This is Getting Interesting

A 4 day rally and the markets are euphoric on the news that Greece will be saved or at least that Europe will rally together to provide the tools to make any Greek default orderly and without hazard.

And yet this morning in the US alone (which has largely resolved our liquidity issues) we saw recessionary economic data emerge in relation to jobless claims and manufacturing data. Moreover, we saw CORE inflation hit 2% which is the Fed target. This means that any additional Fed liquidity can't be based on the idea of deflationary and recessionary threats.

Which way does the topple tips - is anybody's guess. But really, who wants to have to 50-50 guess with their investments?

Shotgun Roundup & Final Bullet?

Keeping consistent with the 2011 theme, let's revisit the 6 market-determining factors for the year:

(1) Gasoline prices breaching $4 -- this hasn't happened and with the recent market decline and decline in prices, this is a noticeable boost to consumer wallets and the economy (in effect, a tax decrease).

(2) Political partisanship -- by far now, the most determining factor of the year in the US. The Fed has flushed the system with liquidity. However, the uncertainty and lack of agreement in DC is keeping the system from being re-calibrated and able to move forward into a new economic growth era.

(3) Sovereign debt issues -- For the US, politicans can only solve this problem by reforming entitlements (something likely left until the 2012 election debate), which means more uncertainty ahead. For the EU, this is a slow killer. The current Euro Fund of hundred of billions of euros is far too short. It needs to be expanded to a min. of $1 Trillion and a safe max of $3 Trillion.

(4) Unemployment above 9% -- continues and, again, is a new systemic reality absent fundamental changes from Congress.

(5) Home values -- double dipped and have no basis for recovery absent a broader level of social certainty which can only be delivered by Congress.

(6) Black Swan events -- unpredictable by definition but anything could happen. A country being forced to leave the Euro. The EU community allowing French banks to collapse. Further downgrades to country, state or company ratings. A 2011 recession. A Chinese property bubble burst.

The Ultimate Factors:

I truly believe the whole kit and caboodle boils down to 2 things: (1) Congress reforming entitlements and the tax code; and (2) The Euro Community creating a sovereign rescue fund that is $2 Trillion Euro in size.

Each has done half. The US has the fiscal stimulus but not the long term austerity. Europe has recession driving austerity but may not have solvency. A second recession (mild in nature) is not unlikely and may have already started (later data, revised, may show). What's more important is creating a stable environment of certainty so that corporations and companies can spend the next 1-5 years transforming themselves to fit the new reforms and expectations -- setting up a fertile ground for 10-20 yrs of economic prosperity. Its a healthy purging of a system gone bad, and the sooner we head down the road of reconciliation, the sooner we may prosper.

My fear is that Germany may not accept the reality that it must pay for and save the Euro, and that the US will push off tough decisions until the 2012 election. And what if that election leaves us with another divided government?

Quarterly Roundup

Now that we're nearly halfway through 2011, let's take a look and recap where we stand in terms of our January-identified course markers for the year.

(1) Gasoline/commodity prices -- thanks to QE2 deflation was avoided but commodity inflation was sparked. Near $4 gas became a tax burden on the economy and helped contribute to the current malaise and 2-2.5% GDP growth rate currently experienced. Fortunately gas prices have recently retreated, although not in a significant enough manner. Unfortunately, other commodities (food-related) continue to rise.

(2) Political partisanship -- whether its a budget, the debt limit or healthcare reform, Washington has failed to show any leadership or, more importantly, effective compromise. Looks like the stalemate will continue largely until the presidential campaigns start up. Political uncertainty breeds business inactivity.

(3) Sovereign debt issues -- Greece, Portugal and Ireland continue to stoke Lehman-esque fears, and US states and localities have been forced to thrash spending and employment in order to make revenues meet budget expenses. These contractionary forces continue to plague without immediate relief in sight -- considering the pitiful rate of recovery currently experienced, growth is not a significant tool or option to reducing debt.

(4) Unemployment above 9% -- high unemployment has hampered consumer spending, which is the main engine of the US economy for better or worse. With weekly jobless claims back on the rise and continuing above 400,000 it appears that what many once thought a temporary influence is truly structural in nature.

