My guess is that there is only one positive outcome all Americans can agree on as a result of last night’s election: no more political ads…until the next time anyway. Now that all the theatrics are over it is time to get back to reality.

I was surprised last night not to hear any exit polling on whether voters are aware of the looming fiscal cliff. I am not suggesting that awareness would have necessarily changed anything, I am just curious – after all, I am an analyst at heart. I hope voters are aware, because it is serious and it must be dealt with immediately.

It may come as a surprise for Americans to wake up today and realize that there have been things happening in the world during the last few weeks other than storms and elections. GDP growth came in at 2 percent, which was better than expected. Unfortunately when one digs into the numbers you see that 0.72 percent of that growth was due to increased government spending, mostly a 13 percent jump in military spending, which looks to me like stockpiling ahead of the draconian cuts coming from the fiscal cliff. That leaves real GDP growth at approximately 1.3 percent, which is still better than we expected but extremely weak, and if I am correct will mean a drop in future military spending as this stockpile of supplies is drawn down even if the fiscal cliff is avoided.

Yesterday the pharmaceutical benefit company Express Scripts reported earnings. They beat expectations but cautioned analysts that next year’s earnings estimates are too aggressive, citing the weak economy when pressed for rationale. Analysts seemed legitimately surprised, and the stock got hammered. What seems strange to me is that sense of surprise; we get the same data as everyone else, and I don’t understand how people do not recognize the lack of economic activity.

Perhaps it is the housing data, which is the one true bright spot in the economy. However, some are behaving as though housing is going to now return to 2005 levels, and that is not going to happen.

Consumers are also more optimistic, although consumer sentiment is almost always a backward-looking indicator: consumers are usually the happiest when the economy has peaked, meaning that things have been relatively good but are about to get much worse. Likewise they are the saddest when the economy bottoms, meaning things have been bad but are actually about to improve. In other words, consumers are almost always wrong. Today I believe that is doubly true, because it is hard to understand optimism in the face of an enormous tax increase. My guess is that most Americans simply have not realized that their take-home pay is about to get significantly reduced come January 1 if nothing is done to avert the fiscal cliff. Either that or they are very optimistic that our leaders will reach a compromise by year-end.

Don’t get me wrong, I hope that optimism is well-placed. However, in my business it pays to hope for the best but plan for the worst. Investing is about making decisions today about the future, which is by definition unknowable. As a result we must deal in the world of probabilities. There must be some probability that no compromise is to be had and that we will indeed go over the cliff. This brings us to last night. The irony is that after billions of dollars spent on ads we are all glad to never see again, we have sent basically the exact same split government back to Washington. The guys who could not agree on anything for two years are now the ones we trust to avoid fiscal disaster. I fear the probability of going over the cliff has been greatly increased.

Beyond the fiscal cliff there is hope. Long-term valuations are reasonable and that is ultimately what drives results, but we must get over this cliff. Caution remains in order.

Chuck Osborne, CFA
Managing Director

~Now What?

What should we think about last week’s jobs report? As I am sure most of you have heard by now the official unemployment rate is finally below 8 percent at 7.8 percent, according to the Department of Labor’s Bureau of Labor Statistics. Since the release of the report the talking heads on CNBC have become screaming heads, and people such as the former Chairman and CEO of GE, Jack Welch, have accused the Administration of fudging the number for political reasons.

For the record, I do not believe there is any grand conspiracy to fudge the numbers. The problem with conspiracy theories is that they assume two things: competency and the ability to keep a secret. It would take an unbelievable amount of skill to fudge the numbers and actually get away with it, with hundreds of economists, market strategists and reporters checking every detail of your work. Then it would take an inhuman amount of humility not to have one person involved “tweet” it out to the world or update his Facebook status to read, “Just fooled America into believing unemployment is getting better.”

With all respect for Mr. Welch’s business career, the conspiracy theory just does not hold water. However, I understand the reaction; something strange happened in last week’s data and it was not just the unemployment report. For those like us who follow economic data daily, there seemed to be a pattern developing: starting around May the formerly mixed economic data started to be all negative. Manufacturing especially fell off the cliff. The Empire State manufacturing report was horrible. Shippers from Fed Ex to Norfolk Southern have warned on earnings, twice in the case of Fed Ex. The August jobs report was horrible. The only “good” data was coming from housing and frankly all that means is that we finally seem to have hit a bottom.

Then out of the blue came the Institute for Supply Management’s (ISM) manufacturing survey which showed a modest expansion in manufacturing activity, especially in new orders. This was taken as a big positive since the expectations were for continued slowing. After that we received another ISM report on the services sector that once again was better than expected. Then, finally came Friday’s big news about the unemployment rate. What has happened?

