'Tis Only My Opinion!

November 2008 - Volume 28, Number 11

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Looking at the Challenges

While the Presidential election will change most of the political players, the basic problems facing the U.S. economy and others around the world won’t change significantly.  Macro factors impacting the word economy in the next few years include:


·         First, demographics continue to change the face of the old dominant cultures.  The G-7 countries are aging faster than the emerging countries.  The demographic changes will alter the political landscape of many countries through immigration policies that will effectively destroy the basic historical values of the society.  The increased demand for diversity in legal systems and acceptable languages is just one result of these changes.


·         Second, the Keynesian theory that governments could spend beyond their income might have worked when the U.S. had a strong currency that served as the world’s reserve currency, relatively low national debt and a GDP built on manufacturing and extractive industries. 


·         Third, the national debt is headed towards infinity, GDP is now largely based upon a consumer and service driven economy while the U.S. currency role as the world’s reserve currency is diminishing. Continuing increases in debt and money supply will fail to generate growth particularly in a deleveraging environment.  The world fiat money system is now headed towards a major adjustment and/or chaos.


·         Fourth, in a deleveraging environment, debt consumes equity until prices stabilize and trust and credibility are restored.  The unwillingness to allow the economic cycle to function in a capitalist society will end up destroying the capitalist society.  The economy is now learning the results of the “law of unintended consequences” caused by failing to understand what the “moral hazard” risks were.


·         Fifth, the failure of political leaders in the G-7 countries to understand the age-old conflicts arising from the basic differences between various religious beliefs, century old tribal customs, and personal responsibility and independence continues to create flash-points throughout the world.


·         Sixth, the centers of innovation and education are moving away from the U.S. and Europe to Japan, China and India. 


·         Seventh, globalization continues to increase and positive capital flows are generated where manufacturing and extractive industries exist which result in stronger currencies.


·         Eighth, those countries with high debt levels and lack of innovation will see increased relative interest rates and depreciating currency levels.

The Election Aftermath

Barack Hussein Obama was elected to be the President of the U.S. largely on a message of change, opposition to the Iraq and Afghanistan wars, a promise to stimulate the economy and a message of bipartisanship unity. His brilliant presentation oratory skills when using a teleprompter energized the electorate.  Despite a large electoral victory, it is impossible to ignore the deep divisions that exist between the rural and urban areas versus the major cities where the Democratic Party is dominant.  Any map of the election clearly illustrates the differences.

His campaign won despite Joe the Plumber. Rather it was Peggy the Moocher otherwise known as Peggy Joseph, a Sarasota, Florida voter who was mesmerized by Obama’s rhetoric of “redistribution of wealth” and believes like many others that:

“I won’t have to worry about putting gas in my car. I won’t have to worry about paying my mortgage. You know. If I help (Obama), he’s gonna help me.”

Whether Obama can accomplish those promises of a “free lunch, gas and a house” is uncertain for the following reasons:


·         His appointment of Rahm Emanuel as his Chief-of-Staff would seem to suggest that bipartisanship unity is already dead.


·         The campaign promise to cut taxes on 95% of Americans will be proven to be nothing but additional welfare.  Interestingly in many areas won by Obama, voters turned down a variety of measures which increased taxes.  If Obama eliminates the Bush tax cuts and increases taxes in the next term, the fate which befell Bush 41 after promising “read my lips, no new taxes” will descend upon Obama.


·         Many of the promised social programs including national health care and education will have to be pared back even if the military budget is reduced by 25%.  If the military budget is cut by 25%, expect wholesale resignations among top military personnel and a withdrawal of American forces from most of Europe, the Middle East, South Korea and Japan.


·         The new administration is likely to be tested severely by Russia, Iran or some other group within the first six months.  Obama’s response to that event will be critical to the eventual success and/or failure of his administration.  If he decides to take the Chamberlain approach, the odds are that he will lose significant support.


·         The status of illegal immigrants could well provide fireworks despite the downgrading of the issue during the campaign.  If amnesty is granted by Obama, expect problems to occur as evidenced by the grass-roots opposition to Bush 43’s proposal.


·         A protracted fight for same-sex marriage or repeal of Roe v. Wade decision on abortion is likely to further harden divisions within the political arena.


