JPMorgan made headlines late last week for a $2 billion trading loss that’s likely to grow over time. Today, the bank’s CIO fell on her sword for the trading gaffe. Ina Drew, a 30-year veteran of the firm decided today was a good day to “retire” from her trading desk.

JP Morgan’s costly error was the result of “reaching for yield,” just like retirees all over the US are doing. When traditional fixed income securities like Treasuries and CDs provide almost no yield whatsoever, the only remaining option is to reach in to riskier markets to try to find some yield. Reaching for yield — overpaying for income-producing securities in a low-rate environment — usually leads to a painful tumble off the proverbial ladder.

As part of the banking crisis fallout, the Federal Reserve pushed interest rates down close to zero, and is telling investors to expect zero rates until 2014. Savers will have gone six years without interest income, all so the Fed can implement its grand experiment to rebalance portfolios away from cash and US Treasuries.

“We’ll buy the Treasuries,” the Fed implicitly says to investors, “so you can push up the stock market to create a wealth effect for the economy.” This begs the question: What happens if the Fed decides to unwind its gigantic Treasury portfolio? Wouldn’t that reverse the stock market wealth effect at warp speed? The answer is yes, but here’s the dirty secret: The Fed is never going to unwind its portfolio. It’s going to be forced by investors (and Congress) to keep the reserves it has injected into the banking system intact, so it can keep rates low on the US national debt. That’s why we’ve been looking for short ideas that would suffer in an environment of rising commodity costs.

It’s inevitable and unfortunate that retirees starved for yield are overpaying for risky assets like REITs, junk bonds and even financial products that create “synthetic” yield. A synthetic yield means a yield created by derivatives, rather than the underlying security. These derivatives often cap upside returns in exchange for higher current income. As such, these structured products are essentially a slow return of capital masquerading as income. Some annuity products sold to retirees fit this description.

Back to JPMorgan, and the specifics of its $2 billion trading mishap. This is important, because it’s a consequence of our still-broken financial system…

JPMorgan last night warned in its 10-Q that it’s going to take an earnings hit in the second quarter from trades in its Chief Investment Office (CIO). CEO Jamie Dimon felt the need to schedule an impromptu conference call explaining the impending losses from CIO’s hedging activities.

JPMorgan’s Treasury and CIO department is tasked with investing the bank’s excess cash, while hedging the credit risk that exists on the rest of the bank’s $2.3 trillion balance sheet. Most people forget that banks are among the biggest fixed-income investors, and are suffering in a low-interest rate environment along with retirees. It’s hard to shed a tear, I know. So JPM decided it was a good idea to play along with the Fed’s encouragement to exit low-yielding securities and move out along the risk spectrum to invest its excess cash to enhance shareholder returns.

JPM’s $1.1 trillion in deposits exceed its loan portfolio by $407 billion, so it has lots of excess cash looking for a return. At March 31, CIO managed a $374 billion portfolio of securities — presumably in a manner that hedges JPM’s credit risk. There is derivative exposure too, as we discover in the 10-Q. The CIO can create synthetic credit risk by shorting credit default swaps, in which it would collect insurance premiums from underwriting the default risk on a specific entity. The result is synthetic interest income if everything is peachy and default doesn’t occur; if not, the result is repeated margin calls and a complete blowup if the reference entity defaults. Think a mini version of AIG in 2008.

Jamie Dimon refused to provide any detail about the derivative trades on the conference call, but we can guess. Here is my guess: JPM owns a boatload of credit risk. Therefore, if CIO were trying to offset this risk, it would probably sell short credit default swap insurance (CDS). Some of the biggest rises in CDS spreads since March 31 were in European banks. If CIO was short a basket of CDS on European credit indexes that included European banks, then its hedging activities could wind up inflicting large losses. If so, the CIO would have had to post more and more margin with its counterparty as the trade went against it. At some point, Dimon was informed of this unpleasant reality and decided to unwind the losing trade and break the news in the 10-Q.

JPM’s conference call was a stark reminder that investing in large derivatives-trading banks (the “Too Big to Fails”) is investing in a volatile cocktail of credit risk. Executives manage this credit risk with minimal disclosure about what types of risk they’re taking. “Just trust us,” is what they say. “We have sophisticated ‘Value at Risk’ models managed by rocket scientists,” they say. As you recall from the financial crisis, this was a formula that blew up spectacularly.

Jamie Dimon was very defensive and combative in response to questions on the call. He couldn’t provide specifics about the mark-to-market loss lurking in the CIO trading books — for obvious reasons: Other traders on Wall Street, like sharks smelling the scent of blood, would make JPMorgan’s exit from these underwater derivatives positions an even-more painful experience, while pocketing derivatives trading profits.

We won’t know any more detail until JPM reports its second quarter, when Dimon promised to provide more detail — presumably after unwinding the losing trades. This episode is one of many flashing signs that the global banking system is more fragile than advertised. JPM has built a reputation as one of the better risk managers among the world’s largest banks. If JPM had this surprise, what derivatives accidents lie in wait at other banks? With the eurozone on the verge of heightened drama and bank restructurings, I don’t think stock market bulls want to find out.

Finally, I’d be remiss to not mention our wonderful financial system regulators. Using the logic of the idiots (Dodd and Frank) that supposedly “reformed” Wall Street after the financial crisis, what we need now is another new regulatory agency. Dodd-Frank was a thin coat of paint over a cracked and broken banking system; since it failed to accurately diagnose the causes of the financial crisis, it was a dud and a nuisance from day one.

