Lying With Statistics...

English statesman Benjamin Disraeli quoted the following (which was later popularized by Mark Twain): “There are three kinds of lies: Lies, damned lies and statistics.”

A professor of mine a few semesters ago appropriately expanded the list to six categories: “Lies, white lies, damned lies, statistics, government statistics, and campaign promises.”

It is the 5th dimension of lies that I’d like to focus on – government statistics. More specifically the statistics provided by the Bureau of Labor Statistics (BLS).

First, for some understanding – the BLS is a unit of the US Department of Labor and is the principal fact-finding agency for the U.S. government in the broad field of labor economics and statistics. They produce surveys, indices and statistics in 4 main categories: prices, employment/unemployment, Compensation and Working Conditions, and Productivity. If you want to read a little more, see this for an overview.

Today we’ll tackle employment statistics. Why? Because it’s a big indicator used to gauge the health of our economy, used in determining policy decisions (both monetary and fiscal), you'll see Wall Street react favorably or unfavorably to it upon the day numbers are released, and it's shouted from the rooftops by all major media when it’s released, thus influencing the minds of the public.

Mainstream media reports the U-3 unemployment rate, which uses a monthly household survey. This is the “unofficial” but official unemployment rate – used by the government and the Federal Reserve. Now, we can take the rate we’re fed by the media, politicians, and the Fed at face value, or like good citizens can dig a little deeper to see what bull we’re being fed.

The official November 2010 number we were given was 9.8% unemployment.

Now let’s dig into the data. I’ll try and make this as simple as possible and guide you through it, but like all good government statistics, it’s confusing for a reason (ha!). I’ll also try and post snapshots of the data if you don’t want to scroll through the linked site.

Go to this site if you'd like the full document (or just look at the charts below for the referenced excerpts). If the link doesn’t open, cut and paste the following into your browser: http://www.bls.gov/news.release/pdf/empsit.pdf

On page 1, you’ll see a summary and some charts. Under the charts you’ll see 15.1 million are unemployed which is 9.8%. Wow - the media can read! They got it right! Feel encouraged that your major media has a brain stem!

Click on the chart and it should open larger in a new window.


Now you can read through all the charts and tables and put yourself to sleep, or can now skip down to page 27 of the document – “Household Data – Table A-15. Alternative measures of labor underutilization”. Like I said, I’ll try and make it easy for you…

“Alternative measures of labor underutilization” – that sounds interesting…what could that be?


Look down the left hand side under “measure”. See U-1, U-2, U-3, etc.? And what did we say, the media, government, and Fed use? U-3 numbers. Now scan across to November 2010 under “seasonally adjusted”. See 9.8??? Great! We’d just matched it up again. 9.8% unemployment.

But wait. What are all these other “U” measurements about? Look at U-5 and U-6. U-5 reports 11.3% and U-6 reports 17.0%. What’s up? Those are much higher than 9.8%.

Read the descriptions:

• U-5 – Total unemployed (U-3 number), plus discouraged workers, plus all other persons marginally attached to the labor force, as a percent of the civilian labor force plus all persons marginally attached to the labor force.


• U-6 – Total unemployed, plus all persons marginally attached to the labor force, plus total unemployed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force.

Now you might be asking the following…”Umm, what is a ‘discouraged worker’, ‘persons marginally attached’, and ‘unemployed part time for economic reasons’”? Good question.

Read the “Note” below the chart.

• Persons marginally attached to the labor force are those who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the past 12 months.
• Discouraged workers, a subset of the marginally attached, have given a job-market related reason for not currently looking for work.
• Persons employed part time for economic reasons are those who want and are available for full-time work but have had to settle for a part-time schedule.

I know, your brain is percolating with questions now. Hold on just another second. One more data table. Go to the next page down – “Table 1-16 – Persons not in the labor force…”


Our mysterious categories actually fall into a larger category of “Not In the Labor Force” or “NILFs”.

Footnote 2 gives a little more data on our beloved “discouraged worker”:

• Includes those who did not actively look for work in the prior 4 weeks for reasons such as thinks no work available, could not find work, lacks schooling or training, employer thinks too young or old, and other types of discrimination.

Okay, so ask your question now – the one that’s been bubbling in your mind…

“Why aren’t the U-5 or U-6 numbers reported instead of the U-3 number? Shouldn’t persons ‘marginally attached’, ‘discouraged workers’ and ‘persons employed part-time for economic reasons’ (also referred to as ‘underemployed’) be included in the official numbers? If they actually are NILFs, why aren’t they included? All categories sound like they are ‘unemployed’!”

Bingo! And there you have it! Our 5th dimension of lying: Government statistics!

Your guess is as good as mine why the numbers are reported this way. One of those, “how many licks does it take to get to the center of a Tootsie Pop?” kind of questions…”the world will never know.” But I’d bet political motivation is high at the top of the list, however. You think those in power want 17% unemployment hanging over their heads during elections? Or perhaps the general population would just flat out revolt…

Think 11.3% or 17% unemployment sounds crazy? Check out the projections from the Center For Working-Class Studies at Youngstown State University here. They have unemployment pegged at 26.9% for August of this year (civilian population), compared to the 9.6% official unemployment figure for August. Think unemployment of 1/4 of the working population would be palatable for many?

Could the government BLS be fudging the numbers? Could the media be less intelligent than we think in their reporting methods and investigation? Could we as a collective society be gullible and less intelligent than we think in believing what we’re told? Should we even be asking these questions?

Move along. Move along. Nothing to see here. 9.8% unemployment. “Pay no attention to the wizard behind the curtain.” “These aren’t the droids you’re looking for.” Change the channel. Who’s on Dancing With The Stars tonight? That is all.

What numbers are you going to believe?

An Education from Critters...

I came across a great video (link below). While sarcastically funny, these cute little cuddly animated creatures give us an awesome education in Quantitative Easing and the Federal Reserve and drive the point home of the ridiculousness of the Fed system. If you have 7 minutes, this is a great watch!

Here’s a little description of some of the concepts and ideas talked about for background if you need it:

Quantitative easing – A.K.A. “printing money”, “goosing the economy”, “laundering money” - Here's how it works: The Fed buys Treasury bonds from banks, providing them cash to lend to customers (where does the cash come from? Why, newly printed money, of course!). Buying so many bonds also lowers interest rates because demand for Treasurys leads to higher prices and lower yields. Interest rates are linked to yields. Lower rates encourage people to borrow money for a mortgage or another loan. At the same time, lower interest rates make relatively safe investments like bonds and cash less appealing, so companies and investors take the cash and buy equipment or other investments, like stocks. The S&P 500 takes off and Americans celebrate with a shopping spree. Businesses see a rise in sales and begin hiring again, and a virtuous cycle of more spending and more hiring ensues…so the theory goes. Read my last post here if you want more.

CPI – Consumer Price Index – a measure of inflation / deflation – an index comprised of a basket of consumer goods and services that takes into account the price of those goods and services. As the price of those goods rise and fall collectively, the measure of the CPI rises and falls. As our cute animated friends allude to, the CPI doesn’t always match up with reality. After all, the CPI is a government statistic produced by the Bureau of Labor Statistics (BLS)…think there’s any chance that the government could alter the statistic to say what they want it to say?

Deflation – A decline in general price levels.

Inflation – An increase in general price levels. In an inflation environment everything gets more valuable except the value of money.

“The Ben Bernake” – Chairman of the Federal Reserve. In the video they pronounce it Ben “Burr-nack”. Unless you want to be made fun of intellectual circles, it’s actually pronounced – Ben “Burr-nack-EE”.

And now, to the video! Click on the link below...enjoy!

http://www.youtube.com/watch?v=PTUY16CkS-k

The Coming Great American Fall (Part 2)...

Like last post, I want to share another article I came across with you. This is a solid article outlining what the Fed (Federal Reserve Bank) is about to do (has done at the time of this post) in regards to “Quantitative Easing” (QE2) and the pitfalls that await us from the actions of a very desperate Federal Reserve Bank. Very educational, in my opinion, so I thought it would be good to share.

To cover our bases, understand that two policy arms exist within our economic system: fiscal policy and monetary policy.

