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Thursday, 30 September 2010

Five Hidden Costs of Gold

by Jeff Reeves

Commentary: Investing in gold isn't as easy as it looks

There's a lot of talk right now about how gold is booming, and how gold bugs who have been stashing bullion under their mattresses over the last decade or so have made a killing.

That may be true if you look at the price of the yellow stuff per ounce. The price of an ounce of gold is up about 30% in the last year, or over 400% in the last 10 years. How does that relate to actual returns for investors?

The truth is that gold has steep hidden costs, and that looking at the numbers on paper doesn't tell the whole story. Here are big costs many investors overlook.

Higher taxes

The affinity for gold investing and a dislike of the government seem to go hand in hand, from predictions that massive government debt will render the dollar worthless to conspiracy theories that there will be another Executive Order 6102 in which Uncle Sam loots your safe deposit box and seizes your gold.

But the biggest reason for gold investors to get mad at the feds is their tax bracket. The IRS taxes precious metal investments — including gold ETFs like the SPDR Gold Trust (NYSE: GLD - News) and iShares Silver Trust (SLV - News) — as collectibles. That means a long-term capital gains tax of 28% compared with 15% for equities (20% if and when the Bush tax cuts expire next year).

While you may see your gold as a bunker investment, the IRS will treat you the same as if you were hoarding Hummel figurines. And that means a bigger portion of your gold profits go to the tax man.

Zero income

Just as the math game on gold price appreciation doesn't tell the whole story, the lack of regular payouts is another reason why the long-term profits quoted in gold are incomplete. Many long-term investors can't afford to stash their savings in the back yard for 20 years. Income is a very valuable feature of many investments and gold simply doesn't provide that.

Remember, simply looking at returns in a vacuum can't tell you whether an investment is "good" or "bad." Is it a good idea for a 70-year-old retiree on a fixed income to bet on penny stocks because they could generate huge profits? Even if those trades pay off, 99 out of 100 advisers would say something akin to "You got lucky this time, but don't tempt fate. Quit while you're ahead and don't be so aggressive."

Similarly, the volatile and income-starved gold market is not a place for everyone. Just because past returns for gold have been so stellar, that does not mean that gold is low risk or that investors who need a secure source of regular income will be well-served.

Gold scams take a toll

In a previous article, I detailed gold coin scams in detail. They include false gradings on the quality of the coins, the use of cheaper alloys instead of pure gold and even brazen scams where you don't actually even own the gold that you buy. And that's just on the coins front. Scams abound in pawn shops and "cash for gold" enterprises that refuse to give you a true value for your jewelry or other gold items.

You'd think it would be obvious that precious metals should never be purchased from anyone other than a broker or seller of good repute who provides proper documentations. But many investors fail to do their homework, or worse, can't tell forged documents from real ones.

Gold is ready-made to be a retail sales item, and with that comes all manner of unscrupulous activity. Vigilant investors can protect themselves, but do not underestimate the very real price of being taken to the cleaners by a gold scam if you don't do your homework.

High ownership and storage costs

Maybe through some creative accounting or selective amnesia at tax time you can mitigate the tax burden of gold. But one expense you can't as easily avoid is the high ownership cost of gold. After all, it's not like you mined it yourself — and all those middlemen between the ore and you want to get paid.

The first is that old tightwad Uncle Sam again. Even if you can avoid him going on the capital gains front, he gets you coming into gold via sales tax on most jewelry and coins. And then there are the high transaction costs and commissions that gold can carry. Anyone who has bought jewelry knows significant markups are part of the precious metals trade, and that's the same for investment gold as it is for engagement rings. The bottom line is that some of your initial buy-in goes towards the business of gold and you'll never get it back, not unlike realtor fees or broker fees.

And then there's the additional cost of storing your gold. You have to pay a fee for a safe deposit box, and if you have a lot of gold, that can run you a few hundred bucks a year for a good-sized box. Of course if you're afraid of that Order 6102 scam pulled by FDR you likely have your gold at home in a safe — so that's a one-shot deal. But are you really foolish enough to distrust the government but trust your gold stash to be safe without insurance?

The presumed "safety" of gold is good on paper, but obtaining the actual metal and keeping it safely stored is a costly endeavor.

Yes, gold can lose value

Proponents of gold love to claim that gold has never been worthless like Lehman Bros. or GM. And while this is true on its face, it is actually a half-truth. While gold may never become worthless, it is foolish to think it will never lose value.

Consider that after reaching a record high of $850 per ounce in early 1980, gold plummeted 40% in two months. The average price for gold in 1981 fell to a mere $460 an ounce — and continued nearly unabated until bottoming with an average price of around $280 in 2000. For those folks in their 40s and 50s who bought gold at that 1980 high, it took them 28 years to reclaim the $850 level. That's hardly much of a retirement plan, unless they lived to be 80 or 90 and just cashed out recently.

Gold is an investment, period. And no matter how gold bugs spin the metal as a hedge against inflation and a sure thing that will only go up, gold can lose its value — sometimes in a hurry, as in the early 1980s.

Jeff Reeves is the editor of Follow him on Twitter at

Business Lessons of "The Social Network"

The Social Network, which opens on Friday, is a clever drama about the early days of Facebook. This fast-paced quasi-courtroom romp, deftly directed by Se7en and Fight Club helmer David Fincher, will probably become the de facto legend of Facebook, because it's just so darn enjoyable.

But you'd also do well to watch it with an investor's eye, ready to absorb valuable lessons about how to ruin an e-business startup.

Like what?
The movie is packed with business-related detail, starting with Facebook founder Mark Zuckerberg's complete lack of entrepreneurial instinct. Without a more revenue-oriented cofounder in early-days CFO Eduardo Severin, the whole project would have faltered long before it became the global icon of online interaction that we see today. That phase was followed by angel investors, and then seed funding -- and then came the lawsuits that frame the entire film.

By watching The Social Network, you can learn at least a little about:

* Venture capital financing: Zuckerberg and Severin bump heads and shake hands with noted PayPal billionaire Peter Thiel and others. The scene takes place in 2003, just after Thiel became filthy rich by selling PayPal to eBay (Nasdaq: EBAY - News) and was hungry for new investment opportunities.
* Startup culture: The Facebook team goes through extremes of low funding, big ideas, and constant challenges at a dizzying pace. At one point, Zuckerberg recruits programmers through a drinking game, which is not something you'll see at any large and established corporation.
* Backstabbing and the lawsuits that follow: This is the heart of the movie and the human takeaway: Success will quickly turn your friends against you. Be prepared.
* Viral marketing: From scene one, Zuckerberg displays a stunning understanding of how to create, grow, and then keep an online audience. Make it cool, get your users to involve their friends, and never accept service outages.
* Network security, and the consequences of its absence: If Harvard's network had been properly hardened in 2003, Facebook and its predecessors wouldn't have existed today. A little bit of hacking can collect a lot of information very quickly.
* Why Silicon Valley still attracts technology startups: It's where you go to meet the smart money mentioned earlier.

A lot of this should interest you if you invest in Valley darlings and online phenoms such as, say, Google (Nasdaq: GOOG - News) or eBay. You'll be better equipped to understand the business environment these companies work in after watching this movie, and the marketing lessons may even make you a better eBay seller and AdWords marketer. In addition, there's always the chance of Facebook going public itself one of these days.

Colored by filters
Mind you, all of these lessons passed through several individual perspectives before they reached the screen. Director Fincher and all-star screenplay scribe Aaron Sorkin (The West Wing, A Few Good Men) surely added their own touches to a book by Ben Mezrich, who never worked for Facebook or attended Harvard. Mezrich's main source and consultant was Severin, who unsurprisingly comes across as a hapless victim in the movie. You want the truth? You can't handle the truth! Or at least, you'll have to accept a version of the truth with any project like this.

Distributor Sony (NYSE: SNE - News) is clearly hoping for a viral hit of Facebookian proportions, since its slate of releases this year has been rather uninspiring. But the marketing has been minimal and not always clear on what the movie is about. None of the trailers convey the courtroom drama feel I got out of the movie, and Sony would have been wise to play up a captivating performance by pop star Justin Timberlake as Napster co-founder and later Facebook investor Sean Parker. In other words, don't buy Sony stock just to capitalize on a runaway hit here -- I don't think that's in the cards.

Some critics compare The Social Network to Citizen Kane with a straight face, and one of my peers at last night's press screening enthused that this was Fincher's finest work yet. Me, I prefer Fight Club, but I'd watch this one again just to reabsorb the business lessons.

Will this movie flop or fly? Discuss in the comments below.

Fool contributor Anders Bylund holds no position in any of the companies discussed here. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. Google is a Motley Fool Inside Value selection. Google is a Motley Fool Rule Breakers recommendation. eBay is a Motley Fool Stock Advisor selection. Motley Fool Options has recommended a bull call spread position on eBay. The Fool owns shares of Google. The Motley Fool is investors writing for investors.

Wednesday, 29 September 2010

The Other Side of Irrational Exuberance

by Stan Blacker

Those of us who make their living in the mortgage and real estate business are used to business cycles. Although the last few years have been worse than any other period since the Great Depression, we're only experiencing the other side of the curve created by the appropriately titled "irrational exuberance" era.

In retrospect, exuberance is not a strong enough word for the culpable actions of the parties that fueled the bubble until it burst. However, this is not another rant about who to point the finger at or which direction the next knock-out blow is coming from. While the real culprits in every Ponzi scheme (or, "bubble") are the sales people who generate the new suckers ("investors"), it's always a handful of loud Armageddon types who make a name for themselves by getting their clients out in time.

But when it comes to housing -- once referred to not long ago as the engine of the economy -- those making the right call this time will be me and anyone else who tells you just how robust our recovery will be once it starts.

Our company operates in Florida, where home prices doubled in less than a three-year period and just a few years later 50% of homeowners owe more than what their homes are worth. So how can I predict that when the inevitable home sales recovery cycle begins, it won't be a barely perceptible flat curve no one will notice until years later? It's actually quite simple.

Housing, like any sector, is based on supply and demand. There's just too much pent-up demand not to expect a flood of home purchases once people perceive we've reached the bottom as far as home prices are concerned. Unfortunately, no one can be sure when that will occur. We will be sure, however, that a sustained bottom has been reached once the perception -- not the fundamentals -- changes, i.e. when Mr. Case, Mr. Schiller and others like them say so. And just like that, it will be, as they say, "Katie, bar the door ...."

Change will be immediate. More renters will become buyers. Kids grow up and become first-time home buyers every year (but less lately). Baby boomers reaching retirement will buy homes in Florida again or second homes. Sure, they won't all buy in Florida. There are certainly enough boomers to go around. And housing stimulates a lot of other sectors like construction, retail, finance and other services that will help add jobs.

Better employment numbers are key to any recovery, but they will also ease the traditional rate of household movement around the country. This number -- based off of natural migrations due to job opportunities in growth areas or joining other family members who previously relocated -- has dropped to record lows in the last few years. Now add all the move-up buyers who make up a large portion of home sales whose plans have all been on hold due to the declining markets. Move-up buyers are previous first-time home buyers who have grown out of their initial purchase or homeowners looking to upgrade.