More legal complexity, more wasted money and red tape and more lack of regulator accountability is what we got, when in reality, a big part of the problem was regulators not policing activities at the Too Big to Fail banks. Here’s an idea — one that banking history expert Jim Grant has been pushing for years: It’s called “capitalism.” Take away the subsidies and bailouts for banks, along with the regulatory red tape. If they want to blow themselves up, fine — but losses would fall on the risk managers making those decisions and bank shareholders, not taxpayers or depositors. Push to return the investment banking business back to the partnership model that worked much better. Then, with the senior partners’ capital on the line, we’ll see how many derivatives blowups occur.

Regards,

Dan Amoss
for The Daily Reckoning

A Big Oops at JP Morgan! originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

But aren’t the problems in Europe rooted in spending more than incomes and tax revenues and having to borrow the difference? Yes. Europe has already run out of money — that is, money defined as having a certain amount of purchasing power today. But what about paper money that will buy less goods and services in the future? Isn’t there plenty of that? Sure, there is! In fact, [in order to finance its Long-Term Financing Operation (LTRO)] the European Central Bank printed about 1 trillion euros in just the last few months.

But this much-heralded LTRO isn’t fueling purchases of risky assets — at least not yet. If investors follow the money, they’ll discover that banks are depositing the three-year euro loans they borrowed from the ECB right back at the ECB! These banks are, obviously, not in a hurry to speculate with the cash proceeds from their three-year LTRO loans.

Here’s the part about EU bank behavior that should terrify anyone basing an investment strategy on the fact that the PIIGS governments will continue to enjoy lower and lower yields at sovereign bond auctions: The banks that borrowed three-year money from the ECB at a cost of 1% per year are willing to redeposit the cash at the ECB for a 0.25% per year return. In other words, banks are willing to suffer a “negative carry” of 75 basis points just to have cash available to satisfy depositors at a moment’s notice.

The most plausible explanation for this behavior: Banks will use this cash to satisfy their own lenders and depositors, many of whom will decide not to roll over their loans to these banks. EU banks are, in short, replacing private-sector funding with ECB funding.

Here is the consequence: the slow-motion nationalization of many European banks. When the LTRO loans mature in three years, many of them will not be able to go back to the private-sector funding model. This will ultimately force the ECB to indefinitely roll over the LTRO loans to insolvent banks. A better name for the “long-term refinancing operation” would have been “infinite refinancing operation” (for as long as the euro exists) — or, for the acronym fans, IRO until RIP EUR.

As European investors realize this LTRO cash will be used simply to satisfy maturing liabilities, we’ll probably go right back to the market environment we saw in July-September 2011. The situation in Europe is as fragile as ever. Political change in Greece has the potential to bring about a messy default, and the April election in France has the potential to spark the end of the euro by ending the Merkel/Sarkozy “bailouts at any cost” status quo.

The euro crisis is about as “solved” as the US financial crisis was solved after the March 2008 Bear Stearns rescue. I remember spring 2008 well, having spent hours identifying the next banking victims of the US mortgage crisis, while the consensus breathed a sigh of relief (as it is today), that the Fed rescue of Bear Stearns “solved” the mortgage crisis.

The only thing these central bank rescues accomplish is to impose the cost of bank bailouts onto the holders of paper currencies. That’s why the S&P 500 Index remains 50% below its 2008 peak in real (gold) terms, even though the index is only 12% below its all-time high in nominal terms.

All the cash the central banks are printing is dry tinder for a great explosion in consumer prices that should, unfortunately, more than offset any meager gains in the S&P 500 that have the talking heads in the financial press so excited.

Here’s the good news: By the end of this bear market, the S&P will be an even tinier fraction of gold prices. If you save heavily in the form of gold, your buying power when the next great stock buying opportunity arrives will be that much greater.

As central banks prop up bankrupt governments with newly created money, an ocean of paper money will be desperate to own gold, bidding it up in the process.

Over the next few years, I expect that as consumer prices rise, investors will greatly hike the rate at which they discount future corporate cash flows, which will result in much lower price-earnings ratios for most stocks.

The list of negative market catalysts is long and scary. The list of positive market catalysts is nothing to get excited about. The most-important positive catalyst to drive the market up from here is an old standby: “Stocks offer a better total return, including dividends, than 2% Treasury bonds and 0% bank CDs.” This meme is ready to celebrate its second or third birthday, by my calculations. It’s front-page news. It’s a talking point for financial advisers and Wall Street strategists. So it’s hard to argue that this well-worn debating point of the bulls is not already reflected in stock prices.

Regards,

Dan Amoss,
for The Daily Reckoning

The Unsolved Euro Crisis originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

A group of the largest central banks in the world announced a coordinated easing program on Wednesday morning. This will involve printing more of their home currencies and lending these currencies to other central banks, which, in turn, will re-lend these currencies to local banks.

Many European banks have, essentially, been cut off from borrowing in the private credit markets. So central banks are going to ignore the fact that most of these European banks are insolvent and offer them easier and easier access to long-term funding in whichever currency they need to borrow.

The entirely predictable result will be similar to what we see in the US: zombie banks whose assets will feature fewer and fewer private-sector loans and more and more government bonds.

How is this supposed to foster global economic recovery? It seems like a perfect accelerant for global stagflation.

In other words, the world will have plenty of consumers, financed by government budgets, which are, in turn, financed by both compliant private banks and central banks. But will the world have enough producers?

The Fed and most of the other central banks believe the Western economies suffer from “deficient demand” and, therefore face the risk of “deflation.” But I disagree…vehemently. Bad credit needs to default and infirm corporations need to perish if the Western economies are to have any chance of beginning a new phase of renewal and growth.

