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

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

National Sovereignty Ceded

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

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

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

Destruction from Within

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

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

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

Race to Gold – the Endgame of Paper

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

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

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

The ‘Strong Dollar’ is Back?

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

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

Will Greece Pay Up?

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

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

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

c) The people of Greece will not accept austerity measures

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

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

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

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

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

Freddie Mac Continues to Bleed

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

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

April Jobs Report

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

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

In order to accomplish this, I am going to cite exact passages from the House Bill from last summer (HR3200) and give you page references so you can download a copy of the bill and follow along if you so desire. I am using the older bill because it is much clearer in language than its Senate counterpart, and while not all of the provisions were passed in the exact same form, I believe this is where we’re ultimately going to end up. I am also doing this since many people simply cannot believe that our reps would put such provisions into legislation and will no doubt call me a liar and a shill. Before anyone gets any ideas about turning this into the sadly typical political muckraking that passes for debate these days, I want to refer you back to the articles I wrote in 2008 issuing scathing criticism of the banker bailout, the AIG bailout, Fannie/Freddie, and the housing relief bills, which were pushed by the ‘other’ folks in Congress. I couldn’t give a rip about politics. I am interested in the impact these bills will have on our economy and American families.

Piling on Debt

One of the planks that was used to promote this legislation was the fact that it will be a deficit-reducing measure. Let’s consider a few things here. The IRS will need to hire upwards of 16,000 agents and require an additional $10 Billion over the next decade (reported in the MSM) to ‘police’ the provisions of this new law. So the public sector will get even bigger. The late Milton Friedman did some fascinating research and modeling that pointed to the fact that every public sector job created destroys roughly 2 private sector jobs. That is 32,000 more private sector jobs down the tubes just on the IRS’ account using Friedman’s research, which has proven to be pretty accurate.

The bill itself is advertised to cost $940 Billion. Looking back a few years, we have Medicare Part D, which was advertised to cost around $500 billion. To date Medicare Part D has already added nearly $7 TRILLION in contingent unfunded liabilities to our national balance sheet. While it would be irresponsible to do a naked extrapolation here, the point is simple; this bill will, in all likelihood, end up costing an awful lot more than what has been advertised.

Martin Feldstein who, incidentally, concurs with the above assessment estimates debt service on the debt created by this new law to run around $300 billion over the next decade. In the new financial landscape where we talk in terms of trillions, a mere $300 billion doesn’t seem like a lot. However, when you consider that $300 Billion represents the total of yearly earnings of over 6.5 MILLION average US families, it is obvious we’re not talking about chump change here.

For a nation that already has liabilities that outstrip assets by anywhere between $15 and $20 Trillion dollars, it seems foolish to even consider more debt, but we don’t even blink twice anymore. Our government is probably already aware of the fact that the debt cannot be paid, so why not pile it on as long as others are willing to let the game continue? It’ll be ok until it isn’t, then we’ll have to think of something else. How’s that for an exit strategy?

The Provisions

Page 22 Section 113 – The Health Choices Commissioner along with the Dept. of Health/Human Svcs will conduct an audit of the books of any businesses that self-insure. This constitutes an additional regulatory burden on the small business that chooses the self-insurance route.

Page 50 Section 152 – This will allow illegal aliens to get health insurance; presumably at no cost since nowhere does it mention charging them or making them pay any sort of taxes, fees, or levies. The section reads that health care will be provided ‘without regard to personal characteristics extraneous to the provision of quality health care or related services.’ Although, ironically, Section 246 contains language that purports to exclude ‘undocumented aliens’ from Federal payments towards affordability tax credits. This is something of a joke since these people don’t file returns anyway and would not be able to take advantage of such a credit.

Page 149 Section 313 – Any employer who has a payroll greater than $401,000 and doesn’t offer a ‘public’ option for employees will pay an 8% tax on its payroll – payable to the Health Insurance Exchange Trust Fund.

Page 150 Section 313 – The following schedule applies to smaller employers who don’t offer a ‘public option for employees. The percentage represents the additional ‘tax’ they will need to pay to the Trust Fund:

Does not exceed $250,000 – 0 percent

Exceeds $250,000, but does not exceed $300,000 2 percent

Exceeds $300,000, but does not exceed $350,000 4 percent

Exceeds $350,000, but does not exceed $400,000 6 percent

Also of interest is the fact that Section 313 states that an employer hasn’t satisfied the contribution requirement if they simply cut the employee’s salary by the amount of the contribution. This is best illustrated with an example:

Let’s suppose Employer A has an Employee X who makes $10.00/hour and Employer A doesn’t offer a ‘public option’ for his employees. By law, the employer is now required to pay an 8% tax on payroll (let’s assume Employer A is in the highest bracket). If the Employer simply reduces Employee X’s wage by 8% to $9.20/hour, the Employer is in violation of the statute and is deemed to not have made a contribution. While on the surface this appears good since it forces the employer to effectively increase total employee compensation, this will be a job-killer. Employer A might very easily choose to reduce the workforce by 8% to keep costs the same.