This group has been reluctant to buy because they know if they wait they'll get a better deal. Why would anyone ready, willing and able to move up make that move if they thought they could pay another 10% or 5% or even 3% less by holding off a little longer? Their decision to wait is validated by the constant media attention to foreclosures, short sales and doomsday predictions. So they wait. And the pent-up demand keeps building, albeit under the surface.

Last week, we received news of the ultimate guarantee that we Floridians will have another boom in our colorful economic history, long characterized by booms and busts. (You'd think the meltdown the country just endured would result in real reform that will lessen the pendulum swings next time, but that's a story for a different day.) Last week, a University of Florida study indicating population growth of almost 20% by 2020 was released. Last year, the Armageddon folks had a field day with the news that for the first time, more people moved out of Florida than moved in. The news of an increase this year, although small, and the 2020 projections, was greeted with mixed reaction -- some encouragement but little solace to the downtrodden.

But there's one obvious conclusion that bodes well for all sectors of our economy -- all those people will need places to live.

The sheer numbers we're talking about in terms of first-time home buyers, boomers, mover-uppers and general migration will drive up the number of transactions and eventually prices as well. As in every cycle, we'll move from a buyer's market to a seller's market -- it's inevitable.

The government and the powers that be are keeping interest rates low enough for everyone who can qualify to refinance their mortgage -- and we're busy because of it. But I think we're going to be a lot busier when the market turns. And it'll be a flood, not a trickle.

Stan Blacker is president of Mortgage Resource Partners in Clearwater, Florida.

5 Things Your Broker Won't Tell You

Adam Bold

You might have an investment advisor or broker who has established a plan that will put you on the right track to meet your goals. Still, you should be aware of some important factors that could affect your financial plan. For those of you searching for an advisor or broker now, these points are key to understanding how their business works and how they can affect your money.

1. Each time your broker or financial advisor sells you investments from XYZ Co., it may pay him or her a commission for using its products.

Many financial advisors accept extra compensation from companies in exchange for selling their investment products. Sometimes, advisors use products exclusively from one company. The extra compensation can include everything from golf balls to trips to exotic locations. It may also include expense-paid client events and due-diligence meetings. Is this in the best interest of investors? No--and it doesn't matter if the compensation is disclosed.

Some investment companies even pay "shelf-space" fees to advisors, which means advisors and firms accept compensation simply for making the paying firms' products available for their clients' accounts instead of using independent research to determine the best investment products. While disclosure of shelf-space fees is required in a prospectus, that doesn't justify the practice of paying or accepting these fees.

Before buying an investment, ask your broker or advisor if he receives a commission or other benefits for recommending that product.

2. After a broker-dealer sells investments to you, he has no legal obligation to monitor them.

Studies have shown that many investors, even experienced ones, aren't able to distinguish the difference in services available from a broker-dealer (registered representatives) and Registered Investment Adviser (investment advisors).

Both registered reps and investment advisors have a legal responsibility to make sure the investments they sell are appropriate at the time of purchase. For the broker-dealer, the legal obligation applies only at the moment of the transaction. For the investment advisor, however, the responsibility is in place every day the client owns the investment and remains a client of the firm.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (see more here and here) that was passed in July 2010 gives the Securities and Exchange Commission (Toronto: SEC.TO - News) the authority, but does not require it, to impose a fiduciary duty on brokers, which means the advice must be in the best interest of investors. However, a broker is still not required to monitor your investments.

3. A broker sells investments you may not need; they might not fit your investment plan.

Many investors end up with a random collection of investments rather than a strategic allocation of assets. I get countless calls on The Mutual Fund Show from people who tell me they're ready to retire and their advisor wants to sell them a variable annuity. They get no road map or investment plan for getting them to retirement--or through the rest of their retirement. They may get some information on the benefits of the annuity, but they're not getting a full explanation of the potential pitfalls.

Do some research on your own before purchasing an investment product to make sure it fits in your financial plan and will help you reach your goals.

4. Your broker has no particular expertise in investment products.

When I worked at one of the national brokerage houses early in my career, each rep sold everything, including mutual funds, municipal bonds, stocks, commodities, etc. Most brokers did not have a particular expertise, and they weren't concerned with how much they knew about the product they were selling. Their primary concern was meeting a quota. The sales pitch was often more important than the merits of the investment.

When advisors earn any designation, they're required to take continuing education and agree to adhere to a code of ethics. They're like doctors who practice in certain areas of medicine as opposed to a general practitioner. Would you want your family M.D. to operate on your heart?

Check your advisor's credentials and ask him which products he knows best. For example, mutual fund investors can look for one of two designations--Chartered Mutual Fund Counselor (Other OTC: CMFC.PK - News) or Certified Fund Specialist (AMEX: CFS - News)--indicating advisors have taken extra training and education in all areas related to mutual funds.

5. Your broker is allowed to sell only certain securities or products, so that's what he'll recommend.

It makes sense that registered representatives sell only what they're licensed to sell. I wouldn't buy life insurance from anyone who isn't licensed to sell it. What doesn't make sense is when someone licensed only to sell insurance recommends an insurance product such as a variable annuity to someone who wouldn't benefit from it.

Along the same lines, an advisor with XYZ Fund Company, for example, understandably is going to sell only proprietary products. It wouldn't be in XYZ's best interests if its advisors were selling investments from competitors. I understand that. But that doesn't mean it's in their clients' best interests.

If your broker is not familiar with a product you're interested in, ask for a referral for someone who knows the product inside and out and how it could affect your financial plan. Every investor wants the choice of the best, most appropriate investments that will help them achieve their financial goals.

No Irrational Exuberance

by Mark Hulbert

Most advisers continue to doubt rally, which is a good sign

There continues to be a strong wall of worry for the market to climb.

Consider the average recommended domestic equity exposure among a subset of the shortest-term stock market timers monitored by the Hulbert Financial Digest (as measured by the Hulbert Stock Newsletter Sentiment Index, or HSNSI). This average currently stands at 22.1%, which means that the average short-term market timer is recommending that his clients allocate more than three-quarters of their equity portfolios to cash.

This 22.1% equity allocation is surprisingly low, given the stock market's strength in recent weeks, and suggests that there is widespread skepticism towards the rally. And that's good news, on the contrarian grounds that the majority is usually wrong about the market's direction.

Early last May, for example, was the last time before now that the Dow Jones Industrial Average was trading above the 10,800 level. And yet the HSNSI then was more than double where it is today -- 51.8%.

So one way of characterizing the net effect of the stock market's gyrations since early May is that it has wrung a lot of bullish sentiment out of the market.

This reminds me of an analogy that some contrarians are fond of using: A bull market can be thought of as a bucking bronco in a rodeo, trying its darnedest to throw everyone off its back on the way to the other side of the ring. Clearly, this bull market is doing a pretty good job of doing exactly that.

To be sure, there is no guarantee that this market will continue higher, just because it has thrown a lot of over eager bulls off its back. Sentiment is not the only factor that influences the market's direction, needless to say.

And even if contrarian analysis turns out to be right in its current analysis, its bullishness is strictly short term. My statistical analysis of the HSNSI shows it to have maximum forecasting power over periods of between just one and three months. It tells you nothing about where the market will be in, say, a year's time.

But, with these qualifications firmly in mind, it is definitely good news that there is a strong wall of worry out there.

You Should Have Timed the Market

by Brett Arends

Everybody knows the last decade on Wall Street was a poor one for investors.

Turns out it was even worse than we thought.

A remarkable new study from TrimTabs Investment Research shows that regular investors needlessly lost billions more than they should have on the stock market. Why? It's the old story: They invested more money in their equity mutual funds during the booms ... and then sold them during the panics.

So even though Wall Street overall ended the decade pretty much level (when you include dividends), average investors lost a bundle. TrimTabs puts the losses at $39 billion. It calculates that mutual fund investors bought into the Standard & Poor's 500-stock index at an average of 1,434. That's close to its record high of 1,565. If investors had invested at random times instead, their average purchase price would have been 1,171.

"It cost them about 20% to buy high and sell low," says TrimTabs' Vincent Deluard.

So even though the stock market today is around its 10-year average, TrimTabs reckons most of those who invested during the decade are actually sitting on hefty losses.

What does this dismal news mean for you, the investor, now?

Oddly enough, it means almost exactly the opposite of what Wall Street is going to tell you it means. The Wall Street crowd will say, as usual: "See, you can't time the market! Just like we told you! So just give us all your money, and just go with the flow."

That this line happens to serve the economic interests of Wall Street is, of course, a pure coincidence. Yet the TrimTabs numbers show, instead, that over the past decade it was actually quite easy to time the market. All you had to do was buy when the public was selling, and sell when the public was buying.

Naturally, going against the crowd is easier said than done. That's why the best professional investors like to say that successful investing is "simple, but it isn't easy."

Human beings are hard-wired to run with the herd. For millions of years, when the herd stampeded, the smartest move wasn't the hang around and wait to see why. It was to run.

And that's how they act on the stock market as well. But when it comes to investing, it's a bad idea. Your feelings are a bad guide. And there is no safety in numbers.

I am frequently surprised at how many people still give in to their instincts in these matters. During the housing boom, anything I wrote questioning house prices automatically drew scathing reactions. Today anything I write that is positive about buying a home draws a similar response. (I'll confess this alone makes me feel bullish.)

At the depths of the stock market lows, early last year, I pointed out that even rock-solid blue chips were being sold off cheaply: My email box filled up with people telling me I was an idiot, that Kellogg (then $38, now $51) (NYSE: K - News) or Procter & Gamble (then $47, now $61) (NYSE: PG - News) or Kraft Foods (then $22, now $31) (NYSE: KFT - News) were doomed along with everything else.

But as the TrimTabs research reveals, our feelings are terrible guides in these matters. Even during a flat decade, people could make money just by going against the herd. They didn't need to know anything else. They didn't need quantitative models, astrophysics Ph.D.s from M.I.T., inside information or privileged access. All that money spent on equity research? All you had to do was look at the latest numbers from the Investment Company Institute, showing whether the public was putting money into their stock-market funds or taking it out. And then do the opposite.

Last week I was in London, visiting one of the best investors I have ever known. Peter handles money on behalf of a small number of rich clients.

He shuns publicity (and requests that I don't mention his last name). He's been managing money for 40 years. Ten years ago he told me to sell the Nasdaq and buy gold.

Over dinner, as he reflected on a long career, he told me that as he has gotten older he has learned that good investing is even simpler than he used to think. He has abandoned most of the sophisticated tricks he tried to use as a young man. He sticks to value, and he runs against the herd.

Right now? He likes some blue-chip stocks, as they are reasonably cheap and no one else seems to be interested in them. He's avoiding fashionable emerging markets. And he's been quietly building a position in Japan. Why? "Everybody hates it," he says. "Twenty-year bear market. It's cheap. And your typical fund manager would rather suck a lemon than invest in Japan."

