If you’ve ever seen ‘The Seven Samurai’, Akira Kurosawa’s masterpiece (although a little slow for most modern tastes, brought up on Sesame Street and accustomed to explosions every couple of minutes in their movies) you’ll remember the somber ending when the elder samurai tells his acolyte “alas, once again we survive” (you see what he really wanted all along was an heroic death). Well, it looks like our democracy will survive again. Accosted by negativity, bolstered by hyperbole, misguided by half truths and yet, we have decided who will be the leading politicians of the next couple of years anyway. Luckily for all of us, we can change our minds every couple of years. The beauty of our democracy is that the founding fathers understood what stupid, boorish and easily lead people would follow them. They kept it fairly simple and kept the political power spread out among an elected legislature, the anointed judiciary and the powerful executive. Having just survived the rule of hereditary kings, they were anxious to keep the powerful executive from exercising too much power.
But, the best part about our elections is that hardly anything really changes, regardless of who we send to Congress (the opposite of progress). The institution is capable of thwarting the will of the people no matter who sits there. But, we shouldn’t be too harsh on them. It is we who ask for all sorts of services and benefits from the government and then decline to pay for them. It is we who keep changing our minds on what the proper role of government ought to be. As George Carlin, the lately departed comedian and social commentator once said, “Stupid and greedy people get stupid and greedy politicians.”
But what is really important is now that the election is over; we can all get back to our day jobs. We can roll-up our sleeves and start working on our lives again. This is what the markets really care about. We defy any of you to look at a chart of long-term stock prices and show where the election years are except by looking at the dates on the bottom. It is remarkable that the trend in stock prices has almost nothing to do with politics and everything to do with how well corporate America is doing. You can see recessions, those are usually when the line dips for more than a couple of months. And, you can see long periods of progress in between. If you take a few minutes to remember what the mood of the populace was like during each of the very sharp stock market declines, you can see that a poor economy, high unemployment, poor earnings and overall lousy prospects reigned at those times. But, then shift your gaze over a couple of years and you will inevitably see that those lousy prospects morphed into a more vibrant economy with growing jobs, rising incomes, a better overall economy and a cheerier outlook for most folks. That is the American way.
We now have a Congress where different political parties control each of the two Houses. We think this will lead both to work diligently on those areas where there is agreement and probably not work successfully on areas where they do not agree. We will see legislation pass that needs to pass and we will see the government function because it has to. There will be the usual amount of grandstanding by members on either side of the aisle and bills introduced with little chance of passage as pay-off for political promises. That isn’t too dissimilar to what goes on at any other time. We’ll see National Ketchup Week proclaimed as well as long lists of judgeships and military promotions approved. We will see budgets hammered-out and programs approved. There will be committee meetings and hearings and demagoguery, just like any other Congress. It will be surprisingly normal. We seriously doubt that our future will be either demonstrably improved or worsened by most of what goes on in government.
We believe we are on the cusp of another period of growth in America. We think that the future of America is one where innovation and hard work lead to new products, better services, stronger companies and a return to optimism. We think the future keeps getting better because our definition of better keeps getting rewritten. The famous “two guys in their garage”, who keep obsoleting iconic products and brands, don’t care who sits in the White House or who controls Capitol Hill. They are going ahead with their vision because it is their vision. They won’t be stopped.
People who work not because there is some great formative concept of governance, but because the light bill needs to be paid will keep at it. People who want a better life for their kids will keep trying to achieve that end as well. People who want a quiet retirement with few of the worries over how to pay for the next box of Cheerios will keep saving and investing. Much of what passes for normal in our lives will still be normal, even with the politics of tomorrow. Once every so often politics rears its ugly head and demands we pay attention. “We the people” then are asked for our votes on the issues of the day. We respond and life goes on. Have a nice break of maybe three months before the politicking for the 2012 elections begin.
Issue of the Week
We get the distinct impression that we have been as clear as mud when it comes to communicating to you on the subject of quantitative easing. We have gotten more questions on this topic than any other by far since the whole issue came up a couple of months ago. Now that it’s in the news all the time, you probably need to know how to respond to questions as they arise.
What is quantitative easing? When your pundit was a young lad in economics class they called it ‘open market operations.’ That is why the most powerful committee of the Federal Reserve is called the Open Market Committee, which met Tuesday and Wednesday last week and announced a major change in their open market operations. In open market operations, the Fed either buys or sells (usually) Treasury bonds to impact the amount of money in circulation and indirectly the level of interest rates.
