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.

A number of months ago, I pointed out the somewhat flawed rationale of using GDP itself as a gauge of economic growth since government spending is a portion of that measurement. Normally, this wouldn’t be a huge problem, but when the government tries to in essence become the economy by spending exorbitant amounts of borrowed money, then GDP loses its usefulness as a measure of genuine economic growth. I willingly admit that it is exceedingly difficult to argue against government spending to a construction worker who is able to remain employed because of a road project paid for with stimulus borrowing. However, we all need to be concerned with the undeniable fact that more and more of our national well-being is becoming dependent on the hazardous practice of reckless borrowing and debt monetization.

Unfortunately, in Bernanke’s jobless recovery, there are few winners and many losers.

Foreclosures Continue to Increase

Home foreclosures in the third quarter of 2009 hit an all-time record high according to RealtyTRAC. Nearly one million homeowners received a foreclosure notice during the past three months. Nevada continues to lead the pace nationally with 1 foreclosure notice for every 23 homes. Nevada is no surprise, but Vermont, on the other hand, is. Vermont, which had barely been impacted by the housing crisis until recently has seen foreclosure rates jump 170% from the same quarter a year ago. Keep in mind that foreclosures continue to run rampant despite numerous fixit attempts at the Federal, GSE, and state levels. The system is still clearly reaping what it has sown over the past decade. These numbers would be far worse if lenders were foreclosing on all the properties that met the criteria. In many low-income areas, lenders aren’t foreclosing at all, opting instead to leave the properties in abeyance and allowing the residents to remain.

Many borrowers are unable to refinance even with historically low interest rates thanks to Bernanke’s MBS buying program because their credit is destroyed. Unemployment certainly isn’t helping. The lack of accumulated savings has left many folks with little or no wiggle room to deal with financial hardships.

The fact of the matter is that as bad as foreclosures are right now they’d be several orders of magnitude worse if it weren’t for government intervention. Unfortunately, this rationale will be used moving forward to justify even more intervention. Obviously the reason things aren’t getting better is because government hasn’t done enough or done it long enough… right? I fully expect to see the $8000 tax credit for first time buyers eventually extended to any buyers, and then somehow fit into refinancing deals as well. Maybe a government-sponsored mortgage holiday is in the works. You laugh? I know people howled when I mentioned the idea of government stimulus by handing out store gift cards, but several politicians have already mentioned doing exactly that.

It is also clear that the Fed has made the decision to work the demand side of the equation by monetizing the mortgage-backed securities market. The Fed has purchased nearly a half trillion dollars worth of MBS in the last 2 quarters in an attempt to artificially suppress rates. During this period, they made one concerted attempt to back off on the purchases and rates immediately shot up as was documented in my 6/5/2009 missive. This action, coupled with the first-time homebuyer tax credit has been a shameless effort to lure renters and younger people into sopping up the excess inventory from foreclosures. This while new home construction continues, albeit at a lower pace. Does all this sound like a recipe for a genuine recovery?

Employment

It continues to be my opinion that the headline unemployment rate will never reach 10%. I realize this is a considerable stretch simply because it is already on the precipice, but I’m sticking with it. Frankly, the headline number, while heralded by the telescreen, is largely irrelevant in the real world. A closer approximation lies in the BLS’ broadest measure U6 (shown below) and even that understates unemployment due to the use of the arbitrary and capricious birth-death model. For decades now, BLS has engaged in the highly questionable and political practice of changing methodologies when the numbers become unfavorable.

Shadowstats does a fine job of keeping up the tradition of the older, more accurate methodology and states employment to be nearly 22%. This is a level of depression proportions, but you wouldn’t know it watching the telescreen. Perhaps again the devil is in the details and when you coalesce the consumer confidence numbers, and the massive and ongoing retrenchment in consumer credit, which I have been screaming about as a signpost for over 3 years, it is easy to see that things on Main Street are not what many would like us to think they are. The retrenchment is certainly good news for the consumer, but bad for growth in our twisted world. Given the proclivities of the American consumestocracy to blow money over the past decade, it is probably a reasonable assumption that the retrenchment is not voluntary. 22% unemployment and a shattered consumer hardly seem like firm foundations from which to build a recovery – even a jobless one.

Credit Card Resets?

And now we move on to our ‘salt in the wound’ section of this week’s journey. We all know very well about the $23.7 trillion (courtesy Bloomberg.com) lavished on the financial system to ‘rescue’ it. We know about the tens of billions in bonuses handed out by financial firms and the nonsensical battles over the AIG handouts Congress occupied itself with while Rome burned. We know full well about the federal reserve’s efforts to artificially manipulate interest rates lower and essentially give away money to the banks, then pay them 15 basis points to store their reserves at cartel headquarters. So after receiving all these perks of the well-connected, the banks are doing the logical thing: they’re sticking it to the consumer.

