Could Q3 GDP Surprise Us?

At 8:30 am Thursday morning, we will be getting the advanced Q3 (third quarter) GDP number. ("Advanced" is actually a misnomer because it's giving us data for the past; we've been in Q4 for almost a month now. It's called "advanced" because this number will get officially revised twice over the next two months.) So, what should we be looking for?

Expectations
Economists currently expect Q3 GDP to have declined 0.5%. This would be the first quarter of negative GDP growth Q4 2001 (when 9/11 happened).

The GDP calculation is extremely complicated with a lot of variables. Ultimately, economists don't think people bought or sold much between July and September. As such, they're now expecting a negative number.

You and I probably won't be surprised by a negative Q3 number. You and I definitely won't be surprised by a negative Q4 number. Our 401k plans have been falling all year. And all of the really horrible news came at the end of September and beginning of October.

But is it possible that the reported GDP numbers will surprise us?

One of Those Variables
...is net exports/imports. In recent quarters going through Q2, this variable has been net exports. That means we're selling more stuff to foreigners than buying stuff from foreigners. Why?

The weak U.S. dollar. Remember, a weak dollar boosts exports. And, exports are a positive to GDP.

Dollar Strengthening
Since July, the dollar is up around 20% versus a bunch of different currencies. This is a big move and it's a big deal. When the dollar gets stronger, buying U.S. goods gets more expensive for foreigners. That means they're buying less of our stuff. That means exports likely fell.

So, that's gonna be bad for GDP.

But...And this is a Big But

Imports just got cheaper. Does that mean we are gonna import more stuff? I actually think we're gonna import the same amount of stuff; it's just gonna be way cheaper.

If imports get cheaper, then it's still possible for the net export number (which is exports minus imports) to get bigger. That would be good for GDP.

But what are we importing besides lead-painted toys and melamine-tainted baby formula?

O-I-L
Oh baby, do we import oil. If you've been following the presidential campaign, you know we import oil. According to the Energy Information Administration (EIA), the U.S. imports 10,000,000 barrels per DAY! What else?

In July, Oil was $147 per barrel. The other day, oil was at $63 per barrel. That's down 57%!! Those are big savings, baby. This is having a big impact on net exports by making that import number smaller.

Speaking of cheaper oil...

GAS PRICES ARE DOWN!!
According to AAA, the national average price of gasoline yesterday was $2.59 per gallon. In July, that was $4.11. That's down 37%!! So, what are the implications?

My Theory of Joe Consumer
Joe Consumer likes to spend money. According to a recent measure, Americans were spending $1.38 for every $1 earned.

I would argue that Joe Consumer doesn't think much before purchases (he doesn't budget). Joe Consumer starts thinking when he looks at how much money he has left (he has a lot of buyers' remorse).

Therefore, I think Joe Consumer is spending all of his new gas savings, and he probably doesn't even realize it.

I'm No Expert
...on computing GDP. But I think the effects of a stronger dollar, cheaper oil, and cheaper gas could--((big inhale))--cause the reported GDP number to be better-than-expected. I think the -0.5% Q3 GDP expectation might be a lowball figure, which has been affected by the extremely negative sentiment and the fact that economists probably don't want to get caught looking too optimistic again.

If I'm right and Q3 GDP is greater than -0.5%, I think you could see a breathtaking rally in the stock markets.

Consumer Shmonfidence

The consumer confidence index fell to 38 in October. Based on a survey of 74 economists, the average prediction called for 52. Worse than that, the most pessimistic economist was looking for 45. This was the lowest reading since 1967, when the index began. The previous low was 43.

Again, the consumer confidence index fell to 38, which is well worse than expected. So why did the Dow soar 11%, or 889 points, to 9065?

What is it?
Every month the Conference Board surveys consumers for their opinions on current conditions and future expectations. Questions include:
1) How do you feel about the current business environment?
2) How do you think the business environment will be over the next six months?
3) How do you feel about the current employment situation?
4) How do you think employment will be over the next six months?
5) How much money do you think you'll make over the next six months?

It's a measure of confidence. It doesn't measure actual earning, spending, or saving activity. You might actually be fine in this economy, but you might feel terrible about it. I bet you could survey a dozen people at Whole Foods and Starbucks and they'll all tell you the economy is doing horribly. But they're still buying overpriced groceries and coffee.

Regardless, why the stock market rally?

Worse Expectations
Perhaps the bulk of investors were even more negative than those 74 economists. It's not unheard of. Everybody knows these economists are always off. Why not form your own opinions? Remember what happened with the September payroll numbers?

Market Bottom
Perhaps people thought the report was sooooo terrible, things couldn't get any worse. This is a classic sign of a market bottom. Literally, it was soooo bad, it was good.

