Friday, February 29, 2008


While Chicken Little is crying about the falling dollar, the news media is playing the part of the Little Boy Who Cried Wolf. While the Chicken is squawking and the media is crying, the real Big Bad Wolf is about to eat Little Red Riding Hood. What is moving this market? Fear is the answer. Fear of a confrontation with Iran -- Fear of a democratically controlled House, Senate and Executive Branch.

One of the false beliefs held by many is that the falling dollar is making the price of oil go up. The price of oil is going up because the demand for oil is strong. It has nothing to do with the price of the dollar. The price of oil has gone up in every country. A major factor in the demand for oil is geopolitical risk. The "Iran situation" is coming to a head. Bush is determined to "solve" the Iranian problem during his term of office. Bush is threatening to put the "big squeeze" on the Iranian economy. If he successfully cuts off the Iranian central bank from the rest of the world, the pressure for a response from Iran will be great. The leaders will be forced to meet at the negotiating table, suffer a serious economic depression or strike back with "whatever". The option of cutting off oil is not a good option for Iran but I do not believe Iran should count on Russian or China or any other nation to force the USA to back off.

Another false belief is that the falling dollar is making the price of stocks fall. The truth is that there is no strong correlation between stock prices and the price of the dollar. To the extent that there is a connection, the fact that the dollar is below the bottom made during the mid 90's mid cycle correction means that the low dollar supports higher future prices as it did in that cycle. The factual relevant correlation is that the weak dollar has made US goods and services very attractively priced to the countries that have strong currencies. US exports are growing by leaps and bounds and foreign buyers are coming to America. While Chicken Little squawks, there is world wide economic strength mixed in with the weakness in the US housing market. Here again, the housing market gets a lot of exaggerated news coverage while the pending confrontation in Iran gets little notice. There is the potential for a lot of trouble ahead but the falling dollar is a symptom of the problem not the cause.


Since the price stocks is nothing but the discounted future value, what has happened that makes the future less bright? The democratic enthusiasm for the most liberal of candidates and the bill passed by the democratic congress yesterday tells much of the the story. The congress passed a bill that would increase the taxes paid by the oil companies by 18 Billion Dollars. This industry paid 27.5 Billion in taxes last year but tax collectors always want more, more, more. The congress knows that more than half the American people will fall for the ruse that these taxes would be paid by the oil companies. You and I know that these taxes would, in the long run, be paid by consumers, and in the short run by the share holders, but we are in the minority.

If we were only talking about oil, the problem would not be big, however, the democrats (presidential nominees and current congress) propose tax increases and hidden tax increases on the great majority of the productive assets of the USA. It is a fundamental law of economics that the more you tax something the less of you have. The increases in taxes on production and profits will mean there will be less production and less profits. The current value of assets must fall if the net profit is to be reduced by higher taxes. Finally, if there is less production, you get back into another classic fundamental economic problem which is too much money chasing fewer goods; inflation. I said in the short run, the taxes would be paid by the shareholders. In the longer term, the companies would cut back on production just enough to raise prices just enough to get the companies back to a fair rate of return. Again, the consumer would ultimately pay the higher taxes.


The partial record of liberals running for President follows:

1952 Adlai Stevenson
1956 Adlai Stevenson
1968 Hubert Humphrey
1972 George McGovern
1980 Ted Kennedy
1984 George McGovern
1988 Michael Dukakis
2000 Al Gore
2004 John Kerry

The democrats who won:

1960 John Kennedy
1964 Lyndon Johnson
1976 Jimmy Carter
1992 Bill Clinton
1996 Bill Clinton

The brief Kennedy-Johnson story is that unlike today's democrats Kennedy was a strong defense, low tax democrat who had the support of southern segregationist. Johnson was one of the most liberal senders of all time but he was elected only after serving the remainder of the Kennedy term. The point of this story is that the only democrats to have won the presidency in more than 30 years have been or have run as "southern centrist". Gore, a southern centrist who was gradually pulled over to the liberal side, won elections to the Senate and to the Vice-Presidency but lost when he ran for president as a liberal.

On the republican side, the winners were:

1952 Dwight Eisenhower
1956 Dwight Eisenhower
1968 Richard Nixon
1972 Richard Nixon
1980 Ronald Reagan
1984 Ronald Reagan
1988 George Bush
2000 George Bush 43
2004 George Bush 43

While the only democrat to win two terms was Bill Clinton, who ran to the right of Bob Dole in 1996, republicans had 4 presidents to serve two terms. Reagan was the only one to run and govern as a true conservative.


The center of the curve has moved one step to the left. George Bush barely won his campaign as a compassionate conservative against Gore, the southern centrist who had moved to the left. George Bush governed like a left wing democrat by passing big spending bills for education and prescription drugs, by offering a middle of the road proposal in regard to immigration, while still protecting his "rich" friends on Wall Street. Still, he only narrowly beat John Kerry who ran about half way between where Obama is and the center. The closeness of the last several elections shows that the parties have been putting up candidates that attract "middle voters". Again, this indicates that the middle has shifted to the left as we all know that candidates Gore and Kerry were lefties who came close against a right hander who swerved left.

Since Obama is far to the left, the question, will Obama win?, is a question of just how skewed the bell curve is. We know that McCain is to the left of all the other republican candidates and we know that Obama has the most liberal voting record in the Senate, so, it would seem that McCain will win the greater share of the "middle" voters. The problem for McCain is that there is not much middle left. There are always a certain percentage of voters who will vote democratic no matter and another percentage that will always vote republican.

The Iraq war and the big mistake of republicans in regard to immigration has energized the left to the point that there is not a lot of "middle" to fight over. George Bush won 40% of Hispanic voters when he ran for governor of Texas and his percentage went up in each succeeding election, but in 2006, Republicans were soundly defeated after cutting off "one arm of the body of the republican party". Yes, both the republican and democratic parties look like ugly reincarnations of Frankenstein. The democrats have a union arm, a trial lawyer arm, an atheist leg, a black leg, etc. Neither democrats or republicans can win as "purest". To quote William F. Buckley Jr., "I believe that compromise is genuinely necessary to sustain social relationships..."


A few post ago, I wrote about "crowd psychology". We have all seen the western movie lynch mob. Good people often get caught living their lives based on "group dynamics". We know that the psychology of the crowd pushes stocks too low and too high. The psychology of crowds is a huge factor in politics, people desperately want to be among the "in-crowd".

If you remember the old elevator gage on Candid Camera, you know a lot about "group dynamics". Put a bunch of people on an elevator and have them all face the back, the elevator stops at the next floor and no one gets off but a new person steps on. The new person almost always can not stand to be the lone guy facing the "wrong" direction. If he starts out facing the front and if at the next stop the next person also faces the back, the odd man is psychologically compelled to turn around. It is very difficult to go against the crowd.

On both sides of the political isle each candidate is pushed very hard to say, "me too". During this campaign, all the democrats faced the back of the liberal elevator and all the republicans faced the back of the conservative elevator, with the one exception of McCain. Obama, for example, has frustrated the heck out of Hillary by being quick to say "me too". Obama and Hillary are for and against all the same stuff. The democratic race came down to a personality contest because the differences on policies were sliced very thin.

After McCain was shot down over Vietnam, he survived 5 years of Hell. It does not matter if Vietnam was the right war or the wrong war, McCain is owed a debt of gratitude by all Americans. While his service is to be honored, it is not a ticket to the Presidency even though it does show his resolve to do what is right.

The amazing thing that happened recently is that McCain survived the republican nomination process. A lot of things had to fall into place and he had to be lucky but he survived, despite the fact that in a number of incidences he refused to face the back of the elevator. McCain has gone against the crowd time and time again. He was a member of the gang of 14 who forced the vote on supreme court justices, he was a partner with Ted Kennedy on education and immigration reforms, he fought and voted against the "Bush Tax Cuts", he joined with Lieberman to propose a cap and trade environmental law, and, he joined with Senator Fiengold to pass campaign finance restrictions. While I generally disagree with him on the bulk of these matters, I respect his willingness to turn around to face the front, to do what he thinks is right no matter what the crowd thinks. Regardless of McCain's position on the issues mentioned, he is far, far to the right of Obama.

The key point is that "pure" liberals will vote for Obama and "pure" conservatives for McCain with the fight being for those in the ambivalent middle. The middle includes animals of all stripes, including economic conservatives who are very concerned about the war and Hispanic economic conservatives who feel betrayed by republicans. In McCain, republicans will nominate the candidate that has the best chance of winning the "terror-war" debate and he will regain some of the Hispanic support lost in 2006.

I have to run. But the market wants an answer to the Iranian question and to the political question. I believe the odds of a win by McCain are better than 55%. I am in the great minority on that belief. The success or failure in Iran and Iraq will influence the success or failure of McCain. The push of the FOMC to lower short rates at least one more time will also benefit McCain. A strong economy and foreign policy success will lead to a solution to the markets concern about "tax and spend, tax and spend.

The time to add money to stock accounts is when prices are low. Now is the time to dig deep!

Thursday, February 28, 2008


They say the opera ain't over until the fat lady sings but Hillary does not need to stick around to hear the last song. To win the nomination, Hillary needed big wins in the big delegate states of Ohio, Texas and Pennsylvania and that was before the super delegates started swinging over to Obama. The race in Ohio is tightening and her lead in Texas is gone! Miracles do happen but Hillary is going to need divine intervention to pull out a win.