Most people's reaction to this is probably to shrug and forget about it. Japan is so over, after all. Why would you want to invest in Japan? Nobody wants Japan.

GIC economists upbeat

ECONOMISTS at the Government of Singapore Investment Corp (GIC) are upbeat about global economic growth this year - especially for Asia. They believe global growth will average 3.8 per cent, as advanced economies advance a more modest 2.4 per cent. However, emerging Asia will lead the world, charging ahead by a much faster 8 per cent, economists at the sovereign wealth fund expect.

The forecasts were outlined by GIC group chief investment officer Ng Kok Song, speaking at a conference on private wealth management on Wednesday. GIC sees more rewarding emerging market opportunities in private asset classes including real estate and private equities, he said.

Publicly listed equities, however, are 'likely to remain GIC's main implementation vehicle for our emerging markets' strategy', he said at the conference organised by the CFA Institute and held at the Raffles City Convention Centre.

According to Bloomberg, Mr Ng said on the sidelines of the event that GIC aims to lift the proportion of investments in public equities and private assets in emerging markets from about 12 to 13 per cent at the end of March this year to the 'high teens' over time. As at March 31, GIC's exposure to emerging market public equities was 10 per cent or one-fifth of its global public equity holdings.

GIC's economists expect Asia to contribute 50 per cent of global growth this year, even though its share of global economic output is 34 per cent, said Mr Ng. China's contribution to global growth will be 26 per cent, he said, and India's, 10 per cent. 'Without doubt, we are witnessing a shift in economic influence of seismic proportions,' he said.

GIC's strategy to focus more on emerging markets strategy was announced earlier this week when the fund released its annual report which showed the 20-year nominal annual rate of return in US dollar terms jumped from 5.7 per cent to 7.1 per cent for the 12 months to March 31.

Friday, 24 September 2010

No, Buy-And-Hold Is Not Dead, Says Tongue--It's Just Sleeping

After more than a decade in which stocks have gone nowhere but down, investors can be forgiven for asking whether the money-making mantra of the 1990s, "buy and hold," is dead.

No, it isn't, says Glenn Tongue, a general partner at Tilson Mutual Funds. It's just that, if you're buying on price, you have to have a different time frame than traders who are gauging "momentum" or "sentiment" and other factors that drive the market's movements over the short term. Specifically, you have to be willing to wait years for stocks to gravitate toward their fair value.

This fair value, by the way, can be above or below the current market price. "Buy and hold," in other words, works the same way when you're betting overpriced stocks will drop: You may be right, but you may also be waiting a while.

In the late 1990s, stocks were extremely expensive on a number of measures, including the price-earnings ratio. These high prices suggested that the market would perform poorly over the next decade, and indeed it did. But predicting the enormous up and down moves in the interim was a different business altogether.

Right now, Tongue says, the market as a whole may not be attractively priced, but many individual stocks are ideal for buy-and-hold investors. Tongue cites Microsoft (MSFT), BP (BP) and Johnson & Johnson (JNJ) as examples.

Thursday, 23 September 2010

Gold ETFs: Deciding What Makes Sense

by Tom Lydon

Gold, gold, gold.

Everyone covets it for one reason or another, millions are out buying it and even more people are talking about it.

Surging interest in the yellow metal is pushing it to new record prices. When prices reach these levels, the result is a bit of navel-gazing in the markets. Why is gold rising like it has been? And, perhaps more importantly, can it continue, or are we gearing up for a spectacular selloff?

A few of the fundamental reasons gold prices are going up and away include:

• International buying. Central banks around the world have been loading up on gold. The International Monetary Fund (IMF) recently sold $403 million to Bangladesh, while China, France and other nations have stocked up.

• Sheer momentum. Gold is expected to gain for the 10th consecutive year as loose monetary policies have flooded the markets with cash.

• Safety. Discussion of quantitative easing from the Fed coupled with lingering concerns about the eurozone still have investors turning to gold for its value as a safe haven.

• Jewelry. It's festival season in India, the world's largest gold consumer. This period in the country drives demand for gold jewelry. Look out, though -- higher gold prices this year could scare some buyers off.

• ETFs. Some observers also believe that the greater interest in gold and silver markets is a direct result of ETFs. The World Gold Council said gold demand grew 414% in the second quarter, and this is largely attributable to ETF demand.

If you're among the investors looking to get a little gold exposure, consider ETFs. Why would you own a gold ETF instead of actual gold? Simply put, it's more convenient.

Owning a gold-focused ETF is a good way to get physical exposure to the metal without the hassle of taking physical possession -- finding storage, paying for storage and so on. Each share of a physically backed gold ETF is just that -- it's backed by 1/10th of a bar of gold.

This gold is stored in secure vaults in London and Switzerland, and the holdings within are audited and inspected on a regular basis. Some investors aren't comfortable with this, and as stated above, if you're not, then gold ETFs may not be the right choice for you.

You have three options to invest in physically backed gold ETFs:

SPDR Gold Shares (NYSE: GLD - News)

iShares COMEX Gold (NYSE: IAU - News)

ETFS Physical Swiss Gold Shares (NYSE: SGOL - News)

The differences between the three come down to both where the gold is held and the expense ratio of each of the funds. After recently slashing its costs, IAU is the cheapest, with a 0.25% expense ratio. GLD and SGOL have a 0.40% and 0.39% expense ratio, respectively. SGOL stores its gold in Swiss vaults, while GLD and IAU have their gold stored in London.

The catch with physical gold ETFs is that long-term capital gains are taxed as collectibles -- a whopping 28%.

If physically backed gold ETFs aren't your style, there are also equity funds that hold miners' stock.

Market Vectors Gold Miners (NYSE: GDX - News) and Market Vectors Junior Gold Miners (NYSE: GDXJ - News) are the two gold miner pure play options available.

The catch with gold miner funds is that they don't track the spot price of gold, so you shouldn't expect them to replicate the metal's performance. Their benefits may outweigh that fact in the current climate.

Both hold the stocks of mining companies. Gold mining corporations held in these funds tend to perform better when the price of gold is elevated, which was demonstrated during the second-quarter earnings season when many of the major players in gold mining reported soaring profits.

However you choose to get your gold exposure, be alert to any signs of a selloff, and have an exit strategy at the ready to avoid getting burned on the downside.

'Money Never Sleeps' Is No Snooze

by David Weidner

Commentary: Gordon Gekko's return is worth the wait

"I'll make you a deal," Michael Douglas's Gordon Gekko says to a rival who is equal parts Lloyd Blankfein and Jamie Dimon. "You quit telling lies about me and I'll quit telling the truth about you."

And with that, "Wall Street: Money Never Sleeps," which opens Friday, rolls into full gear. The follow up to "Wall Street," the 1987 movie that cemented Gekko as Hollywood's symbol of Wall Street excess and greed, is a fun romp. It's also director Oliver Stone's best movie in years.

I'll spare you the cinematic critique and stick to the issues. Suffice it to say this isn't "Citizen Kane."

Wall Street the sequel is preposterous in that it tries to stick closely to the events that shaped the financial crisis. Truth is stranger than fiction and the movie both suffers and gets its poignancy from the facts.

(Note: The movie is produced by Fox which is owned by News Corp., which also owns MarketWatch.)

Telling the truth is a central theme in the movie and in an industry where veracity is always in question. The volume of lies is a matter of perspective. Some financial pros who viewed the film see it as populist outrage. To them, the movie is a lie. Others will see the one-dimensional self-interest that pervades the movie's characters as validation of their suspicions.

Suffice it to say that those of us who work on or follow Wall Street for a living, will scoff at some scenes. A Wall Street chief executive, no matter how rattled, isn't going to throw a painting worth millions across a room, and none would have the guts to commit suicide when their firm goes belly-up. Not too many Fordham grads break into fluent Mandarin when dealing with Chinese investors.

The movie is full of these sort of reality-stretching spectacles. It's the kind of stuff bankers may say undermine the film's accuracy. But they're Stone's equivalent of car chases designed too keep the audience's interest.

Despite its embellishments and its too frequent shots of the Manhattan skyline, "Money Never Sleeps" finds Stone at his story-telling best. The movie begins with Gekko exiting prison. He's broke and no one comes to pick him up. The story then shifts to Jake Moore (Shia LaBeouf) a young trader who is dating Gekko's daughter.

Gekko writes a book and begins warning the financial industry about its practices. Moore's firm pays him an early bonus as it is about to go under -- it's at once a fictional Lehman Brothers and Bear Stearns.

Moore goes to see Gekko speak and is wowed. He seeks a relationship with this legend without telling Gekko's daughter. A deal is made. Gekko will help Moore avenge his company's failure -- blamed on a rival bank -- and Moore will help Gekko get back into his daughter's life.

It's a brilliant conceit that's been concocted by screenwriters Allan Loeb and Stephen Schiff. Like the first film, the push and pull of what's important in life -- money, family, trust -- are evoked. And like the first film, today's pressing issue of government intervention and the "moral hazard" that comes with it are probed.

Douglas's Gekko is at the center of all this and at even more than two hours we don't get enough of him. Gekko, we find, isn't really interested in rebuilding his relationship with his daughter -- something Winnie Gekko sees coming: "he'll hurt us," she says, before she's sucked in through Jake. You can guess what he is interested in.

Despite its look-ins on New York Federal Reserve meetings and use of CNBC footage, "Money Never Sleeps" isn't an accurate depiction of the financial crisis or its players. It's a cartoon. Exaggeration is Stone's device. His fans love it. Others find it irritating.

Josh Brolin, who plays that rival CEO, is so devilish one half expects him to jab poor Jake with a pitchfork. Winnie Gekko's dream of cold fusion energy is so naive and dreamy she seems to have just walked off a Disney lot after playing a princess.

And the ending? A little too neat, too happy, redemption that comes too easy. Again, this is Hollywood. If you're interested in realism, "Inside Job" the documentary directed by Charles Ferguson, opens Oct. 8. I'll be writing about that next week.

But for all of its flaws, "Money Never Sleeps" delivers when it comes to asking the question "Is Greed Good?" which also happens to be the title of Gekko's book. The answer, in fiction as in real life, isn't yes or no. It's nuanced. It's also beside the point. As Gekko says in one of his more hammy lines "It was never about the money, it's about the game."

Games, like movies are for fun. And this one delivers.

Recovery Evident Mainly to Statisticians

by Randall W. Forsyth

Balance-sheet drags remain deterrent to economic rebound.

THE GREAT RECESSION IS OVER, and it's news because, except for the stock market, it's far from obvious.

The National Bureau of Economic Research Monday declared the recession that began in December 2007 ended in June 2009, making it the longest since the Great Depression. It also was the deepest, slashing gross domestic product by over 4%, nearly twice as much as the 1981-82 contraction, which had held the distinction of being the worst since the 1930s.

As the seasons change with the arrival of the autumnal equinox in the Northern Hemisphere, it's useful to think of economic cycles in the same way. The end of a recession may be likened to the winter solstice, the shortest day of the year; after that, the days get longer, but that's not apparent during the short, cold days of January.