Remember, stocks reflect expectations. If sentiment is so terrible you that you can't imagine worse sentiment, wouldn't you expect sentiment to only get better? If you're thinking stocks, this is a pretty good reason to be buying. I hope for the sake of today's stock buyers (and the economy as a whole) that upcoming economic and financial data doesn't reflect worse expectations.

Halloween Special: The Others

If there's one thing I learned from the 2000 and 2004 elections, it's that there are a s***load of people I don't know who are willing to vote for George W. Bush. But this post is not a criticism of Republicans. If you support those ideals, then that's your right.

This post is a reality check for you. If you belong to a group of people, you must realize there is an opposite group of people. These people are real. They're current. They vote. And sometimes, some of them can be quite unreasonable. Here are some of those other people who have been making the headlines.

Racists
Earlier today, the Bureau of Alcohol, Tobacco, Firearms, and Explosives (ATF) thwarted an assassination plot on Barack Obama, which also included killing over a hundred black high school students. The plan was made by neo-Nazi skinheads.

Expect more of this. Studies show white supremacist groups are on the rise. Their recruiting methods are more sophisticated and they're targeting the growing number of jobless, white, middle class Americans. When you're struggling to put food on the table at no fault of your own, you want someone to blame.

Immigration has been a hot topic for years. According to Don Black, founder of Stormfront (the country's larget white-supremacist website), the new hot topic is whether an Obama victory will start a white supremacists' revolution. Stormfront has 144,000 registered members and 42,000 unique visitors each month.

Gun-Toters
According to government data, sales of firearms and ammunition are up 8% to 10% this year. There are three theories to explain this.

1) A President Obama and a Democratic Congress would enact new gun controls. As a result, people are stocking up on guns while they can. Similar pre-emptive purchases occured as Clinton pushed for a ban on assault rifles and right after the Virginia Tech massacre. McCain is also about gun reform, but at least Sarah Palin is a lifetime member of the NRA.

2) With a deteriorating economy comes fear of crime. When people are out of work, they get desperate and they have nothing to lose. They are more likely to rob you. Crime will rise. People are buying guns for protection.

3) With a deteriorating economy comes civil disorder. Again, people are out of work, they have nothing to do, they feel like there's nothing they can do, and they're mad. Civil disorder can get scary. Remember the 1992 L.A. riots and the chaos that ensued in New Orleans after Hurricane Katrina? Gun sales spiked during these events. Again, people bought guns for protection.

Christian Fundamentalists
Remember televangelist Pat Robertson? He supported Jerry Falwell when he blamed 9/11 on "abortionists, feminists, gays, lesbians, and the ACLU." On the January 2 episode of "700 Club," Robertson predicted a recession and a major stock-market crash. When he's right, his followers rise up. Robertson is a Southern Baptist, which is the largest Protestant denomination in the U.S. with 16 million members. (In the interest of full disclosure, I became a card carrying member in the 4th grade.)

We've recently seen the stock market fall 20% in a week. That's a crash. We all know we're about to find out we're in recession.

Worst-case Scenarios
If McCain wins, that would suck for democrats. But democrats have a long history of not doing much. We had eight years of great Bush jokes, Fahrenheit 9/11, and a guy who threw a trash can through a Starbucks window in Seattle. When democrats are asked what they'd do if McCain were to win, the common response is "I'd move."

If Obama wins, that would piss off more than just republicans. You anger the racists, the gun owners, the Christian fundamentalists, the pro lifers, the homophobes...

We've had democratic presidents in the past. But they've always been white men. We're about to elect a black democratic president as we enter a severe recession. You and I might be fine with this. You and I might want this. But remember, there are others.

Happy Halloween.

Korean Vacations on Sale!

I don't know a lot about the Korean economy. However, I do know it's struggling. I also know that one U.S. dollar buys you 1,440 Korean won. (Won is the name of their currency.) A year ago, $1 bought you around 900 Korean won.

Central Bank Rate Cut
Earlier this evening, the Bank of Korea (their central bank) cut its target short-term interest rate by 75 basis points (or .75%) to 4.25%. Rate cuts are intended to help boost the economy by making it cheaper to borrow money. However, rate cuts also tend to lead to inflation and a weaker currency. Inflation data comes at a lag. Currencies trade on a 24/7 market, and it looks like the won is taking a hit tonight.

Bring in the Foreign Buyers
The won has had a rough year, falling over 37% against the U.S. dollar. It's almost like the Korean government is kicking the won while it's down. Perhaps they are trying to boost the economy solely through exports. You see, a weak domestic currency makes local products cheaper to foreign buyers.

In fact, exports are the main reason the U.S. economy has had positive GDP growth in the last several quarters. If you've noticed, we've had a pretty weak dollar for a while. (That's been changing recently.)