But that’s not the plan that’s on the table. “Plan A,” in the modern playbook of central banking is to artificially support asset prices and to bail out sickly too-big-to-fail banks. The plan sounds like it could be relatively painless, but it will be extremely painful.

In the end, savers of paper money will pick up the tab — over a multiyear period — for all of these government- and banking-created disasters. The system of government, banking and central banking, as it’s currently configured, will force the responsible to bail out the irresponsible…once again.

Once central banks start lending to insolvent banks, there can be no orderly exit. When sovereign defaults occur — and they will, in Greece and Portugal, and probably Italy and Spain — there will be an acceleration of money-printing to keep the system propped up.

We may even see the Fed and the ECB lend to the IMF, which will re-lend cash to the PIIGS in the form of a “debtor in possession” loan that will, effectively, allow European banks to keep pretending that they have no losses on PIIGS bonds.

Here’s a fun game: Try to imagine your own fiat-money-driven, rule-changing scenario for “rescuing” the Western financial system. There’s a pretty decent chance the central bankers will try it at some point.

But there’s a big difference between press releases that goose the stock market and policies that foster genuine economic growth. This week, for example, the public in Greece and Italy are likely to be furious when their “technocratic” leaders from the banking establishment sign away their sovereignty to the EU and the IMF at this week’s summit. There will be more riots and strikes, which will make the goals of budget austerity even less likely than they are already.

Despite the obvious state of unavoidable depression in the PIIGS economies, the EU and ECB will get more and more radical in their tactics to protect the core EU banking system from collapsing under the weight of credit exposure to the PIIGS. All of this action is being done to protect banks, and as a result, will steadily suck the lifeblood from the private sector.

In short, I am not optimistic.

Therefore, my strategy at the Strategic Short Report remains the same: Identify the likeliest victims of the ongoing credit contraction in the private sector. American Airlines (AMR), a company I urged my subscribers to sell short several months ago was a classic example. AMR just filed for bankruptcy. There will be many more.

Regards,

Dan Amoss,
for The Daily Reckoning

Print…Ready…Aim originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

Readers of my research service, Strategic Short Report, know that we’ve held a short position on AMR since mid-March. But that’s only part of the story here…

Many families of AMR employees will be impacted by this development, and it’s unfortunate that conditions forced this decision by the company. It’s a stressful day for loyal, hard working employees already suffering under a stagnant, inflationary economy.

The airline industry is deep into a painful but necessary restructuring process. Today’s bankruptcy is a big step toward a better future. We can all hope for a better, healthier airline industry on the other side of this restructuring, and hope that pilots, flight attendants and maintenance crews impacted by this bankruptcy find other opportunities with American or with other airlines.

Thankfully, AMR management and the board of directors did the right thing to avoid risking an even worse fate: liquidation. AMR is entering bankruptcy with several billion dollars in cash. Sustained high jet fuel prices, brought about by aggressive central bank money printing (and the prospect of even more printing) would have rapidly drained AMR’s remaining cash reserves.

The New York Stock Exchange has halted the stock several times today. Other than short sellers covering their positions, there are no natural buyers of AMR stock today.

Few will want to embark on the long, uncertain process of owning AMR stock through bankruptcy, with the thesis that it will retain any value in a “new AMR” on the other side of Chapter 11. Most likely, creditors will own the vast majority of the stock after bankruptcy, diluting the value of a current AMR share to practically nothing.

This is all part of the process. Successful bankruptcy reorganization is as American as “Mom and apple pie.” American history and culture is all about renewal and fresh starts. While painful for many parties, it’s often necessary to restore soundness to an organization.

Corporations, like people, go through different stages of life: birth, adolescence, maturity, and death. In capitalism, corporate death frees up the capital and resources to fuel the next wave of company births. Trying to stop this process with bailouts and zero interest rates only guarantees that we’ll squander ever more resources on situations in need of restructuring.

Pain is a part of life, and trying to avoid it entirely is not healthy. Of course, that may be of little comfort to those affected by AMR’s bankruptcy at this time. We keep them in our thoughts and prayers.

We’ve published eleven Strategic Short Report commentaries on AMR since the March issue (when we first identified the stock as an attractive short) reiterating our case. Our readers had the opportunity to play a profitable part in the important process of aiding stock market efficiency.

Short sellers add to market efficiency by adding selling pressure to overvalued stocks.

In the case of AMR stock, it was overvalued the whole way down, because in hindsight, it was worth nothing…despite Wall Street analysts’ humorous attempts to value AMR as though it were a “call option” on recovery in the airline industry. We simply identified that there was a high probability the stock was worth nothing before the rest of the market. Sometimes it’s rational to panic, and panic early, ahead of the crowd.

In other cases — high-P/E momentum stocks, for example — short sellers add selling pressure where there otherwise would be none. Short sellers help keep bubbles from getting completely out of control and wasting oodles of capital — often sustaining heavy losses while holding short positions that move against them.

Sometimes, disagreeing with market prices is painful, but it is important to remember the vital role that short sellers play in the capitalistic process.

Short sellers add to the efficiency of the economy by acting to raise the cost of capital for companies that, with overvalued stocks, can raise capital on easy terms — easier than more deserving competitors.

It was very unlikely AMR shareholders could have salvaged any value (in the form of future free cash flow or dividends), and in fact, it’s better for employees and the entire organization that shareholders and creditors will lose some or all of their claims on company assets.

