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The Independent Investor: The End of QE II: Wax On, Wax Off

Bill Schmick

"Wax on, right hand. Wax off, left hand. Wax on, wax off. Breathe in through nose, out the mouth. Wax on, wax off. Don't forget to breathe, very important." — Mr. Miyagi, from "The Karate Kid"

Miles of newsprint and thousands of terabytes of Internet space has been devoted to what happens Friday, the day after the end of the Federal Reserve Bank's quantitative easing experiment. Some say it bodes ill for bond and stock prices. Others argue it will have little or no impact. I say it is simply the end of one program and the beginning of another.

The total cost of the Fed's Treasury bond purchase program amounted to $600 billion. The goal of QE II was to put more money in the hands of consumers and corporations (especially small businesses) in an effort to boost spending and hiring. Unfortunately, it did little to jump start the economy in either area.

In a circular exercise similar to Mr. Miyagi's admonition to "wax on, wax off" the Fed purchased the bonds from the banks, hoping that they would in turn lend that sudden windfall of money to us. But instead, these banks just bought back more treasury bonds. The banks simply refused to lend that money and the Fed has no authority to make them.

QE II did result in lowering interest rates to historical lows, however, which allowed financial speculators to borrow money cheaply and to invest that cash (really short-term speculative trading) into commodities, stocks and all sorts of higher yielding securities. Those of us who have retirement savings also benefited somewhat as the stock market rose and we regained some of the losses incurred in 2008-2009.

All it meant for the average Joe was higher gas and food prices as commodities skyrocketed into the world’s latest financial bubble. That actually slowed spending. As for corporations, the big guys already had more cash on their books than they needed. Their profits were exploding as well and none of them felt the urge to hire more labor since they were doing just fine with what they have now. And why not, since their workers have had no wage increases in years, have had their benefits cut to the bone, and if they complained, well, there are always 13.9 million unemployed American who would be happy to take their job at an even lower pay rate ... As for small business, QE II was a total bust for them.

Doomsayers, such as Bill Gross, the highly respected portfolio manager of the world's largest bond house, Pimco, believe that without the Fed’s support, interest rates in the Treasury market will spike, the economy will fall back into recession, and the stock market will tank in response. A host of knowledgeable players subscribe to that theory and have made their views known to anyone who will listen.

Others believe that there are still plenty of potential investors, especially overseas, who will still want to own U.S. Treasury bonds as a safe haven and as a dependable source of income. Interest rates might rise a little, especially on long term bonds (10-20-30 years) but the rise would depend on the growth rate of the economy and inflation expectations. The stock market would no longer be underpinned by the easy money policy of QEII but that might actually be a good thing since it would reduce the amount of speculation that seems to be a massive part of today’s stock markets.

Of course, the caveat here is that Washington politicians come to their senses and do not allow the country to default by refusing to raise the debt ceiling.

In my opinion, I do not think that the Federal Reserve has taken us this far only to cast us adrift to the whims of fate. The Federal Reserve will continue to keep its role as the largest buyer of Treasuries. A week ago, for example, the Fed stated that it intends to use the proceeds of maturing debt that it already owns to buy more treasury bonds as needed. A total of $112.1 billion will mature within the next 12 months. The Fed also holds $914.4 billion of mortgage-backed debt and $118.4 billion of Fannie Mae and Freddie Mac bonds,  which will also mature. That will mean an additonal$10 billion to $16 billion of cash maturing every month. When you add it all up, the Fed has another $300 billion in cash, more than enough to maintain its support of the bond market.

Remember too that the Fed isn't about to give up on the economy just because QE II didn't quite do the job that they intended. Like Daniel in The Karate Kid, the Fed has learned some valuable lessons from their latest experiment.

I predict that they will try again, as early as next month, to come up with yet another way to stimulate the economy. I’m not sure what they have up their sleeves, but I expect we will start hearing rumors about a new plan very shortly. That will certainly play well in the stock market, don’t you think?

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

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Independent Investor: Oil — The New Tax Cut

Bill Schmick

On Thursday, for only the third time in its history, the International Energy Agency decided to release 60 million barrels of oil from global strategic petroleum reserves. They did so in order to "ensure a soft landing for the world economy."

As readers are aware, I suggested that investors "take profits" on oil as it soared past $100 a barrel almost two months ago. I argued that the clearing price on oil should be closer to $85 a barrel, given the slow growth of world economies. I was early in my recommendation, since oil subsequently climbed as high as $112 a barrel before plummeting to its present level of around $90 a barrel. I fully expect my price target will be reached in the coming weeks.

However, while oil dropped 5 percent Thursday, generating an annualized benefit of $36 billion to American consumers, the stock market fell by over a percent equating to a $200 billion loss. To me, that is a major contradiction. Here's why.

In energy, the rule of thumb economists often site is for every $10 increase in the price of oil, Gross Domestic Product (GDP) drops by one half of one percent. By March of this year, we had experienced a $25 hike in a barrel of oil in a very short time period. Economists were predicting that when (not if) oil reached $120 a barrel, the U.S. economy could easily fall back into recession.

