Their first argument is that “Direct (central bank) support is delaying vital post-crisis adjustment and runs the risk of creating zombie financial and non-financial firms.”  Although I was unable to find a suggested remedy in the report, the implication is the BIS prefers failing banks – and the ripple effect it has on the global economic system (we need more Lehmann Brothers!).  Frightening stuff from a central banker!

Then we have the argument that low interest rates are dangerous, because “Previous episodes of low interest rates suggest that loose monetary policy can be associated with credit booms, asset price increases, a decline in risk spreads and a search for yield.”  While this is true, and clearly puts some of the blame for the recession on excessively loose US monetary policy from 2006-2008, it is amazing to see the logic applied today.  The BIS is saying that even though we have experienced a substantial decline in asset prices and a continuing credit crunch, we can’t keep rates low because that might lead to recovery!

The final argument I’ll highlight is the Bank’s concern over deficits.  “High and rising levels of public debt imply significant risks for the global economy. As demonstrated by the recent European debt crisis,  concerns about government default may lead to a sharp rise in interest rates, which could further aggravate financial fragility and put the incipient economic recovery at risk.”

Note the use of the words ‘may’, ‘could’, and ‘imply’.  Here’s some data on interest rates for the US, UK, and Germany.  Remember that the BIS is saying that high and rising levels of debt may lead to a sharp rise in interest rates.

Or, it may not lead to a sharp rise in interest rates.

No matter.  On the basis that there might be concerns in the future which might cause higher rates, which might actually be a good thing as it would prevent another asset bubble, let’s all adopt austerity budgets to cut spending.

Here’s the BIS report’s take on the implications:  “Such (austerity) measures may have adverse effects on output growth in the short term, but the alternative of having to cope with a sudden loss in market confidence would be much worse.”

Basically, we should send the global economy into another recession (or worse), because the potential loss in market confidence may cause problems if we don’t.   Problems like, um, a recession.

This report is frightening because the extraordinary illogical thinking is being espoused by the world’s central bank.

It’s no wonder that economist Paul Krugman believes we may be entering a long depression as a result of this kind of policy failure.

One aspect of this I find interesting is that virtually all of those crying loudest for deficit reduction today are not those who were vocal about it several years ago.  The main proponents of deficit reduction today are in fact the very architects of that deficit.

Despite the blatantly political nature of the debate, the belief that the US must cut its deficits to prevent economic calamity has garnered surprisingly widespread support.  A recent study found that the percentage of Americans citing the deficit as the most important national problem has nearly doubled to 11%, the highest percentage in almost 20 years.

Republicans have pounced on this marketing success, and are now calling for austerity as the only responsible way forward.

Most economists disagree, claiming that austerity programs at this point in the cycle would be lunacy, and endanger the economic future.  They cite FDR’s balanced budget of 1937 that is widely believed to have sent the country back into recession.

There are some economists who are in favour, but the only rational economic argument for austerity now is that continued stimulus runs the risk of debt crisis in the future.  While that may be true in a country like Greece, whose debt is primarily financed in currencies it does not control, the argument holds little weight when applied to the US.

Certainly the investment community does not believe the US is running a risk of a debt crisis in the future.  Rates on US treasury notes are at historic lows.

Why the appeal of austerity?  At one level the argument makes sense.  If a household is in a financial crisis, austerity is usually the only way out of the mess.  Therefore, surely that would be true of a government as well.

Except that a government is very different to a household.   Households can’t tax, or borrow against future income, or promote the general welfare, and government austerity in a time of financial crisis quite clearly exacerbates the problems – as we’ve seen recently with California and other states with balanced budget amendments.  Since tax revenues decline dramatically in a recession, these states are forced to cut services and lay off thousands – which only adds to the downward economic spiral.

Nonetheless, the right wing have found an issue that they believe will help Republicans do well in the mid term elections (already a certainty), and no doubt we will continue to hear the clarion calls for austerity until at least early November.

As an aside, I find it amusing that Republican administrations have been the biggest deficit producers.  Also interesting is the Republican budget alternative calls for increased defense spending and lower corporate taxes, offset by cutting Social Security, Medicaid and Medicare benefits.

