Fixing the Economy

We are seeing some sell-off in the market today because the quick fixes put in by governments and central banks are not working. A lot of authors, including myself, have written a lot about how Federal reserve policies alone and government stimulus are not going to pull the economy out from recession. In fact, by design such policies create more confusion and more volatility in the markets. For example, treasury market is going into bubble territory because 1) US treasury is assumed to be risk-free. 2) Banks can borrow money at 0.1% from Fed and invest in treasury to earn 0.6-3.0% risk-free depending on the duration. And lastly 3) There is an assumption of Fed itself providing the backstop for treasury market in case of disruptions. Even though Fed as of now has stopped buying treasuries but market believes that it can force it to do so if need be.
These are exactly the reasons why M1 money supply has not increased so much even after unprecedented liquidity increase from Federal Reserve. Banks do not have any incentive to lend money as long as the differential between their borrowing costs (Discount window lending and interbank lending, where both these rates are set by Federal Reserve) and yields on US treasuries stays large enough for banks to pour money into treasury market. But Fed is scary of raising rates because it thinks that stock market will not digest it easily. I agree with it in the short-term, may be 3-5 market sessions, but then market will return back to fundamentals.
By increasing the rates, Fed will force banks to go back to their core business of lending money to real customers.
Also, we have to keep one more thing in mind. The concept of money itself was invented to make the exchange process in economy easier. Money is a medium not the end itself. So economy has to grow based on other factors. Though research shows that manipulating the money supply has its effects on economy and thus in-turn on inflation as well. But I am postulating that this effect is more pronounced on reducing the money supply to curb economic growth. It does not work so well in the other direction. By increasing the money supply we can not stimulate growth beyond a limit. The reason is simple. In the former case, economy itself is growing and money is needed for transactions. By reducing money supply we can cut down on some transactions which do not have high value (or return in simple terms). Thus risk aversion increases slightly with reduction in money supply which in turn brings down growth rate. On the other hand, later case has different dynamics. By increasing the money supply we can reduce the risk aversion to some extent thus having some stimulating effect on the growth. However, it is impossible to generate transactions simply by increasing the money supply. Transactions will increase only if economy by "itself" is strong.
So here are few methods to make US economy strong in itself.
We have to create incentives for businesses to innovate. This involves giving them incentive to hire highly skilled work force easily. That in turn means making visa and immigration process for skilled workers easy and more streamlined. By hiring these workers, US companies will not only acquire competitive edge but will also need to create lower end jobs. For example, if a company hire 20 high skilled workers then it might need more office space (construction jobs), more maintenance (janitorial staff, security staff etc.) and more technology support. This cycle becomes self-sustaining as new workers will be willing to invest more in the country in the form of taxes, buying houses and buying other amenities. The only way for US government to make US economy grow at this point is to reform the immigration policy in favor of hiring and retaining highly educated and skilled workers. This will also make US companies more competitive and future-ready in a global economy.
We also have to invest in research and development of future technologies and processes. Government should create incentives for private sector to increase spending in this area by providing more tax reliefs and also by increasing government's own spending in these areas through grants.
We have to realize one more economic reality. Economy always grows "top-down" and not "bottom-up". We need airports and vast number of airport employees not because we could create those jobs first but because we created the aeroplane in the first place. By trying to focus government's approach on saving or creating lower-end jobs (e.g. hourly jobs in construction etc.) at the expense of tightening policies for higher-end jobs (Engineers, MBAs from foreign countries) we'll be doing more harm than good for the long term health of the economy. Government should try to create policies to support growth at the top that will automatically trickle down. How fast it trickles down can be controlled by monetary policies but focus to promote growth at the top is essential. This is the only way to have economic growth.
In the mean time, I am shorting treasuries because it's trading at very high price right now. Once way for retail investors is to buy TBT. If you want to be more aggressive then you can buy TYO and TMV. However, I am not a big fan of 3x leveraged ETFs. PST is a play for shorter duration treasuries. I would stay with TBT though.

