November 5, 2010

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. “Less than Zero,” the Sequel: This week Dudley (former Goldman economist and current NY Fed president) replaces Downey (the actor) in a remake of the titular 1980s tale of narcissism, wealth, and stupidity. In the ’80s movie, based loosely on Brett Easton Ellis’s novel, very privileged kids experiment with a world of self-destructive nihilism and drug abuse. The outcome was less than zero.

Now, a similar character, Dudley, proclaims that the Central Bank’s balance sheet expansion of at least $500 billion (600 was announced) will have the same effect as reducing the Fed funds rate by 50-75 basis points. Currently, the rate is 25 basis points. Let’s see, this round of asset purchases effectively takes us to less than zero. Are we having fun yet?

For monetary historians, this is a period of time that could unassumingly be described as “interesting.” Dudley, Bernanke, and the whole FOMC team – excluding Hoenig – are setting course for the further destruction of middle class wealth and concentration of wealth among the financial elite (don’t forget that insider selling is at record highs; while main street buys the recovery story, insiders and Wall Street bankers are selling).

Artificially low rates are a precursor to higher rates, bubbles, and financial instability. When an institution like the Fed prioritizes stimulus in the here and now with the tools it is using (record low rates and direct monetization), the systemic impact is quite similar to over-stimulus with a foreign substance – overdose. The privileged kids in the movie ultimately see that the piper must be paid. They are more than witnesses to tragedy; they are the characters of the tragic tale.

There was a period of time in the ’80s when both Chile and Mexico went through very difficult financial times. Chile allowed liquidation and bankruptcy to destroy businesses that were losing money. Mexico chose the route of “price stability and higher employment” (sound familiar to the Fed mandate?).

On the surface, Mexico seemed to have chosen the more humane path. Only with the passage of decades can we see that Chilean growth normalized and then moved above trend as a result of those tough and unpopular decisions, while Mexico remained 30% under its growth trend. What we are choosing in the U.S. mirrors the Mexican choice of yesteryear – easier to chew, but ultimately much harder to swallow.

Financial pundits are asking if we will repeat a lost decade in financial growth. The better question is reflected in the film: What about a lost generation? The Fed is setting a course for cheaper dollars and much more expensive real goods. We can only hope the market quickly recovers its sanity, fires the Fed, and quits its dependency on easy money and cheap credit.

2. Fed Policy – Taking Us Nowhere Fast: QE II has been officially launched. $900B is to be monetized between now and next June.

Broken down, it comes to $600B in Treasuries with an average of five to six years in duration, and $300B from asset-backed securities. In addition, the Fed funds rate will stay exceptionally low (at 0.25%) for an extended period, and the principal reinvestment plan derived from mortgages in the Fed’s procession will remain intact.

Bernanke and the non-dissenting governors have justified their actions based on persistently high unemployment and inflation that remains “too low” relative to their mandate. They further state that the decision will promote growth through the “wealth effect.” This is when investor assets rise in price, making them richer, so to speak.

The $600B price tag was $100B above the consensus expectation held by the Street, boosting stocks and commodities to the upside in violent fashion. The only exception to the party on Wednesday was the bond market, which fell nearly 3 full points from top to bottom on the day (this part had to perplex Bernanke). Below we have posted some links to articles that cover the Fed’s remarks and the events that followed.

MWM Comments: There are several disturbing aspects to the Fed’s decision, and I don’t know if it’s possible to cover them all here. The economic logic used to justify this recent decision is so flawed and so backwards that it would take a full-blown economic forum to address them all accurately.

In short, however, commodity prices continue to outperform stocks, bonds, and real estate. This was apparent intraday on Wednesday and Thursday, where most commodity groups averaged 2-6% gains vs. stocks, which gained less than 2%. Therefore, “growth” or even the “wealth effect” is impossible to achieve when measured in real terms. Sure, one’s wages may increase (which we doubt), or one’s assets go up in value (maybe), but if one’s cost of living rises at a faster pace than both, there can be no advance in standard of living.

In previous writings, we have expressed this dynamic at work in greater detail, tracing its origins back to the dot-com crisis in 2000, when the Fed first started “saving” us from the aftermath of the bubbles it ironically created. If we could put a summation sign on the whole mess, the Fed is creating a lot of motion in the markets, but it’s “much ado about nothing.”

In reality, the Fed has opted for lower growth, higher indebtedness, trade wars, and greater instability in the pricing environment – all to protect its hyper-levered friends in the banking sector. It is therefore only a matter of time (which we believe will be short) before stocks discount the massive taxing machine run amok.

Bonds may get a brief relief rally from money fleeing stocks, but this will likely be short-lived, as the weaker dollar will eventually override the benefit, forcing rates higher. Gold and silver look “toppy” in the charts, as well, but this is one place where price gains may be justified in this environment, rendering any corrections in the metals, if they do occur, shallow and temporary – for the moment.

Commodity prices in the news:
Cotton, Sugar, Natural Rubber in China Surge to Records on Supply Concern
Oil Rises to Highest Since October 2008 as Dollar Decline Spurs Purchases
Soybeans Advance to Two-Year High as Dollar Weakens on Fed’s Easing Plan

G20 nations keep word on conservative measures:
Australia, N.Z. Dollars Set for Second Weekly Gain on Higher Rate Outlook
Pound Extends Gain Against Dollar as BOE Keeps Rates, QE Program Unchanged

Fed defends its decision:
What the Fed did and why: supporting the recovery and sustaining price stability
Bernanke defends new $600 bln bond buys
Bernanke defends QE, talks wealth effect in op-ed

Have a wonderful weekend.

David McAlvany
President and CEO

David Burgess
VP Investment Management