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Thoughts on Obama post-Massachusetts





Here is an update of my charts of the polling results from the folks at Rasmussen. Obama's popularity continues to trend down, and the stock market this past week cast a big negative vote on where he is likely headed. Apparently he has decided that the Democrats lost Massachusetts because the electorate is still mad at Bush. His ego is so big that he can't allow himself to even think that it was a vote against him and his cherished healthcare reform. Now he wants to distract everyone's attention from the fiasco by pulling a standard populist ploy and beating up on the banks. When will this guy ever learn? As Charles Krauthammer notes, "You would think lefties could discern a proletarian vanguard when they see one."

If I could paraphrase the late Jude Wanniski, the job of a politician is not to lead the people, it is to figure out where the people want to go and then help them get there.

Obama's headed in the wrong direction, but that doesn't mean all is lost. On the contrary. The electorate is jumping up and down and waving its arms, and not all politicians are deaf or blind to the message. There's a new politics afoot, and what is happening on the political margin is not Democrats vs. Republicans. It's now about more government programs vs. fewer; government bureaucrats making decisions vs. individuals making decisions about what's in their best interest;  more spending vs. less; free markets vs. mandates; more income redistribution vs. less; higher taxes vs. lower taxes; and more individual freedom vs. less. It's no longer about abortion or same-sex marriage or gay rights or welfare. Our fiscal situation demands that we put aside the social issues for now and focus on the role of government in our lives.

Obama needs to refocus and perhaps triangulate as Bill Clinton did following the Democrats' trouncing in the 1994 elections. If he doesn't, his party and the electorate will rise up against him, and the Massachusetts massacre will be repeated. Sooner or later he will need new advisors, and he will need to focus on the economy and drop healthcare. More spending programs and populist attacks on banks and big business won't work anymore. He won't be able to push his former agenda any further—he's got to find a new one, and it has to be more palatable to those who want less government and more individual freedom. At the worst we will end up with gridlock, and if we're lucky we may see Obama & Co. moving in Clintonesque fashion to the center, where things can get done. Whatever the case, it's a huge improvement considering where we've come from.

Optimism is still the order of the day.

To close, here are some timely quotes from Ronald Reagan that are worth repeating:


"Socialism only works in two places: Heaven where they don't need it and hell where they already have it."

"Here's my strategy on the Cold War: We win, they lose."

'The most terrifying words in the English language are: I'm from the government and I'm here to help."

'The trouble with our liberal friends is not that they're ignorant; it's just that they know so much that isn't so."

"Of the four wars in my lifetime, none came about because the  U.S. was too strong."
"Government is like a baby: An alimentary canal with a big appetite at one end and no sense of responsibility at the other."

'The nearest thing to eternal life we will ever see on this earth is a government program."

"It has been said that politics is the second oldest profession. I have learned that it bears a striking resemblance to the first."

"Government's view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it."

"Politics is not a bad profession. If you succeed, there are many rewards; if you disgrace yourself, you can always write a book."
HT: Don T.

Implied volatility update



This chart shows the implied volatility of equity and T-bond options. Implied vol can be thought of as a proxy for the level of fear, uncertainty and doubt that inhabits the market. Implied vol has fallen sharply over the past year as the market's many and deep-seated fears were resolved: the economy hasn't fallen down a black hole; this isn't another Depression; there is no deflation; Obama is not going convert the country to socialism; we aren't going to have a global trade war; political balance (gridlock is a good thing) is returning; there are many signs of recovery.

There are still lingering concerns, of course. How fast will the recovery be? Are we being set up for another slump? How will the Fed reverse its quantitative easing? Will inflation go up a little, a lot, or not at all? Will trillion dollar deficits go on forever? Will businesses find the courage and the capital to create new jobs?

Despite these concerns, I think there has been enough progress on many fronts that the future looks appealing, if not bright. Our financial markets have largely healed, and our political system is working to provide checks and balances. The economy has undergone a tremendous adjustment process, with the result that we now have a relatively solid base upon which to build a recovery. The housing market has also undergone radical adjustment, with an unprecedented decline in prices and residential construction, but this also is a necessary step and a base upon which to mount a recovery. The global economy is recovering as well.

I think it still pays to be an optimist.