Obama is the very good politician who, ironically, mastered the Bill Clinton play book. Obama has promised to spend massive amounts of money on all sorts of government programs. As a big city democrat it should be no surprise that in his eyes it should be the federal government building and supporting local trains, buses, subways and L ways. His biggest source of funding? Like Bill Clinton's, "the peace dividend". In Bill's case, the failure of Hillary's massive health care program and his reduction of military spending, allowed him to spend a lot of government money on a lot of domestic programs while making a lot of "friends". Bill was certainly not the first politician to "pay off" the people who voted him into office but he was certainly one of the most prolific. Hillary has been reluctant to show her tax returns because she would have to show how much money Bill has collected from "friends". It is sad to know that CEO's of corporations and successful politicians do not need to worry about what their tax bracket is, provided they continue to have close "friends" in high places.

One of the many ironies of Bills term in office is the fact that it was the enormous size of Hillary's health care plan that scared the congress over to republican control for the first time in 40 years and it was this switch that enabled Bill to become a President of great accomplishment. The republican congress and Bill lowered the capital gains tax, passed several major free trade reforms and passed welfare reform. Hillary ran into the tricky problem of trying to take credit for the economically successful Clinton years while having to run against most of his "republican" policies. It is easier for Obama to attack NAFTA and in his next breath express his support for free trade than it is for Hillary to do the same when she is on record for trying to take credit for this great accomplishment of her husband.

The impossible task for Obama is to spend "the peace dividend" several times over when there is no peace. Withdrawing from Iraq is not the route to peace but only the route to bigger war. The situation is similar to the days when Hitler "annexed" Austria with the tacit "permission" of Roosevelt. It is better to confront early and often rather than to wait for the war to become a World War.


The USA has plans to tighten the noose around Ahmadinejad's neck. The UN security council continues to drag its feet, giving Ahmadinejad every chance to "make a deal", even so the vote will likely take place next week and even Russia is ready to vote yes. Once these latest sanctions are imposed, the US is prepared to tighten the noose again by adding the Iranian central bank to the list of sanctioned banks. This will make international commerce for Iran very difficult and thus put severe pressure on the country leadership to "make a deal". The citizens are already unhappy with a weak economy, rationing of goods and high unemployment. If the second richest oil country is in bad economic shape during a time of $100 oil, the sanctions must be working.


Financial market observers continue to be totally confused by the contrast of the slowing world economy and booming commodity markets. Many observers are using the word stagflation to describe the current situation. They believe the economy is dying a slow death while inflation is out of hand, as is evidenced by the housing slump in the USA and the price of gold and oil. Part of what they miss is that inflation is a very late indicator which means that by the time inflation shows up, the economic slow down is over.

One of the commodities "trades being put on" is the stagflation trade which is to buy gold and to sell oil short. The idea being that inflation continues unabated, the price of gold will rise and if the economy slows the price of oil will drop. The opposite commodities trade is the "peace dividend trade" in which gold is sold short and oil is bought long. The idea here is that if a deal is made with Iran, the price of gold will fall like a stone while the world wide economy and the price of oil will strengthen.

The average fellow is not long one and short the other. The average fellow is afraid that the tightening of the noose on Ahmadinejad will cause a provocative response. If there is going to be an oil embargo or a war with Iran, it makes sense for gold and oil to be very high and for the dollar to be very low. There is no conundrum here! Here again, the extra cheap dollar is giving a strong boost to the US economy. Isn't the invisible hand of Adam Smith wonderful? How about the law of unintended consequences? We have the fear of war pushing the dollar down which is increasing US exports and boosting profits while causing others to fear an economic collapse because they see the dollar going down!

The timing is about right in terms of the business cycle. The Chinese Yuan hit a low in early 1995 about the same time as the dollar hit its low (the Chinese attempt to peg the Yuan to the dollar). By late in the year 2000, the Yuan had rallied from 75 to 110. It bottomed at 90 in 2005 and is now back to 103 and probably headed to 130 by the peak of the coming boom. Today, it took $1.50 to buy one Euro and at one point you could buy one for 78 cents! While the dollar has bounced along the bottom about a year, the Yuan has been rising, however, the dollar will catch up in a hurry and then some when a couple of things occur: when "a deal is made" with Iran or when US rates get so low that the US economy begins to soar.


The previous big declines in US short rates have given small banks the license to print money. After suffering for 19 months of yield curve inversion, small banks are about to enjoy an economic "sweet spot". They will enjoy steady loan demand from small businesses while enjoying low cost deposits. The Russel Small Cap Value Index is heavily loaded with small bank stocks and it is an option in most 401-K plans. The index has underperformed the market for a couple of years. I would be aggressive and move the bulk, if not all of my 401-K money to the index.


The Bush administration has no good reason to discuss how close we are to a deal with Iran. By keeping the negotiations on the "QT", if there is a deal, the Bush team wins but if not nobody knows the difference. With or without a deal, the demand for oil is about to "go elastic" as "stuff" starts to fall into place.

The "stuff" includes every thing from electric cars, hybrid electric cars, and "share cars" to extra oil from here there and everywhere. Big and steady improvements are being made in battery technology at the same time that large numbers of new power plants are being built. The beauty of a battery powered car is that it can give up electricity during peak load times and accept electricity during off peak times. While environmentalist do not like coal fired power plants, one plant is far more environmentally friendly than the 1000s of internal combustion cars it can replace. In the mean time, car companies are moving up the hybrid learning curve and down the cost curve very quickly. In 2004 there were 10,000 hybrids on the road in America and in 2008 there are over 80,000. Better batteries means more units will plug in to the grid and that engines will be smaller. With more than half of the worlds population now living in big cities, the electric models make sense for a lot of people. The "share a car" systems are growing quickly. The average city dweller who sells his car and joins a "share a car" program, reduces his annual auto mileage from over 5,000 to less than 400. City people can take the bus or subway to work but they need a car for the occasional evening outing.

Honda is the first to have started limited commercial production of a hydrogen powered fuel cell car. The most interesting part of their system is the "home hydrogen appliance". These appliances are hooked to the electrical grid and to a natural gas line. They use electricity during off peak time to convert natural gas into clean burning hydrogen. The hydrogen is used as the fuel for home and cars.


Dozens of existing refineries are being built and dozens of older refineries are being expanded. It took a few years to get new oil fields developed but now that several are coming on line, the new refineries are being built to accommodate the extra crude.


At the turn of the mid cycle turn of the 1980's, oil did not decline in price, it crashed. I see a similar event on the horizon. A deal with Iran would certainly surprise the great majority. Just remember, the opera ain't over until the fat lady sings and the noose is around the skinny chickens neck!


During the upcoming general election campaign the question that will be repeatedly asked: "Are we safer today than before 911?" Asked in another way: "Is al-Qaeda capable of pulling off another major attack.

Obama talks about withdrawing from Iraq while putting more effort into Afghanistan. The problem with this strategy is that the battle being fought in Afghanistan is with the Taliban not al-Qaeda. The Taliban allowed al-Qaeda to operate training camps in Afghanistan before 911 but those training camps were put out of business when the first US bombs fell. Chasing akl-Qaeda out of Afghanistan was easy enough but eliminating the Taliban would require a large military action for a small benefit.

Go back in time about 19 years and we discover that with the Taliban was able to defeat Russia. Sure, the US helped by supplying arms (see Charlie Wilson's War), but it was the tenacity of a tribal people living in remote, mountainous terrain that won the war. Taliban tribesmen on horseback were able to prevail against Russian tanks and Heine Helicopters. US and NATO forces support the Afghanistan government forces but these forces at current levels have very little chance and, are not even making a sincere effort, to win control of the Afghanistan mountains.

Even if the US-Allied forces were to win control of the mountains of Afghanistan, al-Qaeda has crossed over the border into the mountains of Pakistan. Obama's emphasis on Afghanistan goes nowhere, unless he is prepared to send US troops into the mountains of Pakistan.

There is evidence that al-Qaeda forces have reorganized within the border of Pakistan. Part of the reason they have reformed in Pakistan is because they have been beaten back from Afghanistan and Iraq. Their military losses have been heavy and, most importantly, they have lost and continue to lose their top leaders. There is little evidence that this group has the ability to launch a 911 style attack. Were it not for the support of "national sponsors" this group would be of little concern to the rest of the world. Do we really believe that Obama is ready to invade an allied country? It makes good rhetoric to say that George Bush is fighting the wrong war but it is foolish to suggest that wiping out the tribes who live in these mountains is the top strategic US objective.

Iraq is strategically located between Iran and Syria and these three nations were, for a number of years, among the nations that openly backed terrorism. The most powerful country in the region, Iran, is a sponsor of terrorism and it is developing nuclear technology. It would be morally wrong to ignore this country's willingness to supply suicide-homicide bombs for the purpose of killing innocent men, women and children.

It is sad to say but, in order to make the people of the world, Americans included, willing to stand up to the terrorist, the "Weapons of Mass Destruction" part of the story must be emphasized. It is true that the prior government of Iraq used chemical weapons to kill thousands of people, it is true that Iran has pledged to wipe Israel off the map, and it is true that Iran has worked on nuclear weapons, but even if this were not true, the encouragement of those willing to blow up innocent people is the reason to confront these governments. In the case of Pakistan, the government is on the side of defeating terrorist. If the government of Pakistan was the sponsor of the terrorist, then Pakistan should be next on the list to confront. Obama's words that the war in Iraq has only served to distract us from the war in Afghanistan totally misses the mark. His words are nothing more than poll driven political rhetoric. Obama needs cover so that he can switch horses before the general election. During the primary, Obama is the left wing anti war, anti NAFTA candidate. When the general election starts, he will be the anti Osama bin Laden, free trade candidate.