Anyways, if you're like me and you're investments are down 40%, take a vacation to Korea where everything is now 37% off for U.S. tourists.

Technical Sell-off Equals Tremendous Opportunity

When the economy is deteriorating, corporate earnings tend to decline, and the real values of stocks fall. Lower stock values justify lower stock prices. But there are other things outside of value that could cause stock prices to fall. In fact, many argue that these “technical” factors are forcing stock prices to fall well below what they’re actually worth. This difference between a stock’s price and value is called alpha, and if you invest correctly, you make money as this gap between stock price and stock value closes.

Let’s run through a few non-value, or technical reasons why stocks may be trading below intrinsic value.

Panic Selling
If you’re invested in stocks, you hate to see prices fall. Many people will sell stocks, giving no thought to value, because they don’t like the possibility that a stock may fall further; they become risk averse. Unfortunately, the act of selling causes stocks to fall. In other words, panic selling causes stocks to fall further, which induces more panic selling.

When you sell your mutual fund shares or reallocate your 401k plan to hold less stocks, you are selling stocks. High net worth investors have been cashing out of hedge funds as well.

Margin Call for Average Joe
Brokerage firms allow people like you and me to invest on borrowed money, or margin. Investing on margin is referred to as leverage. Brokers will lend you up to a dollar for every dollar you have. However, if you invest on margin and your investments fall, your broker will force you to put up some more money. This is known as a margin call. But what if you don’t have the cash? Well, you’re gonna have to sell some of those stocks, whether you like it or not.

When the stock market falls 40%, you can bet a lot of these investors have received margin calls.

Margin Call for Steroid Joe
Hedge funds have special relationships with brokerage firms. Their brokers are called prime brokers. Because of this special relationship, hedge funds get to borrow even more money. Some have been known to borrow $30 for every dollar.

Let’s say a hedge fund is borrowing $10 for every dollar. If the fund’s investments fall 10%, then that hedge fund is effectively worth nothing.

Hedge funds are getting their margin calls. Many are shutting down their shops completely (i.e. liquidating their assets). All this equates to a shit load of selling. Some experts have attributed 300 point swings in the Dow to hedge fund liquidations. Unfortunately,this is hard to prove because hedge funds keep their trading activities secret.

Deleverage
Even if a hedge fund has been successful, prime brokers and banks realize that allowing huge amounts of leverage is too risky. Leverage is part of the reason banks like Lehman Brothers have gone belly up. As a result, everyone is deleveraging. In other words, they are selling stocks and returning that borrowed money.

Sitting Ducks
Then there are successful hedge funds who are in great financial shape (e.g. reasonably levered) and they're making money, but they’re selling their investments anyways. It’s hard to estimate how much of this is actually going on. Anecdotally, it’s rumored that the SAC Capital, a $16 billion fund led by the most successful trader alive, has 50% of his firm assets sitting as cash. Ken Griffin's $18 billion Citadel Investment Group is 30% cash. John Paulson’s $35 billion Advantage Plus Fund, which has made billions of dollars betting against the market, is currently 70% cash.

It’s hard to know why they are doing this because hedge funds are highly secretive. One reason may be redemptions. In other words, fund managers are expecting some of their investors to cash out. As such, these hedge fund managers want to have cash on hand.

Or maybe they think the market is too risky. Hedge funds have a reputation for being extreme risk takers. But they’re not playing the market!!

It's Not You, It's Me

It's not the company value thats pushing stocks down; it's the investor.

In My Opinion...

Stock prices reflect an extremely terrible future for our economy. As you know, I have a pretty negative outlook. But, based on valuation backed by my negative expectations, I believe stocks seem extremely cheap.

I think technical factors have caused prices to fall well below value. In other words, I believe there is tremendous alpha in the stock markets. I have no idea where the stock markets will be over the next few weeks or months. I think in the near term, technical factors will be partially responsible for wild swings. Eventually, these technical factors will dissipate and the markets will work more efficiently. But by that time, you will have already missed the opportunity.

Risk Transfer: Why Employers Love 401k Plans

I’ve spent a lot of time telling people they were stupid to not set up their 401k plans. And I will continue to do so. But if you haven’t yet set up your 401k plan, you probably feel pretty smart right now.

Regardless, the 401k plan is a big headache for Joe the Employee. It’s supposed to be.

Pension Plans
There are two basic types of retirement plans. The first type is called the defined benefit plan (e.g. pension plan). Basically, if you work at a company for a while, then after you retire, your employer will send you pension checks for the rest of your life.

Employers who offer pension plans have to manage a pension liability account. This is an investment account full of bonds and stocks. The employer’s goal is to make sure this account is big enough to help pay for those pension checks.