China looks good (2)



Here's an update to my post last month, showing China's GDP growth returning to double digits as expected. This is very impressive, and surely qualifies as one of the most impressive V-shaped recoveries to date. Yet the market is concerned that measures imposed by the government to curb bank lending, announced today, coupled with a rise in the required reserve ratio for banks last week, will threaten China's economic future. I see these measures instead as moves in the right direction.

Because China's currency is linked to the dollar, and the dollar is historically very weak and the Fed is promising zero interest rates for a long time to come, it is in China's best interests to resist the inflationary pressures that flow from a weak currency. Tighter monetary policy is one way to do this, but ultimately China will probably have to revalue the yuan against the dollar—unless the dollar rises appreciably in the interim. But neither a revaluation of the yuan nor a tightening of monetary policy should pose a threat to China's growth, because they would amount to appropriate measures to limit inflationary pressures. It's never a bad thing to do the right thing.

It's useful to recall the unwritten law of central banking. A central bank can successfully implement monetary policy by choosing one of three policy tools: controlling the exchange rate, controlling the money supply, or controlling an interest rate. Often central banks that choose the first option become tempted to use one or two of the other tools at the same time. We saw this in the years leading up to the S.E. Asian currency crises of 1997, when central banks raised interest rates to cool off their economies (at the IMF's suggestion, I might add) while also keeping their currencies pegged to the dollar. This can work for short periods, but it inevitably results in undesirable or unforseen consequences. The problem is that it is just about impossible for any human to use two policy tools to hit one policy target; the complexity is just too great. If policymakers can stick to just one tool, then markets and the economy can adjust given time.

Think about it: if China says the yuan will be fixed to the dollar, but then it raises its interest rates above dollar interest rates, this has the effect of attracting capital that would otherwise go to the U.S. Increased capital flows have to be purchased by the central bank in order to keep the exchange rate stable, but this increases the money supply and that, in turn, can put downward pressure on interest rates and/or result in an "overheated" economy. In short, the combination of these policies can end up in undesirable cross-currents.

So China is probably making a mistake by tightening monetary policy instead of just revaluing the yuan. But it could take a long time for this mistake to generate serious imbalances in the economy. In the meantime, investors know that China has a virtual mountain of reserves with which to back up its currency. That means the Chinese yuan is NOT going to lose its value; it can only remain steady versus the dollar or rise. So on the margin, the central bank's tinkering with monetary policy only increases the appeal of investing in China, since it means higher interest rates (which is equivalent to curbing bank lending) and/or an increased likelihood of further yuan appreciation against the dollar. And the more money that is attracted to China, the more resources it will have at its disposal to continue growing. For now, it's a virtuous circle.


Full disclosure: I am long CHN at the time of this writing.

Fama on the financial crisis and "credit bubbles"

Eugene Fama, father of the efficient markets hypothesis, makes some good points in this interview in The New Yorker Magazine. Questioned as to whether the credit market could be considered efficient if "people were getting loans, especially home loans, which they shouldn't have been getting," he replied:

That was government policy; that was not a failure of the market. The government decided that it wanted to expand home ownership. Fannie Mae and Freddie Mac were instructed to buy lower grade mortgages.

In other words, it wasn't inefficient markets that led to the financial crisis, it was government intervention in markets that caused the crisis.

Questioned as to whether the credit market bubble that inflated and then burst could be considered an inefficiency that led to the 2008 financial crisis, he replied:

I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people saved too much during that period?
I like this response because I have argued along the same lines before. To say that a credit bubble (commonly viewed as a significant rise in the ratio of household debt to GDP) caused our problems is to ignore some important facts. In the absence of any evidence that the money supply grew by an unusual amount relative to the size of the economy (on average, M2 grew only 1% per year faster than GDP from 1997-2008), then the large increase in credit outstanding that we observed over those same years was the result of voluntary private sector activity.

Credit can be created by one person lending money to another, but that does not result in any increase in money outstanding, nor does it create any new demand. (New money is created only when banks extend credit via the fractional reserve system; when they do so, then the money supply expands.) If I take money out of my pocket and lend it to John, I have created credit, and the money I don't spend he now has to spend. Perhaps he turns around and lends it to George; that adds further to the amount of credit outstanding, but again it doesn't increase the amount of money in the system, nor does it create any new demand—it only shifts demand from one party to another.

