The gloves are off now. Our President has called those who oppose the current health care bills liars, and of course there is the now-infamous South Carolina congressman who lobbed the accusation at President Obama himself. I thought one was supposed to refrain from such lack of civility, but since it seems to be all the rage, let me give it a try.

In his The Wall Street Journal column this morning, progressive writer Thomas Frank said conservatives are “…ignoring the fact that our current troubles are the consequence of government’s withdrawal from the economy.” Well, Thomas – you lie!  Man, that doesfeel good. While I am at it, there have been others who claim that the crisis of the last year was all the government’s fault – I could not find one in particular to pick on this morning – and to all of them I say, “You lie!” Wow, this is fun.

All of this lying reminds me of a quote from Lyndon B. Johnson: “There are plenty of recommendations on how to get out of trouble cheaply and fast. Most of them come down to this: Deny your responsibility.”

This week the G-20, the leaders of the 20 largest economies in the world, will meet in Pittsburgh. They have a solution for the global financial crisis: cap the pay of bankers.  For a year they have been pushing the populist notion that this whole crisis was caused by banker greed, and that they (governments) had nothing to do with it.  So the simple cure for greed is to cap pay.  This fits all of LBJ’s aforementioned criteria: it is cheap, it can be done quickly, and it denies any government responsibility for the crisis.

Unfortunately it won’t actually fix anything, and in fact it will bring on a host of new issues. There is no doubt that pay packages in the financial world can be excessive, but the only people who are actually hurt by that are the owners of these companies who would otherwise be reaping those rewards. Shareholders, not the government, should be policing the pay packages at the firms they own.

The economic truth is more complicated than simple right vs. left, capitalist vs. socialist. The truth is there is plenty of blame to go around. The truth is unless governments around the world, starting with our own, admit their role in this mess, there will be no real solutions.  They will add yet another layer of regulation, creating new distortions in the market that will create some future crisis for the next generation to clean up.  Let’s just hope the next generation is more honest than our current collection of liars.

Chuck Osborne, CFA
Managing Director

~“You Lie!”

We are in the midst of a new gold rush. Gold briefly went over $1,000 per ounce and is still hovering at those levels. Everywhere you look, you find someone pushing gold and other “inflation hedges” as they preach the gospel of runaway inflation.

There is one minor problem with their gloom and doom inflation talk:  we are actually experiencing deflation. Prices, as measured by the consumer price index, are lower today than they were a year ago; as of July 31, consumer prices were down 2.1% over the last year. Producer prices, as measured by the PPI, were down 6.8%. We are experiencing deflation, and the price of gold should be going down, not up.

The argument for future inflation is compelling. The Federal Reserve has been flooding the system with money in an effort to fight deflation and to avoid financial collapse. Congress and the current administration are on a record-breaking spending spree. This path, if we continue down it, will lead to inflation. The question is when.

As reported in today’s The Wall Street Journal, the money supply in the U.S. is actually shrinking. M2, a measure of the money supply that includes timed deposits such as CDs, has shrunk 4 weeks in a row at a 12% annualized rate. That is a deflationary signal.  However, put aside these inconvenient data and pretend for a second that the runaway inflation is already here. Is gold really the best place to be? What is the true value of a bar of gold?

The problem with gold as an investment is that it has no real value. It does not grow, it does not pay a dividend, and it has no real practical use. If you buy a bar of gold and bury it in your backyard, 20 years from now when you dig it up, you still have the same bar of gold and only a hope that someone will be willing to pay more for it. If, instead of gold, you had buried a share of a company 20 years ago – let’s say Research in Motion, maker of the Blackberry – you would have buried a little-known maker of two-way pagers and dug up a global giant in telecommunications.

Companies are dynamic. They don’t just change in price, they change in value. While the initial onset of inflation may hurt companies, a prolonged inflationary environment helps. The best hedge against long-term inflation is actually equity ownership in companies with the power to pass price increases on to customers.  Those who are chasing gold at $1,000 per ounce are most likely making a big mistake.

Chuck Osborne, CFA
Managing Director

~All That Glitters Isn’t Gold

Yesterday President Obama officially announced that he would nominate Ben Bernanke for a second term as the Chairman of The Federal Reserve.

“Ben Bernanke has led the Fed through the one of the worst financial crises that this nation and this world have ever faced,” Obama said from Martha’s Vineyard, Mass., as Bernanke stood by his side. “As an expert on the causes of the Great Depression, I’m sure Ben never imagined that he would be part of a team responsible for preventing another.”

In our opinion the President has done exactly the right thing. Bernanke has been attacked by both the right and the left, but the truth is that he and the other Fed governors deserve the lion’s share of the credit for avoiding what could have been the second Great Depression.

