Saturday, May 30, 2009

Light at the End of the Tunnel – And It’s Not a Train!

From the Desk of Joe Rollins

Here in Atlanta, we are cycling out of our monsoon season into the heat of summer. Because of my workload during tax season, I usually miss most of the beautiful spring days. After tax season ends, in most years it has already become too hot to want to stay outside for very long. This year, however, the weather has been different.

Things are really changing all over. Cats must be sleeping with dogs and the world must’ve turned upside-down! In Atlanta, it has rained almost continuously since the 1st of April. Lake Lanier’s water tables are back to normal after years of drought, and my rose beds are so wet that a few days of heat would be appreciated. I have no fear, though, that the weather will return to normal. I expect that our typical hot and humid days are just around the corner.

So it is with the economy; normalcy has returned, although it crept in under the radar. Today is the last trading day for the month of May. Can you believe that May is the third straight month where all the major indexes have made a profit? With all of the hand wringing and calls for panic, the major stock market indices have slowly – but profoundly – made a turn for the better.

The chart below reflects how quickly and dramatically the stock market indices have completely turned around. Through the end of May, the Standard & Poor’s Index of 500 Stocks and the NASDAQ Composite are now positive for 2009 and the Dow Jones Industrial Average is only marginally negative.

On Wednesday, the National Association of Business Economists reported that 90% of their economists predicted a recovery in the U.S. economy to take place in 2009. In fact, 74% of the economists predicted that the economy would recover during the 3rd quarter of 2009. May I remind you that I made the same prediction many months prior, without the wealth of information that these learned economists possess? Sixteen percent of the economists said that the recovery would occur during the 4th quarter of 2009 and the remaining 10% said it would occur during the 1st quarter of 2010.

It’s hard to believe that the 3rd quarter begins in just one month. Even though many were predicting only a few months ago that the U.S. economy was on the virtual edge of a financial abyss, now almost all economists are projecting the turnaround to be in the near future.

It’s fascinating that this turnaround is occurring without the massive spending of the stimulus bill. Yes, it’s true that some of the stimulus money has made its way into the economy, but a vast majority of it has yet to be spent. You’ll recall that the mandate was that the money would need to be committed in the first 120 days after the bill’s passage. We just passed the 100th day, and only a small fraction of the stimulus money has made its way into the economy.

As I have often written in these posts, the U.S. economy is a fabulous corrector of its own abuses. The economy tends to correct itself without governmental intervention due to capitalism and entrepreneurship. The more government interferes with the economy, the worse it becomes.

I never believed that the economy was as bad as was being reported by the financial press, but even if it was, it is now on the mend. It’s unfortunate that panic caused us to appropriate literally trillions of dollars that will now be forced into the economy when it’s probably not even needed at this point. The deficits that are being projected for the economy over the next decade are truly mind-boggling in size. During the height of the panic, we felt we needed – and our Congress approved – massive spending undertaking for years to come unlike anything ever seen in the history of this country.

Now the economy is recovering without the aid of massive spending, yet the vast majority of the stimulus bill has not been spent nor will it be spent for several years. In retrospect, our government panicked to the ultimate price of the taxpayers.

I want to briefly review a few of the topics I have covered over the last eventful eight months. One of my posts explained the importance of the 3-month LIBOR interest rate. This is the interest rate that is used for interbank lending. Therefore, the higher the rate, the less likely banks are to lend to each other. In September of 2007, the 3-month LIBOR rate got as high as 5.7%. During the panic of October, 2008, the rate neared 5%, and it basically stayed at this level until it began falling very recently. As of yesterday, the 3-month LIBOR rate had fallen to 0.67%, which is one of the lowest rates on record. The economy has fixed itself and now banks are more than willing to lend to each other.

I previously wrote that the 10-year Treasury rate was yielding a minuscule 2%. Investors were so afraid of taking on risk that they were willing to accept a measly interest rate rather than risking their capital. Yesterday, the 10-year Treasury rate was at 3.5%, which is up 75% from where it was recently. Investors are no longer willing to accept diminutive yields on cash and government bonds when virtually every asset class is producing higher rates of return.