So in case you’re concerned that you “profited from the bankruptcy” of a storied American company in 2011: rest assured, you did not. In a very small way, you accelerated a painful but necessary process. Further operation of AMR in its current form would have simply squandered scarce resources in the hopes that shareholders and creditors would have some degree of return on their investments.

We all learn from each trading and investing experience (myself included). Profit or lose, we can get better by building a working knowledge of which strategies work, and which do not. After enough experience selling short, you begin to identify the telltale signs of a good, potentially profitable idea.

If we are still in the midst of a 15-20 year bear market — as I suspect — adding short sales and a sensible amount of put options to your portfolio is prudent. Hopefully, our ideas have helped your portfolio weather the recurring 2011 financial hurricanes.

Here’s hoping a revitalized, slimmed-down American Airlines comes back stronger than ever.

Best regards,

Dan Amoss,
for The Daily Reckoning

American Airlines Retreats to Fight Another Day originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

Last week’s euphoria over the Euro bailout turned around sharply this week on news that the political situation in Greece is worsening. That’s been the pattern for months.

The grim reality is that “rescue plans” can’t fix what’s broken. The Western nations are suffocating under mountains of debt…and there are only two known “cures”: default or inflation.

The default option is quick, direct and painful…but very effective. The inflation option is slow, indirect and somewhat less painful…but very ineffective. Inflation is more an anesthetic than a genuine cure, which is the reason why politicians prefer it to an outright default.

So it should be little surprise that the politicians of the euro zone have been signaling very clearly that they intend to “inflate away” the Greek-cum-Italy crisis. They will embark on a European version of Ben Bernanke’s quantitative easing tactic — i.e. print money to buy the bonds of troubled PIIGS governments.

Since the default option in not on the table, the PIIGS crisis won’t be close to resolved until we see the ECB overtly or covertly monetize a lot more PIIGS debt. The math doesn’t work without heavily diluting the wealth of eurozone savers via inflation.

We will see much more debt monetization; this week’s interest rate cut from the ECB was just the start of monetary easing in Europe. On this subject, I dug from my files a piece I wrote for Strategic Investment in March 2007.

Here is an excerpt from this essay, which has become even more relevant today than when it first appeared three and a half years ago:

I think more clearly on a train. The rumbling helps focus my mind… Passengers are very much a part of their landscape, yet detached — a perfect occasion to sit back and think about the world that flies past the window.

Here in America, the world that flies past the window is one in which capitalism has become a wealth-transfer process instead of a wealth-creation process. Without genuine wealth-creation, however, the US dollar’s value will become increasingly suspect.

A few weeks ago, as I was rolling up the tracks from Baltimore to New York, my gaze landed on an oil refinery. A little while later, I spotted a casino. Then I started to think about these two very different forms of capitalism — one that relies on an intensive investment of physical capital and one that relies almost entirely on paper money.

Is one of these forms of capitalism inherently better than the other? Does one of them produce a more enduring prosperity?

Yes, to both questions.

Passing by Sunoco’s Marcus Hook Refinery, you can’t help but admire this feat of engineering. Situated on the Delaware/Pennsylvania border, this 800-acre campus covered in miles of steel pipe has the capacity to crack 175,000 barrels of crude oil into refined products in a single day.

Harrah’s Chester Casino & Racetrack does not produce gasoline. It does not produce anything…except a transfer of wealth. It stands in stark contrast to the refinery. The only similarity between the two is that you wouldn’t want either in your backyard.

Yet in the all-important calculation of gross domestic product (GDP), a dollar pumped into Harrah’s one-armed bandit is treated the same as a dollar Sunoco invests in maintaining its refinery. For those who only look at surface numbers, GDP can be a very misleading gauge of economic health. In itself, it tells you nothing about capital formation.

Will America’s capital formation process continue in a sustainable manner when investment dollars are constantly diverted away from refineries because they are too “capital-intensive?”

The ability to cheaply unleash crude oil’s chemical energy is made possible by intellectual capital that has compounded over the years, thanks to consistent investment in research. This intellectual capital translates into material wealth when it’s combined with physical investment in steel, concrete, and the like. Productivity improves as this process of intellectual and physical investment is repeated and refined over time.

Compare this with intellectual capital stored in the minds of mathematicians writing algorithms for Harrah’s computerized slot machines. Casinos are good businesses because the house always wins. But aside from the entertainment value they provide, they do not add to the capital base of the US economy.

Instead, casinos are a vehicle to transfer wealth from gamblers to Harrah’s shareholders. While this casino’s perpetual profits add to overall corporate earnings numbers, does it really create wealth?

Who contributes more to the wealth creation process in the United States — the maintenance worker at Sunoco’s refinery or the Ph.D. mathematician writing algorithms for Harrah’s?

As I consider this question, our train approaches the Philadelphia stop. The urban decay surrounding the University of Pennsylvania’s ivy-draped buildings comes into focus. Ghosts of factories long dormant stand hollow.

This landscape must represent the picture of progress to proponents of the “information economy.” Most Penn students are trained for roles in finance, medicine, and law, while most residents of surrounding communities face a bleak future in this very same information economy.

Someone in China is able to undercut entry-level manufacturing wages by 90% in order to earn a standard of living that approaches the US poverty level. This leaves non-information workers the option of working in un-exportable service industries.

Not all of us can enjoy the privilege of thinking for a living. But all Americans do have the right to vote, and we have every reason to expect a louder populist voice at the ballot boxes as we head down the bumpy transition to an information economy. As most populist politicians have done in the past, they will make promises that can be paid only through newly printed paper money.