Consumers bear the brunt of higher energy prices. Every one cent increase in the price of gasoline takes $1 billion out of our pockets. And actually it is much more than that (almost double) when you include things like home heating, electricity and price rises in alternative sources of fuel such as propane.

The real tipping point in impacting our consumption behavior occurs when energy prices reach 6 percent of average consumer spending, which occurred in March 2011 at 6.27 percent of spending. At that point, the top 20 percent of income earning Americans were spending 7.9 percent of their disposable income on food and energy. That may be a manageable hit for the rich, but not so for the bottom 20 percent of income-generating Americans. For them, energy and food account for a whopping 44.1 percent of after tax income. No wonder consumer spending and employment fell off a cliff.

As a result of higher energy and food prices, together with the fallout from the Japanese earthquake and tsunami, our economy has hit a soft patch which triggered the present decline in the stock markets. But circumstances have changed and in my opinion it won't be long before market players begin to realize that.

We can't have it both ways. The steep decline in oil and other commodity prices will boost consumer spending and economic growth while reducing unemployment. For consumers, it should be a matter of days before we begin to see this decline reflected in the price at the pump, in electric bills and in other areas. It is an instant and fairly hefty equivalent to a tax cut. Corporations will feel it too, but consumers benefit from that as well in the form of lower prices for products.

Right now, investors can't see the forest for the trees. With Greece threatening to collapse, unemployment rising a bit and the economy still slowing, it is hard to focus on what is just around the corner. But that, my dear reader, is exactly why I write this column — to help you focus on the horizon because there are better days are ahead.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

 

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Independent Investor: Time Is Running Out For The Presidential Cycle

Bill Schmick

Here we are in the middle of June, in the third year of a presidential cycle, and no one is talking of its historical bullish implications. Despite all the present gloom and doom about the economy and the stock market, here's something to remember. There has never been a negative return in the stock market during the third year of any president's four-year term since 1939.

Sure, there could always be a first time. And if you look at the historical data and compare it to this cycle, you can understand why. Usually, the year immediately following a president's election is negative. Barak Obama's first year, however, was extremely positive. The stock market lows were put in March of that year and the S&P 500 Index gained 23.5 percent in 2009 and then another 12.8 percent last year.

Right now, all three stock market averages are roughly flat for the year after climbing as high as 8.9 percent earlier in the year. Most pundits believe we still have more downside ahead of us. How much is the question. Some strategists believe we are closer to a bottom than a top; me included. Of course, we could technically have an up year by simply gaining 1 or 2 percent from here. Yet, only once in the last 72 years has the S&P 500 closed more than 10 percent below its previous end-of-year close during a president's third year in office. On the other hand, the index has gained over 10 percent (or more) at least once during the third year on 15 out of the last 17 occurrences. We have yet to do that.

There is a political rhythm to this cycle that makes a good deal of economic sense. Initially, when a new president is elected, he makes the hard choices and absorbs any negative fallout in the economy in his first and second years. Raising taxes or cutting spending are simply two examples of a new administration "biting the bullet" early on. By year three, re-election considerations come to the forefront.

The state of the economy is usually a major determinant on who will be elected and what party will dominate the political arena. This election cycle it is already clear that the economy will be the major factor in next year's presidential election. Traditionally, the sitting president will do everything in his power (whether a lame duck or not) to insure that his party garners the most votes possible.

The problem this time around is that the Obama administration has already done everything in its power to both stimulate the economy and get people working again. The Federal Reserve Bank and its board, which is ostensibly above politics but in reality owes their positions to the sitting administration, is already doing all they can to stimulate the economy. Tactics such as reducing interest rates and other "easy money" policies are already in place and have been for two years.

I have often said that when things look the darkest, that's usually the time to pay attention to the facts and not get sucked down into an emotional morass. Although the presidential cycle is not, nor will ever be, the determining factor in whether this market finishes the year with a loss or a gain, I believe it is simply another arrow in my quiver when I say that good times lie ahead for the market and the economy this year.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

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The Independent Investor: Another Round of Layoffs Looming

Bill Schmick

Last week's uninspiring gain in employment disappointed Wall Street and sent the markets into the doldrums. As July approaches and the start of most state and local government's new fiscal year begins, expect a lot of pink slips in the mail.

Unfortunately, the continued slow economy and the end of federally-sponsored stimulus programs are delivering a one-two punch to most state budgets. Since states are required to balance their budgets each year, cutting spending is a necessity. Most economists are forecasting at least a loss of 110,000 jobs in local government sectors in the third quarter.

Negotiations with state employee unions have been largely one sided. Either the unions accept large wage and benefit concessions or the axe will fall. Most unions are digging in their feet, arguing that there are other areas of the budget more deserving of cuts or that taxes should be raised on those best able to afford it in order to balance budgets. Their arguments are falling on deaf ears.

