GDP grew 3.5% in the third quarter of this year, exceeding expectations of 3.2% and sending the markets up nicely after a week-long downturn…then back down, and then…is the recession over? Well…maybe.

In digging into the GDP numbers more deeply it becomes a more complicated story.  Consumer spending was up 3.4%, but this was largely driven by the “cash for clunkers” program that boosted auto sales.  Will the consumer continue to spend in the absence of government incentives?

Exports increased 14.7% and imports increased 16.4%.  (Exports are additive to GDP, imports are subtracted from GDP.)  Both of these should be seen as good signs, as global trade had fallen off dramatically and it will be difficult to have a sustained recovery without robust global trade.

Inventory buildup played a major role, but was not as dominant as some economists had projected.  This is good news, as this means there is still more to be done to rebuild inventories and any increase in demand should boost production.

Government spending increased 7.9%, which adds to the GDP for this quarter.  However, government money must come from somewhere.  Personal taxes increased $4.8 billion while disposable personal income decreased $20.4 billion or 0.7%, and real disposable personal income (adjusted for inflation) dropped 3.4%.

This is truly a mixed bag. There is some genuinely good news and some genuinely bad news. Economists’ reactions have been as mixed as the data.  Some fear this is simply a “sugar high” from government programs, while other feel this is the beginning of the real thing.

It isn’t just the economic data either.  While the vast majority of companies have reported better-than-expected earnings in the quarter, there have been some notable exceptions. Exxon’s earnings were down 68%, just a few days after their British competitor BP delivered much better-than-expected results.

I find myself siding with the pessimists.  This is surprising, because my outlook usually swings from bullish to extremely bullish, but it is hard to see how economic growth can be sustained when disposable income is decreasing through a combination of higher taxes and higher unemployment.

The most likely scenario from here is that we muddle along, with the economy and the market going nowhere.  But, that isn’t all bad: to go nowhere, some companies must win while others lose. This is a stock-pickers market, and that should continue to bode well for us.

Chuck Osborne, CFA
Managing Director

~Trick or Treat?

Everything was going so nicely, then it dropped off a cliff. Yesterday the market was heading for nice gain in response to a blowout quarter from Wells Fargo among other positive earnings reports. Thus far 76% of the S&P 500 companies that have reported have beaten expectations for Q3 earnings.

Then out of nowhere, we got hit by two bombshells. First Richard Bove of Rochdale Securities downgraded Wells because he didn’t like where their blowout earnings –$0.61 per share vs. estimates of $0.39 per share – were coming from.  Wells’ stock went down a little more than 5%.

The second bombshell came from our pay czar. Earlier in the day, reports suggested that the grand czar of compensation would not really be cutting the amount of compensation as much as the structure, attempting to tie compensation more to long-term corporate success vs. annual bonus. Guess again – total compensation cut 50% and salaries cut 90%.

The first shock received most of the credit for tanking the market, but I believe it is the second headline that deserves more attention. The downgrading of Wells Fargo after a fantastic quarter is certainly bold, but we don’t put much credence in analyst predictions. As Bloomberg pointed out in August, if an investor with a $10,000 portfolio had taken all Wall Street analyst advice in March of this year – meaning they bought all the stocks rated buy, and sold short all the stocks rated sell – they would not only have lost everything but also would now owe $6,000. This during the steepest market rally in more than 70 years.

If your time horizon is a few weeks or months, now may be a good time to sell Wells Fargo. However, if your time horizon is three years, you may want to consider that the current Wells Fargo, after the Wachovia merger, is selling for less than the old Wells Fargo did for most of 2008. After running up from a low of $7.80 to the $30 range there may be some pull-back, but longer term Wells Fargo will be one of the two strongest banks in the country. Not a bad place to be.

The second story has staying power. No one is going to come to the defense of executives at Bank of America, Citi, or AIG. If they do, the angry mob will certainly tear them apart. However, there are two very important questions we should be asking. First, is this justice or is this revenge? The end result of the two can often be very similar, but the difference is huge. How something is done is often as important, if not more important, than what is done. One could argue that had the government not stepped in, these firms would have failed and these executives would have received a 100% pay cut. Then that person might be accused of suggesting that a truly free market is more just than, say, the rule of a czar.

The second question we should be asking is one that comes from David McCullough’s biography of John Adams. Adams stopped at a tavern while traveling and overheard the locals discussing British actions regarding taxation. One man said to the rest, “…if Parliament can take away Mr. Hancock’s wharf and Mr. Row’s wharf, then they can take away your barn and my house.” Where will the pay czar stop? If he stops here, then I don’t have a problem with it. These firms essentially have become wards of the state, so the state arguably should have some say in what pay structures look like. The concern in the market is that he won’t stop, in which case no one will care until it impacts them, and then it will be too late.

This uncertainty is starting to look like the end of the rally. At the very least this rally is becoming fragile, and we remain cautious.

Chuck Osborne, CFA
Managing Director

~Fragile

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