Paper money is popular under democracies. Under the control of a central bank, paper money provides modern economies with the illusion of great flexibility and resilience. Without the rigidity of the gold standard, bad bank loans are easily swept under the rug.

But what are the long-term costs of paper monetary systems? How can an economy develop in a healthy, sustainable manner when wealth’s scale constantly changes?

Contrary to popular opinion, paper money is not wealth. Paper money is a claim on wealth. It only has value to the extent that it can be exchanged for things — a bushel of corn, a gallon of gasoline, a dental cleaning, or an Intel microprocessor.

When the government prints more money, it gives a public fixated on asset prices the illusion that they are growing wealthier, when, in fact, they are growing poorer. As paper money becomes more and more plentiful, the producers of valuable products will eventually demand more units of money in exchange for their product or service.

Investors should expect the current momentum behind populist political movements in the US to grow stronger. This will be bad for the dollar, bad for longer-maturity bonds and bad for the stock market, but good for gold prices.

The global economy now floats on a sea of paper money.

This grand monetary experiment has been in place for only a few decades — a mere tick in the clock of civilization. We know how this show ends, having seen previews in Weimar Germany and several banana republics.

Will the price of gold ultimately increase from its current $620 to $3,000 per ounce? I expect that it will.

Investors who hold gold will be very reluctant to sell it when dollar-holders around the world anticipate the endgame of paper monetary systems. For its holders, gold will serve as a solid bridge on the journey from this monetary system to the next.

Gold is no longer $620 an ounce, like it was when I wrote this essay. But neither is gold $3,000 an ounce, which is where it will likely be if I revisit this essay again in 2014. But however high the gold price may climb from here, one thing is clear: The faith-based monetary system is breaking down. Gold will not break down with it.

Regards,

Dan Amoss,
for The Daily Reckoning

The Illusion of Capital originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

The weight of US economic data points to a recessionary environment over the next few quarters. Analysts have not cut their 2011 and 2012 earnings estimates far enough to reflect the recent dramatic deterioration in economic conditions.

The stock market may seem somewhat cheap, based upon overall valuation numbers. But that’s not necessarily encouraging. The stock market typically looks cheap on a trailing earnings basis ahead of a recession. So I would expect the stock market to remain week for several months, but probably not collapse. That’s because the very low yields available on bonds are unlikely to attract capital away from the stock market. On the other hand, low rates can’t really send stocks surging, either. In the coming months, I expect most stocks to slowly grind lower, interrupted by bursts of central bank-fueled rallies.

The euro crisis may come to a head in the next few weeks. Germany may need to suffer a 2008-style market sell-off before the public is scared enough to support the “Eurobond” concept. This fear catalyst alone could pull down the rest of the global stock market, given the size of the problem — at least until we see a fiscal transfer union and/or a much more aggressive European Central Bank.

And the Federal Reserve looks like it’s laying the groundwork for QE3. We have seen trial balloons floated in the press — most recently by Chicago Fed president Charles Evans. In an interview with The Wall Street Journal, Evans said, “We need to do much more to increase the level of [monetary] accommodation.” In a CNBC interview, Mr. Evans expressed his opinion that demand from emerging markets — not QE2 — drove the 2010-11 rally in commodities. Therefore, using Evans’ logic, another round of QE “accommodation” would not lead to another surge in commodities.

Apparently, the academic ivory tower blinds one from the obvious: QE2 exported US dollar inflation to China and other export-oriented economies. They have been returning the favor in the form of higher prices for products exported to the US. QE3 would accelerate this trend, possibly even sparking a panic out of US paper. This is a longer-run prospect if the Fed doesn’t start acknowledging the connection between the size of its balance sheet and commodity prices.

In the shorter run — as in the next several weeks — the stock market would likely have to sell off sharply from here before support for more QE reaches a critical mass. Then, once QE3 is implemented, after a short “sugar high,” the stock market would look ahead and start discounting the impact of higher raw materials prices on future cash flows. Companies without pricing power are at risk of a margin squeeze. In particular, several of the companies that I have recommended selling short in my investment service, Strategic Short Report, are facing this exact risk.

It’s obvious that the appetite for more “fiscal stimulus” is not great. Tonight, we’ll hear President Obama’s latest job creation proposal. There will be the typical Keynesian “get cash into consumers’ hands” proposals — stimulus that won’t work…again.

But there’s a chance the Obama administration might try to implement a backdoor, off-balance sheet, stimulus plan. Several newspaper articles have hinted that we could see a proposal to streamline mortgage refinancing through Fannie Mae and Freddie Mac. This could happen regardless of Republican opposition.

These two housing-bubble-inflating institutions have been out of focus since entering conservatorship three years ago. They guarantee hundreds of billions worth of mortgage-backed securities that pay yields in the range of 5-7%. The homeowners paying these rates haven’t been able to refinance, mostly due to a lack of home equity. Loosening the loan-to-value requirements could result in a surge in refinancing at rates closer to 4% for 30-year mortgages, which would result in a wealth transfer from creditors to borrowers. While putting extra monthly cash into many household budgets, this policy would be the latest in a long line of policies we’ve seen over the past three years to transfer wealth from savers to borrowers.

This idea looks like it has Ben Bernanke’s fingerprints all over it, because he seems frustrated that his rate cuts haven’t translated into cheaper borrowing costs for many households. Also, if many GSE-guaranteed mortgages currently yielding 5-7% were to prepay after refinancing, Bernanke could reinvest the proceeds of the Fed’s mortgage-backed security holdings into more Treasury purchases…a “mini QE” operation. Such a plan, if it unfolded, would add to the inflation problem in the US.

