Friday, December 26, 2008

Reminders of My Father's Sermons

From the Desk of Joe Rollins

As many of you know, my father was a district superintendent for the Methodist Church, and he directly supervised over 120 rural churches in Southwest Virginia and Northeast Tennessee. On Sundays he would often travel to visit his churches, and since I was the youngest in the family I was often brought along for the ride. Many of the churches that we visited only had 15 or 20 families as members, and after the Sunday service my father would meet with the church’s minister.

Being a child, I most looked forward to the potluck picnics that took place after the business meetings on these Sunday ventures with my dad. Since I wasn’t required to attend the business meetings, I was usually the first person in the food line at the picnic. This was a plus since my favorite dish – fried chicken – was usually the first thing to disappear. It also meant I was guaranteed a slice of pecan pie, my dessert of choice. Life was definitely simpler for me in those days…

It’s funny how certain events bring me reeling back to memories of my father. For instance, I thought I had a good deal when I bought my very first home in 1975 in Decatur, Georgia for $32,000. At that time, interest rates on home mortgages were at approximately 11%, which actually seemed relatively low given the high inflation rates in the mid 1970’s. As you may recall, this was just after the oil embargo of 1974. When I proudly went over the details of my home purchase to my father, he reminded me that after World War II, he was able to obtain a mortgage loan at 5% interest. Isn’t it interesting that 65 years later, you can actually get mortgage loans at lower interest rates than what my father was able to obtain just after World War II?

All of the recent talk in the media comparing our current scenario with the Great Depression has reminded me of some of my father’s sermons. The sermons that resonated most with me concerned events that he had lived through himself. Of course he spoke of religious events in his sermons, but I was always captivated when he spoke of more recent events when preaching. Two topics in his sermons that I found particularly interesting concerned the bombing of Pearl Harbor and the death of Franklin Delano Roosevelt.

When speaking of Pearl Harbor in his sermons, my father spoke of what a terrifying and trying time it was for Americans. As Americans were coming home from church on Sunday, December 7, 1941, they found out that the Japanese had unilaterally attacked the U.S. naval base at Pearl Harbor. Hawaii was not admitted to the Union until August of 1959, but because it had been a U.S. territory for nearly 60 years, it was considered to be part of the United States. Until the bombing of Pearl Harbor, the U.S. had basically been neutral in World War II, although we were steadily increasing embargoes and sanctions after Japan’s expansion into French Indochina. The day after Pearl Harbor was bombed, the U.S. declared war on Japan and subsequently, on Germany. Considering that Pearl Harbor wasn’t actually a part of the U.S. Union at the time of the attack, there have been only a few very minor attacks on U.S. soil since the mid 1800’s with the exception being September 11, 2001.

My father also liked to talk about President Franklin Delano Roosevelt in his sermons. As many know, FDR was elected to four terms in office as U.S. president – the only U.S. president to have served more than two terms – and he was beloved in America and throughout the world. FDR served from 1933 to 1945, during the Great Depression and during World War II. His unexpected death on April 12, 1945 left the nation in shock and in grief.

The other night, I watched a three-hour special on FDR on the History Channel, which took me reeling back to my father’s sermons. I learned an enormous amount watching the show that I hadn’t known before. Much of it had to do with economics during the Great Depression and the general state of FDR’s health. I had always heard that the real turn in the Great Depression occurred when FDR was elected in 1932 and instituted a massive public works program called the “New Deal” upon entering office in 1933. It was my understanding that this flood of spending by the Federal government on these public works programs during the Great Depression was what allowed economic recovery and prosperity. As I will explain later, the impression I had was woefully incorrect.

I also remember my father’s impression that FDR died suddenly and without warning. While his declining health had not been released to the general public, he had been looking old, thin and frail in the months leading up to his death and it was common knowledge to those close to him that he was not in good health. In fact, one of his secret service agents exclaimed that at the time of FDR’s death, he was just a shell of a person in a big suit. His body had deteriorated to the point that his eyes were sunken and he suffered almost constant debilitating pain. But the public at large was never made aware of FDR’s increasing health issues. On the afternoon of April 12, 1945, FDR died of a massive cerebral hemorrhage after complaining of a terrible headache. It seems strange today that the health of the most important political figure in the world was hidden from the public. Today, no one in public office has any secrets.

