misallocation of capital, more bubbles, and more unpleasant results. For savers, the news continues to be bad. We have demonstrated why it is in the government’s interest (a necessity really) to keep rates as low as possible. That means a continuation of the ridiculously low money market, CD and savings account rates. No doubt the pie charts referenced at the top of the essay will need some changing; it seems someone’s taken a few slices away.

This Week in the Markets

US equity markets are getting hammered early this Thursday morning on news that first time jobless claims jumped to 496,000 last week. First time claims have been trending upward over the past few weeks. Yesterday, new home sales put in the worst performance in the history of the data series. This despite the extension of the tax credit program for first-time (and now other) homebuyers. Bad weather was blamed for much of the sour performance. It seems recently the weather is getting blamed for any data point that isn’t in line with the ‘slow but steady recovery’ mantra being put out by the establishment. Oil is back at the $80 mark after being beaten down over the past couple of weeks. On the demand side, petroleum product demand appears to be bottom bouncing; any serious increase in demand will be bad news for consumers at the pump this summer. Forecasts are already in for an average pump price of $3.25-$3.50 this summer.

The Dollar – The Ultimate Opportunist?

It should not be lost on even the most casual of observers that the US Dollar is dead. How can I say this when it is in the middle of yet another ‘rally’? And aren’t the folks in Washington telling us how strong the Dollar is more and more vapidly and with greater frequency? The fact of the matter here is that the Dollar has, for quite some time now, not been able to rally itself based on its own merits. Remember that currencies are essentially a zero-sum game. Their value is measured in terms of other currencies. One goes up, another must go down. Taking a look at recent Dollar rallies, they’ve happened essentially because bad things have happened in Euroland or elsewhere, whether it is the latest debt crisis with the PIGS (an unfortunate acronym, but who wants to be called a BRIC anyway?) or the massive liquidation of 2008. These were not exhibits of the Dollar’s strength, but rather of a mental model that still hasn’t adjusted to the fact that the Dollar’s run is over. Add to that the lack of an available substitute and voila – instant dollar ‘strength’.

Think of it this way: if our currency were strong for fundamental reasons, say for example gold backing, genuine budget surpluses free of accounting chicanery, trade surpluses, and similar positives, then countries wouldn’t be sneaking around backrooms around the globe forging agreements to sidestep it. Foreigners wouldn’t be twisting their brains trying to figure out how to get out from under their pile of US Treasuries without upsetting the apple cart. Put mildly, a wheelbarrow full of plutonium would be received better in most financial centers these days than one filled with US Dollars.

Beware of Greeks bearing Debt?

If anyone here in the US still has doubts about what ultimately happens when a nation abuses credit and engorges itself with debt, all they need to do is look at Greece. The small Mediterranean nation needs to raise about $73 Billion in new money this year. While that seems like a mere pittance, it constitutes about 20% of Greek GDP. Greece also faces bond redemptions of $8 and $9 billion in April and May respectively. While Greece has by far the worst debt problem (at the moment) in the EU, it doesn’t stand alone. Portugal, Italy and Spain are also having issues of their own and the whole mess is threatening Euro stability, and by function helping the US Dollar.

These are real problems for sure, but what is amazing is the continued complacency by media and policymakers alike when it comes to the US and our debt levels. Our level of official borrowing will tally around 12% of GDP in 2010, however, if you look at the GAAP deficits and the resultant borrowing, it is always much higher than advertised. There is an important distinction to be made between Greece and the US, however, and that is the fact that Greece is essentially a hostage of the European Central Bank where the USGovt has a bank willing to issue as much rope as we can possibly need to hang ourselves. We’re hostages of the Fed, but most people aren’t easily inclined to look at it that way. We’ve been trained to believe that when we run deficits we’re borrowing from ourselves. Back in the era when we used US savings bonds to fund government activities, there was at least a modicum of truth to that. However, since we’ve gone overseas and to the internationally-owned Fed for more and more help, we’ve been slowing ceding our national sovereignty to foreigners much in the same way Greece et al have given themselves over to Brussels.

This is why every freedom-loving person should have a healthy fear of global central banks and even regional currency blocs. The very survival of the PIGS now rides on the whims of Merkel, Sarkozy, and Trichet. Flashback to the weekend of September 13th 2008 when Lehman Brothers here in the US was in the same shoes as Greece is today and then ask yourself how much we’ve really learned over the last 18 months. This is what happens when you globalize and intertwine the fortunes of nations and then base it on the fraud of a fiat currency system, the casino mentality, and a healthy dose of public ignorance.

