Monday, November 8, 2010


I'm hearing Amazon might be pricing a $1.25 billion convertible offering this week.

Fed Speakers Rule the Headlines


Jim Bullard, St. Louis Fed Reserve Bank president (and anti-Warsh), repeated his support of QE 2 this afternoon in a speech that suggested that the real effect of the policy will be felt in three to six months.

QE2 may not deliver the anticipated virtuous and smooth circle of economic growth that the Fed desires.

"Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

-- Fed Chairman Ben Bernanke, Washington Post op-ed

He cited that easy money will be a palliative to domestic economic growth by spurring confidence and higher stock prices. Bernanke further expressed his belief that a virtuous circle would be encouraged by:

1. lowering mortgage rates, making housing more affordable and allowing homeowners to refinance; and

2. reducing corporate bond rates, which will likely encourage investment.

"It's hard to have a big impact on the short-term interest rate that is already zero, and on the bond market ... two things are working in opposite ways on the interest rate."

-- Former Federal Reserve Chairman Paul Volcker

"Lower risk-free rates and higher equity prices -- if sustained -- could strengthen household and business balance sheets, and raise confidence in the strength of the economy. But if the recent weakness in the dollar, run-up in commodity prices, and other forward-looking indicators are sustained and passed along into final prices, the Fed's price stability objective might no longer be a compelling policy rationale. In such a case -- even with the unemployment rate still high -- we would have cause to consider the path of policy. This is truer still if inflation expectations increase materially."

-- Kevin Warsh, Member of the Board of Governors of the Federal Reserve

I wrote that, while QE2 will anchor short rates to near zero, it remains unclear to me whether QE2 will generate much lower mortgage and corporate bond rates from here.

If anything, government bond yields over 10 years in duration are going in the opposite direction.

At last week's close, the 30-year U.S. treasury bond (which is not the beneficiary of Fed buying but is an indicator of future inflationary expectations) finished at its lowest level in price and highest in yield than at any time over the past several months. Since QE2 was telegraphed by the Fed in the late summer, the 30-year bond yield has risen by nearly 65 basis points vs. the shorter-dated 10-year U.S. note's yield, which up by less than 10 basis points.

In this morning's Wall Street Journal op-ed Federal Reserve Governor Kevin Warsh warns that the Fed, by expanding its balance sheet, has become more of a price maker than a price taker in the government bond market. But, if market participants come to doubt these prices -- or their reliance on these prices proves fleeting -- "risk premiums across asset classes and geographies could move unexpectedly."

In his Washington Post op-ed, Chairman Bernanke suggested that mortgage rates will move ever lower. I just refinanced my mortgage down to a 3.50% seven-year ARM. In the fullness of time, how much lower can mortgage rates drop from my rate of 3.50%? And, what if the U.S. 10-year note continues to rise in yield? It is the rate on which mortgages are principally based!

The problem with the housing market's recovery is a large shadow inventory of unsold homes coupled with high unemployment. For months, a generational low in interest rates has failed to dent the weakness in the residential real estate markets. Moreover, it is my continued concern that the consequences of QE2 will be harmful (likely producing screwflation), which is bad for the average American consumer buying the average American home.

However, the math of the virtuous stock market cycle seems less cooperative than Chairman Bernanke insists.

In support of my view, I highlighted the research of the Federal Reserve Bank of Atlanta and other reports to illustrate that consumers have historically spent $0.03 to $0.04 out of every additional dollar of stock market wealth.

Households own nearly $11 trillion in equities, ETFs and mutual funds. I then assumed that the Fed's move has been responsible for a 10% rise in stock prices, serving to increase the aggregate value of equities by $1.1 trillion. Applying the historic stock market wealth multiplier mentioned in numerous research pieces on the subject would only translate to a modest $40 billion rise (or thereabouts) in personal consumption expenditures in a U.S. economy with a GDP that exceeds $14.0 trillion.

Not much beef there.

The Rich Get Richer, and the Poor Get Poorer

* The top 1% of U.S. households own 38% of all mutual funds and stocks.

* The next 9% of U.S. households owns 43% of all mutual funds and stocks.

* The bottom 90% of U.S. households owns only 19% of all mutual funds and stocks.

"There is one rule that works in every calamity. Be it pestilence, war or famine, the rich get richer and poor get poorer. The poor even help arrange it."

-- Will Rogers

Let's now move one step further and determine how broadly the domestic economy will be influenced by the approximate $1.1 trillion of stock market wealth that may lead to consumption gains and how likely the historical multiplier ($0.03 to $0.04 of consumption per every dollar of stock market appreciation) will hold up in the current cycle?

According to University of California at Santa Cruz Professor G. William Domhoff's "Weath, Income, and Power," the U.S. wealth (and the holdings of stocks and mutual funds) are highly concentrated in a relatively few hands. As of 2007, the top 1% of households owned 34.6% of all privately held wealth, and the next 19% had 50.5%, which means that just 20% of the people owned a remarkable 85%, leaving only 15% of the wealth for the bottom 80% (wage and salary workers). In terms of financial wealth (total net worth minus the value of one's home), the top 1% of households had an even greater share: 42.7%.

In terms of types of financial wealth, the top 1% of households has 38.3% of all privately held stock, 60.6% of financial securities and 62.4% of business equity. The top 10% has 80% to 90% of stocks, bonds, trust funds and business equity, and over 75% of non-home real estate.