In years gone by, there was this whole cottage industry of Fed watchers who would parse every Fed announcement and every Fed publication for insights into the Fed’s policies and operations. Then along came Alan Greenspan and he just told everybody what the Fed was thinking and doing. The Greenspan Fed also didn’t focus on open market operations so much as just telling the world what they wanted to happen. If what they wanted didn’t happen very soon, they’d go in and use open market operations to make it happen. But, they weren’t at all circumspect about it.
When the Fed was worried about the approach of Y2K (remember when western civilization hung by a computer cord?) he used open market operations to create some extra money just in case the economy had to handle some glitch somewhere in the financial system. When the money wasn’t needed in 2000, he used open market operations to pull the money back out and probably tipped the economy into the short, shallow recession in 2000-2001. When the financial markets reeled from the impact and when the nation reeled from the 9/11 terrorist attacks, the Greenspan Fed cut interest rates to 1% to cushion the blow and created enough money to turn things around.
The Bernanke Fed follows much the same line as far as operating in the open and not trying to camouflage their actions. So, when they were concerned that the implosion in mortgage-backed securities threatened most of the major financial companies, they brought interest rates to zero and instigated a massive open market operation that ultimately bought $1.75 trillion in mortgage-backed securities to prop-up the prices of those bonds but also flooded the economy with money to end the recession and jump-start the recovery. That was QE1.
So, when you hear quantitative easing, or QE2, just think open market operations, buying and selling Treasury bonds to affect the money supply. So, why do we bother with calling it QE? Because open market operations go on all the time. The Fed has many tasks to fulfill and one of them is to act as the fiscal agent of the Federal Government. So, when paychecks go out to Federal employees, the Fed’s balance sheet goes down. When tax payments are made to the Treasury, the Fed’s balance sheet goes up. There are a whole bunch of housekeeping tasks that the Fed performs that require it to fuss around in the markets either buying or selling Treasury bonds. QE is a program to raise the money supply that is apart from that. In this age of openness, call it glasnost at the Fed, they needed a new term to differentiate the one from the other.
So, will it work? That is a whole other question.
This QE was not just what everybody expected or wanted. The ideas range all the way from easing until the economy says uncle, to not easing at all. Some argue that it would take up to $5.25 trillion in Fed purchases of Treasuries to get the economy moving and keep it moving. There was an equally vocal group who argued that no amount of QE would help and would probably do as much harm as good. So, we have an old fashioned conflict of ideas. Since we can’t put both propositions to the test, we can only look at which side seems to have the better case when this experiment is over. Stay tuned, but it will be years before we know for certain.
The one thing that is certain is that the Fed is going to be very important to everyone in the next many months. So, the Fed is going to buy somewhere around $75 billion of Treasuries a month on top of the maybe $50 billion they will have to invest from the $1.75 trillion in agency mortgage-backed securities they bought in the last couple of years in QE1. We have said many times (and we doubt you believed us at the time) that the reason Treasury debt is riskless is that in the worst case scenario they can print the money to pay us off. Well, that is just about what is going to happen now. The Fed is going to create money out of thin air, use that cash to buy Treasury notes and bonds and then sit on them until they mature. That is the same thing as printing money to pay off investors.
Actually, the Fed will probably buy just about as many Treasuries in the next 6 to 8 months as the Treasury will offer for sale in all their auctions. You might see them actually raise the size of the issues in the range of years that the Fed has said they are going to target.
Economic News
Personal income declined in September by -0.1% according to the Bureau of Labor Statistics. The drop was impacted by drops in transfer payments and by a drop in interest income. Taxes rose in the month.
Consumer spending rose by 0.2%, leading to a drop in the savings rate. Spending was particularly robust in durable items, cars, refrigerators, cell phones. The savings rate has dropped to 5.3% from 5.6% in August.
The ISM Manufacturing Index rose to 56.9% in October from 54.4% in September. This gauge of purchasing manager’s experience in the real economy is widely seen as one of the better insights into what the business community is doing. In October, the ISM saw improvement in exports and durable goods. Among the sub-indices, the employment index rose to 57.7% from 56.5% the month before, the new orders index jumped to 58.9% from 51.1%, and the production index rose to 62.7% from 56.5%, all in all, a surprisingly strong report.
ISM Services were reported at a level of 54.3%, well above even the most optimistic forecasts. The benefit of a bounce in services, where most of the US economic output arises, could mean an increase the pace of growth in the fourth quarter.
Motor vehicle sales rose to 12.3 million units at an annual rate in October from September’s 12.0 million pace.
Productivity rose by 1.9% in the third quarter according to the Bureau of Economic Analysis. That is the slowest rate of increase in this recovery so far. That sounds like bad news, but in fact it is quite normal. During recessions, employers start reducing costs by letting go their newest, least experienced workers and those that are less productive. The impact is that output per worker rises. When demand starts to rise with the next recovery, we see a rise in productivity as the current workers work harder and for longer hours to meet demand. When no more production can be wrung from current employees, new employees are hired to keep up with demand and productivity slows.