As you can see below in the chart entitled, “U.S. Unemployment vs. Dow Jones Industrial Average: 1925-1945,” when FDR took office in 1933, the unemployment rate in the U.S. was a staggering 25%. While the rate declined to 14% in 1937, it increased again from 1938 to 1940 to rates between 15% and 20% before declining to rates below 5% in 1942 with the start of World War II. Comparing the unemployment rates of the Great Depression to our current unemployment rate of 6.7%, you can see the incorrect comparisons being made by the media concerning our current economic environment and that of the Great Depression.

The chart also illustrates my misperception of the success of the New Deal, leading me to perform some research to determine why it was unsuccessful. FDR was an old-fashioned politician who believed that the government shouldn’t spend money that it didn’t have, which makes sense theoretically, but really doesn’t work. And so, even though FDR wanted to do public works projects, he didn’t want the government to borrow money to make these projects work. Therefore, from 1933 through 1940, the Federal government didn’t borrow any money in an effort to stimulate the economy.

Additionally, the Federal Reserve System believed that it shouldn’t interfere with banks and instead allowed those that were unsuccessful to fail, causing thousands of bank failures in the United States during the 1930’s. Comparatively, 25 banks have failed in the U.S. during 2008. Also, since the Federal government was not collecting as much tax revenue due to the poor business environment, Congress – in its misplaced wisdom – increased taxes on an already failing economy. The combination of no deficit spending, a Federal Reserve that was draining cash out of the system and higher income taxes led to almost a decade of high unemployment and devastating economic conditions in the United States.

In early 1941, the United States was forced to enter World War II. At that point, we had no choice but to use deficit spending to create the armaments necessary to fight the war on two fronts. I’m sure all of you have heard about Liberty selling war bonds – these are now known as the U.S. government-guaranteed bonds that we read about in the papers today. As you can see from the chart, once the government began deficit spending, the unemployment rate fell dramatically in the early 1940’s. Coupled with the enlistment in the armed forces and the manufacturing necessary to make war products, the U.S. economy moved into high gear with virtually full employment in 1944 and 1945.

This chart also shows the Dow Industrial Average for the years of 1925 to 1945. As you can see, the market crashed in 1929 and continued to go down through 1932. It then rallied upward, even in spite of the most horrific economic news possible. After a downturn beginning in 1936, it began moving upward at the beginning of World War II. This chart is on the Dow Jones Industrial Average only; it doesn’t include dividends. In any case, those of you who believe that it took 25 years for the stock market to recover after the crash of 1929 can plainly see that that’s not the case. If you include reinvested dividends in the average, the full value of the 1929 crash was recovered in approximately 10 years.

I am writing this to illustrate that the Federal Reserve’s action this fall relatively assures us that the economy will snap back rather quickly. As noted on the chart above, the economy continued to struggle with no improvement during the time that the Federal Reserve was not deficit spending. However, immediately after the Federal Reserve began borrowing money and pouring it into the economy, unemployment decreased and the stock market exploded upward. The chart above clearly demonstrates the dynamic impact of flooding the economy with cash. Not only is the effect positive, it is also incredibly fast.

Over the last several months, I’ve been discussing the Federal Reserve’s techniques for putting money into the economy. Interest rates have been reduced to virtually zero, and the Federal Reserve has also used their open market capabilities to fund and purchase distressed assets from banks and become the lender of last resort for a frozen economy. The Fed has additionally pumped money into virtually every business in need of short-term liquidity. It’s now estimated – probably conservatively – that the Federal deficit for 2009 will be close to $1 trillion. While that number is enormous, it is necessary in reviving our economy and recreating the confidence required to move the U.S. economy forward.

I have also provided a chart below of the Federal Reserve’s money base entitled “St. Louis Source Base: Billions of Dollars: NSA.” All the money in the U.S. economy begins with this base of cash generated by the Federal Reserve System. Please note that the chart moved up gradually from 2002 through 2008 before it exploded and virtually doubled over a relatively short amount of time. As you can tell, the actions by the Federal Reserve today are completely different from those taken during the 1930’s. In the 1930’s, taxes were increased, cash flow was decreased, the money supply was decreased and the government did not utilize deficit spending. In 2008, however, taxes were decreased, the money supply was increased to the point of explosion and deficit spending was used to create commerce. Those of you who fear that this recession will be prolonged just do not understand the dynamic impact of flooding our economy with this much cash.

