"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.

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.