The Pendletones

The Pendletones

We’re back on our inflation kick this week after complaining about the analyst community last week.

Dr. Bernanke was out trying to rebuild the credibility of the Fed as an inflation fighter last week in speeches, a Wall Street Journal op-ed and Congressional testimony. The Fed has a dual mandate (which is sort of rare among central banks) to maintain stable prices and foster economic growth (actually full employment). To do both at the same time requires the balancing skills of a world-class acrobat. We have had few of those folks work at the Fed over the years.

The Fed was created as a response to the Panic of 1907, when a severe banking crisis brought many banks down and caused a recession (or panic as they used to call them). The idea behind the Fed was to create a bank that would be the ‘lender of last resort’ to other banks and help to stabilize the banking industry in the US. Several European countries had central banks and we wanted one too.

From the outset, the Fed has been independent of the Treasury, which used to perform some of the Fed’s functions. The idea was that a true government agency monitoring the banks would look out for the government and not the banks. So, the structure that was developed was one where the member banks own the Fed through ownership in the 12 District Reserve Banks. ‘We The People’ have no stake in the Fed except as customers or shareholders of the member banks.

So Dr. Bernanke was talking with the nice folks in the Congress (the opposite of progress) and he told them the Fed has a plan to manage the inflation threat once the economy is back on its feet, the so-called exit strategy. As we mentioned a couple of missives ago, ‘once the economy is back on its feet’ is subject to interpretation and the Fed will likely be unwilling to call it prematurely. So, just like the last time around, the Fed will likely keep rates too low for too long. Not that the Fed doesn’t mean well, but they will have a hard time pulling the trigger on that first interest rate increase (well maybe be not the first, but the fourth). Imagine the howls from every Congressman (the opposite of progress-man?) when the raises begin. The administration will want the economy to be very healthy before rates begin to go up. The Fed will have a tremendous amount of political pressure to keep rates low for a long time. Fighting inflation is not in anyone else’s mandate until it is too late.

Bernanke means well and the Congress has to look like it cares about inflation, but that is a lot easier now, when inflation isn’t an immediate threat. When the Huns were ravaging Gaul, the Roman Senate was all afluster. When the Huns were bearing down on Rome, the Roman Senate was nowhere to be found.

Our outlook is that the Fed will err on the side of fostering full employment and a solid economy rather than fighting inflation. Don’t be surprised when the Fed is surprised at just how stubborn inflation is in three years.

Good News

The Leading Economic Indicator came out on Monday last week and it was up, again. Though not as strong a reading as the month before, it was still up. Direction is more important than magnitude in that series, but it is nice to have both. The gain of 0.7% was right in line with average forecast of the economics fraternity.

House prices rose for the first time in a while according to the Federal Housing Finance Agency. The gain was nearly 1%. Not all parts of the country participated in the gains. New England and much of the East Coast didn’t gain, nor did the inter-mountain West. But, for people financing their homes through Fannie Mae or Freddie Mac, the gains outweighed the losses. Reports from the Case-Shiller Index or from the National Realtors Association haven’t confirmed these results. So, this might only impact the lower end of the housing market. Stay tuned, more at 11:00.

It must be 11:00. Existing home sales rose 3.6% in June. This is the third rise in a row. The average price for resale homes rose from May, by a whopping $200, but at least it rose. Prices are down by 15.4% from June 2008. The inventory of unsold homes fell 0.7% but continues to be high at 9.4 months at recent selling rates. Distressed and foreclosure sales made up 31% of sales. Condominium sales jumped 14% from the prior month. Condominiums tend to have lower prices and emphasize the trend toward lower priced homes selling better than higher priced homes.

Other Economic Numbers

Consumer sentiment, the University of Michigan version, fell in mid July. In June, this reading was roughly 70 and now it is only 66. Why so glum? Mostly the drop came from lowered expectations about the future. Funny, these folks almost always project the recent past into the future and their guesses about the immediate future are usually wrong. So this maybe should have gone in the good news area above, but it really is bad news as sentiment had been rising.