In my last post, I tried explaining why the Federal Reserve System is making cash the equivalent of trash as it pertains to investing. If you haven’t read that post, here’s the link – Cash Is Trash. Some readers questioned what safe alternatives there are to CD’s, money market accounts and other investments of that nature. Something that always escapes me is why someone would be willing to invest in a money market account making less than one-half of 1% annualized when there are viable alternatives.

For example, you can currently purchase something like Consolidated Edison, which has an annualized return on dividends of 6.1%. Utility companies have no competition since they are a monopoly in the New York area. Even more interesting is that the almost miniscule interest being earned on money market accounts is taxed at a maximum rate of 35%. Dividends earned from Consolidated Edison are only taxed at 15%. Which seems like a better investment to you? I can almost understand the reluctance to make such an investment if the rates were similar, but when you can earn almost twelve times the rate of return with the very conservative investment of Consolidated Edison as compared to a money market account and also enjoy a significant tax benefit, then further analysis at the very least seems to be warranted.

It seems like the media has become the proverbial Grinch that stole Christmas. I awoke this morning to another depressing headline on Yahoo: “One in Five U.S. Adults Have More Credit Card Debt than One Year Ago.” I suppose it would’ve been a reach to explain that four out of five adults had less credit card debt than one year ago. Leave it to the media to emphasize the negatives, but maybe I suffer from “glass half full” syndrome.

It also seems like everyone is proclaiming that this Christmas season will be the worst for retailers in over 40 years. From a totally unscientific standpoint, every retail operation I’ve visited over the last month has been tremendously busy. It wouldn’t surprise me to see the figures in January reflect that retail sales are flat – not negative – for December.

As we get through the holiday season and investors once again have the confidence to open their investment account statements, I hope they will closely evaluate the investments that offer the opportunity to earn many times the rate of return currently offered for cash. Just as the Federal Reserve wants you to believe, cash as an investment is poor as compared to higher yielding investments that have very little risk attributes. Once this tremendous supply of cash is reinvested, the stock and bond market will get back to its normal range and the potential for profit will be enormous.

We wish you and yours very happy and healthy holidays.

Best regards,
Joe Rollins

Saturday, December 20, 2008

Cash Is Trash

From the Desk of Joe Rollins

It sure seems like our government is trying to convince us that “cash is trash” these days. In a time of incredible financial uncertainty, it appears that many investors feel more comfortable being in cash than in other types of investments. Cash seems to give investors a level of comfort that other investment classes just don’t seem to be able to provide. But I always find it ironic that people will flock to the malls to purchase clothes that are on sale while the average investor tends to avoid stocks at all costs when they are on sale.

There’s no question that the government is encouraging investors to take more risk and invest in stocks and higher yielding bonds. The interest rates being paid by government-guaranteed debt are staggering. The Federal Reserve System clearly has a plan: They are attempting to make cash so unattractive from an investment standpoint that even the most unknowledgeable investor will redeploy their cash into something that has the potential for a higher rate of return.

It may be hard to believe that as of this past Thursday, the benchmark 10-year Treasury bond sank to an annualized yield of 2.078%. That’s the lowest rate on a 10-year Treasury bond since November 1, 1977. A common barometer for mortgages is that they are priced 1.5% higher than the 10-year Treasury. Using the yield from Thursday, it’s possible that we might see a new mortgage rate at 3.6%. If we saw a 30-year mortgage at 3.6%, it would be the lowest ever recorded in the history of the United States.

You may recall my suggestion from a few weeks ago that the Federal government could solve the real estate issue in the United States by offering long-term mortgages at 4%. At the time I wrote that post, it was actually a stretch to get the rates down to 4%. Based upon yields from Thursday, however, it is not only possible, but it is likely that rates could soon be at 4%.

Even more astonishing than the rate on the 10-year Treasury bond is Thursday’s rate on the 30-year bond. It was only last Saturday that I wrote that the 30-year Treasury had briefly traded at the unbelievably low rate of 3%. Only five trading days later, the 30-year Treasury is yielding 2.547%. This is an extraordinarily low rate by any definition.

As I mentioned a few weeks ago, it would be very simple for the Treasury to enter the open market and issue 30-year Treasuries at 2.547% and then inject that money into Freddie Mac and Fannie Mae to make 4% mortgages available almost immediately. The Treasury hasn’t announced that they will do this yet, but I feel relatively sure that they’ve read my posts and that this will almost assuredly come to fruition at some point in January.