To be brief, fiscal policy is under the control of the federal government and is related to how the government taxes and spends. Monetary policy is under the control of the Fed, and relates to the control of the money supply and changes in interest rates. Fiscal and monetary policy is a balancing act. Given that our federal government has been so excellent at maintaining a disciplined approach to fiscal policy (NOT!) the Fed has taken a much more active role over the past few years in influencing the markets to try and restore the economy.

Also keep in mind that the Federal Reserve System exists as an independent system. While certain heads are appointed, the Fed is free from the wishes of the government – their decisions do not have to be ratified by federal executive or legislative branches. Kind of spooky to think that such an independent unchecked quasi governmental arm has such incredible power to influence the markets. But I digress…

As you read the below, ask yourself this question: “Is the Fed in touch with reality?”

FYI - Any emphasis in the below article is mine. I also included notes about what actually went down today regarding the announced amounts for QE2...

The Fed's big gamble: Here's what could go wrong
The Federal Reserve readies plan to lift all boats. Who knows how it will play out?
Matthew Craft, AP Business Writer
November 3, 2010

The Federal Reserve is about to take a huge risk in hopes of getting the economy steaming along again. Nobody is sure it will work, and it may actually do damage.

The Fed is expected to announced today that it will buy $500 billion to $1 trillion
in government debt (the actual number came in at $600 billion today), and drive already low long-term interest rates even lower. The central bank would buy the debt in chunks of $100 billion a month (will be $75 billion), probably starting
immediately.

Economists call it "quantitative easing." It gets the name "QE2" -- like the ship -- because this would be the second round. The Fed spent about $1.7 trillion from 2008 to earlier this year to take bonds off the hands of banks and stabilize them.

Here's how it's supposed to work this time: The Fed buys Treasury bonds from banks, providing them cash to lend to customers. Buying so many bonds also lowers interest rates because demand for Treasurys leads to higher prices and lower yields. Interest rates are linked to yields. Lower rates encourage people to borrow money for a mortgage or another loan.

At the same time, lower interest rates make relatively safe investments like bonds and cash less appealing, so companies and investors take the cash and buy equipment or other investments, like stocks. The S&P 500 takes off and Americans celebrate with a shopping spree. Businesses see a rise in sales and begin hiring again, and a virtuous cycle of more spending and more hiring ensues. (or so the story goes)

But many analysts and even supporters of the plan see dangers. It could make the weak dollar even weaker and lead to trade disputes with other countries. It could lead bond traders to believe that higher inflation is on the way, and they could derail the Fed's efforts by pushing rates higher. Many investors argue that it may create bubbles as hedge funds and other speculators borrow cheaply and make even bigger bets on stocks, commodities and markets in developing countries like Brazil.

"It's a desperate act," says Jeremy Grantham, co-founder of the investment firm GMO. Grantham says it's a clear message from the Fed to the rest of the world: "The U.S. doesn't care if the dollar weakens."

Here is a look at the ways the Fed's strategy could backfire:

DOLLAR DROP

As word trickled out over recent months that the Fed was planning a new round of bond purchases, the dollar sank. It hit a 15-year low to the Japanese yen Nov. 1. Why? In the simplest terms, a country that cuts interest rates makes its currency less attractive to the worlds' investors. The interest rate is also the investors' yield, the payout they receive. When that yield falls, the world's banks move their money into countries with higher rates. They may exchange U.S. dollars for Australian dollars then invest the money in higher-paying Australian bonds.

"The Fed aims to push up the prices of stocks, bonds, real estate, and you name it," says Bill O'Donnell, head of U.S. government bond strategy at the Royal Bank of
Scotland. "Everything is going to go up but the dollar."

A drop in the dollar can help companies like Ford that sell their products abroad. When the dollar weakens against the euro, for example, one euro buys more dollars than before. Foreign customers notice the price of the Explorer they've been eyeing
is lower in their currency, yet Ford still pockets the same number of dollars for every sale.

The downside is that a weakened dollar pinches people in the U.S. because anything produced in other countries becomes more expensive, like oranges from Spain or toys from China.

"Look around you," says Thomas Atteberry, a fund manager at First Pacific Advisors. "How many things can you find that were made in the U.S.A?"

BLOWING BUBBLES

Buying bundles of Treasurys knocks down interest rates, making borrowing cheap. But it also motivates investors to move out of safe investments into riskier ones in search of better returns. The stock market, for instance, rises in value and everyone with some of their savings in stocks feels wealthier. Ideally, it produces what economists call a "wealth effect": People who feel better off spend more.

The problem, according to some critics, is that cheap borrowing costs and buoyant markets make a fertile environment for bubbles, which eventually pop. "The effort to help the economy sets up another more dangerous bubble," says Grantham, who warned of Japan's surging real estate and stock markets in the 1980s, soaring Internet stocks in the 1990s and the housing market in the 2000s.

Stocks in developing countries are a likely candidate for the next bubble. Cash from Europe and the U.S. has plowed into emerging markets, such as Brazil and Chile, since the financial crisis, largely because these countries have less debt and faster economic growth than in the developed world.

Another concern: Hedge funds borrowing cheap money can magnify their bets, taking a loan at 2 percent to buy a security that's rising 10 percent. They sell the security, pay off the bank and pocket the rest. That's true whenever interest rates remain low. Falling rates allow speculators to borrow larger amounts. In the extreme, losses from hedge funds and other borrowers can put their banks at risk and leave governments to clean up the mess.

The game only works as long as the investment keeps climbing. When the bubble breaks, the fallout can devastate an economy.

"I think bubbles are the main villain in this piece," Grantham says.

Cheap debt provided the fuel for the housing bubble, allowing home buyers to take out larger loans on the belief that somebody else would buy the house at a higher price. Fed chief Ben Bernanke's answer, Grantham said, is to start the cycle over again by blowing a new bubble. "All they can do is replace one bubble with another one," he said.

FALLING FLAT

For others in the bond market, the greatest worry isn't that the Fed will flood the economy with dollars and lets inflation run wild. It's that the Fed will prove too timid.

"Whether QE2 works or not will be decided by the bond market," says Christopher Rupkey, chief economist at Bank of Tokyo. "Without a big number that gets the market's attention, the program they announce could be dead on arrival."

News reports that the Fed may spend less than the $500 billion bond traders have been betting on has helped push long-term rates higher in the last three weeks. David Ader, head of government bond strategy at CRT Capital, sketches one scenario if the Fed shoots too small. Say the Fed announces a $250 billion plan. The yield on the 10-year Treasury note, which is used to set lending rates for mortgages and corporate loans, could jump from 2.6 percent to maybe 3.2 percent.

"If the Fed's efforts fail we suddenly look like Japan," Ader says. "Japan started off wimpishly, then did it again, and again and then they wound up losing a decade."

So why is the Fed doing QE2? Answer: to get people, businesses, and institutions to borrow money and spend in order to pump up our economy.

Does this not sound completely asinine to you as it does me?!?!?! If people would just borrow more money to spend and pump up our economy, things will get better…fa-la-la, tra-la-la??? You’ve got to be kidding me!

The problem is debt! Not the affordability to be able to access it!

I think the Fed has completely lost touch with reality here and is putting us in a place of more risk.

QE2 is an academic exercise…one of the few remaining tools in the tool bag for the Fed. They are getting desperate. It may seem like sound economic reasoning to institute QE2, but desperation often clouds judgment. This is not a move grounded in reality.

The news media has been much more focused on the elections...however, the real news may have just happened under our noses in QE2. If the Fed's bet here doesn't pay off, we may be in for a longer economic recovery and suffer worse consequences than had they just left things alone.

Don't say you weren't warned...

The Coming Great American Fall (Part 1)...

No, I’m not referring to the changing of the season from summer to autumn…

I’m referring to the collapse of the greatest civilization the world has ever known.

To preface, let me say that I tend to be a contrarian and see things from the “glass is half empty” side of things. So take that with a grain of salt anytime I post about the demise of America. However, what I’m trying to do with this blog is give you a blend of “wake-up calls” and useful financial information – as not everything you get in the mainstream media is accurate . . . imagine that.