It seems to us that only one of two things could be occurring. One possibility is that we, and most other market watchers, have been wrong about the economy and we simply had a summer break in activity and now we are back to work. The recent data could support this outcome and the return to 2 percent growth – still slow, but better than the 1.3 percent of the second quarter and the seemingly even slower activity in most of the third quarter.

The other possibility is that these reports are statistical blips caused likely by the looming fiscal cliff. When one digs into the employment numbers, there were 114,000 jobs created in September. The population grew by 206,000, so jobs created obviously did not by itself lower the unemployment rate. What lowered the rate is that revisions added approximately 800,000 jobs of which approximately 600,000 appear to be part time. This is why the “underemployed” rate remained the same at 14.7 percent.

So we have a sudden increase in manufacturing orders,orders and a large increase in the number of part-time employees – many of whom are typically temporary. If I were a procurement officer in the Armed Forces and saw the cuts coming to my budget next year should the fiscal cliff not be averted, I would be stock-piling. If I were a civil servant with projects to be done I would be doing everything possible to get them done by year-end, including hiring part-time and temporary workers. In other words this could be a natural reaction to the impending fiscal cliff.

How will we know? We believe the answer will be found in third-quarter earnings reports and company forecasts. If things are as bad for companies as we previously believed, then it is likely that these improvements are illusionary blips. If, on the other hand, companies surprise on the up-side, or more importantly report signs of improving activity, then this may be a real improvement. We hope for the latter but the prudent course is to be prepared for the former. With the International Monetary Fund announcing yesterday that the risk for another global recession is “alarmingly” high, that unfortunately seems like the safer bet.

Chuck Osborne, CFA
Managing Director

~Figures Lie and Liars Figure

“Our destiny is frequently met in the very paths we take to avoid it.”
– Jean de la Fontaine

We are all products of our experiences. Sometimes in life we, or someone around us, make a mistake whose consequences are so painful we promise we will “never do that again.” Too often in those circumstances we end up making all new and sometimes bigger mistakes. George W. Bush believed that his father made a mistake when he did not take out Saddam Hussein in the first Gulf War when we had most of the free world by our side. Determined not to make that same mistake, he made all new ones.

Similarly, Ben Bernanke came into the job of Chairman of the Federal Reserve (Fed) largely by his reputation as a scholar of the Great Depression, and specifically all the mistakes that were made by the Fed during that period. He is determined not to make those same mistakes, and as a result he is making all new ones. For those who need some catching-up: the Fed has announced a third round of quantitative easing (QE3). So-called quantitative easing occurs when the Fed purchases bonds, usually Treasury bonds, but this time they will also purchase mortgaged backed securities, in the open market in an attempt to lower longer-term interest rates.

I will get into why I believe this is a mistake and what it means for investors, but first I think it is important to understand why the Fed is doing this now. They are pursuing the strongest measures they have taken thus far since the beginning of the financial crisis because things are not just failing to improve fast enough; things are getting worse. Unemployment came out last week and the headline number seems encouraging. It dropped to 8.1 percent vs. the previous reading of 8.3 percent. However, when one digs into the numbers, that entire decrease is caused by people giving up and leaving the workforce. As Mortimer Zuckerman, chairman and editor in chief of US News and World Report, recently pointed out, when one adds the eight million Americans who have given up and dropped out of the workforce to the scores of people in the category the government calls “underutilized labor,” the real unemployment rate is closer to 19 percent.

On top of this we have the discouraging report from the Census Bureau: 46.2 million Americans now live in poverty, which represents 15 percent of our population. This number was actually down from last year but not in a statistically meaningful amount, so for all intents and purposes it has remained constant. However, median incomes fell by 1.5 percent in real terms.

As we reported earlier, GDP growth, while still positive, is slowing. Manufacturing activity is slowing dramatically. The numbers of people actually out of work are rising. Incomes are dropping. This is no longer a weak recovery. We are in an economic downturn. We will let the academics decide if it qualifies as a new recession, but regardless of titles things are now getting worse, not better.

This is why the Fed is so eager to take action and why their action is so extreme. I believe they are making a mistake. The Fed has tried quantitative easing twice before (two and a half times before if you count the “Twist” program) and thus far they are 0 – 2 (or 0 – 2.5) in actually helping the economy. It did not work before and there is little reason to believe it will work now. To put it simply, interest rates are already at record lows, making them even lower is not going to change anything. That is not the same as saying the former rounds of quantitative easing did not have an impact. They led to strong, although temporary, rallies in the stock market and in commodities.

Here is our scenario of what happens with QE3: The economic activity does not change at all. No consumer or business person is currently sitting on the sidelines because they thought interest rates were too high. None of the real issues – declining incomes, high unemployment, regulatory uncertainty, unrest in the Middle East, the recession in Europe, etc. – have gone away. We do not see how this will help in any real economic sense. In fact it will most likely cause prices at the pump and prices at the grocery store to rise, as its forbearers did. So we will likely end up with a scenario where incomes keep dropping while the prices on things we need to survive day in and day out continue to rise. In other words, we believe QE3 will make things worse in the real economy.

