Some Even Worse News

In a post on Thursday, we mentioned the steep decline in state and local government saving. The next day, revised GDP data from the Bureau of Economic Analysis (BEA) showed that state and local government finances (along with most other variables) were in worse shape than initially believed.

Here’s a graph as of Thursday’s post, before the latest revisions:

And the revised graph following Friday’s report:

Where it was previously believed that significant savings had occurred from 2009 through 2010, it now looks as though no net savings ever materialized at the state and local level. And while state and local finances were sharply deteriorating according to previous estimates, they are almost $50 billion worse than believed following yesterday’s revisions. 

To repeat from Thursday’s post and a client note earlier in the week (bold added):

The [debt ceiling and deficit reduction] issue is a…straw man that distracts policymakers [and the electorate] from actual issues like unemployment. It’s important to understand that every dollar the government receives in taxes or in debt auctions was previously spent by the U.S. Treasury (or in unusual cases, created by the Federal Reserve to buy something other than outstanding Treasury debt). So the President and House Speaker’s recent comments that the U.S. could ‘run out of money to pay its bills’ is utter nonsense. The primary purpose of Treasury debt is to provide holders of U.S. dollars (including China!) with an equivalent asset that pays interest. That’s it. And the rest of us cannot save unless the entity that creates the money that we save is running deficits. 

As we noted on Thursday, there’s not a large historic sample to work with, but it looks like the trajectory of state and local government savings has been a reliable indicator of recessions in the past. And with yesterday’s revisions, this variable becomes an even stronger vote in favor of a looming recession.  Inventories showed a slight bump recently, but are now negative year-over-year. Business investment looks OK, but growth in software and equipment has definitely peaked and is declining sharply. Corporate profits are positive, but the rate of growth has peaked and is falling sharply, and there are signs that they will start to decline in the next six months or so. Certain demographic trends will also turn negative in 2012. Taking all of our indicators as a whole, we have an even higher level of confidence in our call for a recession taking hold by 2012, though the final shape of a debt-ceiling resolution (i.e., if the so-called “savings” are almost entirely backloaded) could temper our view.

Of course, equity markets are not currently discounting a recession, and it’s unclear when they might begin to. However, each time I see a long-term chart of the S&P 500, I wonder why more technical analysts aren’t calling for them to, given the 20-year fabled head-and-shoulders pattern that the S&P 500 is forming in rather dramatic fashion:

Assuming there is a resolution to the debt-ceiling impasse, stocks could gain some of their recently lost ground. But given the overall investing environment, they’re anything but a bargain at the moment.

In our Special Opps portfolios*, beyond our continuous search for promising but unloved orphan securities, we have been raising cash levels, tilting toward lower-volatility, higher-yielding stocks, and placing some negative bets in the form of long put options and bearish ETFs** (though one of the latter positions was closed out near the end of trading yesterday). In our strategic portfolios***, allocations remain relatively conservative.

We continue to believe that long-term Treasuries (20-years or more to maturity) still offer the best balance between risk and return. In equities, we favor lower-volatility stocks with stable underlying cash flows and attractive dividends, as well as Japan, which, as maddening as its political environment can be, is less likely to hurt an investor today than almost any other equity market on earth. It’s neither glamorous nor go-go, but that’s not what prudent investors should be after (unless you can buy it on the cheap, of course!).

Admittedly, these are highly contrarian calls, but in a macro environment as negative as the prevailing one, that only tends to reinforce our views. Economic policies are being set by the herd around the world, and there’s simply no way that markets will be left untouched.  

