by Jonathan Bernstein

Yes, it’s true, “headline risk” explains volatility, at least on the surface. But no other news driven market of recent decades, had anything like the volatility we’ve sometimes seen since 2008. Think 1989-91, which included Drexel’s bankruptcy, and Iraq’s invasion of Kuwait. Or even 1987, where volatility reached extreme levels, but didn’t stay that way for long. Or 2000-01, where the Nasdaq had some very volatile days, but the other indexes weren’t affected nearly so much.

Only the Thirties saw so many big daily fluctuations, because investor emotion plunged and soared in the extreme from day to day, just like it has recently – only much more so then than now.

Volatility was Greatest in The Thirties; Only 2008  Looked Anything Like It

 If you don’t believe me, here are some numbers. In the whole period of 1989-91, the Standard & Poor’s 500 (SPX) had a total of only five – five! – days in which the daily price range exceeded plus or minus 3%. In 1974,  the S&P had only nine days in which the S&P moved more than 3%. Pretty gentle, considering that the market fell about 45% in 1973-74. In 1987, the total of high range days was also nine. However, when we look at 2008, there were 42 such days, just for one year. Quite a difference.

Since the SPX began in 1957, I use the Dow for earlier history. Of the 20 biggest daily percentage losses in the Dow’s history, nine of them occurred between 1929 and 1933. And of the 20 biggest daily gains, 15 of them occurred between 1929 and 1933– and one more in 1939.

Of course part of the reason for the big daily percentage gains (and losses) of the Thirties was that large point fluctuations had an exaggerated effect on the calculation of daily percentage moves, since those fluctuations were measured against a smaller post-Crash base. On the other hand, the ’29 Crash took the Dow down almost to turn of the 20^th century levels, and we didn’t see many big daily percent fluctuations in the years 1900-1928. Even though that period included the Panic of 1907 and the post WWI market break of the early Twenties.

And how about this chart? To my eye, it looks as though nearly all of the 5 year period 1930-35, the two hundred day moving average of daily ranges held firmly above 1.5%, and even touched 2.51%. These days 3% is considered a big daily move but then that was not that much more than the average for at least one two hundred day period.

Investor Emotion is Exaggerated When Economic Collapse is Feared

So what links the Thirties markets and more recent  markets, to account for today’s volatility extremes? My answer is that in the Thirties, investors feared that things might all come undone, and that kind of fear has surfaced occasionally since 2007.  As we know all too well, when people are afraid of a US credit crisis (2008) or European contagion, they just sell all risky assets. And when investors think the danger has passed, buying panics happen instead. Investors really hadn’t acted like this since the Thirties.

I read the News from 1930 blog every so often, because it illustrates at least some similarities of market psychology then and now. Each of the blogger’s entries centers on excerpts from Wall Street Journal articles written on one given day in the Thirties, to show readers what drove markets at the time. And a recent entry from that blog, which includes WSJ snippets from September 25, 1931, could almost be ripped from today’s headlines. Fears about a break in sterling, which was an issue not so long ago. Fears of the US losing its foreign exchange reserves, which then consisted of gold held at the New York Fed. Big fluctuations in silver, driven in part from demand swings in India. No wonder the Dow fell 7.1% that day.

If you scroll down you’ll see the entry for September 24, 1931, when stocks soared 6.0%. That’s right, the Dow notched a 6.0% up day on the 24^th, followed by a 7.1% loss on the following day. We didn’t see numbers like that in 2011, nor did we so much even in 2008. History hasn’t repeated itself,  but it has rhymed.

What news drove the September 24^th buying? Again, the headlines look eerily familiar – other than the re-opening of the London Stock Exchange after a two day shutdown, at least. The American Stock Exchange (remember them?) lifted its ban on short selling, foreign currencies rallied, US workers took wage cuts. The more things change…

Just as an aside, bank analyst Thom Brown recently said on Bloomberg, that the banking sector’s beta is now about two; ie., if the S&P moves 1% up or down, bank stocks will move twice as much.  My explanation of this: when collapse is feared, bank collapse is feared the most. And when panic lifts, investors pile back into bank stocks. It’s hard to believe that not too many years ago bank stocks were considered staid dividend payers.

