David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).
Saturday, October 31, 2009
This is going to be a big week. And it comes on the heels of another weekend bank-failure announcement, and as we absorb the Geithner testimony and the discussion draft hearing in front of Barney Franks’ House Financial Services Committee.
Ours views of this Geithner-designed proposal are harsh and already known to readers. It has the makings of another PPIP-type fiasco; but in this case the damage could be lasting, since it involves a government super-regulator structure and not just a single program. This is a mix of politics and money and power at its worst.
It seems as if criticism is mounting from all sides, labor and business, left and right, Democrat and Republican. Geithner really hurt himself when he danced around the direct questions pertaining to “secret lists.” Mr. Secretary: when you were asked if there were going to be secret lists, why didn’t you just say yes? By not answering the questions directly you opened yourself up to an entire scrutiny of the flaws in the bill and lost your already damaged credibility. As for secret lists, it is time for the federal government to stop. Make rating scores public. Stop mouthing the word transparency while practicing opacity. That may restore the term moral hazard back into usage, in place of what we have witnessed. Kevin Ferry aptly described the current condition as “moral swamp.”
The first question for this week is easy. Will the Fed signal a policy change in the text of the release at the end of its meeting? If yes, what will it be? If no, will there be any revelation of the internal disagreements within the Fed? All eyes will be focused on this event at 2:15 PM, Wednesday, November 4.
There is real and serious division within the Fed. The regional Federal Reserve Bank presidents are being marginalized. They know it and do not like it. They are a lot closer to the real economy than the ivory-tower, Washington-based board. The Geithner proposal draft only exacerbates this marginalizing of the FOMC members who are presidents and not governors.
Among the Board of Governors a threesome of Chairman Bernanke, Vice-Chairman Kohn, and Governor Tarullo appear to be the new inner core. Tarullo seems to have replaced Governor Warsh, who held this insider’s insider position last year while Tim Geithner was still at the Federal Reserve Bank of New York. David Wessel’s book In Fed We Trust provides insight into this threesome and how it operates.
We wish Wessel had been less polite. For example, he didn’t stress how the Fed has interpreted the requirements for “sunshine” in its deliberations. Here is why it hasn’t: There are supposed to be seven governors. We have written and spoken about that repeatedly. Politics have held the number to five seated governors for over three years. Obama has continued this policy of holding the Fed captive. Senator Christopher Dodd was the point man on this in his capacity of chair of the Senate Banking Committee.
When you have seven governors, a normal decision is made with four votes of the board. And an emergency power invocation is made with five. But when you have only five, the designed supermajority rule becomes a unanimity rule. So we now have and have had a situation where any governor holds a veto. Today, Obama appointee Tarullo holds a veto in his hand, as does every other governor. If Tarullo disagrees with Bernanke, Kohn, Warsh, and Duke, he can stop them from any Fed emergency action. Notice how the emergency actions have receded from prominence since Tarullo became a governor.
The key here is in the interpretation of the sunshine requirement. The Fed is taking the position that when three governors are together, it does not constitute a “meeting,” because the sunshine meeting rule is set for seven governors, not five. Therefore, Bernanke is acting as if four are required to convene a meeting. Wessel has described the use of this stratagem during the crisis decision making. Is this the same Fed that wants to sponsor transparency?
When markets do not trust the central bank, they can be very punishing. These market-driven actions occur at the margin. They are not recorded in public pronouncements. They appear in transactions. That is one of the reasons the US dollar has been chronically weak. The actors in world finance do not trust the United States. Who can blame them after what we have delivered to the world during the last two years.
There are other reasons for dollar weakness, too. Here is a short list: massive issuance of federal debt, dramatic and expansive federal spending programs, Obama policies that will hurt productivity, layers of government regulation on top of what is already in the pipeline, forthcoming tax increases that will ultimately take the top US personal-income bracket to somewhere between the rate in Denmark and that in Sweden. Denmark and Sweden rank number one and two among the most highly taxed and socially managed people and economies in the world. The US will be vying for the top position in 2011 if all the present offerings are enacted into law.