So now the Europeans are left in a pickle. They have to come up with the right words to soothe the markets. They’ll need to offer words that promise all sorts of coordinated actions and large applications of money while actually doing nothing because they can’t afford it. Their economies are now stumbling out of recovery because there never was a recovery, just a shell created by inflation and debt.

America should take heed. It was easy to ignore when it was Argentina, Zimbabwe, and Iceland. However, we’ve done the same thing here. Our government believes that borrowing and saber rattling will force the economy to grow. Europe is the latest shining example of the utter failure of such thinking.

]]> http://www.sutton-associates.net/blog/2010/02/12/club-med-and-the-dollar/feed/ 0 http://www.sutton-associates.net/blog/2010/01/08/the-search-for-income-continues/ http://www.sutton-associates.net/blog/2010/01/08/the-search-for-income-continues/#comments Fri, 08 Jan 2010 17:13:23 +0000 TwoCentsEditor http://www.sutton-associates.net/blog/?p=348 One thing that is unlikely to change as we begin a new year and decade is the fact that savers continue to sit in the corner wearing the proverbial dunce cap. They’re an often unmentioned casualty in a world of bailouts, big government spending, and general financial irresponsibility. In a normal, healthy economy, savers would be the focus of attention. In our deviant economy, however, where more people are employed by government than goods-producing industries, savers are disregarded. Harsh words? Absolutely. Certainly no one in charge has actually come out and said it, but as the old adage goes, actions speak much louder than words.

However the news is not all bad. As I chronicled in the first piece of this series, there are ways to find income – even in this environment. And contrary to the popular investing misinformation you don’t have to take on a boatload of risk to get it. The goal of this essay is to discuss in generic terms some of the methods I’ve used to find income over the past few years and introduce one of the more obscure income vehicles for those investors who might be interested in a little risk. With CD rates still in the basement, and investors in US Government bonds losing 3.5% in 2009, most people are probably looking for some new ideas to make money in our brave new financial reality.

Preferred Stocks – A Well-Kept Secret?

If you’re willing to spend a little time doing research, you will find literally hundreds of preferred stocks from food companies to manufacturers to financial and insurance companies. Many are eligible for 15% tax treatment making their comparative yields even higher. Speaking of yields, they will vary greatly based on both the type of company offering the preferred stock, the rating, and the supply and demand dynamics for the security. The following is not meant to be an inclusive, exhaustive description of all the characteristics of preferred shares, but is intended to provide some basic information about preferred shares to frame the discussion.

Preferred stocks are really a hybrid of common stock and bonds. Preferred stockholders generally don’t get voting rights in company matters, but are first in line for dividend payments. Some are cumulative some are non-cumulative. Cumulative preferred shares accumulate dividends in the event payments are suspended for any reason. In the event payments are reinstated, preferred shareholders are paid first and they’re paid for any dividends accumulated during the payout stoppage. The preferred stocks of major companies are generally listed on exchanges, but there are also many that are available Over-the-Counter (OTC).

Preferreds are like bonds in that their stated yield is based on the face value of the stock. For example, a preferred that pays $1.00/year and has an face value of $25.00/share would have a yield of 4% and be designated as such. If you discover this stock a year later at $26.00/share and buy it, your yield based on the purchase price would be a bit lower at 3.85%. Conversely, if you buy in at $24.00/share, your yield would be higher at 4.17%.

Two ‘Preferred’ Model Portfolios

Let’s look at two ‘model’ portfolios. These have been constructed over the past few years when it became obvious that we were heading into a period of near-zero rates due to the Fed’s propensity for putting the liquidity hammer to the floor.

The first consists of just 4 issues – all preferred stocks of utility companies in equal proportions:

Due to the fact that one of the components was only issued less than 2 years ago, we only have that period of time to compare the model to the benchmark S&P500 and Dow Jones Industrials. From a risk and volatility perspective, the model comes in with a standard deviation of 12.82% while both the Dow and S&P comes in at nearly twice that with the S&P at 23.87% and the Dow at 24.32%. In terms of return, the Dow and S&P both lost around 7.5% annually for the period while the model gained nearly 9% annually during the same time. So to frame the comparison, the model beat the indexes by roughly 33% with about half the volatility during the worst financial crisis in recent memory. The chart below graphically displays the returns:

Admittedly, during the ongoing bear market rally, the indexes have beaten the model soundly, but remember the purpose of the model – income. The model yields just over 6%. The charts above show that the model did an excellent job of protecting capital while providing stable income. And it was done with very little in the way of volatility except for a 2-month period in late 2008 when the globe’s financial system stood on the precipice. It must be noted that many investors have chosen to use this type of investing strategy for growth as well, opting to use their cash distributions to purchase more shares. Compounding at 6% sure won’t win many awards on CNBC, but in the real world where people are trying hard to protect their savings, it is a valid construct to consider.

