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November 2010 Investment Journal 

November was a truly momentous "news" month for investors, and there is a lot to write about. The US election and resumption of Quantitative Easing by the Fed were defining moments for the markets early on, followed by the debt-induced capitulation of Ireland to its proposed new monetary masters in the EU and at the IMF. In Asia, governments led by China began implementing measures to cool inflation, which is being driven by large inflows of foreign capital.

Performance wise, US stocks were flat for the month, while long Treasuries slipped 2.00%. Gold was up a modest 2.7% in November, but continues its' year to date run for the roses with a 27% overall gain.

The US election results clearly demonstrated a desire for more fiscal restraint, but the proof, as they say, is in the pudding. There is a whole punch list of must-fix short term problems to address in December (for investors, chief among them are tax rates and the AMT, and estate tax guidelines), so we're certain to see some reaction by the markets to whatever compromise comes out of DC.

The US Fed met during the November election and issued their latest pronouncement the next day, which was primarily a confirmation that they indeed would be launching a new round of bond buying. With that clarity, a torrent of analyses were issued. In all the post-mortem QE II discussion, we believe two points stand out. First, the Fed is seeking to raise the value of the stock market to make consumers feel wealthier (the "wealth effect"), and therefore spend and borrow more. (Bernanke said so himself, in an astonishing Op-Ed defense of the Fed's actions published the next day in the Washington Post): 

Second, they are determined to drive down interest rates to encourage lending, although the evidence suggests they are "pushing on a string".

There are numerous problems with both of these goals, and not many good options. Perhaps the most important is that the new fiscal hawks in Congress are going to restrain spending, so this "new" stimulus coming from the Fed is going to be completely offset by cuts (or, more accurately, restrained further increases). Maybe earnings will increase to support higher stock prices, but many of the new dollars being pumped by the Fed into the markets are heading immediately for overseas destinations, or into oil, gold, agricultural commodities etc. It doesn't do much for the real economy, and, at the same time, it increases costs for everyday (mostly imported) items. $4.00 gasoline anyone?

With respect to interest rates, they are going to be targeting short to intermediate bond purchases/yields, which are already at rock bottom lows (the Five Year Treasury Note yields 1.25%). To lower interest rates which really impact the vast majority of consumers, they should be buying long term bonds at close to 4.00%, to drive them to 2%. (But then the banks which own the Fed wouldn't get to print profits from the carry-trade, whereby they borrow from the Fed at near 0% and earn that 4% by investing the proceeds in long bonds, levered by an average of six-to-one. That's a 24% contribution to the top line, with no risk of loan payment delinquencies, impaired asset charges, and re-pricing risk. What's the line about not biting the hand that feeds?)

Secondly, even if rates were low enough to entice borrowers, consumers are in no mood to re-leverage, and the best use of funds might be just to buy all the underwater mortgages that will never be repaid. That, and a little tax and regulatory relief, might be the best prescription for re-starting the American economy.

Among the most vocal critics of the Fed's policies has been John Hussman, a noted fund manager and economist. His provocative take on the Fed's actions and the ongoing credit problems appeared in a November 15 website posting, whose main passage follows:

"From my perspective, an 'economic recovery' that requires a tripling in the Fed's balance sheet, continues to average 450,000 new unemployment claims weekly, and relies on fiscal stimulus to counter utterly stagnant personal income, is ipso facto (by the fact itself) not a 'standard' economic recovery. We have swept an enormous volume of bad debt under rugs, behind dams, and in back of curtains (not to mention in off-balance sheet vehicles such as Maiden Lane that were created by the Federal Reserve). But it is all effectively still there, festering. Meanwhile, our policy makers are trying to reignite financial bubbles in order to create an illusory 'wealth effect' to propagate spending patterns that were inappropriate in the first place.

It is a bizarre notion that a credit crisis can be solved by bailing out lenders while doing nothing about the obligations on the borrower side. Think about it - what we have said to lenders is, here you have these homeowners who can't pay for their houses. Foreclose on them, sell the homes at half the price, and the public will make you whole (largely through Treasury bailouts to Fannie and Freddie, made necessary by Federal Reserve purchases of these securities).

Heck, if the public is going to be on the hook anyway, at least notice that at equivalent cost to the public, the mortgage could simply be written down to half its value, with the homeowner now able to pay the balance off and the lender getting the public handout to make up the difference. But of course, that would reward the homeowner. So instead, we simply make the lenders whole while people lose their homes and foreclosure investors flip the homes at a profit in return for providing liquidity at the auction. That way, the same amount of public funds can be spent through the back door without Congress even getting involved.

Memo to Ben Bernanke - throwing money out of helicopters isn't monetary policy. It's fiscal policy. How is this not clear?

The proper way to deal with a major debt crisis - indeed, the only way nations have ever successfully dealt with major debt crises - is through debt-equity swaps, restructuring and write-downs. There are numerous ways to achieve this with mortgages. My preference would be swaps of principal for pooled property appreciation rights (administered, but not subsidized by the Treasury). In any event, until our policy makers wake up to the need to restructure debt, so that the obligation is modified for both the debtor and the creditor, our financial system will increasingly tend toward a giant Ponzi scheme. We are racing toward the financial equivalent of a mathematical singularity, where the quantities become so large and outcomes become so sensitive to small changes that the whole system becomes unstable."

We have long noted and remain concerned with Dr. Hussman about systemic risk, which is amplified by the use of derivatives trading. In a little noticed Bloomberg story this month, "the biggest Wall Street banks are pushing the U.S. Treasury Department to exclude foreign exchange derivatives from new regulations, a move that would leave a $42 trillion market largely outside of federal oversight":


What former IMF Economic Director Simon Johnson has called the "oligopoly of banks" continues unabated, with participants confident in their ability to "manage" risk off balance sheet in the largest, deepest, most active, complex and globally inter-connected market anywhere.

