Ravengate
Partners - Stock market, economic and political commentary by Patricia Chadwick

Last week’s employment numbers were worrying; this week the indication seems that maybe jobs are increasing.  Next week will tell us more and the week after that some more.

Suddenly the market seems to be extra jittery about these numbers, and triple digit moves in the Dow Jones are a nearly daily occurrence.  Why the sudden panic?

After a monumental depletion of inventory in our economy, with “nothing left on the shelves” so to speak, the U.S. economy has benefitted from a significant inventory rebuilding.  It has added meaningfully to GDP over the last two quarters.

Now comes the moment of truth – will the consumer maintain the pace of acceleration in spending or are we entering a period of economic slowdown, incurring fears of a possible W shape to the economy (down, up and then down again before really getting back on track).

Retail investors, who have been guarded in their return to the markets over the last 18 months, appear spooked by the recent volatility as indicated by the significant redemptions in mutual funds.   And they have reason to be, despite some really good news.

Here’s the good news:

Corporate balance sheets for American companies are in great shape. Continued productivity gains are enhancing companies’ cash flow and profits.

Earnings growth will be excellent this year and most likely again next year.

To the extent that the stock prices reflect profits and the trend in earnings, the market’s correction we have been experiencing over the last month provides a good opportunity for long term investors.

So what is the problem?

The problem lies in the vast middle of our economy – those small to medium sized companies that are not publicly traded, companies which cannot get the access to capital as large companies can.  Without their participation in the recovery, unemployment will stay unacceptably high, because those are the companies that make most of the new hires.

In addition, State and local governments are being forced to make cut-backs because, unlike the private sector, their balance sheets are in bad shape and their cash flow is negative.

And to top it off, the economic stimulus program is going to be winding down just as Federal taxes take a giant step up.

I don’t believe these negative forces will result in another recession, but I am sure they will dampen demand at the margin.  And the markets do not like uncertainty.

But relative to where the economy and the financial system stood only 18 months ago, this is heaven.  From my standpoint, that means that panic selling is an opportunity to buy stocks.  I think we may have quite a few of those opportunities over the next few quarters.

For the last six months or so, the economic news in the US has been pretty good. Productivity has soared and most of the economic reports have been going in the right direction, producing a recovery that is not stellar but better than what we had. Given that fact that the real estate market remains in crisis mode, with the supply/demand characteristics indicating a long and painful restructuring, the rest of the economy has put in a pretty good showing.

But lurking in the background have been a number of issues that eventually would come to the fore. Primary among them were (1) the end of the one time home-buyer tax credit, (2) the wind-down of the Government stimulus program, (3) significant Federal tax increases, and (4) increased belt tightening by state and local governments.

Now the fiscal crisis in Europe threatens to add a new dimension to thwart the economic recovery in this country. The dollar’s strength – or better said, the Euro’s weakness – has been so precipitous that it could jeopardize the ability of the U.S. to improve its own trade deficit. Euro-sclerosis has long impeded job creation, as the non-profit Government sector of the economy has been the primary source of job growth for much of the area. It is almost inevitable that the Governments of most of the European Union countries will be forced to lay off workers, to cut back on far too generous benefits and to engage in years of belt tightening. That will not be good for economic growth.

It is too early to tell how much of an impact Europe’s woes will have on our economy here in the U.S., but for sure the impact will not be positive.

This week will bring a number of early indications of the trend in the recovery on the home-front – jobs, home sales, productivity and construction. They will start to tell the story, but it will unfold slowly.

The recovery looks as though it may be turning into some sort of W.

Listening to Warren Buffett as he discussed Goldman Sachs on Squawk Box yesterday morning, I was struck by both his eminent business sense as well as his common sense. His assessment of the securities firm and its CEO, Lloyd Blankfein, was reasoned, and was based on his many years of dealing with the company as well as his own immensely sound and proven business acumen.