British GDP fell in the second quarter, as if this is any surprise. But, the size of the fall did surprise analysts. As we have been saying for quite some time, the Europeans started down the declining path after we Americans and are still declining. Our recovery will likely come first and theirs will follow. Most analysts are now frantically lowering their forecasts for the rest of Europe and some are even cutting their US estimate.

Weekly Stuff

Technicians like to say the stock market likes to climb a “wall of worry,” which translates into a contrarian outlook that so long as we’re all worried, the market can go up. Once we all accept that the market will go up forever, then we will have a higher risk of trouble. The “wall of worry” continues as so many of our brother and sister pundits continue the hue and cry about all the issues that still face the economy and the capital markets. Those issues are well known generally and largely discounted by the huge declines last fall and this winter. The simple fact that the market is a discounting mechanism and looks ahead by months rather than look sideways or even backward is what makes the “wall of worry” so persistent a comment from the technicians.

Once we solve all the problems there will be no more upside. That is one way to look at 2007 with the benefit of hindsight. By 2007, we were no longer concerned about a tech bubble, terrorists or hardly anything else. With no “wall of worry” to climb, the market was overbought, over-believed, over-owned and set-up to drop. The only worry back then was why there was so little to worry about. Today, we don’t have that problem, there is plenty to worry about. So, we climb further up the “wall of worry.”

Stocks made good gains again last week with the major US stock indices moving up by 4% or better, nearly 5% in the case of the Russell 2000. The foreign indexes were higher by call it 5% (a little bit less on the developed side, a little bit more from the emerging side). With one more week to go in the month, it looks like we’re back on track to have a really good month, not April good but still good. There is still time to mess this up, but we’ll cross that bridge when we come to it.

Bonds were generally higher all over the world. They seem to have come through our little inflation worry with flying colors. Now that the Fed has assured everyone that they are aware of all the inflationary risks they have created with their massive stimulus (as noted above), we can all sleep well knowing that the Fed knows they’ve behaved badly and they won’t do it again. At least for the time being the bond market isn’t going to be too concerned about inflation. That ‘time being’ may not last very long, but last week it was in full force. Inflation risks are all the rage, which means that they aren’t immediately likely.

Ever have that problem where you get a song stuck in your head and you can’t remember or figure-out why? You wrack your brain trying to figure it out until you’re going crazy lying in bed not being able to sleep thinking of nothing else. Then, while you’re driving to work, it just happens to come naturally. Of course, the Pendletones! Well, the bond market has been worrying about inflation until it is at its wits’ end, to no avail. Inflation is out there, but you can’t get too worried about it until it hits. The Fed has put that day off for at least a few months and likely a year or more. Whether they are right is still an open question. But, until we know, there is no sense in worrying about it. (The Pendletones was the first name used by a bunch of kids from Hawthorne, California who became the Beach Boys.)

Real estate securities markets were strong last week as it appears the same ‘green shoots’ that everyone is starting to see in residential real estate are starting to show in commercial. The outlook for development is still awful, which is good for existing buildings. No one in their right mind would build a new shopping mall right now, so that is a little more demand for the existing shopping malls. The same goes for office buildings, hospitals, industrial parks and other areas of commercial property. The gates of financing heaven have opened for many of the owners as avenues to refinancing, even if at unattractive terms, are reopened. Financing debt maturities by issuing more stock is one option while refinancing in the debt markets is now a possibility.

Commodity markets were strong last week almost across the board. The energy complex was the strongest segment, but there was strength nearly everywhere. Evidently the pits think the recession is over and the recovery is on.

Au revoir

Several astute readers noted that we were wrong last week to attribute to Nixon the comment that “if we’ve lost Cronkite, we’ve lost the war.” That was Lyndon Johnson talking. We should have double checked that before we sent it out. Many apologies. But, we’ll doubtless do it again, so be on your toes and believe none of what you hear and only half of what you see.

Have a really great week.

Karl Schroeder, RFC
Investment Advisor Representative
Schroeder Financial Services, Inc.