People on the right have attacked him for being too loose with monetary policy and leading us down the road to potential hyper-inflation. Their argument is understandable, as loose monetary policy played a significant role in inflating the housing bubble that put us here in the first place. But this does not change the fact that Bernanke was not dealing with normal times and he was not easing monetary policy during a time of growth as his predecessor had done. Bernanke was dealing with a crisis, and he took bold and aggressive measures to battle that crisis – ranging from lowering interest rates to nearly zero percent to buying treasuries to keep longer-term rates down, and from backing the banks to buying mortgage-backed securities. The list goes on. Those bold moves are the reason our economy has leveled off and perhaps begun to grow again.

We hear from the mass media and those on the political left that the stimulus is what has saved us – Congress passed the stimulus, and a few months later the economy shows signs of improving. Sounds logical, right? Yes, except for one small detail: more than 80% of the stimulus has not yet been spent. Moreover, the amount that has been spent is being overstated. For example, one of our clients is a government agency that has received their stimulus money, so the federal government counts that money as “spent,” but the agency has not spent it yet – it is sitting in their bank instead of in the US Treasury. Hardly stimulating.

The fact is that fiscal stimulus has never worked. It didn’t work for FDR during the Great Depression, it didn’t work for Germany after WWII, and it didn’t work for Japan in the 1990s. There are two schools of thought on why this is. To simplify them, there is the “it has never worked because it doesn’t work” school, and the “it has never worked because they have always done something wrong” school – not spent enough, spent it on the wrong things, etc.  This latter school, proffered most notably by Paul Krugman of the The New York Times, boldly stated at the time that the size of the entire stimulus was too small to work. Now the same people claim that the meager amount that has been spent deserves credit for what rebound we have seen. When contrasted, that argument is so absurd that it is hard to say it out loud and keep a straight face. But, Krugman and company have never been ones to let things like facts get in the way of their theories.

Is Bernanke perfect? No. Has he made mistakes? Yes. But, Ben Bernanke saved us from the second Great Depression by acting aggressively and boldly while withstanding a great deal of criticism. If inflation does rear its head, we will need such a man to beat it. The President was right to nominate him for a second term.

Chuck Osborne, CFA
Managing Director

~Take Two: Obama Nominated Bernanke for a Second Term

The market rally in July was stimulated by better-than-expected earnings reports. Now we are entering the quiet period when most companies have already reported, and we won’t get much company-specific news until October, when companies report their third quarter results.

Now the market seems to be driven by what I would describe as a nervous sentiment. The market is up substantially from the March bottom while the economy, though improving, is not great. Unemployment continues to worsen and consumer sentiment was surprisingly negative last week.

We think a lot of the nervous sentiment is stemming from the health care debate, which is all our clients have wanted to talk about over the last few weeks. In politics it is impossible to please everyone, but it is possible to not please anyone, and Congress and the administration have seemed to do that. Part of the backlash on health care, in our opinion, is simply because people feel it’s too much, too fast. Public perception is that the government has taken over the auto industry and bailed out the banks, now on to health care. It is simply too much to digest.

The market also is beginning to look forward. We have averted a true disaster and stock prices have jumped off those worst-case-scenario lows. However, someone will eventually have to pay for all of this big government and that makes the future look not so great from a market perspective. We don’t see a significant downturn at this point, but our caution is increasing. Third quarter earnings reports can’t get here soon enough.

Chuck Osborne, CFA
Managing Director

~What’s Driving The Market Now?

We just completed one of the best Julys in history with the S&P 500 up 7.56%. The reason? Earnings. It’s all about earnings. By and large, companies have reported earnings that have been far better than expected.

Many in the mass media have been fretting about the fact that while earnings are indeed better than expected, they still are not really good on an absolute basis. Worse still, many companies reported improved earnings just because of cost reductions, not increased revenue. What these commentators don’t seem to understand is that there are two factors that lead to the overall level of the market: the first is earnings, and the second is price.

The value of a stock is the present value of future earnings, and the current market price reflects the consensus opinion of what those future earnings are going to be. The price changes when the opinion of the future changes. This is why the best companies are not usually the best investments – the best companies are already expected to be great, therefore their greatness is already priced into the stock and although they may continue to do extremely well, their stock price is unlikely to increase greatly.

The real question investors should be asking is not how good are earnings going to be, but are earnings going to be better or worse than expected. That is what moves the market.

While we are growing more cautious ourselves, this negative spin on the market movement among the mass media is actually a sign to us that this rally may continue a bit longer. After all, the lower the expectations, the easier they are to beat.

Chuck Osborne, CFA
Managing Director

~This Market Just Keeps Going Up