As long as the Fed and other central banks maintain super-easy policies, we will see a steady erosion of corporate profit margins. Directly: The cost structure of operating business will make “higher highs,” in technical parlance. Indirectly: Corporate pricing power will remain weak as commodity inflation is working its way through the pipeline, squeezing household budgets. But none of this is obvious to Fed economists, because their Keynesian models don’t say that the world works this way.

In the wake of last week’s depressing payroll report, it looks like we’re back into another leg of the “risk off” trade. Plus, the European banking system remains stressed.

Hold your short positions!

Regards,

Dan Amoss,
for The Daily Reckoning

Stay Short! originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

Last Wednesday, the Chairman and his colleagues announced:

The [Federal Open Market] Committee currently anticipates that economic conditions – including low rates of resource utilization and a subdued outlook for inflation over the medium run – are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

Applying this perspective to monetary policy, the Fed promises – i.e., threatens – to maintain its failed policy of suppressing short-term interest rates, thereby punishing savers and promoting debt accumulating and consumption. This is an inflationary policy, which will continue to fuel the cost pressures that are already unfolding at many US businesses.

The 2-Year Treasury note yield collapsed to below 0.2% in the wake of the Fed’s policy announcement last Tuesday. As recently as April, when the 2-Year note yielded 0.75%, the market was expecting Fed rate hikes at some point before 2013.

The Fed has effectively decreed that the US Treasury shall pay no interest on notes issued with a 2-year or lower maturity…and not much interest on notes all the way out to the 10-Year.

With this week’s announcement, the Fed pinned the front end of the yield curve to zero. This action will act to lower the average interest rate of the national debt over the next two years, which is a wealth transfer from savers to the federal government.

This is all part of the “financial repression” as outlined by Bill Gross of PIMCO: savers’ wealth stored in banks and Treasuries will be clipped by a few percent per year, as rates remain well below inflation. This inflation tax is a wealth transfer to the government as it gets to spend the newly created money first, before it gets transmitted through the banking system (losing value in the process).

Fast-forward to mid-2013: short-term rates are still near zero (in accordance with the Fed’s new guidance) and the national debt has grown from $14.3 trillion to more than $16 trillion. In 2013, the cost of this debt will depend more than ever on the Fed’s interest rate policy. As a result, the Fed will come under extreme political pressure to keep rates at or near zero.

There is a huge cost to the Fed’s decision on Tuesday: it has given away its ability to hike short-term rates in the event of a US dollar crisis. If foreign creditors accelerate the pace at which they’re already diversifying out of the dollar, inflation may pick up to uncomfortable levels. While the “money velocity” of domestically held dollars may remain low in a sluggish economy, the velocity of dollars held outside the US is likely to increase.

While banks and bond investors have renewed confidence that short-term rates will be near zero for the next two years, the Fed hasn’t bought itself a free lunch. Foreign creditors will continue to lose confidence in the US dollar as a store of value. The dollars that exist outside of the US as a result of past trade deficits – along with the future dollar “exports” – will not remain as sequestered as they have in the past. Their owners will look to exchange them for something with a better chance of preserving their purchasing power: gold, oil projects, farmland, mines, or blue chip stocks.

The Fed is gambling that these creditors will prefer stocks as a store of value. But given the past two weeks of trading, I’m not so sure about that. And how did QE2 ultimately work out as a market-propping manipulation? Where is the Russell 2000 now, Mr. Bernanke?

One thing is for sure: hoarding gold, oil, and other industrial commodities is now an even more attractive proposition than it was prior to Tuesday’s announcement from the Fed. Savers now know there is little chance of earning a positive real return until 2013.

Thanks for nothing, Ben!

Regards,

Dan Amoss,
for The Daily Reckoning

Bernanke to Savers: Save This! originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

It looks like computer-driven, high frequency trading shops, which now account for the majority of trading volume, hammers stocks much more quickly than human investors And there aren’t enough human value investors (at these prices) to absorb the supply of high-P/E stocks from high-speed trading shops looking to sell.

These shops aren’t liquidity providers; they’re parasites that worsen volatility, extract economic rents from long-term investors, and make rational investors who aid the vital process of market efficiency want to throw up on their trading screens.

As investment horizons have shortened, the market has gotten dumber — especially regarding the macro picture.

Rather than doubt the sustainability of the economic stats in early 2011, the market didn’t ask any deep questions, and rallied mindlessly. Now that we get a cluster of terrible data points in the space of the past week (downward GDP revisions, ISM near 50, etc.), we take the elevator down in gut-wrenching fashion.

Common sense dictates that GDP and ISM numbers would weaken when new supplies of fiscal and monetary stimulus drugs were cut off, so why was this a surprise?

Both forms of stimulus (fiscal and monetary) remain very aggressive, but it seems the stock market requires off-the-charts stimulus in order to maintain its high valuation. Even after the past weeks’ selloff, the S&P 500 is still trading at a Shiller P/E ratio of 20. I think it’s reasonable for it to trade down into the low-teens, because stimulus has temporarily pumped up corporate profit margins. The catalysts to drive the Shiller P/E into the low-teens should be some combination of stimulus hangover and a rising CPI.

Don’t listen to the strategists spouting “the Fed model” as justifying much higher stock prices. The Fed Model goes like this: “10-year Treasury yields are 2.5%, so the P/E on ‘forward operating earnings’ should be 30,” or 35, or whatever number suits the strategist’s objective.