The problem is that another 911 could happen. To prevent another 911, the USA and the rest of the world must confront states that support terrorist behavior. Americans would be elated for Osama to meet his doom but killing this one man is not the key to limiting the threat of terrorism. Iran is the biggest remaining piece to the stop terrorism puzzle. Countries such as Libya have turned 180 degrees. Let us hope and pray that the government of Iran can be turned as well!

Tuesday, February 26, 2008


Inflation is up and home prices are down, it is just a bad, bad, bad, bad news day. The market is up. Even before the "market" was up, most stocks were up. All kinds of little stocks are moving in the right direction.


Good news! The free trade horse is out of the barn and there is no way for Hill-Obama to put it back. The bad news is that they will severely damage the US economy if they are able to implement even a small portion of their protectionist ideas. The other good news is that even if elected, they will not be able to get much of what they have been proposing past the congress. There is political irony flowing in all directions.

You might recall that Abraham Lincoln, a republican, was "a champion of the people", the black slaves in particular. What you may not remember is that Lincoln was "the champion of big business" who said to heck with the prices paid by the little guy. When a government places a tariff (tax) on imported goods, the government raises the profits for that business but causes all the consumers to pay too much. Lincoln was the champion of equality who promoted inequality by his close ties with railroad barons and by his tax and spend policies.

In one of the all time biggest transfers of government wealth to the hands of the few, Lincoln slapped a 44% tariff on imported goods so that his administration could pay for the construction of privately owned railroads. History books are apt to mention the building of the transcontinental railroad as the crowing economic achievement of the Lincoln administration but the fact is that Lincoln was dead in 1862 many years before the railroad was completed and the "Golden Spike" driven in 1869 was only a publicity stunt. The spike was driven after the completion of the connection from Omaha Nebraska to Sacramento California, well short of the Pacific Ocean and very well short of the Atlantic.

The "gentleman" that made the most off the construction was Thomas Durant. The law passed by congress outlawed more than 10% ownership by any one person. Durant, who made his first fortune by smuggling cotton during the war, paid other people to hold shares for him in their names. He ultimately owned 50% of the Union Pacific. His list of tricks included putting oxbows into the routes because he was being paid by the government for each mile constructed. He also played dirty tricks to grab land that was then sold to the government at inflated prices. On other occasions, he let out false rumors of where the spur lines would go to give him a chance to buy shares in competing railroads that would ultimately receive the rights to these lines. In other words, Durant paid bureaucrats and congressmen to gain insider information. No one knows for sure how many congressmen looked the other way while Durant plied his corrupt trade but the Union Pacific went bankrupt a couple of times along the way.

Durant was not the only one who took advantage of the government. On more than one occasion, an eastern leg would purposely miss the connection to the western leg so that two tracks were built parallel to each other with the government stuck with the bill for both tracks. In another ploy, "agents" of railroads pretended to have the right of imminent domain to take land, it was sign it over for a little bit of money now or lose it in court with no compensation. By some accounts, Frank and Jesse James got into the train robbing business after their Mother was cheated out of the family farm. Another tragedy occurred when certain Indian Lands were taken. The Indians fought back but the railroads hired soldiers to kill tens of thousands of buffalo, demoralizing and starving the Indians. Still, the worst part of the story was the treatment of laborers. The US had just fought a war to free black slaves so it would not have been kosher to rely too much on "negro" labor. Since the work was hard and dangerous, other minorities were "recruited". The Irish and Mormon's were paid from $1 to $3 per day. The Chinese, many of whom were "Shanghaied" were lucky to receive 50 cents and a bowl of beans per day. To speed the tunneling through the mountains, a volatile compound called nitro-glycerin was introduced. No one knows how many Chinese were killed before the story was reported. From the governments point of view, the link-up of California to the east was worth whatever the cost, because a significant percentage of Californians wanted to succeed from the Union.

At any rate, Lincoln imposed the horrendous tax of 44% on all foreign goods for the purpose of building the transcontinental railroad. After the devastating war, the people needed to complete the long talked about "manifest destiny" of a United States from "sea to shining sea". As any student knows, new "taxes die hard" and we should know by now that any country that isolates itself from the rest of the world ultimately pays a dear price. By 1929, the size of tariffs had fallen from 44% to less than 8%. When the depression hit, big government republicans, Hawley and Smoot naturally thought that the problem could be solved by legislating a series of tariff increases. Uh Oh! this was exactly the wrong policy needed. Before the ink had dried on the final bill and well before the bill was signed into law, Canada and other nations retaliated. The bill was signed into law June 17, 1930 and a tough economic time was turned into The Great Depression.


Dwight Eisenhower was the first "champion of the people" versus the historically "big business republicans". Ike was not liked by "conservative" republicans because he continued the democratic "new deal" tax and spend policies. Even the reduction of war spending did not keep Ike from adding to the government deficit. He continued to expand "domestic programs". The construction of the Interstate Highway System was basically a "new deal, make work, project". The most economically sound part of his administration was his trade policy. Ike followed the Roosevelt and Truman lead and by 1956 the success of his trade policy forced many to repudiate the failed policies of the past.

Over the years, a couple of good trade steps forward were always followed by at least one step backward. Along the way, big unions joined big business to fight for exorbitant profits and wages by "protected businesses", this, all at the expense of consumers who were forced to overpay for the goods and services offered by these "protected industries". In modern times, there have been three presidents who deserve the most credit for championing the cause of lower prices for the people. They were John F. Kennedy, Ronald Regan and Bill Clinton. The president, who was at the right place at the right time and who did the most for the people was Bill Clinton. During his term, in 1994 NAFTA and in 1995 the WTO came into being. NAFTA gets the most press but all members of the WTO are automatically granted most favored nation trade status with all other members.


As Paul Harvey would say, "Here is the rest of the story".

Moises Naim gives us a clue to the rest of the story in "Foreign Policy Magazine", where he reports that from 1983 to 2003, sixty-six percent of all tariff reductions were unilateral! In 1992 when the European Union lifted barriers to internal trade of goods and labor, the US was left with little option but to come up with our own expanded trading alliances. But, the root of the story goes back further. It is no coincidence that free trade agreements started happening after the Reagan tax cuts of 1981 and after the privatization of industry by Margaret Thatcher in England. Today, people worry about the weak dollar but are they willing to reduce corporate taxes? Why not?


The old business story is to make a good product and the world will beat a path to your door. This can and will happen in the country that allows free trade. The entrepreneur in a free country will be able to buy the raw materials he needs at the lowest price and he will be able to get the highest price available when he sells his finished products. In the event that another country imposes a tax on his raw materials or his finished goods, he will do fewer transactions with that country. The big mistake would be to retaliate for imposing the tax with counter taxes. The country that imposes the tax is the country that reduces its trade activity. Since it only makes sense to do profitable trades, the country that reduces its trade activity is the country that reduces its profits and ultimately its wealth.

With 66% of all tariff reductions from 1983 to 2003 being unilateral reductions, it is clear that world leaders have come to understand the truth of free trade, which is that the country that is harmed by tariffs is the country that applies them. In 2006, we enjoyed a world wide booming economy. The weighted average GDP growth in 2006 was better than 4%! This strong showing could not have been possible without trade. In 2006, global merchandise trade grew at the annual rate of 15%!

The horse is out of the barn and any country who would try to put it back would harm themselves. Trade is win-win or zero! A couple of weeks ago, Chavez of Venezuela made himself a laughing stock by threatened to suspend oil trade with the USA. Anyone with a lick of sense understands that trade is a two way street. We want to buy oil from Chavez and he wants to sell it to us. If he were to choose not to sell his oil, his country would be bankrupted in a few weeks.


It was almost 100 years to the day between the imposition of 44% tariffs by Lincoln and the passage of Kennedy's 1962 free trade policy. One might conclude that we learned our lesson from history. However, today, Hillary and Obama are running as protectionist and our congress still practices outrageous practices similar to those that made Thomas Durant a very wealthy man. Today, 5% of the congressional districts collect more than 50% of the total farm subsides paid!

Polls of economist show that 87.5% to 91% believe free trade benefits America. Polls of voters show that 60 to 65% believe that free trade hurts America. Among democrats, 80 to 85% of voters believe free trade hurts America. As a result, Hillary and Obama make misleading statements about trade. They have both expressed their belief in free trade but when campaigning in a state like Ohio that has lost manufacturing jobs, they both demagogue NAFTA. Since NAFTA was passed, the USA has added 27.5 million net new jobs. In the 15 years before and after NAFTA, about 3 million manufacturing jobs were lost. The fact is that industrial robots have permanently eliminated about 6 million jobs over the past 30 years.


People naturally like to remember the "good old days". In the 1950's the average Mom was a "stay at home" Mom. Boomer's like to remember how nice it was for Mom to be home before and after school. My wife and I went the extra mile to make this happen for our own kids during the 1980's and 90's. The problem is that we had to work as hard as the Mom's of old. The average Mom in the 1950's worked in the home 52 hours per week and spent a lot more time in "volunteer" activities, such as keeping the nursery at Church on Sunday. Men, in the 50's, worked two and three jobs, their regular jobs and their "home" job. Many a home owner was a jack of all trades. My Dad was one who never stopped working. He maintained a tractor, raised a big vegetable garden, maintained the house and the list goes on and on. We used the same black and white TV for 25 years because he was an expert TV repairman. In addition to being an auto mechanic, he was a paint and body man too. He would come home after dark from a long day working on an anti-ballistic missile system only to start up his next home project.