In other words, if the stock market collapses and that pension liability account shrinks, your employer has to put more of its own money in that account. Remember, your benefit is defined. This means your the size of your pension payments are promised by the company.

Big headache for the employer. No headache for you.

401k Plans
The second type of plan is called the defined contribution plan (e.g. 401k plan). Basically, you are allowed to put a portion of your paycheck (Pretax! Yea!) into a 401k plan, which is your retirement account. It is your responsibility to make this account big enough so that you can live off of it during retirement.

What’s your employer’s role. First, they take a big stack of confusing pamphlets from Fidelity, Blackrock, Vanguard, etc about growth, value, income, and different sized caps. Then they stick it in an envelope, hand it to you, and tell you good luck.

More importantly, most employers will offer to match your 401k contributions with their own contributions. Hence, it's a defined contribution plan. And they’re happy to give you some extra cash. Why?

If the stock market collapses and your entire retirement plan shrinks by 40%, it’s your problem.

Big headache for you. No headache for your employer.

Risk is Transferred
Thanks to the 401k plan, employers can pass to you the hot potato of retirement planning risk. But risk isn’t always a bad thing. Risk may be risky, but if you’re not retiring in the next 5 years, you can really clean up on stock investments. I can (almost) guarantee that.

Triple X Throwdown

There are some products and activities that are recession-proof (or non-cyclical). No matter how poor you are, you will always buy toilet paper, diapers, and tampons and you won't stop eating, drinking, and smoking.

Sex is another one of those activities. People love to do it. It’s also the cheapest form of entertainment and exercise. But not only is sex non-cyclical, it might be counter-cyclical. In other words, there's evidence that the sex business is growing.

Drug companies and pharmacies have warned investors that patients are increasingly splitting pills and skipping doses. But, as always, there are outliers. Pfizer says Viagra sales are up 13%. Eli Lilly says Cialis is up 21%.

Church and Dwight says sales of Trojan condoms and First Response pregnancy tests are up. Johnson & Johnson told us that their women’s personal health products category grew thanks to a spike in KY jelly products.

First, Stocks. Then the Economy

On average, the stock markets peak seven months prior to the beginning of a recession. They also bottom six months into a recession. In, other words, stock markets usually hit bottom and begin to rebound long before the economy goes from recession to expansion. So, don’t get too excited if the stock market looks like its going up. Because if we’re still in a recession when the stock market bottoms, you and all your friends are still at high risk of losing your your jobs.

First, Recession. Then “Recession”
On average, the official “recession” announcement occurs around seven months after the recession actually begins. The end of the recession announcement tends to come 15 months after it's over. These announcements come from the National Bureau of Economic Research (NBER). Literally, they’ll come out and say that a recession began a few months ago. Thanks for nothing.

A "Recession" is Not a ""Recession""
Also, contrary to popular belief, the NBER measure of recession is not simply two consecutive quarters of negative GDP (gross domestic product) growth. When making its determination, the NBER considers all of the economic indicators in a much more sophisticated manner unclear to me. Based on the opinions of economists I follow, the U.S. recession began in December 2007 or January 2008.

I wouldn't put too much weight into these stats when making investment decisions. Just remember that stocks reflect expectations. Unfortunately, this concept becomes clear only in retrospect.

Buffett, Krugman, and the Red Sox

Yesterday, some of us witnessed the greatest rally since 1929. The Boston Red Sox were down 7-0 in the seventh inning of an ALCS elimination game. But they didn’t stop playing. In 2.5 innings, the Sox turned it around and won 8-7.

Th economy is rapidly deteriorating and uncertainty is high, as reflected by stock market volatility. No one knows for sure when things will get better. Most would agree that things will get worse first. But there should be no doubt that this economy and this stock market will recover.

Today’s New York Times Op-Ed section included pieces written by Warren Buffett, arguably the greatest investor of all time, and Paul Krugman, the year’s recipient of the Nobel Prize in economics. Buffett is basically telling us that today’s stock market is the investment opportunity of a lifetime. Krugman calls on government to stop quibbling about deficits and increase spending now. These people are smarter than you and me. Here’s some of what they had to say.

Buffett: Buy American. I Am
“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

Krugman: Let’s Get Fiscal
"And this is also a good time to engage in some serious infrastructure spending, which the country badly needs in any case. The usual argument against public works as economic stimulus is that they take too long: by the time you get around to repairing that bridge and upgrading that rail line, the slump is over and the stimulus isn’t needed. Well, that argument has no force now, since the chances that this slump will be over anytime soon are virtually nil. So let’s get those projects rolling."

You can find these articles at New York Times Opinion.

Rising Mortgage Rates: A Bailout Side Effect?