We should keep in mind, though, that voters are generally more concerned about the state of the economy than about a potential future debt crisis – not at all surprising when over half of those in a recent survey admitted to being financially impacted by the recession.  The 11% who nominate deficits as the country’s biggest problem are swamped by the 55% who nominate unemployment or the economy.

The Obama administration has fortunately not bought into the austerity argument, and whether the right wing likes it or not, the President may be the only thing keeping the US from a double dip.

Republicans are using the deficit as an excuse to be the party of no.  According to Senate minority leader Mitch McConnell:  “Americans see what’s happening in Europe, and they’re begging us to bring the debt under control, to cut it down before we face a similar fate. Instead, Democrats in Washington just keep piling on, as if they’re oblivious to the consequences.”

Don’t forget that these are the same Republican senators who drafted multi-trillion dollar tax cuts a few years ago.  Cuts that were not ‘paid for’ with spending cuts and clearly contributed to massive US deficits.  Cuts where Mr McConnell was indisputably ‘oblivious to the consequences’.

The time for fiscal austerity was five years ago, not today.

The biggest contributor to the increase in the deficit is the soft economy.  Tax revenue declined dramatically in 2009 as corporate profits dropped, wages and bonuses dropped, and fewer people were employed.  Spending automatically increased as unemployment rose and entitlements kicked in.  The impact of these far outweigh the cost of the stimulus package and TARP.

Consequently, the best way to decrease the deficit in the current climate is to do whatever it takes to get the economy back to strong growth.  One can argue about the kinds of actions best suited for that, but clearly belt tightening is not among them.  Whether this is ignorance on the part of Republican Senators, or an attempt to create a double dip in advance of mid term elections, I’ll leave to the reader to decide.

A few months ago, I thought only a dip in growth in China could stall the recovery.  I didn’t account for Republican senators.

After each bust, pundits were quick to call the end of the world as we know it – just as during each boom different pundits were justifying the asset inflation with end-of-the-world-as-we-know-it arguments.  (It’s not about profits, it’s about eyeballs!)

Well, the pundits are certainly active again, with well written arguments about how Europe is imploding, China is shrinking, US unemployment is not coming down, deficits are out of control, and so forth.

In this part 2 of Why I am a Bull, let’s take a step back and look at where we are in the economic cycle.  Here’s a chart showing the S&P 500 index from its peak in 2007 until June 2010.  Also on the chart is the same index from its peak in 2000 through the last downturn and beginning of recovery.

As you can see, this downturn was sharper than the last (peak to trough of 17 months this time vs 25 months last time) and the recovery has been a bit sharper as well.  Where we are now corresponds to about March 2003, which marked the beginning of a period of very strong returns in the stock market.

Now let’s look at what’s in the papers.  Concern over the wars in Afghanistan and Iraq.  North Korea’s growing aggression.   European banks desperately trying to get bad loans off their balance sheets.

Major concern over growing government deficits, with comments like:  (the current administration’s actions) “have utterly transformed our fiscal outlook, for the worse … nothing short of an economic miracle can save us from a fiscal crisis … And there’s a lesson here that goes beyond fiscal policies. On almost every front the outlook for the United States now seems far bleaker than it did two years ago.”

Add to that a chorus of concerns that we are now in a new, slow growth reality.  Like these comments:  “(T)here are tangible reasons to doubt that the United States will soon return to the heady times … The federal budget deficit is rising, and the aging of the population will slow the growth of the labor force.  Consumers will probably not increase their spending as rapidly as they did in recent years, and businesses — having invested so much in the boom years — still have a lot of idle factories and machinery.”

If you followed any of those links (which I would encourage), you’ll note those articles are all from March 2003.

I don’t mean to dismiss the current concerns.  Greece and other European countries still have pain ahead, continued deficits are ultimately unsustainable, the oil spill is nothing short of a disaster, and the next couple of years are unlikely to be great years for the US economy.

However, all of these worries, and more, are already priced into stocks, and none of them shake my belief that now is a good time to go long.

All things are wearisome, more than one can say.

The eye never has enough of seeing, nor the ear its fill of hearing.

What has been will be again, what has been done will be done again;

there is nothing new under the sun.

They are wrong, and the next couple of posts will try to explain why I am much more optimistic.

I’ll start with some long term analysis of the US stock market.  Here is a chart of the S&P 500 index over the last 50 years.