When Hill-Obama talk about the decline of the middle class, they are playing to the crowd. The best measure of standard of living is the measure of ones time. How much work time does it take to buy a radio today relative to 10 years ago? Today, people think that they are more busy than ever before but the reality is that people do more of the things they "want to do" today. They drive their kids to the soccer match because they want to. The great majority of the people of the 50's were busy "earning a living". Most did not consider going rock climbing, golfing, biking or first Saturday Night Bridge.


The market is climbing the "wall of worry". Each day it seems like there is bad news in the morning and higher stock prices in the afternoon. All the while, my confidence grows that our country will not be steered into the left hand ditch. The good common sense and accumulated knowledge of the American people will prevail!

Monday, February 25, 2008


For a few months, it has seemed like the buyout fever had been cured. Take note, it is coming back. Several buyout bids have been made in recent weeks and several purchases have been negotiated. The MSFT -- YAHO deal and the DAL - NWA deals have gotten the most press but there have been many others.

Folks, financing is available. Loans are being made. Business is getting done. There is NO RECESSION!

The pump has been primed. Trillions of dollars on the sidelines is ready to flow.


After under-performing the market for a couple of years, small cap US stocks are likely to do well for a couple of years. It is time to switch you 401-K money to the Russel Small Cap Value Index!

Sunday, February 24, 2008


Even though Hillary and Obama have proposed socialist policies in their attempts to win the democratic nomination, Ralph Nader has once again entered the race as an independent. The effect is to help keep Hill-Obama to the left. Had Nader not been a candidate 8 years ago, Gore would have beaten Bush. Now one can argue that the republican congress would not have allowed Gore to spend such big money as has Bush but the entry of Nader does tilt the odds a little bit toward McCain.

Obama's supporters certainly have enthusiasm but will "the mad in the middle" support Obama or McCain. The far right has threatened to stay home but, so far, McCain is being left with more freedom to try to capture "middle men" than Obama.


Even though NWA pilots will get 25% raises upon merger with DAL, they are still battling for the best seniority deal they can get with DAL pilots. I expect the issue to be resolved within a few days because the one time bonus and increased pay are calling.


This week offers a lot of potential for a financial turn around. A bailout of the mortgage insurance companies would cause a whole lot of mortgage backed securities to bounce in price. Banks, investment banks and insurance companies should see the first bounce but the ultimate ripples should be far and wide. The market has repeatedly had trouble negotiating the mid cycle turn because short term interest rates have had to be lowered to save the financial economy before the speculative fever has been run out of the commodities economy. The turn of the mortgage market will ultimately result in the turn in the price of gold and oil.

We have been here a few times in recent months but, this time, I believe we will get over the hump!

Saturday, February 23, 2008



About 18 months ago, I bet a friend, giving him 3 to 1 odds that Hillary would not be the next president. At the time, I said I would almost make an even odds bet that she would not be the democratic nominee. Then I was surprised that no major player stepped up to give her a serious challenge. Al Gore apparently came close to making a run but, who can blame him of staying out of the race when he is enjoying huge profits by fanning the fears of environmental Armageddon. When the contest got down to two extreme liberals and Hillary, I thought I had lost my bet. I assumed she would win the nomination and be in good shape to win the support of moderates during the general election.

However, it turns out that, I underestimated the willingness of democrats to go left, go left, go left. For a long time, Hillary carefully chose her words such that she could still move toward the center for her general elections run. This was making me nervous because I felt that a moderate Hillary would have about a 50/50 shot at beating a moderate McCain. Here again, I found a new surprise. In recent weeks, Hillary has unsuccessfully tried to move to the left of Obama. It will never be known for sure but it appears that she could not win the democratic nomination by running as a centrist candidate. What was not clear early on was the amount of resentment the left wing has over the switch Bill Clinton made from democrat to "republican" for his second term. Clinton ultimately signed off on powerful and positive economic reforms, including welfare reform and free trade. He was even able to successfully run to the right of Bob Dole for his second term election. Bill's republican policies served the country well but Hillary has been forced to run against her own husbands record. By the way, Bush tried the Bill Clinton strategy in reverse. He attempted to dress up his conservative positions with a little bit of liberal sheep clothing. He passed democratic big spending programs such as "no child left behind" and "the prescription drug benefit" but ultimately got no credit from democrats and scorn from republicans for these poor substitutes for real reform.

Obama has done such a masterful job of keeping Hillary cornered that one has to respect his chances in the general election. What we are dealing with in regard to elections is the psychology of crowds, or according to Carl Jung the collective unconscious. Democrats are determined to elect a true liberal to the presidency and they intensely believe that they can win with a candidate from the extreme left. Gustave Le Bon was a student of crowd psychology back around the late 1800's in France. His book, La Psychologie des Foules is about how irrational crowd behavior can be. I can't remember the name of the researcher who did the study but it has been shown that if 7 of your friends say something is true, the odds are that you will decide to agree even if you know the something to be false. If 7 friends agree that "it is true" and if an 8th friend has not yet expressed his opinion, the odds jump to the 90% range that you will agree to the "false truth". Another way of saying this is that we really do want to avoid the potential of being ridiculed by our friends as the "odd man out". This is probably the reason the greatest inventions tend to be made by lonely individuals. People who had rather seek truth than to be told what is truth.

William Trotter talked about crowd psychology in terms of "heard instinct". Any student of the stock market is familiar with Bull and Bear Market Psychology. In a Bull Market, the crowd bids up the price of stocks far above their intrinsic worth and in a Bear Market, profits and value do not amount to a hill of beans. Right now, stocks earn an average of about 50% more than bonds but the public believes what they are being told by their friends in the media. This is sometimes referred to as the "halo effect"; if one teacher gives Johnny a good grade, the next teacher is more likely to grade him well and vice versa.

The current democratic nomination process has taken on a Bear Market "halo". No matter what the evidence shows, the war is going badly as is the economy. In the recent past, democrats have won and lost the presidency due to third party candidates. This time they are determined to nominate a candidate so far to the left that no Ralph Nader will rise up to siphon off votes primarily from democrats. That is the logical part of the current fervor for leftist positions, but, have the democrats moved so far to the left that they cannot hope to win the majority of "moderate" "independent minded" "middle of the road" voters?

Around 1966, a follow up to the study of "madding crowds" was done by William Schutz. His study showed that there are three stages to joining a crowd; inclusion, control and affection. In the last debate, when Hillary showed what seemed to be sincere affection for Obama, I almost fell on the floor. Obama has gradually moved Hillary from the centrist opponent to just another "me too liberal".


There are big problems in the USA in need of a governmental nudge. Corporations should be required to submit executive pay packages for shareholder votes. Funding for universal preschool should be made available (perhaps by reducing government funding for 16 to 18 year olds). School choice should be the law of the land and funding should follow the student to the school of choice. Health care spending should be returned to the control of patients. Immigration reform should take control of our borders while allowing "competitive immigration"; we should welcome the most eager and most qualified to come to America. Corporate taxes need to be reduced in order to help consumers and in order to attract more jobs to America. Taxes on work and capital should be reduced dramatically and partially replaced with excise taxes on harmful activities such as burning dirty coal. Silly subsidies, such as payments for growing corn, should be eliminated. Social Security benefits should be indexed to wage inflation.


The Ambac re-cap will be a private transaction with no tax dollars going to bail out businesses, which is the right way to do business in America. Unfortunately, businesses are lobbying hard to add new "corporate" welfare programs. Duke Power, GE and others who stand to make billions off cap and trade systems, are eager for another big government program. Both McCain and Hill-Obama support these grand governmental schemes. All politicians find it hard to resist the mighty dollars available to those willing to support "corporate largess".

Another huge lobbying campaign is for companies to receive government funding for research and development. Believe you me that the company that is able to invent or discover the way to turn cellulose into fuel or a stem cell into a new heart will reap unimaginable rewards. Billions of dollars are being spent on all sorts of research; it makes absolutely no sense for politicians or bureaucrats with vested interest to pick or choose which projects should be funded. The idea that the government should give companies upfront bonuses for looking for profitable commercial processes is as silly as it gets. What a long way we have come from the days when Ben Franklin invented "stuff" as a public service to the current times when "pigs" want to feed at the government trough before sticking the royalty payments to consumers. By the way, there are tons of people who think they have great ideas worthy of research. When they can't find funding for their research they tend to blame the market place. The reality is that it may take some selling to find support in the market but the government is far more likely to turn down a good idea.


All is not lost because the mad crowd to the extreme left is almost matched by the size of the mad crowd to the extreme right. The political fight this fall will be to win the schizophrenic middle. Some in the middle will be for the republican strong position against terror while perhaps these same individuals might be against the republican position to reduce corporate taxes. Others, having a hard time making a choice, might be for the republican position for school choice while being for the democratic position for universal health care. Some will be swayed by the educated political skill of Obama and others by the educated military mind of McCain. We should all hope that neither party gains control of the house, senate and presidency because history has shown how wasteful one party control can be. It usually takes a very long time to repair the damage done by one sided legislation.