There is currently $3.76 trillion in money market accounts across the United States. Money market accounts are averaging a return of 1% per year, but this rate is falling dramatically and some of the major banks are already quoting money market rates at 0.2% on an annualized basis. It is hard to imagine why so many investors are willing to accept an almost minuscule rate of return.

I find it fascinating that almost 60% of the entire value of all traded securities in the United States is currently in money market accounts. Traded securities now approximate $7 billion after the significant haircut they’ve taken in 2008. Money market accounts now represent over one-half of the value of all the listed securities in the United States.

There is, of course, a major negative to the public concerning lower interest rates. Older investors who depend upon CD’s and other investments of this nature can no longer earn very good rates with these investment types. To support their lifestyles, even these investors will be forced into looking at alternative investments that will offer them a higher rate of return.

This past Tuesday, the U.S. Federal Reserve System announced that their overnight lending rate would be decreased to 0.25% annualized. On Friday, the Bank of Japan announced that they would be reducing their overnight lending rate to 0.1% annualized. I want to make sure that everyone understands that I’m not talking about 1% annualized; I’m talking about one-tenth of 1% annualized. Therefore, all of the banks in the United States and Japan can essentially borrow the money for nothing from the government. The U.S. prime rate is currently 3.25%. It doesn’t take a genius banker to figure out that they can borrow money from the Federal Reserve at zero and loan it to the general public at the rate of prime and earn a 3.25% spread on the use of the Fed’s money.

Those who argue that the reduction in the rate of prime means nothing to the average consumer are wrong. It may mean nothing to the traders on Wall Street, but it means a great deal to Main Street. Virtually all equity lines-of-credit enjoyed a rate reduction in 2008 from the prime rate of 7.25% at the beginning of the year to the incredibly low current rate of 3.25%. Almost all credit cards now have some sort of index off the prime rate. Coupled with the enormous reduction in fuel costs and the significant reduction in interest rates, almost all consumers have enjoyed a quasi-tax reduction in the last few months. The significant cash flow to the consumer in the reduction of gas and interest will ultimately improve consumer spending.

Even with the incredibly low interest rates illustrated above, the Federal Reserve doesn’t seem to be satisfied. On Tuesday of this week they announced that they would enter the open market and repurchase their own Treasury debt. The Federal Reserve’s purpose in taking this action is two-fold: First, it further forces down interest rates on this debt. Again, the government is trying to force investors in cash to redeploy that money into higher yielding investments. Second, and most importantly, the Federal Reserve System is trying to flood the economy with cash. Every time the Federal Reserve purchases security instruments, it replaces them with cash.

An investor previously thought that he was in a great long-term investment guaranteed by the government at a high rate of return. But the next day he finds that his bond is gone and that the government has replaced it with cash. Given that the alternative for investing that cash probably means an annualized return at less than 1%, then it is highly likely that this money will find its way back into stocks and bonds.

My purpose in providing you with the foregoing is not to focus on open market actions by the Federal Reserve. Rather, it’s to illustrate why the government is forcing interest rates so low. An important byproduct of these actions will be mortgages that will be available within the next six months that have never been available in this country before. These low mortgage rates will make homeownership available to virtually all Americans. With small 3.5% down payments on FHA loans, homeowners will be able to purchase homes with government-guaranteed mortgages as long as they have reasonable credit and are employed. Coupled with the new Federal tax credit of $7,500 on a new home purchase (a 15-year no interest loan to eligible taxpayers), buyers will be able to make a down payment and qualify for loans. With loan interest rates, anyone who can afford an apartment in America should be able to own a home.

The second benefit of these incredibly low interest rates is that it makes investors realize the folly of investing in cash. Today a one-month Treasury bond is yielding exactly zero percent. It will not be long before money market funds, based upon Treasury yields, will be negative. Additionally, taxable money market funds will continue to fall and before long all will be returning less than one-half of 1% annualized.

The day will soon come when investors realize that their cash is returning nothing and they decide to reinvest their capital in stocks and bonds. When this finally occurs, the $3.7 trillion currently invested in money market accounts will create an unprecedented rush of buying. It will be the most spectacular bear market rally ever recorded. I wish I knew exactly when that will happen – it could be a week, a month or even six months. The timing is clearly uncertain, but the fact that it will happen is now assured.