I read the following article the other day online and it appealed to my inner contrarian, so I thought I’d share with you. You may disagree or find the notion of America in decline as absurd, but I think it’s worth a read and reflection. This is one of those “wake-up calls.” I think we can learn a lot from history, but as you’ll read below, apparently we in America aren’t very good students of history. Any emphasis in the below article is mine – FYI.

For your consideration...

The Rise and Fall of America
by Robert Kiyosaki
Monday, October 18, 2010

Alexander Tytler (1747-1813) was a Scottish-born English lawyer and historian. Reportedly, Tytler was critical of democracies, pointing to the history of democracies such as Athens and its flaws, cycles, and ultimate failures. Although the authenticity of his following quote is often disputed, the words have eerie relevance today:

A democracy is always temporary in nature; it simply cannot exist as a permanent form of government.

A democracy will continue to exist up until the time voters discover they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by dictatorship.

The average age of the world's greatest civilizations from the beginning of history has been about 200 years. During those 200 years, these nations always progressed through the following sequence:

• From bondage to spiritual faith;
• From spiritual faith to great courage;
• From courage to liberty;
• From liberty to abundance;
• From abundance to complacency;
• From complacency to apathy;
• From apathy to dependence;
• From dependence back to bondage.

Tytler's Cycle and the U.S.
In looking at American history, we can see Tytler's sequence in action. In 1620, the Pilgrims sailed to America to escape the religious bondage imposed by the Church of England. Their spiritual faith carried them to the new world.

Because of their deep faith, the Pilgrims left England in spite of the high percentage of deaths incurred by earlier American settlements. For example, when Jamestown, Virginia, was founded in 1607, 70 of the 108 settlers died in the first year. The following winter only 60 of 500 new settlers lived. Between 1619 and 1622, the Virginia Company sent 3,600 more settlers to the colony, and over those three years 3,000 would die.

In 1776, the Declaration of Independence was signed. From spiritual faith the new Americans were garnering great courage. By crafting the Declaration of Independence, the colonists knew they were essentially declaring war on the most powerful country in the world -- England.

With the onset of the Revolutionary War, the colonists were moving from courage to liberty, following Tytler's sequence. By demanding their independence and being willing to fight for it, a new democracy was born. This new democracy grew rapidly for nearly 200 years.

Then, in 1933, the U.S. was thrown into the Great Depression and elected Franklin Delano Roosevelt as president. Facing total economic collapse, Roosevelt took the U.S. dollar off the gold standard. At the same time, Germany, also in financial crisis, elected Adolf Hitler as its leader. World War II soon followed.

In 1944, with WWII coming to an end, the Bretton Woods Agreement was signed by the world powers and the U.S. dollar, once again backed by gold, became the reserve currency of the world.

After the war, America passed England, France, and Germany to become the new world power. Having entered the war late, the U.S. emerged as the creditor nation to the world. Our factories weren't bombed and the world owed us money. The U.S. grew rich financing the rebuilding of England, France, Germany, Italy, and Japan. The American democracy was transitioning from liberty to abundance -- maybe too much abundance.

In 1971 President Nixon violated the Bretton Woods Agreement by taking the U.S. dollar off the gold standard because America was spending more than it was producing and the U.S. gold reserves were being depleted.

In 1972 Nixon visited China to open the door for trade. What followed was the biggest economic boom in history -- a boom fueled by the U.S. borrowing money through the sale of bonds to China, one of the world's poorest countries at that time. The sale of these bonds financed a growing U.S. trade deficit. China produced low-cost goods, and we paid for them with money borrowed from the Chinese workers.

American factory production, which had fueled the American boom after WWII, was "shipped" overseas along with high-paying American jobs. America was shifting from abundance to complacency. Rather than produce, we borrowed and printed money to maintain our standard of living.

In 1976 America celebrated its 200th anniversary as a democracy. Rather than produce, we kept borrowing to finance social-welfare programs. Over the next three decades or so, America slid from complacency to apathy.

In 2007 the subprime crisis reared its ugly head. And by 2010, unemployment increased to double-digits, even as the rich got richer. Once-affluent people walked away from homes they could no longer afford. The U.S. moved from apathy to dependence.

Today we're dependent upon China to finance our debt as well as fill our stores with cheap products. At the same time, millions of Americans are becoming dependent upon the government to take care of them. If Tytler is correct, the American democracy is presently moving from dependence back to bondage.

Filling the Void
History reminds us that dictators and despots arise during times of severe economic crisis. Some of the more infamous despots are Hitler, Stalin, Mao, and Napoleon. I find it interesting that the U.S. is now dependent upon Chairman Mao's creation, the People's Republic of China, for the things that we buy and the money that we borrow.

To me, this is spooky, foreboding, and ominous. While the Chinese people, as a rule, are good people, my business dealings with Communist Chinese officials have left me disturbed and concerned about the rise of the Chinese Empire. As you know, China doesn't plan on becoming a democracy. With money, factories, a billion people to feed, and a massive military, could they put the free world into bondage?

Although I don't like the way the Chinese do business, I continue to do business in China. I have to. They're the next world power. I cautiously believe that trade, business, and understanding offer better options for world peace and prosperity than isolationism.

Now the Western world must seek to grow stronger financially as China continues to gain power. To do this, our schools need to offer more sophisticated financial education to children of all ages.

This is not the time to be complacent or apathetic. This is the time to think globally.
Putting up trade barriers would be disastrous. Instead, it's time our schools train students to be entrepreneurs who export to the world rather than employees looking for jobs that are being exported to low-wage countries.

Please be clear. I don't fear the Chinese. I fear our own growing weakness. Only a weak people can be oppressed. Today, America has too many people looking to the government for financial salvation.

In 1620 the Pilgrims fled the spiritual oppression of the Church of England. Today Americans may need to flee the financial oppression of our own government as our democracy dies. If we follow Tytler's cycle for democracy, our financial dependence will lead us to financial bondage.

Some Information on Bonds...

The economic times we live in have created a lot of fear and uncertainty. What you’ll historically see in such times is this: a “flight to safety” as people pull money out of equities (stocks) and put it in bonds or hold in cash.

So why put money in bonds? Let’s have a look at what bonds are so we can understand why they are “safe.”

While we think of bonds as investments, they ironically represent debt. What happens is that when the government or a company wants to raise money, one way they will do so is to issue bonds – meaning, investors will purchase bonds (usually in $1,000 increments) from the issuer (the government or company) in exchange for a promise of future payments plus interest as their return on investment. Bonds can be for a duration of anywhere from 3 month to 30 year bonds. They all vary depending on the issuer. Typically, you’ll also see either a semi-annual (twice a year) or single interest payment on the bond; and at the end of the term of the bond, you’ll get your initial investment back. So a bond represents debt for the issuer. They issue a bond to get money now for a project and have to pay you back over time. They are in debt to you (the bond holder).

From the standpoint of the government, the Treasury issues new bonds frequently to finance the national debt. We can’t pay for our spending as we go, so we’ll issue debt now to get money now, and will pay it back later. Many countries purchase our debt issuance. For instance, China holds a large amount of U.S. treasuries issues. Thus, the U.S. is in debt to China for financing our spending. See a long-term problem here? But I digress…

The below gives you an idea on bond payments and the cash flows that come from them (single annual coupon payment).

So why is a bond “safe”? Because the issuer is bound by the terms of the bond issue and you get predictable income in return (assuming the issuer doesn’t default on the promise to pay). In an uncertain environment when you may have a negative rate of return on your stock investments, it sounds pretty good to have a “sure thing” like bonds, huh?

A lot of people have been thinking so too.

Last year, retail investors put over $380 billion into bond mutual funds. This year, another $240 billion has gone in. In contrast, over $75 billion has come out of equity (stock based) funds this year. Last year, it was more to the tune of $150 billion coming out of equities…yikes! That’s a lot of money moving out of the stock market and into the bond market…

Let’s stop right here and make a big distinction between bonds and bond funds.

