July 25, 2009

Market Insights - 25 July 2009

Weekly Snapshot
• Warren Buffett will create a series "The Secret Millionaire's Club" to teach children how to invest their money (Marketplace)
• California's Senate approved a package of bills to balance the state budget by closing a $26.3 billion shortfall (Reuters)
• UK economy falls by 0.8% in Q2, twice as much as economists had forecast (AP)
• The IFO business climate index for Germany rose to 87.3 in July, highest level in 9 months (Economy.com)
• Microsoft's quarterly profit falls short as sales fall 17% (Market Watch)
• U.S. Initial jobless claims rose 30,000 to a slightly lower-than-expected 554,000 (Bloomberg)
• U.S. Existing Home Sales in June increased 3.6% to a seasonally adjusted annual rate of 4.89 million units (Briefing.com)
• Macau's casino gambling revenue fell 12% from a year earlier to $3.7 billion (WSJ)
• California legislative leaders reached a compromise to close the state's $26 billion budget shortfall (WSJ)
• Ben Bernanke explains the Fed’s Exit Strategy (WSJ)
• The U.S. index of leading economic indicators rose 0.7% in June, the third straight monthly gain (WSJ)

Chart of the Week
Here is an interesting chart from David Altig's recent Blog post: A look at the recovery

We quoted David Altig before when he pointed out how far apart the forecasts and views of some economic experts are in terms of inflation expectations. This chart here shows a different angle - not just the discrepancy between forecasters but how much on aggregate the GDP forecasts diverge from a pattern seen after previous recessions: The deeper the recession, the faster the recovery (see red encircled area).

Based on the data from a panel of 50 economic forecasters (blue encircled area), he concludes:
"Either we are about to continue making history—and not in a good way—or current guesses about the medium-term economy are way too pessimistic."

Source: http://macroblog.typepad.com/macroblog/

Recommended Read
Please consider: Rating agency model survives largely intact

Here we go again... in spite of all the public outcry over conflicts of interest, or as some believe criminal behavior, in assigning Triple A ratings for some of the most obscure debt instruments, the major credit ratings agencies are back in the game of assigning credit ratings as if 2008 never happened. In fact, as the article suggests, some of them have been doing so well recently that their stock prices recovered significantly despite being a potential key factor in exacerbating the credit crisis.

Do not expect any meaningful change to come from governments or from more regulation - it simply won't happen. Regulators have been equally at fault here because a) they fail to see that despite all disclosures, credit ratings agencies are still paid by the bond issuers, a conflict of interest that should not be there in the first place; and b) this is not a question of freedom of speech because the agencies are privy to non-public information and should be held accountable when blatant mistakes and misrepresentations are made.

But change may come from disillusioned investors, both large and small, and maybe things will be different this time around...

As the article notes: "The largest pension fund in the US, the California Public Employees' Retirement System (Calpers), has filed a suit against the three leading rating agencies over potential losses of more than $1bn over what it says are "wildly inaccurate" triple A ratings. That is just one of many. S&P currently faces about 40 separate law suits from investors and institutions."

Investing legend Warren Buffett recently sold a large stake in Moody's and reduced his long-standing holding from 20% to 16.9% (I wish he had reduced it to zero...). Perhaps the investing public could also vote with their feet and simply avoid purchasing any of the ratings agencies' shares, maybe even avoid rated debt issues altogether. As long as conflicts of interest prevail, financial services cannot regain their trust from the investing public.

As I noted in a previous newsletter, one of the best analogies I have read in a long time came from Attorney David Grais during an NPR interview: http://www.onthemedia.org/transcripts/2009/05/29/03

…in the arena of structured finance, it’s as though the rating agencies are in the kitchen helping to cook the meal. And then when the meal comes out, they sit down, eat the meal and then write a rating of it, or a review of the meal. That’s when, in my opinion, they lose the protection of the First Amendment.

Sam Jones went one step further when he said: "The agencies didn’t just help cook the meal, they wrote the recipes."

As long as the (financial) reviews are written by the same people who cook the meals and write the recipes, one should simply stay away from doing any business with these groups altogether...

The Fed's Exist Strategy
U.S. Federal Reserve Chairman Ben Bernanke outlined the Central Bank's exist strategy in an OpEd piece at the Wall Street Journal. Among the many discussions and raised eye-brows I have witnessed, here are two of the more interesting commentaries I came across:

At Long Last - Fed Explains Exit Strategy

The Fed’s exit strategy in full – and why not many people believe it

My take on this:
Ben Bernanke is not in an enviable position and credit must be given to the fact that at least there is somewhat of an attempt towards explaining what perhaps none of us will ever be able to fully grasp, i.e. the intricate workings of central banks. There also appears to be an acknowledgment of the fact that inflation, while not currently a threat, will eventually set in and money supply will need to be tightened to keep a lid on inflation.

But unlike a suggestion made by Mr. Bernanke, I would hate to see that the Fed should incentivize banks by paying interest on their deposits with the Fed. Why pay the middle man? The banks are already swimming in too much free money. Fractional Reserve Lending is considered by many free market advocates and Austrian School economists as the root cause of two evils facing economies: a) continuous expansion of money supply leading to ongoing inflation over time and b) the business cycle with its boom and bust patterns.

A simple antidote for higher inflation would then be to raise the minimum reserve requirements for banks to an appropriate level needed to pull money out of the economy. If banks cannot or will not lend more money than they have on reserve, an expansion of money supply would be contained. In fact, that is exactly what has been happening in recent months after the credit crisis. Banks have been sitting on cash but were not willing to lend it. Since then, general price levels have also been in check. Not only that, it would also have the nice side-effect of reducing debt levels and household leverage, perhaps one of the most crucial factors of the credit crisis. But of course, that would require complete (political) independence by the U.S. central bank - not just on paper, but in practice...

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