The prospects for a divided government are the best they have been in a long time. The market is likely to begin to discount this improvement in the weeks ahead. The market had a very bad day the same day that the negative article broke in the NY Times was published. By Friday afternoon, it was clear that the article had no legs and that it had served to unite conservatives behind McCain. The market moved up Friday after the Ambac story broke but, the upturn for McCain might have smoothed the upward path.

In any event, I have taken a couple of Saturday hours to write because the market upside from here is great.


Friday afternoon the story broke that Citibank, Wachovia Bank and others are in negotiations to re-capitalize Ambac, one of the mortgage loan insurance companies. The stock market went from down a little to up a lot in the last hour of trading. Is this Ambac story likely to be true? If so, what will the consequences be? WOW! The market is ready to move!

The story is likely to be true because it is in the best interest of the banks to snatch a share of ownership in this deeply discounted company while saving their own hide! Bank shares have fallen sharply but the mortgage insurers are down from the $80 area to the $10 area! Right now, banks hold billions of dollars worth of mortgage backed securities that have been written down to various levels of "cents on the dollar". This does not mean the assets are only worth "cents on the dollar". The reality is that the great majority of mortgages in America are being paid and will be paid at 100 cents on the dollar plus interest!

The insurance companies are, no doubt, the first line of defense. They are like cannon fodder on the battlefield and they will suffer each time an insured mortgage goes unpaid. However, the big decline in interest rates last month means the interest rate on most of these loans will remain near the original issue rate. Many a homeowner who has been frightened to death by the talk of soaring mortgage rates will be greatly relieved to discover that his rate is going to stay about the same.

Pundits who talk about the soaring foreclosure rate imply that the credit markets are in bad shape. On the corporate side, balance sheets have perhaps never been better. For the first time during my life, corporations are net savers! On the consumer side, consumer debt outstanding has come down as percentage of total assets for 4 years in a row. Bankruptcies are low, interest rates are low and employment is strong. To say that foreclosure rates are soaring is like saying that a rainy day after a prolonged drought is likely to make the dam break; lake levels rise quickly after the first rain but the size of the lake expands as the lake level rises so the second, third or fourth rains of equal amounts do not increase the water level as much as the first rain. The situation in the credit markets is that problem loans had gotten to very low levels so the recent problem did cause a big jump relative to the prior year but not a big percent in terms of total loans outstanding. To put it another way, during the recessions of 1973-74 and 1990-91 a lot of banks went belly-up but banks are in good shape this time around. Northern Rock Bank in England is the exception that proves the rule.

Yes, a lot of banks, hedge funds and insurance companies hold mortgage backed securities and there is little trading in this market. I submit that there is little trading because holders do not want to sell during a temporary down turn. If you were CEO of a bank holding securities that have a par value of $1,000 are paying interest on the $1,000 and are backed by insured mortgages that are by large measure being paid on time, would you be willing to sell for $600?

The recent whine has been that the two big mortgage insurance companies might lose their AAA rating which would limit the ability of banks to make new mortgage loans. The two big insurers, MBIA and Ambac, are solvent, they have the assets to honor their obligations. They do not have the assets necessary to maintain their AAA credit ratings. What if?

What if Citibank, WB and others were to invest enough cash into Ambac such that the AAA ratings would be secure. The billions of dollars worth of securities being held by these banks would appreciate back towards par value. The banks would once again be able to make loans to credit worthy borrowers who do not have 20% down payments available. Suddenly, pent up home demand would be released. Demand for homes would increase such that those struggling to pay would have greater incentive to do so and the option to sell would look more attractive as the price bubbled back up. Even the demand for foreclosed homes would be improved. In the past several months, 11 months supply of unsold homes has fallen to 7.5 months, even though the selling rate has been slow. In other words, the number of homes coming on the market has been less than the number of homes being sold. Speed up sales a little, and the unsold inventory will come down at a very fast pace and the "housing crunch" will be over. The psychology will have suddenly switched, on the buy side from "no need to buy in a hurry, home prices and interest rates are falling" to "we had better buy now while there are still bargains left". On the sale side, the psychology will switch to "lets wait to put our house on the market because prices are going up".

What if the pressure were suddenly off the FOMC to lower interest rates?

There is a strong possibility that a deal will be worked out this weekend to re-capitalize Ambac. A second group of banks, those who use MBIA as their insurance provider, will follow the Ambac lead. In other words, it is likely that the market will know that the mortgage credit crunch is over by next week and perhaps as early as Monday. With the credit crunch over, the rational for the FOMC to reduce short rates more will be "fini". The world wide economy is simply too strong for lower short interest rates if there is no longer a "housing crisis".

If the short interest rate cutting cycle is over, then the commodity surge is suddenly over. The price of gold, oil and other commodities should decline as soon as it is clear that the FOMC will once again focus on inflation. Once the price of gold turns, it will turn with a vengeance. Huge holdings of commodities have been sequestered as a result of commodities having become a "financial asset class". The gold ETF's must purchase gold in order to issue new shares in the fund. Once the shares are redeemed, the fund no longer has the funds to support the price of gold. Once this gold starts coming back on the market, the extra supply will reduce the price which will make more people sell shares of the funds. This feedback loop will not end until there has been a significant decline in commodity prices.


The steep drop in commodity prices will give the FOMC the ability to raise interest rates by doing nothing. The latest headline inflation rate of 4.3% combined with a fed funds rate of 3% leaves a real interest rate of negative 1.3%. People have been paid to hoard commodities. This is the reason you may have heard the stagflation word being bandied about. In the 1970's, the economy went through a prolonged and devastating period of higher and higher inflation rates and negative real rates. The fear is that we are now in or about to move into a similar period.

The fear is a reasonable fear to have if you listened to the latest Hillary -- Obama debate. The fiscal policies supported by Hill-Obama are essentially the same as the Johnson policies that got the prior wage-price spiral started. In fact, Hillary has even proposed a five year mortgage rate freeze which is similar to the ineffective Nixon responses to the problem. There is political risk of a return to stagflation, however, on the monetary side of the equation, we are no where near the failed policies of the 1970's. After Johnson decided to offer the nation both "guns and butter" by fighting the Vietnam war without funding the war with higher taxes, the FOMC "monetized the debt". This means the FOMC printed the money to pay for the war. Money is just like any other commodity, produce too much of the stuff and the value of the stuff must fall. By the end of the late 70's all money was "hot money", you needed to spend it today because it would buy less tomorrow. Good news: the FOMC has not been printing money to monetize the Iraq war. The money base has not grown hardly over the past 4 years.

Again, if Ambac and MBIA are re-capitalized, the housing mortgage market will quickly "return to normal". The housing crunch will be over and there will be no reason for the FOMC to increase the money supply or to cut short term interest rates. The psychological support for higher gold prices will be suddenly gone. Oil, gold and other commodities will lose a big chunk of inflation risk premium. Headline inflation will fall hard. Suddenly a 3% fed funds rate will represent a high real rate. High real rates will reduce the attraction of gold all the more. Oil and gold are routinely hedged by one another and they trade together. The decline in gold will be accompanied by a decline in the price of oil. The central bankers of the world will breath a sigh of relief as their job of holding down inflation will be much easier. Low inflation is on the other end of the stock market see-saw.


Friday, February 22, 2008


When my wife and I operated our resort condo rental business, we bought a lot of furniture. The purchases were non events on our income statement. When we bought the furniture, we simply traded cash for furniture on our balance sheet. Following the federal law, we expensed the furniture over the seven years following the purchase. If our rental income stayed the same, the portion of the furniture expensed during the year showed up as a loss on our income statement.

Today, the pundits constantly focus on consumer spending to tell us if the economy is doing well or not. They like to tell how consumer spending is more than 70% of the annual GDP. The point is valid if kept in context but the big picture is much bigger indeed. When Duke Power builds a power plant, it does not show up as consumer spending. Power plants are like beach furniture. Power plants generate a lot of cost and a lot of revenue but it takes a lot of spending before there is a profit or loss to report.

National income is essentially equal to profits plus wages. But profits is a net number. It takes a lot of purchases of a lot of goods and a lot of sales of the final product to produce profits. Profits might be 5% of the amount of sales. When we typically see a figure for investment in the US accounts, we are usually looking at net investment which is an extremely small number relative to the investments made. Over long periods of time, net investment grows at about the same rate as profits are a percentage of sales. In the case of the furniture mentioned above, the furniture loses its value over time but the government allowed us to "get ahead" a little by allowing us to write off twice as much of the annualized value in the yearly years of ownership. Also, in the event the furniture lasted more than 7 years, we enjoyed the ownership of some used furniture without showing it as an asset with real value on our books. If we sold the fully depreciated furniture for any amount, the entire amount had to be reported as a taxable gain. In the USA there is a lot of value in fully depreciated plant and equipment. It often stays frozen in place in order to avoid capital gains taxes.

One point I am trying to make is that Americans have a net worth of 58 trillion dollars (much more in assets) but the pundits focus on the annual, double entry accounting, income of 14 trillion dollars. The fact that the 58 trillion is growing rapidly is dismissed as not newsworthy. Put another way, our condo rental business lost money year after year but the value of the condos went up year after year. The American people continue to enjoy a net increase in net worth even though they have been told that their house is falling in value.