So far, I’ve been referring to “bonds” in a generic sense. Up until now, talk of bonds has been academic for the purpose of understanding the structure of a bond and how its “safety” is derived. From here on out, I will be talking about “bond funds”.

When I say “bond funds” we are talking about funds (similar to a mutual fund) that are comprised of many types of bonds and bonds with many different durations (for instance a bond may be comprised of 3 month bonds, 1 year bonds, corporate bonds, municipal bonds, 30 year Treasuries, etc.). Funds that hold bonds typically don’t buy them and hold them for the entire life of the bonds. Bond funds employ strategies to buy and sell bonds before they reach maturity based on changing interest rate structures, yield to maturities, and call provisions. Sound confusing? It is, actually. Bonds surprisingly are a lot more complex than stocks if you choose to do anything other than to buy and hold them.

What’s important to understand; however, is that bonds work different than stocks in regards to interest rates and the interest rate can affect the price/value of the bond. If you are to understand one thing about bonds and bond funds, understand this: Bond values and interest rates have an inverse relationship. That means that when one goes up, the other goes down – and visa versa. For instance, if interest rates rise, prices of bonds decrease. Conversely, if interest rates decrease, prices of bonds increase.

Why? It has to do with the valuation of a bond. Think about it…if you hold a bond that is promising a 5% coupon rate, but you can now purchase a bond with a 6% coupon rate in the market, the better deal is to go with the 6% rate, right? Who would buy your 5% bond now? Well, you can’t adjust the interest rate to match the 6%, but you can adjust the price of the bond to entice buyers to buy your bond…so you’d lower the price to attract a buyer.

Additionally, it’s also important to know that the longer the maturity of the bond, the more sensitive the return will be to a change in interest rates. So a one-year bond is going to be less sensitive to an interest rate change than would be a 30-year bond. To compensate for this “interest rate risk”, longer term bonds have more yield (pay more interest) than do shorter term bonds. The reason: to entice investors to buy longer term bonds, they need to pay them more interest for them to justify the risk being taken.

Very theoretical stuff, I know. Let’s try a quick example just to drive home the point. If you own bonds with a five-year, 10-year, and 30-year maturity and interest rates go up 1 percent in one year, the following would happen: the five-year bond will lose 0.5 percent of its value, the 10-year bond would fall 4 percent, and the 30-year bond would lose 12 percent! Ouch!

As of this writing, yields on US Treasury Bonds were: 0.11% for 3 month; 0.16% for 6 month; 0.36% for 2 year; 0.51% for 3 year; 1.13% for 5 year; 2.53% for 10 year; 3.96% for 30 year. These yields get plotted on a “yield curve”…something that would look like this:


Now that you have this understanding and background, I’ll share with you my concern about the current state of the bond markets.

As we noted, in times of economic uncertainty, what you have is a “flight to safety” and a lot of people move out of equities and move into bonds. As was noted, a ton of money has moved into the bond markets lately. Here’s the concerning part: Currently, the Federal funds rate and thus interest rates of many “safe” bonds (government bonds) are at major lows. With lowering interest rates and a large market demand for these safe bonds, prices have been pushed higher. Now, do you think that the Federal funds rate will stay low forever? No! Even though we have historically low rates, and even face another round of money injection into the economy (the Fed’s “Quantitative Easing” being talked about), eventually, the Fed will take action and we will be facing an inflationary environment with interest rates on the rise. So, as was discussed, if interest rates increase, prices of bonds decrease. The risk that is now forming in the bond markets is that bond funds will see large loses once interest rates begin to climb – because the value (the price) of those underlying bonds in the fund will decline. Participants in those bond funds will start to realize investment loses.

Now, far be it for me to call a spade a spade, but I’d venture to say we’re experiencing a bond bubble. It’s as if we have a complete reversal of the dot-com bubble of the late 1990s. Everyone was high on stocks and money was pouring in. Now everyone is scared and money is pouring into the bond markets. This looks like classic herd mentality to me.

In light of the above information, I’d recommend that you research your current investment mix to see what your exposure is to bonds…specifically long-term bonds. FYI - Any mutual fund that you hold typically has a bond component as well - this problem is not just specific only to bond funds.

I’m not advocating that you bail out of bonds or bond funds altogether, but you need to understand and know what your risk exposure is to a bond bubble burst. Any bond fund or mutual fund that contains bonds that are TIPS (Treasury Inflation-Protected Securities) or low-duration bonds (short maturity bonds) will be relatively safe. TIPS provide protection against inflation, as they are structured so that the principal (the value) increases with inflation and decreases with deflation (i.e., the principal is positively correlated to inflation). As was already mentioned, bonds with shorter terms (3 month or 1 year bonds, for example) aren’t as affected by changes in interest rates and aren’t as subject to as much loss. Thus, low-duration bonds have less volatility because you are not locked into a long-term yield. This would be more advantageous in a rising interest rate environment.

As a side note, when interest rates begin going up, that is generally a sign that the economy is on more solid footing. A way to offset some of the bond risk is to invest in funds that have high yielding dividend stocks, say anywhere between a 4 and 7 percent dividend yield. This will provide a consistent stream of income from the routine dividend payments, and will also benefit from capital appreciation in an improving economic environment.

If you want to read more about bonds and the hypothesized bond bubble, just do a search for “bond bubble” online and I’m sure you can find people far more intelligent than myself discussing these issues at length.

Top 5 Things An Investor Should Know...#2

Before continuing our “Top 5 Things An Investor Should Know”, let’s review #1: Unregulated Capitalism is a Bad Thing. Why? Because investors need to have a level playing field. Without a level playing field, we find ourselves no longer in a capitalistic system – only imperialism. Personally, I maintain we are already on the road to imperialism unless things change. But I digress…

Now before we jump into #2, let me give a brief background on an important underlying and controversial theory (that is, it’s controversial in the finance world – we’re a boring bunch) that will come into play in this post: the Efficient Market Hypothesis (EMH). Simply put, the theory suggests that the financial markets are “efficient” based on the information exchange available in the markets. For example, the price you pay for a stock reflects all current information available in the markets for that particular stock, company, industry, and economy. The price you pay reflects the current / updated value of that stock. Three versions / degrees exist of EMH (stick with me, this may help clarify some more). The weak form of EMH says that pricing in the markets already reflects common information publicly available (historical prices, dividends paid, financial reports, analyst reports, etc.). The semi-strong form says that pricing in the markets reflects all common public information AND instantly changes to reflect new information (the word “instantly” is key here). The strong version of EMH affirms all of the others and also says that pricing takes into account “insider” information; i.e., information that is not made public.

There is debate on both sides of the table as to whether or not EMH has legs to stand on. For example, “if markets are efficient, how come we get ‘bubbles’?” An efficient market would never have “bubble” events if everything is always at an optimal point, right? At the same time, technology has opened up a whole new world for the flow of information and the speed at which market prices are updated. Traders (and computer programmed traders) can execute trades much faster. On the whole, it would appear that the market pricing reflects value much faster and more “up-to-date” – so we have reason to believe that markets operate much more efficiently with technology than without. There’s plenty more from both sides of the debate, but I won’t bore you here (if not already!).

Myself, I tend to believe some elements of EMH exist in the markets, but there is evidence that markets are not entirely efficient. So I take a little of both…

If you grasp the above theory a little bit, then these concepts will help you understand the following…

Now - on to #2 of the “Top 5 Things An Investor Should Know”.

#2: You Can’t Beat Wall Street at Making a Quick Buck

Make no mistake: the financial firms on Wall Street are some of the most sophisticated, smartest, and most motivated institutions on the planet. Big money is made daily. Financial firms of all kinds have thousands of Ph.D.s, CFAs (Certified Financial Analysts), mathematicians, and computer science whizzes on staff all concentrated on studying the daily movements of the markets, the minutia of company financials and industries, and the economy at large. They have some of the fastest and most technological sophisticated computers available with computer algorithms programmed to take advantage of mispricing in the markets within fractions of a second (ever heard of high frequency trading?). They also have tons of money available at their disposal in which to invest based on their conclusions. They have war chests solely for lobbying politicians and getting favorable legislation. They have former employees in government positions and they have former government employees on staff.