It is pretty easy to see that just these four provisions add some serious burdens on what are considered to be small businesses. These are the business that employ somewhere in the neighborhood of 80% of all workers and create roughly 60% of new jobs. The most logical response of these businesses will be to cut staff or reduce non health-related benefits such as retirement contributions. Still mired in a severe recession, small businesses have not been able to grow top line revenues (nor have large ones to any meaningful extent for that matter) and are therefore going to be focused on controlling costs. This is precisely how the firms that have survived have done so over the past 2 years. This law will put many of them under. I wonder if BLS will take this new reality into account when it pulls CESBD (birth/death model) adjustments out of the black hat each month?

This says nothing of the encroachment on civil liberties such as the IRS having direct access to your bank accounts (Page 59 Section 1173A) and the creation of a National Heath Card ID and giving government instant access to your financial information (Page 58 Section 1173A).

All this and we still haven’t considered the overall impact this will have on the macroeconomy. We know that half a trillion dollars will be transferred from consumers to government vis a vis the ‘Shared Responsibility’ doctrine espoused in the law and it will likely be much more than that. That is an additional half trillion dollars that will not be spent efficiently by consumers, but will be squandered by government. Ok, I’ll admit it – I am deeply skeptical of any government ‘Trust’ Fund. For those who want to bicker on this point, I refer you to the status of the Social Security ‘Trust’ Fund as my basis for skepticism.

We also know that $500 Billion worth of Medicare cuts will be made, which essentially means that another half trillion will disappear from the pockets of households in pursuit of paying higher Medicare premiums. The beauty of the shift is that it is essentially GDP neutral since government spending counts in GDP at the same weight as consumer spending. In this new world of socialized everything we clearly need a new way of measuring economic output or at least differentiating legitimate output from the activities of our borrow and spend politicians.

With all the debt being accumulated, the money being pulled from the real economy in favor of the centrally planned utopia sought by so many on Capitol Hill, and the pressures brought to bear on businesses by this ‘reform’, it is hard to contemplate a set of circumstances under which we avoid another steep contraction in the real economy. It will be interesting to see how long it takes to go from recovery to contraction. My guess is about as long as it takes for a Baskin Robbins double dip to melt.

Framing the Discussion

Once again it becomes necessary to properly define terms and concepts since failure to do so will almost certainly result in the forthcoming analysis being misconstrued.

The establishment of the corporation as an ‘artificial person’ by the Supreme Court in 1819 was used to give the corporation (an assembly of individuals of indeterminate size) certain rights that were normally reserved for individual people or ‘natural persons’. For example, a corporation can enter into contracts, file suit, and be sued. Corporations can even be charged with and convicted of criminal offenses, although generally, criminal charges often pass through the corporate veil to members of management as well. The corporation as it were cannot commit a crime of its own volition, but only by the action or inaction of someone entrusted with making decisions for it. One right that has not been conferred to corporations is the right to physically vote in political elections, however, corporations have been able to financially support political candidates for quite some time now.

Until the mid 1800’s, the government issued all corporate charters, and the applicant had to demonstrate that what they were doing or proposing to do would be in the public interest (a novel idea). How many corporations today do you think would fail this acid test? Even in the era of the public interest doctrine as we’ll call it, there were many folks including Andrew Carnegie and John D. Rockefeller who sought to skirt the public-interest doctrine by organizing as limited partnerships or Trusts.

The Issue

At issue for the Supreme Court to decide was a 20-year old ban on corporations and labor unions providing money for campaign advertising. The Supremes took it a step further and also struck down part of the McCain-Feingold campaign finance reform law that banned corporate and union-paid ads in the closing weeks of political campaigns. While on the surface, this looks like a victory for the First Amendment; I think it does little more than pave the way for corporations to buy even more politicians; and to do so under the protection of the law.