People see the massive amounts of money flowing from pockets in the USA to the pockets of the oil producers and think the high price of oil means that there has been inflation. This flow of money is like the money my wife and I spent on furniture. We were not made less well off by our purchases. Buying the furniture allowed us to charge a good rental rate for a week at the beach. We profited or at least believed we would profit from the purchase of the furniture or we would not have bought it. Buying oil is the same. We only buy oil because we benefit more than it costs. If we did not, we would buy something else. If the price were really too high, we would buy a scooter, bicycle or shoe leather. The purchase of the oil did not create or destroy money. The oil seller traded one asset for another as did the purchaser. The seller is left with the choice of how to "spend" the money, but if all he does is trade it for another asset, then no inflation has occurred.

The current high price of oil is encouraging a lot of people to look at ways to produce more oil and it is encouraging a lot of other people to look at ways to use less. The real mind bending, counter intuitive and most important point is that it is not the spending that stimulates the economy but it is savings that does the trick!


The reason I went though the mess above about how the consumer is really a much smaller piece of the total economy than the consensus belief is because it is not consumer spending that stimulates the economy. Again, moving money from cash to oil is only an exchange of one asset for another. But, what happens when a hundred dollars are deposited into a five year certificate of deposit? The bank is allowed to lend about $92 of those dollars to another person. The person who deposited the $100 still has his $100 in the bank but the second person has $92 to invest.

The congress of the US just went through contortions of logic to explain why the "stimulus" package needed to go to the poor people who would spend it. The idea was to get the maximum "bang for the buck". When an individual, business or government borrows money to spend, they have increased the money supply and thus they have given the economy a short term boost and a long term financial obligation. They have also started a ripple effect whereby each dollar is re-deposited and re-lent an average of 5 times. Thus one dollar of new spending can become $5 of new spending. The fact that the government is likely to spend the first borrowed dollar unwisely, does not take away the stimulative effect of the remaining dollars.


The good news is that dollars are still flowing in and out of banks. Because the world wide growth momentum is so strong, the FOMC held their feet on the economic brakes for 19 months. Six months ago, excess liquidity finally dried up and the FOMC began to gradually let up on the brakes. Six weeks ago, liquidity finally started showing up again as evidenced by the drop in LIBOR rates.

Despite what is being said by financial news reporters, the credit markets are not "frozen up". Loans outstanding are rising. Asset values are down and yet there is plenty of money available. The potential for a big bull market is strong.

The short term problem is that commodities are still getting all the "juice" from speculators. Gary Shilling has this part of the story nailed. Investment managers must show investments in "hot areas" on their books or the public will take their money elsewhere. The thing is that there are several million people now trapped in a barn that is about to catch fire. Investors will not be able to get out of the barn fast enough to save themselves from financial loss.


Once the money starts to flow out of the commodities pocket, where will it go? I believe big cap stocks that have technology franchises will be among the beneficiaries. Companies such as IBM and MSFT will enjoy strong business growth for the next several years and they will enjoy high price multiples for those earnings. The combination of higher PE's and higher profits will lead to much higher stock prices.

The 58 Trillion Dollars of American net worth could easily swell by 10 trillion in just a few years. This will not show up as new money or inflation. After the big run, the public will once again be ready and willing buyers. I hope you buy all you can now so that you can be a willing seller.


It seems like a very long time ago when I wrote that energy stocks would pass the leadership torch to US big cap growth stocks. At the time, I encouraged readers to move their 401-K accounts out of small caps in favor of the S&P 500 index, which was the "good part" of the call. The S&P has outperformed the Russel 2000 for almost two years. The expectation that tech stocks would beat the energy stocks has been a mistake so far. Still, I had rather be early than late to the party and this party is just getting started.

The broad energy index was up 31% over the past 12 months whereas the technology index was flat. The last 5 weeks made up a significant part of that performance spread as oil prices bubbled up one more time. Those who have stayed with the energy sector have done well but the risk from here are high. Inventories in the US have been building for several weeks because the high price is destroying demand.

High inflation rates in China, India, Australia and many other countries are pushing government officials to consider tighter policies. The US is already on the "other side of the hump". US officials are providing both monetary and fiscal stimulus whereas many other countries are either holding the line or even making tightening moves. Tighter monetary and fiscal policies will slow the demand for oil and give producers time to bring the several new elephant fields on line.

China will remain the wild card as it continues in its hyper drive mode in preparation for the Olympics. No matter, the price of commodities always over and under shoots and huge investments are underway which will increase supply. Sooner or later the profits in the tech sector will lap the profits in the oil business.


In the US, the yield curve is very bullish. The talk about the extreme problem of mortgage resets in the US has died. With the Fed Funds Rate at 3%, the resets problem is no longer a big deal. Low short rates have given business and individuals lower payments on floating rate loans and the opportunity to make reasonable "borrow and spend" decisions.

The numbers show a steady increase in commercial and industrial loans, in consumer loans and even in real estate loans. Clearly there is a bit of schizophrenia in the air. Sentiment surveys show that people are very concerned about the economy but at the same time they are generally confident about their own situation. People are complaining about all the jobs that have left America but most have the best job they have ever had.


Which person is most likely to be happy? The person who consistently makes more than $100,000 per year, the person that consistently makes about $60,000 per year or the person that made $40,000 two years ago, $45,000 last year and $50,000 this year? The answer is the third person. People want to know that they are making progress. The average employee at American Airlines makes $84,500 per year but he is not a happy person. AMR employees gave up wages to help the company survive and now they want the wages back. The employees at CAL make an average of $66,000 per year but, the company did well this year and the average employee got a bonus check of $4,500. The CAL employees tend to be happy.


In Greg Mankiw's posts about income and happiness, he reports that surveys have consistently shown, since 1972, that Republicans are happy relative to Democrats. Indeed, 45% of republicans report being very happy compared to only 30 percent of democrats. I think the reason is that democrats tend to believe either the USA is going down hill or that the "little guy" in America is being "left out". Republicans tend to believe in the Horatio Alger story, even the poorest republicans believe they can pull themselves up by their individual efforts. Democrats are more likely to believe that they need help to survive. As a result, many democrats are "trapped" by reliance on the assistance of others.

The story is told of a single mother in Boston who found a better job. Her old job paid $25,000 per year and the new paid $35,000. Unfortunately, she could not make ends meet after accepting the new job. Her new income reduced her rent subsidy, eliminated her free child care vouchers and disqualified her for the Earned Income Tax Credit. She was financially better off in the old job.

The other problem democrats have is that they tend to believe the rhetoric of the politicians and the constant drone of bad news. John Edwards was one who campaigned on the premise that the poor in America are getting more poor by the minute. The reality is that Americans in the bottom 20% of income brackets in 1991 got an average increase in income of 91% between 1991 and 2005. To be fair, I am thankful not to be among the bottom 20%, but the bottom 20% often routinely receive non reported income of one sort or another. My church offers groceries to several hundred people at no charge. I am glad to contribute and thankful that I do not need the assistance but I do grow tired of hearing about how badly we have it here in America.

The really sad thing is that the poor are routinely mislead in exchange for their vote. One of the common ploys is to suggest that middle class taxes will be lowered by raising the taxes on corporations. The reality is that the poorest of Americans pay no direct income taxes but they pay indirectly when they buy products. Companies are routinely demonized for making profits but we all know that without profits those businesses would not exist and the jobs they provide would not exist. The very large company, such as Exxon, has to earn a lot of money to pay the owners a fair return. As such, it makes a lot of profit and it pays a lot of taxes. Indeed, in each of the last 4 years Exxon has paid more income taxes than the combined total paid by 50% of all families in America. When the politician says that he will not raise taxes on the middle class but only on the wealthy, he surely understands that it will be the middle class that will be hurt the worst when they go to buy gasoline.


Sentiment surveys show an up-tick. Lots of little things are ready to add up to extra spendable income for the average person. The $600 checks will be in the mail soon. The new payment rates will go into effect on student loans in a few months. Floating rate loan payments have started to fall. Car companies are cranking up to offer rebates, low interest rate loans and zero interest rate loans. The elections are more than 8 months away so there is time for a lot of good things to happen.

One of the things I expect to happen is a breakout in the price of US stocks. Those people who are adding money to their accounts every month have been seeing a "lucky hit" every now and then. In some cases they have increased shares in a stock they already own and have brought their average purchase price down. In other cases, they have bought new stocks that have bounced off very low prices.


John McCain has pledged to cut the corporate tax rate from 35% to 25%. The Chairman of the House Ways and Means Committee has also pledged to cut the corporate income tax. A few months ago, the likelihood of tax decreases seemed slim. The case for lower corporate taxes is strong. The story of the miracle of Ireland is compelling. The economy of Ireland had suffered for a very long time before taxes were reformed. The rate was cut from 50% to 12.5%. Books have been written about the economic boom that followed. Today, Ireland is among the most wealthy of all nations and tax revenues are higher than they have ever been. Indeed, tax revenues have increased from 1.6% of GDP to 3.6% of GDP. The dramatic improvements in standards of living has made rich and poor alike very happy.

Ireland is one of 24 countries that has cut tax rates in the past 20 years or so. As a result, US corporate rates are the highest to be found. McCain understands that lower tax rates are needed in America in order to create the new jobs in America.


The primary reason the USA has benefited so greatly by the Technology Revolution is because our individual tax rates have attracted the best and the brightest. The smartest people are drawn to work in the USA. The USA has low individual tax rates and a steady influx of "brain power". Britain, which levies significantly higher taxes on high income people, has been suffering from a "brain drain". It only takes one word to tell the remarkable story of what it means to a country to encourage the best and the brightest to live and work in America: GOOGLE! All Americans are better off to have this profit making machine head quartered in our country.