The steeper the yield curve between short-term rates and long-term rates, the more money banks can make. For example, if banks can borrow cheaply but lend at a much higher rate, their effective rate of return is dramatically improved. Today we have the steepest yield curve ever in our history. The 1-month Treasury rate is 0.11% and the 10-year Treasury rate is 3.5%. Never has the upward inclining yield rate been this dramatic. Notwithstanding all of the negative news you hear in the financial media, you do not need to know any more than this to predict that banks will report extraordinary profits this quarter – from banking, not investing.

Remember the infamous TARP plan proposed in September of 2008 that started the panic? Doesn’t that feel like decades ago? It’s hard to believe so much has happened in the intervening eight months. It was announced yesterday that the U.S. Treasury and the FDIC are postponing the implementation of the purchasing of toxic assets. You may recall that this is the exact proposed plan that got the panic rolling. Here we are, eight months later, and there is a likely chance that the TARP will never be implemented. So far, not even one toxic asset has been sterilized.

As I wrote in my post during that time, banks are unwilling to sell assets at the prices people would be willing to pay for them. The banks believed from the beginning that the prices were too low and that there was a high likelihood that price levels would recover. There are few investments for banks to make these days with higher rates of return, so banks want these toxic assets to improve their profitability. In fact, as convoluted as it sounds, the banks proposed to the U.S. Treasury that they would be willing to buy their own toxic assets. Of course, this was a sleight of hand by the major banks to indicate their own confidence level in their assets.

It was believed last summer that the reason the price of oil went to $150 a barrel was because of the extraordinary strength of the world economy. Obviously that was not the case, and as it became clear that many economies were faltering, the price of oil dropped down into the mid $30 per barrel range. Have you noticed that the price of oil has exploded in the last few weeks? Today a barrel of oil is $66. It’s unlikely to assume that the price of oil would double if the worldwide economies were falling further into recession. There are signs in all the commodities that positive economic activity is occurring since they are virtually all accelerating higher.

Investors are beginning to believe that the stock market increases are for real. During April, investors invested $12.3 billion in new money in stock funds. This was only the second month of positive cash inflows over the last year. Even more astounding is that investors withdrew $27 billion from stock funds during the previous month of March to turn around and invest $12.3 billion of new money during April.

Today there is roughly $3.5 trillion invested in stock mutual funds. It is currently estimated that the total commercial cash in deposit accounts exceeds the full value of the stock mutual funds. Only a small portion of this cash, which is earning virtually zero percent, would make the stock market go dramatically higher. As investors become disenfranchised with earning less than ½ of 1% in money market accounts and less than 1% on their CD’s, they will seek the higher rates of return that financial markets offer. When that happens, the stock market will go up even higher.

All of America has lost a great deal of money over the past year from financial assets and real estate. All of our retirement and liquid assets have been depleted. I vividly remember begging my clients to invest in their IRA’s at the lows of the stock market in February and March of 2009. Very few did so. With the market up some 35% in the intervening few months, I’m willing to bet that those who didn’t wish they had.

I consistently see misplaced blaming regarding the reasons for the financial meltdown. Politicians are notorious for incorrectly placing blame. It’s true that there were bankers who did things wrong, and it’s also true that Wall Streeters took advantage of the situation for their own economic benefit. But the true source of this financial meltdown can only be attributed to our government itself. The following quote from Thomas Sowell, a well-known U.S. economist, succinctly characterizes the current financial situation: “Riskier mortgage lending practices, imposed by government, were what set the stage for many mortgage payments to stop, and thus, for the financial disasters that followed.”

In the end, blame should be placed where it properly rests. The Federal government’s intervention with private industry is where the mistake began and ended. They forced banks to lower their lending standards to boost homeownership, and that was the principal mistake. Then they encouraged Fannie Mae and Freddie Mac to finance the whole mess by buying up the bad loans. These governmental agencies were essentially threatened with extinction if they did not comply with the government’s ill-advised mandates.

The end result is that the government forced private industry to do what it did not want to do and the financial results are self-evident today. Now, by the government’s own estimate, we are going to have to borrow $9 trillion in new debt to recreate the American economy in the eyes of the current government. With the government’s own extraordinary track record of ineptitude, you should not be anything but discouraged for the future.

As the last eight months have shown, private industry and the U.S. economy are more than able to recover on their own. My hope is that as the economy continues improving over the next 12 months, we will abandon all of these ridiculous unneeded governmental spending programs and get back to a U.S. economy controlled by business people and not politicians who have no experience in working in the private sector.

Everything mentioned above is just my thoughts and opinions. As always, I could be wrong.

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