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.