Google is currently using the 100 million cell phone users in Japan as a test lab. So far, the most interesting discovery is that Internet mobile phone use will not be nearly as "location oriented" as once thought. The Japanese search for anything and everything on their phones just like we do on our lap tops. Once a person gets used to connecting to the Internet by phone, he is just as likely to connect while sitting on his home sofa as anywhere else.

The Japanese use emoji to speed up their cell phone conversations. Emoji are animated cartoons. There are over 600 "standards" so far. One can send the message to "please take the dog for a walk" by selecting the correct emoji with just a few key strokes.

Google is certainly not the only profitable high tech company. Wii and others have produced several more neat interfaces for computers. As you might expect, the Wii interfaces include things like skis, dance floors and snow boards.


Innovations are coming hard and fast. In the area of stem cells, cells have been adapted to produce insulin. The cure for diabetes is a matter of time. Heart surgeries are being done by thin robotic rods that require small entrance holes. Damaged hearts are being injected with stem cells and new muscle and veins are being grown. AE Biofuels, symbol AEBF, is preparing to build commercial ethanol plants where "cocktails of enzymes" will convert grass and cornstalks to fuel.


It was about 100 years between the kite flying days of Ben Franklin and the invention days of Thomas Edison. In other words, electricity was around for a long time before the right genius came along to put it to use. A nice little bit of trivia is that Edison's first invention, at the age of 21, was an electronic voting machine. Deja vu!

The voting machine was invented in 1869 but electric lights in New York City were not common until around 1910 (if memory serves). It took a long time for electricity to reach the average man. It took the telephone 100 years to reach 90 percent of the market. Right now, 87% of the people in America have a cell phone. In just a few years, 90% of Americans will carry pocket sized super computer terminals.

Buy the chip makers, the software providers, the infrastructure companies and the service providers!

Thursday, February 21, 2008


Yesterday, I mentioned that the weak dollar is used as "the excuse" for all that ails. The reality is that the very low price of the dollar is cause for great optimism. Do you want to buy a dollar when it is over priced or when it is cheap?

Today, a flood of dollar buying is in evidence. US exports of manufactured goods just went up more than 13% over last year. Both foreign and domestic businesses must consider locating plants in America right now because it is cheaper to build a plant with US dollars than with Euro Dollars.

Investors in US stocks will get a double bang for their buck over the next several years. In 1996, when the dollar was almost as cheap as it is now, was at the start of the second half of the 90's business cycle. As the business cycle progressed, US stocks soared in value in dollar terms. In terms of other currencies, US stocks rocketed off the charts. History does not repeat but it certainly rhymes. Over the next several years, the odds are good that the dollar will bounce off this major low and as it does, the incentive for foreign investors to buy US assets will be great.


The flip side of the US dollar price is the corn price. At or near the end of each commodity cycle surge, the price of corn gets out of whack. In 1974 the price of corn traded at $4 per bushel, a year later the price was down to $2.50 and within three years corn traded at $1.80 per bushel. By the end of the 1970's, oil had once again soared in price and corn traded for $3.95. By 1982, the price had fallen back to $2.15 and by 1986 the price had fallen to $1.45. In 1996, at the mid cycle turn, corn traded at $5.50 per bushel and it fell to $1.90 per bushel by 1998. As recently as November of 2005 corn traded at $2 per bushel but in January it was trading around $5.40.

Tons of corn syrup go into tons and tons of food products. Coke and Pepsi use very large quantities in drinks and Pepsi sells corn chips to match. The volatility of the price of corn is the main reason that the government issues two sets of inflation figures. The core rate of inflation does not include food or energy. The price of food and energy goes down in real terms over time but they each spike up in 4 and a half and 9 year patterns.

The bond market is forecasting inflation of about 2%. The most recent CPI headline numbers show 4.3% inflation. The long term average is 4.1% but we live in a time of "disinflation" forces. The USA is set up to see very low inflation for the next several years, partly because as our dollar strengthens the price of foreign goods will fall.


In case you are not aware, the dollar has not fallen in relative value for the past 6 months. Once the FOMC started cutting rates, the dollar stopped falling. The prospects for economic growth increase as US interest rates are cut and this makes the dollar more attractive to own. Pundits consistently state the relationship between interest rate cuts and the dollar strength upside down. They focus on the real short term effect of lower US rates causing money market investors to seek higher yields in other currencies.

When a few economic numbers were weak last week, the dollar bears come out of hiding, gold soared, oil soared and the pundits whined that the FOMC is between a rock and a hard place. They constant fear is that the economy is getting in worse shape so the FOMC needs to cut rates but the FOMC cannot afford to cut rates because that would cause a decline in the dollar.

One can look at a chart of Fed Funds Rates and the dollar and determine in about 5 seconds that the relationship is the other way around. The dollar fell and fell some more as the FOMC raised interest rates in the mid 90's cycle and in the mid 2000's cycle. Then, when the FOMC cut rates in 1996 and late in 2007, the dollar started to turn. By 2,000, the dollar had retraced its steps all the way back to the prior peak.

Are governments concerned about inflation? Sure they are! As the dollar climbs back up the mountain, the price of US corn (we only grew 100 million acres last year) will rise in price for the rest of the world. The price is ready to tumble in dollar terms.

Falling corn and oil prices in dollar terms will mean US interest rates can remain relatively low. Low interest rates means the value of assets are discounted at lower rates. The price of US assets is ready to soar!

Wednesday, February 20, 2008



Can you comment on the recent surge in oil prices? I saw a note in the USA Today that a contributing factor is the low value of the dollar. Since oil is exchanged for dollars, a weak dollar requires more of them to buy oil. Why are we allowing the value of the dollar to fall so much?

Also, I heard someone say that this recession is different than recent recessions. The recession in the early 80's and 90's were caused by the Feds raising interest rates to moderate the economies. This person said the current recession is caused more by fundamental issues such as the credit crunch, oil, etc. Therefore it will take longer to get out of it. What do you think about that?


First of all, the dollar is the ready and handy excuse for all sorts of ills. In truth the dollar is only a medium of exchange, just a convenient tool to facilitate the exchange of goods. The dollar is a commodity, no different than a barrel of oil or a bushel of corn. The price is set by supply and demand. Short term traders constantly bet on the future price of a bushel of corn, a barrel of oil and a quantity of dollars. In the short run, the price of a bushel of corn might jump up or fall down for any number of reasons but the real variables that make for significant moves are how much corn is planted and how much is demanded. The price is also greatly influenced by the availability of substitutes. If the price of farm land gets too high in the corn belt of the Midwest, driving up the price of sweet corn syrup, more sugar beets and sugar cane will be grown in southern locals. The substitution effect is more powerful than is commonly understood. In the same way, the Japanese may decide to build an auto manufacturing plant in the USA if the value of the Japanese Yen is high relative to the price of the dollar.

In the old days, a gold dollar was a gold dollar and that was all. The value of that gold might go up or down relative to the value of a bushel of corn or a barrel of oil but the dollar was never anything more than $1. This concept is simple enough but it created huge problems, both before and after a "standard price" was set for an ounce of gold. The following is a list of some of the panics and depressions of the past:

the panic of 1819,
the panic and depression of 1832,
the panic of 1837,
the panic and 6 year depression of 1837-1843,
the panic of 1857,
the panic of 1873,
the world wide panic of 1893,
the presidential papers panic of 1893,
the panic of 1901 part I, part II and the stock market collapse,
the panic of 1907,
the panic and depression of 1929-1933

Speculators made and lost bundles during these volatile times. For example, in the panic of 1907, the average stock price fell by 50%.

There have been 8 or 9 post WWII recessions and the average depth of decline of stock prices and the percentage of people suffering from lost jobs and bankruptcies has been no where near the levels reached in earlier times.

Part of the problem of using gold or silver as the medium of exchange is that there are truly occasional supply shortages. In attempts to eliminate or to dampen the severity of the panics and depressions, governments would set a price at which they would exchange paper currency for gold or silver. When the price of of silver or gold was incorrectly priced by the governments, people would exchange all their paper currency for the one priced too cheap. A lot of "games" were played to try to solve the problems. In at least one incidence, England was forced to make silver coins smaller and smaller in their attempt to avoid running out of this "precious" commodity.

Over time, the fractional banking system took hold. The fractional reserve system developed because it solved a number of problems. Instead of charging a customer a fee to store his gold, the bank was able to lend a portion of each customers gold to others, earn an interest return and still have enough gold to pay off any one customer who asked. When central banks developed, which were operated by governments, the fractional system became the way a government could in effect grant itself its own "line of credit".

Today, dollars are "printed" as a result of purchases of government bonds issued by federal governments but they are also "printed" as the result of the process of lending and depositing by bank customers. To make the math simple, we can use a 10% reserve requirement. A bank with $1,000 on deposit and operating on a 20% reserve requirement, as dictated by the central bank, could grant a loan to a customer equal to $800. No matter how the $00 was spent, it would sooner or later make it back as deposits at banks. These banks might then make new loans equal to 80% of $800 or $640. This process could be repeated time and again such that theoretically the original $1,000 has become about $4,000 worth of loans. Of course, the total amount of money outstanding is influence by how quickly the loans are paid off. The combination of terms and reserve requirements in the USA today leads us to the situation where there is about $5 outstanding for each $1 held in reserves at central banks.