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania-registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, nor is it a recommendation to engage in any investment strategy. This material does not take into account your personal investment objectives, financial situation and needs, or personal tolerance for risk. Thus, any investment strategies or securities discussed herein may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment activity, and it is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any investment strategy or security. SCM does not guarantee any specific outcome from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. *The Special Opps strategy is primarily focused on capital appreciation through the identification and exploitation of opportunities across a broad universe of equity, debt, and derivative securities, including OTC and foreign securities, and publicly traded partnerships that, in the view of the manager, are compellingly valued. There is a substantial risk of loss, including permanent loss of principal. **Options and inverse or leveraged ETFs involve significant risk, including total loss of principal. *** Our strategic or Comprehensive Portfolio is a carefully designed, long term allocation, invested primarily in fixed income securities and exchange traded funds (“ETFs”) that replicate various equity, fixed income, commodity, and financial market indices, in proportions that SCM believes will provide efficient diversification. The underlying allocations are tailored to each Client’s objectives and tolerance for risk, and may include allocations to cash or cash equivalents. As with any type of investing, there is a significant risk of loss, including permanent loss of principal.

More Bad News

Though we might see a relief rally should a debt ceiling resolution take shape, the bad news continues to pile up for market and economic bulls. Here are some of the latest (confirmation bias openly admitted to!):

Advance GDP estimates for 2011Q2 were pretty lousy, with some nasty downward revisions to prior quarters.

And from Mark Hulbert, we learn that insider selling has accelerated to its highest level since 1974:

…consider last week’s sell-to-buy ratio for just those issues listed on the NYSE or AMEX. That came in at 13.10 to 1, which is the highest reading for this ratio since when Vickers began collecting the data, which was October 1974.

…the other occasions in recent years in which the sell-to-buy ratio rose to close to the same level it is today were on the heels of more or less uninterrupted rallies over the previous two or three months. That’s not the case now, of course, suggesting that insider selling this time around may not be so benign.

…the extensive Vickers database encompasses many other earnings seasons besides the current one. Also, the latest insider sell-to-buy ratio is higher than almost all comparable readings from those prior seasons.

And lest we let a dysfunctional U.S. Congress take our eye of another looming systemic risk, Moody’s has announced that Spain’s government debt rating is under threat of a downgrade. Yields on both Spain’s and Italy’s debt  have spike back to pre-European Union (EU)/Greece agreement levels and are threatening to climb higher (falling prices cause yield to rise). Being funded by users of the euro (EU member states) rather than by the actual issuer of euros (the ECB), the developing fiscal facilities in the EU lack a vertical money component, and are thus very limited in their ability to absorb a cascade of sovereign debt crises. If markets retreat from Spain and/or Italy’s debt, then the EU’s rescue facilities could be tapped out in short order. This cycle of panic and relief will continue until something drastic enough to shake the ECB out of its late-1920s ideological straitjacket occurs.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania-registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, nor is it a recommendation to engage in any investment strategy. This material does not take into account your personal investment objectives, financial situation and needs, or personal tolerance for risk. Thus, any investment strategies or securities discussed herein may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment activity, and it is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any investment strategy or security. SCM does not guarantee any specific outcome from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such.

Less Than 50% Chance of Debt Ceiling Resolution?

In an interview with Reuters on July 18, Stan Collender offered a couple of observations that we made in a client note this morning.

First, he predicted that the Tea Party Repupublicans in the House (and Tea Partiers themselves) are a stronger force than leadership in both parties anticipated. That’s something that we observed today after last night’s debacle in the House. Kudos to Stan for predicting it 11 days ago.

Second, he correctly pointed out that the inability to pay simply doesn’t exist for the U.S. government. It can only default based on an unwillingness to pay. That’s a meme worth repeating every time someone claims that the U.S. is ‘running out of money to pay its bills,’ or that ‘the government’s budget is just like a household’s or business‘. Unless we’re still on a gold standard, nothing could be further from the truth.

Unfortunately, he put the likelihood of a resolution at less than 50% and argued that it could take a major market reaction to force Congress’ hand, much like what happened with TARP [It's important to note that the resulting haste of TARP's passage certainly didn't help with the agency risks and costs it ultimately entailed].

We expressed similar views in a client note this morning:

Keep in mind that at the height of the financial crisis and recession of 2007-2009, it took a 1,000-point drop in the Dow in order to motivate Congress to approve TARP after it initially rejected it. If things get hairy enough, that episode might repeat itself in some form. 