Clients often ask me why we do not sell out of stocks and bonds and put the money in cash until things recover. Quite simply, the explosive rally that will occur once the cash in money market accounts is reinvested will happen without warning. If you are not invested now, then it is likely you will miss that opportunity. Frankly, we don’t want to miss out on that opportunity and that is why we remain invested at all times.

With the holidays and the end of the year just around the corner, we realize that 2008 has been a difficult year. We greatly anticipate 2009 to be significantly better, and in fact, given all of the actions by the Federal Reserve, it could be a record year by all investment standards. We hope that you have enough confidence to participate in that recovery.

In the meantime, we wish each of you and your families a wonderful holiday season. We look forward to working with you in 2009.

Best regards,
Joe Rollins

Saturday, December 13, 2008

"What We've Got Here Is a Failure to Communicate"

From the Desk of Joe Rollins

When thinking about the economy lately, I’ve found myself being reminded of Paul Newman’s character, Luke Jackson, in the 1967 film classic, “Cool Hand Luke.” For those who are unfamiliar with the movie, Luke was a spirited inmate in a Florida prison camp who refuses to conform to the system. To the aggravation of the prison Captain, but to the delight of the other prisoners who idolize him, Luke cleverly escapes time and time again only to be captured and returned to the camp.

In one scene, Luke has been caught again after unsuccessfully breaking from the chain gang and makes a characteristic wisecrack to the Captain. The infuriated Captain strikes Luke with his baton, forcing him to fall and roll down a hill. While Luke remains hunched over in the ditch, the Captain declares: “What we’ve got here is a failure to communicate.”

In another famous scene, Luke has a boxing match with Dragline, another prisoner played by the great George Kennedy. Dragline is three times as big as Luke, and easily knocks Luke down with every blow. But Luke will not give up – he manages to get to his feet after every knockdown, even though Dragline implores him to stay down since he’s so badly beaten. With Luke still swinging away, Dragline finally just walks away.

The U.S. economy has been reminding me of Luke Jackson lately. There is no question that the economy is terrible right now; there’s no question that consumer sentiment is at an all-time low, and; there’s no question that the stock market has been severely impacted by the economy and consumer sentiment. In spite of those beatings, the economy keeps standing up and fighting for its ongoing recovery.

It seems that all of the positives we presently have in the economy are failing to be communicated to the general public. For example, this morning the Department of Commerce reported that – excluding car and gasoline sales – retail sales were actually up in the month of November. How many times have you heard over the last weeks and months that retail sales are expected to be terrible because consumers are tapped out? Why is there such a diversion between the news we hear on TV and the actual facts?

It was announced yesterday morning that European corporations issued more bonds during the month of November than in the entire history of debt in European bonds. Why do we only hear that there is a lack of credit availability when an entire continent is establishing records in the issuance of new debt?

As I write this post, the S&P 500 is essentially flat for the month of December. The news has been dreadful lately, and because of that, the public’s presumption is that the market has been down enormously in December. However, the facts truly do not support that perception. There’s no doubt that the market has been extremely volatile and that the down days have been more dramatic than the up days. Regardless, a foundation has indisputably been established that reflects we are working in a positive vein in trading. The financial news may not tell you that, but the facts are undeniable.

This past week, it was announced that Federal Reserve Chairman Ben Bernanke intends to start issuing bonds through the Federal Reserve System. Not Treasury bonds, but bonds from the Federal Reserve System itself. Many people wonder why the Federal Reserve System would actually need to reduce the money supply with all the money currently being injected into the banks. As I have explained before, the way the government reduces the money supply is by forcing member banks to purchase bonds. After a bank closes for the bank and before they reopen the next day, bonds replace their available cash, leaving the banks without liquidity during that timeframe. Without liquidity, the banks are unable to extend credit and reduce inflation.

Although this didn’t receive much publicity, it’s clear to me that the Federal Reserve’s purpose in issuing bonds through the Federal Reserve System is to reduce cash in the system. There is such an enormous amount of cash floating the financial system at the current time that the Federal Reserve is anticipating severe inflation issues in the future. I find it somewhat strange that the Federal Reserve would be concerned about inflation when all you hear about in the financial news is the possibility of deflation. The money supply has grown over the last 12 weeks to $317 billion. Annualized, that is $1.373 billion. That kind of money growth is unprecedented!

I also can’t help but notice that interest rates continue to fall. In previous posts I have discussed the three-month Libor rate, which was at one time a severe detriment to interbank lending. Earlier, the three-month Libor was at 6%, but today that rate has dropped all the way down to 1.92%. The credit market has dramatically improved over the last several months, but that would be nearly impossible to tell by watching the financial news alone.

