Down the Rabbit Hole

“If I had a world of my own, everything would be nonsense. Nothing would be what it is because everything would be what it isn’t. And contrary-wise; what it is it wouldn’t be, and what it wouldn’t be, it would. You see?” From Alice in Wonderland

I’m quite sure that Charles Dodgson – better known as Lewis Carroll- didn’t have Washington DC in mind when he wrote Alice in Wonderland, but it is hard to escape the conclusion that economic policy is being formulated either somewhere down the rabbit hole or possibly over the rainbow and surely by Tweedledum and Tweedledee. The Tweedles also seem to have partaken liberally from the bottle labeled Drink Me and gorged on some kind of mushroom because logic and proportion have fallen sloppy dead in the Wonderland we call Washington DC. (With sincere apologies to Grace Slick)

How else can one explain economic policies which propose logically inconsistent solutions to our economic problems? It is as if the policies being proposed are intentionally opposite of what is actually needed to solve our problems. The US economy is overly indebted? The solution, offered with a straight face, is to ensure that credit is cheap and widely available. If individuals won’t or can’t borrow, have the government borrow in their stead. The US saves too little? The solution is for the Federal Reserve to reduce the interest rate paid on savings. The US has too many “too big to fail” banks? The solution is surely to make them even larger. The US dollar has been falling in value for most of the decade? The solution, of course, is to increase the supply. The US invests too little? Well, it must be that capital gains and corporate tax rates aren’t high enough. The US unemployment rate is too high? The solution is obvious; make it more expensive to hire new employees. Apparently all you have to do to create a thriving economy in Wonderland is to do the opposite of what common sense would dictate. Remember though we’re down the rabbit hole, so when I say thriving…..

Healthcare reform is another instance where the solution offered for the alleged problem defies logic. President Obama – and a plethora of other politicians – has told us repeatedly that the key to solving the budget problems of the government is to reduce the amount we spend on healthcare. As a solution, adding 25-40 million new government mandated and subsidized healthcare consumers to the equation would seem an illogical first step to reducing health care expenditures. Call me naive - or crazy – but if the goal is to reduce government expenditure on health care, wouldn’t a good first step be to get the government out of the healthcare business? If the goal is to reduce total health care expenditures wouldn’t it make sense to either reduce demand or increase supply or - here’s a radical thought – both? And by the way, how do we know that, as a nation, we are spending too much on health care? Is there some magic % of GDP that we should spend on health care and anything above that causes…..what exactly? And one other thing the reformers should consider; health care is the only private industry that continued to add jobs through the recession. Do we really want to trust politicians to “reform” the last private industry that is still growing? Primum non nocere would seem to apply here.

Economic policy is not as hard to formulate as politicians make it seem. Contrary to what a lot of policy wonks and economists will tell you, it really is largely a matter of common sense. If the country has a lot of debt, the answer is to pay it down. If the country is saving too little the answer is to consume less and provide sufficient incentives -higher interest rates work fine –  for savers. If the dollar is falling in value the answer is either to limit the supply or increase the demand. If the government is spending too much on health care, the answer is to reduce government involvement in healthcare. If the price of health care is rising more quickly than everything else, the answer is to either reduce the demand or increase the supply. Most of the debate in Wonderland DC ignores the logic of what needs to be done because it involves costs and benefits rather than just benefits. Unfortunately, there is no free lunch – even in Wonderland.

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Economic and Market Review

The economic data released last week was generally positive and continued to indicate a fairly rapid rebound in economic activity. Like the stock market, the economy seems to be recovering to the level that prevailed just prior to the sudden stop last fall. Well, except for employment – employment will take longer, a lot longer, to recover. What happened last fall was mostly a response to the massive uncertainty introduced by Paulson, Bernanke, Geithner, Bush, McCain, Pelosi, Reid, Frank, Schumer and Obama -did I leave anyone out? – and while most of these yahoos are still around, the public has figured out a couple of things since then. First is that the financial system isn’t about to collapse because the financial system has bought every politician with any influence on policy. Second is that even as dimwitted as this crew is, there is a limit to how much damage they can do to the economy. Americans are a resourceful bunch and they are adapting to the new circumstances. Yes, we’re spending a bit less and saving a bit more, but it isn’t that drastic a change.

Retail sales fell 1.5% last month, but ex autos was up 0.5%. Import prices were reported higher something that shouldn’t surprise anyone with the dollar falling. Inventories fell again and while the inventory to sales ratio also fell, it appears there is more to go before there is a signficant restocking cycle. Consumer prices rose by 0.2% in September. Prices are still declining year over year, but the rate of decline has already troughed and will evaporate soon. Oil prices fell a lot during the crisis and unless they fall soon, the year over year comparisons will turn negative (meaning higher inflation) this month. Inflation will be more difficult for the Fed to ignore by the end of the year. The NY and Philly Fed surveys continued to show growth this month; the Philly version showed tepid growth while the Empire State version was more robust. Jobless claims resumed their slow but steady fall. I think we’ll start to see some net job growth once claims fall under 500,000 so we’re getting close. Industrial production rose and it wasn’t all due to autos. And lastly, in what was in my opinion the most positive report of the week, TIC flows turned positive in August. Private investors were net purchasers of $21.3 billion in US securities. There is still a significant outflow for the year, but maybe we’re seeing a turn.

Stocks were up on the week as earnings have generally been better than expected. Roughly 3/4 of companies reporting so far have beaten expectations. More importantly, revenue is looking a lot better this quarter with about half the companies reporting so far beating expectations. Unfortunately, the companies beating expectations aren’t seeing much of a pop in stock price while those missing raised expectations are getting beaten up pretty bad. In other words, beating expectations this quarter isn’t much of a surprise and isn’t doing much for stock prices. I remain skeptical of this rally and am maintaining some cash. I would likely be a buyer on a dip, but patience is a virtue here. The dollar continued its slow death march to zero and that helped commodities on the week. Crude oil broke out to new highs for this move and the commodity indices followed. Bonds were down on the week, but corporates held up better than Treasuries. The bond market is my biggest area of concern at this time. A spike in interest rates seems inevitable if the dollar keeps falling and that won’t do anyone any good.

Selected Charts

US stocks made another new high for this move. I still think upside is limited and a consolidation is likely. I wasn’t right last week; we’ll see.

Commodities finally broke out to the upside. Buy the dips:

Crude oil led the commodity rally. Deflation my foot:

Platinum also broke out and as I said a few weeks ago, is a better buy than gold:

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