Mr. Buffett understands risk and how markets work. He knows that in the world of buying and selling complex financial instruments, responsibility is a two way street. Caveat emptor. The buyers of the instruments at issue were not naïve individuals, unfamiliar with the vicissitudes of the market; rather, they were sophisticated investors, looking for a risky investment with a kick. Mr. Buffett admitted to making mistakes of his own, to failing to see the bubble in the residential real estate market. It was reassuring to hear him make that admission.

What a far cry his interview was from the experience last week of listening to the many U.S. Senators (on both sides of the aisle) grilling Goldman Sachs employees. It was plainly evident that none of the Senators comprehended the financial instruments at stake. Rather they were grasping at headlines – grandstanding, haranguing and trying to intimidate – force feeding isolated words and phrases to make theatre and to obfuscate their own enormous culpability in the real estate bubble and its subsequent bursting. Unlike Mr. Buffet who readily confessed that he isn’t right all the time, not a single Senator admitted to pressuring the banks to relax mortgage lending standards. Nor did any of them mention Fannie Mae and Freddie Mac, for which they have oversight and which have been so preposterously mismanaged.

The Federal Government is powerful, more powerful than any corporation in this country. If it wants, it can destroy a company, because it has infinite staying power and no profit motive. That is precisely what it did to Drexel Burnham, to Arthur Andersen, to Lehman Brothers. It can create an environment that makes it expedient for customers to abandon a company and for employees to jump ship. And in that way it can bring down any company if it so chooses.

Rather than admit their own involvement in the global financial crisis, Congress and the White House appear bent on finding scapegoats. Wall Street is an easy target, and the most profitable of the Wall Street firms is the easiest and most expedient target. And Congress, given its miserably poor standing in the polls, is hoping that by vilifying the private sector they will find redemption. That will not work.

Financial reform is needed. The citizens of this country would be well served by thoughtful and reasoned legislation that would mitigate the risk associated with rampant leveraging. If Congress really wants redemption, let it admit its own errors and work together with the private sector in the best interests of the people it is supposed to serve.

November cannot come too soon.

There is a large part of the U.S. economy that is not on investors’ radar screens. I am not referring to the underground economy or the barter trade economy or the money that is paid to illegal immigrants.

The invisible economy is much bigger than that. It is the vast part of our GDP that is not measured by stock prices on stock exchanges. I am talking about the “Ma and Pa” entities, the family run businesses, the real estate companies, the printing presses, the restaurants – companies not publicly held because they are either too small or because they prefer to remain privately held. They are the primary engine of job growth in this country. Many, many of them are profitable and well managed. Some of them are quite large. But most of them are small, and therein lies the problem.

As the banks continue to deleverage and shrink their over-bloated balance sheets, they must of necessity lend less. They are happy to lend to the Federal Government, which may have a dreadful balance sheet but is considered a good risk. They are even happier to lend to large, publicly traded and already well-financed corporate giants whose earnings have been improving. Fortunately, there are more and more of those companies these days which is good news. The banks are also increasingly lending to homebuyers, now that the risks have been mitigated due to lower home prices and increased down payments.

But left out in the cold are so many small companies with good business plans and positive working capital and profits. It is those companies that have been ignored or denied capital, as the banks have restructured their balance sheets. Without bank financing, many of them cannot carry on business, much less grow.

There is no lobby for this large and silent sector of the economy, no spokesperson to plead their case to the Government or to the banks for them. If they are left without access to capital, they will eventually fail and that will be a serious problem for employment growth and for sustained economic expansion.

The current burgeoning recovery in the economy is evident in the earnings of many our biggest companies in a wide array of industries, and their stock prices are reflecting the improved earnings and the stellar productivity gains achieved. But in order for the U.S. economy to recover fully, the great unwatched and unseen segment must also participate. Today much of that part of our economy is still in recession and without the banks serving them as banks should, they will remain there.

It’s all about the delta in the economy. That is, those little bits of change that add up and have the potential to make a meaningful impact – for better or for worse.

We are seeing positive delta all over the place in the U.S. economy. On the job front, the employment numbers are getting better. On the manufacturing front, inventories are being rebuilt. On the spending front, the consumer is getting a bit more venturesome.

