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.