I heard a strategist selling this garbage on Bloomberg Radio this morning. First of all, the Treasury yield is a completely manipulated instrument, and doesn’t correspond to the cost of capital for corporations through economic cycles. Secondly, the duration of stocks, however you measure them, is at least three to fours times greater than the duration of the 10-year Treasury, so it’s comparing apples to oranges. The Fed model spits out dangerous conclusions for investors. Four years ago, John Hussman used robust statistical analysis to deconstruct and invalidate the Fed model.

So the strategic outlook for stocks remains negative. Valuations remain high and headwinds will start blowing harder against corporate profits. As for the tactical environment facing stocks…

Europe is the reason for yesterday’s 5% market crash. Bank runs are rumored to be hollowing out the Italian banking system. This “fear trade” will likely continue until the European Central Bank reverses course from its tightening stance, and aggressively buys PIIGS bonds. Most central banks will yet again inflate their balance sheets, which will only exacerbate the stagflation plaguing the global economy.

We should get a relief rally in the S&P 500, but probably not until we go lower — low enough to panic central bankers. German central bankers in particular will change their “hard money” tune once they see their domestic banking system at risk. I agree with the “hard money” central bankers’ view on subsidizing the PIIGS, but ultimately, a critical mass of European central bankers will push for a policy of ballooning the ECB’s balance sheet.

After the next bout of coordinated global central bank easing, I think we’ll transition into a grinding, sideways-to-down market. Gold prices should benefit from a new round of easing.

This is not 2008. I’m confident at this point that the crisis has transitioned to the following: private capital and small business withering on the vine, as each sovereign debt flare-up elicits a new round of central bank easing. This applies to nearly every economy, including the U.S., the euro zone, China, and Japan.

Crony capitalism is, unfortunately, still a dominant force. It slows the healthy process of creative destruction, slows the mobility of capital and labor, and keeps consumer prices higher than they otherwise would be. But it’s the price we paid for the 2008 bailouts.

Cronyism will eventually come back to bite most big banks and corporations as the inflation created to fund bailouts works its way into cost structures, which in turn shrinks profit margins.

Regards,

Dan Amoss,
for The Daily Reckoning

Crony Capitalism at Work originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

To switch metaphors, the so-called recovery is not the fruit of sustainable underlying demand; it is merely the weed of rising inflation expectations. Let me explain…

Much of the recent improvement in economic statistics can be chalked up to inflationary expectations. Business operators believe that future prices for many goods and services will be higher next month than they are today. As a result, many companies – and some households – are asking themselves: “Why don’t we buy the supplies we’ll need in the future today?” Those with savings and capital can afford to do so.

This buying activity, which is driven by expectations of higher prices in the future, results in a transfer of future economic activity into the present. It’s the type of activity that Keynesian central bankers like Ben Bernanke want to encourage. But the transfer of future economic activity into the present carries with it the same problems we saw during the housing and credit bubbles: when the “borrowed-against” future finally arrives, we see a collapse in demand for the pre-bought items.

An example of this phenomenon was the spike and crash in the construction of new homes in the US. During the peak years, several years’ worth of future demand was pulled into the present.

Bernanke’s goal of inducing a benign rise in expectations for future inflation will backfire. Pushing consumers and businesses to “buy now” with the expectation of higher prices in the future is hardly different from subsidizing the reckless growth in debt-driven economic activity in 2004-07. As a result of Bernanke’s quantitative easing experiments, we’ll see sugar rushes in economic activity, followed by hangovers. The result will be stagflation.

While some industries and companies enjoy pricing power, most do not. Those without pricing power will see weaker profit margins as higher raw material prices flow through the chain of production.

I continue to be amazed by the market’s complacency in the face of obvious deterioration in the economic picture. There’s no denying the recessionary impact of gasoline spiking to $4-plus per gallon – and staying there for some time. The International Energy Agency estimated this week that the turmoil in Libya has shut in between 850,000-one million barrels of oil per day. Governments and investors around the world are more interested in securing their oil and food imports than they are in holding US dollars paying negative real interest rates.

Central banks and governments remain blind to the inflationary consequences of their policies. Based on his public comments, Ben Bernanke seems to view rising energy and food prices as a deflationary shock to the US economy – which would, in his mind, necessitate even more money printing. He sees no connection between the expansion of the Fed’s balance sheet and rising prices for necessities. He blames the weather and growth in emerging markets. How convenient!

One would hope that Bernanke understands the dilemmas that faced one Rudolf von Havenstein, president of the German central bank during its hyperinflation of 1921-23. In a research piece posted on Zero Hedge, SocGen strategist Dylan Grice offers an interesting perspective of von Havenstein’s experience. Here is a snippet:

[Let’s] not ignore the parallels [between Weimar Germany and today’s monetary environment]: as is the case for today’s central bankers, Von Havenstein was faced with horrible fiscal problems; as is the case for today’s central bankers, the distinction between fiscal and monetary policy had blurred; as is the case for today’s central bankers, the political difficulty of deflating was daunting; and as is the case for today’s QE-enthralled central bankers, apparently respectable economic theory reassured him that he was doing the right thing.

Grice’s piece is over a year old, published at a time when the consensus view was expecting a “self-sustaining recovery” and an “exit strategy” from QE1. Instead, after a few short months of economic deterioration in mid-2010, Bernanke came out blazing with his QE2 guns. So the question must be asked: how are endless QE programs not considered an effort to monetize the US federal deficit? Everyone has their own answer, but it’s hard to imagine that more investors won’t start worrying about a dramatic collapse in confidence in the US dollar.