If you go to Craig’s List, you will see that the job postings are steadily on the increase. Try to find a carpenter (as I am doing right now) to fix the garden fence destroyed by the storm two weeks ago, and he is busy. But only two months ago, he called wondering if there was any work he might do to bring home a little extra income. That’s positive delta.

And perhaps best of all, the state of the corporate balance sheet in the U.S. is healthy, really healthy. That, together with the astounding productivity gains they have been achieving, may encourage companies to increase capital investments. That would certainly provide more positive delta.

But we all know that delta can work both ways, and we need to keep our eye on what negative delta might also be out there to offset the brightening economic picture.

Here’s what comes to mind. Will China continue to be the engine of growth in this recovery? If so, then the delta force will gather strength. If not, if in fact China’s growth is peaking, we could be in for a nasty pullback.

Will there be negative delta as the Federal Government stimulus program comes to an end later this year? It is hard to believe it won’t have some impact, but if the private sector has developed enough of its own momentum, maybe the two will wash each other out. That would be good news, because private sector demand is more sustainable and more profitable than Government stimulated demand.

What will be the impact of the cessation of the $8000 tax credit for new home buyers at the end of this month? Most likely, it will be negative delta on home sales and home prices.

What will happen when unemployment benefits start to run out? Will the delta impact be negative? Or when the census workers are no longer needed? Or what if oil prices sky rocket? For sure that will be force negative on the consumer’s pocketbook. Or if interest rates head up too soon and too fast? A few small negative bits of delta can also add up.

It’s all food for thought. But for sure right now, there are more positive bits of delta than there have been for the last two years.

Yes and No!! That’s the honest truth and that’s the way it’s been throughout history in an innovative and vibrant economy like ours in the U.S. Some jobs constantly disappear while new ones are being created. Unfortunately, the job destruction part often comes harder and faster than the job creation part.

Just a decade ago, we experienced the Dot.com bust in this country. The “new” economic paradigm came crashing down and the “old” economy survived despite its foretold demise. The bloated workforce dedicated to an industry that seemed to go from infancy to adulthood in the span of less than five years, found itself decimated. Those Dot.com jobs have not been restored. But the technology that spurred the meteoric rise of the Dot.com industry did not die. And steadily over this last decade, continued advances in the area of telecommunications have spawned innumerable jobs in our economy.

A decade before that, we experienced the S&L crisis, where a large number of savings and loan organizations met their untimely demise through their own mismanagement. That was just as their future seemed glorious in the aftermath of the industry’s deregulation by Congress. The housing industry came to its knees. But it did not die; slowly and steadily, after the bloated inventory of second and third homes became absorbed into the economy, housing once again became a vibrant industry.

And only ten years before that, we lived through the rise and fall of the energy industry. With oil prices hitting $40 per barrel in 1980, (that was the equivalent of over $100 today) workers in the northern states were leaving “the rust belt” as the manufacturing heartland of this country was dubbed, to head for the “gold” in the oil fields of Texas. The migration was huge, raising real estate prices in the Southwest and decimating them in Michigan, as auto workers became oilfield workers. And then hardly a year after the peak in prices, it all ended. The price of oil came crashing down and oilfield millionaires turned into oilfield bankrupts. Homeowners abandoned their mortgaged houses and the State of Texas was the least exciting place to live.

This go round is really no different in its nature. An industry, in this case the banking/mortgage industry, brought about its own destruction. By using borrowed money with abandon in order to grow, by encouraging its customers to pile on debt and by lowering its own standards for lending, the banking industry sowed the seeds of its current crisis. Now, as the industry shrinks from its bloated size, it is shedding employees that were needed only when it was overweight. A trimmer industry will emerge and some people will be hired back, but not to the levels of just two years ago.

But fear not, the spirit is willing even if the flesh is weak. That entrepreneurial spirit is alive and well in the U.S. New industries will arise and they will create new jobs – green jobs, telecommunications jobs, jobs in industries without a name as of yet. It will take time and that is the frustrating part. And a decade from now, a new economic crisis will raise its ugly head to prove yet again that trees do not grow to the sky.