Deposit Insurance Keeps Volatility Down, At Least When Compared to the Bad Old Days

Of course the bank bailouts and massive liquidity injections (of which there is much to dislike) helped the markets regain their calm within months of the Lehman (LEH) bankruptcy. Just as important, though, is the fact of deposit insurance. These days, a frightened investor can go to cash and park it in an FDIC insured account, something we now take for granted. But until the FDIC began offering insurance in 1934, investors had no such comfort. Hundreds of banks blew up each year in the Twenties and the flow accelerated into the Thirties. And back then when banks failed, depositors often came out with nothing. One could find safety only by stuffing cash or gold in the mattress.

If we go back to our numbers on daily volatility we can also see that big percentage moves got noticeably rarer starting in 1934. Coincidence? I don’t think so.

Due to the FDIC, and Treasury’s new money fund guarantee, the 2007 money market panic that broke out after the Reserve Fund “broke the buck” was a walk in the park compared to Depression-era liquidity panics. A bad day in the Thirties could vaporize your savings, even if you had them in the bank. On the good days, fear of ruin would give way to fear of missing the mother of all bottoms, since investors well knew how cheap stocks were then. Today we see at least an echo of this.

What Traders Should Do

 While volatility has fallen off in recent weeks, I don’t think it’s gone for good. No matter which way the markets go from here, volatility should rebound; it’s hard to imagine really calm markets until we resolve the overhangs of public and private debt, here and in Europe. Therefore, those who like to play volatility should think about buying volatility while the VIX sits in the low 20s. If the trade works,  lock in partial gains when you can and hope to sell the rest of the position near the VIX resistance levels of recent months. Of course if this rally just keeps going (and some recent rallies lasted longer than I thought they would) the trade breaks even at best.

All the related instruments I know of have their tradeoffs: the VXX has the problems common to leveraged ETFs; VIX futures entail contango risk at rollover time, and theta eats away at option positions. But I do like the risk/ reward here for volatility longs. Conversely, shorting the VIX near last fall’s highs worked out well, and could do so again.

This post has been updated.

Disclosure: No position in securities mentioned.

by Jonathan Bernstein

In my view, it’s a good thing that the recent Eurozone deal has basically ended the issuance of CDS on sovereign credits. Why shouldn’t big banks and insurers bring back the forgotten art of credit analysis, and look carefully at what they buy?

I know, there is an argument that CDS allow some borrowers who might not otherwise be able to obtain funds, to issue bonds. But in the end, lending money to debtors who can’t repay ends badly for all concerned.

Sovereign CDS Exist to Make Possible Loans that Really Shouldn’t Be Made

If the Eurozone wants to help its poorer members, it should do so with outright grants or other funding that is workable longterm, rather than go through a lending charade. If it doesn’t, tell the truth and move on.

As many readers know, the Eurozone structured Greece’s 50% haircut as “voluntary” so that banks writing CDS on Greek bonds would not have to pay off. Having seen that, investors won’t bother buying worthless CDS “protection” for sovereign bonds going forward. Therefore sovereign issuers who can’t sell bonds on the strength of their own creditworthiness, won’t be able to scrape through by having underwriters issue CDS to cover the risk.

 A centralized CDS Exchange Would Be More Transparent But Market Size Would Have to Be Limited

Writers such as John Mauldin and Barry Ritholtz, to name two, say that we could reform the CDS market by requiring that all CDS be traded on a centralized exchange. They make a good point – an exchange traded market would be safer than the current system — but I have difficulty envisioning a deep and liquid market for exchange traded CDS. I’d rather explore ways to wind down existing CDS and ultimately ban them, but if you are going to keep them, I think the exchange traded model is the best choice.

Of course if all CDS traded on one centralized exchange, risk would be decidedly lower than in the current model. CDS writers would have only one counter party, the new CDS exchange, whereas banks now hedge by making canceling trades with other banks. This exchange traded model would also increase transparency, since the exchange and financial regulators could monitor CDS writers’ exposure in real time. The trouble is, that such an exchange could not easily protect itself from default risk in size. Let’s see how this would have to work.