(5) Home values -- after rising due to short-term government stimulus, housing values have resumed their decline and actually double dipped into deeper losses. Without immediate relief or stabilization occurring until early 2012, housing will continue to rob the economy of construction jobs, credit flow and consumer confidence.

After running through these issues, we should add 1 more to the mix:

(6) Black Swan events -- Japan's nuclear meltdown is just an example of unpredictable events that can only have negative impacts on a wide scale, even if relatively short term in nature. Japan's activity has certainly robbed the US economy of growth. Weather, war and politics can also fit into this category in certain regards at any time (e.g. Arab Spring). The unpredictable is often times most reliable influence.

In sum --- it doesn't appear suprising that the S&P remains where it started for 2011. Again, so long as none of these factors erupt but instead remain simply negative influences -- then there should be no risk of a double dip recession and a stock market meltdown. However, should Greece default or some other new variable enter the game, not only will it have large consequences, but a debt-laden government and exhausted Fed may not have many bullets left to fight back.

March Madness Begins

Basketball wise, but also geopolitically. Middle East revolutions continue and protests overnight in Saudi Arabia spark fear that a major oil producer may enter the same chaotic fate of its neighbors and counterparts. With the Mid East you just never know.

With the Mid West the same could be said. State budget fights continue to highlight the debt burdens that the US is facing locally and federally. Even Repulican plans appear as a joke with cuts of $60 billion while a $1.6 Trillion 2011 deficit looms.

All that being said -- things are fairly on course and (barring a Mid East oil disaster) crunch time is upon us. The ultimate questsion in charting the next step for the US economy in the near term and its longterm growth (for those of us concerned with retiring, etc) is right now -- what will the politicans do with the budget and what will the Fed do to support (or wean itself from) the economy?

The hope = (1) no oil shock + (2) a long term budget proposal that will reduce deficits and restructure entitlements (I'm talking years long term here; while immediate cuts and action are necessary, anything absolutely drastic at the federal level may shock this fragile economy into contraction, esp with considering my next point) + (3) very slow Fed weaning (this means continuing its Treasury purchases and low rates; when the Fed disappears from the Treasury mark in June, there will be effects and higher rates, but minimal and slow weaning is good and necessary; rate hikes can come later).

Is inflation a concern? Somewhat but mostly at the energy level (gas). Considerable economic slack and low housing costs/rents will keep inflation subdued and from truly crippling family budgets for the time being.

Finally, keep an eye on what some call The Rule of 10. The economy tends to suffer when the 10 year Treasury rate and the price of gas hit and/or exceed 10. Currently, gas is at 3.50 and the t-rate is at 3.5. Gas could easily hit $4 or beyond with Saudi concerns. And the end of Fed purchases in June could take the t-rate above 4%. Something to be mindful of.

2011 Course Markers

As the year gets under way, I think its best to identify the key elements that will shape and steer the markets over the next year, or as I see it at least.

(1) Gasoline/commodity prices ($4 gas will be an impediment to consumer spending and economic growth while commodities have benefited and will continue to benefit from excessive Fed support).

(2) Political partisanship (if the sides don't work together and we get gridlock, then that means we continue to run high deficits, which is dangerous, so be mindful and take note of how much meaningful legislation, spending cuts, etc are being passed).

(3) Euro country & US Municipal debt issues (will result in strained finance situations, spending cuts and/or high deficits, increased unemployment and currency waves).

(4) Unemployment above 9% (or more truly, whether the economy starts to create 300,000 new jobs each month, which is the amount necessary to truly reduce the under-employed and un-employed numbers).

(5) Housing values (the biggest equity play for any American is their homes' equity and those values have begun decreasing again - for 4 consecutive months now and last month showed the first year-over-year decline since the tax credit recovery took hold -- which portends further foreclosures, more inventory, low demand and potentially lower housing prices still).