So, do you think you and I stand a chance of making a fortune by buying a stock that was mentioned in the Wall Street Journal, or on CNBC by the sensationalist talking heads, by a recommendation from a stock broker (who is probably recommending it to all of his clients), or even by buying one of those infomercial computer software trading packages you see on TV? PUULLLLEEZZZZ.

Odds are, if you are looking to flip a stock quickly and make a pile of money, you will lose.

Why? Elements of the efficient market hypothesis (EMH) would suggest that such a large number of professionals engaged in investing activities would move prices to an optimal level – and fast. If there are a ton of people engaged daily, hourly, minutely, in exploiting mis-pricings then prices in the markets are corrected quickly. Thus, the profit available in a stock has already been picked clean by the Wall Street vultures before you and I even get wind of the stock, not-to-mention buy the stock and hope to sell it quickly for a large profit. Understanding this, will save you time, energy, and money.

The age old investment advice you hear is: “buy low and sell high.” Even though it’s such a common thing to hear, it hardly rings true for the average investor. Most investors “buy high and sell low” because they hold out too long. Most of us buy a stock due to hype or a “hot tip”, see it go up, and then try to wring out just a few more pennies of profit before selling for a gain. However, it never happens. Instead we find ourselves holding on for just a few more pennies whereupon the stock crashes before it can be sold. Now we are too emotionally involved in the stock and hang onto it…hoping that it will go back up. Then the stock tanks further. Finally we sell defeated. Ironically, days later after selling, it recovers in a rally. Oh the irony. Oh the painful sting. The sickness in the gut. This happens over and over to people daily. Sound familiar to any of you?

Did you know that most common investors don’t even beat the average market returns?

Why?

Fear, Emotions, Anxiety, Greed, Herd mentality, Lack of long-term vision - all factors that typically contribute to selling low and buying high. Much of this is studied by those in “behavioral finance.” I won’t pretend to know much about behavioral finance, but what I can say is that there is a HUGE difference between you and I as investors and those on Wall Street making investment decisions. We operate on emotions and impulse; Wall Street operates on calculated planning and objective factors in their investing.

So what should the average investor do?

1) Don’t try and beat Wall Street at their game of fast money. Don’t think you can make a quick buck. For one, financial institutions have millions of dollars in the coffers to fall back on if a trade doesn’t pan out. You and I don’t have that luxury. A big loss can hurt us big and set us back. Trying to get rich quick, or build back your nest egg that was lost in the last two years in one shot increases your exposure to risk and losing even more. Understand that building wealth takes time. Trying to get rich quick will more than likely burn you…

2) It’s important to have a financial plan and stick to it for the long-term rather than let fear and greed work its way in. As I’ve mentioned before, turning off the TV sensationalist talking heads will help decrease your anxiety levels as well. Keeping an eye on a longer horizon will help decrease anxiety and allow you to make more objective decisions. Plus it will help you weather the storms that come along by allowing you to focus on the long-term goal.

3) Diversification is still one of the best ways to protect yourself and your investments. For example, holding a small handful of stocks only is a bad way to diversify. Better to hold some mutual funds or index funds across asset classes to diversify the risk.

I’ll go more in depth on some of these things in future posts. For now, suffice to say, don’t get caught up in trying to make a quick buck!

Top 5 Things An Investor Should Know...#1

Over the coming weeks, I’ll unpack what I’ll call my “Top 5 Things An Investor Should Know”. Hope you find it insightful and interesting…

This week starts with #1:

Unregulated capitalism is a bad thing.

Don’t get me wrong, I’m a capitalist. I believe in profit taking. I also lean much more to the free market economy side than to Keynesian economics (see this for more on free markets vs. Keynesianism). But, unregulated and unchecked capitalism has resulted in the “Wall Street Gone Wild” situation that we’ve experienced over the past decade - from dot com bubbles, to exorbitant profits, to a global meltdown, to exorbitant profits at the expense of the taxpayer (bailouts), to exorbitant profits, to exorbitant profits, to exorbitant profits.

While I don’t want to get too much into politics, it’s important to understand how politics and regulation affect the markets…I’ll try to keep this simple.

Let’s begin in the 90s when the Clinton administration thought it would be a nice idea that more people in America owned homes. I believe the exact words were: "Every American deserves to live the American dream". Well, most everyone that could afford to own homes already did in the booming economy. But what about those that couldn’t own homes (because they couldn’t afford them)? Well, the administration put pressure on the financial institutions and Fannie Mae and Freddy Mac to relax lending standards to those that didn’t and couldn’t own homes. Enter subprime mortgages and ARMs (Adjustable Rate Mortgages) - instruments considered “creative financing”. People (that normally would be turned down for a home loan) could now get loans and realize their American dream of home ownership. Hurray for the American dream, right? It sounded good…

Fast forward to 1999. An important piece of legislation known as the “Glass Steagall Act” was repealed. For understanding, Glass Steagall was put in place after the events of the Great Depression occurred. It in essence built a wall between any crisis Wall Street might have and “Main Street” not allowing a spillover effect – and was in effect for 65 years. Add in the “Commodities Futures Modernization Act of 2000” that kept financial derivatives from regulatory oversight and required no money down of the issuer in reserves to back up the derivatives, and we had massive deregulation and now the seeds for economic destruction. Financial institutions (Goldman Sachs, Lehman Brothers, Bear Stearns, e.g.) and insurance companies (AIG anyone?) got bigger and bigger.

At the same time, these financial institutions were piling more and more into creative financing and financial engineering. For example, consider mortgage backed securities (MBS): taking mortgages, bundling them together, and selling them in packages or slices. The problem, as we’ve discovered, was that many of those MBS packages had subprime mortgages in them…some even comprised of most all subprime mortgages!

Now what happened in 2007? You have people with a home loan that couldn’t normally afford it, a recessing economy, and a dash of job loss. That resulted in loan defaults. People couldn’t afford to make their home payments anymore. What happened to those mortgage backed securities that were grounded in the assumption that people would make their home payments? All the big institutions issuing those seemingly good investments (which were actually junk) and getting them rated as good (I’ll have more to say about ratings agencies in another post) began having cash problems because they couldn’t cover the defaults (because they weren’t required to have money in reserve).

Wall Street took risky bets, peddled junk, and got caught. Now, a true hardcore free market and capitalistic approach would have been to let the companies fail and send a clear message to any institution wanting to gamble with other people’s money. Economist Allan Meltzer puts it like this:

“Capitalism without failure is like religion without sin – it just doesn’t work.”

And how about a proverb:

“He who oppresses the poor to increase his wealth and he who gives gifts to the rich – both come to poverty” (Proverbs 22:16).

Apparently this isn’t the case in America any more. Instead, these institutions were labeled “too big to fail” and received a bailout - billed to the American taxpayer (thank you George W.). After all, the Washington elites had buddies on Wall Street that needed to maintain their quality of life, right? It might strike some as strange that such reforms benefitting these companies also happened with former Goldman Sachs elites at the helm of some key administrative positions (e.g., Robert Rubin, Secretary of the Treasury under Clinton and 26 year veteran of GS; Henry Paulson, Secretary of the Treasury under George W. and former CEO of GS). You might also find the article in this link interesting, if not upsetting at the least. Evidence of more crony capitalism? But I digress…

So in hindsight was making the American dream available to all worth it? Was deregulation worth it? It’s a nice political tactic, but in hindsight it cost us a lot. There is a reason that some people get turned down for mortgages – they can’t afford them. No matter how creative institutions got in their financing, the bottom line is that those mortgages should never have been handed out because the recipients couldn’t afford it. Financial institutions knew this, but the government prodded them along. They acquiesced like good boys and girls, then saw the deregulation gap open up and took the car for a joy ride while their proverbial government parents were asleep.