The entire issue comes down to the corporation as a person. Is the corporation entitled to all the same rights as a natural person? The very fact that the Supreme Court in 1819 designated corporations as artificial persons rather than natural ones indicates that they are not. Keep in mind that the spirit of corporate law is largely centered on limited liability, not enabling the corporation to wield disproportionate power in the political process (which arguably was already happening anyway). Take our largest corporations, with billions of dollars in quarterly profits. They are generally controlled by a Board of Directors and major shareholders; the number of which is comparable to those in attendance at a typical Little League baseball game. It is naïve to think that the American people can muster as much financial influence in Washington as even one large company, let alone all of them. The bottom line here is that a corporation is a creation of man and is not entitled to all of the same rights that are imbued in us by God. The framers of the Constitution, following along this line of reasoning, focused the founding documents on individual liberties rather than commercial ones.

Detractors of this line of thinking will accuse me of being hypocritical because on one hand I urge government to get out of the affairs of business, yet on this issue I encourage it to do the opposite. To reconcile these two disparate positions, one must understand the intended purpose of government. Our government was designed to protect the rights of the individual and to prevent people from running roughshod over each other. With that in mind, it would stand to reason that government shouldn’t be telling firms the maximum amount they can pay employees. It shouldn’t be bailing those companies out when they fail either. But it certainly should be preventing companies from stampeding the American people by making the electoral and legislative processes available to the highest bidder.

In conclusion, it is my opinion that what happened yesterday was misconstrued as being a First Amendment issue when it really is an issue of equal protection. Granted, groups like the NRA and other issue-specific groups have been shut out of certain political advertising in the days leading up to elections. That is wrong because those groups are speaking (hopefully) on behalf of their members as a cooperative. A corporation really can’t make that claim at the same level. The White House immediately issued a statement decrying the ruling, and although I agree in this instance, it must be pointed out that every single President in the corporate era has gotten money from corporations for their campaigns. That generalization can be extended to nearly every other political office in the country as well. The bottom line is that this activity was already going on anyway, but now the way has been paved for it to accelerate and increase in magnitude.

Yesterday’s ruling will allow corporations to dump unlimited funds into the coffers of political candidates and overtly buy the legislative process, using the government as a tool to enrich corporate bosses. It is easy to see why the power elite who controls the major corporations was most dissatisfied with the public interest doctrine in place in the 1800s. They greatly prefer that their companies be held to the doctrine of shareholder interest since any action that increases shareholder value is deemed appropriate and acceptable even if it encroaches on the rights of other citizens. Make no mistake about it; the government has already largely been purchased by the highest bidder. Yesterday’s decision legitimizes this previous illegitimate activity and gives the green light to a complete takeover of our government by large corporations.

I’d like to close with two quotations by Thomas Jefferson:

“Experience hath shewn, that even under the best forms of government those entrusted with power have, in time, and by slow operations, perverted it into tyranny.”

“I have the consolation of having added nothing to my private fortune during my public service, and of retiring with hands clean as they are empty.”

What does this mean? It means more reliance on foreigners for everything from food to fuel, to consumer trinkets. It means larger trade deficits (since you can’t export government – although it would really be nice to export the whole doggone thing right now!), and further pressure on the US Dollar.

Cost vs. Price

It would probably be rather hard to find a single American that didn’t know the price tag of the stimulus bill. $787 billion has been included in nearly every news piece regarding the topic. What most people are not aware of, however, is that $787 billion only represents that amount of money actually put into the economy by the feds. It comes nowhere near addressing the actual cost of the program. A good recent example of this miracle of government accounting is the Medicare part D prescription benefit program. The price tag was $394 billion, but the cost is much higher – around $8.7 trillion and counting depending on which numbers you want to use. Granted this represents the net present value of the cost of these ongoing benefits over a 75-year period, but you get the idea.

Fortunately for taxpayers, the stimulus package is not an ongoing expenditure (yet), and as such consists of predefined outlays. Despite this, the total cost of the bill as compiled by the Congressional Budget Office is approximately $3.27 trillion. Amazing in this is the fact that we’ll pay nearly as much for debt service on the stimulus bill ($744 billion) as the measure was supposed to provide to the economy! Talk about sticker shock. The gory details are here.

The question now becomes one of return on investment. What exactly are we going to get for our $3.27 trillion? It had better be good too, because nearly all of it is borrowed from someone – either foreigners or the Fed. Unfortunately, such is not the case. Using the $3.27 trillion projected cost, the ROI for the stimulus bill stands at a whopping -415%. In the private sector, such a revelation would result in a project being killed instantly in the concept phase. Not so in the hallowed halls of Congress where the laws of economics and common sense do not apply.

A Good Deal for Taxpayers?

We have been assured in almost doublespeak fashion that the stimulus bill was necessary, and was in fact, a good deal for the American taxpayer and would create or save millions of jobs.

