"Well, Who Are You Gonna Believe, Me Or Your Own Eyes?" - Chico Marx in Duck Soup

From the Desk of Joe Rollins

The purpose of this memo is to provide you with my thoughts regarding the U.S. economy and the dismal performance of the U.S. financial markets during the first six months of the year. Frankly, the media’s coverage of our current economy has left me in a state of confusion. There is so much bewilderment, fear and misinformation being reported by the press that I figured it was an appropriate time for me to weigh-in on the controversies.

I recently read an online article proclaiming that the U.S. economy is as bad now as it was during the Great Depression. Given that unemployment is currently at 5.5% as compared to 1933’s unemployment rate of 25%, this parallel would appear to be a reach used only for maximum sensational effect. I have actually heard five different television financial analysts say that the U.S. has been in a recession since November of 2007. However, the widely accepted definition of a recession is two consecutive quarters of negative GDP growth, and the first quarter of 2008’s GDP was recently revised to a positive 1% annualized. Therefore, we have not even experienced a single quarter of negative GDP growth yet, much less two.

It is almost assured that the second quarter 2008 GDP growth will also be slightly positive. This is probably not because of positive business operations; it is more likely due to strong consumer demand, mainly an effect of the economic stimulus checks that were recently issued. So, even though we have not yet had a single negative GDP quarter, some media members are claiming that we have been in a recession for over eight months. Can you see why I am so confused?

The cost of a barrel of oil as of this writing is up over 45% just in 2008 alone. While worldwide demand for oil is definitely higher, there has certainly not been an increase in demand of 45%. In fact, the demand for oil in the U.S. was actually down in 2007 while developing world economies have most certainly experienced an increase. At these levels, I see no justification for such dramatic increases in the price of oil. Of course, oil is in a long-term pattern of price increases, but nothing justifies a 45% price increase in such a short period of time.

I am leery of characterizing any particular area of investing as a “bubble,” but the price of oil may just qualify. Given that there has been a 45% increase in crude oil so far this year, this does not appropriately reflect supply and demand. Therefore, it is possible that crude oil could suffer a serious decline in value -- easily between 20% and 30% overnight -- if supply is confirmed to be greater than demand. Even though this is the only asset class to show a profit for the first half of 2008, it is a very risky investment for the average investor.

It is interesting to note that there has been a 20-fold expansion of trading derivatives involved in oil and gas over the last two years. I also find it interesting that there is a seemingly direct correlation to the increases in derivative trading on these commodities, which has driven up prices. In essence, commodities is the only asset class that has made any money whatsoever in 2008. We currently have a large speculative investor class buying paper commodities that clearly have no intention of ever taking delivery of these products. What possible reason do pension plans and private foundations have for buying these commodity derivatives except to profit from the commodities?

The intentions of the derivatives were to protect the public from escalating prices and to lock-in prices at predictable levels. Because there has been such an explosion in derivatives, the price now has nothing to do with the underlying supply and demand for the products. Unfortunately, a vast number of these derivatives are bought by Middle Eastern countries that benefit not only from the increase in the price of derivatives, but also in the underlying commodity itself since they are the producing countries.

Many of my clients have invested in banks or hold bank investments. It is absolutely staggering to see that some banks are now down 80% from their value only last year, and their values continue to fall almost daily. In future years, we will likely look back at this time and marvel at the poor information we were using to evaluate bank investments during 2008.

Unquestionably, banks employ many brilliant economists and businesspeople. I think it can be said without reservation that it is absolutely unlikely that these brilliant businesspeople invested in over a trillion dollars in worthless, sub-prime mortgages. In fact, the real issue here is not uncollectible mortgages, but rather, the way these uncollectible mortgages are required to be valued on the books of the banks. Press releases only refer to write-downs of these mortgages, not write-offs. The entire banking industry in the United States is suffering a severe case of over-accounting regarding these mortgages. By distorting the write-downs, the value of many portfolios that contain bank investments are being destroyed. When these write-downs eventually reverse and become phantom income, I am sure we will have the opposite opinion. But for the time being, I do not think it is even remotely possible that all the major banks in the United States are leading to insolvency. As investors, I urge you to carefully evaluate this matter thoroughly before believing everything the media offers on this subject.