Back to the rest of this week.
Friday’s unemployment report may reveal an unemployment rate at or even above 10%. Whether the number is 9.9 or 10.1 is not the issue. The key is that chronic and very high unemployment is going to be with us for a very long time. The U-6, or underemployment rate, is likely to be 18%. The rate for married men with spouses present will be around 8%. Jason Benderly taught me about the importance of this one. Other record unemployment rates will occur for teenagers, those with lower levels of education, and those with disabilities. The last one will be extraordinarily high. The unemployment rate for those with all types of disabilities will top 70%. For those with cognitive disabilities, the unemployment rate will approach 90%. Does anyone really expect the Fed to raise interest rates in the face of these numbers? I don’t.
Remember, the Fed has never raised interest rates coming out of a recession before the unemployment rate peaked and clearly marked that peaking with at least five or six months of improvement. Even if this coming report is going to mark the peak, history shows that the Fed would not make its first move until next summer. We do not expect a rate increase, but let’s assume it for the point we wish to make. We repeat: even if this report marks the peak, history shows that the Fed may be facing its first move next summer. Does anyone believe that this politically influenced and politically threatened Fed will raise rates next summer, when the unemployment rate is still in the 9%-plus range and it is an election year? We don’t.
So, the Fed is expected to hold the target short-term policy interest rate to ¼ of 1% for some additional and prolonged time. We have written on how a very low shorter-term policy rate anchors all rates because of the use of forward rates in the managing of debt. Experience shows that the top yield on the 10-year Treasury note is likely to be limited to about 3-¾% to 4% as long as the Fed is holding the short-term rate near zero. We also know from Japan and elsewhere, including the US, that the bottom of the 10-year note yield range could be as low as 2%, or even lower if deflationary psychology creeps back into expectations.
We conclude that a range of 3% to 4% defines the yield on the 10-year Treasury note for the foreseeable future. For markets this means tax-free Munis are still a desirable asset class, since they contain a great deal of the “tax arbitrage” and since future tax rates are likely to be higher than present ones. We also like the Build America Bonds, since they tier in an alignment with tax-free Muni rates. BABs are taxable municipal securities that came into existence in 2009 under a special new Obama administration program. We believe they are a terrific bargain for the investor who uses them properly in portfolio constructions.
As for US stocks, we believe the American market will be higher by next spring. We are targeting a range for the S&P 500 of 1200 to 1300 and believe that the index will fully close the “Lehman gap” created by the waterfall selling after Lehman Brothers failed. We are nearly fully invested and expect to use any weakness in November to deploy any cash residual in accounts.
In the international arena we have taken some of the stellar profits in emerging markets. Some of these positions have nearly doubled. Presently the international accounts are holding a cash reserve of nearly 13%. We expect to deploy those funds in weakness as the long-awaited correction in these extended markets unfolds.
At the end of this coming week we will leave for a three-country Asian trip. Tokyo comes first, then Hanoi, and lastly Singapore. An exciting GIC delegation trip is ahead. Details on Hanoi and Singapore may be found at www.interdependence.org. Our meetings include central bankers, finance ministries, and stock exchanges, as well as various investors and banking and academic professionals. Private roundtable discussions will round out the information gathering. The GIC is honored to have Philly Fed President Charles Plosser join the delegation and speak in Singapore, and Philly Fed First VP Bill Stone with us in Vietnam.
We will try to write impressions during the trip if time permits and if jet lag doesn’t suppress the flow of words. Fortunately, email and phone work on our 3G BlackBerry in all three countries. That has been my experience in the past in Singapore. Last time in Narita Airport, I had to borrow a Japanese keyboard; that required lots of help from the Japan Airlines business center. We expect to do better this time.
David R. Kotok, Chairman and Chief Investment Officer, email: firstname.lastname@example.org
Copyright 2009, Cumberland Advisors. All rights reserved.
Category: Think Tank
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