The ballyhooed cash for clunkers program deemed such a success ended up costing taxpayers around $24,000 for every car sold under the program. This when the actual benefit to the buyer was only $4,500. Some other examples, courtesy of AP, include:

- A company working with the Federal Communications Commission reported that stimulus money paid for 4,231 jobs, when about 1,000 were produced.

- A Georgia community college reported creating 280 jobs with recovery money, but none was created from stimulus spending.

- A Florida childcare center said its stimulus money saved 129 jobs but used the money on raises for existing employees.

One disconcerting admission in the past week came from Christine Romer, the head of the Council of Economic Advisors. She stated that the largest impact from the stimulus had already been felt and that moving forward, the stimulus would only serve to prevent the economy from slipping further rather than contributing to any growth. Sounds like a recovery eh? It would sound as if Ms. Romer is already laying the groundwork for the next brainchild of economic ignorance: Stimulus – The Sequel. Here are her quotes:

“By mid-2010,” she said, “fiscal stimulus will likely be contributing little to further growth.”

“While job losses will likely end early next year, robust job gains may still be several quarters away,”

“This is not a normal recovery, Coming out of this, we’ve got lots of things working against us.”

Like the laws of economics for starters?

What also must be noted is that the federal deficit alone for FY 2009, which doesn’t included net present value of unfunded liabilities, was $1.4 trillion. The fact that such a large sum of money had to be spent to prevent an all-out collapse of the US economy should be alarming to anyone with a pulse. The fact that current projections are for $1 trillion plus deficits annually for the next ten years should curl your eyebrows.

Let’s assume for a minute that Ms. Romer is correct and that we’ve seen all the bounce we’re going to get from the stimulus. According to AP, the number of jobs created directly by stimulus spending was around 25,000. Sure, there are probably some others that slipped through the cracks and it is very likely that some firms held off on layoffs because of the temporary burst of cash. But lets look at the cost of those jobs JUST in terms of the debt service created by the stimulus bill. Each of the 25,000 jobs created cost the taxpayer $29,600,000 in debt service alone.

Keep in mind that unemployment has been going up constantly during the time when we were getting the maximum ‘benefits’ from the stimulus. As soon as the money wears off, firms will fall back on their original plans, which include cutting back on staff. Another stimulus package will be needed – and soon – to stave off the infamous double dip that many economists and commentators have long been forecasting. The proverb that a house built on a rock will weather any storm, but one built on sand will certainly collapse rings very true in our current state of affairs.

The real question that needs to be posed to anyone supporting additional foolish stimulus needs to focus on an exit strategy. How will additional stimulus create a foundation for fundamental, healthy economic growth? The short answer is that it won’t, but lets make them answer anyway.

It is therefore worth chronicling his recent reversal on the prognosis for the US economy. Long known as a ‘bear’ and as recently as June 15th skeptical of Helicopter Ben’s ‘Green Shoots’, Roubini now sees ‘light at the end of the tunnel and for once, it is not a train’.

It is hard to understand how any economist who looked at our broken system in a proper enough fashion to predict what has happened over the past 18 months could suddenly come to a different conclusion given that virtually nothing has changed – unless you want to count the exacerbation of many of the problems which got us into this mess to begin with.

How could persistent multi-trillion dollar deficits, more intrusive government policies, the apparent guarantee of additional tax burdens, debt monetization, and higher than expected unemployment numbers (even the watered down BLS numbers are above administration and Fed estimates) cause someone of Roubini’s intellect to suddenly change his mind and see green shoots instead of yellow weeds?

Whatever the reasons were, the markets loved it. The DOW continued its winning streak, dragging the NASDAQ and S&P500 with it. Interestingly enough, the Wilshire 5000 did not exactly follow suit, actually losing ground at the end of the day while the benchmark indexes gained.

This is just another bit of anecdotal evidence that the rally from March 6th has nothing to do with green shoots for the broader markets and the economy, but rather resembles Jack’s beanstalk. And we all know what happens when you play with magic beans.

Added from Roubini’s Blog on 7/16:
“It has been widely reported today that I have stated that the recession will be over ‘this year’ and that I have ‘improved’ my economic outlook. Despite those reports – however – my views expressed today are no different than the views I have expressed previously. If anything my views were taken out of context.”

If you go to the NYSE website, you will be able to find what is called an Industry Classification Breakdown or ICB. There are ten major industries with varying numbers of supersectors, sectors, and subsectors under each major heading. Now let’s say for example, in your reflections on what the major economic and investing themes happened to be that you zeroed in on consumer staples as an area that is positioned for success. At this point we are assuming that you’re not interested in just finding an ETF or Closed-End Fund that gives exposure to firms that produce consumer staples, but are interested in becoming more acquainted with some of the individual firms themselves. Once you have performed your basic analysis, you’ll know which firms you’d want an ETF or other Fund to include or can purchase them outright and will be an informed shopper so to speak.