·         Foreign aid for almost all areas other than Africa and Israel will also be severely reduced.


·         Obama is expected to further increase the research budget for alternative fuels other than nuclear energy while simultaneously reducing coal-based energy production.  Ethanol production will continue to be subsidized while the off-shore and Alaskan drilling bans will be reinstated.


·         The changes in the makeup of the judiciary which have seen a large number of vacancies will tend to move the country seriously away from the Constitutional government formulated by the founders.  Obama will probably have at least three Supreme Court appointments during his first term.

The concentration of the public on the cost of energy and peak oil has overshadowed the very real concern that the supply of food is becoming critical throughout the world. Environmental regulation, costs of seed and fertilizer, lack of clean water and a reduction of productive land will converge to further restrict food supplies in the next decade.

The one thing that is certain is that the government share of GDP will increase and under Obama may surpass 50% due to increasing programs and a declining GDP. In 1947, the total government share of the economy was only 22% while as Bush II leaves office, it is about 43%. The correct term for big government is simply socialism and under Obama, we will continue to see more of it.

It is highly doubtful that the economic problems will enable Obama to win a second term. 

Obama’s International Problems

Obama has promised to withdraw U.S. forces from Iraq.  If he does, expect Iran to attempt to dominate the region and various Sunni and Kurdish allies including the Saudis will be concerned.  The U.S. can not allow Iran to move into the Kuwaiti and Saudi oil fields.  The Jordanians and possibly the Turks will bring pressure on Obama to not withdraw from Iraq. 

The Lebanon, Syria and Israeli tensions continue to increase.  With Iran possibly detonating a nuclear explosion last month, Israel is faced with a difficult decision about the nuclear capability of Iran.  Obama will have a difficult time of implementing a withdrawal of U.S. forces from Iraq because of the regional historical animosities.

Obama is also faced with the Afghan problem which he has stated is the real war.  The Europeans are not very supportive of the conflict and the global financial crisis will prevent them from providing much support.  Further, most European nations are woefully unprepared in both equipment and manpower to assist in any major way.  Obama can continue the war but unless he is prepared to widen the conflict into adjacent countries, he may only be able to reach a political accord with the Taliban.  If that happens, Obama’s supporters both domestic and foreign may begin to wonder about his resolve.

Obama will also be facing challenges from both Putin and Medvedev on both the economic and foreign policy fronts.  The Russian intervention into Georgia in August and the political realignment of the Ukraine clearly suggests that Obama is facing a Russian move to increase its sphere of influence. 

Obama could well ask the Europeans to resist the Russian moves.  However, the Europeans are in a difficult position as their energy needs are provided by Russia and the will to fight another cold war is lacking.  Moreover, NATO is basically a paper tiger and the talk of an EU military force is not credible based upon the historic differences in the EU.

While the Europeans were euphoric about Obama’s election, the hard facts are that the Europeans are in no position to provide troops and a revived NATO to confront the Russians. Further, the Europeans are probably unwilling to support a global financial system that doesn’t subordinate American financial authority to an international bureaucracy. Perhaps during the next decade, both militarily and financially, Russian influence may supplant American influence in Europe.  Remember, the U.S. has already moved the bulk of its military forces and supplies out of Germany and into the Middle East.

Obama like many elected officials simply fail to understand the “art of the possible” and the impact of the “law of diminished expectations.”  Moreover, in an extremely complex environment and society, it is almost impossible to understand how a change can work or what the “law of unintended consequences” will expose.

The U.S. Economy and Markets

However, it is easy to forget the size and resiliency of the U.S. economy.  The real question is if the crucible that created the “Greatest Generation” has been broken.

Corporate profits have been falling and until at least stabilization sets in, the outlook for the major indices remains difficult.  While the P in the P/E ratio can fluctuate, it is the E factor that is under pressure at this time.  With the new administration certain to increase the cost of regulation along with corporate taxes and possibly, an excess profits tax, it is difficult to see how corporate earnings will recover in the near-term.

A major portion of the financial crisis can be laid at the foot of politicians, the mortgage industry, investment banks, rating agencies, and institutions that bought mortgage-back security tranches that were unable to perform due-diligence or manage risk as well as investors who purchased homes thinking that prices would continue to go higher.

