US Economy

As is well known now, Federal Reserve transcripts released last week confirmed that Fed Chairman Bernanke was caught unaware by the brewing mortgage storm that rocked many of the banks his Fed is charged with overseeing. As Bernanke put it in 2006, "So far we are seeing, at worst, an orderly decline in the housing market." Bernanke went on to note that a cooling of the housing boom was a "healthy thing." Fed critics from the left and right will doubtless seek to use Bernanke's utterances as weaponry meant to further discredit a Fed Chairman who is expert at always being wrong, but they'd be unwise to do so. Instead, they should use Bernanke's musings to explain in more confident terms why the Fed's presumed regulatory mission is a total contradiction.

Thanks to an explosion of Keynesian deficit spending around the world, an explosion that has predictably correlated with weak economic output, major ink is being spilled about the economic crack-up unfolding before our eyes. To state the obvious, wasteful, capital destroying governments can only spend what they first extract from the private sector. In the above sense government spending is always and everywhere an economic retardant. That's the case because governments by definition are not disciplined by profit, thus explaining spending that merely consumes capital. Conversely, a private sector that is burdened by profit demands must as much as possible deploy capital with an eye on creating more of it. Put simply, capital placed in the hands of politicians disappears, while capital placed in the hands of private actors frequently leads to innovations that allow the proverbial impoverished shoemaker to purchase equipment that expands his shoe output. Whether governments are in deficit or surplus mode, their spending nearly always weighs on economic output.

In an economically-themed speech last week in Kansas, President Obama revealed for all to see just how divorced he is from reality, and why his departure from the White House in 2013 is essential. It's not that we can't recover from another Obama term - that's the easy part - but that as a serious nation we can't have a president who possesses such unserious views. Call it a pride thing. Though Obama acknowledged up front the certain wonders of free markets, he only threw out the initial bouquet to decry those same unfettered markets. As he put it, "the free market has never been a free license to take whatever you can from whomever you can," as though those who participate in the marketplace on the way to great fortune somehow took from others in doing so. Really?

By now most readers are familiar with an exciting energy innovation called hydraulic fracturing, or the shortened word used to describe it, “fracking.” The energy extraction technique has led to major natural gas discoveries stateside, not to mention petroleum finds that have many Americans confident about easy, domestic oil access as far as the eye can see. About energy exploration, it should be said up front that this column in no way objects to it occurring anywhere and everywhere. And while all energy subsidies – brown and green – should be abolished with great speed, to the extent that private investment exists to support the sourcing of energy, the federal government should get out of the way. All that said, it says here that the excitement underlying fracking is overdone. Though all technological advances are something to embrace, for individuals to be exuberant about fracking amid a world awash in oil is the equivalent of Americans dancing in the streets over new techniques discovered for the easy manufacture of t-shirts.

In business school in the late '90s, like just about everyone else in my class I attended a speech given by Morgan Stanley's then CEO. Thanks to a strong dollar and relatively low taxes at the time, Wall Street was booming and Morgan Stanley was seen by most as one of the premiere jobs for an MBA student to secure. Of note, the Morgan Stanley head stressed that as seemingly everyone desired San Francisco as a place to work, that better hiring options existed in other locales. In particular, so desperate was Morgan Stanley for India hires that he told anyone interested to approach him after his presentation. The latter anecdote is notable considering all the talk within the commentariat - including articles written for RealClearMarkets - about California's certain decline. Supposedly high taxes, claustrophobic regulations and nosebleed spending are authoring its imminent demise; one that began with great speed several years ago.

The 'lost generation' angst of Generation Zero and the Occupy Wall Street movement that somewhat animates it is merely a repeat of the slacker GenX movement of the early '90s, and surely other economically downcast periods for young adults before then. Each time we hear that today's angry generation will underperform that of the parents, and each time this is a nonsensical illusion wrought by bad economic policy.

A flat tax would be a huge improvement on the present abomination that is the tax code, but it still penalizes work, may raise too much revenue, plus it institutionalizes the impoverishing notion that the rich should pay the most to the federal government. A consumption tax would end the work penalty, it would encourage the savings that author all economic advancement, plus it would be the one way for the citizenry to limit what the government collects, thus making it more difficult for Treasury to raise huge sums of money that Congress ultimately uses to wreak economic havoc.

More than once over the years this column has sought to expose the absurdity of Gross Domestic Product (GDP) calculations. On their face they presume that the U.S. is an isolated economic island, rather than an integrated aspect of a global economic whole. Nobel Laureate Robert Mundell long ago observed that the only closed economy is the world economy, and as such, U.S. production (think the globalized manufacture of Apple's iPad, or Boeing's 787 Dreamliner) is a function of ties to economic activity occurring around the world. GDP presumes a country alone, and worse uniformity; the latter certainly belied by the profound difference between New York City and its neighbor in New Jersey, Newark. Worse, what often drives GDP up is far from something that would be considered economically stimulative. Indeed, government measures of inflation are notoriously slow to pick up on the horrors of dollar devaluation, but when devaluation leads to higher prices, GDP increases. Government spending, for the latter having no resources that it hasn't first extracted from the private sector also boosts GDP, and then if imports to the U.S. decline (a flashing negative economic signal if there ever was one), this actually registers as growth in the calculation of this most worthless of measures of our economic health.