The research above indicates that the wealthiest households will receive almost all of the benefit from the appreciation in stock prices (that has seemingly been generated by the optimism regarding the success of further monetary easing), as the top 1% of the households own nearly 39% of the stocks and mutual funds in the U.S. and the next 9% own another 43% of the stocks and mutual funds. The bottom 90% of the households own only 19% of the stocks and mutual funds.

I recognize that the wealthy have historically accounted for much of the spending growth in the U.S. The bullish argument is that there will be a multiplier effect of the $40 billion increase in consumption -- a trickling down, producing payroll and inventory growth that will add further to real GDP (above and beyond the $40 billion estimate).

"Policy makers should be skeptical of the long-term benefits of temporary fixes to do the hard work of resurrecting the world's great economic power. Since early 2008, the fiscal authorities have sought to fill the hole left by the falloff in demand through large, temporary stimulus -- checks in the mail to spur consumption, temporary housing rebates to raise demand, one-time cash-for-clunkers to move inventory, and temporary business tax credits to spur investment."

-- Kevin Warsh, Member of the Board of Governors of the Federal Reserve

Given the challenges of reviving our domestic economy from the economic and stock market carnage of 2007-2009, the nontraditional headwinds that make the current cycle so unique and the unevenness of the wealth benefit, I remain less certain that QE2 will even translate to the lower end of the historical relationship ($0.03 to $0.04 per $1 of market gains) of spending to stock market wealth creation. Here's a list of reasons:

* Artificiality of policy and persistent structural imbalances/headwinds. QE2 is a temporary program that has seemingly marked up stocks for the benefit of the highest earners and most wealthy Americans. In a sense, QE2 is a cash for stock market gains program (similar to cash for clunkers or the tax credit for new home buyers) that appears to be a gift to the wealthy (and large corporations that have access a cheap and hospitable debt market anchored with zero interest rates). At the same time, it potentially hurts the savings class with little benefit to small businesses and to the average American, who gets hit with screwflation in higher food, energy and other costs that eat further into real incomes.

* Less trickle down/multiplier. There might be less trickle down in stock market wealth to consumption than many suppose, given the hit to confidence from the depth of the recession, the high level of under- and unemployed (and the impact of the structural jobs issues), the fiscal imbalances in our local and state governments, the unintended consequences of higher costs of stuff, the still-persistent hangover from the 2008-2009 stock market dive and the current low levels of business and consumer confidence. Economic traction better happen soon in order to justify the stock market traction of the past three months.

* Screwflation creates more imbalances of wealth. The forces of screwflation (i.e., rising costs, limited wage growth and still-elevated underemployment and unemployment) run deep and are impactful to the majority of Americans. Again, the virtuous cycle of confidence (and job growth) better happen shortly.

* The savers class gets screwed, too. Low interest rates will continue to penalize the incomes of the growing savings class -- a maturing baby boomer generation and current retirees/elderly. I strongly suspect that the lost interest income (in fixed income maturities under 10 years) and reduced purchasing power eliminates the full benefit of an estimated $40 billion in consumption tied to higher stock prices.

I fully recognize that lower short-term interest rates, the implementation of QE2 and the likely extension of the Bush tax cuts reduce the downside risks to the economic outlook and appreciably lower the risk of deflation.

And I fully recognize that, by having fought the stock market's advance, I am fighting an uphill battle.

"With all due respect, U.S. policy is clueless. (The problem) is not a shortage of liquidity. It's not that the Americans haven't pumped enough liquidity into the market.... The U.S. has lived on borrowed money for too long."

-- German Finance Minister Wolfgang Schäuble

But in order to move toward self-sustaining growth (which would ratify the stock market's rally), our domestic economy needs an intelligent, creative and transformative fiscal response to tame our deficit and grow jobs, not more cowbell that benefits the richest Americans.

I continue to argue that the largesse of QE2 will not deliver the anticipated virtuous and smooth circle of economic growth that the Fed desires but that our domestic economy will remain on a path of uneven, below-historic and (potentially) vulnerable growth, owing to policy mistakes and other exogenous events. In the fullness of time (maybe sooner than later), developing commodity price inflation, declines in real incomes and further drops in our currency may serve as further headwinds to a self-sustaining domestic economic growth cycle.

A Bottom for BAC?

Late last week, litigation surrounding $352 billion of claims against BAC were dismissed.

This information was disclosed in the company's third-quarter 2010 10-Q.

While the issue of reps and warranties will plague the company for a while, the continued credit-quality improvement coupled with the dismissal suggest that Bank of America's problem-ridden shares have bottomed and provide value.

Over There

German industrial production unexpectedly dropped by 0.8% in September.

"German industry is slowing down ... European governments are stepping up the pace of fiscal tightening, while world trade growth has weakened as well."
-- Aline Schuiling, economist at ABN Amro Bank

I continue to question the efficacy of "QE 2," which has served to stoke the animal spirits -- and I conclude that the worldwide economic recovery remains anemic and vulnerable to policy mistakes or exogenous factors.

In support of that view, last night we learned that German industrial production unexpectedly dropped by 0.8% in September compared to expectations of 0.4% growth and August's rise of 1.5%.

Run, don't walk, to read Peggy Noonan's latest editorial in The Wall Street Journal.

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