I also find it very interesting that much of the sub-prime mortgage disaster was caused by our own government in the first place. Many believed, including the Federal Reserve, that it was desirable and necessary for all Americans to be homeowners. The Fed encouraged banks to make loans to all potential buyers, regardless of their financial ability to repay the loans. But now, the biggest risk we are facing is the overreaction of the banking industry to the sub-prime crisis.

Before, banks were making loans to anyone and everyone in order to fulfill the Fed’s request. With new legislation and regulations, I fear that the pendulum will swing too far to the other side. Banks are now leery of making loans to even capable borrowers, and that risk is greater than the sub-prime problem we have today. I can only hope that lenders will continue to reasonably evaluate potential borrowers and extend loans when appropriate. There is no question that the pendulum swung too far in one direction and created the sub-prime mess, but we cannot afford the risk of withholding credit to good borrowers to the point of strangling the economy.

Furthermore, I just do not understand why so many Americans have such a negative viewpoint of the economy when things are actually quite good. Unemployment is only at 5.5%, which is very low by historic standards. Individual income continues to rise ahead of inflation even as recently as May of this year. Undeniably, housing prices are down, but then again, most people do not have any intention of selling their homes right now anyway.

Since homes are lived in, they have a utility value. If a home is worth less today than it was last year, it really has little economic effect on the homeowner’s day-to-day life. It is true that there are some homeowners in sticky situations concerning their mortgages, but a vast majority of homeowners -- 95% -- have no mortgage problems, and even those who do will likely wind up keeping their homes since homeowners in trouble will receive government assistance. Home prices are clearly down, but they are still worth over one-third more than they were in 2000. The tightening of credit and the easy availability of borrowing on home equity lines is now a thing of the past. The more I consider that possibility, the more I think it might be a good thing for Americans to not have such easy access to credit.

Inflation is definitely higher in 2007 than it was in prior years, but the fact is that we have had almost 16 continuous years of inflation-free living, and we should not be surprised to see it tick up in any single year. It has been proven time and time again that U.S. living standards today are the highest they have ever been in our history, and this includes the living standards for the middle class and the poor.

When I listen to the negative news reported by the financial media, the contradictions are glaring. There were recently more than $150 million in box office movie ticket sales in one weekend alone. This does not even include the enormous amounts spent on $5 boxes of popcorn and $5 soft drinks at the concession stands. Moreover, even though the price of gas is at historic highs, we still seem to suffer from daily traffic jams in Atlanta. With everything I have read on how the consumer is pinched and how no one has any money to spend, I find it fascinating how hard it is to reserve a table in a nice restaurant on a Friday night. Is this indicative of a recession? Based on the foregoing examples, it is definitely not evident to me. Perhaps this just goes to show that what we sometimes see with our own eyes is different than what is reported by the media.

Skeptics often report the U.S. dollar being so devalued that Americans no longer have influence on the world economy. In fact, the exact opposite is true. Please review the “Exports of Goods” chart I have provided to the left. As you can see, with the decrease in U.S. dollar value, net exports from the United States have exploded as the U.S. has become more competitive with the rest of the world. The lower dollar has actually allowed U.S. manufacturers to compete on a level playing ground, and now the rest of the world wants to come to the U.S. to produce goods. There is no question that this explosion of exports is leading to additional jobs in the U.S.

Foreign auto manufacturers are coming to the United States to build state-of-the-art car plants. These new plants contain high-tech, heavy machinery that will revolutionize the way cars are manufactured throughout the world. These foreign car manufacturers recognize that the United States has the most skilled labor force and a business environment that promotes new businesses. In contrast, the legendary U.S. car manufacturers -- Ford and General Motors, for instance -- are closing old plants and opening operations in Communist-run China. For the most part, they are fleeing the United States to avoid their union contracts, since they are anti-productive and prevent them from generating profits in this country.