The average 30-year mortgage rate jumped to 6.46%, up from 5.94% a week ago. The last time we saw a spike like this was 1987. Higher mortgage rates means even fewer people will be buying houses, vacant home prices will fall, and owned-home values will decline. This also means the value of all those bank-owned, mortgage-exposed securities (the cause of the credit freeze) just ticked down. That makes me nervous. Let’s talk about how this happened. But first…

Intro to Bonds
There is a wide variety of bonds out there. For our purposes, we’ll talk about the three hugest bond categories, listed in order of riskiness:
1)Government bonds: These include T-bills (Treasury bills), T-notes, and T-bonds. When you buy these, you’re lending money to the government. These things are guaranteed by the government. If the government is short of cash, the Treasury will print you up brand new cash. No risk means low rate of return for investors.
2)Fannie/Freddie bonds: Fannie Mae and Freddie Mac were set up by the government (i.e. they’re government sponsored entities, or GSEs) to help move mortgages and make them cheaper, because homeownership was thought to be good for America. Because the government has a hand in these organizations, GSE bonds are considered less risky than corporate bonds. But, they’re not explicitly guaranteed by the government. As such, GSE bonds have moderate risk and offer a moderate rate of return for investors.
3)Corporate bonds: Companies, including banks, issue these to raise money. But companies are allowed to go bankrupt. This higher level of risk means a higher rate of return.

Lehman Brothers was a company that went bankrupt. That sucked. A lot of people, including other banks, were holding Lehman bonds. A ton of people had CDS exposure to those bonds. A bunch of institutions still have accounts at Lehman that are currently frozen. And ultimately, it destroyed confidence between banks. It is not good for a bank to go bankrupt.

Uncle Sam’s $250 Billion Bet on Banks
On Tuesday, behind closed doors, the Treasury, the Federal Reserve, and the FDIC basically forced a couple big banks (including Citigroup, JPM Chase, and Bank of America) to accept a government investment. In return, America would get ownership stakes in the banks and a 5% annual return. There were other terms to the deal, but that’s not important to this discussion. Ultimately the banks were borrowing money cheaply and, assuming those banks don’t go belly up, the taxpayers would earn a decent rate of return.

Bank Bonds Suddenly Look Sweet
Now that the government has a hand in these banks…maybe they won’t be allowed to go bankrupt. Very quickly, the risk level of these banks’ bonds fell. In fact, bond market action suggested the bank bond risk was similar to GSE bond risk. In other words, banks bonds' risk now reflected that of the second category of bonds we spoke of. But bank bonds offer a higher rate of return than GSE bonds. So why buy GSE bonds?

The Effect on and of Fannie/Freddie Bonds
In order to compete with bank bonds, GSE bonds have to offer a higher rate of return. In order for GSE bonds to offer a higher return rate, mortgage rates have to go up. The dynamics of this relationship are complicated, and I’ll explain in a future post. I suspect we’ll hear more about Fannie Mae and Freddie Mac in the near future. That might be a more appropriate time to explain how the GSEs operate.

The Big Picture
So, did the Treasury consider the bank bailout’s effect on mortgage rates? Gosh I hope so. Regardless, no plan was going to be perfect. Especially a plan that had to be rushed. I think this mortgage rate spike might just be a side effect, sort of like a mild fever after a vaccine. Remember, the primary goal of the bailout plan was to unfreeze credit in an effort to prevent Great Depression 2. I believe that Great Depression 2 would be much, much worse than any effects of the mortgage rate spike we’re seeing now.

Importance of Economic Indicators

It’s the third or fourth day of unfreezing in the credit markets, as reflected by lower interbank lending rates (i.e. LIBOR rates) and declining short term corporate borrowing rates (i.e. commercial paper yields). But those rates are still high and the thaw is coming at a painfully slow rate. Good companies are still having a tough time paying bills while running their businesses. Regardless, the global flood of government-backed money into banks has at least changed the direction of the credit crisis. Let’s hope it stays that way. We’ll keep an eye on this. Our other eye can now refocus on the big picture: the economy as a whole.

From Worse to Bad
Thanks to government intervention, the chances of avoiding Great Depression 2 have improved. Eventually, we may have to worry about inflation, tax, and federal budget implications of all this money flying around. For now, the most important thing is to keep roofs over as many peoples heads as possible and soup kitchen lines as short as possible.

So why the f*** did the Dow plummet 733 points or 8%?!?! Like I said in my Oct. 11 post, even if credit unfreezes, we still need to think about the underlying economy. And today we got the numbers on two key economic indicators: retail sales and the producer price index.