How, you say? In the form of higher interest rates on credit cards, additional fees, higher minimum payments, and ironclad rules on repayment terms with substantial penalties for non-compliance. So all of those folks who dodged a bullet on mortgage resets just might get one after all when they open their next credit card statement. After all, if we can’t get consumers to take on debt, we can do the next best thing – charge them more for the debt they do have, right? You can’t make this stuff up.

The above are just a sampling of the stresses that exist on the backbone of our real economy: Main Street. So the next time you hear a government or quasi-government official discussing economic optimism or a jobless recovery, all you need to do is ask yourself, “For Whom?”

But why pick on M2? The reason here is simple. The Conference Board’s index of leading economic indicators (LEI) assigns M2 a whopping weight of 35.8%. So just creating money automatically means good things will happen? Here we get yet another insight into one of the many flaws of Keynesian economic theory. Average weekly hours in manufacturing is the second largest component of the index or LEI and is assigned a 25.49% weight. It should be immediately obviously that significant changes in M2 could easily overshadow diverging movements by other components of the Index. The full chart is displayed below, from the Conference Board’s website:

Thursday morning, the Conference Board reported that its LEI rose by .6% for the month of July and has in fact been rising for the past 6 months. Interestingly enough, M2 was cited as applying negative pressure in July’s number. However, even this number is not immune to hedonics. The Conference Board adjusts M2 by the Personal Consumption Index deflator which is based on guess what? The CPI. So by using a negative deflator, the Conference Board is alleging an increase in ‘real’ M2, which has been helpful to the LEI over the past few months. However, money supply doesn’t equal economic activity and we’ll show you why.

Before we get too far into this analysis, let’s present some baseline definitions of M1 and M2:

M1 Aggregate: M1 includes funds that are readily accessible for spending. M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts.

M2 Aggregate: Equals M1 + savings deposits, time deposits less than $100,000 and money market deposit accounts for individuals.

Many economists view M2 as a good measure of near term inflationary pressures. M3 is generally regarded as a longer-term inflationary indicator, which is why it was used in last week’s 50-year analysis.

What also needs to be looked at is the velocity of circulation of the aggregates. This is the turnover rate or the number of times each dollar within the aggregate changes hands in a given period of time, generally a year. Obviously, velocity of circulation or turnover is an indicator of the level of economic activity. The higher the velocity, the more times in a given year a particular dollar changes hands. And vice versa. The velocity of circulation is arrived at by taking GDP and dividing it by the appropriate aggregate.

In the chart below, we see the velocity of circulation for M2. It is interesting to note that M2 velocity peaked in 1997, then fell into a 2003 trough, rose again slightly, most likely in response to ridiculously low interest rates, then plummeted from 2006 through the present. Obviously, we would expect to see velocity decrease during a recession since there is diminished activity. The current plunge in velocity has happened despite over $1.3 trillion of deficit spending just in the last 10 months. A few weeks ago we made the case that deficit government spending should be discarded from or at least discounted in GDP. Following that logic and recalculating M2 velocity based on the lower GDP reading, we would currently have a M2 velocity of 1.54 vs. the 1.70 displayed in the chart; a decrease of 9.41%. In essence, the $1.3 trillion in deficit spending is causing a near 10% overstatement of activity as represented by M2 velocity.

The admission is readily made that perhaps not all deficit spending would find its way into M2; some might certainly end up in components which are exclusive to M3, and so the adjustment is meant to be illustrative in nature and indicative of the distortions that government spending is causing in metrics that were previously more closely related to the real economy.

Perhaps even more interesting is the obvious sluggishness in the response of M2 Velocity to interest rate stimulus in the form of the Fed Funds Rate.

Taking a look at the two preceding interest rate lowering campaigns, the Fed Funds Rate (FFR) peaked in 1989, then bottomed in 1993. Velocity responded fairly quickly, beginning a steady climb up towards the end of 1991 or about halfway through the rate-cutting cycle. The FFR peaked again in 2000 and the next rate-cutting campaign lasted until late 2004. Again, velocity responded rather quickly, bottoming, then beginning to climb in early 2003. The response to that stimulus, however, was much less than the prior, even though the magnitude of the stimulus was similar. The FFR peaked again in late 2006 and the next rate-cutting campaign began in earnest and has stopped only because rates have essentially hit zero. So this rate-cutting campaign has lasted nearly 3 years, and there has been absolutely no response in M2 velocity to speak of.

If this isn’t an indication that monetary policy has lost the majority of its effectiveness, then I don’t know what is. Perhaps the Conference Board could take into consideration that it is easy to inflate, but it is considerably harder to generate even cursory activity, let alone real economic growth simply by printing more money.