As with the seasons, the springtime of recovery is nowhere in sight at recessions' end. But in past cycles, 30 months after the peak of economic activity (analogous to the summer solstice), the recovery was in bloom. We're still in the February of this recovery; past the low point but the sun remains low in the sky, occasionally shining but bringing little warmth.

This cycle is different because it was the result of a plunge in wealth, which is ongoing. According to the Federal Reserve's latest flow of funds data, households' wealth contracted by $1.5 trillion in the second quarter owing to the stock market's decline. More importantly, Americans' wealth remains nearly $10 trillion, or 15%, below the yearly peak reached in 2006.

A number of commentators have noted in the second quarter's data an increase in households' real estate assets, to $18.8 trillion from $18.7 trillion in the preceding quarter. Notwithstanding their skepticism, the rise is possible given the federal government's tax credit to qualifying home buyers that expired during the second quarter, which goosed prices and sales volumes temporarily.

Not noticed was the sharp upward revision in the Fed's tally of residential real estate values in the latest flow of funds report. The level of housing assets increased by some $4 trillion, retroactively back through 2009. That statistical revisionism no doubt is as gratifying to homeowners as the news that the recession ended last year is to the ranks of the unemployed.

Another revelation is that much of the reduction of Americans' liabilities—a bigger factor in the improvement in their balance sheets than growth in their assets—has been the rising tide of defaults.'s Real Time Economics blog put numbers to that observation () made here previously.

In this column late last year ("Middle Class Money Angst Visible in Dry Fed Data," Dec. 11), I contended the contraction in household debt in the third quarter of 2009 "wasn't just because of Jane and John Q. Public's pledge to get their financial houses in order after having tapped their houses as automatic teller machines. Their debt also was extinguished in the rising tide of mortgage defaults and home foreclosures, not exactly a wealth-enhancing trend."

Three months later, this trend was still apparent in the fourth-quarter report. At the time ("Middle Class Money Angst Still Apparent in Data," March 12), the second part of the headline explained: "Fed's Flow of Funds numbers again show average Americans' net worth gaining more by mortgage defaults than asset appreciation."

And three months ago, the same phenomenon continued ("No Champagne Wishes or Caviar Dreams," June 10) So-called strategic defaults—where homeowners determined it wasn't worth continuing to pay a mortgage worth more than the property—helped push foreclosures to a record at the time.

No respite is in sight, however. With foreclosures surging, spirits of homebuilders remain at rock bottom. The National Association of Home Builders/Wells Fargo reported Monday its confidence index remained at a cyclical nadir of 13. Index readings under 50 indicate conditions are poor. RealtyTrac reported last week that evictions under foreclosure were at a record in August.

Foreclosures may slow, albeit for non-economic reasons. GMAC Mortgage, a unit of recently rebranded Ally Bank (the one heavily advertised in commercials saying even kids know it's not fair to screw you, the customer) Monday said it halted foreclosures in 23 states for procedural reasons.

That doesn't change the doleful reality that, according to Institutional Risk Analytics, "we are less than one-quarter through the total corpus of bad loans and foreclosed properties in the U.S." Citing a presentation by Laurie Goodman of Amherst Securities, one-third of U.S. households have negative equity—owing more than the asset is worth—in their homes, which means one-fifth of them is vulnerable to foreclosure. So massive is the backlog of foreclosures that it takes 18-24 months from a borrower being in default and until they are evicted, according to Goodman.

IRA's Chris Whalen contends loan-to-value ratios in excess of 100% are less problematic that the loss of jobs by one or more of the breadwinners of the household. Whether it's the inability or unwillingness to pay that's more important, defaults and foreclosures have become so numerous that there's a backlog.

Regardless of the declaration of the end of the recession issued from some ivory tower, saying it won't make it so.

Wednesday, 22 September 2010

Why There's No Joy Over the Recession's End

Maybe we need a new definition of "recession."

It will come as no relief to the 15 million Americans who are unemployed, but a committee of august economists has finally declared that the recession is officially over. In fact, it ended more than a year ago. No, you didn't miss the celebration. There was none.

For all the drama of the last few years, the final act of the Great Recession was remarkably anticlimactic. A group of economists from the National Bureau of Economic Research, a private, nonprofit group, has finally decided that the recession ended in June 2009. That's the point at which economic activity stopped falling and began rising. Economists call this a "trough," since it's the low point at which the economy bottomed out. It took 15 months to know this for sure because the number-crunchers like to have a year's worth of data to analyze--and there's no hurry to make a determination that has little effect on the real economy.

Ordinarily, it might boost consumer spirits to have official confirmation that we're on the way back to prosperity. Yet even economists seem mystified by a "recovery" characterized by sky-high unemployment, falling incomes, record poverty, and an endless housing bust. In its recession-ending announcement, the NBER noted that hitting the trough in June 2009 wasn't exactly like making it to happy hour on Friday afternoon. It was more like the unidentifiable moment when you stop getting more drunk and start getting less drunk. "The committee did not conclude that economic conditions since that month have been favorable," the NBER explained, "or that the economy has returned to operating at normal capacity?. The trough marks the end of the declining phase and the start of the rising phase of the business cycle."

The problem now is that the rising phase has nearly stopped rising. After a year's worth of decent growth fueled by government stimulus spending, Federal Reserve maneuvers, and a rebounding stock market, the recovery has clearly stalled. Companies have stopped laying people off in droves, but are barely hiring. State and local governments, once robust employers, have been slashing their own payrolls as their budgets fall. The housing bust seems headed for a fifth miserable year, with sales tumbling following the end of government incentives and prices likely to follow downward. The stock market, in response to all the gloom, has sagged since April.

The NBER's pronouncement means that if the economy slips back into recession, it will officially be two back-to-back recessions, not a single prolonged one. To most people, the distinction makes little difference. Yet by dating the end of the recession, the NBER provides a better way of comparing today's economy with earlier periods--and guessing what might happen next.

Jobs usually take a while to return once a recession has officially ended, and this time obviously is no different. The surprising thing is that in one way, the job market today is bouncing back faster than it did after prior recessions. The total level of employment bottomed out in December 2009, according to the NBER--just six months after the recession ended. After the recession that ended in November 2001, it took 21 months for employment to drift down to its low point and turn upward again. That might signal that we're doing better now than during the "jobless recovery" that followed the 2001 recession.

The reason it doesn't feel that way is that the 2007-2009 recession was longer and deeper than prior downturns--and we now know how much longer and deeper. With an end date to the Great Recession, we know that it lasted 18 months. The average length of a recession since World War II has been 11 months, and the longest, before the one we just endured, was 16 months. Forecasting firm IHS Global Insight points out that the latest recession was also the most severe since World War II, with GDP falling 4.1 percent from its peak before the recession to the low point in 2009. We still haven't regained all that lost ground.

That makes the current "recovery" worse than the lowest moments of earlier recession. The current unemployment rate is 9.6 percent--a tenth of a point higher than in June 2009, when we hit that trough. When the 2001 recession ended, unemployment was just 5.5 percent. When the 1991 recession ended, unemployment was 6.8 percent. Compared with today, those troughs seem like mountaintops.

The question now is whether the economy will continue its slow improvement or sink back into another bout of recession, like it did in the early 1980s. Back then, a short recession gave way to a mirage recovery, followed by a longer recession. Overall, the economy was in recession for 22 months out of 35 between January 1980 and November 1982.

IHS pegs the risk of a double-dip recession this time at about 25 percent. Others think the odds are higher and a few argue that we're already in the second dip. What economists agree on is that it will feel like a recession for a long time, no matter what the statistics say. When the unemployed begin to find work, home values stabilize, consumers start spending, and the government stops stimulating, that will signal an end to the nation's psychological recession. Maybe then, we'll celebrate.

13 Reasons We Are Not in a Depression

by James Altucher

This past week David Rosenberg posted an article, Here Are 13 Signs We're Actually In a Depression Right Now. I disagree. He is analyzing from a "glass half empty" perspective, without noticing that there is decent growth in much of the data he examines. Let's take a look at his items one by one.

1) Wages and Salaries are still down 3.7% from the prior peak.

Hours worked per week, after hitting a low in October '09, is now actually at its highest since January 09. Here's the chart. Number of temp workers has also been moving up steadily over the past year.

When employers start pushing their employees to work overtime and start using more temp workers, it's almost always a precursor to higher full-time employment, which is a precursor to higher wages. We are already starting to see the results of this: The jobs opening index surged last month. Here is the data at the BLS. Job openings went up by three million. Meanwhile, initial jobless claims fell to 451,000 last week, lower than people expected.

2) Real GDP is down 1.3% from the peak.

This doesn't seem like a Depression. In the Depression that started in 1930 GDP was down:
1930 -8.6%
1931 -6.4%
1932 -13%
1933 -1.3%

The GDP has now experienced growth for the past four quarters. Growth does not equal a Depression.

3) Industrial production is still down 7.2% from the peak

True. But it's also 7% up from the lows in 2009.

4) Employment is still down 5.5% off of its peak.

See #1 above. All of the leading indicators on employment suggest that we are going to see full-time hiring. Additionally, its not uncommon for a recovery to be jobless at first; in fact, its the norm. Click this link from Google Trends and you can see the phrase "jobless recovery" appears for years in news reports after every single recession.

5) Retail sales are still down 4.5% from peak.

Am I the only one that is looking at this from a glass half-full approach? We're about 8% higher off the lows. Here's the data. Sure, we're at 10% unemployment and retail sales are down. But the recovery has been fast and furious since the lows in 2009.

6) Manufacturing orders are still down 22.1% from the peak
7) Manufacturing shipments are still down 12.5% from the peak
8 ) Exports are still down 9.2% from the peak

ISM Manufacturing is at 53. Any number over 50 signifies growth. We've had numbers above 50 for 14 months in a row. So while we are certainly off the highs, it does seem that 14 months of growth doesn't qualify as a massive Depression.

9 ) Housing starts are still down 63.5% from the peak
10) New home sales are still down 68.9% from the peak
11) Existing home sales are still down 41.2% from the peak
12) Non-residential construction is still down 35.7% from the peak

I agree that these are bad numbers. Months of inventory (the amount of time it would take to sell all of the existing homes for sale) is at 12.5 months, an all-time high. The expiration of the tax credits on housing caused a plunge in sales, showing that government policy, while a temporary salve, ultimately doesn't do anything.

What needs to happen is for the banks to start lending again. Here is the money supply data. While at an all-time high now, its growth has slowed since the recession began. Lending needs to begin again. However, encouraging news is that housing prices are up 4.4% in the last quarter. If housing prices are truly stabilizing, which it appears they are, banks will not be afraid to lend against them. Then the virtuous cycle will begin. Again, was this bump in housing prices due to the tax credits? We'll find out this quarter.

Admittedly, the Homebuyers Tax Credit caused a spike up in the housing data that was probably irrational. But the expiration of the credit is also causing a spike down that is irrational. We won't know the true state of housing until later this quarter or the next.