This is where the Archimedes principle kicks-in. Archimedes is the guy who discovered the power of leverage. His famous quote made around 200 BC was that with a long enough lever and a place to stand he could move the world. The leverage of the government is large. A tiny move in the bank reserve requirements can change the potential total money supply by at least 5 times the amount of deposits on hand. The percentage of reserves required is a very blunt and powerful tool, thus, the reserve requirements are not changed often. What is changed fairly regularly is the charge for borrowing reserves from the central bank. When the Federal Funds Rate is decreased, the door is opened for banks to make repetitive, profitable loans. When deposit rates are well below longer term fixed rates, banks have great incentive to lend money, accept more deposits and lend still more money.


The President, Treasurer and Chairman of the FOMC must politically always hold to the line that they support a strong dollar. In reality there are advantages to having a weak dollar. As a result, our government, under republican and democratic administrations have practiced policies that cause the dollar to decline in value. This is a complicated topic but the old saying that if it walks like a duck and quakes like a duck, it must be a duck. The value of the US dollar has declined for hundreds of years. We talk about the falling dollar all the time when we talk about inflation.

Over the past 50 years, the government has paid an average of 5.4% on the 90 day treasury bills it issues. The government has paid an average of 5.4% on the money it borrowed in this fashion, or did it? During this 50 years, the average inflation rate has been 4.1%. The government paid 5.4% interest but paid back with dollars that had depreciated by 4.1%. The cost to the government of the borrowed money was 5.4% minus 4.1% or 1.2%, or was it? The government levied taxes on the 5.4% at an average rate of 18%. Thus the governments net cost was 5.4% times .82 minus 4.1% or .3%, or was it?

The reality is that the government actually makes money off seinorage, which is the difference between the value of money and the cost to produce it. If it cost a nickel to make a $100 bill, the difference between cost and value is 95 cents. If that hundred dollar bill is lost, burned up or worn out in a remote region of Siberia, the government has printed a piece of paper and sold it for $100. Even for dollars that are not destroyed, the government issued a peace of paper in exchange for canceled debt in the amount of $100 and the government pays no interest on that $100 for as long as it floats along. Since the dollar has just kept on declining in value for the past 50 years, one of these dollars kept in a piggy bank for 50 years will now buy 13 cents worth of goods.

All of the above amounts to saying that the dollar falls because the government wants it to fall. One of the "beneficial effects" of the falling dollar is that it serves to speed up the redistribution of stagnant wealth.


In the past 30 years or so, the world has enjoyed more than just a technological revolution. It has also enjoyed a financial revolution. The revolution is similar to the development of the fractional banking system. People around the world have come to realize that owning a fully paid for house is similar to the days when "money in the bank" literally meant gold on deposit. The gold paid no interest and yielded no profit. The value of gold over time only keeps up with inflation. In the example of the $1 in the piggy bank now buying only 13 cents worth of goods is the same thing as saying that a $1 worth of gold in the piggy bank 50 years ago would buy a dollars worth of goods today. Money tied up in real estate is money that could be put to more productive use. As you can appreciate, I am writing this statement at the worst of times. It takes people variable lengths of time to learn how to properly use credit and some never learn. There will always be people who borrow too much and there will always be skilled borrowers who hit tough and unpredictable situations. Still, we don't throw away our kitchen knife or skill saw because they have the potential to cut our fingers off.

The tough thing to learn is that the bankers, insurance companies, brokers and other "commercial borrowers" are in competition against you. This means that the best time to borrow is when it is toughest to do so. Banks do not want to loan money when there are mortgage pools selling for 30 cents on the dollar. The bank that buys a pool of mortgages for 30 cents and sees the repayment of 95 cents plus the full interest due on the 95 cents, makes a lot more money that loaning you money at 6% to buy a house. The fact that you might buy the house at a discount of 30% of next years value gives the bank no great joy.

Over the years, it has been interesting to watch insurance companies dramatically jack up the price of insurance on beach condos near the bottom of the market bottom. The excuse is always placed on a storm like Katrina that happened way back in 2005. The fact is that it is easier to accumulate large quantities of real estate at cheap prices if insurance rates are high during the worst of times.


In cycle after cycle the phrase is repeated that this time is different. Indeed, history does not really repeat it self but history does rhyme with itself. The readers friend says that the recessions of the 80's and 90's were the result of the Fed raising interest rates to moderate the economy. He went on to say that this recession is a result of fundamental issues such as the credit crunch, high oil prices, etc. I would like for your friend to show me another time in history where the FOMC held sort term interest rates higher than long term rates for 19 months in a row!

Central bankers and investment bankers cooperated to cause the credit crunch. Mixing weak loans with strong was done in a way to poison the whole barrel of loans in the short run. The US government went along with the strategies employed by investment bankers to sell polluted barrels of mortgages to any and all comers. Then, after the FOMC put the hammer down on interest rates over a period of 19 months and dried up pools of excess liquidity, the government rules dictated that the entire barrels of mortgages be treated as toxic waste. The great majority of paper in these barrels is "money good paper". Most of these mortgages will be paid in full along with the stipulated interest payments. Yes, this is "different" than last time. In 1989 the government put the hammer down and put a lot of banks and savings and loans out of business. The government established the Resolution Trust Corporation of America to buy up the "bad loans" and foreclosed properties. Those who bought properties at the depressed prices of that day made out like bandits.

This time is different in that the decline in real estate values has really not been much. Sure, there are pockets of misery but in more than half the cities of America the average home went up in value over the past 12 months.


The story of the high oil price is the opposite of the rest of this story. The primary reason the price of oil is so high is because of tremendous world wide economic growth. The price of oil has gone up because even at $100 per barrel there is still demand for oil. The fact that the dollar has fallen has made the price of oil go up less in terms of other currencies but even so the price of oil has gone up.

It is not unusual for it to take time for price to cure price. The demand for oil is inelastic (not flexible) in the short run. The guy that owns a new V-8 SUV is not willing to sell at a loss to reduce his demand for oil. However, given a little time, high oil prices cause aggressive exploration and aggressive conservation.

The second reason the price of oil has stayed high is political. Misguided souls have fought to "save the environment". The result has been that the cheapest available sources of new energy have been put off limits. The USA owns a trillion equivalent barrels of oil or so that is just off the coast. This oil could be accessed with no real long term environmental damage. By the same token, nuclear power plants could be built that would reduce our oil needs. Instead, trillions of tons of dirty coal are being mined. The railroads are having to add the second set of rails to the great coal fields of America. Another angle to the problem is that energy investors have had to build in the risk that they will be "assaulted" by the policies favored by Hillary and other democrats. Exxon Mobile just paid $30 Billion to the US treasury in taxes but Hillary wants more. If you are an XOM shareholder, do you want the company to spend 6 Billion on a new refinery that will need 30 years of profitable operation to make sense, if Hillary is prepared to change the rules after the plant is built?

The third reason oil prices are high is because of political risk in the producing countries. This risk is more perceive than real but the perceived risk has added as much as $20 to the price per barrel. The reason the risk is only a perceived risk is because the producers would be hurt badly by any disruption in production. It is in no ones long term interest to stop the flow. Chavez has threatened to shut down supplies but the country is already suffering through a "food crisis". Iran's official unemployment rate is 11% but, the real rate is probably at least 20%. Still as long as people believe the risk is high, they will respond accordingly.


There is a lot of good news brewing for oil consumers. The timing of most of the good news is uncertain. Elephant oil discoveries that should have come on line by now have been delayed. The Caspian Sea has turned out to a tough environment for bringing a monster field on line. The super monster fields discovered in Brazil will take several more years to come on line, but in the mean time the total size of the find continues to be assessed and estimates of total size continue to be raised.

More immediate help will come from "a little more from here and a little more from there". Angola, Newfoundland, Ghana and a long list of other places will add production this year. Economics ultimately wins battles and the plan being hatched by Iran and Iraq to jointly develop fields along their borders shows the power of the profit dollar. It makes sense to jointly develop fields rather than to fight to suck out the most the fastest. The science of oil recovery requires pressures to be maintained. A new well in Iran might destroy the investment made in a well in Iraq and vice versa.

As long as people believe oil prices are going up, they will hoard supplies. However, over time, the belief that prices are going to go up will be the straw that allows us to get over the camels hump.

This time is different in that global economic growth has not slowed as much as one would expect by the time of the mid cycle turn. China has raised rate and increased reserve requirements again and again but it just reported an inflation rate of 7.1%. The government is allowing the Yuan to float up more quickly and the numbers are showing up in the US trade accounts. The US has seen extraordinary strength in exports of manufactured goods.

Yes, our dollar is now so cheap that our industrial production is strong even during a time of recession in housing and autos! In the old days, recessions in housing and in autos at the same time meant the rest of the economy was in sad shape.


For me, the more important question is when will the stock market soar? The stock market will appreciate well before the bottom of the economic cycle. Indeed, the US is still likely to avoid going into a full blown recession because the steep drop in interest rates has already started to work its magic. Problems are already being "solved". Another shoe could fall but the evidence suggests that old shoes are getting repaired. I believe it was AMBAC that just raised $2 Billion dollars. The big investment bankers have made deals with sovereign investment funds to give them the strength to hold and buy more of the deeply discounted mortgage pools. The big drop in rates means has taken 300 basis points off rate resets. Suddenly a number of homeowners who were expecting rate increases will see rate decreases.

As I have pointed out, the four legs to the investment stool all support higher stock prices. The answer to when the recession will end (if there is a recession) is that it will end about 3 months after the stock market soars.