You can see the market got a bit ahead of itself in the latter half of the 90s, and the irrational exuberance label was deserved.  The expansion from 2002-2008 was very much in line with the long term trend, and the recession has now moved stocks significantly below that line.

But, the pessimists argue, what about earnings?  The underlying corporate earnings aren’t there, and the market is being held up by an unrealistic Price/Earnings ratio!  The trend will not continue!

So, let’s have a look at that data.

Again you can see the late 90s is a unique period.  Since the recession, there is a spike in 2009 (due primarily to company write downs in one quarter), but current PE ratios are consistent with history.  And given the decline in long term interest rates over the last 20 years, there is a strong economic argument that PE ratios should be higher.

Adding to that, corporate earnings have recovered fairly well since the recession, and are forecast to continue growing.  This is in spite of the problems in Greece, the oil spill, the deficit, and even President Obama.

Of course the past is not an infallible predictor of the future, and things that have never happened before are happening every day.  Nonetheless, the fundamental expectation of continued earnings growth and low interest rates suggest that the market correction is just that, and not the beginning of the end for the economy.

In the next post, I hope to have a look at where we are in the cycle and what we can expect.

Clearly this has not always been the case.  Below is a chart comparing the Dow Jones Industrial average to the US dollar broad currency index.  (I have inverted the dollar index to make it clear.)

Before the Asian currency crisis in 1998, there was actually a pretty strong positive correlation – as the market improved the US dollar strengthened.  Something changed after that, and the correlation has clearly moved to a negative one.

I think this is due to a combination of two factors.  First, exchange rates used to be determined by underlying balance of trade and differing inflation rates.  In the last couple of decades these forces have been swamped by the volume of financial trades, and exchange rates are now a function of investor sentiment.  Second, the US dollar is seen as a safe currency (despite the uninformed ranting of the right wing), and investors believe the US dollar will not have a run due to lack of investor confidence (as happened to Russia, Thailand, Mexico, and others).

As a result, US dollar strength has become a proxy for investor risk appetite.  As uncertainty and fear creep into investors’ minds, risk appetite decreases, investors want to hold US dollars (or US dollar assets), and the dollar strengthens.  As fear recedes and the appetite for risk expands, investors are more willing to venture into non US dollar assets, and the dollar weakens.  This seems to be happening largely in transactions called “carry” trades, where investors borrow in US dollars at low interest rates, and invest in higher yielding assets in other currencies.

Personally, I don’t see the relationship between the market and exchange rates changing soon, and suspect the inverse correlation will continue at least until US interest rates return to more normal levels (making the carry trade less interesting).

It does suggest that professional investors do not agree with Fox News that “Greece’s current woes will be (America’s) future”.  It also suggests that the exchange rate is driven by market sentiment, and not the other way around.

Markets have corrections.  A typical bull market has a long, slow upward movement, followed by a short, sharp downward correction.  This ‘sawtooth’ pattern is quite normal.  If you believe the market is in a longer term bull, these drops represent buying opportunities.

However, something over 60% of trades are now done by computer.  These trades, also known as High Frequency Trades (HFTs) are managed by computer programs written and administered by hundreds of different firms.  Although each firm has its own algorithms and proprietary coding, the reality is that they largely act in the same way, and in a very interconnected way.  So if one large trading program initiates a ‘sell-off’ switch, the resulting trades may well trigger other HFT programs to move into sell-off mode.

On Thursday, a normal bull market correction was hit by this selling tsunami.  Almost all of it occurred outside the floor of the NYSE, where human market makers had called a short halt to allow trades to clear.

The truth is that no one knows what happened.  The SEC has called a meeting of all exchanges on Monday to try and figure it out.  However, on a basic level, selling volume overwhelmed buying volume.  If there were then sell orders ‘at market’, there is no limit to how low the market can momentarily go.  In a few minutes, all buying orders were cleared, and apparently where there were no buy orders shares were selling at 1 cent.  Several hundred of these trades are likely to be cancelled, although that process sounds a bit fishy to me.  If you are willing to turn your trading over to your computer program, and the program sells shares indiscriminately, seems to me that should be your risk.

At any rate, some investors responded on Friday by placing buy orders on major stocks at very low prices, hoping that another HFT sell down would allow them to buy cheap.  That may not be a bad idea.