13) Corporate profits are still down 20% from the peak

Now this is clearly a glass half-full analysis. You have to see the actual chart:


Are we down off the peak? Or have we spiked off the lows and on our way to recovery? You decide. Meanwhile, with corporate profits spiking, corporate cash in the bank is at an all-time high of about $2 trillion. And companies are confident enough to spend that cash:
A) 162 companies in the S&P 500 have increased their dividends this year versus just two decreasing.
B) $150 billion in share buybacks have been announced this year versus $20 billion at this point last year
All of this bodes well for the market.

I want to add some notes about the market. Right now, the market is baking in a double-dip recession. With interest rates near 0% the market should be experiencing a level of P/E expansion. Instead, versus interest rates, we are the lowest P/E levels ever with the market trading at barely 12 times next year's probable earnings (even if I discount the estimates) versus the historical average of 15. Whats the best way to play this? I like some of:

Warren Buffett's holdings: JNJ XOM
George Soros's holdings: MON AAPL YHOO
John Paulson's holdings: BAC C

James Altucher is a managing partner of Formula Capital, an alternative asset management firm, and an author on investment strategies. Unlike Dow Jones reporters, he may have positions in the stocks he writes about.

Bulls Go to Extremes: Don't Buy the "Breakout", Sell It, Prechter Says

Stocks jumped Monday with the Dow rising 1.4% to 10,753 and the S&P gaining 1.5% to 1143, its highest close in four months.

The S&P eclipsing 1130 for the first time since late June would seem to confirm the long-awaited technical breakout for the index, and could pull many reluctant investors off the sidelines. "Many automatic buy and sell orders are set around market milestones such as these, and investors watch those levels closely for clues about which way the market may go next," the AP reports.

But the wise move now is to sell this recent rally, says Robert Prechter, president of Elliott Wave International.

"I think we're getting ready for another leg on the downside," Prechter says, citing evidence of what he says are extreme levels of optimism, including:

  • -- The most-recent AAII poll shows bearish sentiment at 24%, less than at the Dow's peak in October 2007.
  • Mutual fund cash positions being at record lows, which Prechter says should be taken at "face value" rather than the result of massive redemptions from equity mutual funds.
  • The TRIN Index (a breadth indicator) at one of its lowest levels in recent years, indicating extreme buying pressure of stocks at 52-week highs, i.e. investors chasing momentum/performance.

In addition, Prechter notes volume has been punk during the rally in recent weeks a sign, to him, that buyers lack conviction.

The veteran market-watcher says the current environment is similar to the 1930-31 period. "The market can make its high while optimism makes a peak despite the fact you're going stair-step lower," he says. "What we had in May with the ‘flash crash' was the first wave down."

Prechter predicts these periods of downturns sandwiched around 4-5 months of recovery "where people think we've hit the bottom" is likely to "go one for quite a long time" until a true bottom is reached well below the March 2009 lows, much less today's levels.

Tuesday, 21 September 2010

France and Spain push for tax on global capitalism

Steven Edwards

UNITED NATIONS — France and Spain called for a tax on global capitalism on Monday, telling the opening day of a UN summit on development the recession has made “innovative financing” essential to help the world’s poor.

Nicolas Sarkozy, the French President, and Jose Luis Rodriguez Zapatero, the Spanish Prime Minister, spoke after Ban Ki-moon, the UN Secretary General, called on rich countries to “not balance budgets on the backs of the poor.”

Canadian activists said Mr. Ban’s request applies directly to the Canadian government’s intention to freeze foreign aid next fiscal year as a deficit-reducing measure.

While the leaders of several developed countries have pressed the idea of launching a global finance tax before, speaking about it anew at such a widely attended summit gives it added weight.

“We can decide right here — why wait?” said Mr. Sarkozy.

“Finance has globalized, so why should we not ask finance to participate in stabilizing the world by taking a tax on each financial transaction?”

Mr. Zapatero said alternative financing was needed that is “not as vulnerable” as rich-country budgets during a recession.

“My government is committed to defending the new tax, and making it a reality…” he said.

“It appears sensible, just, and logical that we ask [for this] minimum effort to take millions of people out of misery.”

However, his government is among those cutting development aid in the face of the financial crisis.

In contrast, Canada’s new aid budget is US$5.165-billion, a record. It plans to freeze foreign aid next fiscal year to reduce the deficit.

The three-day conference is reviewing progress on eight development goals meant to halve poverty levels and improve living standards among the world’s poor by 2015.

Mr. Sarkozy said France would boost its contribution to the Geneva-based Global Fund to fight HIV/AIDS, tuberculosis and malaria in poor countries and challenged other nations to follow suit.

Insiders have suggested Stephen Harper, the Prime Minister, who will deliver Canada’s address today, will also announce increased payments to the Global Fund.

But Canada and the United States show little enthusiasm for a financial transaction tax.

Earlier, Mr. Ban said there has been progress in trying to achieve the Millennium development goals (MDGs), based on pledges governments made at the Millennium Summit in 2000.

But the advances were “fragile.… Being true means supporting the vulnerable despite the economic crisis,” he said.

“We must not draw back from official development assistance — a life-line of billions, for billions.”

The UN Secretary General will also call on rich countries this week to spend US$169-billion on a UN plan he says will save the lives of 15.6 million women and children by improving access to health care.

Progress on the MDG target of achieving a 75% reduction in maternal deaths during pregnancy has been slow.

Proposals for achieving the MDGs varied widely.

Evo Morales, Bolivia’s President who is vehemently anti-capitalist, wants the world’s resources nationalized so the “dividends they generate will remain” in their respective countries.

In keeping with his country’s gross national happiness index, Jigme Thinley, Bhutan’s Prime Minister, proposed adding “happiness” as a ninth MDG.

“Since happiness is the ultimate desire of every citizen, it must be the purpose of development to create enabling conditions for happiness,” he said.

Barack Obama, the U.S. President, will speak at the summit tomorrow. He is expected to reaffirm Washington’s commitment to the Millennium goals.

Aides say his administration is determined to boost the United State’s aid budget to US$52-billion, from its current level of about US$25-billion, despite concerns over the country’s economy and continuing high unemployment rate.

The U.S. President is expected to press for new strategies that would see recipient countries commit to becoming more accountable and increase their efforts against corruption.

France has been among the leading advocates of looking to new sources of financing for development, and was the first country to introduce a tax on airline tickets to pay for aid.

In addition to Spain, countries supporting him include Japan, South Korea, Brazil and Norway. Britain during the previous Labour government was for it, but the new government of David Cameron fears financial institutions will move to other regions, such as Asia.

Business leaders also say the tax would dry up financial flows and slow efforts to stimulate worldwide economic development.

Postmedia News

Is Google a Monopolist? A Debate

by Amit Singhal and Charles Rule

Amit Singhal of Google argues the competition is one click away. Charles Rule, an attorney whose firm represents corporations suing Google, counters that the company commands a share of search advertising in excess of 70%—the threshold for monopoly under the Sherman Act.

By Amit Singhal

Last week, "Googling something" took on a whole new meaning. Instead of typing your question into the search box and hitting Enter, our newest invention—Google Instant—shows constantly evolving results based on the individual letters you type.

Instant is just the latest in a long line of search improvements. Five years ago, search results were just "ten blue links"—simple web pages with some text. Today search engines provide answers in the form of images, books, news, music, maps and even "real time" results from sites such as Twitter.

The reason for all these improvements is simple: It's what you want. When you type in "weather" (or just "w" in the case of Google Instant), you want the weather forecast right away—not a collection of links about meteorology. Type in "flights to San Francisco," and you most likely want flight options and prices, not more links asking you to enter the same query again.

We know these things with a fair degree of certainty. We hire lots of great computer scientists, psychologists, and linguists, who all contribute to the quality of our results. We carefully analyze how people use Google, and what they want. And what they want is quite obvious: the most useful, relevant results, as quickly as possible.

Sounds pretty simple. But as Google has become a bigger part of people's lives, a handful of critics and competitors have raised questions about the "fairness" of our search engine—why do some websites get higher rankings than others?

It's important to remember that we built Google to delight our users—not necessarily website owners. Given that not every website can be at the top of the results, or even appear on the first page of our results, it's not surprising that some less relevant, lower-quality websites will be unhappy with their rankings. Some might say that an alphabetical listing or a perfectly randomized list would be most "fair"—but that would clearly be pretty useless for users.

People often ask how we rank our "own" content, like maps, news or images. In the case of images or news, it's not actually Google's content, but rather snippets and links to content offered by publishers. We're merely grouping particular types of content together to make things easier for users.

In other cases, we might show you a Google Map when you search for an address. But our users expect that, and we make a point of including competing map services in our search results (go ahead, search for "maps" in Google). And sometimes users just want quick answers. If you type "100 US dollars in British pounds," for example, you probably want to know that it's "£63.9p"—not just see links to currency conversion websites.

Google's search algorithm is actually one of the world's worst kept secrets. PageRank, one of our allegedly "secret ingredients," is a formula that can be found in its entirety everywhere from academic journals to Wikipedia. We provide more information about our ranking signals than any other search engine. We operate a webmaster forum, provide tips and YouTube videos, and offer diagnostic tools that help websites identify problems.

Making our systems 100% transparent would not help users, but it would help the bad guys and spammers who try game the system. When you type "Nigeria" you probably want to learn about the country. You probably don't want to see a bunch of sites from folks offering to send you money … if you would only give them your bank account number!

We may be the world's most popular search engine, but at the end of the day our competition is literally just one click away. If we messed with results in a way that didn't serve our users' interests, they would and should simply go elsewhere—not just to other search engines like Bing, but to specialized sites like Amazon, eBay or Zillow. People are increasingly experiencing the Web through social networks like Facebook. And mobile and tablet apps are a newer alternative for accessing information. Search engines aren't the "gatekeepers" that critics claim. For example, according to the research firm Compete, Google is responsible for only 19% of traffic to

Investment and innovation are considered strong indicators of a competitive marketplace. Last week's launch of Google Instant was a big bet for us—both in terms of the complexity of the computer science and the huge demands it puts on our systems. Competition for eyeballs on the Web helps drive that risk-taking and innovation because consumers really do have the freedom to vote with their clicks and choose another search engine or website. In an industry focused on tough questions, that's clearly the right answer.

Mr. Singhal is a Google fellow who has worked in the field of search for over 15 years, first as an academic researcher and now as an engineer.

'Trust Us' Isn't An Answer
By Charles Rule

'What goes around, comes around." That pretty much sums up the predicament in which Google currently finds itself. If you listen carefully to Google's complaint that antitrust regulators have no business poking around in its business, you'll hear the echoes—if not wholesale appropriation—of the arguments once propounded by Microsoft.

In case you might have missed it, a decade ago Microsoft was a pioneer of sorts in establishing the relationship of antitrust to high-tech. Its Windows operating system was labeled a monopoly, and the company was accused of employing a litany of "bad acts" to prevent rivals like Novell, Netscape and Sun's Java from threatening Window's dominance. I should know. I represented Microsoft then and still represent the company today.