It is astonishing to see U.S. car manufacturers fail at the hands of foreign companies that have excelled in the field with revolutionary plants, no union contracts and only a desire to build quality cars at a low cost. American car companies must conform or they will fail since they will be unable to compete in international commerce by building cars in China It is only a matter of time until we see Toyota and other great car manufacturers create a U.S. base of operations that will dwarf the legendary American car companies. While you may argue that this would be bad for American auto workers, it is undebatably positive for the average car-buying consumer in the U.S.

The political rhetoric regarding the lack of jobs is also quite puzzling to me; the facts just do not support all the noise being made. If you review the “Civilian Employment” chart to the right, you will notice that civilian employment in the U.S. has exploded from 136 million workers in 2002 to in excess of 146 million workers in 2008. This explosion of employment was in the face of NAFTA, immigration issues and other concerns that supposedly limited U.S. employment. As such, the facts indicate that more workers now have jobs than ever in the history of this country.

Regarding the recent jump in gas prices, it is time for us to realize that a price increase will help accomplish in this country what probably should have happened years ago. Higher gas prices will lead to conservation of energy and development of alternative power methods. We are already seeing the proliferation of wind power and some progress in building nuclear power plants. Furthermore, there are absolutely no environmental reasons for not drilling for oil off our shorelines. The Chinese are drilling exploratory wells off of Cuba’s shores, a mere 100 miles from our shorelines. It only seems logical that we would want to capture the economic benefits of drilling for oil within our own coastal waters.

The U.S. Congress has been totally ineffective in instituting any type of energy policy. Due to environmental concerns, there has been no major energy legislation passed in decades. Even today, Congress cannot come together to pass a single bill to try to wean the United States from its full reliance upon oil from the Middle East, which we often purchase from potential enemies. However, in spite of Congress’s ineptitude, major oil fields have been discovered in North Dakota and all over Canada. Higher gas prices will lead to more exploration in our own country, which will solve the problem without governmental intervention. The best way to solve this issue is for the U.S. to become energy self-sufficient. The combination of new exploration, energy conservation and alternative fuels will help accomplish that goal in our lifetimes.

However, if you believed the media, you would think that all Americans are economically hamstrung by the cost of gasoline. In fact, most people are only marginally impacted. It has been determined that the average American uses approximately 20 gallons of gasoline per week, which actually seems high to me. On average, that represents 400 miles driven per week or approximately 20,000 miles per year, but I think that most Americans drive less than that amount. However, assuming those numbers are correct and the cost of fuel is up $1 from last year, these amounts are not catastrophic. This dollar per gallon price increase would mean that the average American was paying an additional $20 per week for fuel, or $1,040 per year. While no one wants to pay an additional $1,000 per year, I have a hard time believing it has led to the financial catastrophe the media is reporting.

On another matter, regardless of your feelings pertaining to the war in Iraq, one would be hard-pressed to question whether real progress has been made over the last six months. It is even looking brighter that there will be a resolution to this issue in the next few years. Even Thomas Friedman, the famous author of The World is Flat who has been critical of the war in Iraq, now seems to have a different opinion and sees the positive effects of helping to stabilize that country. Congress has now committed to funding our military through June of 2009, which should be the end of major expenditures in Iraq. Remember, we have been in Korea for 55 years, allowing one of the most prosperous Democratic countries -- South Korea -- to evolve.

In summary, I will be the first to admit that the economy is slower than it was a few years ago, but it certainly does not merit such rampant pessimism. A recent CBS News/New York Times poll reflected that 81% of respondents think the country is on the wrong track and 78% believe the U.S. is worse off today than it was five years ago. In contrast, a current Harris poll reported that 82% believe their situation had improved or held steady over the last five years. I guess the truth probably lies somewhere between those two incongruent poll results. The economy is definitely not great, but it is certainly not terrible either. Employment continues to be high and incomes are rising. American industries continue to produce quality products, and corporate profits, while certainly not growing at prior year levels, are still growing. Corporate profits could not grow forever! But the economy is actually pretty good, even though attitudes are bad. The world is full of broken men and women that have dared to bet against the U.S. economy.

The purpose of this memo is not to explain away the true losses that the financial markets have realized during the first six months of 2008. Rather, I want to point out to you that things are essentially fairly good, and the pessimism in the U.S., for the most part, is unwarranted. Best regards.