All that being said, even if these issues don't get resolved in 2011, I remain unconvinced that they will truly erupt in the next 12 months. Perhaps it'd be better if they did since an inflating situation only pops more damagingly, but let's enjoy the prosperity while it exists, and hope the government recognizes the medium and long-term budget concerns and takes meaningful actions to resolving them.

Lehman Brothers and the 1250 S&P Level

Lehman Brother's collapse was a true marker of the beginning of concern, panic and frantic uncertainty regarding the US financial system. Prior to the collapse, the S&P had taken about a year (late 2007 to late 2008) to recede from its all-time high (around 1540) to 1250, representing nearly a 20% correction. Bearish, yes. Unheard of, by no means.

Then Lehman occurred, and the S&P spent the next 6 months plummeting to its 666 level, representing approximately a 46% drop from the 1250 level.

With the introduction of TARP and US backing of the financial system (at ANY cost, literally), the markets began their rally which has now been on-going for 21 months. And where are we at currently? 1258 on the S&P.

The answer = restored capital and, consequently, confidence in the US financial system.

Not the answer = a dramatically improved financial condition of the US deficit or the US economy as whole.

To interpret the recent bull run back up to 1250 levels as a "recovery" of the US economy is a mistake. While the economy is on surer footing due to the stability of the financial system - certain regulatory and systemic actions are still needed. Meanwhile, political partisanship and easy money policies threaten to exacerbate and re-ignite the same fuse that burned the US economy 2 years ago. Tomorrow? No. But eventually, unless actions are taken.

I simply think its important to recognize that evaluating the stock market (and its gains) off the 666 S&P level may not be truly fair. Panic and uncertainty exagerate losses. Perhaps its the 1250 level and what 2011 brings (both in terms of gains and/or political action) that will be most telling.

Blast from the Past

(1) Japan engaged in multiple rounds of quantitative easing during their historical (and still on-going) bout with deflation and a stagnant economy. Both times, the Japan stock market saw material gains over 50%+ even if the economy itself only improved modestly.

Ben Bernanke's first round of QE has helped jumpstart the American stock markets by creating a rare bull run that began in March 2009 and just hasn't stopped since. Meanwhile, the US economy has moderated to a 2.6% GDP rate of growth (above deflationary scare levels but well below the 4% goal level). Ben started his second round of QE last month essentially and will continue it through early 2011.

Does that translate into continued market gains, and strong ones at that? If so, does that mean that the price of commodities and oil continue to surge? And if so, aren't rising producer prices (via commodities) and rising gas prices at the pump some consumer spending headwinds that may prevent the economy from moving above that 3% growth level?

(2) Many economists will say that the perfect solution for the 2008 crisis is/was = immediate fiscal and monetary stimulus coupled with medium and long term austerity measures. Problem is - many economists will also tell you that that is very difficult to achieve politically.

So far we've received the immediate/short-term fiscal and monetary stimilus (see stimulus bill, quantitative easing, TARP, bank re-capitalizations and extension of Bush tax cuts). Now the question comes: will Congress be able to agree to medium term and long-term spending reductions (i.e. balancing the budget and restructuring long-term entitlement programs, healthcare, medicare, social security, etc)?

Congress just added nearly a Trillion dollars of debt to the deficit with the Bush tax cuts extension. Then what did they do - attempt to pass a fiscally responsible and balanced budget? No, they tried to pass a one year budget bandaid that included billions of dollars in earmarks to earn Senate votes.

If there is no political will or compromise on medium and long term spending cuts, we risk being as poorly leveraged as Spain, Ireland and others in 5 or 10 years.

Did 3Q GDP disappoint?

It's hard to say that a 2.6% GDP for 3Q 2010 is disappointing considering you're coming off a 1.7% 2Q 2010 and, by most accounts, the 4Q data appears to reflect a continued increase in economic activity from 3Q. But here is some less than good data to consider -- but remember, its now old data from a quarter that ended in Sept.

(1) consumer spending ("personal consumption") was revised down from the previous estimate from 2.8% to 2.4%. We all know consumer spending is key to US health for better or worse.