Consider this: the Dow Jones Industrial Average (commonly referred to as “the Dow”) first crossed the 10,000 level in 1999 and it finally crossed back over 10,000 this last month (as of this writing, the Dow is around 10,750). After including dividend income on stocks, the Dow has returned approximately 15% since 2000 – that’s about 1.5% per year. Investors could've done better holding bank certificates of deposit. Five-year Certificate of Deposits (CDs) were yielding 7% in 2000 and 4% in 2005 -- which would've returned 5.5% per year over the same period (and a total return of 71%). CDs are certainly not giving off those returns anymore. But most of us “sheep” owned investments in the stock market and between 2000 and 2010 Wall Street lost 20% of our retirement playing the stock market.

The real winners here in all of this? Wall Street. Over that same period, Wall Street pocketed hundreds of billions for themselves. Wall Street bonuses, even during the crisis, barely slowed or retracted. For example, the U.S. Treasury Department’s “pay czar” reported in July that 17 banks gave executive $1.6 billion while receiving billions in bailout money at the same time. Keep in mind, that’s only 17 of the 419 companies that took bailout money! When the crisis hit in 2008, these institutions off-loaded trillions of debt on taxpayers and received taxpayer money. Average Wall Street bonuses for 2009 were up 17 percent when compared with 2008. For those that didn’t fail (err, were left to fail like Lehman Brothers) they emerged even stronger and more wealthy. In May 2010, Goldman Sachs reported making money on in-house trading and investments every trading day in the year’s first quarter – even though only seven of nine of their “recommended” trades for investors like you and I paid off. In the second quarter, they only had ten days of in-house trading losses. They win, we lose. See how this works? The rest of the economy is in shambles, many people are out of work, and many unfortunate folks who took the bait and signed up for a subprime mortgage also have no home now. Wall Street wins, we lose.

But before we get too worked up bashing Wall Street, here’s the deal. Even though it peeves many on “Main Street” (me included), we have to understand that Wall Street played within the boundaries of what they were allowed to do. At first blush, it seems as though they are acting unethically (I wouldn’t disagree), but with an increasingly deregulated market, more opportunities are available and capitalism says that there will be profit takers. In the face of deregulation and relaxed lending standards (thank you Clinton and Bush administrations) within a capitalistic system, Wall Street moved in and did what it does best: take profits.

Thus the old adage is true and can be applied to deregulation: “give them an inch and they’ll take a mile.” This is why regulation is so important in a capitalistic system. Without some regulation and boundaries in place to keep the playing field relatively level, the hedonists in the market are further unleashed and eat everything in sight.

Bad news, good news...

To stray off the investment topic for a post, I couldn’t help but post this (I’ll return to investing next week). I came across a handful of charts on a blog that I follow called “Calculated Risk” and wanted to pass along for your observation (FYI – Calculated Risk is an excellent blog for any of you economics/finance nerds out there…it daily posts economic/finance data and indicators. For you non-economic/finance types, I dare say you’ll find it boring!). The following four graphs tell an incredible story about unemployment and the current state of the economy. Employment is always a huge factor in the “health of our economy” equation. It is also a factor that helps pull our economy out of the hole and back on solid footing…after all, the more people are employed, the more of their paychecks get pumped into the economy, right?

Keep in mind, the unemployment numbers are based on data from the government – the Bureau of Labor Statistics (BLS) – so I might venture to say the situation is actually worse than the charts below might indicate. However, we’ll take their data at face value for now. One day I might post about the BLS and how they conveniently falsify determine their unemployment numbers.

Anyway, I always like to get the bad news out of the way first so here you go…

What do these last two charts mean? Basically, it’s going to take the economy a lot longer to recover than it has in the past.

And now for some good news:

Despite high unemployment and a prolonged economic downturn, people are increasing savings and paying down debt. Have a look at the following two charts. The second shows “revolving consumer credit” - if you recall the post from Debt Happy, revolving consumer credit is credit card debt.

Of course, as has been noted before, people who pay off debt and save more are in effect not pumping money into the consumer machine and propping up businesses. But as I've also proposed, we’ve been living with an overinflated economy based on wants, not needs. More individual saving and less individual debt will help purge and deflate the economy to a healthy level. I consider this good news.

“No discipline seems pleasant at the time, but painful. Later on, however, it produces a harvest of righteousness for those who have been trained by it.” - Hebrews 12:11

Some beginning thoughts on investing...

I think I’ve been beating up on debt long enough in my posts. I hope everyone reading realizes how bad of a situation we are in as a country. I hope it’s also caused you to question your own life and how you spend money and consume.

I’m going to start to transition into some information on investing. Being in business school during this economic downturn has been interesting, to say the least, and has been like a having prime seats at a movie, sporting event, or play. More like a play probably (ha!). I hope my observations are helpful as I begin to unfold some thoughts on investing and the financial aspects of our economy.

So…

Up until this economic downturn, why do people invest in the stock market? Historically, the main reason is that one could earn more in stocks than they could with holding cash or investing in bonds. The “risk premium” is the amount that one is supposed to earn in interest by taking the additional risk of owning a certain investment. If one doesn’t get paid a premium for taking the risk, they should look elsewhere to put money.

Now, over the last 120 years investors were paid approximately 2.0-2.5% more each year (on average) to invest in stocks than in bonds. Not bad, but problems exist. Depending on what investment a person is in, risk premiums can be higher than 2.0-2.5% or well below it (especially in economic downturns). Also not in this factor is something called "selection bias", meaning that funds or investments that ultimately failed over the selected time period weren't included in the calculations. This starts to get real ugly, though, when we have to face up to the fact that we have no idea when economic downturns will occur – or how long they will last.

So what does that mean? Earning a 2.0-2.5% risk premium is based on picking the right investment and also on timing. Well, that’s not very comfortable to me because it’s not something that can be controlled nor can it be predicted…more like random luck than investing. Heck, we might as well take cash to a casino instead and play, right?

Now, I’m not saying we should just give up and not do anything, nor am I saying we should sell all our investments and stop investing, or even take it to the casino. What I’m trying to get at though, is that we grossly underestimate risk.

We’ve been sold a bill of goods that says, “put your money in the stock market and you’ll make a fortune.” While that might have been more true during the developing dot com bubble (where even a monkey picking stocks off a page could have made money), it is not the case today. The markets are extremely volatile and we don’t understand risk. Putting money in equities (stock related investments) exposes you to the possibility that you could lose it all, some, or none. How many brokers tell you that at the outset of investing your money, hmmm?

Here’s a statement worth time to ponder: “Past performance is not an indication of future performance.” Meaning, just because an investment has had a decade of positive returns, doesn’t mean it will have another decade of such returns. Anyone heard of a little oil company by the name of British Petroleum (BP) that had a little problem in the Gulf of Mexico? Yeah, they had a stock that gained in value for years. Since the spill, their stock price has been pummeled. Think anyone saw that coming?

Gone are the days of “easy” investing…we all need to get comfortable with that fact.

R I S K. It has to be considered. It has to be understood. It’s more of a factor than we think.

A good quote...

I came across this quote from Tony Blair’s new memoir “A Journey”, out this week, and couldn’t help but find it incredibly insightful and to the point.

Regarding stimulus, Keynesianism and re-regulation, Mr. Blair writes:

"Ultimately the recovery will be led not by governments but by industry, business, and the creativity, ingenuity and enterprise of people. If the measures you take in responding to the crisis diminish their incentives, curb their entrepreneurship, make them feel unsure about the climate in which they are working, the recovery becomes uncertain."

Worth some thought…

An Interesting Symbiotic Relationship: Spending and the Economy.

Symbiotic (pronounced - "sim.bi.at.ik"): “of a relationship with mutual benefit/demise between two individuals or organisms.”

So here’s a thought that will boggle your mind: During an economic downturn people tend to work harder at paying off their debt, putting money into savings, and curtail spending - by doing so, they contribute to and exacerbate the downward spiral of the economy.

What? Isn’t paying off debt, saving and investing a good thing? Yes, it is…but only a good thing for the individual.

The growth of an economy is dependent on consumers spending their money. If our discretionary spending was actually going to savings and investing instead of being spent on luxurious vacations, dinners out, new clothes, the latest and greatest electronics, and a whole host of other meaningless and unfulfilling products, demand for such goods and services would go down. As demand goes down, production of those goods and services goes down (or is eliminated) – then there is less need for employees to work to produce the goods and services. Business profits decrease and unemployment occurs. Ouch.