Retail Sales Figure
I've suggested that moving forward, “we won’t be buying as much as we used to.” I’m not qualified to quantify a decline, but my tone was pretty negative. Perhaps I was too bleak, but it turns out the opposite certainly wasn’t true. Today, the Commerce Department told us that September retail sales fell 1.2% month-over-month. That may sound like a small number, but let’s not forget how big the economy is. Let’s put it this way: if normal body temperature of 98.6 degrees rose by 1.2%, you have a slight fever of 99.8 degrees.

Nobody Likes Surprises
So, a 1.2% decline. What idiot wasn’t expecting a decline in retail sales? Well, an important survey of pretty smart economists revealed an expectation for 0.6% decline. That means the actual number was 0.6% (or 60 basis points) worse than the expected number. This is a big margin. What if Obama is ahead in the polls, but come November he loses the election. That would be unexpected, right? Well, when it comes to worse-than-expected economic data…

…the Stock Market Sells Off
Remember, stocks reflect expectations. Most would argue that weaker-than-expected retail sales caused much of today’s 733 point decline. Another chunk of that decline probably reflects a new expectation for worse-than-initially-expected economic data to come. In other words, expectations for the economy are deteriorating. And for those who believe we're in recession, weaker data means a deeper or prolonged recession.

If you can follow this logic, then you’re probably qualified to discuss the day-to-day swings in the stock markets at your next cocktail party.

More Cocktail Party-Talk
The Dow closed at 8,577 today. That’s 1.5% higher than Friday’s closing price of 8,451. Hmm. I might argue that people think America’s economic prospects look better today than they did Friday. But not as good as it did Monday when it closed at 9,387.

Whatever the case, these swings reflect uncertainty. And uncertainty translates to volatility. And there's still a lot of very uncertain data to come.

Look on the Bright Side
The Producer Price Index (an important measure of inflation) fell 0.4%, as expected. Why did they fall? Oil prices are down. At $73 per barrel today, oil is down 50% from its July 11 high of $147. That means all of the oil derivatives just got cheaper. These include gasoline, jet fuel (plane tickets), heating oil, plastic, and all kinds of chemicals. Things are getting cheaper. Enjoy.

One More Thing
Today’s retail sales metric reflects September performance. The Dow opened Oct. 1 at 10,847 and closed Oct. 15 at 8,577, down 21% in 15 days. If you have stocks in you 401k plan, that sucks. October has been a crappy month. At the end of the month, how much do you think retail sales will have fallen?

Beware of the Stock Markets

The Dow Jones Industrial Average had its best day ever, jumping 936 points or 11%. This doesn’t make you an idiot for not throwing all your money into the stock market on Friday. Such a move would’ve been an attempt at market timing and it is a dangerous game. Market timing is the stock market equivalent of playing roulette and putting all your chips on one number. Okay, so it’s a little different.

Why Do the Stock Markets Fluctuate?
Stocks reflect expectations. Finance theory says a stock reflects today’s value of all the money that a company will make (after paying its bills) in the future. On a given day, if the future looks brighter than we thought yesterday, the stock will go up. In the last few weeks, due to freezing credit markets and evidence of a deteriorating economy, the outlooks of almost all companies fell. And so did their stocks. But stocks often get oversold, presenting strong buying opportunities.

Why Do Stocks Get Oversold?
The most common explanation is panic selling. Let’s take you for example. You see your 401k plan fall 25% and you’re feelings get hurt. You don’t want it to fall further, so you instruct your 401k administrator (e.g. Fidelity, Blackrock) to take your money out of stocks and put them somewhere else (e.g. cash, money markets, bonds). You’re not alone; millions of people do this. Even rich people were doing this; hedge funds have been reporting all kinds of problems because their investors wanted their money back. All this asset reallocating involves forced selling, and then stocks fall even further causing more panic.

A lot of people argue that stocks initially fell on weakening expectations, but they fell way further on panic and emotions. This is when level-headed investors like Warren Buffett start investing. In fact, Buffett very recently poured billions of dollars into Goldman Sachs (GS) and General Electric (GE).

Why Were Stocks Up So Much Today?
Simply put, today’s outlook was better than Friday’s outlook. In their continuing efforts to unfreeze the credit markets, global governments over the weekend opened the floodgates of cash injections, backstops, bailouts, and insurance. I’m sorry, but even I can’t keep up with what’s being offered. Credit may be unfreezing as banks seem to be lending to each other a little more (as reflected by lower LIBOR rates). One bank (Mitsubishi) invested a ton of money in another bank (Morgan Stanley); that suggests some banks aren’t afraid of catching STDs anymore (see my previous posting).

What Don’t We Know and What Do We Expect to Know?
Well first of all, the banks and the credit markets were closed today in the U.S. (Columbus Day) and Japan (Health and Fitness Day). As such, we don’t know for sure how they’ll react to this weekend’s news. And remember that $700 billion bailout plan that everyone was talking about? That still hasn’t been put into play.