As is evidenced above, M2 Velocity is certainly not directly proportional to M2 growth. The determinant in velocity of circulation is GDP. Take for instance the period between 1991 and about 1996. M2 growth was relatively flat, yet velocity increased dramatically. This tells us that GDP increased despite the lack of increase in M2.

However, had one stopped there and not looked at consumer credit, (largely unaccounted for in the monetary aggregates) which went ballistic in 1993, the above chart would have led them to believe that there was genuine economic activity during that period. The only reason I chose to even mention this is to point out how the law of diminishing returns has played out again. Consumer credit, which was able to stimulate a significant increase in M2 velocity (activity) in the 1990’s, was not able to do so in the early part of this decade even though it increased steadily until the latter part of 2008.

As many readers have already noticed, recent essays have focused on picking apart the major economic reports and pointing out distortions and possible distortions where they exist. The reason is simple. Many self-directed investors, consumers, and even advisers make important financial decisions based on the fact that some number went up when it was supposed to go down or vice versa. It would make sense that those same people would want to know where that number came from, how it was derived, and what the risks to the presented analysis are before making those important decisions.

We have bundled together the series ‘Basic Financial Analysis’ in PDF format for anyone who would like a copy. Also included in the PDF is an unpublished section on portfolio monitoring. To obtain a copy, please visit: http://www.sutton-associates.net and click the report banner.

]]> http://www.sutton-associates.net/blog/2009/08/21/leading-to-what/feed/ 1 http://www.sutton-associates.net/blog/2009/05/22/triple-a-or-bust/ http://www.sutton-associates.net/blog/2009/05/22/triple-a-or-bust/#comments Fri, 22 May 2009 18:02:12 +0000 TwoCentsEditor http://www.my2centsonline.com/blog/?p=225 If you take a short walk down memory lane, it will not take you very long to find the carcass of New Century Financial along the side of the road back in March 2007. It would be a full 12 months before the word recession would be mentioned in the US mainstream media and stock markets would roar into their all-time highs six months after the disintegration of New Century. Much of the early portion of the credit crisis as it was called focused on mortgages and after that, mortgage-backed securities. Wow, haven’t heard that term in a while, have we?

Much of the scuttlebutt at the time centered around the ratings which were assigned to these mortgage bonds and people started asking questions about how all of these Triple-A rated bonds could suddenly be worthless and why bonds with this high of a rating were paying historic spreads above and beyond US government debt of the same maturities (which are also rated Triple-A).

An Example of the spread between Triple-A rated securities

Of course the foundations for this comparison in the first place are the quality and status of US government debt, which, until recently, was sacrosanct in borrowing circles. In the past week there have been headlines galore (again) that the US is in jeopardy of losing its Triple-A credit rating. Given what we already know about the government’s finances, how can a pristine credit rating and Uncle Sam be mentioned in the same sentence? And perhaps more importantly, can ratings issued by the major agencies be worth more than a defaulted mortgage tranche after the ratings fiasco of the past few years? Consider the following:

“According to the Financial Times report, “Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch Triple-A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.” Yet the ratings were maintained at Triple-A.”

So why the big todo about the US Government and its Triple-A rating? The point is it shouldn’t have one to begin with. While I am sure this statement doesn’t constitute a revelation to anyone, it is a point that most in the main stream media are once again missing. Some big names have lost Triple-A credit ratings over the past few months. General Electric and the venerable Berkshire Hathaway are two notable examples. AIG lost its Triple-A rating in 2005, and bond insurer Ambac lost its Triple-A rating in 2008.

In the case of normal businesses, the credit rating is a reflection of the firm’s financial position and the market forces that are likely to impact the firm over various periods of time. The firm’s balance sheet is examined. Its revenues and obligations are dissected. The credit rating is then assigned based on the preponderance of these factors and indicates to investors the likelihood of default on the firm’s debt. Investors are then able to make informed decisions. At least this is how it is supposed to work.

Moody’s / S&P Default Probability Models

However, there is one major difference between a normal business and the US Government. Unlike a normal business enterprise, the US Government has a bank on retainer that can create money from nothing and is willing to lend at ridiculously low rates. It can accomplish this task in many ways, but the most direct is called monetization, which consists of the Fed buying bond issues directly from the government. Ostensibly, this is done to prevent the government from having to fund its massive appetite for funds externally. As if there is something honorable about owing your future to a private bank as opposed to another sovereign nation. Further evidence of the Fed’s willingness to monetize additional debt emerged this week:

“Some members noted that a further increase in the total amount of purchases might well be warranted at some point to spur a more rapid pace of recovery.”