Ironically, the only thing to help improve the economic situation is for all of us to spend, spend, spend. But no one wants to do so in bad times and instead goes into self-preservation mode.

Now to stray off topic…

So what is this economic downturn telling us? I’d suggest a couple of things:

We are a society that has grown from consuming for needs to wants.
In our great prosperity as a nation we’ve gone from providing for the essentials for ourselves – basic needs like food, clothing, housing, etc., to now splurging with our excesses for our whimsical wants – fillet mignon instead of sirloin, designer jeans instead of basic denim, the tricked out 5,000 square foot home instead of a 1,200 square foot 2 bed 1 bath for two people to live in. We no longer are concerned with just taking care of the basics, but are concerned with “quality of lifestyle.” Thus our “tastes get more refined” and we spend accordingly.

Our economy is overly bloated and based in the consumption of goods to fulfill wants, not needs.
With such whimsical spending based on desire and want creates new businesses and markets to fulfill the desires of the upwardly mobile populace. What has happened; however, is that the knowledge workers don’t care to work in basic manufacturing, agriculture, etc. for it is now “beneath them” and we delegate and outsource such functions. Then when the economy turns south and spending on luxuries slows, we wake up and realize that our economy is farce and built on the fleeting back of luxury goods and there are no businesses left in our own country that can produce basic goods to fulfill wants – we’ve delegated them all away!

We are a society that is immature, lacks depth, and lacks meaning.
In the great quest to attain a level of “quality of lifestyle”, we have borrowed to achieve our fancies. We can’t patiently build savings to buy what we want because we have to have it now. Such immature spending has put us in a bad spot as a nation and we are dealing with the fallout of debt. This also highlights something much deeper. Why must we spend to appear “to have it all”? Why must we “keep up with the Joneses”? Perhaps we lack the character and personal fortitude to not care what people think about us? Perhaps we spend and consume because we don’t know who we are as individuals? Perhaps we don’t like what we see in ourselves and just cover it all up with more spending. I think “yes” to all. Additionally, I think that what we spend our money on reflects our values. Any economy that has been built on ingesting luxury goods reflects a hedonistic value system. Unfortunately as we are witnessing, hedonism results in a dead end.

It’s time to get over ourselves.

For your consideration…

Don't Believe the Media Bull...

Contrary to what you may hear on TV and the financial channels (I like to refer to them as the “sensationalist talking heads”), American companies are NOT in as great of financial shape as we are led to believe. Federal Reserve data show that American company debt has been rising, not falling (note: this is debt of non-financial companies).

“But, companies are holding records amount of cash”, you’ll hear. Yes, it’s true – they are sitting on mounds of cash. But guess what? They borrowed out the wazoo to get that cash on hand! Total American company debt (again, debt of non-financial companies) is at a record $7 trillion. Depending on the sources you read, non-financial company debt translates to approximately 50% of GDP. That’s an incredible number folks.

So why are we being told in the media that companies are in great shape? A few thoughts:

1. “Record cash” is a great story. “Liabilities” are not. Just like the prophets of old telling of the disasters to come who were largely ignored for the favored false prophets telling of peace and prosperity ahead - such is the case with the media and the public when it comes to financial news. We want the hot sound bite: “piles of cash” and will ignore that pesky “liabilities” line on the balance sheet of the same company.
   
   
2. Bottom line, Wall Street needs your money to get paid. Think about it: if companies aren’t in good shape and have taken on more debt than normal (commonly referred to as “overleveraged”), they are a more risky investment. Risky investments tend to scare people away. For-commission brokers and firms peddling the products that hold those companies suddenly don’t have customers. No customers means “no pay.” They need you to “play.” Their livelihood depends on you investing. Seems a little convenient to me (for the for-commission crowd) to tell the rest of us a half-truth making us believe that companies are in great shape. Thus, we have a conflict of interest.
   
   
3. We’re nearing elections. A “strong America” is a great story. Optimism, not doom and gloom, inspires people. I fully expect to hear more about this from both sides of the aisle the closer we get to elections – in spite of the data that suggests otherwise.

So, my soapbox statement for today: consider the source when you hear ANYTHING from the media or financial channels about the economy and the strength of American companies. It’s highly likely there’s a huge hidden agenda. Personally, I don’t even watch the stuff anymore…unless I want a good laugh.

Musings on the National Debt...Part 2

In part 1, we went over the main schools of thought of how the government attempts to pay down the national debt via accumulated savings. Let’s take a moment and gain a grasp of the magnitude of the national debt problem.

As you’ve probably noticed, there’s a national debt clock that is at the top of this blog. I think it’s pretty important to be aware of our situation as a nation. In the same vein, a pretty fun website for finance and economics nerds is http://www.usdebtclock.org/. The debt clock widget above is pretty cool, but USDebtClock is the widget above – on steroids! Check it out, if you dare…

Among all the information that is being continually updated on the USDebt site, here’s an important nugget: the ratio of U.S. public debt to gross domestic product (GDP), is around 62%. Total national public debt (as you can see above) is approximately $13.3 trillion – around $43,000 per citizen – and is growing (coincidentally, the average annual income in the U.S. is around that same $40-45K amount). At current rates of growth, the debt will actually be larger than GDP sometime around 2020. Not good folks.

Now, if there are any savings/surpluses or they just feel like throwing money towards paying back the national debt, the government voluntarily cuts a check to the Treasury.

Guess what? In fiscal 2009, the Treasury received a little over $3 million in voluntary debt-reduction contributions from the government. A whopping $3 Million!!! Based on that rate (known as “service rate”) it would take more than 4 million years to pay off a $13.3 trillion debt. Keep in mind that $13.3 trillion is growing every day too, so that 4 million years expands as the debt swells.

So let’s have some fun with numbers for a minute to get some understanding of the magnitude of our debt (I know, I know – “finance nerd”):

• With an average annual income of $42,000, it would take the country's 139 million workers 2 years and 3 months to pay off $13.3 trillion, if everyone simply wrote a check to the government in the amount of their average income (feel like not earning anything for 2.25 years?).
  
  What if we took our 2009 U.S. household savings of 1.2% (see Cause and Effect), set it aside, and paid it to the government? It would take 188 years to pay off the debt. Hmmm, not very encouraging.
  
  How about if we set aside 3% of household savings that would go to debt reduction? It would take 75 years. Not bad - only one generation of workers at 3% to pay off the debt…sounds good right?

How many of you feel like voluntarily writing a check to the U.S. government for 3% of your income for the next 75 years? No? Hmmmmm… Well, if you won’t voluntarily hand over money, it may become mandatory – spoiler alert: tax increases ahead!

Think I’m joking? Just the other week, Treasury Secretary Timothy Geithner said the current administration will allow the Bush era tax cuts to expire in 2011 (see the following charts for how that may affect you). Estimates are that allowing the tax cuts to expire for upper-income earners would increase U.S. revenue by more than $800 billion over the next 10 years (for perspective, that’s only about a 6% dent in the $13.3 Trillion debt total). There are also plans to reinstate the estate tax to 45%, possibly increase the tax on dividends from 15% to 39%, and add a 3.8% tax on investment incomes for high-income earners to help pay for the new health care legislation (a.k.a., ObamaCare).

I ran across the chart below showing the tax rates under the Bush tax cuts and what the rates would return to if the cuts expire…

You may be flabbergasted to see that the lowest tax bracket’s marginal rate will go up 5%. Don’t worry, the current administration knows how to get votes and won’t let the lower and middle classes be hurt by tax increases, thus they will most likely extend the Bush era cuts for the lower and middle classes and let the cuts expire for upper-income earners (keep in mind, not everyone pays taxes…in 2009, 47% of people didn’t owe any taxes come April 15th). The rich will get hit the hardest under the 2011 proposals (see this second chart below with proposed 2011 tax policies).

Finally, here’s a chart with some different tax scenarios and where that puts national debt as a percentage of GDP. I thought this was a great illustration.

1) 100% debt to GDP happens in 2020.
2) 100% debt to GDP happens in 2022.
3) 100% debt to GDP happens after 2030.