(2) deflation and the Fed's quantitative easing plans got a little justification as prices were revised down from 2.3% increase to only 2.1% increase, the lowest in 50 years. Interesting and surprising by most accounts

(3) Corporate profits were revised down from 3.2% increase to 2.4% - although small gains in top line revenue growth are likely to continue to result in large bottom line profit impacts considering employment will stay muted and corporations are as lean as ever nowadays.

(4) Final sales (another reflection of consumer demand) was revised down from 1.2% to 0.9%.

(5) Inventory building did present a strong increase to help support the GDP growth figures and suggest hope of continued business sale expansion.

All in all, 2.6% lives in that world of uncertain but hopeful growth. Less than 2% indicating potential deflation and serious concerns, while near 4% growth is the goal.

Musings a Month Later

Thirty days since the last minor retreat and stocks have again resumed their upward trend. What's most interesting is the real bullish commentary that has started to become consensus for Q4 and 2011 US growth. 2011 S&P projections range from 1350 all the way up to 1550! A few thoughts to keep in mind along the way and during what should continue to be a positive trend:

(1) Easy money from the Fed, increased corporate/consumer confidence and moderate economic growth are the things bubbles are made of. But even so - why not enjoy the reinflating of the bubble while its occuring! Sure, I would never try to catch a falling knife and perfectly time a market, but it appears that Congress and the Fed are on the path of keeping taxes low, not yet restricting spending, keeping interest rates low and easy money flowing.

The consequences will surely be high inflation, a weak dollar and high interest rates - but not for awhile.

(2) Sovereign debt issues continued to be handled with enough caution that markets aren't freaking out. Spanish yields are increasing and frustrating rates after bond vigilanties have worked through Greece and Ireland, but each country gets reassured by IMF and EU emergency fund support and the concerns have remained relatively contained.

Eventually, all of the PIIGS and even the US will be forced to address their sovereign debt issues - but not for awhile.

(3) Housing starts remain very depressed and foreclosures have continued to be managable, relatively speaking. Add it up and you have a more stable housing market that can slowly....slllllowly work through all this excess inventory.

Plus, real estate is local - so if you're not in Florida, Nevada or California, you may feel quite positive about housing over the next 3-5 years.

(4) Unemployment is moderating and coming down. Technically, the % number will remain high or rise, but the true number - the "underemployment number" - is coming down as companies are slightly hiring, government stops laying people off due to budget cuts and part-time workers become full time employees.

It remains that the US may need to adjust to a higher level of long term unemployment. That provides a drain on the economy in the form of aid and less consumer spending. But that impact is less noticed for the time being - so why not continue the trend of not worrying about it right now.

Overall -- the current environment is as "pro-growth" as it gets. When austerity, bond vigilanties and inflation hit, there will be new concerns - but all things considered, those don't appear on the radar just yet - and if we can get the economy growing fast enough now, we may have some adequate tools to fight those battles in a responsible way later.

Healthy Correction?

After failing to break through the April highs of 2010 (around 1220 on the S&P), the market is now challenging a fairly strong support level around 1190-1194 on the S&P. A failure to hold at this level could trigger another 3-5% dip that would amount to a cumulative 8% correction or so. By most standards a fairly healthy one at that.

Let's consider the current "supporting winds" that encourage bullishness:
(1) Retail sales and consumer spending continues to improve;
(2) strong corporate earnings; and
(3) the Fed's move to inject approx. $900 billion in sum over the next 6 months into the economy and to keep long term interest rates low.

And now for the "head winds":
(1) European sovereign debt issues re-emerging (altho a kick-the-can-down-the-road resolution to these should occur sooner than later);
(2) Cisco earnings that showed significantly poor outlook heading into year end (thus far the market has not yet extended this negativity to the rest of the tech sector; although I find it hard to believe Cisco is an isolated case here)
(3) Emerging market and commodity inflation concerns (although not immediate);
(4) Political gridlock and business uncertainty regarding structural factors (housing, healthcare, etc).
(5) Chinese intentions to raise rates and/or other measures to control inflationary and bubblish growth

All in all - the headwinds (while severely troublesome in the long term) don't appear ready to inflict immediate consequences. Pair that with gradual economic improvement and you may well emerge from this correction with a resumption of bullishness.