For a moment on Friday, the 30-year Treasury bond actually hit the 3% level. This is an all-time low for the 30-year U.S. Treasury bond. As I’ve pointed out in prior posts, this is the vehicle that will bring back the residential mortgage industry. It’s easy to illustrate how this process would work for the government:

The Treasury would enter the open market and sell 30-year Treasury bonds at 3%, and then they would turn the money over to Freddie Mac and Fannie Mae to distribute long-term mortgages to new homeowners and to refinance mortgages at 4%. Even though the government would have to pay the interest at 3% on the debt, they would still be earning 4% on the money. This one step alone would provide the opportunity for rescuing the residential home market early in 2009.

I continue to hear the so-called experts recommend that investors buy 10-year Treasury bonds, which today are at 2.58%. It is almost a given due to the liquidity currently in the system by the government that inflation will accelerate in coming years. It is highly likely that in a few years, inflation will far exceed the 2.58% coupon rate on this U.S. Treasury bond.

If an investor wants to sell this bond anytime during the 10-year period, it is highly likely that they will lose principal. For example, if current interest rates on a 10-year Treasury were at 4%, then when you attempt to sell this bond with a coupon of 2.58%, you will lose approximately 40% of your principal balance. How any knowledgeable investment advisor could recommend to their clients that they should purchase an instrument that cannot be profitably sold during its term – and one that will unquestionably have a negative rate of return – defies logic.

Much has been said about the potential risk of the TARP funds potentially costing taxpayers billions of dollars. It seems that few people are giving credit where credit is due. The current five-year Treasury rate is 1.56%. The economics of the TARP money is relatively simple: the TARP money invested in the financial institutions has a five-year window. The Federal Reserve borrows money from the general public in the open market at 1.56% and then invests it in banks earning 5%. There’s almost no chance that this TARP money will not be a net positive for the Treasury at the end of five years. However, in the last week I have heard numerous politicians and commentators express dismay over the billions that were wasted in bailing out the banks. Statements such as those are nothing short of blatantly false!

On another matter, the financial press reported yesterday that a top Wall Street broker, Bernard L. Madoff, was arrested for fraud to the tune of $50 billion. Madoff is a former NASDAQ chairman who has had an almost 50-year career trading on Wall Street. It seems like the bad news just keeps getting worse…

According to the FBI, Madoff’s investment-advisory business “deceived investors by operating a securities business in which he traded and lost investor money, and then paid certain investors purported returns on investments with the principal received from other, different investors.” The SEC said it was an ongoing, multi billion-dollar rip-off and they asked the court to confiscate the firm and its assets.

It should be emphasized that Madoff’s investment-advisory firm is operated completely differently than Rollins Financial’s. The funds in our clients’ accounts are maintained at an independent custodial firm – either Charles Schwab & Company or Fidelity Investments. Our clients receive statements on a monthly basis from the independent account custodian, and clients have access to analyzing their accounts through the custodian at any time. This is materially different than the way Madoff operated his investment-advisory business.

At Madoff’s firm, all of his clients’ money was commingled making him able to pay returns to some clients by using new money coming in from other investors. Madoff himself referred to his actions as “a giant Ponzi scheme.” While Madoff’s actions are devastating to his clients, it will have no effect on the future of stock market investing as a whole.

Rollins Financial has no commingled money in our clients’ portfolios, nor do we even have the ability to commingle our clients’ portfolios by virtue of using Schwab and Fidelity as independent account custodians. Therefore, the risks associated with being a client of a firm like Bernard Madoff’s are not inherent in our business model.

I recognize that 2008 has been a disaster for the financial markets. However, there is a significant fix in place. The government is doing everything necessary to create liquidity and to improve the financial markets. You may not hear about this in the financial press, but there is evidence everywhere that the coordinated worldwide efforts to improve the economy are working. Why the general public believes it is not working has more to do with the financial press’s failure to communicate all the facts.

There is no question that nearly all economists are forecasting a turnaround in the economy sometime during 2009. Today we are only three weeks from the beginning of 2009, and I only wish that the general public could take a good, hard look at the positive effects of the rush of liquidity before making a decision that will harm their financial security for years to come.