The key points for investors:

Markets are getting more skittish, but still seem to expect an agreement. But like the two major parties, they may have miscalculated on the strength of the new blood in the House (who sincerely believe they’re doing the right thing). We should know in the next few days.

The August 2 deadline is probably not when the Treasury would “run out of money”, but there could be a payments crisis some time during the month. Time will tell on that one too.

Treasury and the Federal Reserve (and, one would assume, the White House, but there hasn’t been much noise from that corner since the president’s speech [earlier this] week) are busy crafting plans to deal with a situation where there’s no agreement. There are ways around a debt ceiling impasse, but whether the Executive branch will have the spine to pursue any of them remains to be seen (and the only way to prove that austerity won’t help the economy is to let it happen, unfortunately; if the president were to do something bold and constructive, his opponents could point to ongoing stagnation as evidence that it didn’t work).

With or without an agreement, the effects are largely the same. Without an agreement, there will be a sudden shock to the supply of U.S. dollars (i.e., there will suddenly be far fewer of them than the world demands; same goes for Treasury debt, as long as investors expect to be made whole at some point). With an agreement, the effects will be the same, but drawn out over a longer time period. Either way, the outlook is bearish for riskier asset classes and the U.S. and global economies.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania-registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, nor is it a recommendation to engage in any investment strategy. This material does not take into account your personal investment objectives, financial situation and needs, or personal tolerance for risk. Thus, any investment strategies or securities discussed herein may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment activity, and it is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any investment strategy or security. SCM does not guarantee any specific outcome from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. 

Want to Destroy the U.S. Economy? Balance the Budget.

Great post from John Harvey at Forbes:

I can think of nothing more fundamentally foolish, more unequivocally self-destructive to our economic well being today than attempting to balance the US federal budget. It is totally unnecessary and every dollar we cut from government spending is a dollar taken from someone’s income. That we should be so enthusiastically pursuing such a policy when there are almost 14 million unemployed workers is mind boggling. How is further lowering the effective demand for goods and services supposed to help? It cannot, of course, and will only serve to make things worse–much, much worse.

Political Herding, One More Time

One more time, as few people are making this observation—from our earlier post today on unemployment claims (bold added):

Despite appearances, almost every single member of Congress (and policymaker in Europe!) believes in the same highly questionable macroeconomic principles, specifically the loanable funds market and the intertemporal government budget constraint [pdf] in a fiat monetary system. [7/28/2011 - Add in the money multiplier as well.] This means that despite the rancor and election-related jockeying, we are actually witnessing an episode of massive ‘mimetic isomorphism’ or herd behavior. And in complex adaptive systems like financial markets and economies, such behavior dramatically increases [pdf] the risk of severe dislocations.

To paraphrase from an October 2009 post:

Unanimous agreement over the existence of a severe fiscal crisis in the U.S. is indeed unusual. But economists and politicians question the existence of a crisis at their peril.

As a result, political leadership in the U.S. (and around the world!) is starting to look something like this:

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania-registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, nor is it a recommendation to engage in any investment strategy. This material does not take into account your personal investment objectives, financial situation and needs, or personal tolerance for risk. Thus, any investment strategies or securities discussed herein may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment activity, and it is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any investment strategy or security. SCM does not guarantee any specific outcome from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. 

Initial Claims: Nice Print, But Uncertain Outlook

Initial unemployment claims in the U.S. unexpectedly fell below the 400,000 mark last week. While that’s welcome news, the current uptrend is still intact, and we won’t know if it’s been broken until September-October (do we break below the spring 2011 lows?). We’ll also need to watch the January-February numbers closely (does the trend of falling highs from the January 2009 peak continue?).