Bust and Boom and Bust?

Jeremy Grantham is a widely followed money manager who spent a lengthy amount of time with Mario Bartiromo earlier this week (29 min interview available in CNBC video logs).

In sum, Grantham stated that the Fed's recent moves were intended to exude investor confidence and help the stock market pop, which in turn would encourage spending and sustain the current economy recovery.

Grantham went on to state, however, that the easy money move by the Fed would only end up resutling in a boom-bust cycle like that of 2003 through 2008. More importantly, at the time of the next bust, the US would not longer have the option of stimulating the economy out of recession (since it will be so heavily indebted already).

While I certainly believe that this outcome is possible, I believe it hinges on one assumption: that the Fed's move (or future moves of QE3, QE4 to infinity and beyond) will work in causing economic growth in the near term.

I posit that QE2 will result in diminshed results (with additional QEs resulting in even more diminshed returns comparitively). This would mean we would have an economic malaise and very possibly an environment of stagflation (whereby high inflation results in emerging markets and is this transmitted to the US via our imports -- combined with lackluster economic growth and wage gains).

I also posit that the markets have currently priced in QE2 fully. And are now digesting whether to price in a near term economic boom (which would be followed by bust according to Grantham and history in general) or the more dire stagflationary environment.

Regardless, don't both cases leave you back at "Go" in the end?

The absolutely MUST in order to prevail against any future busts (and to provide fertile soil for future economic growth) is to fundamentally restructure the systemic causes of US debt (healthcare, social security, housing, etc). Any political failure to do so will most certainly leave us doomed to repeat 2001, 1988-1992, 1982-1983, etc.

Glass ceiling?

The market's 80% rise from its 2009 March lows has been quite a story -- defying concensus criticism and attesting to the resilience of the US business climate. Granted, 1219 is still a far cry from the 1550 range of mid 2007.

So what does the past 20 months portend for the next 20? Is it possible that we're hitting a glass ceiling?

We're sitting at the year highs for the S&P (matching what was reached around April of this year), and 1219 is the resistence level to watch.

But also consider it this way: the market has rallied on inventory restocking, the return to some sense of normalcy, economic data that has proved positive as it was compared to absolute worst case data from 2008, strong corporate profitability, and excessive stimulus and quantitative easing that is actually focused at creating bubblish growth.

If you consider that all that is baked in the cake -- and that the economy is still only growing at 2% and likely to continue growing at such modest rates, then what does the market have left to hope for/process?

How about - rising commodity costs? higher gas prices hitting consumers? even if higher prices don't get passed onto consumers, corporate profitability will be squeezed. A weak dollar may improve exports and inflate people out of debt nominally but it may also lead to higher interest rates, which would only stifle housing and both consumer and national debt obligations.

The systemic debt problems of the country have not changed on iota. Yes, the financial system is once again stable, but the things that churn the US toward its annual 1.3 Trillion debt problem haven't been touched.

Meanwhile, you have state and local governments in a debt crunch and European countries such as Greece, Portugal and Ireland are returning to the national stage with talk of more help being needed.

Financial collapse has been saved and the markets love it. But actual debt servicing and restructuring has yet to happen -- and that MUST be dealt with for any healthy economic growth to occur.

The question becomes -- when will the markets deal with the debt concerns? Maybe when that's all they have left to focus on?

"Escape Velocity"

Pimco coined the now popular phrase "new normal". However, their phrase I like the most, and which is most pertinent to today is "escape velocity."

The idea is this - the US economy is growing at slightly less than 2% currently. Our annual deficit is bigger and our overall debt very concerning. One school of thought says, now that you have growth, you should tax and/or reduce spending to reduce the debt. However, this is a very dangerous approach to take to an extreme b/c you risk the somewhat fragile 2% growth turning into 0% growth by hindering economic incentive and investment.