Is an entity that requires this type of arrangement for its financial survival deserving of the highest credit rating? How about an entity that is going to have to borrow 46 cents for every dollar it spends during FY 2009? How about an entity that is institutionalizing trillion dollar deficits for the next decade? How about an entity that has a bare minimum of $53 Trillion in contingent unfunded liabilities (nearly four times GDP)?

After this most recent bevy of news headlines regarding the rating situation, Treasury Secy. Tim Geithner promptly got on TV to talk about cutting the budget deficits.

“It’s very important that this Congress and this president put in place policies that will bring those deficits down to a sustainable level over the medium term,” He added that the target is reducing the gap to about 3 percent of gross domestic product, from a projected 12.9 percent this year.

Putting this in the context of our current situation, this would require the deficit to be cut from a projected $1.8 Trillion to just $418 Billion – which is where it was before the current blowout. This is an important distinction as promises by government officials to actually balance the budget are fading quickly into the ether. Now we’re only worried about carrying ‘sustainable’ debt. The problem is that none of these debts are ever paid back and as such, they accumulate all the while piling on interest.

In order to pay off our debt, not only would we have to stop running deficits, we’d actually have to run surpluses. If we ran could manage a surplus that was 3% of GDP each year, it would take us over 30 years to pay off what we already owe on the national debt. That is three decades of smaller government, bare essential expenditures, and the complete dissolution of the ‘cradle to grave’ mentality our government has espoused for the last half century.

Geithner, 47, also said that the rise in yields on Treasury securities this year “is a sign that things are improving” and that “there is a little less acute concern about the depth of the recession.”

This is nothing more than just economic pumping. What the rise in yields is really saying is that when the Fed doesn’t step in and buy US Government bonds that nobody else wants them either. Why would any sane individual lend to somebody that is up to their eyeballs in debt and isn’t even the least bit interested in changing their behavior? To make matters worse, why would any sane individual lend to an entity that proposes to repay the loan in currency that is losing its value?

30-Year Bond Yields

In the above chart, we can see the yield for the 30-year bond. The Fed began indirectly monetizing in the fall of 2008 as the proceeds of TAF, TSLF, etc. went directly to the Treasury window driving yields to nothing. Another spurt of direct Fed monetization in March led to a quick drop in yields, but since then they have been moving relentlessly higher. Foreigners have not stopped buying US Treasuries by any means, but they have certainly slowed their purchases. This leaves the Fed as the buyer of last resort. Certainly Secy. Geithner understands all this, especially considering he used to be the President of the NY Federal Reserve Bank.

Does any of the above sound financially virtuous and deserving of a pristine credit rating? In the end it matters not what Moody’s or S&P have to say about the creditworthiness of the US Government. Our creditors are already speaking. And they aren’t singing our praises.

In our ‘Spin Cycle’ podcast, we are currently doing a 7-part series in which we depict the factors affecting the US economy as sides of a Rubik’s Cube – independent, yet interrelated. On June 3rd, we welcome Professor Laurence Kotlikoff to discuss generational accounting and our mounting debt. To listen, visit www.my2centsonline.com/radioshow.php

]]> http://www.sutton-associates.net/blog/2009/05/22/triple-a-or-bust/feed/ 7 http://www.sutton-associates.net/blog/2009/05/15/hedging-your-bets/ http://www.sutton-associates.net/blog/2009/05/15/hedging-your-bets/#comments Fri, 15 May 2009 19:44:52 +0000 TwoCentsEditor http://www.my2centsonline.com/blog/?p=221 05/15/2009

While it may seem rather inappropriate to talk about hedging strategies while the markets are retracing at least a portion of 2008’s devastating plunge, common sense continues to support the position that the worst is yet to come. Granted, focus has shifted to ‘less bad’ economic data and the anointing of government spending as the elixir that will return the American economy to prosperity. Yes, that whole “We’re going to spend our way to prosperity” mantra is once again in play. Make no mistake about it; what we are witnessing right now will be viewed years from now as the biggest suckers rally in history – so far.

That said, now is the time to start talking about protecting portfolios from the next move down. The techniques below were used either singly or in tandem to drastically limit losses in our client portfolios during the 2008 liquidation. Some of these strategies have been sold to the investing public as ten feet tall and bulletproof, but don’t work out too well unless the intricacies are understood. And still others are exceedingly complicated to execute and rely on a preponderance of difficult predictive successes to be beneficial.

Flight to Cash and Equivalents

This move is an obvious one and constitutes either a partial or total exit from the market in question and the capitalization of whatever gains/losses existed to that point. Depending on the type of account you’re dealing with you will have a taxable event. Under many circumstances, it may be detrimental to sell out of the market. This can especially be the case if you are one of those folks who have invested in a dividend-producing portfolio and need the income from those investments for living expenses. Obviously, people in this position don’t want to see their portfolio go down in value, but can’t necessarily afford to sell those assets either.