Money, Media and Politics

This picture is the true testament of our selfishness and cruelty. But I am surprised that financial reporting channels like CNBC and Bloomberg allow their anchors to take drastically partisan positions on such matters. Through all my years of experience in investing and financial world, I have found one eternal truth. That, to make money you have to be neutral. The minute you start wearing democrat or republican idiotic ideological hat, you tend to make foolish investments. Then it is beyond my understanding why reputable channels like CNBC and Bloomberg are trying to side with BP.
I am a Chicago school follower and fully believe in free market enterprise. But free market does not mean that we give the freedom to everyone to do what they want to do without any respect to law of the land. If that is the case then, idiots like Kudlow on CNBC will argue that we were wrong in punishing Enron executives for creating havoc in energy markets back in early 1990s, we were wrong in punishing WorldCom and Martha Stewart for doing illegal activities. Then why on earth are we trying to favor BP and saying that by implementing an escrow fund, Obama administration is trying to shakedown BP? If Mr. Kudlow and other CNBC anchors have their way then they will soon ask to legalize prostitution, remove ban on drugs etc. These are also industries in some context.
Following free market ideology does not mean closing your eyes and argue like a fool. Chicago school of thought is based on critical thinking more than on any single ideology. We are encouraged to question the norm. Capitalism can thrive only if we use our brains and not by following an ideology to the extreme so that we walk on the edge of being idiot.
Today, Bloomberg also reported that letting BP go under due to this oil spill will not be good for the economy. We can improve the economy by pushing for child labor, prostitution, gambling and drugs also. I want to ask that Bloomberg reporter what he thinks about these ideas. His argument is as ridiculous as it can get.
If a company can't do the job properly that it is supposed to do then free market dictates that it should be eaten over by more efficient enterprises. Here is a company, BP (British Petroleum), which pays its CEO almost 10 million dollar in salary who does not even know precisely how many deepwater rigs they have (based on his testimony in Congress). Is this the best way of running a company. If they can't even fire the guy who has been making downright stupid comments throughout the oil spill fiasco then I think BP deserves to go down.
All the shareholders of BP, which I guess include Mr. Kudlow, some of his fellow reporters and of course Louisiana judge who overturned the drilling ban recently, are in for a huge surprise. The longer they hold their investment in the hope of republicans (in this particular case only, I am not saying democrats are any better) being able to do something, the more money they will loose.
I don't think BP will survive if government implements the plan to recover the claim costs from the company. And rightfully so. Any company where CEO does not know what is going on in the company does not and should not survive for long. We have had Lehman Brothers as an example. BP is relatively too small to fail. All the jobs will perhaps still be working on the same assets/departments albeit under a different company name (Exxon, Conoco, Shell etc.) depending on which company gets which assets.
I normally don't agree with politicians though in this case I agree with Obama that it is in our best interest for a great future to start thinking about our appetite for energy and waste. We are also partial culprits here. But it is also our collective responsibility to make sure that BP pays every dime and more than compensates for management mishaps that it has been practicing until now without worrying about consequences. Their should be some reigning in of corporate greed that harms innocent lives in the process of enriching few stakeholders. Free market preaches better efficiency through better management and thoughtful resource utilization to maximize profits. It never teaches us to take short cuts. Whether BP fails or survives will depend on the ability of its board and management to bring the house in order. Though one thing is very clear, BP's stock is worthless at this point whether you like it or not.

Analysis of Jim Cramer's CANDIES

Since quite a few retail investors watch CNBC and particularly Jim Cramer because his theatrics make his opinions more fun to watch and perhaps more credible too. In past few days he mentioned a fun word, Candies (basically it's an acronym for Chipotle, Apple, Netflix, Deckers, Intuitive Surgical and Salesforce). These are all growth stocks that have given some good returns until now. So I thought it will be a good idea to put these into some perspective for investors and followers here. Growth stocks are good because they provide good returns as the underlying company is in the growth phase and their earnings are increasing at a fast pace. As analysts align their expectations with real earnings, these stocks tend to go up. However, investors should keep in mind that growth stocks are much more volatile too and any one event can totally wipe out gains in these stocks. In fact high returns are a result of much higher risk in these stocks. The risk is even higher for those investors who try to play the catch on role and missed the initial up moves. Also these stocks are highly dependent on the economy and consumer buying power.
Lets start with Chipotle (CMG). Stock is already up almost 70% for the year-to-date. I believe at this point all the earnings growth is already priced into the stock. Unless company opens a lot of new restaurants and can operate them profitably, stock will have significant resistance going forward. Also competition from similar concept chains like Qdoba (a unit of Jack-in-the-Box, JACK) and startups like Burrito Beach is bound to take some traffic away from Chipotle.
Apple (AAPL) is a little complex story. Its biggest problems are that it's already too expensive and almost every analyst has buy recommendation on it. It's a very crowded trade. It has launched innovative products but the bigger problem is that most of these concepts seem to come from one father figure in the company, namely, Steve Jobs. I wish him good health but investors might be in for the biggest disappointment if he retires or is simply unable to actively participate in the company. Then AAPL will be like RIMM or HP or may be even both combined. Current valuation of the company might not seem too rich based on recent products but it is too overvalued based on the success of one person. Now Apple's ardent followers will vehemently contest it but Apple's history tells me that it's like any other device manufacturer without Steve. Considering the highest target for stock so far is around $370/share. That represents a 30% gain from current level of $275/share but any disappointment on the way may be too costly for those investors who are trying to get on the ride at this point.
Netflix (NFLX) is a good stock which has enjoyed no-competition environment so far. But returns on this stock going forward will depend on the actions of the competitors rather than the company itself. Recently services like Redbox and Hulu are trying to take some market share. But it's too early to tell the outcome in digitally delivered subscription based content.
Deckers (DECK) is a pure consumer play. And I don't think that majority of US consumer is going to be in a comfortable spending situation anytime soon. Though earnings multiple is not too high for this one, but any downside in net earnings itself may change that multiple drastically.
Both Salesforce (CRM) and Intuitive Surgical (ISRG) are B2B plays and their earnings are the result of many factors including ease of credit, macro-economy and overall business conditions. As we know, economy is not out of woods yet and there may be significant pressure on discretionary spending in businesses also similar to the household situation.
All of these stocks have gained more than 40% year-to-date and I believe that at this point these particular growth stocks reflect a balance of their growth potential and sales environment. Any downside in economy may get reflected with bigger downside in these particular stocks. So instead of getting into these names at current levels, I would advise investors to stay away until a pullback in these names. Any new positions should be opened only as a pure speculative plays rather than a long term investment.