The view from down under is that this is a bull market correction and buying opportunity.  The nervousness about Greek debt is overblown, American consumers appear to be spending, job growth is continuing, and there is no double dip recession.

And Happy Mothers Day.

But just to add a bit of fuel to the economic recovery fire, there are more signs of continued and strong economic growth.  Reporting season is under way, and in the first quarter, company performance is surprisingly robust.  Of the 106 companies to have reported earnings so far, the average result is 7.4% above forecast – meaning profits are not just up but are also up more than analysts expected.  68 companies reported earning of 5% or more above forecast, and only 4 reported earnings 5% or more below forecast.  (Apparently the analysts were wary of the recovery as well).  GE, sometimes viewed as a bellweather of the economy due to its highly diversified earnings stream, was a whopping 31% above consensus forecast.  UPS, another company closely associated with the overall economy, was 30% above forecast.

This is not just the result of belt tightening.  Revenue growth of the S&P 500 was 15% in the first quarter (over the first quarter last year) and is now forecast to be nearly 15% for the full year 2010.  You can’t belt tighten your way to higher revenue.

This should be humbling to those who jumped on the bandwagon of economic collapse and then couldn’t get off, but it probably won’t be.  (Amazingly, some are still riding on the creaky thing.)

However it is heartening to the rest of us who are pulling for the US economy.

The poll also illustrates the difference between the general and the specific.  Although only 5% want to reduce the deficit through increased taxes, 59% of Americans favor raising taxes on families making over $250,000.  Maybe they don’t think taxing the rich will reduce the deficit, but it still sounds like a good idea.

When asked what areas of the budget should be cut, the only one supported by a majority (71%) was foreign aid, which represents about half a percent of spending (most of which goes to Israel).  About three fourths of government spending is on defense, social security, medicare, medicaid, and mandated programs that generally fall under the ‘aid to the poor’ category (unemployment, welfare, etc).  80-90% of Americans oppose cuts to any of these areas.

Yet, most Americans said a candidates position on the deficit was either very important (47%) or the most important factor (10%) in deciding whom to support in the next election.  Another 25% said it was somewhat important, so presumably 82% of Americans will care about their candidate’s position on the deficit.

If this poll is an accurate reflection of voter feelings on election day, it would suggest Democratic candidates focusing on reducing the deficit by raising taxes on the wealthy should prevail over Republican candidates talking about cutting taxes and reducing spending.  The view from down under is that the poll is not accurate in this regard, and when it comes time to vote people won’t care about the deficit as much.   Voters will weigh their candidate’s stand on the deficit with all the other factors, and probably accept a general ‘concern’ about the deficit as sufficient.  Since any firm proposal for deficit reduction (other than raising taxes on the wealthy) will meet with voter rejection, a heightened level of rhetoric is all we’re likely to hear, and next year’s Congress will continue to have no mandate for deficit reduction.

Eventually this will have to change.  As Ben Bernanke said last week:

The arithmetic is, unfortunately, quite clear. To avoid large and unsustainable budget deficits, the nation will ultimately have to choose among higher taxes, modifications to entitlement programs such as Social Security and Medicare, less spending on everything else from education to defense, or some combination of the above. These choices are difficult, and it always seems easier to put them off–until the day they cannot be put off any more. But unless we as a nation demonstrate a strong commitment to fiscal responsibility, in the longer run we will have neither financial stability nor healthy economic growth.

Here’s a chart of monthly job creation (or loss) over the last ten years in the US:

The job gains announced for March 2010 look pretty good in the historical context, very close to the average monthly job gains for the boom years 2004-2006.  So why is unemployment not dropping?

The number of people ‘marginally attached’ to the labor force dropped by about 270,000 in March.  These are people who want to work and have looked for a job at some point in the last 12 months, but because they have not looked for a job in the last four weeks they are not counted as unemployed.  A drop in the marginally attached is a sign of a growing economy.  As people start to think there may be a job for them, they start looking for work (although this number can drop for other reasons, like people going back to school).  As the marginally attached start to look for work again, it increases the number of unemployed – even as new jobs are being created.  There were still 2.3 million marginally attached workers in March (compared to an average 1.5 million from 2004-2006).

The view from down under is that unemployment is likely to remain close to 10% for some time.  Even with relatively strong job growth, the effect of the marginally attached re-entering the labor force will keep the headline number high for the next six to nine months.