In terms of the average investor, this is undoubtedly the easiest hedge to execute with the opportunity costs being commissions, possible tax consequences, and the forfeited gains if you’re wrong.

Going Short the Market

Shorting shares and/or indexes is one way investors will choose to hedge portfolios during times when they believe markets will head lower. Let’s use the DJIA as an example.
Let’s say that an extremely prescient (and lucky) trader identified the last major top in the Dow Jones on 5/19/2008 at 13,028.16. That day he shorted 100 shares of DIA at a price of $130.23 for a total of $13,023 with a $10 commission. So our trader has $13,013 in his pocket, knowing he’ll have to cover those shares at some point. Let’s assume once again that our trader gets lucky and picks the precise bottom on 3/6/2009 with the DIA at $66.23 and decides to cover. He buys 100 shares for $6,633 ($10 commission) and has $6,380 as his gain.

Obviously, this is a best-case scenario, and ironically enough, this is often how many investment ‘get-rich-quick’ schemes are presented.

The following is the flip side of shorting the market.

In this scenario, our trader, having seen his brokerage account drop by 25% since the beginning of 2008 decides to short DIA on 10/22/08. He is scared to death of a further decline. He shorts 100 shares at a price of $84.59 on the DIA, pays the same $10 commission and has $8,449.00 in his pocket. Unfortunately, he has picked a short-term bottom and the market rallies substantially immediately after he takes his position and our trader is scared into covering on 11/4/08 at $95.19. Including commissions, his short position just cost him a quick $1,080 – in just 9 trading days.

With the benefit of 20/20 hindsight we can easily point out that our trader would have been much better off waiting a few more weeks to cover. He would not have lost anything, and in fact would have helped his portfolio.

The take-home point here is that shorting is not for the faint of heart. You’d best have a solid understanding of market behavior and fundamentals before even considering short-selling shares. As we learned above, the risk to the trader is unlimited. Lets say the DJIA would have gone all the way back up to its 2007 high after our trader shorted on 10/22/2008. He’d have been out over $5,700. In shorting, the rewards are finite (a stock can only go so close to zero) whereas the risks are theoretically infinite.

For the average investor, shorting shares is difficult in that you must pledge the balance of your account as collateral in case your bet goes bad. This nullifies the ‘qualified’ status of IRAs therefore IRA custodians will not extend margin privileges to IRA accounts. Standard brokerage accounts may be used to short stocks and such an account could be used to hedge other investments. While this strategy may bear occasional fruit, it is not for everyone, particularly those with short time horizons or a low appetite for risk.

Inverse Funds – Not what they’re cracked up to be?

Before beginning this segment, a few things must be said. For those who read this column regularly, you know that I rarely use specific companies or funds in these discussions, and tend to stick to sectors, fundamentals, and macroeconomic conditions. However, in this article, specific examples are going to be used to illustrate the points made and to show investors how these funds don’t always perform the way they’d expect. This is not to imply that there is an attempt to deceive on the part of the fund sponsors, but rather a misunderstanding by the investing public of the stated objectives of these funds.

Dow Jones UltraShort Profund (DXD) – The stated objective of this fund is as follows:

The Fund seeks daily investment results, before fees and expenses that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones Industrial Average.

Let’s use a couple of hypothetical examples to illustrate how a leveraged inverse fund works. We enter our position when the DOW is at 10,000 and the price of DXD is $100/share. For the purposes of the example, we’re going to forget about the expense ratio. While the expenses must be considered, they are not necessary to make our point.

So over the course of our hypothetical 10-day trading period, the DJIA lost 8.28%. Conventional wisdom would have expected DXD to come in at a 16.57% gain. However, it only returned 14.44% (before expenses). Granted, this is not a big difference, but when you start putting it in the context of a million dollar investment you’re talking about some serious money.

Now, for the sake of argument, let’s use DOG, which is the non-leveraged inverse ETF for the Dow Jones Industrial Average, and see what happens.

The performance of the non-leveraged inverse ETF wasn’t quite as bad as it netted 7.64% (before expenses) when compared to an 8.28% loss in the Dow Jones Industrials Average.

Now let’s apply a real-world example from earlier this year and watch what develops:

On February 9th, 2009, the Dow Jones Industrial Average closed at 8270.87. The Ultrashort DOW ETF (DXD) closed at $58.07 that same day. Now, shortly before close on 5/13/2009, the Dow Jones Industrials Average is at 8274.05, while DXD is at $51.33 – a difference of $6.74 from the 2/9/09 price. Conventional logic would have surmised the DXD prices would be within a few cents given the trivial difference in DOW levels. For comparison, the non-leveraged ETF (DOG) closed at $71.82 on 2/9/2009 and sits at $68.60 shortly before the close on 5/13/2009 – a difference of $3.22. Conventional logic would have also expected the price of DOG to be very similar. What is going on here?