Putting one and one together of China's currency move

In what may appear as a victory for US and Tim Geithner specifically, china today announced its intention to let the renminbi float more freely against a basket of currency. However, the range is still kept at plus or minus 0.5% daily. I am not at all surprised by this move for two reasons: First and foremost, it seems like a symbolic move to me than a real move. Second, it looks like Chinese government is trying to appease the local public by letting the Yuan appreciate a little bit so that economy has less inflationary pressure in the short term.
However, these constant intervention in today's markets by central banks are putting investors at a huge risk. The reason is simple, long term investors make their decisions based on analysis focusing on assumptions about a company's revenue and its cost of capital. These regular interventions by central banks give rise to confusion about those assumptions and result in more volatility. Looks like central banks have become more short term market focused around the world rather than being focused on long term growth of their respective country's economy. This sea-change started from market focused actions of Greenspan during his term at Federal Reserve and that trend has now spread to the whole world with faster speed of information these days. For example, low earning people in India are reeling under intense inflation pressure but central bank there is reluctant to make any large rate moves due to market concerns. What these economists at central bank don't understand is that markets are governed by valuations. And irrespective of their moves market may still find itself overvalued and go down.
Given the cyclical nature of growth, I think market still looks to go down. The reason is simple: people don't buy a house every year, a car every month and a laptop everyday. So by making predominantly easier policies, we can move the future demand around to today in the hopes of stimulating the economy. But it makes the danger of future shortfall even more exacerbated because demand is not evenly spread out.
I believe that we had much higher growth until 2008 due to loose policies and given the cyclical nature of economy, we are not going to get the real demand back until end of 2011. Central banks should understand these limitations and not try to intervene unnecessarily. Irrespective of their moves, market will eventually reflect these fundamentals and current path for it is go down as analysts trim down their earnings expectations. According to my analysis, S&P500 will have to go down to at least 850 before earnings expectations are aligned with fundamentals for next 2 years.
Current move by China to let the Yuan move will hurt Chinese stocks quite a bit as most companies will find it more disadvantageous than beneficial to them. But as I had written in my earlier blogpost, central bank in China was really running out of the options to prevent asset bubbles in the country. While it will help in identifying the fundamental strength of the economy, I believe that emerging market economies are solely reliant on developed economies. Most of the local demand is due to increased earnings of local people from export driven industries. So the "real" fundamentals are much weaker than most investors would like to believe.
I think with more interventions from central banks, market will go down even more as we try to manipulate demand. This will make the recovery even more prolonged and painful. I would ask investors to keep taking money off from the market as it makes upside moves because market is prime for huge downside move as valuation aligns itself with economic reality.
Technical chart below shows that S&P500 is hitting the upper envelop of (20,2) Bollinger band and RSI is getting again into over-bought category.

This means that next big move for S&P500 will be a huge down move to 1000 in the short term.
Any short-term increase in import prices of US companies will put even more downward pressure on their earnings as they will find it increasingly difficult to pass on the price increases. So S&P500 looks more overvalued now.Specifically, I would be selling Chinese stocks if People's Bank of China really lets renminbi move. BIDU is highly overbought and with an over 100 P/E ratio it's a sell candidate. Shorting China ETF (FXI) is a good option for the medium term, specially if it makes any up-move in the aftermath of PBC's announcement.