In Hartford, Conn., for example, Gov. Daniel Malloy has given the unions a choice of massive layoffs or $1.6 billion in concessions. In New York, Gov. Andrew Cuomo is demanding $450 million in give backs or unions should prepare for 9,800 state employee layoffs. Vermont's state unions, on the other hand, have decided to pre-empt the layoff threat by agreeing to take furloughs amounting to 40 hours a week over the next year. Massachusetts is still negotiating its budget but you can bet legislators will be going down the same road as neighboring states.

At the same time, tax revenues, although rising, are still anemic at best. In states such as New York, Connecticut and Massachusetts, where a large slug of tax revenues is dependent on Wall Street jobs and bonuses, the news is less than positive.

Banks and brokers are considering a new round of layoffs. Some banks are already laying off, like First Niagara Financial Group in Connecticut. Morgan Stanley said it will be reducing headcount while Wells Fargo and Bank of America/Merrill Lynch have been shutting offices across the country. Others are planning the same thing.

The entire banking sector continues to struggle with the de-leveraging process of bad loans, foreclosures, new regulations and volatile financial markets. Stock markets are not what they used to be, nor are the IPO markets. Readers are probably aware that volume on the exchanges has plummeted, despite an 80 percent rebound in the averages.

The disappearance of retail investors after the financial crash, the advent of exchange traded funds, which are quickly replacing individual equities as the investment of choice, and the massive increase in electronic trading have conspired to gut the profitability of what was once a huge profit center for the financial community.

When you combine the state and local layoffs and new layoffs in the private sector, the total will make further gains in employment problematic in the short term. It may very well take until next year before we see unemployment fall by much more than a half percent.

It isn't the end of the world, unless of course you are one of the unemployed or soon to be. The plus side of the layoffs and other spending cuts that will shortly confront us is that it will put our local and state governments on a firmer financial footing. That is extremely important down the road since municipalities will need to continue to borrow money through bond offerings in the municipal markets. Without balancing budgets, that would become extremely difficult. It appears to me that layoffs, no matter how painful, are better than bankruptcy. 

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

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The Independent Investor: Japan — The Sun Is Beginning to Rise

Bill Schmick

Readers should know by now that I'm a contrarian. The worse things seem to get, the more interested I become. Take Japan for example.

This island nation has suffered one economic bad spell after another for over 20 years. Japan is a depressing tale of economic and political mismanagement that has resulted in years of negative interest rates, a huge budget deficit, a stagnant economy, moribund stock market and a disillusioned and aging population. The massive earthquake and tsunami that triggered a nuclear disaster at a nuclear power plant in the eastern part of the country was seemingly the last straw that broke this country's back.

Japan is now officially in recession, which started in the last quarter of 2010, and has both widened and deepened thanks to these calamities of nature. Faced with enormous rebuilding costs, any effort to rein in the government's huge deficit looks hopeless. As a result, last week Moody's Investors Services placed Japan's government debt on review for a possible downgrade after changing its view in February from "stable" to "negative."

So why am I interested in investing in a country faced with this unending list of woes?

After two decades of lackluster efforts to revive the domestic economy, a new approach has been forced on the nation's leaders, thanks to the earthquake and tsunami. An enormous re-building of parts of the economy has to be undertaken, similar to the kind of reconstruction Japan undertook after World War II. Experts estimate it will cost $200 billion to $300 billion.

Japanese corporations need to increase their capital expenditures in order to regain lost capacity as well as to invest in improving their supply chain operations against a repeat of this kind of disaster. In addition, they will spend more money on earthquake proofing existing factories and office buildings and acquiring alternate power sources. This could add another $150 billion to $200 billion to national spending.

Aside from all the spending that is beginning in the near future, the government will maintain its extremely loose monetary policy. Interest rates will remain at 0 percent for the foreseeable future. At the same time, the yen is expected to decline as investors shy away from bonds that are rated "negative" by Moody's and an economy that is in recession.

To my way of thinking, here is an economy that is on the eve of a massive stimulus program, a declining currency (good for increasing exports), a corporate sector hell-bent on increasing capacity and re-gaining global market share (think autos) and a population that is willing to finance the effort regardless of Moody's outlook on their bonds. In the eastern region, new housing (unlike the U.S.) is in great demand. And unlike our own financial institutions that refuse to lend despite low interest rates, Japan's banks will lend and lend to corporations and individuals in order to help the recovery effort.

What this indicates to me is that a V-shaped economic recovery in Japan is a strong possibility. If I'm right, the stock market is a screaming buy.

Over the longer term this particular set of economic variables may actually pull the country out of its decadeslong deflationary quagmire. Japan as a nation needs to spend again, build again and buy again. Up until now, there hasn't been the will or a really compelling reason to do so. Now, whether you call it divine intervention or simply the flip side of a bad set of circumstances, Japan has its mojo back. It may take a few years before all of the above unfolds, but I think we are on the cusp of dramatic change within this country. Remember, you heard it here first, folks.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

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