Here’s what. It is all in the objective of the fund. Remember how it mentioned the daily performance? These funds track the index on a day-by-day basis, but as time goes on, the tracking becomes more and more sloppy. Volatility enhances this condition as was evidenced in our 10-day hypothetical study from above.

It is due to the fickle nature of mathematics that a 10% drop followed by a 10% gain doesn’t put you back where you started. This is where the inverse funds fail to protect portfolios in the longer-term. Now, if prices always moved in straight lines, the inverse funds would do fine. Obviously prices don’t behave that way. The above analysis should not be construed as an indictment of the DOG and DXD inverse funds, but rather suggests they only be used with a clear understanding of their objectives. Furthermore it must be realized that you might not get quite the level of protection you anticipated even if you’re right and the market goes down but takes a lazy path to get there.

For the average investor, inverse funds are an easy way to ‘short’ the market without actually taking the full risk of shorting. Think of it this way: if you invest in an inverse fund and the fund goes to zero, you’ve lost only your initial investment. Your actual risk is known going in. A second plus is that inverse funds may be bought in non-marginable accounts like IRAs. The major drawback, outlined above, is that you may not get the performance you expected for your buck – particularly over extended periods of time.

Using Options to Hedge Portfolios

Another potential strategy for hedging portfolios is through the use of options. We have previously discussed covered call writing for the purposes of generating income, but this week’s topic varies considerably and requires looking at things from a totally different perspective. This discussion focuses on using options for protection ONLY – not for day trading or other speculative activities.

While this is not intended to be a primer on options trading and involves prerequisite knowledge, there are some important concepts that must be highlighted when using options for hedging purposes. For most average investors, hedging with options involves the purchase of put options, which can be done from many types of accounts. However, individual brokers have their own restrictions on what can and cannot be done in particular types of accounts.

Time – Options are good for a specified period of time and after such time has passed expire worthless. Even in the month (or sometimes more) before their witching (expiration), options begin to degrade in value and investors find that they’re not doing their job in terms of protecting the portfolio. Options have ‘sweet spots’ and if you’re going to use them to protect a portfolio you’d better be able to align the option’s sweet spot with the period when the market’s decline will be most dramatic. Otherwise you’re not getting the full benefit of the option and your portfolio isn’t being protected. This is no easy task by any stretch of the imagination.

Strike Price – In the case of the Dow Jones Industrials Average, put options could be purchased on DIA. If you feel the decline will last 6 months and start today, you’d look at options that expire 11/2009 or beyond. In the case of DIA, 12/2009 put options are available. Now you must decide how far you think the market will fall. Buying an option with a strike price that is too low may result in it staying out of the money in which case you might not get the full performance; especially if the decline is not as steep as you anticipated. Buy an option at a strike price that is too close to the current price of DIA and you’re going to pay a hefty premium for the option. If your prediction ends up being right that won’t be an issue, but if you are wrong, you just wasted a lot of your money.

Know Your Portfolio - A common mistake of investors who use options for hedging is that they buy the wrong option. It is imperative to understand the components of the portfolio that you’re trying to protect. For example, hedging a portfolio of junior gold mining stocks with Dow Jones Industrials Average puts is probably not a great idea. While the junior gold stocks may trace the DJIA to a certain extent there are plenty of times when such is not the case. Using a simple statistical correlation study between your portfolio’s value and the value of different market indexes can help you identify which markets your portfolio tends to track and you can then hedge more effectively.

The major benefit of buying options is that you’re taking a known level of risk. Your outlay for the option and related commissions is the extent of your risk. If you are wrong and the market moves up your option will expire worthless and you lose your initial investment only. It must be noted that this defined risk does not apply when one is writing uncovered (naked) options. These types of activities are extraordinarily risky and are highly inadvisable merely for hedging purposes.

In conclusion, there are many other factors that play into hedging and would require a dissertation to elucidate all of them to proper justice. Each investor must consider their own objectives and risk tolerance and should also consult a qualified advisor before implementing any investment strategy.

The important thing to take away from this discussion is that if done properly, hedging can provide relative comfort during periods of market mayhem such as we just witnessed last year. However, if undertaken without a solid understanding of both the benefits and detriments of the hedging methodology you choose to employ, not only will you not enjoy comfort, you’re quite likely to be a regular in the antacid aisle at your local pharmacy as well.

Improper hedging techniques and use of hedging vehicles are some common mistakes investors make. Consider taking a look at our free report about 7 additional mistakes investors make – and how to avoid them. To get your copy click the following link: www.sutton-associates.net/7mistakes_report.php

Back in 2006, Marketwatch Columnist Mark Hulbert made the comment that those who had invested at the 2000 market top had finally gotten their money back.A long six years to get back nominal dollars that had decayed significantly by the time they were ‘gotten back’.