Microsoft countered that, far from being a monopoly, it was under intense competitive pressure and that the allegations of bad acts were actually the self-interested complaints of rivals unable to keep pace with Microsoft's innovations. Taking up the cause of the victims, state and federal antitrust regulators (and counterparts around the world) challenged Microsoft, and after an epic battle, they won.

Google now finds itself in those same antitrust cross-hairs, accused of being today's monopoly gatekeeper to the Internet. There are a growing number of complaints in the U.S. and Europe that Google has used its search monopoly to exclude actual and potential rivals, big and small. How exactly? Rigging clicks by lowering competitors' rankings in Google searches is one way. Another is locking up critical content, like video and books, so that rival search engines are frustrated in trying to provide their users with access to that content. The result has been Google's overwhelming dominance.

Ironically, many of the most ardent defenders of Google are the same individuals—such as Eric Schmidt, Google's CEO who was an executive at Sun and later Novell—who devoted so much time, money and effort to pushing the frontiers of the law and government regulation against Microsoft a decade ago.

Much like Microsoft's arguments about a general software market, Google likes to claim its business is only a drop in the bucket that is the general advertising market. But after lengthy investigations, the Justice Department and Federal Trade Commission have concluded that search advertising is unique and constitutes a separate market. In the U.S., Google commands a share of search advertising well in excess of 70%—the consensus threshold for monopoly under the Sherman Act. Google's share in most places around the world is even higher.

Like Microsoft, Google claims "competition is just a click away." But for an advertiser hoping to reach consumers when they type in a query about the products the advertiser sells, Google is where the queries are and more than 70% of all ad-supported queries flow through Google's search engine. Yahoo once provided a choice, and Bing is still hanging on. But there's reason to believe that Google's strategy has been to deprive any rival—big or small—of the queries and advertisers necessary to create real alternatives for users.

Again like Microsoft, Google claims its antitrust problems are the result of a cabal of disgruntled competitors. And it is true that Microsoft's rivals such as Mr. Schmidt's Sun and Novell provided much of the evidence, and at least some of the impetus, against Microsoft. But in monopolization cases, which are about exclusion of rivals from the marketplace, it is almost always the excluded victims who blow the whistle on monopolists.

Unlike Microsoft, however, Google so far has offered little more than cursory justifications for its actions. Microsoft at least believed what it was doing reflected its innovation, which, though perhaps rough on rivals, benefited consumers.

Google smugly brushes aside allegations against it, expressing indignation that anyone would deign to question such a hip, warm and fuzzy company. Google's defense seems to be: Trust us, whatever we do will be good for the rest of you. And, we're way smarter than you, so you'd never be able to comprehend what we're doing anyway.

Whether Google likes it or not, the Microsoft case resolved antitrust's role in high-tech. And the last 10 years have shown that reasonable antitrust rules can be applied to prevent exclusionary conduct by dominant tech firms without destroying market forces. Complaints by leading Googlers, who were once strong proponents of those rules, that the same rules should not apply to Google are disingenuous at best.

The application of antitrust must be consistent. Failing to apply antitrust rules evenhandedly—particularly to politically well-connected monopolists like Google—would neither be just nor promote the cause of free-market capitalism.

Mr. Rule, head of the Justice Department's Antitrust Division in the Reagan administration, is an attorney with Cadwalader, Wickersham & Taft LLP. His firm represents Microsoft and is counsel of record for two companies currently engaged in antitrust litigation against Google—myTriggers and TradeComet.

Saturday, 18 September 2010

The Chances of a Double Dip

By Gary Shilling

Investor attitudes have reversed abruptly in recent months. As late as last March, most translated the year-long robust rise in stocks, foreign currencies, commodities and the weakness in Treasury bonds that had commenced a year earlier into robust economic growth - the "V" recovery.

As a result, investors early this year believed that rapid job creation and the restoration of consumer confidence would spur retail spending. They also saw the housing sector's evidence of stabilization giving way to revival, and strong export growth also propelling the economy. Capital spending, led by high tech, was another area of strength, many believed.

Not So Fast

But a funny, or not so funny, thing happened on the way to super-charged, capacity-straining growth. In April, investors began to realize that the eurozone financial crisis, which had been heralded at the beginning of the year by the decline in the euro, was a serious threat to global growth. Stocks retreated (Chart 1 ), commodities fell and Treasury bonds rallied and the dollar rose. It is, after all, just one big trade among these four markets, so their correlated actions on the down as well as the up side aren't surprising.


Furthermore, investors began to worry about the health of the U.S. economy and the prospects for a second dip in the Great Recession that started in December 2007. The gigantic 2009 fiscal stimuli of close to $1 trillion was running out, threatening a relapse in an economy that was running on government life support. The $8,000 tax rebate for new home buyers was expiring April 30 and might be followed by a drop in house sales as had its predecessor that expired in November 2009 as the spike in activity early this year only borrowed from future sales. The outlook for exports had turned negative with the robust buck, sagging European economies and the current "stop" phase of China's "stop-go" monetary and fiscal policies. With unemployment remaining high last spring, investors began to fret that consumer spending would falter as fiscal stimuli was exhausted.


Although investor views of the economy have reversed in the last five months, the reality probably hasn't. The good life and rapid growth that started in the early 1980s was fueled by massive financial leveraging and excessive debt, first in the global financial sector, starting in the 1970s and in the early 1980s among U.S. consumers. That leverage propelled the dot com stock bubble in the late 1990s and then the housing bubble. But now those two sectors are being forced to delever and in the process are transferring their debts to governments and central banks.

This deleveraging will probably take a decade or more - and that's the good news. The ground to cover is so great that if it were traversed in a year or two, major economies would experience depressions worse than in the 1930s. This deleveraging and other forces will result in slow economic growth and probably deflation for many years. And as Japan has shown, these are difficult conditions to offset with monetary and fiscal policies.

The deleveragings of the global financial sector and U.S. consumer arena are substantial and ongoing. Household debt is down $374 billion since the second quarter of 2008. The credit card and other revolving components as well as the non-revolving piece that includes auto and student loans are both declining. Total business debt is down, as witnessed by falling commercial and industrial loans.

Meanwhile, federal debt has exploded from $5.8 trillion on Sept. 30, 2008 to $8.8 trillion in late August. Many worry about the inflationary implications of this surge, but the reality is that public debt has simply replaced private debt. The federal deficit has leaped as consumers and business retrenched, which curtailed federal tax revenues, while fiscal stimulus, aimed at replacing private sector weakness, has mushroomed.

Four Cylinders

As discussed in our May 2010 Insight, in the typical post-World War II economic recovery, four cylinders fire to push the economic vehicle out of the recessionary mud and back out on to the highway of economic growth. At present, only one - the ending of inventory liquidation - is generating significant power. The other three - employment gains, consumer spending growth and a revival in residential construction - are sputtering at best.

The Inventory Cycle

Historically, the liquidation of excess inventories accounts for major shares of the decline in economic activity in recessions. Around business cycle peaks, the sales of manufacturers, wholesalers and retailers begin to weaken but their managers can't tell whether that's the beginning of a major drop in business or just a minor dip in an upward trend. So they delay cutting production and orders until the downward trend is firmly established. Meanwhile, inventory-sales ratios leap as the numerators, inventories, rise and the denominators, sales, fall. That makes cuts in production and orders imperative and propels the economic downward trend in the process.

That was also the case in the Great Recession. In our view, it really started in early 2007 with the collapse in subprime residential mortgages, and then spread to Wall Street that summer with the implosion of the two Bear Stearns hedge funds in June. But these were financial declines, and recessions are measured by production, employment and spending, which are dominated by the goods and nonfinancial services segments of the economy. So the recession didn't officially start until December 2007.

Consumers Go On Strike

Furthermore, it wasn't until late 2008 that the collapse in home equity as house prices nosedived (Chart 2), rising layoffs (Chart 3) and the drying up of consumer lending drove consumers into retrenchment. But they suddenly went on a buyers strike in the last four months of 2008, and the results were leaps in inventory-sales ratios. Consequently, the cuts in inventories to get rid of unwanted stocks were far and away the biggest in the post-World War II era.



The reduction in inventory liquidation has been key to economic growth starting in the second half of 2009. In the third quarter of last year, it accounted for 66% of the 1.6% annual rate real GDP gain and 58% of the fourth quarter's 5.0% advance. The inventory-building in the first quarter of this year was responsible for 67% of the 3.7% annual rate rise in real GDP and 36% of the rise of 1.6% in the second quarter. In total, in the last four quarters, the inventory swing provided 58% of the 3.0% rise in real GDP.

Whether inventories will continue to hype the economy remains to be seen. As of June, the inventory-sales ratio for retailers had returned to its downtrend, but was still above trend for wholesalers and, especially, manufacturers. Furthermore, it's one thing to complete the liquidation of unwanted inventories but another to rebuild them significantly. The latter probably requires sales strength originating in other areas of the economy, and the other three cylinders of the economic engine aren't providing it in meaningful ways. Quite the opposite. It appears that recently disappointing retail sales have stuck merchants with unwanted goods that may be liquidated if consumers continue to retrench.

Employment Lags

In post-World War II recessions before the 1990-1991 decline, payroll employment's bottom came close to the low point in the overall business decline and was followed by rapid rebounds (Chart 4 ). In the mild 1990-1991 and even shallower 2001 recessions, however, the job market remained weak for over a year into economic recovery. The same is true this time, assuming the economic decline ended in July 2009, as many believe. What's changed?

It isn't that a shallow recession results in weak job recovery because even though the 1990-1991 and 2001 downturns were mild, the Great Recession certainly wasn't in terms of jobs (Chart 4). A more likely explanation is that globalization, starting in the 1980s, forced American business to cut all costs vigorously, including labor costs, by outsourcing to domestic and foreign suppliers, promoting productivity and curtailing hiring. This has been especially prevalent in the last decade.


Jobs Lost Forever

Despite the huge employment losses since the end of 2007, many of those jobs are unlikely to return. Of the 7.7 million net nonfarm jobs eliminated between December 2007 and July of this year, 86% were in construction, manufacturing, wholesale and retail trade, finance and leisure and hospitality. These six sectors accounted for 44.5% of nonfarm payrolls in July, only about half as much as their losses. Furthermore, job losses in those industries spawned employment losses in service and other sectors that depend on them. Home building, for example, spurs employment in the production of appliances, furniture, home furnishings and homeowner insurance and provides revenues that support state and local employment.

Given the gigantic overhang of excess house inventories and resulting further price declines, it will be years before residential construction shows any meaningful revival, as we've explained in past Insights and will update next month. Similarly, financially troubled and massively vacant commercial real estate will inhibit new construction and jobs for many years.

The inventory cycle did stabilize manufacturing employment in recent months, but that inventory-related bounce is over and the 2 million manufacturing jobs lost since December 2007, if anything, will probably become an even bigger number. Goods production continues to move offshore. job-reducing productivity gains continue in manufacturing, and consumer retrenchment and deflation will continue to curtail consumer durable goods consumption. Wholesale and especially retail trade will continue under pressure with the 25-year consumer borrowing and spending binge now replaced by a saving spree (Chart 5). That retrenchment as well as persistent business spending restraint will continue to retard jobs in leisure and hospitality.