Suppose you are chief risk management officer of this exchange, call it the CDSE. You’ve lived through the AIG fiasco and the Greek restructuring, so you know this much: if a large asset class gets unglued (MBS in the case of AIG, or PIIGS sovereign debt) many of the banks exposed will all experience liquidity issues, simultaneously. Lending would slow down and a systemic crisis would result.

Therefore, as the CDSE’s CRO, what would you do? You would make sure that the exchange traded CDS contract allows for very strict position limits, not only by each credit, but by asset class being protected. In this example, you would probably limit CDS writing on, let’s say, all sovereign credits that are not backed by a printing press, rather than just Greece, or even just the PIIGS countries.  And these limits would stand in addition to the more traditional position limits for each contract that each CDS writer would have to abide by. The maximum hedgeable size of the sovereign CDS market might well be smaller than the current outstandings.

Without strict position limits, the CDSE couldn’t count on the ability of the CDS writer to buy back the CDS he wrote, or to post adequate collateral, during a systemic crisis; unlimited position sizes could get unmanageable. In crisis mode the cost of the protection would skyrocket to some amount commensurate with the expected bondholder haircut. Buybacks would be prohibitive if they could be accomplished at all.

Furthermore, in a banking crisis, you might have to jostle with bank regulators (like the FDIC and its foreign equivalents) to get your mitts on the amount of cash collateral you would need to feel comfortable. Therefore you’d have your own, independent credit analysts monitoring the exchange traded credits, and you would be raising margin requirements rapidly at the first hint of trouble. You can’t afford to be unprepared when real trouble hits, and your margin policy would have to be aggressively pro-active in order to protect the market before a crisis broke.

In this your model would be the way Goldman Sachs (GS) demanded collateral from AIG before the 2008 crisis was obvious to everyone. And like GS, you wouldn’t wait for S&P or Moody’s to downgrade anyone you are exposed to.

I don’t want to overdo the dark side, but I’m harping on crisis conditions for a reason. That’s when sovereign credits often go bad, and in the last 30 years, we have had three such instances: Latin America in the early 80s, Asia in 1998, and now Europe. If you are planning a CDS product to insure against sovereign risk you have to think about crisis conditions before product launch, not after.

Banks Like CDS Writing When they Can Shift the Risk

Banks don’t like the idea of exchange traded product, because it is commoditized and commands lower profit margins than the current model of over the counter, custom product. Nor would banks like the idea of tying up large amounts of cash collateral when writing the CDS under a risk regime that would work for any rational exchange.

In other words, the obvious way to make CDS profitable for the bank – or at least as profitable as banks would prefer — is to shift much of the risk onto someone outside the banking system. In the cases of AIG (and probably the PIIGS), that “someone else” turned out to be the nearest taxpayer.

Which brings me back to my opening statement. If you are going to buy bonds, know what you are buying, because in the event of systemic trouble, credit enhancement may itself become as worthless as the bonds being insured. GS and its ilk were lucky and got bailed out in 2008 when AIG failed. On the face of it the European sovereign bondholders were less lucky, and while they might get bailed out too if the coming European bank recapitalization turns out to be favorable, we don’t know yet how that will turn out.

by Jonathan Bernstein

China Trade Bill

 The China Trade Bill would impose a tariff on Chinese imports to the US in an effort to get China to revalue the yuan. The purpose of the bill is to reduce the US bilateral trade deficit with China. Its boosters, including Senate Majority Leader Harry Reid, say the bill could create 2 million American jobs it if it becomes law.

The China Trade Bill sailed through the Senate but its prospects in the House are doubtful. Speaker Boehner has said he won’t allow it to come to the floor for a vote – because he knows it would pass easily if it did. (Ironically the House passed the bill in 2010 but the Senate did not.)

While I think it’s a poor solution, the China Trade Bill addresses a real issue. The Sino-American trade imbalance can’t go on forever. At some point – when China is less dependent on the US market – China will be less willing to accept US paper in exchange for Chinese goods. If we let the situation go, eventually China will “fix” it, and do so on China’s terms.