We wrote the pilot issue of the Centsible Investor in early November 2007; right after the market peak. Was this an accident? Hardly. Our keynote article in that issue dealt with our purchasing power coming under attack and we vowed to put together a portfolio model that would fight inflation by providing a high rate of current income with a secondary goal of capital preservation.

Today, I am proud to announce that while the Dow, NASDAQ and S&P are all down (38%, 39%, and 40% respectively), that the total return on our Portfolio Model is now positive at .51% as of close of business 5/8/09. Where traditional investors had to wait several years from the bottom to get their dollars back, our Portfolio Model has accomplished the same feat in just over 2 months – and has paid great dividends while we waited!

For those who have been subscribers over this 18 month roller coaster called the markets, I am hopeful that our publication has demonstrated its worth and you will consider renewing. For those who have not subscribed to this point, I am hopeful you will consider doing so. The attack on our purchasing power is only beginning and will feed on the inflation created to support unsustainable government spending and the various bailouts. Vigilence is required now – more than ever.

As an added incentive, we are currently offering $30 off our one year subscription. Get 12 issues plus interim updates for just $99. This special will last through Memorial Day.

The Centsible Investor’s Subscription Page may be found below. If you have any questions or need assistance, please reply to this email.

http://www.sutton-associates.net/newsletter.php

Best Regards,
Sutton & Associates, LLC

DISCLAIMER: The statements made in this communication are for informational and educational purposes only and do not constitute an offer to either buy or sell any security, nor should any statements herein be construed as investment advice. Neither Sutton & Associates, LLC nor any contributor to the materials contained in the above-referenced report shall be liable for any losses as a result of these or any other investments.

Recently, there has been more than idle talk about converting most of these loans to equity stakes, which do NOT need to be paid back. Furthermore, future disbursements would like be made by buying equity stakes in the firms rather than making loans. Sound the same? Not quite. Here are some reasons why:

1) In the event of bankruptcy, creditors are paid off before shareholders from any proceeds of liquidation. Given the vaporization of BSC and LEH, this is definitely worth mentioning. Historically, shareholders are left holding the bag in a true bankruptcy and subsequent liquidation.

2) Even if the firms remain solvent, there is significantly more risk in holding equity than debt. The taxpayer’s investment would be subject to all the risks generally associated with holding stocks. Taking a look at the performance of banking stocks during 2008 gives a pretty good idea of what I am talking about here.

3) Current shareholders are negatively impacted by dilution if more shares are created out of thin air for the government to purchase. And even if the shares are bought in the open market, the mere size of the stake could have a rather deleterious affect on existing shareholders should that stake need to be sold en masse.

4) By taking an equity interest, the government is consummating an incestuous relationship with the banking industry. Nationalization is the term typical used in this type of situation, but the term has become taboo in the mainstream media in recent weeks.

5) Also, bear in mind that the banks don’t really need this money at all. They have been printing their own currency for years now via unregulated, non-transparent OTC derivatives. Now that some of their bets have gone bad, the taxpayers have been forced to ‘legitimize’ this activity by the infusion of trillions of less-funny-money (dollars).

Sea changes can be either dramatic or subtle. The recent direction in terms of supporting the financial system sounds subtle enough, but with dramatic results.

Desensitization

Increases in consumer confidence during the past two months are indicative of desensitization. Consumers are becoming acclimated to weak economic conditions, poor stock market returns, and the continued accumulation of job losses. This desensitization has been emphasized by the mainstream media; particularly in the past few months. The take-home message of articles and news reports has shifted to ‘be happy things aren’t getting worse’ and people are doing just that. Bargain hunters have been lured into many areas including housing, stocks, and even retail products. Meanwhile, important fundamentals like GDP, unemployment, foreclosures, and household net worth go largely unmentioned and underanalyzed.

Where are Consumers Spending Their Money?

What is telling, however, are the reports coming out of some individual sectors in the consumer landscape. Traditional economics breaks goods and services down into two major categories: staples and discretionary. This division follows the old-school definition of needs vs. wants. However, today, the lines have been blurred quite a bit and goods that would have easily been considered discretionary even 10 years ago are now regarded as staples.

The following NAICS category charts were selected because they represent areas that are extreme examples in the staple—discretionary continuum. And for comparative purposes, the total US Retail Sales chart is included at the end of the series.