Financial activities jobs stabilized with the March 2009-March 2010 revival of Wall Street, but the likely continuance of more recent weakness in many securities markets will lead to more layoffs and bonus cuts. The federal government, naturally, has added people, 262,000 since December 2007, as it expands in response to the weak economy. But state governments cut 6,000 on balance and local municipalities 128,000, largely in education.

Diligent Cost-Cutting

American business has been diligently cutting costs since the recession started in December 2007, especially labor costs. A recent survey shows that over half of adults have been affected by some combination of layoffs, wage and benefits cuts, involuntary furloughs and involuntary shifts to temporary jobs. Many may never be restored to their earlier statuses. Those layoffs lucky enough to find new jobs often are paid less than earlier.

About 20% of major employers with over 1,000 workers cut or eliminated their 401(k) plan contributions during the downturn but half have failed to restore them so far. Of those with 500 or fewer employees that cut contributions, only 36% have reinstated them or plan to in the next 12 months, according to a Fidelity Investments survey. Furthermore, 10% of all employers plan to reduce or eliminate matching 401(k) contributions in the next year.

Consumer Spending

All the layoffs, involuntary furloughs, and temporary jobs and benefit and wage reductions have been instrumental in the rebound in corporate profits, but devastating to employee compensation. This spells weakness for consumer spending. Also, consumers are no longer saving less and borrowing more on credit card, home equity and other loans to bridge the gap between income and desired spending growth. Furthermore, home equity has evaporated (Chart 6 ) and tight lending standards on credit card and other loans prevail. So they're on a saving spree and debt reduction binge, further slashing the outlook for consumer spending, the third cylinder that normally fires to propel economic recovery from recessions.


In fact, without massive fiscal stimuli, subdued compensation and the recession would have pushed consumer outlays down substantially. Our calculations show that consumers saved 80% of the tax rebates they received in the summer of 2008. And they initially saved 100% of 2009's tax cuts and special payments of $250 for each Social Security beneficiary. Those actions resulted in the spikes in the saving rate shown in Chart 5. This is remarkable since the tax cuts did not go to highincome people, normally the only big savers. Also, those folks are relatively few in number so they received few of the extra Social Security checks. Consequently, middle- and lower-income households stepped out of character to save heavily.

Households are deleveraging their balance sheets with a vengeance. Since the end of the fourth quarter of 2007 when stocks began to collapse, personal sector assets have fallen $3.0 trillion. Some $1.8 trillion was in equities and $277 billion in mutual funds due to losses on balance and withdrawals from equity direct ownership and from mutual funds. Investors put money into mutual funds on balance in January, March and April, but cut their holdings, especially in stock funds, in May and June. Also, private pension reserves fell $754 billion from the end of 2007 to the end of March 2010 and government pension reserves in household accounts were down $290 billion. Increases of Treasury bond holdings of $533 only partially offset the decline in government agency and securities of $593 billion. Meanwhile, liabilities of the personal sector dropped $500 billion, largely due to the decline in mortgage and consumer debt as some debts were repaid while others were written off as hopeless.

Support By Government

Since the recession began in December 2007 through June 2010, personal income from wages and salaries, proprietors' income, rents, interest, dividends and transfers such as pension benefits, Social Security, Medicare and Medicaid payments and unemployment insurance increased $285 billion. It would have declined $247 billion without a $532 billion increase in government transfer payments. These increases in government transfers also flowed through to Disposable Personal Income (after-tax income), which further benefited by lower personal taxes that fell $382 billion due to tax cuts and the lower taxable income resulting from layoffs, wage declines and bonus cuts.

In total, DPI was enhanced by $532 billion from the increase in government transfers and $382 billion from the lower taxes. Without these significant boosts, DPI would have fallen $247 billion since December 2007 instead of rising $667 billion. Without question, and much more so than in any previous post-World War II recession, the consumer has been supported by massive government money in the form of increased transfers and tax cuts. And these numbers do not include wages from jobs created by federal spending on infrastructure or saved by federal transfers to state and local governments to curtail teacher layoffs and other employment reductions.

Where Did The Money Go?

What happened to that $667 billion increase in DPI and what does it tell us about the likelihood of a chronic consumer saving spree? About 43% of it was spent and 64% saved, so maybe some of the earlier tax cuts were spent, but with delays. Nevertheless, a 64% marginal saving rate does seem to support our chronic saving spree thesis.

Also, in terms of spending and saving, note that whatever has been going on in the consumer arena has been supported by massive federal stimuli. Those stimuli may persist at near current levels in future years due to chronic high unemployment, as noted in earlier Insights, but seems unlikely to rise at the rates they did since the recession began due to their effects on the already massive federal deficits. Republicans and even some Democrats in Congress are so worried about the mushrooming deficit that current stimuli is unlikely to be renewed at least until unemployment leaps further. In that case, the resulting withdrawal of support for consumer outlays may push them down. So the leap in consumer spending as a share of personal income (Chart 7 ), which has been propelled by tax cuts that were only partially offset by saving increases, is highly unlikely to persist.


Evidence of recent consumer retrenchment is rampant. Consumer confidence has flattened as people worry about employment and income prospects as well as losses on their stocks and houses. Credit card loans outstanding fell 10% last year and promise to fall further as consumers repay debt, lending standards tighten and the new federal law cuts the profitability of credit card lending. Meanwhile, banks report that demand for consumer loans continues to drop, although at declining rates.

Increased saving is not only being used to repay debt but also to rebuild 401(k)s. Fidelity Investments found that in the second quarter, 5.3% of participants raised their contribution while 2.9% reduced them. That excess of increases over decreased has persisted for five quarters and follows three quarters of the reverse. Still, the numbers that tapped their accounts for loans or hardship withdrawals also rose.

Subdued Spending

On the spending side, vehicle sales in July were at an 11.5 million annual rate, up from the sub-10 million levels of 2008-2009, but well below the pre-recession levels. Consumer spending on TVs, computers, videos and telephone equipment rose 1.8% in the first half of 2010 compared with a year earlier while appliance purchases fell 3.6% and furniture outlays dropped 11%. Apparel sales also lost out to electronic gadgets. This shift reflects two forces. First, consumers are saving more and spending less on equipping their houses that are no longer appreciating but now depreciating assets. Second, they still want the satisfaction of buying iPads and other Small Luxuries, an investment theme we identified years ago and explained fully in our August Insight.

Housing Remains Depressed

The housing sector is an important generator of the normal economic recovery even though residential construction only accounts for 4.7% of GDP on average in the post-World War II years. It's the volatility that matters. Residential construction was 6.3% of GDP at its recent peak in the fourth quarter of 2005, but fell to 2.4% at its low in the first quarter of 2010. This 3.9 percentage point decline is very significant, considering that a 3% top to bottom decline in real GDP constitutes a major recession.

State and Local Government Spending

Spending by state and local governments is not one of the sources of economic revival after recessions end because it has been such a steady 12% to 13% share of GDP since the early 1970s. In the early post-World War II decades, it grew rapidly to finance the education of the postwar babies and the growth of mushrooming suburbs. Municipalities have also provided a steady source of jobs since, until recently, many fewer employees were laid off or fired than in the private sector and relatively few quit. Years ago, the "social contract" held that those employees received lower wages than private sector workers, so early retirement provisions and lush pensions allowed them to catch up in their later years. But since the early 1980s, the private sector has been globalized with very little growth in real incomes. Meanwhile, state and local government employees have continued to receive pay raises in excess of inflation and now have wages that are 34% higher than for private sector employees (Chart 8).


Federal Help

As part of its fiscal stimulus program, the federal government is transferring $246 billion to state governments to prevent more school teacher layoffs, help fund Medicaid cost increases and plug other holes in state budgets. Federal money is filling 30% to 40% of state budget gaps, but 46 states are projecting a collective deficit of $121 billion for the 2011 fiscal year that begins next July 1, equivalent to 19% of their budgets. And 39 states see gaps that total $102 billion for fiscal 2012. Unless federal assistance continues, these deficits will be much larger. All the states but Vermont are required to balance their budgets in one form or another, but most are honored in the breach as fiscal gimmicks and creative accounting get really creative.

Budget legerdemain no doubt is related to the rapid growth in state spending in recent years and leap in debt. State and local governments now use debt to fund investments that used to be done on a current budget basis, and some issue debt to cover up routine budget shortfalls. Total state and local bond debt outstanding leaped 93% between 2000 and 2009, from $1.2 trillion to $2.3 trillion.

It obviously takes a lot of gnashing of teeth in the outer darkness for state and local government to flatten, much less cut, their spending after a decade of 6% to 7% annual growth rates. Jumping municipal employment is the main reason for mushrooming spending in earlier years, and cutting often unionized state and local workforces is very difficult. Since the Great Recession started in December 2007 through April, private payroll employment has dropped 6.8%. Still, state and local jobs have declined but by much less, only 1.4%. In July, state and local governments, which employ 9.5 million, cut 48,000 jobs, 102,000 in the past three months and 169,000 so far this year.

Raise Taxes

In reaction to their financial woes, many state and local governments have attempted to raise taxes and fees. The usual suspects include higher sin taxes on tobacco and alcoholic beverages as well as taxes on companies based out of state but doing some business in the state. Attempts to raise taxes and cut spending have proved wholly inadequate to solving state and local government funding problems. And those woes appear chronic, especially if our forecast of slow economic growth and even deflation is valid. Rises in taxable personal and corporate incomes will be muted. Retail sales and taxes on them will be sluggish as consumers persist for the next decade in their saving spree, replacing the borrowing and spending binge of the last decade.

House prices are likely to fall further in the next year or so, under the weight of gigantic excess inventories. Even when those inventories are worked off, house prices will probably rise little, if at all, in a low inflation or deflationary climate. Historically, they've been flat after correcting for overall inflation and the growing size of houses over time. And now that house prices have fallen nationwide for the first time since the 1930s, home buyers no longer see their abodes as also great, leveraged investments, and want smaller, cheaper houses. That will also reduce assessments on property taxes.

Meanwhile, commercial real estate high vacancies and severe financial problems will take years to resolve, keeping prices depressed for some time (Chart 9 ). So, all things considered, local government property taxes are likely to be curtailed for many years. Meanwhile, municipal expenses will be hard to cut. Chronic high unemployment will spawn high Medicaid enrollment and costs. Welfare and unemployment benefit costs will no doubt rise as well.


Deteriorating finances are raising the risks of defaults on state and local obligations and even municipal bankruptcies. Harrisburg, Pennsylvania's capital, will not make a $3.3 million municipal bond payment on $51.5 million debt that's due in two weeks, and earlier this year, city officials discussed bankruptcy. Harrisburg also lacks the funds to continue payments for the $288 million debt on an incinerator project. Earlier, Jefferson County, Ala., home of Birmingham, defaulted on $227 million due on its disastrous sewer upgrades.

Taxpayer Revolt?

