The Republican budget proposal will eliminate the national debt while still preserving costly entitlement programs like Medicare and Social Security, Rep. Paul Ryan told CNBC.

Speaking just hours before the spending plan gets its formal introduction before Congress, Ryan, head of the House Budget Committee, said the debt will peak at 74.5 percent of gross domestic product in 2014 and then drop from there.

“We’ve got to show the country that we can get this situation under control and grow the economy, and that’s what we’re doing,” he said. “So whether (Democratic Senate Majority Leader) Harry Reid is willing to pass this bill or Barack Obama is ready to sign it, I don’t know the answer to that question.

“What I do know is I can’t look my kids and my constituents in the eyes with my conscience being clear and not know that I didn’t do everything I could to try and fix this problem before it got out of control.”

Among the key tenets in a budget resolution to be presented are fundamental changes to the way Medicare and Medicaid are financed. The resolution forestalls action on Social Security, though Ryan said he expects a bipartisan agreement on that issue later this year.

More broadly, the plan contains provisions that Ryan has said will slash $4 trillion from federal spending over the next decade.

The resolution is necessary as a potential shutdown looms over Washington and Congress must approve raising the national debt limit.

Ryan acknowledged the political obstacles he will face both from Democrats and some members of this own party who may bristle at the aggressive spending cuts involved.

“The problem in Washington is, they take any honest and sincere attempt to fix this problem and use it as a political weapon against you in the next election,” he said. “We can’t let that deter us.”

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.

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 probablynot 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

Main Street Under Pressure

Since last summer there have been fairly regular stories even in the mainstream press about banks cutting limits on credit cards. It would seem as though the bankers had decided that the age of consumerism had gone too far. Ironically, these actions happened concurrently with the largest giveaways in the history of mankind. In the past 9 months the United States, #1 on the world financial stage, has committed an entire year of economic output to stem the ongoing crisis. How do banks respond? By cutting credit card limits. It is like giving a small child sweets until the kid is in a frothing sugar-frenzy, then locking up the candy dish. The analogies are nearly limitless, but the point is obvious. While the banks screamed for the elixir of easy Fed credit, they slammed the door on Main Street. For their part, consumers at some levels have cut back on their spending, which is a good thing. The unfortunate reality is this: Even the most prudent and responsible consumer will have a bad month. There will be a string of unexpected expenses, and that individual might need to carry a balance for a while to get things straightened out. Job losses will cause exactly this type of situation and now in many cases the credit is not there.

Another unintended consequence is that when credit lines are cut, utilization goes up and suddenly the most frugal appear to be on a spending bender. Take the person who has $25,000 in total credit from a number of different sources. Say on average the individual uses $5000/month for regular expenses, but never carries a balance. Now let’s assume that their lines are cut in half. Their utilization just doubled from 20% to 40%. Their new application for a small business loan might now be rejected because they’re judged to be a bad credit risk due to the 40% utilization. More unintended consequences.

Another amazing development has been the continuation and acceleration of foreclosure activity despite all the political rhetoric over the past 15 months from both sides of the aisle in terms of ‘helping’ homeowners. According to RealtyTRAC, foreclosure activity, which includes default notices, repossessions, and auction sale notices, increased 6% from January 2009. This same measure increased nearly 30% from February 2008. So despite trillions of dollars pledged to Fannie, Freddie, Bobby, Lulu, and anyone else with a leaky balance sheet to supposedly assist homeowners, not only is foreclosure activity not abating, it is increasing.

Runaway government spending

As most are acutely aware this tax day, their contribution to the team effort of bailing out the economy will not be near enough. Not only will their continued (and increasing) participation be needed, but that of their children, and grandchildren will be required as well. While I could sit here and tally up the various tabs, totals, and sums, it would be pointless. The public is mind-numb from hearing these staggering figures. It is very difficult to even fathom a billion let alone a trillion. However, this reality has dawned on an increasing number of people over the past few months and they are understandably perturbed. We have hopefully learned a valuable lesson, and that is that liberty is akin to a seedling. It is planted, but then must be watered, fed, and protected from the harsh environment in which it lives. While Americans were out collectively living it up over the past umpteen years, that harsh environment has wreaked havoc on our seedling. The bad news is that we’ve got a lot of work to do. Hopefully the sheer magnitude of our task doesn’t discourage us from doing it.

Big Bank Profits = Bubble Watch

After 6 quarters of dire forecasts, failures, predictions of failure, and uncounted bailouts, big banks are suddenly earning money again. Interestingly enough, most of these newfound profits are coming from the investment banking sides of their businesses. Translated, that means they’re back to their old tricks again and it is back to business as usual. Secure in the knowledge that their backs are securely covered by ‘We the People’ and without fear of extinction, the winners of the 2008 financial crisis have been refreshed, revived, and are back at it. Since our economy and monetary system are still compromised by the same structural imbalances that existed before the crisis, it is again time to go on “Bubble Watch”. The ingredients are there: very cheap money from the Fed and existing dislocations in many markets. The only thing missing is you. And this little fact could cause quite a problem. Americans, quickly growing weary of the accelerating boom-bust cycles, and still punch drunk from the last beating are not likely to be as willing to participate in the next bubble.

One of last fall’s pieces focused on the causes of the Great Depression and tried to dispel the myth that the market crash of 1929 was somehow solely responsible for the mess that followed. We pointed to a nagging reality from 1929 and that was the proportion of Americans living in poverty. More than half were living below a minimum subsistence level, which at the time was $750/year. Essentially one half of the population was unable to support further economic growth. That was one of the underlying structural imbalances. The crash and subsequent misguided government responses were the triggers that caused the Depression.

How much different are we really today? Sure, the poverty line has been adjusted upwards in nominal terms, but fundamentally, how many Americans are below it now? Perhaps the most important variable that has changed in the past 70 years is the reliance we have on credit as a society. How many of us would be living below the poverty line, unable to participate in the economy were it not for VISA, Mastercard, and equity lines of credit? The recent spikes in unemployment will only exacerbate the situation, causing further reliance on credit for subsistence; credit which is shrinking by many measures.

In conclusion, it is particularly disheartening that nearly all of the political focus spanning the last two administrations has been about getting credit flowing again, with only token talk of job creation and fostering legitimate economic growth. The actions have been no better. The vast majority of bailout and stimulus dollars have gone to the financial system to encourage lending and borrowing rather than to the real economy. Our fiat monetary system’s reliance on debt for its growth is the elephant standing in the room each time a press conference or media event is held. It is the elephant nobody in charge wants to talk about. It is the question nobody in media wants to ask. And, at the end of the day, I would imagine that is why so many people came out on Wednesday and will continue to do so. They aren’t interested in parties. They just want to talk about elephants.