The situation with grocery stores is a primary example of how aggregate consumption numbers are reported, which will be explained in greater detail later in the article. Just reading the chart, Americans spent less at grocery stores from the middle of 2008 through the beginning of 2009, which is when we called the bottom in terms of consumer prices. Did people eat less or just spend less on what they purchased? In all likelihood it is the latter, given that grocery store shopping is one of the most basic of spending types. For the sake of thoroughness, included below is the same chart for big-box/warehouse type stores just in case everyone abandoned their local grocery store for lower prices at BJ’s and Sam’s Club.

You’ll notice quickly that the rate of growth in warehouse club spending has been declining steadily since the beginning of the decade. Spending has also flattened considerably in the past 6 months. Clearly Americans didn’t take their unspent grocery store dollars and run to the warehouse clubs, so our initial conclusion is intact.

Gasoline station spending fell off a cliff from July through December, indicative of falling gas prices and people cutting back on the purchases of accoutrements such as drinks and sandwiches. In a similar fashion to grocery store sales, there has been a recent increase in spending at gas stations reflected by the price of gas jumping from near $1.50/gallon to around $2.00/gallon nationally.

Obviously, jewelry is far at the other end of the staple-discretion continuum, and is a good indicator of purely discretionary spending. It is pretty apparent, at least from this graphic, that this type of discretionary spending (in total dollars) is contracting rapidly, now at a year over year rate of around -22%. Massive discounting by many national and regional jewelers have certainly contributed to fewer total dollars spent as well.

Above, we notice the same tail in total retail sales starting at the beginning of 2009. This change in total retail sales correlates well with our data on consumer level inflation and brings the mainstream’s assertion of the re-emergence of the consumer into question.

Inflation Returns to Consumer Prices

In early January, a number of our in-house statistical indicators turned positive in terms of the spillover of monetary inflation into consumer prices and we discussed this issue in detail in 2/20/2009’s article “The Turning of the Tide?”:

“If we have indeed witnessed the inflection point where the trillions of dollars parked in investment and commercial banks are finally being let out to play, then our wealth and purchasing power are about to come under serious attack. Obviously the risk in putting such an assertion to paper is that if we return to the previous trend of falling prices even for a brief time, the entire construct will be discredited rather than the possibility that the timing was a bit off being acknowledged. There are some factors that would help us to confirm or deny that such an inflection point has taken place……”

Since those indicators went positive, we have received affirmation of our observations from PPI/CPI, the GDP Price Index or GDP Deflator, nominal retail sales, and import prices. It is the retail sales portion that applies here, and the key lies in how that report is interpreted. It absolutely must be remembered that almost all of these aggregate spending metrics report in total Dollars, NOT units. Nor are these numbers adjusted for ‘inflation’. They are adjusted for seasonal factors that are at the discretion of the reporting agency, but that is it. What this means is that increases in consumer prices (especially in staple goods since people are less likely to cut back) will be interpreted as economic growth when retail sales are reported because people are spending more money. Conversely, when prices fall like they did from July through December of 2008, the interpretation will be economic contraction.

So the question needs to be asked: Did people actually buy fewer goods and services (an actual retrenchment) over the past 6 months or did they just pay less for some of the things they purchased thereby causing retail sales to drop?

The answer is more difficult to find than one might imagine.

We know from the Advance GDP report on Wednesday of this week that personal income in the US dropped by an estimated $59 billion (2.0% annualized) as job losses put more and more Americans on the unemployment rolls. The rate of decay in personal income grew from $42.9 Billion or 1.4% annualized in Q4 2008.

The report also gleaned that personal outlays increased .7% in Q1 2009 after falling 9.5% in Q4 2008. Looking for example at the CPI for that period, we find that using the old CPI methodology that consumer prices increased 1.18% for Q1 2009. By extension then, if consumers would have purchased the exact same quantity of goods as they did previously, they would have spent 1.18% more yet they only spent .7% indicating that less goods/services were purchased. A terribly small cutback for sure, but certainly not the growth trumpeted by the mainstream media.

For comparative purposes let’s apply the same analysis to Q4 2008. Using the same CPI methodology as the previous paragraph, consumer prices dropped 2.93% in Q4 2008. So if consumers had bought the same quantity of goods/services, they would have spent 2.93% less. Yet consumers spent 9.5% less indicating a significant cutback.

One conclusion we can draw from this cursory analysis is that while consumers spent more in Q1 2008, they didn’t really buy more. Still, in the face of rising unemployment, falling housing prices, and general economic malaise, consumers are still trying hard to hold onto yesteryear after a very brief period of belt-tightening.

In our ‘Spin Cycle’ podcast, we are currently doing a 7-part series in which we depict the factors affecting the US economy as sides of a Rubik’s Cube – independent, yet interrelated. Episodes include Interest Rates, Economic Growth, Debt/Monetary Growth, Energy, Demographics, Geopolitics, and the State of the Consumer. To listen, visit www.my2centsonline.com/radioshow.php