Saturday, December 6, 2008

Blast From the Past

From the Desk of Joe Rollins

When President-elect Obama announced his financial consultants last week, I felt a “blast from the past.” One of those consultants is the 81-year old financial giant and former Federal Reserve Chairman Paul Volcker. Many have called Volcker a “giant,” but they’re often referring to his physical size and not his standing in the financial community. However, I have always had great respect for him since he was willing in the 1980’s to take the political heat for his controversial efforts to improve the economy, which ultimately led to an economic boom that arguably continued until this year.

Much can be learned by Volcker and the mistakes made by his successor, Dr. Alan Greenspan. Everyone knows that if you don’t learn from the past, you’re destined to fail in the future.

It may be difficult to imagine, but Paul Volcker used to testify before Senate while smoking a large cigar. His physical size – all 6 feet 7 inches – dwarfed the desk he sat behind. He looked as if he was sitting behind a grade school desk! In many cases, the hearings became extremely confrontational, but the giant in the room never backed down, not even for a minute.

When Ronald Reagan was elected President in 1980, inflation was in the double-digits. The United States – while under the economic direction of President Gerald Ford and President Jimmy Carter – was bordering on hyperinflation and suffering from a lack of public confidence. Federal Reserve Chairman Volcker convinced Reagan that tough medicine needed to be administered in an effort to cure the economy and for business to move forward. In the intervening years, the Federal Reserve increased the prime rate of interest all the way to 20%. Coupled with the tax cuts pushed through Congress by President Reagan, economic prosperity ensued for nearly 20 years.

Volcker recognized that the economy had to endure the bitter pill of higher interest rates and lower expansion in order to recover. He was a giant of a man in that he took the political pressure from Congress in order to cure the economy. Interestingly, Paul Volcker is a long-time Democrat (even though he never discussed his political affiliation during his years as Federal Reserve Chairman) who was able to successfully work with a Democrats and Republicans alike. It has always been interesting to me that the thanks he got for doing such an excellent job as Federal Reserve Chairman was being replaced by Dr. Alan Greenspan in 1987.

Dr. Greenspan’s first action as Federal Reserve Chairman was to increase interest rates dramatically, creating the stock market crash of 1987. After that, he slowed down the growth of money and choked off the economy, creating the recession in 1990. He created a poor economy by slowing money and creating higher interest rates, which effectually guaranteed the election of Bill Clinton. Ironically, by the time President Clinton entered office, the economy had already started recovering and we had several great business years.

After September 11, 2001, Greenspan lowered interest rates and kept them at such historically low levels that they helped to create our current economic crisis. In many respects, the financial chaos that we’re seeing today is directly attributable to the actions of Dr. Alan Greenspan.

Arguably, Greenspan’s actions were some of the major factors responsible for the election of Barack Obama, a Democrat. Isn’t it ironic that a lifelong, staunch Republican, Dr. Greenspan, was instrumental in getting two Democratic presidents elected?

There’s no doubt that these are extraordinary times. The last 90 days have been incomprehensible – not to mention excruciating. Nearly every day a new record is established either on the upside or the downside. Here are some examples of recent astounding events:

Today the 30-year Treasury bond is quoted at 3.04%. In my post from two weeks ago, “Fixing the Housing Crisis,” I wrote that the 30-year Treasury was yielding 3.48%, which was a 50-year low on the 30-year Treasury. Today, it’s only 15% better – in two weeks!

A two-year Treasury bond today is yielding 0.8% annually – not 1%, but 80% of 1%. Therefore, you could invest your money with the Treasury for two years and basically get nothing more than the amount of your original investment. Rates this low have never been seen before in the United States.

The Bank of England reduced their equivalent to the Federal Funds Rate this week to 2%. This is the lowest rate for the Bank of England since 1951 and matches the lowest since 1694! The European Central Bank (the “ECB”) reduced their benchmark interest rates 2.5% annualized. This is the lowest rate ever for the ECB.

The U.S.’s federal funds rate is presently 1% annualized. The Federal Open Market Committee (the “FOMC”) meets next week, and there is wide speculation that they may reduce the federal funds rate to 0.5% annualized. If they do, that will be the lowest rate ever in the United States.

In June of 2008, a barrel of oil was selling for nearly $145. A barrel of oil is selling today for $41. Therefore, in only five months the price of oil has declined almost 72%. In actuality, not only has oil decreased in price, but a broader list of commodity prices has also been cut in half. A period of disinflation is occurring everywhere at the current time. What makes this so remarkable is the speed at which these changes have occurred.