From this it follows that, as Fama notes, if you argue that there was "too much credit" in the system, then you are also saying there was perhaps too much saving. Yet many of those who worry about too much credit also argue that another big problem in the U.S. economy in the past several decades has been profligate consumption and a very low savings rate. Someone is very wrong here, and it is the misunderstanding of how credit works that explains it.

Those who point to a credit bubble as the culprit in this crisis fail to understand that the growth in credit is not the same as an inflationary expansion in the amount of money. Credit can grow very rapidly or very slowly without creating any necessary implications for inflation. In a low and stable inflation world, it is entirely possible for credit to experience rapid growth. Indeed, rapid growth in credit is most likely to occur when conditions are stable and confidence is high.

When inflation is high and volatile, lending money becomes a very risky business and credit dries up. I know, because when I lived in Argentina during the triple-digit inflation of the late 1970s, I discovered that the average maturity of loans was measured in months, not years. To buy a house, for example, the best terms I could find were 30-60-90: one third of the price in 30 days, the next third in 60 days, and the final third in 90 days. When inflation and risk are high, no one wants to lend. Lending flourishes, in contrast, during periods of stability and confidence.

If you're looking for a guilty party to blame for the financial crisis, blame the federal government for mandating inefficiencies in the way FNMA and FHLMC operated, and blame the Fed for keeping interest rates too low for too long. The Fed's easy money policy caused the demand for money to decline. As a result of easy money, people came to want less money and more things, and that's one reason why housing, commodity and gold prices rose so strongly in the years leading up to the crisis. The price of the dollar fell and the price of things rose, and the rise in housing prices greatly exceeded the rise in incomes. This was the "bubble" that eventually popped: prices that got out of line with the ability to pay.

Moral: don't confuse "credit" with inflationary monetary policy. They are two very different things.

Yet again, rising uncertainty drives a temporary selloff



I'm going to blame Obama's proposed restrictions on the activities of banks for today's selloff. It seems that he is unwilling to accept the message of the voters in the Massachusetts special election. In his ignorance he is joined by the hopelessly biased New York Times, whose editorial stated that "To our minds, it is not remotely a verdict on Mr. Obama’s presidency, nor does it amount to a national referendum on health care reform..."

Both instead are blaming the economy, which in turn they say is the legacy of Bush and those unfettered, greedy capitalist banks. So he is going to go after the banks and try to divert attention from his own shortcomings. Populist appeals of this sort, however, are not going to restore his popularity nor will they endear the public to his big-government message. Tuesday's vote made that clear.

When you see Obama and the Democratic establishment turn a deaf ear to the powerful message that came out of yesterday's election, then you just have to keep betting against them. They won't be able to hobble the banks, just as they weren't able to saddle us with a disastrous healthcare reform.

Still, as the chart above shows, these maneuvers create great uncertainty, and thus the VIX index shot up today as stocks fell. What I think we'll see sooner or later is that the economy is capable, once again, of improving despite all the headwinds originating in the White House. I remain optimistic and so I see selloffs such as these as buying opportunities.

Weekly claims update



Weekly unemployment claims were higher than expected, but blips like this happen all the time. The 4-week moving average hardly budged, in fact. I see no signs that would suggest the economy is about to turn down. We're still on track for a moderate recovery.

Leading indicators: another V-sign



As I said before when I posted this chart back in September, I don't pay much attention to the "leading economic indicators." They don't really lead, and they can sometimes be "mis-leading." But they can be very good coincident indicators, and they appear to have done a good job of calling the end of the recession back in mid-2009. They've turned up quite sharply over the second half of 2009, and are exhibiting the classic signs of the beginning of a new business cycle. I don't see any signs that would suggest this recovery is at risk anytime soon.

Export activity continues to rebound



Export activity continues to rise, and that is good news for just about everyone. I've been showing this chart since early last year, pointing out that data on container shipments from the ports of Los Angeles and Long Beach were likely leading indicators of overall U.S. export activity. Outbound container shipments from Los Angeles surged 40% last year (the green line in the chart), marking a significant V-shaped recovery in the wake of the collapse of global trade in late 2008. We've already seen U.S. goods exports rise 18% from the lows of April '09, so we can most likely expect to see continued strong gains in the months to come (because shipping data is more up to date than the export data that is reflected in the GDP stats), and this will in turn be an important source of growth for the economy.