Payrolls rose by 151,000 in October the Bureau of Labor Statistics announced, far above the number forecast by most economists. Most guesses were for a gain of 60,000 to 70,000 workers. The private sector gained 159,000 jobs while the public sector lost 8,000. Also, revisions to prior month’s reports added 110,000 more jobs to the work force.
The unemployment rate stayed the same at 9.6% though labor force participation and the work force didn’t budge. The pace of 151,000 workers is roughly the number which over time would keep the unemployment rate steady at the current level. We need far more monthly new jobs to get the unemployment rate down.
Hourly earnings rose by 0.2% for the month while the average work week increased by 0.3%.
Weekly Stuff
We dare you to come up with a better week than the one we just went through last week. Sure, there are weeks when stocks did better, or at least more consistently. We’ve had weeks when the stock market has gained nearly 10% in a week. But, usually in those weeks bonds don’t do all that well or some other part of the investing fabric gets rent somewhere. But, last week, nearly everything went up. The one obvious casualty of last week was the dollar, but that is its own story and one we will get to another time.
US stocks gained a bunch on the week. All the major and minor indexes were up due to the strength in stocks on Thursday. Sure, stocks were up and down on Monday, they were up and down on Wednesday, too. But, the strength on Thursday overshadowed everything else. Most of the major indexes set new recovery highs on Thursday. The Dow, S&P 500 and NASDAQ all set new highs. The Dow Jones Transports set a new high, which gives us a Dow Jones Theory buy signal, or should at least.
Foreign stocks chimed in with gains as well. The MSCI-EAFE set a new recovery high as did the MSCI-EM (the emerging markets index). Both indexes gave a good accounting of themselves on the week. Every country specific market we track closely was up on the week.
US bond markets were broadly higher on the week. Treasuries celebrated the slightly bigger QE that was announced, while other high grade markets looked forward to the spill-over from the Fed buying that should impact their markets. The lower rated market followed stocks higher.
Foreign bond markets weren’t all on board with the broad rally. German bunds slipped with the rise in the Euro and new conflict surrounding austerity packages in France and Greece and a return to crisis in Ireland. But, Japanese, British and most other national bond markets held their own on the week. Emerging market nations gained.
Real estate markets tended to follow the stock market higher. US real estate securities were generally higher with the index gaining 5%. Foreign real estate markets were generally higher as well, just not so dramatically so. It helped that financial shares in most markets were leaders last week.
Finally, commodity markets were also in bull market form. Crude oil gained 7% on the week, though natural gas failed to follow. Most agricultural commodities were higher as were most industrial commodities. The precious metals were higher as a group, but only silver managed a gain that was as big as the index.
Just remember, no one needs financial guidance or assistance in a week like the one just completed. As much as we all dislike convoluted markets with all the attendant discord, those are the weeks that keep us all in business.
We also failed once again to adequately celebrate Guy Fawkes Day. This is a British semi-holiday to remember a failed plot to kill King James I of England (James VI of Scotland). Guy Fawkes and a bunch of co-conspirators planned to kill James I and install his daughter (a Catholic) on the throne of England. Fawkes was put in charge of the explosives that were secreted under the Houses of Parliament and to be detonated during the King’s planned speech there. Fawkes was caught while he was guarding the gunpowder and tried and convicted of treason. November 5, 1605 was the date when the plotters had planned to blow-up Parliament and kill the King. The date is still celebrated in England with bonfires and fireworks.
It is hard in this country to remember that much of the world is torn by inter-religious conflict. Hindus and Muslims still fight it out in parts of India, while different brands of Muslims fight in various Middle Eastern countries. Different brands of Protestants can’t stand each other in parts of Europe, while different brands of Orthodox Christians are trying these days to mend their differences before all of them are gone. It wasn’t that long ago when Catholics or Jews were denied some of their Constitutional rights in different parts of the country. Maryland was established as a specifically Catholic colony during colonial times.
It was the history of Europe in the few hundred years before the American Revolution that prompted the founding fathers to specify in the First Amendment that:
“Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the Government for a redress of grievances.”
It only took us 150 years to totally misconstrue those words and not allow kids to say a little prayer before tests. In fact, read it again and tell me where it says the government can stop people from worshipping anywhere they please, even in school. The free exercise of religion is under attack and that is one thing the founders made explicit in their amendment. Oh well, we promised to stop being political.
Have a great week.
Karl Schroeder, RFC, CSA
Investment Advisory Representative
Schroeder Financial Services, Inc.
480-895-0611