Having said that, the bill highlights a major fallacy in how America approaches the rest of the world. The China Trade Bill would in effect tell China to revalue its currency at America’s pleasure. Not a great idea, because the Chinese can peg their currency wherever they want to, and they don’t care to be pushed around by other countries. The bill represents a swell idea for Chinese politicians to stoke nationalistic fervor at America’s expense. China has also threatened a “trade war” if the bill passes.

On the one hand, China’s threat of a trade war is less fearsome than it may sound. If trade between the US and China fell to zero, China, which runs a big trade surplus with the US, would lose far more in exports to the US than America would lose in sales to China. America might lose access to some goods it no longer produces, but eventually America could rebuild the manufacturing infrastructure it has lost and would come out stronger after doing that. China might buy less US treasury bonds but then again – there would be no bilateral trade deficit to finance, and the dollar would be the stronger for that as well.

What We Can Do:

On the other hand, America could — theoretically at least  –  do much more for our trade balance, and our economy, without provoking a high profile confrontation with China. In my view, the problem is twofold.

First, we must support the industries that are important to our future, rather than let China pick off its American competitors. We have to care about what industries America will be in, or we won’t be in them anymore. For example, Evergreen Solar set up its manufacturing facility in Devens, MA, aided by a $43 million incentive package it received from Massachusetts in 2008. In 2009 the company started shifting production to China, and shuttered the plant earlier this year. Evergreen CEO Michael El-Hillow stated that Chinese state-owned banks and municipalities had offered unbeatable assistance. Even though labor is far cheaper in China, labor accounts for only a small percentage of total cost, El-Hillow said. The partnerships with banks and municipalities actually outweighed the labor cost differential.

In addition, Evergreen said that while it cut its cost per watt of solar capacity from $3.39/watt in 2009 to $1.90 in the fourth quarter of 2010. Yet the Chinese undercut Evergreen further and were selling panels at $1.60 by then, and could produce them for a cost of $1.35.

Now, some  companies – think SolarWorld, which filed antidumping complaints yesterday, October 19, against China – believe that China gives its solar firms incentives that violate WTO rules. In their view, illegal Chinese subsidies are decisive in helping the Chinese companies cut their cost so much. Maybe they are right, and sometime within the next year US agencies will decide whether countervailing import duties are in order.

My feeling is, who cares? A year is an eon in internet time, and by then the Chinese will have solidified their advantages even more. In any event, Massachusetts could only do so much to hold onto Evergreen, and without Federal help, efforts at the state level were doomed to failure. With the concomitant departure of First Solar (FSLR) to China, anything the US eventually elects to do will be in the realm of playing catch-up.

I could give lots more examples, but perhaps one of the most egregious is that Pfizer shut its famed R&D laboratory in Groton, Connecticut this year, along with its equally distinguished British lab, and will shift much of its R&D to Shanghai. For many years, outsourcing advocates have maintained that America will not suffer much if “low level” assembly and manufacturing work shift abroad, as long as the “knowledge work” stays here. Well, now the knowledge work is leaving too.  What has the Obama Administration done about this? Well, not a whole lot.

Closing the Groton lab will do more than harm American competitiveness. According to Medpage, Today, the abrupt lab closure will in effect throw away irreplaceable knowledge and expertise in the area of antibiotics and other treatments to fight infectious disease. While this move might improve Pfizer’s short term profits, just how wise is it, given the increasingly serious problem posed by drug resistant “superbugs?”

My point is, tariffs can only do so much, if we have not identified and nurtured our key national assets before the fact.  Yes, that is protectionism, but then again, protectionism is what nearly all governments do these days. Leaving US firms to compete individually against China in an industry that China wants to dominate, is tantamount to kissing the US firms goodbye.

I don’t know what the solution is to what I see as the second part of our difficulty: US managements, in many instances, simply favor outsourcing rather than producing in the US, even when US production costs are comparable to costs to produce elsewhere.  For example in mid-2009, when GE needed wind turbine parts, a company named ATI arranged a deal to set up a plant in Michigan to make them. When Chinese companies made a counteroffer to GE, ATI was able to match the China price. Yet GE decided to source the parts in China despite this. Similarly, a quick search online will yield plenty of results where consulting firms will tell companies how to get their “globalization policy” up to snuff and where the opportunities are to outsource various corporate functions. As anyone who has spent any time in the corporate world can tell you, consultants dream up solutions that “confirm” the existing biases of their clientele.