Again, stocks reflect expectations. Stock investors expect U.S. and Japan banks to respond positively to this weekend’s news. Stock investors also expect the $700 billion bailout plan to work to at least some degree.

How To Play This Market
If you’re convinced we’re near a bottom, then it’s still not too late to start moving money into the markets. To put things into perspective, the Dow is down 34% from a year ago. On Friday it was down 41%. However, you should invest a little bit at a time over a period of time (i.e. dollar cost averaging). And make sure you’re investing money that you won’t need within the next two to ten years. Most experts and investors aren’t convinced the stock market will just shoot up; if this were the case—trust me—the Dow would’ve closed much, much higher today. Uncertainty put a ceiling on the stock markets today. And uncertainty translates to volatility.

Before You Go…
There’s still a lot of news to come out. Some of it could be bad sending stocks down. At this point, expectations are so low that even no news would be good news. We’ll see.

Financial Crisis in English

Before a few weeks ago, layoffs have been isolated to a few industries (e.g. construction, finance). If you hadn’t been laid off, you were probably taking a hit on your 401k plan, mutual funds, and stock portfolios. More recently, stocks have plummeted. I have a big diverse group of friends working various jobs; in the last two weeks, almost all of them have reported layoffs at their companies. Even seemingly strong companies in healthy industries are laying off people. My job for the last 2.5 years has been to analyze companies and find out what may affect them. My experience is limited, but based on research I’ve done and experts I’ve spoken to, I believe ongoing economic/financial crisis has escalated to a higher order of magnitude and I also believe the media is doing a poor job of explaining what is really going on. This is an extremely complex situation and there's no short explanation. Give me a few minutes, and I’ll explain why things are really f***ed right now and why our future is f***ed.

Credit, the Frozen Credit Markets, and the Alphabet Soup
In the business world, almost every financial transaction involves cash and borrowed money (i.e. credit). This includes buying inventory, paying employees, paying rent, and in many cases paying off borrowed money. If your company has trouble accessing credit, they’ll have trouble meeting these obligations (i.e. not enough goods on shelves, lay offs, eviction, and bankruptcy). Assuming your company is healthy (i.e. strong balance sheet, well-capitalized), at least some customers and some suppliers will having trouble operating because of lack of credit. Everyone from the Gap, to Ford, to Boeing sells stuff to customers on borrowed money. And even Chinese sweatshops operate on borrowed money. If your customers can’t buy stuff and your suppliers are preventing you from selling stuff, you’re going to take a hit. Right now, a sh*tload of people/companies can’t access credit because credit markets have been frozen for a while. And every day credit is frozen, people are getting laid off and companies are going out of business.

Why aren’t banks extending credit (i.e. lending money to people and companies)? Well, banks need that cash right now for at least 4 reasons:
1) Banks own a lot of unsellable (i.e. illiquid) MBSs, CMOs, CDOs and a ton of other securities whose worth is determined by home values, which are plummeting. Because banks have to constantly update the cash values (i.e. mark them to market) of these securities, it looks like banks are losing money.
2) Banks have already lent out a lot of money so that people could buy homes, buy cars, and get college educations. They’ve also already lent money to those companies we just talked about. And now banks are terrified that a lot of those borrowers will not be able pay them back.
3) Banks are afraid that customers and clients will pull their deposits out of the bank (i.e. a run on the bank).
4) The CDS problem: Holy sh*t. Literally, God only knows how big this problem might be. A CDS (or credit default swap) is an insurance policy on a bond. It’s estimated to be a $62,000,000,000,000 unregulated market. Let’s go straight to an analogy. Nick has a car. AIG sells him a car insurance policy. Then I think, “Hmm, I don’t own a car, but I’d like to get money if Nick crashes his car.” AIG is convinced he won’t crash his car, so they are happy to sell me a policy and collect an insurance premium. In fact, they sell a hundred people like me that policy on Nick’s car. Then other people realize how AIG is making money. They start selling insurance policies on Nick’s car. For years, people make and lose money when the chances of a car accident increase and decrease. This process is repeated for other people’s cars. But now Nick totals his car. Suddenly, billions of dollars of cash needs to trade hands on one $30,000 car. It gets worse. Nick’s car accident directly causes the losers in this transaction to crash their own cars. In reality, Nick’s car is Lehman Brothers and that insurance policy is a CDS. All of those other buyers and sellers of CDSs are banks, insurance companies, hedge funds, pension funds, etc. all over the world. What’s worse? They all engaged in these transactions with borrowed money. Nobody knows for sure who owes how much money. CDSs were and are also traded on mortgages and all of the alphabet soup.