The 2nd school of thought says that in order to reduce debt, we must have a truly vibrant and profitable economy -- one that grows at 4% or more. If that occurs, then we will be creating jobs, profitability, income, revenue - and at that point in time the economy can (literally) afford to be taxed in order to reduce our debt.

The problem = the longer we wait for that 4% growth economy, the larger our debt grows.

Escape velocity is the idea of spurring the economy very quickly to that 4% growth level and leaving behind these times of 2% growth while debt continues and continues to grow.

So today's move by the Fed to announce $600 billion in quantitative easing (really $900 billion b/c they are also continuing a current program whereby there are spending 250-300 billion in treasury purchases) is an all-out gamble on the 2nd school of thought... the markets should love this for the short term (6 months?) as well as for the long term, if it works.

Potential outcomes/consequences of the move?
(1) Inflation in emerging markets
(2) Debasing the value of the dollar
(3) Stagflation (below average growth in an environment of inflation)
(4) Rising asset prices, esp. commodities
(5) Lost or gained credibility for the Fed (based on if it works or not)

Failure to achieve "escape velocity," however.... might feel like landing on wet cement.

Elections Eve & The Solution to the Economy

Tomorrow = election day and what many believe will mean the beginning of a divided government. Whether it be a divided Congress or a divided Congress/Pres. administration, division is believed to = idealogical divide = no new legislation. While some consider this a benefit to business (via a reduction of the amount of law/regulation that can be imposed on the business community), there is another viewpoint, and one that thwarts the potential solution to our current mess from being implemented.

The Solution == short term fiscal and monetary stimulus + medium term deficit reduction and medium/long term fiscal restructuring to reduce government programs (i.e. Medicare, Medicaid, Social Security, Healthcare).

In practice, this means:
(1) Congress pass stimulative measures such as a payroll tax holiday and a temporary tax holiday for corporations to bring money into the US that is currently overseas (due to lower taxation).
(2) Helicopter Ben continues with very modest treasury purchases - maybe 250 billion over 3 months - in the short term and then re-evaluate this plan every 3 months.
(3) Extend Bush tax cuts for all but the very "rich" (i.e. those making 250,000+ as a couple) -- only to repeal them after one or maybe two years from today
(4) For the medium term, taking budgetary actions that are committed to ensuring a balanced budget no later than 5 years from today.
(5) For the long term and the sake of staving off debt-default, Congress must reorganize & restructure our systemic debt-laden institutions (incl. Social Security, Housing, Healthcare, Tax Code/taxes, and Medicare/aid).

The Reality = a political divide that will prevent any short term fiscal stimulus, any moderate term budget credibility, and any long term systemic restructuring. Which leaves only the Fed to attempt to ensure growth via Quantitative Easing measures which are either limited sucessfully or ensure high inflation if successful fully.

Political gridlock may be a market boost for the near term, but the problems that helped cause the debt-laden US economy are still here as they were in 2000, and that means that the symptoms of those problems will return sooner or later.

The Trillion Dollar Question

As of July 1, the S&P was around 1010. A few days ago it was topping at 1185 (a fairly key S&P threshold).

The economic picture and concerns aren't much changed since my last post in early October. Unemployment is stubbornly high. Home sales bump along all-time low levels. Home prices are slowly resuming their decline (altho the foreclosure freeze may help stall this actually). Government inaction and high debt levels continue to concern. And GDP growth continues to be positive albeit at too slow of a pace to translate into actual job creation, increased spending, etc. Corporate earnings show strong profitability but inadequate revenue growth.

What's accounted for the rally? One simple thing -- the expectation that (as a result of these uneventful and arguably dire circumstances) the Fed will engage in a second round of Quantitative Easing to spur the economy once again (a-la March 2009 onward).

The announcement comes November 3rd.

Many expect the Fed to engage in $500 billion worth of easing over the next few months. Some want to see the phrase $1 trillion mentioned. Some believe it would take $6 trillion to have an actual impact though.

So what to make of the situation -- the July through October rally of approx 15% may be confirmed if the Fed announces what it expected. But then the question becomes, will the easing work, again? Hope alone cannot sustain the markets indefinitely.