The U.S. stock market: Where we go from here

The U.S. stock market is rallying, and the U.S. dollar is slowly declining in value relative to a basket of other currencies. Although inflation may not occur for another six to twelve months, an oncoming inflation will cause demand for assets that can grow, such as: income-producing real estate, gold, global growth stocks, and the world’s better managed currencies.

The political infrastructure of the U.S. and Europe will change

The recent primary election season in the U.S. has given full voice to the forces of change in the U.S. political system. We believe the current wave of fiscal conservatism will make itself felt in government. Many Americans are tired of a government run by lobbyists for big business, big labor, big military, big environmental activism, and big government. If the new representatives, who will be carried into office in November 2010, can avoid being bought by these same lobbyists there will be a change toward smaller government and less favoritism for the five big influences mentioned above.
If, after election day, the newly elected officials are sophisticated enough to deeply understand how the U.S. financial system works, and if they are able to cut spending while keeping the stock market and banking system operating so that commerce can be enhanced and expanded, we will enjoy a very positive era in U.S. stocks. Much depends upon how the newly-elected congress members view the stock market. If they agree that the market is the engine for financing business formation, which in turn leads to higher employment and economic growth and a reversal of the current malaise, the outlook is sunny. We will keep watch and notify you.
We expect the same story will be true throughout Europe. Spending on many programs must be and will be diminished.

As an investor looking toward the future one might want to consider the effect of these trends upon U.S. or European environmental, defense, or banking stocks. We would not be surprised to see less spending in all of these areas by the U.S. government. On the other hand, a weaker U.S. defense spending cycle may encourage foreign nations to buy more armaments for themselves from U.S. companies. The budget of the United States cannot be cut enough solely by cutting healthcare and social entitlements. Environmental spending, foreign direct and military aid, and military spending must be cut to create enough impact to balance the budget.

U.S. bonds

As we have said in our recent letters, we believe that the U.S. bond market has probably entered a prolonged period of decline in price, thus interest rates will rise over time. Since that time, bond yields have risen and bond prices have fallen. During late 2010, it is possible that we will see a small rally in bonds. Many are expecting a slowdown in U.S. economic activity in early 2011. It is possible that U.S. manufacturing and retailing will slow in late 2010 and prices may temporarily fall for manufactured goods. On the other hand, prices for food will rise and strong demand for raw materials and manufactured goods will continue in Asia and Latin America. We believe that these forces counterbalance one another and the effect will be a possible slowdown in U.S. and European growth in late 2010 to early 2011, with no long-term slowdown. This short-term slowdown could cause some to seek the safety of bonds. We would avoid the temptation to buy bonds. In our opinion, rising food prices globally and rising inflation in the emerging world will eventually make its way to the developed countries. When inflation arrives in the U.S. and Europe, bonds may begin a rapid decline in price.
Around the world, investors are looking for ways to increase the yield in their portfolios. During this period of low global interest rates, many government bonds offer little interest yield, and the ones that do, do not offer a margin of safety due to poor credit quality. Many investors have asked what they should do if they must keep their pensions in U.S. dollars or if they have trusts which are legally designated for U.S. dollar instruments.
For U.S. income investors whose cash balances are earning next to nothing and who are not able to purchase foreign currency debt instruments in one of our recommended currencies, an allocation to Treasury Inflation-Protected Securities (TIPS) may be suitable for conservative income portfolios, especially for those investors who see inflation on the horizon. TIPS are U.S. government bonds whose principal is adjusted by changes in the Consumer Price Index (CPI). The relationship between TIPS and the Consumer Price Index is that as the CPI increases, the amount of principal that TIPS investors receive at maturity increases. The amount of interest that TIPS pay to investors every six months also increases, because the coupon rate the TIPS pay is calculated on the adjusted principal balance. Should we enter a period of deflation, the interest payments and principal balance will decrease, however TIPS also provide some deflation protection. At maturity, holders receive the adjusted principal, or the original principal of the bond, whichever is greater.
TIPS are not going to keep up with inflation perfectly, but they may be better than no protection at all for an income portfolio.