While the consensus answer to both of those questions seems to be “yes”, we remain skeptical. The U.S. yield curve remains steep, normally a positive sign, but one that we believe has little relevance going forward, based on Japan’s experience (admittedly an almost irrelevant sample of n = 3, but it makes plenty of sense in our macro framework). Most other indicators—notably in financial markets, fiscal/sectoral balances, and employment—are flashing bright yellow at the moment.

Yields, spreads, and prices of default protection on sovereign debt in Europe and China are blowing out.

Europe’s current policy approaches can’t possibly work without causing a recession or worse, and the eurozone economy appears to be on the threshold of recession. While this will be a rude but well-deserved awakening for the ‘core’ of France and Germany, it has the potential to cause Lehman Brothers- and AIG-like shockwaves across global financial markets. And if Europe’s various policymaking bodies dither at all (a high probability event), it could very well tip the global economy back into recession.

Although not widely discussed, it appears that the financial systems of China and some other important emerging economies are in a fragile and vulnerable state. Any shocks in these markets would also have a negative impact on world financial markets, and contraction in any key emerging market economies would also be quite detrimental to the rest of the world.

In the U.S., despite some heroic efforts, state and local governments fiscal positions are deteriorating sharply, which has historically been a harbinger of recession:

Temporary hiring may be starting to roll over, a phenomenon that preceded the last two recessions (another admittedly small sample) by less than a year:

Second quarter earnings season has included several mass layoff announcements from major U.S. companies. Although few are likely to shed any tears over it (even though a recent article from The Atlantic argues that it’s cause for concern), the financial industry is being particularly hard-hit. The July Mass Layoffs Report from the BLS, due in late August, will be an interesting read.

And of course, the debt ceiling debate rages on in the U.S. Congress. A book could be written about the severe errors being made on all sides*, but for now, an excerpt from a recent email to our clients should suffice:

(1)     The issue is a red herring or straw man that distracts policymakers from actual issues like unemployment. It’s important to understand that every dollar the government receives in taxes or in debt auctions was previously spent by the U.S. Treasury (or in unusual cases, created by the Federal Reserve to buy something other than outstanding Treasury debt). So the President and House Speaker’s recent comments that the U.S. could ‘run out of money to pay its bills’ is utter nonsense. The primary purpose of Treasury debt is to provide holders of U.S. dollars (including China!) with an equivalent asset that pays interest. That’s it. And the rest of us cannot save unless the entity that creates the money that we save is running deficits. Until inflation starts to take hold (as opposed to relative price movements, such as higher commodity and lower home prices), there are far more important things to worry about, such as unemployment and household balance sheets, than federal budget deficits and ‘debt’ (dollars are a debt of the federal government too; to be consistent, the deficit-phobes should say that our grandchildren will have to pay them all back too; they don’t, which leads to the conclusion that they are utterly inconsistent). Reading between the lines (market action, comments from certain pundits and politicians), it sounds like a deal is close, and that both sides are jockeying for the most favorable position going into the 2012 elections (the GOP wants a shorter-term agreement in order to create a distraction for the president and his party during campaign season, while the Dems want to extend further in order to prevent that). It’s pretty astounding that our political leaders would risk so much for election strategy, but that’s our system at work.  

(2)     Treasury Secretary Geithner has issued other deadlines for default before the current August 2^nd one, and they’ve all been wrong. Besides his credibility starting to wear thin, this means that there may be more time to strike a deal without adverse consequences (an analysis released yesterday by a Wall Street firm makes this argument, though I’ve only seen the headline at this point). A recent Reuters article also made the point that a ‘default’ would require some serious IT programming by Treasury, as most of its payments are automated (it is the largest single daily transactor in the global marketplace). This sort of proves the point above about Treasury spending first and “borrowing” later (though few people have picked up on it), and implies that at least some payments would continue for a time if an agreement on the debt ceiling isn’t reached.