When we put on our investor hat this becomes a difficult environment in which to make decisions. On one hand, everything in the real world is getting worse. On the other hand, cliché’s exist for a reason and “don’t fight the Fed” is a long-time Wall Street cliché. Over the next several days we will be reviewing opportunities to potentially increase market exposure, but we still believe it is prudent to be cautious. All the short-term traders are as happy as can be that they got their wish for QE3. Soon, however, companies will begin reporting third quarter earnings, and all the data points to very painful numbers. The question is, what trumps what? Market momentum and easy money vs. economic slowdown and depressed earnings. In the long run actual results have always mattered, and while that has not been the case this year we still believe it is the most prudent path.

Ben Bernanke is doing everything in his power to avoid the past mistakes that took a bad situation in the early 1930’s and turned it into a Great Depression. Unfortunately in his effort to avoid that destiny he may very well have put us on the road to it. One thing is certain, he is not making the same old mistakes; he is making brand new ones.

Chuck Osborne, CFA
Managing Director

~“We’ll Never Do That Again.”

Managing Director

~The Price of Everything But The Value of Nothing

I first realized that I think differently than most people when I was a senior in high school. I was in Political Science class with Dr. Davies – one of those exceptional teachers that really made a difference in a lot of kids’ lives, including mine. Dr. Davies had asked the class to research the War Powers Act and be prepared to discuss whether it was constitutional. He began the class with a quick poll, and it turned out I was the only one in the class who thought the act was not constitutional. He allowed my classmates to make their arguments first, and they all talked about how it made sense in a modern, fast-paced world to allow the Commander in Chief to commit our Armed Forces without having to wait for Congress. They made very logical arguments. Finally Dr. Davies looked at me and asked me why I disagreed with my classmates. I told him that I didn’t disagree, and then I apologized because I must have misunderstood the assignment; I thought I was asked to determine if the act was constitutional, not whether I thought it was right. What happened next I will never forget: Dr. Davies, who had been leaning back on his desk, jumped to his feet and started to applaud. He announced to the class that I got the only “A” on our assignment, not because I was correct – I don’t recall if he ever told us the “right” answer – but because I was the only one to get the point of the exercise.

The point of reliving this story is not to start a debate with my many attorney clients and friends about our Constitution, – a debate I would surely lose; the point is that I often believe we get the wrong answers in investing, and life for that matter, not because the answers we get are necessarily incorrect, but because we are asking the wrong questions.

Yesterday the market rallied strongly based on a short speech by Mario Draghi, president of the European Central Bank (ECB). He told a group of investors that the ECB can and will do what is necessary to save the Euro. I have not seen the entire transcript of his speech, but based on the reaction I would not be surprised if he wrapped it up by thrusting both fists in the air and declaring, “I am invincible!”

Well, Draghi is not invincible, and saving the Euro may or may not be a worthy cause, but it is not going to solve the real issues. When Draghi made his statement what he meant is that the ECB still has the ability to loosen monetary policy and reduce interest rates. There has been similar talk from our Federal Reserve Bank (Fed), that they might provide some form of easing – QE3, or something new. The problem with these actions is that they miss the point. We do not have a liquidity crisis, either here or in Europe. The globe is drowning in currency as every major central bank in the world has their pipes wide open and it still has not jump-started the economy. Opening the pipes further is not going to help.

Central banks are very good at liquidity problems. If there was a lack of liquidity the central banks around the world could act, just like Milton Friedman and Anna Swartz argued they should have during the Great Depression, and it might work. Unfortunately, the economic world lost Anna Swartz earlier this summer, but before she left us she warned that policy makers were responding to the wrong crisis. It is not that their solutions are inherently incorrect – after all she co-authored this playbook – but they are simply trying to answer the wrong question.

The question for policy makers is not whether the ECB can “save” the Euro, but rather, Can Europe enact the necessary reforms to rebuild economies that can grow and be self-sustaining? For investors the right questions are, How deep is the recession in Europe going to be, how long will it last, and how much of it will spill over to our shores? Thus far this quarter 60 percent of Standard and Poor’s companies have missed on revenue, largely due to slowing sales from their European customers. Earnings have been somewhat more positive on a relative basis, but this is largely a result of lowered projections, which the market has yet to price in.

It seems like there are some bulls out there grasping on every seemingly positive straw. Unfortunately, the ECB can’t solve the problems in Europe, and the Fed cannot solve the problems here. It looks like a lot of short-term traders are missing the point: Investing isn’t about monetary policy; it is about corporate profits, which are a function of economic growth. Those who keep waiting for central banks to ride to the rescue are asking the wrong questions.

Warm Regards,
Chuck Osborne, CFA
Managing Director

~Missing The Point