It is good to see that the President has bipartisan support for the budget proposal to give tax incentives to small companies in this country.

Over half of the workforce in this country is employed by small companies and most of the job creation comes from small and new companies. Tax relief such as recommended in the bill, will help in spurring private sector growth and pulling the economy out of the recession.

However, if simultaneously, the Government turns around and raises income taxes on individuals or corporations, the overall economic benefit will be non-existent.

The Federal Government cannot endlessly pour money into the economy to create new jobs. Sooner or later it must let the private sector take over. As the Federal support is withdrawn, the private sector needs to be given incentives to take risks and make investments. Raising income taxes will have exactly the opposite effect.

During the late 1990s, when the Federal Budget went from deficit to surplus, it was after President Clinton had cut the capital gains tax. What ensued was a strong wave of capital investment and corporate profits growth both of which generated huge incremental tax revenues – both income and capital gains – for the Federal Government.

Admittedly, the deficit turned surplus of the 1990s was augmented by the sharp cut in defense spending by the Federal Government, not an option on the table today. However, despite the vocal concerns of many pundits, primarily on the far right, the level of the U. S. Government debt and even the very high current budget deficits, should not necessarily doom us to third world status.

What we need in this country is private sector growth, not Federal Government loans injected into the economy. The Federal Government should do all that it can to augment and support the private sector, so that it can remove itself as the agent of stimulus. Only then will hiring commence and personal income start to grow.

The productivity gains that the U.S. economy has achieved over the last twelve months have been nothing short of impressive. Through a combination of increased output and reduced hours worked, unit labor costs have been declining. In the tough world of economics, this is the way the system works.

In a capitalist system, productivity gains are essential for long term success, for the ability to raise real wages and to increase standards of living. During periods of economic growth, it can be relatively easy to grow profits. Productivity often appears to be a bit of a luxury. Holding on to hard-to-find labor carries a higher priority than the marginal profit produced. Capital investment rises along with labor costs – a bit of a guns and butter approach, as profits are easy to achieve.

But when the economy is in a recession, as it is today, the business of finding ways to reduce costs and squeeze profits out of diminishing revenues becomes a necessity. Management cuts the workforce, knowing that labor is cheap and easy to find. And lo and behold, marginal profit starts to increase.

UPS is a case in point. The headline in this weekend’s Wall Street Journal read: “UPS Raises Profit Expectation”. The subtitle was: “Shipper Plans to Eliminate 1,800 Jobs…” That workforce reduction was in addition to the 13,000 jobs it cut in 2009. Despite a significant increase in its fourth quarter volume, as retailers panicked and decided to fill their shelves for the Christmas selling season, the company rationalized its new workforce reduction by pointing out the productivity it has been able to achieve through technology.

The dilemma occurs when the economy bottoms out and starts to improve, a condition that appears to be emerging today in this country, and in many other countries around the world. Wary of the strength of the emerging economic resurgence, managements are loathe to hire laid off employees. So they push production harder and achieve even greater productivity. It looks like a virtuous cycle for capital. What is lacking is the benefit to sidelined human capital. The labor force is the last element to participate in the economic rebound.

There is no reason to believe that this economic cycle will be any different. In fact, given the depth and breadth of the current recession, I believe that employment gains will be slower to emerge as the economy improves. This will be evident in a continued high level of unemployment even as profits continue to grow and revenues rebound during this year and next.

The 10% official rate of current unemployment in the U.S. understates the true level, which includes all those workers who have been discouraged from seeking employment after months of endlessly searching. As the economy improves and those job seekers re-emerge, they will once again be counted in the statistics of the unemployed, further depressing the official Government rate of unemployment. The decline in a number of Federal Government stimulus programs will only exacerbate the situation.

Expect the unemployment rate in the U.S. to stay high throughout this year. I will venture to say it will not likely go below 9%. I hope I am wrong.