Remember from Part 1, we mentioned that tax increases historically have the opposite effect from what was intended: weakened incentives for production and ultimately, lower tax revenues. Not to mention, if you raise taxes on the rich, they tend to find ways around tax laws - having a team of lawyers and accountants to find the loop holes (my personal opinion, of course).

All of these proposed tax changes are just a start. Don’t be surprised if you see more taxes initiated or value added taxes (VATs) proposed in the near future.

So bottom line, what’s the solution here? It’s hard to say. From the debt to GDP chart above, you’ll notice the three trends are still upward sloping. So, all the current proposals will do is buy us a little more time and extend the timeline for us to hit the 100% debt to GDP ratio. Historically, nothing has really worked to curtail spending over a long period of time. As I mentioned in part 1, you don’t get to $13.3 trillion if you’re doing things right.

If true change is to happen, some politicians may have to do some very unpopular things in the best interest of the nation – and they need to be long-lasting changes. Tax increases are inevitable and we may very well have to suffer with tax increases for quite some time. It would be a nice gesture; however, if the government stopped its runaway spending in light of the burden they are about to put on us to bail out their spending. Think they have it in them to stop the spending bleeding?

Then again, “we the people” could always voluntarily write a check to the government to pay down the debt…

Anyone? Anyone?

A Short History in Economic Thought...

John Maynard Keynes and Friederich Von Hayek. Remember these two names for they are the fathers of two of the most prominent economic schools of thought. They are also the theorists of two viewpoints that are in direct contrast with each other.

“Why should I care?”

Answer: Understanding their views will help you understand current courses of action (or lack of) by our government in response to the recent financial crisis. I’ll try to keep this simple…

John Maynard Keynes is most well associated with “Keynesian economics”. In the simplest explanation, Keynesian economics would be - “government intervention” in the markets. The argument is that, sometimes the private sector (anything not a part of the government) doesn’t do a good enough job and makes mistakes; therefore, the public sector (the government) has to step in to help stabilize things. This is done through short-term stimulus during the bad times in hope of bolstering long-term growth, then saving surpluses during good times. This sounds relatively simple and not too involved, right? Just like a drug addict; however, you have to wonder if/how such stimulus can be pulled and whether or not governments can actually relinquish their positions of control after having stepped in.

Consider that the economies of the Soviet Union, China, and much of Europe during the 30s, 40s, and 50s were overly involved in the aspects of their respective economies. Setting prices on everything from wages and the price of commodities (grain, oil, metals, etc.) and/or either owned or took control of the major industries of the economy (railroads, steel, oil, coal, telephones, etc.). They took responsibility for the distribution of goods and social welfare (sometimes referred to as “central planning”). During the Great Depression, these European and Asian countries actually flourished while the capitalistic and free market oriented United States floundered. It would not necessarily be fair to say that Keynesian economics results in socialism or communism; however, many of the practices of Keynesian economics can be found in countries with such governmental systems.

For the U.S., Keynesian economics took front and center stage when President Franklin Delano Roosevelt (FDR) took office. FDR initiated massive government intervention during the Great Depression (The New Deal) – employing the unemployed to build highways, bridges, dams, airports, railroads, etc. It was one of the largest expansions of infrastructure in our history. All paid for by the government and via debt. Then World War II occurred and we produced bombers, tanks, bullets, and bombs. Again, all paid for by government debt. See the chart below for a visual on how much government spending went on during that time without the revenue to back it up. Wow!

The Great Depression ended with the advent of WWII. Post-WWII saw the return of economic prosperity. Keynesian economic thought was on the upswing and was held up as the reason for the return to prosperity. Thus, the government continued on instituting Keynesian ideals and practices in the economy until the mid-to-late 1970s. Organizations like the IMF were born out of the Keynesian movement after WWII.

Friedrich Von Hayek could most be identified with “free market” economics – unconstrained from the hand of government meddling. His groundbreaking work, The Road to Serfdom, was a response to much of what he saw wrong with central planning and the European socialist systems around him during the 30s and 40s. If you’ve heard the term “laissez-faire” (meaning “let it be” or “hands off”) regarding economics, his ideas of free market economics support a similar viewpoint. Hayek wasn’t completely government averse, he believed the government did have a role to play with monetary policy and work-hours regulation, but only a small role. The major force of his arguments; however, was that market forces should be unleashed and unhindered. Then, and only then, will we have truly optimal efficiencies and prices in the markets. Similar to the tide of an ocean, unleashed markets are not meant to be controlled, but rather one is to come alongside and flow with the tide of the market forces

However, because of the prominence and seeming success of the Keynesian approach from the 1940s to the 1970s, Hayek was vilified by the economic establishments and his ideas mostly disappeared into obscurity in the economic world. His work did find favor with the London School of Economics and the University of Chicago; however, where he worked during that time and a small but growing underground of free market economists began to emerge. Milton Friedman was a student of his and also helped popularize the ideas of the free markets in the 70s and 80s.

During the 1960s and 1970s, the governments of the United States and the United Kingdom became more and more involved in the affairs of the economy. By the time Richard Nixon was in office, a crisis was growing as inflation and unemployment was a huge problem – known as “stagflation” (ironically, Keynesian economics suggests that inflation and unemployment cannot occur if proper planning and intervention are in place). True to Keynesian economics, the government stepped in and set maximum prices on goods and commodities as well as wages. However, the basic principles of supply and demand overwhelmed the price ceilings and shortages occurred. Farmers, for instance, stopped selling because the prices set for their goods did not cover their costs of producing. The same was true for oil. Shortages were such a constant thing that the government initiated a rationing system for fuel for vehicles.

Similar problems were also occurring in the United Kingdom. However, in 1979, a woman by the name of Margaret Thatcher (an adherent of Hayek’s free market principles) was elected as British Prime Minister. She set out to release many of the government entities, or government supported entities (coal, steel, airlines, railroads, electricity, etc.) to the private sector through deregulation – freeing them to market forces. At almost the same time Ronald Reagan was elected President in the U.S. Reagan, like Thatcher, was a believer in free market economics and begin enacting policies to free up markets to perform on their own without government controls. What we saw was massive deregulation of many markets, privatization, and dismemberment of many monopoly type institutions. Over time, competition and market forces brought about stabilization to prices and the economy began to recover. With the U.K. and U.S. leading the way in prosperity, other nations begin to follow suit in enacting free market policy in the 1980s and 1990s.

History is quite interesting – and not without its irony. We’ve had wild swings in these two viewpoints: From the success of early 1900s free market capitalism to its collapse in the 30s, to the success of socialism and communism beginning in Europe and Asia in the 30s and the success of Keynesian economics from the 40s in the U.S. to its collapse in the late 70s, to the emergence of free market capitalism from the 80s to the 2000s.

Present day? What would you guess? We are seeing a swing back away from free market capitalism and much more governmental involvement. Courtesy of our financial crisis, the government has stepped in and “rescued” many failing organizations with bailouts. It has propped up home owners and banks by taking care of bad mortgages. It has provided money to state governments for spending on infrastructure. We are crossing the dividing line and moving back to Keynesian economic viewpoints. Even in the White House, Lawrence Summers, Assistant to the President for Economic Policy and Director of the National Economic Council; and Christina Romer, Chair of the Council of Economic Advisors (it was actually just announces that Christina Romer is stepping down to return to teaching) are both outspoken Keynesian economists and huge influencers of the President.

So here’s the trillion dollar question (I bet some of you have been thinking it)…it is the question that has been asked a lot as of late: “Are we better off over the past few years having had the government inject stimulus via bailouts and taking an activist role in intervening in the markets?” There is much debate about this. I won’t go into it here. Ultimately, what’s done is done, “it is what it is” as the saying goes.

The greater issue at play is: “how will the embracing of the Keynesian economic viewpoint by our government affect our economy and financial system in the long-run?” Will it spur economic growth or just create more unserviceable national debt? How much longer can we try and spend our way out of a crisis? Can the government stop its spending habits once we get out of our mess or, like a crack addict, will it have an incredible taste for spending that it cannot wean itself from?

Thoughts and questions for your consideration…