The power of incumbency as it applies to the presidency is vastly overrated. Ever since the floating dollar was foisted on the economy in 1971, presidents who've overseen a weak dollar have failed, those who did the opposite succeeded. From Nixon to Carter to Bush Jr., weak dollar presidents were failed presidents, and the dollar signals that Obama is not going to win in 2012. In late September of 2009, this column observed that James Grant’s economic exuberance was very much overdone. Specifically, Grant had penned a Wall Street Journal opinion piece in which he proclaimed that the looming economic recovery would “be a bit of a barn burner.” Notably, Grant’s general presumption about recessions/rebounds was correct. With U.S. recessions having historically acted as cures for them ridding the economy of all the malinvestment and labor mismatches that had brought on the downturns to begin with, logic spoke to a major rebound from the horrors of 2008. Grant cited a research report from economist Michael Darda, who noted that the “most important determinant of the strength of an economy recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-1939 period.”

ValueExpectations.com sets out to understand and identify the growth that a company needs to generate (implied sales growth) over the next 5 years in order to justify the company's current stock price. Measuring the spread between a company's expectations for sales growth and what it has historically delivered will give you a good idea of which one has the best chance of beating those expectations, and thus is more likely to outperform. AFG's Value Expectations provides a convenient way for money managers to easily unlock the expectations currently "priced-in" to an individual company or on an aggregate basis for an entire industry, sector or index. Applying this technique for an entire index is a good way to tell if the index, as a whole, is overvalued or undervalued. In today's letter we will analyze the embedded expectations in the S&P 500 Index to see if "expectations" are high or low, relative to the growth the index has achieved historically.

“Visionary, innovator, wizard, billionaire”, those were the words USA Today used to describe the now deceased Apple co-founder, Steve Jobs. More impressive, though not surprising, was USA Today’s reportage of an outpouring of praise for the technology guru from millions of individuals around the world. Though Apple products continue to confuse this writer, what’s undeniable is that Jobs profoundly changed the commercial landscape with his technological innovations. And then for the many out there who presume that U.S. is in the midst of a long-term economic decline, Jobs’ life reminds us just how silly such an assertion is. That’s the case because without diminishing Jobs’ accomplishments for one second, the simple truth is that Jobs was but one member of a rather large fraternity of brilliant American men whose eventual passing will be a worldwide event. Down as the U.S. economy might seem at the moment, its rebound is near certain for the greatest collection of entrepreneurial and creative talent the world has ever known still residing within these borders; many still innovating.

Dissembling about the capital destruction debacle that was his Administration's loan guarantee to bankrupt green-energy firm Solyndra, President Obama told ABC News last week that "if we want to compete with China, which is pouring hundreds of billions of dollars into this space...we've got to make sure that our guys here in the United States of America at least have a shot." Of course if the president were better schooled in basic economics, he would well understand that "our guys" do have a shot to compete in this space thanks to U.S. capital markets being the deepest in the world. Thanks to angel financing, venture capital, PIPEs, convertible bonds, bonds themselves, and stock issuance, those with a good idea have myriad options when it comes to marrying their innovation with capital. And there lies the obvious problem with Solyndra. Unable to raise needed operating funds in the private markets, it was forced to go to the federal government to get what our markets would not provide.

It almost goes without saying that whenever a merger or corporate buyout is announced subsequent reporting will center on the anti-trust implications of such a combination. Though corporations are in theory acting in the best interests of their shareholders, the existence of anti-trust lawyers means that does not always pass muster with the Justice Department. This sad reality reared its ugly head yet again yesterday with the Department of Justice's decision to block the AT&T/T-Mobile merger. Much like Microsoft over a decade ago, and A&P nearly 70 years ago, AT&T was damned no matter its future plans for the merged entity by an utterly confused DOJ. Assuming the blocked merger would have led to greatly reduced wireless prices for consumers or, in the reverse, higher prices due to allegedly enhanced pricing power, a schizophrenic Justice Department would have blocked the deal either way. For the broader economy, just another body blow among many restraining its natural evolution.

A recent USA Today headline, “Weakest start-ups since early ‘90s”, probably didn’t surprise economist Bruce Bartlett, assuming he saw it. He wrote about a similarly soft entrepreneurial environment in the 1970s. Indeed, while the modern Bartlett has seemingly moved to the dark side, his 1981 book, Reaganomics, written before Ronald Reagan reached office, remains essential reading for anyone who wants to understand economic policy. In his classic book, Bartlett not only explained why entrepreneurialism is essential for economic growth, but also the barriers governments erect to it that must be reduced in order to get a nation’s restless minds producing. First up is the loss of innovation that results from reduced startups. Though Reaganomics is 30 years old, Bartlett made a point that likely remains true today that “the largest proportion of important new inventions are still the result of individuals working virtually alone, rather than by big corporate laboratories.”

Our last quarterly letter began with a discussion of the pending end of QEII and its likely impact on Treasury yields. The best-of-the-best fixed income investors disagreed: Bill Gross positioned for rising yields. A large buyer was exiting the market, after all. Jeff Gundlach was ready to prosper as interest rates fell further. QEII was inflationary, of course, and as it subsided so too would the inflation premium. A mere three months later the above-the-fold story still centers on Treasury yields, but this time from an entirely different angle. We are quite happy to be situated in modest, class-B office space (we’re value investors after all) in Northern Virginia far from the siren song of Wall Street. Unfortunately, we’re all too close to what has become the loudest noisemaker in the investing world: Washington, DC. America’s best and brightest appear at loggerheads in their attempt to raise the debt ceiling and the August 2nd deadline is fast approaching. The headlines read, “Prepare for Default and Chaos!” The headline, “Don’t Panic!” doesn’t sell papers, but just as with QEII we submit there are two sides to this coin.