In my last post on March 2007, I mentioned that I did not intend to update the e-log commentary until I thought there was a situation where investors might be misreading something. I still believe that there is entirely too much noise in the media and among Wall Street firms that distract any sound minded individual from carrying out investment strategies. I think America’s investors are mis-reading something and we’re in a position to say something relevant now. I mentioned in previous posts that my real concern for the economy centered on consumer spending and savings habits:

“What’s slightly more disconcerting is that while consumer debt is higher than it’s ever been in recorded history, consumer savings is at its lowest point since 1933. Most Americans feel they can spend more, given the values of their homes; the biggest asset for most families has risen sharply in recent years. Aside from the worry of an asset bubble, the real problem is that our national savings rate is actually a negative number, meaning that Americans have spent all their disposable income, the amount left over after paying taxes, and dipped into their past savings to finance their purchases. One does not require much financial savvy to recognize that this is a trend that simply cannot continue for long.” (March 2006)  

And again in March 2007…

“For the most part, the US economic engine is firing on ‘most’ cylinders, businesses are doing well, unemployment is low and in spite of our current account and trade deficits, America is still the investment vehicle of choice for the rest of the world. So where is the problem? The problem is the same one that I wrote about last March. I’m still concerned about American spending and saving habits. For long-term economic health, US consumers need to be better savers and responsible citizens.”

As they say in the south, those chickens have come home to roost and eventually became ‘the third shoe’ that we were looking for in our last post. The consumer debt cycle has peaked and personal credit has dried up. With a decline in home prices, no longer can homeowners use their equity as an ATM machine. In October of 2008, consumer savings began to rise again and as recently as May of this year, consumer spending rose just 0.3%, while savings rose to 6.9%, the highest level since December 1993. Of course, economists are worried about a slowing economy as consumer spending drops while Americans repair their personal balance sheets. All in all, though necessary, it’s not such a bad pain to bear.

Source: National Federation of Independent Business

The events that warrant my current post, and where I think investor’s may be led astray is in our country’s current state of “hopenosis”, a combination of wild government expansion and fiscal irresponsibility with an overlay of false optimism spread by a fully partisan media.

Consumers seem to have awoken to their poor financial habits and have been measurably taking action, but they are certainly not paying attention to the future implications of current political and fiscal moves in our rapidly expanding government.

As I’ve mentioned in the past, it’s quite difficult to talk about the economy and fiscal policy without mentioning politics, since both are either regulated, or directly affected by politicians. So I’ll unapologetically dive right in and say- The ‘cause’ of my current concern begins with George Bush’s response to our economic crisis and ends with our current leadership. In deeming companies ‘too big to fail’, Bush cast aside one of the very distinctions that makes our country great- free market economics. Simply stated, when everyone who runs the race finishes first and no runner is allowed to fail, the race becomes far less interesting and the competition itself becomes suspect.

This move of course, was closely followed by the election of a young, intelligent, articulate and charismatic President named Barack Obama. Barack is a former member of ‘The New Party’, comprised of members of the Democratic Socialists for America, an offshoot of Communist Party USA, and has certainly championed Socialist policies, even openly declaring his intention to pass policies that redistribute America’s wealth to effect perceived ‘social injustices’. There is a point during this post that my liberal readers will begin to get angry, either not seeing Socialism as an anti-American ideology, or not recognizing corporate nationalization, redistribution of private wealth, or expansive entitlement programs as Socialist policies. For this, I will simply say that there is no gentle way to discuss the facts and that investing in and of itself, is a capitalist endeavor inasmuch as it is our end to seek and gain personal profits from our investments and that capitalism is the antithesis of socialism… they do not mix well.

Redistribution plans are occurring at a breakneck speed and most Americans are willfully unaware and woefully uninformed. In the recent American Clean Energy and Security Act, that passed in the House last week, its centerpiece is a “cap and trade” provision that has been rightfully disdained as ‘cap and tax’. It is in fact a tax on energy everywhere it’s consumed and on everything it is used to make or provide. It is the largest tax increase in American history- a tax on all Americans- even the 95% that President Obama pledged would never see a tax increase. Also buried in the bill, beginning in section 264, we see that further inner-workings of this bill are simply yet another entitlement transfer program.

This program, in addition to the pork laden stimulus plan, the proposed healthcare “reform act” and many others that the President has spoken about all rely heavily on borrowed dollars to rapidly expand government departments and balance sheets. For the portion that cannot be funded with borrowed dollars, there is now talk of a Value Added Tax (VAT) that taxes the same materials multiple times through the manufacturing process and whose costs will certainly be passed onto consumers. There is no logic in thinking that we can spend ourselves into prosperity, particularly while raising taxes during the worst economic crisis we’ve seen since the depression. The President views himself and his policies in a similar light as Roosevelt and the Works Progress Administration, falsely believing that it was the WPA that ended the depression. The current stimulus plan allows for $30 Million to study field mice in Nancy Pelosi’s voting district, $400k to study drinking and sex habits of homosexuals in Argentina and a separate $1.2 Billion in non-military aid to Pakistan. I’m not sure how these things are going to stimulate our economy, but will tell you that even if the WPA as a stimulus measure had ended the depression, there certainly weren’t earmarks on the level and direction that we’re seeing today.