The strong rebound in global trade that we have seen this past year is a very good reason to be bullish about the future.

Housing starts vs permits





Recovery skeptics are making a big deal of the fact that housing starts fell 4% in December (seasonally adjusted). Recovery fans are excited about the 10.9% rise in building permits, which would point to higher starts next month. I look at both these series and see signs that activity has probably stabilized and may be rising. If things have only stabilized, this would be a very good sign for the residential construction sector, because it would signal that the supply of and demand for housing was coming into balance. That's an important ingredient in the stabilization of prices. And stable home prices (and they may actually be rising on average) would do wonders for the value of many hundreds of billions of subprime mortgage-backed securities that are priced, I'm told, to the assumption that nationwide housing prices are going to fall another 15%. If home prices don't fall 15%, then the prices of those securities must perforce rise significantly; that in turn would generate huge gains for the portfolios of institutional investors and financial institutions that are holding them.

We don't really need to see housing turn up to be optimistic about the future; we only need to see signs that housing has finally stabilized.

Another sign of a housing bottom




This Bloomberg index of the stocks of major home builders is up 133% from its Mar. '09 low. That's pretty impressive, especially since housing starts are up only 10% over the same period, and the NAHB index of builders looks pretty flat. I think this is a clear instance of the market "looking across the valley" of current despair. Residential construction has fallen to all-time lows relative to the market, and is way below the levels needed to keep up with a growing population. The industry has contracted for four straight years, and this can't go on forever. We've most likely seen the bottom in housing. Of course, the recovery may take awhile and it may be tepid, but the bad news is a thing of the past. Now, it's only a question of how fast and how strong the recovery is.

The 4% barrier



10-year Treasury yields are a great way to measure the market's degree of optimism. When they dropped to almost 2% at the end of 2008, they were telling us that the market was extraordinarily pessimistic, in fact terrified that we faced years of depression and deflation. At 3.7% today, the market now thinks that while depression is unlikely, the economy is still going to be plagued by years of weak growth. If 10-year T-bond yields rise above 4%, which I think is likely, that will be a good sign that the market is coming to accept that we have at least a decent recovery on our hands. At 5%, the market would be telling us that the outlook for the economy was becoming rather robust and/or inflation was clearly moving higher than the Fed's 1-2% target zone.

Higher interest rates are definitely not something to fear, at least for now. They would have to go much, much higher before they became a threat to growth, and by that time the economy would be a lot stronger than it is today.

"Mass" tipping point?

(Apologies for not posting for several days. I was enjoying a 4-day ski vacation in Lake Tahoe.)

If Scott Brown wins his Massachusetts Senate seat in today's special election, I think this will mark a major tipping point in U.S. politics. (The first tipping point arguably came last year in March and April, when Obama's agenda first started running into difficulties. I remarked at the time that I thought he was far too liberal for the tastes of America's voters, that he would not find it possible to push through his agenda, and that this was a reason to be bullish on stocks, especially since they were so cheap.) Now we see the centerpiece of the liberal agenda running into a brick wall of resistance. As the WSJ editorial today points out, "The real message of Massachusetts is that Democrats have committed the classic political mistake of ideological overreach."

One of the drivers of the equity rally this past year has been the inability of the Obama administration to implement all of its far-left agenda. Going forward, one of the drivers of continued equity market gains could be the beginnings of an actual rightward shift in policies, not just a failure to move to the left. At the very least, Congress may now start operating as a divided house, and Divided Government is a thing devoutly to be wished at this point. A little less government would be a very good thing. We've come a long way in the past year, thank goodness.

UPDATE: With Brown's decisive win, this changes the political landscape to an enormous extent. I don't see how healthcare reform can pass in anything like its current form. Furthermore, I don't see how we could see any significant, hard-left measures pass between now and the November elections, when Democrats are sure to lose their commanding majority in Congress. We are now in a new era of Divided Government, and that is a Very Good Thing from the market's perspective. Obama, the One-Year Wonder, is now faced with the need to salvage his presidency. Will he choose the high road, and call for Congress to scrap the current healthcare proposal and start again from scratch, with true bi-partisan input? Or will he choose the low (Chicago) road, and go for broke? These are exciting times.