People working in the private sector apparently were willing to accept the higher pay, more job security and better retirement benefits for state and local employees in past years. High employment in the private sector and robust economic growth at least held out the hope that their lots would improve tomorrow. But with slow economic growth, limited income expansion and high unemployment now expected by them for years, voter attitudes appear to be changing.

Americans still want basic municipal services like police and fire protection, good schools for their kids, clean streets and garbage collection. But they apparently are deciding they're paying too much for those services; that 34% higher wages for state and local employees compared to private sector workers isn't justified as pay cuts multiply in the private sector and those laid off earn much less if and when they can find another job; that 66% higher benefit costs is over the top, especially as private sector employees are paying more of their health care premiums and seeing their defined benefit pension plans replaced by much more uncertain 401(k)s.

As taxpayers revolt, there are plenty of things that can be done to reduce state and local government costs in an orderly way. Following in the footsteps of bankrupt GM, two-tier wage structures are being established with existing employees continuing at current salary levels, but new hires paid the much lower wages adequate to attract qualified people. And the new people are enrolled in defined contribution pension plans that require employee contributions, not defined benefit plans, while their retirement ages are increased.

Foreign Trade

Another economic sector that normally isn't a significant engine of economic recovery but is important at present is exports since the Administration hopes they will double in the next five years and provide meaningful economic growth. The President's zeal to achieve that goal rises as he realizes that massive fiscal stimuli have not revived the economy, and already-huge federal deficits impede further rounds of big spending.

But two significant problems are likely to retard export growth in future years - rising protectionism that clearly impedes foreign trade, and finding foreign countries that will buy this doubling of American exports. It's like the story of the stockbroker who calls his client during May's Flash Crash to tell him that stocks are collapsing. "Sell my entire portfolio!" yells the distressed client. "Sure," retorts the broker, "but to whom? There are no buyers."

Foreign Buyers?

As far as foreign buyers of U.S. exports is concerned, the reality is that many of those markets that are showing robust growth and therefore might be able to absorb American products, lands like China and Germany, are major exporters themselves, not importers on balance. Indeed, it's no surprise that the EU's measures of both industry and household confidence shows that export-led Germany has the highest level while the economically weak Club Med net importers are at the bottom of the pile (Chart 10).


Currency changes have only limited effects on export or import prices. The volatility of U.S. import prices is only about one-fourth that of the dollar and a third in the case of American export prices. Why? Many products are sold under long-term contracts and immune from most currency fluctuations. Also, importers and exporters resist reflecting the full extent of exchange rate changes in their prices. If the yen is strong against the dollar, importers of Lexus cars shave their profit margins to offset some of the higher prices in dollars to avoid losing market share. Conversely, U.S. exporters to Japan don't pass on in lower yen prices the full extent of the dollar's decline in order to increase their profits.

The "processing trade" in which components are imported, assembled and then re-exported makes up about half of Chinese exports. This reduces the importance of the yuan's exchange rates. Furthermore, even goods with more domestic content aren't completely sensitive to exchange rates in a global world. About 50% of a Chinese manufacturer of children's clothes costs are fabric and around 50% of the fabric's costs are cotton, a globally-traded commodity priced in dollars. So, 25% of the total cost is not affected by yuan fluctuations. Also, another 25% might be in the combined profits of the clothing and the fabric producers, and could be adjusted to offset currency fluctuations - or production moved to lower-cost Vietnam or Bangladesh if the yuan leaped in value.

Double Dip Recession?

We've made our case for very slow U.S. economic growth in the quarters, indeed the years, ahead. The economic rebound due to the inventory cycle is over. Employment and consumer spending remain weak. Housing is too overburdened with excess inventory and the resulting price weakness to revive any time soon. State and local government spending and employment are retreating. And meaningful export gains are unlikely as economic growth abroad slips. Interestingly, the consensus forecast is moving toward our position as growth estimates have been reduced rapidly in recent months. In both April and June, the Wall Street Journal's poll of economists (not including us) expected 3% economic growth in the second half of this year. We wonder if they still do.

Will slow growth deteriorate into another recession, the so-called double dip scenario? Before exploring that question, let's define a double dip. It seems to mean a second period of economic decline following the 2007-2009 nosedive. That could imply that the recession that the accepted authority, the Business Cycle Dating Committee of the nonprofit National Bureau of Economic Research, pinpointed as commencing in December 2007, is still underway. Sure, real GDP grew in the last four quarters, but it's common to have quarters of gain within recessions. In the 11 post-World War II recessions so far, seven, including the 2007- 2009 decline, had at least one quarter of rising real GDP within the recession. In fact, two - the 1960-1961 and the 2001 declines - didn't even have two quarters of consecutive decline. Even in the 1929-1933 economic collapse, GDP rose in six quarters.

Still, to have a four-quarter interlude between the declining phases of the same recession would be unprecedentedly long, assuming that real GDP declines in the current quarter. So another period of economic weakness could be classified as a second recession, much as the 1981-1982 decline, which started in July 1981, only 12 months after the 1980 recession ended.

Slow Growth to Recession

We're on record for a 50% or higher probability of a second dip or another recession, whatever it would be called. The composition of the ECRI Weekly Leading Index remains proprietary, but its growth rate has fallen to the level that in the past was always associated with recessions (Chart 11). Historically, however, recessions have been propelled by shocks. The post- World War II downturns prior to 2001 were caused by Fed tightening in response to threats of economic overheating and the resulting higher inflation. Since then, other shocks have been responsible. The 2001 recession resulted from the 2000 collapse of the dot com bubble augmented by the 9/11 shock. The 2007-2009 downturn resulted from the collapse in subprime residential mortgages that commenced early in 2007.


In the current economic and financial climate, it's highly unlikely that the Fed will tighten credit for years. In fact, the central bank has shifted from planning last spring to withdraw liquidity as the economy grew to renewing quantitative easing and worrying about deflation and subpar growth. It said after its August 10 policy meeting that household spending is being retarded by high unemployment, slow income growth, lower home equity and tight credit conditions while bank lending "has continued to contract."

Pushing On A String

Conventional monetary ease is now impotent with the federal funds rate close to zero , the money multiplier collapsed and banks sitting on hoards of cash (Chart 12) and over $1 trillion in excess reserves. Sure, large banks report to the Fed that they are easing lending standards for small business, but after the intervening financial crisis, many fewer potential borrowers are deemed creditworthy than in the loose lending days. Furthermore, the small business trade group, the National Federation of Independent Business, reports that 91% of small business owners have had their credit needs met or business is so slow that they don't want to borrow. The Fed is pushing on the proverbial string.


The Fed also worries about deflation, which means that even zero interest rates are positive in real terms, as has been the case for years in deflationary Japan. Also, deflation encourages buyers to wait for still-lower prices in a self-feeding cycle, as is seen in Japan and as we have discussed often in conjunction with our forecast of 2% to 3% per year chronic deflation. In it s post- August 10 meeting statement, the Fed said that "measures of underlying inflation," already low, "have trended lower" lately and are "likely to be subdued for some time." James Bullard, President of the Federal Reserve Bank of St. Louis, recently warned of the risks of deflation.

Deflation is a scary phenomenon, but we can't resist noting that the Fed as well as many other forecasters are moving in the direction of our forecast. In contrast, an April 6 Wall Street Journal piece by Peter Eavis stated unequivocally, "No one in their right mind would bet on inflation remaining substantially below 4% for the next 10 years." Maybe we better have our head examined.

A Baby Step

So, with conventional monetary ease exhausted and further fiscal stimulus on hold because of the already-huge federal deficit, the Fed at its August 10 meeting took a baby step toward more quantitative ease by deciding to buy Treasury bonds to replace the maturing and refinanced Treasury and mortgage-backed securities in the $1.7 trillion hoard it finished buying earlier this year. With low mortgage rates, refinancings were projected to raise the Fed's portfolio contraction from an earlier estimate of $200 billion by the end of 2011 to $340 billion, with another $55 billion coming from retirement of Fannie Mae and Freddie Mac debt held by the Fed.

Furthermore, the Fed is open to further steps if the economy continues to slip. It could buy even more Treasurys or mortgage debt. But would the resulting lower interest rates encourage prospective home buyers who now know that house prices can and do fall? Would another $1 trillion in excess reserves induce more bank lending than the first $1 trillion? The Fed could also promise to keep short-term interest rates low, but it's already said it would for an "extended period."

It could cut out the 0.25% it pays the banks on their reserves, but would that induce reluctant banks to lend? Finally, the Fed could set an inflation target over its formal 1.5% to 2.0% range. That would be anathema for inflation-wary central bankers, and how could the Fed hit that target in a deflationary world where ample supply exceeds weak demand? Despite all the credit easing actions that Chairman Ben Bernanke, in his famous November 2002 speech, said the Fed could take if the federal funds target reached zero, the credit authorities are about out of ammo - except for dumping money out of helicopters. Remember the "Helicopter Ben" moniker?

Other Shocks

If the Fed is highly unlikely to shock slow growth into recession, what could? This brings us back to the series of seemingly isolated events that are occurring on the deleveraging road, such as further financial woes in Europe, a crisis in commercial real estate, a nosedive in the Chinese economy and a slow motion train wreck in Japan. They are all possibilities - as are other shocks here or abroad that we don't foresee. Maybe the exhausting of federal stimulus will be enough to trigger an economic downturn. Keep your eyes pealed, however, because it won't take much disruption to push the fragile global economy back into decline.

Houston, My Book, and New York

Tuesday was a very special day. My co-author, Jonathan Tepper of Variant Perception (based in London), and I spent the entire day reading the first complete rough draft of our forthcoming book, The End Game. We went cover to cover, making comments and notes. Of course, I had read the bits and pieces, but not in one sitting. I have to say that I am more than happy. It is a very good first draft, much better than I thought it would be. There is a lot of work ahead, of course, to try and make it a great book, but I can "feel" it. And I think we have managed to capture some very difficult topics and make them simple and maybe even a fun read. We are on target for a January 1 launch.

We make what I feel is an overwhelming case for a period of slow growth in the developed world, with more volatility as the base case. The research we review is very strong. But there are pockets of potential if you step back and take off your localized blinders.

I will be in Houston (along with Gary Shilling, David Rosenberg, Bill King, and Jon Sundt) at the one-day X-Factor Conference on October 1. Quite the lineup. You can learn more by going to Then I will be in New York in late October, speaking at the BCA conference and a few media events.

It has been interesting talking with investment types in Europe. They are very curious about the US and what they perceive as our lack of seriousness about the deficit. It appears that Greece has focused their attention. And of course, I get off the plane from Malta yesterday and the headline in the Financial Times says, "Greece rules out possibility of default." I know that made me feel better. And gave us all a laugh. If you have not, read the piece from Michael Lewis in Vanity Fair on Greece. And then share my amusement about the chances of no default.

It is time to hit the send button. I feel a nap coming on. Jet lag has been worse than normal this trip. And maybe another glass of Prosecco to ease me into slumberland.

Your excited about almost finishing this book analyst,

John Mauldin

Copyright 2010 John Mauldin. All Rights Reserved

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