It is important to understand that stock market investing relies heavily upon interest rates. The lower interest rates become, the more attractive stocks are. With money market accounts at major banks now generating less than one-half of 1% annualized, we will soon see a tremendous movement away from commercial money market accounts into the stock market by investors seeking higher returns. The only superior alternative to money market funds is stock market investing.

Also this week we received word that the Federal Reserve is proposing a major program to offer new home mortgages at 4.5%. It appears that the Federal Reserve read my “Fixing the Housing Crisis” post, where I suggested exactly the same program. In my post, I recommended that mortgage interest rates be cut to 4% given the rate on the current 30-year Treasury bond. The Federal Reserve recommended a 4.5% rate, but that included the fees for brokers and other closing-related expenses. Because the 30-year Treasury bond has fallen to such a low level, it should now be doable for the Treasury to offer mortgages at 4.0%. I would appreciate it if Dr. Bernanke would give me some credit for the idea...

If this program is approved, it would make homeownership available to almost all Americans. In theory, any credit worthy individual who can afford rent would be financially able to purchase a home at a price within their means. This program will be totally different from the sub-prime mortgage fiasco. The rates on these loans will be fixed for 30 years and will only be extended to credit-deserving individuals. This will not only benefit the homebuilding industry but also the homeowners themselves. I cannot envision a more win-win situation.

Just two weeks ago in my post of November 22nd, I indicated that stocks had gotten so cheap that it was worth looking into purchasing some, especially General Electric and Goldman Sachs. As mentioned in that post, General Electric was at $12.84 per share and Goldman Sachs was at $52 per share. Those same two stocks are selling today for $18 and $70, respectively. Accordingly, General Electric has had a total gain over the two-week period of an astonishing 40% and Goldman Sachs is up a cool 35%. I know it’s hard to believe that these gains occurred in only a two-week period, but I want to assure new investors that these are not normal times.

I understand that the news on the economy is terrible; that is not unusual during a period of severe economic contraction. But I am also sure that the time to invest in the stock market is when things look grimmest. I cannot imagine things looking grimmer than they look today.

The purpose of today’s post is to illustrate that things really are getting better. Interest rates have decreased dramatically and credit is becoming more and more available. The Federal Reserve is buying mortgages and credit card receivables. The new program to directly fund homeownership will make a dramatic difference. There will be a significant positive turn in confidence when some of this money starts reaching the consumer.

The public in general and Wall Street in particular should appreciate the appointment of President-elect Obama’s financial team. Each and every single appointee is experienced in the hard knocks of the financial world. It is encouraging to see that there will be a smooth transition of power between the Bush administration and the Obama administration. In fact, some of the key positions are actually holdovers from the Bush administration.

When public confidence is restored, there will be a rush for those who are currently invested in low yielding money market funds to get back into the stock market. It’s hard to even imagine another period of time where an investor felt more comfortable being in a money market account paying one-half of 1% per year, taxed at 35%, instead of owning stock in something like Southern Company, which is now paying a dividend of 4.6% annualized at a tax rate of 15%. One day soon these money market funds will migrate back to the stock market, which will create a spectacular buy of stocks.

The issues regarding the U.S. economy today have not been solved, but never in the history of finance has there been such a coordinated worldwide attempt to stimulate the economy. It is estimated now that the U.S. and other countries will be injecting close to $4 trillion in new liquidity over the next 12 months. This influx of money will create better credit, more jobs and higher income to consumers. The inevitable result will be higher stock prices!

I find it incredibly ironic that the culprit of the current bad economy is the consumer. For years and years, the financial press criticized consumers for spending and borrowing too much. In mid-September, when they announced that all the banks were suffering severe financial difficulties, consumers rightly shut down and quit spending. Purchasing items like automobiles came to a halt, and consumers were only purchasing necessities. I keep hearing that consumers are deleveraging, but I honestly think they’re just being conservative.

The end result is that because consumers weren’t spending, the car companies suffered, the retail stores had poor sales, and people got laid off. In real terms, a bad economy was created by bad publicity. No one will ever know whether the economy would have survived without all the negative press, but I cannot at this point believe that the economy is really as bad – or will stay as bad – as the financial press touts.

A broad band of economists is currently projecting positive economic events by the second half of 2009. Stock markets tend to rally approximately six months prior to the economy improving. Given that six months is in January of 2009, we should be looking for better financial results shortly.