The week after Christmas is always my favorite time to go to the movies. Shopped out, and with no more appetite for food, the indulgence of sitting (popcorn free) for two hours in the cinema is sublime. I choose my movies carefully. I am not a “special affects” person; blood and guts disgust me. So my list of possible movies to attend is always far shorter than most people’s.

This past week, I saw four movies and did not regret going to one. In case that sounds a bit like damning with faint praise, I should clarify by saying that of the four, one movie stood out from all the rest. It was Invictus. The combination of brilliant acting by Morgan Freeman and Matt Damon as well as the deep message was a moving experience. At times I actually forgot that Morgan Freeman was on the screen – I thought I was looking at Nelson Mandela.

The movie seemed so perfectly timed, so relevant and so needed right now. It depicted national leadership at its best – the ability of a man, despised by so many, to rally his country together against all odds and to find the best in each other. It actually brought tears to my eyes on several occasions.

The economic and social problems of South Africa in the mid-1990s were far graver than those we face here in the U.S. today. The political divisions among its citizens were far deeper than those existing in our country now. But as elected President, Nelson Mandela led his country and his countrymen and women by his own example. He did more than just cross the aisle, to use American parlance. He forced people who hated each other to come together, to work together and to achieve greatness through that bonding.

In this country today, we have serious issues that need to be resolved – health care, national security and recession are but the largest. Unfortunately, partisanship appears to be of greater importance to our Congressional representatives than reaching mutual agreement on solutions. What we need now is a Nelson Mandela, a leader who can bring together the warring factions within the Government and make Government work for, not against, the common interests of all of us. Let’s hope President Obama can wear that mantle in the second year of his presidency.

Oh, by the way, the three other movies I saw and enjoyed – in varying degrees of enjoyment – were An Education, It’s Complicated, and Up in the Air. Meryl Streep (It’s Complicated) is simply the finest actress today.

It is good news that the Senate Banking Committee yesterday approved Ben Bernanke’s nomination for a second term as Chairman of the Federal Reserve. But it is disappointing that the 16 – 7 vote did not include a single Republican. For once, I am happy that Republicans are in the minority in the Senate, which will now require a full 60 votes to confirm Mr. Bernanke. Let’s hope there are at least a few Republican Senators who see the wisdom of keeping Mr. Bernanke.

It is disconcerting to observe how yesterday’s hero can morph into today’s villain. A year ago at this time, Ben Bernanke was truly engaged in saving the world from financial collapse. His comprehensive understanding of the financial markets and his knowledge of the causes and catastrophic decisions leading up to the Depression served the U.S. and the world well.

Because last year’s financial crisis did not culminate in a global financial catastrophe, (thank goodness) the world has forgotten how close we came to the brink of disaster. It is ironic that both Houses of Congress can find no cause to blame themselves for any of the events that led to the financial crisis and the ensuing recession. All they can do is heap blame on Wall Street and the Fed Chairman. Ironically the most outspoken critics of Wall Street and Mr. Bernanke, Senator Christopher Dodd and Congressman Barney Frank, were the most aggressive proponents of the Government policies that led directly to the crisis. It seems a bit like a case of “The lady doth protest too much, methinks.”

Unlike Congress, Mr. Bernanke has admitted to errors. But to be fair, most of the issues that led to the crisis were in place well before he became chairman.

The Federal Reserve has a dual role. It is charged with safeguarding the purchasing power of the dollar, i.e. managing inflation, and promoting full employment. However, it cannot singlehandedly guarantee these two objectives. What the U. S. economy has needed throughout this financial crisis is liquidity and the Fed has and continues to provide that. Today deflation is a far greater risk than inflation. With the economy in a recession, the velocity of money had declined putting little upward pressure on prices. The time will come for rates to rise and money policy to tighten, but now is not the time when unemployment is high and asset prices are low.

If the Senate has the best interests of the U.S. at heart, it will vote to retain Mr. Bernanke for a second term as Chairman of the Federal Reserve.