(3)     As lousy as the consequences at home would be, the most significant impact of a U.S. default or the agreements currently under discussion will occur abroad, notably in the emerging-market darlings of the past ten years, especially those who (a) rely on purchases from the U.S. and (b) carry external sovereign debt in U.S. dollars. In other words, any entity that owes U.S. dollars but doesn’t have the power to create them will be at risk (obviously, this will put a lot of U.S. households at risk too)…

…[These (Europe, the U.S., and China and other key emerging markets)] are the big secular themes at work, and as noted at the outset, there are no secular positives at the moment. That’s an unusual and very dangerous development for investors.

This is the most dangerous and unbalanced macro environment that I have witnessed in my investing career. As Warren Mosler recently put it, “I’ve never seen this kind of systemic risk looming in my 40 years in the financial markets.”

Keep your seatbelts fastened and eyes on the road ahead.

* Despite appearances, almost every single member of Congress (and policymaker in Europe!) believes in the same highly questionable macroeconomic principles, specifically the loanable funds market and the intertemporal government budget constraint [pdf] in a fiat monetary system. This means that despite the rancor and election-related jockeying, we are actually witnessing an episode of massive ‘mimetic isomorphism’ or herd behavior. And in complex adaptive systems like financial markets and economies, such behavior dramatically increases [pdf] the risk of severe dislocations.

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (SCM) is a Pennsylvania-registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, nor is it a recommendation to engage in any investment strategy. This material does not take into account your personal investment objectives, financial situation and needs, or personal tolerance for risk. Thus, any investment strategies or securities discussed herein may not be suitable for you. You should be aware of the real risk of loss that accompanies any investment activity, and it is strongly recommended that you consider seeking advice from your own investment advisor(s) when considering any investment strategy or security. SCM does not guarantee any specific outcome from any strategy or security discussed herein. The opinions expressed are based on information believed to be reliable, but SCM does not warrant its completeness or accuracy, and you should not rely on it as such. 

And The Award For Most Misleading Headline Goes To…

…CNBC! In a display of incredibly shoddy journalism back in April—leaving aside the question of whether it was intentional or not—the network ran a story by James Politi of The Financial Times, but decided to slap its own title on the piece.

The original FT headline and article:

Nervous Wall Street warns on debt limit

A group of the largest US banks and fund managers stepped up the pressure on Congress and the Obama administration to reach a deal to increase the country’s debt limit, saying that even a short default could be devastating for the financial markets and economy…

The following day, CNBC ran the FT article, but with its own headline:

US Banks Warn Obama on Soaring Debt

Really, CNBC? Really??

Greenspan: I Am Ill-Aware

We couldn’t have said it better ourselves, Mr. Chairman.

Emphasis added, in part to illuminate how accurate the self-assessment of his awareness is:

In a blunt critique of his successor, Fed Chairman Ben Bernanke, [Alan] Greenspan said the $2 trillion in quantative easing over the past two years had done little to loosen credit and boost the economy.

“There is no evidence that huge inflow of money into the system basically worked,” Greenspan said in a live interview.

“It obviously had some effect on the exchange rate and the exchange rate was a critical issue in export expansion,” he said. “Aside from that, I am ill-aware of anything that really worked. Not only QE2 but QE1.”

QE stand for ‘quantitative easing,’ which involves the purchase of financial assets by a central bank using newly created money.

First, Greenspan’s right that QE2 did little good, as the Fed was merely swapping one type of government liability (Federal Reserve notes) for another (U.S. Treasuries). This seems to have merely amplified (temporarily) the prevailing but inaccurate economic models  employed by many market participants. This was reflected in the speculative portfolio shifts of the last six months (which interrupted temporarily by unrest in the Middle East and North Africa, the disasters in Japan, and renewed financial turmoil in Europe).

A program like QE2 shouldn’t be expected to have much of an economic impact. It’s even possible that the central bank activism it displayed caused some uncertainty at the margin, which would have had a negative impact on the economy.

But QE1 and QE2 were vastly different programs, with very different effects. Anyone who’s not “ill-aware” would know (and publicly admit) this. QE1 involved Fed purchases of privately created financial assets, which almost certainly had a stabilizing effect on markets and the economy.