That said, when you go to the ICB listing for Consumer Goods, you will find the following:

Clearly you are not interested in examining all of these areas. Your focus as decided above is on staple goods. Immediately, the broad category of Leisure Goods can be eliminated. Automobiles can probably be eliminated as well if we’re focusing totally on staples or necessities. This leaves a wide sampling of categories. For the purposes of this discussion and in the interests of brevity, we’ll limit our analysis to a single sub sector – Food Products.

Before we continue, some limitations of this search methodology must be identified as well. The NYSE search is only going to show the firms that are listed on NYSE. It will not show international firms that are listed on other major exchanges, but not on the NYSE. The good news is that many of the larger firms are dual-listed. The bad news is that by limiting your search to only NYSE-listed issues, you will likely miss some good possibilities. Many of the other major exchanges such as the TSX also have similar search capabilities and by spending a little time, you can quickly assemble a rather comprehensive list of investment possibilities within any given sub-sector.

A look into the Food Products sub-sector reveals no less than 46 US-listed companies and their related securities. The information provided is limited to the name of the firm, the ticker symbol, last trade / trade date, volume, change($), and change(%). At this point, the biggest tendency for individual investors is to scan the list, find the name of a firm they know and start their search there. This is not the way to go; emotion has already entered the equation and in your mind you’re already playing favorites and biases have taken control of the process. At this point, you must consider your own objectives:

• When will you need this money?

• What do you anticipate eventually using the money for?

• How much money do you have to work with?

• What is your risk tolerance?

The answers to these questions will help you decide on what types of firms you’re looking for. Do you want large companies with low volatility that pay high dividends? If you’re approaching retirement, this might be the way to go. If you’re younger and are looking for capital appreciation, you might consider looking at some of the smaller companies that are more volatile, but have more room to grow. Are you risk averse? The fact that you’re looking at consumer staples to begin with might say something about your willingness to accept risk (wait, I picked that category!).

This is an important part of the process. We are now connecting the economic themes that we decided will be important with our own personal situation. The worst thing anyone can do is take his or her own themes, then just grab someone else’s prepackaged strategy without considering if it actually fits. It is the financial equivalent of buying a pair of trousers without bothering to look at the size, choosing rather to buy them because you thought they looked good on somebody else.

So in our hypothetical analysis, we decided that the economy is in recession and is likely to be there for some time, and have come to the conclusion that people will cut back on discretionary spending (which they have). We realize that inflation is a problem, and so leaving our capital in a bank account is not the greatest idea if we expect to maintain our purchasing power. Food products will certainly not be the only theme we invest in, but it is a good starting point.

Large or Small?

The next issue becomes the determination of what constitutes a large company and what constitutes a small one. Obviously, there are a number of characteristics that may be used to determine this, but one of the most generally accepted definitions is the firm’s market capitalization. Market capitalization is the share price multiplied by the number of outstanding shares. Another way of expressing market cap is that it represents the public opinion of the value of the company. The sizing of companies can generally be lumped into the following brackets:

• Large-Cap Companies $10 Billion – $200 Billion (or more)

• Mid-Cap Companies – $2 Billion – $10 Billion

• Small-Cap Companies – $200 Million – $2 Billion

• Micro-Cap Companies – Less than $200 Million

Using the Food Products sub-sector as our continuing example, of the 46 issues in that category, the breakdown is as follows:

As is evidenced by the chart above, there is a solid distribution of firms in this sector according to size as measured by market capitalization with most of the companies (33) falling in the small or mid cap range. This distribution is good news as it means that no matter what your investment goals and risk profile, you should be able to find a reasonable number of firms that are desirable for addition into a portfolio, or are firms that should be looked for when looking at ETFs and open/closed end funds.

Using this methodology it is fairly easy to drill down to potential specific investment possibilities from a variety of economic themes. What we need to accomplish next is creating a definition of value and the parameters by which we will measure it. Next time we’ll take a look at some of the popular valuation metrics and develop a few of our own as well, which we can add to our toolbox as we continue to chase the oftentimes elusive concept of value.

Individuals interested in learning more about the major macroeconomic themes should take a moment to listen to some of our informative podcasts. We’ve recently had guest experts like Laurence Kotlikoff; John Williams of shadowstats.com, and Bill Murphy of GATA appear to discuss their areas of expertise. For more information or to listen, please take a moment to visit www.my2centsonline.com/radioshow.php

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.

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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.