Let’s now take a look at a second model: one that has a bit more history behind it. It consists of 2 utility company preferred stocks, a telecom preferred, a no-load special purpose mutual fund, and a preferred stock ETF – in equal proportions. As a general rule I don’t favor mutual funds because of excessive fees, confusing sales charge structures, black-box management, and high expense ratios, but there are a couple of funds that exist for a single purpose, don’t have the other detriments listed above, and as such are suitable for inclusion in portfolios.

Much like the first model, this one has a much lower volatility than the benchmark S&P/Dow. Annualized Std Deviation is 9.44% compared to 22.01% for the S&P and 22.57% for the Dow. On the return side of the ledger, the model provided an annualized return of 7.02% while the Dow and S&P were both around -9%. The data on this model goes back to August 2007 – before the market’s top. The chart below graphically illustrates the comparison between the model and the benchmarks.

The cumulative return for the model was 16.94% over the 2.3-year period as compared to a loss of 20.44% for the S&P and a loss of 19.74% for the Dow. The model beat the benchmarks by 36% on average yet sported less than half the volatility of those benchmarks.

There are countless other combinations that can be explored. These two models were focused on utilities. Truth told, we construct similar models across a variety of industries that would perform similarly, and in fact do so on a regular basis to provide effective portfolio diversification.

ELKS – Hidden Income or High Risk?

A rather obscure income vehicle that generates high levels of income, but unfortunately, also carries significant risk is the ELK or Equity Linked Security.

ELKS are derivatives of the first degree in that their performance is directly linked to that of an underlying security – usually a stock. The main selling point of ELKS is that they generally sport much higher distributions than the underlying shares and mature in a year.

So what’s the catch? Terms will vary depending on the particular issue, so you will want to be sure to read and thoroughly understand the prospectus before clicking the ‘Buy’ button. The size and nature of the principal repayment for an ELK is linked to the share’s performance during the time period before the ELK matures.

Let’s say for example you purchased an ELK that was linked to Company ABC’s stock. Let’s say the ELK was issued when the price of the shares was $20/share. The ELK might be structured that you will receive back 100% of your principal (plus the distributions, which are received regardless) if the price of ABC’s stock is at all times at least 90% of what it was when the ELK was issued. In this case, you will want ABC’s stock to stay above $18/share. If this condition is not met and the stock drops below $18 (even before maturity), you will receive a pre-determined number of shares of ABC stock for each ELK you own as opposed to your principal in cash.

Sounds like a rip-off doesn’t it? Not necessarily. Let’s say you really wanted some shares of ABC stock because they pay a solid dividend. You buy the ELK, collect the enhanced dividends for a year, and if the stock does drop below the threshold, you have your shares. If not, you have your cash and a stellar return and can go share hunting later or buy another ELK. If this is your intention, then make sure you’ll be adequately compensated in shares in the even you don’t get your principal back in cash.

There certainly are drawbacks. First, ELKS are issues of Citigroup Funding, Inc. and as such you are dependent on Citigroup’s solvency for your payments. Right now no one seems to be concerned about bank liquidity, but that is likely to change moving forward. Secondly, due to the structure of the ELKS, there is an incentive for Citigroup to issue ELKS for those shares it holds in its various dealer accounts that it wants to unload and has a belief will go down during the time the ELK is active. This may not be true in every case or even at all, but it needs to be mentioned regardless. That is why, as a general rule, I don’t consider ELKS unless I’m interested in owning the underlying shares because ending up with them is a very real possibility. Another drawback is that if the price of the underlying shares skyrockets, you don’t get to participate fully in the move. You just collect your distributions, and then your principal at maturity. Obviously, if the underlying shares tank, as can happen, you could theoretically end up with shares that are worth much less than your initial payment for the ELK – even with the distributions included.

From a taxation perspective, ELKS are often subject to favorable tax treatment. First, part of the distribution payments are considered as option premium payments and as such don’t need to be declared until the ELKS mature. So you get deferred tax status on a portion of your distributions, which is nice. Secondly, if the price threshold is broken and you receive shares instead of your principal at maturity, then the portion of the payment associated with the distribution (treated as an option premium) reduces the stock basis and isn’t counted as income.

In conclusion, it is possible to find income in this environment without taking on inordinate amounts of risk. Granted, preferred stocks and ELKS carry more risk than a bank CD, but given the graphs shown above, the two models registered little more than a slight bump during the worst crisis in 100 years yet outgained CD’s by several fold. ELKS are a bit more complicated and carry some additional risks, but the potential rewards are commensurate with those risks. Investors should always seek a thorough understanding of the nature of any investment and consult with a qualified adviser before making any investment decisions.