Gold prices are at all time highs…be wary of intervention intended to manipulate gold’s price

Gold prices ended last week at all-time highs. We have been bullish on gold for most of the last seven years and have watched it move from below $300 to above 1,280/oz. We continue to be bullish on gold.
Presently, gold prices are rising due to investor fears of further quantitative easing by several central banks. We also believe that it is our responsibility to remind gold investors what has happened in the past when gold prices have risen rapidly. Historically, gold’s appreciation has created tension with some central banks who realize that rising gold price in their currency is the equivalent of a failing report card for their monetary and fiscal policies. We believe that gold will be increasingly volatile after it reaches $1,500 per ounce, and although it will move higher in the long run, holders should be ready for some serious volatility in the price. We recommend for the first time that gold be traded more aggressively after it rises above $1500 per ounce.
As a report card on how effectively countries are managed, gold has no equal. However, this very attribute of reporting on financial foibles, can make gold many enemies among powerful governments with poorly managed monetary and fiscal affairs. These governments will want to keep gold price down so gold will not be such an obvious reminder of their economic mismanagement. Be prepared to take profits on at least part of your position in gold and gold shares on price spikes and buy back on dips

Derivatives were the major cause of the financil, banking, and credit crisis of 2008.

This is a topic that we warned about for three or four years before the crisis of 2008. Although the solutions to the problems of over-leverage in the financial system were available at the time, the combination of weak derivatives with weak counterparties, and shoddy accounting were in existence for some time. Apparently, nobody was interested in solving these problems at that time. People can correctly blame the U.S. Congress, the rating agencies, complicit auditors, greedy bank executives, and traders, but the vehicle that all of these parties used, and which ultimately failed, were derivatives

Today, derivatives are a bigger problem than ever

In spite of the efforts or Paul Volcker and a few others, derivatives continue to be abused. To be frank, the SEC, the U.S. Congress, and the Obama administration either do not understand or are beholden to those entities that create derivatives. They have not taken enough action to gradually unwind the problem, and we may very easily have another crisis like 2008, even larger in magnitude, if something is not done to reign in derivatives and other products which create excessive leverage in the banking system and in the economy.
The Basel 3 accords and the U.S. financial reform bills are the equivalent of putting band-aids on a terminal hemorrhage. They are too little, with a too-long waiting period to be implemented. They contain many loopholes that will allow the aggressive and greedy to circumvent that which they wish to.
A few good things are being done. For example, this week, the SEC agreed to propose rules to help investors spot firms that slash debt before quarterly reports and then reinstitute it later; a practice known as “window dressing”.
More unwise things are being done by the government-sponsored FHA. Real estate collapsed due to over-leverage. In spite of this, more leverage is still going into the system, and it is the U.S. government which is driving a return to the over-leveraged system. The over-leveraged system is destined to fail again at some future date. An article titled “FHA Loans Revive Easy Credit and Risks to Government” in the September 20, 2010 Investor’s Business Daily, points out that the subprime loan market is not dead and that in fact it is as dangerous as it has ever been. Should a default take place on these new subprime loans, the FHA, and eventually the U.S. taxpayers, will pay the bill. In some FHA programs only a 3.5 percent down payment is required to buy property, the remainder of the purchase price is guaranteed by the FHA. The loans are often made to cover seller’s concessions and mortgage insurance. In these cases, the financing can actually exceed 100 percent of the value of the home. Quite often, the FHA borrower has no equity in the home at all (from day one) and will be more likely to default on their mortgages if they experience difficulty with their cash flow, or if the property falls in value. It is stunning to see the U.S. government promoting this kind of highly-leveraged lending…again.

Not enough has been done to ensure the safety of the financial system and avoid a repeast of the 2008 experience. Here is what Anton Valukas has to say.

Who is Anton Valukas?
Mr. Valukas is a former federal prosecutor and the head bankruptcy examiner of the Lehman Brothers bankruptcy. He and his team wrote 2,200 page report on the Lehman bankruptcy and how it came about.
According to an article in The Wall Street Journal on Sept 18, 2010 titled “Lehman’s Accidental Historian”, Mr. Valukas said he “would like to see ‘hard and fast’ regulatory requirements for liquidity levels and risk limits for the most important financial firms. Once they hit clearly stated ‘trip wires’, regulators would be compelled to act. ”The article goes on to state that “After spending 14 months examining Lehman, Mr. Valukas, said he found a culture with little respect for its own stated risk limits. It blew through those restraints repeatedly, he said. What made things worse: Federal regulators knew about it, but failed to act. ”The gist of the story is that Mr. Valukas was not trying to gather indictments. He was trying to understand exactly what happened.
In our opinion the story is simple, too much risk-taking, too few controls on the risk-taking, too many incentives to take risk. If you are correct, you get rich. If you are wrong, you get another job and try the same thing again elsewhere. During 2008, the public taxpayers took the risk and got the bill.
We should make sure this never happens again. The way to do that is to have much tighter controls on the risk-taking functions of banks, and have all derivatives cleared through independent clearing agencies and traded on exchanges so they will be liquid and fungible instruments.