Just like the savings and loan crisis in the 1980’s, fortunes will be made by investors willing to purchase the distressed tranches at pennies on the dollar by actually looking at the collateral and payment histories.  Overall, most mortgages even sub-prime are being paid on a timely basis.  Even with the economy in a recession and a rising unemployment rate, not all of these mortgages will go under unless the government action encourages homeowners to cease paying their mortgages. The opportunity is there just like in the 1980’s to make a killing as those currently holding the “distressed paper” want out at any price.

The lack of transparency in the CDS market needs to be addressed immediately.  If it takes a shut-down of the entire market structure for a few days and/or weeks so that derivatives can be offset, that is the price required to restore confidence even if some banks and/or institutions go under.  It is more important to restore confidence than to continue to use taxpayer funds to bail out institutions whose management was instrumental in causing the financial crisis.

The major indices remain in a long-term bear market which began in 2000.  The rally that began in June 2004 and topped in October 2007 was simply a bear market rally.  The fall from the October 2007 highs is simply the second leg down in the bear market.

The question is then how to identify those sectors and/or companies that will produce profits or increased purchasing power for investors going forward.

Defense industries and coal companies are certainly ones that might be negatively impacted by the new administration. 

Companies in the solar and clean energy fields could well benefit although the tax credit for solar was extended for eight more years.  It is doubtful if nuclear energy will receive substantial report from the Greens.  Despite the many arguments against global warming that have surfaced recently, it would appear the new administration might achieve a ratification of the Kyoto Treaty.  It will be ironic if the Senate ratifies Kyoto just as the new Little Ice Age begins.

It should be evident that the consumer-driven economy in the U.S. is undergoing a change.  As credit availability dries up, consumers are redirecting their disposable income and savings will increase after credit is reduced.  Unfortunately, the reduction of consumer spending increases the deleveraging process.

Demographics suggest that home-health-care industries might find increased opportunities. Related health industries, however, might be negatively impacted by increased national regulation including pharmaceutical companies.

A basic problem for not only the U.S. but the world economy is that overall manufacturing capacity has grown greater than demand requires. For example, the U.S. auto industry annual production capacity is greater than 16 million when a replacement rate is probably only 7 million.  Likewise, housing could build 2 million units despite a requirement under normal lending standards of less than 1 million. 

If overseas workers are laid off because exports to the U.S. drop, political unrest in places like China, South Korea, Thailand, Malaysia, Pakistan and India could increase.  It is possible that the unrest could unseat governments.

To move beyond the current malaise, we need to be seeking the next “big thing.”  In decades past, it was the auto, TV, air travel, or the internet that sparked a significant change of direction in the economy.  It will be some new innovative idea, perhaps, nanotechnology, or microbiology or agricultural breakthroughs that will be that spark.  However, without innovation and access to capital, the time-frame will lengthen.


We are probably only about halfway through the major bear market. It would appear that the major indices are trying to find a bottom but the economic fundamentals are failing to provide the necessary inputs that would help in making that judgment call.

Once a base is formed at, or near, the bottom, I would expect that the market will be in a six to twenty-four month consolidation pattern with the possibility of a trading range of 20-30%.

We will continue to look to invest in companies that have rising sales and rising profits.  While we expect there to be fewer of them in the next six to twelve months, there will be opportunities for our portfolios.  We also believe there will be declines which can be successfully shorted. Overall, closely ratcheting stop-losses, and managing trading targets, will likely be critical for investors trying to outperform short-term deposit accounts.

With the financial crisis far from being over, prudent investors unwilling or unable to closely monitor their portfolios might want to stay on the sidelines.

As always, remember that the data you see is from the Ministry of Truth.  There is a considerable difference in making “decisions under uncertainty” and making “decisions using bad data.”  Wise and successful investors know the difference.

But then - 'Tis Only My Opinion!

Fred Richards
November 5, 2008

Corruptisima republica plurimae leges. [The more corrupt a republic, the more laws.] -- Tacitus, Annals III 27

This issue of 'Tis Only My Opinion was copyrighted by Adrich Corporation in 2008.
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Last updated - September 18, 2008