Banks make money because they are allowed to take a fraction of customer deposits, lend them out, and collect interest. Regulators require and investors want banks to always keep a fraction of that money on their books. The 4 reasons we discussed make banks’ books shrink. That’s why they won’t lend money. The last time banks were this tight, we ended up in the Great Depression. The business aspect of World War II got us out.

Fear, The Central Banks, and the $700bln Bailout Plan
Central Banks across the globe have been lending trillions of dollars to banks (via rate cuts, TAFs, TSLFs, etc.) so that they have more cash on their books. Central Banks thought this would give banks the confidence to lend money, but instead, banks are hanging on to this money because they’re still afraid of going the way of Bear Stearns, Lehman Bros, and Washington Mutual.

You should also know that banks constantly borrow and lend from each other; this is key to the flow of money. But they’re not lending money to each other either (as reflected by high LIBOR rates). Why? It’s kind of like the banks are not having sex because of fear of STDs. Some banks have different levels of STDs (in the form of MBSs, CDOs, etc.). If bank A lends money to bank B and B dies of an STD, then A will get sick. The cure for these STDs is improving home prices. Central Banks are handing out condoms in the form of federal loans and insurance, but banks are still terrified.

The $700 bln Bailout Plan will buy MBSs, CMOs, CDOs from banks, effectively converting these things to cold hard cash. In theory, the government will buy this for more than nothing (helping banks) and less than they’re really worth (which is great for tax payers). The government will be able to do this because the only non-govt investors willing to buy these won’t pay sh*t for them. And the banks aren’t willing to sell for sh*t prices. Unfortunately, it will take weeks before we know it works.

The Spiraling Problem
Banks lend less, companies default, unemployment rises, individuals default, banks get weaker, banks lend less, companies default, unemployment rises, individuals default, banks get weaker, banks lend less, companies default, unemployment rises, individuals default, banks get weaker, banks lend less, companies default, unemployment rises, individuals default, banks get weaker, banks lend less, companies default, unemployment rises, individuals default, banks get weaker…

What Else Do We Know
On average, economists expected the U.S. would lose 100k nonfarm jobs in September. Last week, we found out that we lost 159k jobs. Year-to-date, U.S. companies have cut 760k jobs. Also, more and more people know something is wrong. They might not understand what’s going on, but they know their 401k plan is evaporating, their friends are getting laid off, and all those people on TV say things are terrible. Remember, 70% of GDP is consumer spending. If consumers spend less, companies make less stuff, companies need fewer employees, and even fewer people are buying stuff. This speeds up that downward spiral.

What if Credit Unfreezes and Businesses and Consumers Are Free to Borrow Again
Let’s assume the government interventions work and credit markets unfreeze completely tomorrow. This would help the spiraling slow and perhaps stabilize. But things won’t go back the good ol’ days that we’ve had in recent years. Banks are currently deleveraging. You see, banks borrowed a sh*tload of money so they could lend a sh*tload of money. After seeing other banks collapse (e.g. Bear Stearns, Lehman Bros, Washington Mutual) and struggle (e.g. Goldman Sachs, Morgan Stanley, Citigroup, Bank of America), banks will lower their borrowing levels and ultimately, they will be lending money at lower levels. Fool me once, shame on you; fool me twice, shame on me. Say goodbye to easy credit. Joe Sixpack won’t be able to buy that pickup truck, that house, or that LCD tv. [This cycle will last a generation. Leaders who live through the current crisis will die, and a new generation will make our mistakes all over again.]

But even if you do have credit, do you think the average consumer is going to borrow like they used to? Millions of people are getting kicked out of their homes. You or someone you know just got laid off. Your 401k plan just went straight to hell. Most of us have less money or we’re scared of not having enough. The President and the government all want us to go back to spending so that the economy gets rolling again. As long as we spend like crazy, people will have jobs, and the politicians will have done their jobs. Maybe we’ll continue to buy sh*t we don’t need, but I think there’s a good chance we won’t be buying as much as we used to. [This cycle will last a generation. Parents who live through the current crisis will die, and a new generation will make our mistakes all over again.]

Conclusion and the Outlook
The recent economy had been built on a foundation of high levels of borrowed and lent money, collateralized by mortgages. Everyone (borrowers and lenders) thought housing prices would increase forever. Americans spent $1.38 for every $1 of income during this period. (Mexicans spend 60 cents and Europeans spend between 85 cents to $1.) Wall Street and home buyers bet trillions of dollars on this idea. Well, they were wrong. And now everyone’s paying for it.

The old economy was built on this bad assumption and no government intervention will change this realization. The new economy won’t make that mistake again. Americans are not as dumb as they look and they will be smarter about their purchases. Unfortunately, this will cause the economy to shrink toward some sort of equilibrium. Millions of jobs will be lost, unemployment will rise, real income will fall, and we will struggle as a nation for years.