The proposed budget cuts from the Obama administration and Congress are jokes. They are woefully inadequate. And polls this week revealed that even many self-identified Tea Party members have no desire to cut Social Security and Medicare benefits. The weaker the political will to enact painful budget reforms, the faster the federal debt will grow. The faster the debt grows, the more the Fed will be pressured to monetize, which boosts the money supply. The further the money supply grows, the more urgency investors around the globe will feel to buy gold, silver, and other hard assets.

Demand for gold should keep growing in the coming months, as Bernanke and other central bankers willfully ignore the inflationary consequences of their actions. It’s hard to imagine a reversal of this trend until we see much more political support in Congress for handcuffing the Fed or changing its so-called “mandate.” As Rep. Ron Paul noted in his questioning of Bernanke recently, the Fed’s quantitative easing enables reckless federal spending like an accommodating bartender enables an alcoholic.

Investors looking to protect their portfolios from the ravages of deficit spending and money printing will look to buy gold.

Regards,

Dan Amoss
for The Daily Reckoning

Inflation 1; Economy 0 originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".

But true economic growth is production-driven, and adds to the supply of goods and services in the economy. True economic growth is not inflationary. Rather, inflation is driven by runaway government deficits and bloated central bank balance sheets. And right now, we have plenty of both. So we have every reason to expect the CPI, even with all of its window-dressing shenanigans, to soar past 2% in short order.

I’m surprised at how complacent the stock market remains in the face of obvious pressure building on the CPI. If the Fed doesn’t react to a rising CPI by tightening policy, Treasury yields will keep soaring, and inflationary psychology will take root among most producers. If the Fed does react by ending Quantitative Easing and raising short-term rates, it doesn’t require much imagination to guess what would happen to a stock market that’s running entirely on fuel from the Fed. Either of these potential scenarios is bad for stocks. The only scenario that argues for further rallies in stocks is if – miraculously – even with unprecedented money printing and deficits worldwide, the CPI doesn’t continue rising.

A rising CPI will give more ammunition to the growing chorus of Fed critics in Congress. At this week’s hearing, when questioned about the building pressure on consumer prices, Bernanke answered that it would be easy to stop this trend by reversing his policies. But you know he’s terrified at the prospect of tightening. He’s an academic with his head in the sand.

When asked about the impact of QE2 on global food prices, Bernanke responded that the destabilizing spikes are due to weather and rapid growth in demand for grains in emerging markets. What a lame excuse! As an admirer of Milton Friedman, he must know that “inflation is always and everywhere a monetary phenomenon.” Inflation isn’t a “weather phenomenon.”

Without forever-growing money supplies, price spikes in one set of goods, like food, would be offset by price declines in more discretionary goods. But in today’s world, demand isn’t limited to what one can produce and save; it’s boosted further by what one can get from government handouts and what one can borrow at the Fed window at 0%.

Yet after all the experiences of recent years (including the early 2008 experience in oil and grains), Bernanke is still oblivious to the consequences of debasing the world’s reserve currency. In his view, if the world doesn’t conform to his personal Phillips Curve and output gap models, there must be something wrong with the world, not his models.

Bernanke has the intellect to understand the negative consequences of the Fed’s radical policies, but he simply chooses to ignore them or rationalize them away. By pushing on the monetary accelerator last fall (rather than wait for another “deflation scare”), Bernanke is going to undermine public support for the Fed. As a result, Bernanke gambled that he could spark a stock market rally. He indeed sparked a rally, starting last August – one that looks very long in the tooth.

But the fact remains that there is no direct “transmission mechanism” from the Fed’s balance sheet to the stock market. Speculators have to have a very specific, benign perspective on Fed policy in order for Fed policy to impact stocks. Today’s misplaced faith in the omniscience of the Fed will soon fade, and when it does, the market will return to intrinsic value very rapidly. The day trading robots and speculators counting on a “Bernanke put” will all look to sell at the same time, and patient investors won’t look to buy until prices fall much closer to intrinsic value. Using the most robust, back-tested historical valuation models, the best estimates of fair value for the S&P 500 that I’ve seen is somewhere in the range of 800-1,000 – 25% to 40% below current levels.

At times like these, it is often constructive to contemplate probable outcomes – to thoughtfully consider the likely winners and losers that soaring food prices will create. The shares of Ag equipment guys and fertilizer companies have been soaring. For example, the shares of Deere and Caterpillar have both more than tripled since Chairmen Ben announced his very first QE program on March 18, 2009. Fertilizer company stocks like Potash and Mosaic have also been on a tear. All these companies are on the receiving side of rising food prices – more or less.

But what about those companies who are on the paying side? Food producers and processors of all types are struggling to accommodate soaring food costs into their business models…and their share prices are showing the strain. Pilgrim’s Pride, Tyson Foods, Sanderson Farms, Kellogg, General Mills and Safeway have all turned in conspicuously poor stock market performances during the last several months.

I recently issued a bearish call on another likely victim of rising food prices. This company is subject to many of the same food price stresses that have been buffeting the companies cited above. Yet, for reasons that are not completely intuitive, the shares of this particular company continue to trend higher. Nevertheless, I suspect rising food costs will put the breaks on this uptrend and cause the stock to reverse course.

This company is facing serious fundamental stresses that will cause similar problems for individuals as well. Inflation is here, folks…whether we like it or not. No use in complaining. Better to prepare.

Regards,

Dan Amoss
for The Daily Reckoning

The Food Crisis is a Dollar Crisis originally appeared in the Daily Reckoning. The Daily Reckoning, published by Agora Financial provides over 400,000 global readers economic news, market analysis, and contrarian investment ideas. Recently Agora Financial released a video titled "What Causes Gas Price to Increase?".