Recently, political writer, Mark Steyn, summed up the problems with the current programs as such:

“The 44th president's multi-trillion-dollar budget, the first of many, adds more to the national debt than all the previous 43 presidents combined, from George Washington to George Dubya. The President wants Europeanized health care, Europeanized daycare, Europeanized education, and, as the Europeans have discovered, even with Europeanized tax rates you can't make that math add up. In Sweden, state spending accounts for 54% of GDP. In America, it was 34%—ten years ago. Today, it's about 40%. In four years' time, that number will be trending very Swede-like.

But forget the money, the deficit, the debt, the big numbers with the 12 zeroes on the end of them. So-called fiscal conservatives often miss the point. The problem isn't the cost. These programs would still be wrong even if Bill Gates wrote a check to cover them each month. They're wrong because they deform the relationship between the citizen and the state. Even if there were no financial consequences, the moral and even spiritual consequences would still be fatal. That's the stage where Europe is.”

Our recent economic crisis had a root cause of too much available credit and too much easy money, coupled with poor consumer habits. Yet the government’s strategy for dealing with the problem seems to be more of the same. The response, as Gerald Celente, director of the Trends Research Institute, describes “Phantom dollars, printed out of thin air, backed by nothing… and producing almost nothing… this defines our next big disaster- the bailout bubble.”

To compound the problem, the historical watchdog of tyranny and fiscal malfeasance, the media, has long since abandoned any sense of non-partisanship and merely reports those things that will be pleasing to the administration and happen to coincide their own agenda. This activity often occurs in state-run media outlets in Socialist countries and does not work well in a political system where citizens have the responsibility to shape their government by voting. To make honest situational assessments, Americans need to be able to know that the information they are getting is both factual and complete. Valuable points of criticism aren’t being reported via traditional media outlets and I believe there will be a significant disconnect in what Americans perceive to be occurring and what is actually occurring in our country.

Of course this type of “reporting” serves a purpose, as Larry Boone, from Barclay’s Capital states, ‘reassuring news’ is an effective antidote for social unrest. As an example, completely absent of economic evidence, the treasury recently reported that ‘green shoots’ of economic activity were beginning to sprout, but could not cite any specific examples that were independent of companies merely spending the stimulus or TARP (or TRAP) money they had received. A few reputable media outlets begin to notice the reports for what they represent. The Financial Times, stated in April, “Talking-up recovery prospects can make sense, economists believe. Expectations of better times ahead, if enough people believe in them, can become self-fulfilling.” Now even the weakest economist should clearly recognize this thinking as “Voodoo Economics”. And if the market relies on nothing but confidence (without actual economic data or progress), then it is a confidence game and the ring leader is a ‘con man’. Caveat Emptor.

Aside from the obvious connection about how these critical political points trickle into the economy and our own finances through earnings and taxation policy, they also affect investor’s abilities to make informed decisions at critical market junctures. For instance, we have recently experienced a 38% recovery from the March low, as illustrated in the chart of the S&P 500 below:

There is every reason to believe that after such a steep correction in 2008, the market should simply continue to rise. However, given a broader scope and more information, it’s easy to see why we continue to bounce against this resistance level of 950 that I’ve been talking about for the past month. The average investor may not understand that share price appreciation is not equivalent to economic recovery. Though the market is a forward looking indicator, it continues to look for good news. And while it may work well to mesmerize a crowd, the ‘hope and change’ rhetoric does not offer a full disclaimer as to what the final costs will be for government expansion and earmarks and most importantly, who will be paying the bill. Fortunately for us, the market knows and is often times more honest than the media.

When the crash of 1929 occurred, the market bottomed at 198.69 and over the next few months completed an amazing 50% retracement to 294.07 as illustrated below:

Source: Richard Russell

President Hoover declared that the worst had passed and there was an incredible sense of optimism, which was followed by headlines such as “Happy Days are Here Again!”

During this period of time however, things got progressively worse…

Source: Richard Russell

And still worse…

Source: Richard Russell

With the stock market bottoming out at 41.20 in 1932. Even as the market continued to recover, the economy did not. During the depression:

• 6,000 banks went out of business,
• 9 million savings accounts vanished,
• 85,000 businesses went bankrupt,
• 13 million people were unemployed,
• 400,000 farms were repossessed,
• 2600 schools were closed,
• 2 million men became homeless

Now I don’t tell you these things to indicate that I think we will be entering a depression, but to tell you that unchecked optimism can be extremely dangerous and coupled with dishonest reporting, it can lead to disaster. Misguided stimulus, taxation and fiscal policy will most certainly lead to either massive inflation or deflation. Governments cannot print the kind of money we have printed without implication.

I mentioned in my last post that we were in a stock picker’s market for the foreseeable future; this remains the case, but going forward, we intend to spend an exceptional amount of our focus on risk management. Regarding risk management measures, please call us if you would like to know more; I think it’s a story worth hearing.

We currently hold large cash positions in our discretionary portfolios for two reasons:

1) To protect profits taken after recent price appreciation.

2) I feel there is very little risk premia in taking new positions until we see the S&P breakthrough the 950 level on a closing basis. At this point, it’s more important not to lose money than it is to make money.

The growing chasm between political parties and ideologies seems to widen every day and regardless of my political thoughts, there are still some very good things the President can accomplish during his presidency. A cautious warning should be noted however; in the words of one client “If he continues to wage war on capitalism and those who create jobs and wealth” any social good that he may accomplish will be surpassed by lasting damage done to our economic system.