The G20 meeting in Korea in mid-month was preceded by a call by the World Bank to begin the debate on re-adopting gold as a global reference point, along with harmonized actions to address global imbalances. This marks a sea change in risk perception by global monetary authorities, and dovetails with our belief that currencies are the ultimate source of global financial risk. The World Bank "manifesto" can be read here:

The US position to "stop the austerity programs" and promote domestic growth and consumption fell on deaf ears in Seoul, as China, Germany, and everyone else who matters lambasted the US Fed for its monetary profligacy. According to most observers, never before has the US been "schooled" in such a fashion.

Meanwhile, bond yields rose significantly in November on "peripheral" Eurozone bonds, especially those of Ireland, forcing that country to accept a "bailout" from the EU and the IMF, under terms which are still being negotiated. (We have been cautioning investors for some time that the Euro credit crisis was not over, just quiescent pending further developments. As the Irish, like the Greeks, have discovered, there is more "fixing" to do than first projected.)

Over the weekend of November 20-21, Ireland requested "assistance" from its European partners, as deposits/capital quickly fled the likes of Anglo Irish and Allied Irish Banks. Ireland is effectively bankrupt, as its leaders in 2008 pledged the resources of the Country to backstop the loans of its banks, in one of history's most ill-advised blanket guarantees.

Throughout the prior week, Irish authorities vehemently denied the need for assistance. These tired and oft used chorus lines simply repeat the spectacle of turning tragedy into farce. (Three days after the Irish capitulation, the Portuguese PM said: "There is no relation between Ireland and Portugal". He'll be singing that line again until the modern day descendants of intrepid explorer Vasco da Gama take their turn sailing into Bankruptcy Harbor. That's another coming scene from Act Two, which will follow the Greek and Irish turns on center stage.)

The flagrant illegality of the assistance has been noted by many observers, who point out that the "TARP" fund set up for this purpose (called the EFSF - European Financial Stability Facility) by mandate can only be used to assist sovereign issuers. Ireland has enough money in the Treasury to last until next May, so the real story here is how the European banks (who hold a boatload of toxic Irish bank debt - which they willingly bought when times were good) succeeded in avoiding a "haircut" on their bonds and are asking the Irish people to pay for their mistakes. (Does anybody remember the European Stress Tests from just four months ago, when all the banks in Europe - including Ireland - were pronounced "healthy"?)

In short, the taxpayers of Ireland will be obligated to atone for the sins of their myopic government through harsh austerity measures and increased taxes for as far as the eye can see. This is much more than a financial markets story, as the Irish government will probably fall, and social unrest will force the new government to reconsider the harsh terms imposed upon their people. The debts themselves will have to be negotiated down to terms more bearable (50 cents on the dollar anyone?) or repudiated altogether, as Ireland might then withdraw from the Eurozone (especially if they are forced to renege on their prized possession, an ultra-low 12.5% corporate tax rate.) By almost all accounts, there is simply no way for Ireland to "grow" its way back to health, and it is likely that this "debt trap" scenario will be lurching its way from stage to stage around the global financial theatre circuit for a while.

This extra-lengthy journal could not close without directing our readers to perhaps the most important speech ever given on the modern global economy by a sitting US Federal Reserve Chairman. Ben Bernanke addressed the annual European Central Banking Conference in Frankfurt Germany on November 19th, and laid out the case for taking it to the Chinese and other emerging markets for continuing to pursue self-centered and unbalanced policies. Regardless of whether or not you agree with him, it is a must read for anyone interested in the global economy (our take is summarized below):

Bennie B points out that the global recovery has really been a "two-speed" phenomena, with lesser developed countries resuming a healthy growth profile while the US and others lag. While briefly explaining QE II and urging a return to more sane fiscal policies by Congress, the real dig is at China and others, who have perpetuated "incomplete adjustment of (foreign) exchange rates" - i.e. deliberate suppression of their currencies through "intervention", thus creating unfair advantage to their economies. BB argues that private capital flows are being distorted by the unnecessary accumulation of reserves in emerging economies, naming China as the chief culprit. He argues that it is in global self-interest for currencies to find a natural equilibrium, lecturing China that "the benefits of shifting productive resources to satisfying domestic needs must outweigh the development benefits of continued reliance on export-led growth."

He effectively says that the US will no longer tolerate activities that damage our ability to export (i.e. currency suppression). This trigger point has been reached due to deeply imbedded "structural" unemployment in the US. and the need to regain jobs that were long again exported overseas. (Minutes from November reveal that the Fed downgraded yet again their outlook for US employment prospects.) Our read is that the reserves that China holds in the form of US Treasury Notes (and is the "ammunition" they have to intervene in the currency markets) will be impaired through US Dollar devaluation if they don't allow the Renmimbi to rise. The "game of chicken" continues.

More troubling than the China threat is BB's reference to the need for a supra-national monetary policy: "It would be desirable for the global community to devise an international monetary system that more consistently aligns the interests of individual countries with the interests of the global economy as a whole." While we have long known of ongoing cooperation among global central banks, this sounds to us like the first public call for merger (we might all be singing the same song soon -- "Bennie and the Jets"!)

In notable equity market news, the big story for us was Cisco Systems (CSCO) reporting a big "miss" in earnings on Nov. 15. They attributed the turmoil to an abrupt fall-off in orders from state and local government. Where there's smoke there's fire? It could be an early warning sign that others who depend on the local public sector may come up short. With the change in the electoral make-up of many state houses (including here in NC, which went Republican for the first time since the late 1800's), it would not be hard to envision a clampdown in spending of all sorts coming.

Thank you for reading our Journal. We'll be publishing our Annual Review of Markets next in mid-January 2011.
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