Even more importantly, in the early 1980s, key business lobbies such as the Business Roundtable and the US Chamber of Commerce, shifted their opinions from favoring US operations to favoring outsourcing. And after they did so, US policy shifted that way too, resulting in such agreements as NAFTA and the WTO. It was this rewriting of trade rules that made outsourcing workable. If Corporate America hadn’t wanted outsourcing, it simply wouldn’t have happened.

The contrast with Germany and Japan is striking. Both countries remain export powers even though their labor is far more expensive than is labor in China. The difference? Again, I would submit, is that Corporate Germany and Japan, Inc. care about maintaining employment in their home countries, while Corporate America does not.

In other words, if Corporate America wanted to produce here, we still would be, and we wouldn’t need a China Trade Bill.  And because Corporate America does not want it, the bill will almost  certainly not become law — neither the Republican leadership in the House nor President Obama would dare offend campaign contributors that way. The bill simply gave Reid a chance to grandstand, before going about the business of enacting more job export measures such as the “free trade agreements” with Colombia and South Korea.

Matt Taibbi’s Rolling Stone piece proves that the Fed hasn’t just fallen down on its job as a regulator because it has come to worship the banks it is supposed to regulate. It is now nothing less than bagman to the world, an agent for siphoning off the wealth that America earned the hard way over the centuries.

Before Greenspan’s 1987 appointment the Federal Reserve, for all its faults, was renowned for its rectitude, and for the prestige of the large cadre of economists who work there. It was the kind of institution that was an honor and (pun intended) credit to the United States. It was the kind of place that few countries could imitate, and added to the aura of the US as an “exceptional” country.

Some of us remember how economists used to debate Fed policy. Was the Fed able to damp the violence of economic cycles as it intended, or was it actually exaggerating them, being “pro cyclical?” Should the Fed use discretion in creating money or should it follow a rigid rule when it added money to the economy? During recession, how much stimulus should the Government apply through fiscal means (say,  creating temporary jobs through public works programs, remember that?) and how much through the monetary system at the Fed? We cared about whether the Fed was right or wrong, but no one doubted that the Fed was a serious place. Ph.D. candidates looked forward to the opportunity to work there.

Then Greenspan instituted his “put” and took the Fed down several notches, but its status was still redeemable. Until, as Taibbi shows, 2008. The Fed usurped the FDIC’s job then; it lent incalculable sums to keep insolvent banks running when the FDIC should have shut those banks down. But not only that: the Fed became an agent of petty corruption. Through the Fed institutions like Goldman Sachs and Morgan Stanley became America’s dukedoms, their partners’ wives the Eva Perons of our time.

Now the Fed has become a mechanism by which the country’s treasure is plundered for the benefit of oligarchs around the world and by which the dollar is being debased. In 1987 under Volcker the Fed was custodian of the world’s unquestioned reserve currency; now the Fed destroys that currency’s value and the wealth of anyone foolish enough to hold it.

Read the excerpts and weep, but the whole thing is worthwhile.

“In August 2009, John Mack, at the time still the CEO of Morgan Stanley, made an interesting life decision. Despite the fact that he was earning the comparatively low salary of just $800,000, and had refused to give himself a bonus in the midst of the financial crisis, Mack decided to buy himself a gorgeous piece of property — a 107-year-old limestone carriage house on the Upper East Side of New York, complete with an indoor 12-car garage, that had just been sold by the prestigious Mellon family for $13.5 million. Either Mack had plenty of cash on hand to close the deal, or he got some help from his wife, Christy, who apparently bought the house with him.”

-snip-

“It’s hard to imagine a pair of people you would less want to hand a giant welfare check to — yet that’s exactly what the Fed did. Just two months before the Macks bought their fancy carriage house in Manhattan, Christy and her pal Susan launched their investment initiative called Waterfall TALF. Neither seems to have any experience whatsoever in finance, beyond Susan’s penchant for dabbling in thoroughbred racehorses. But with an upfront investment of $15 million, they quickly received $220 million in cash from the Fed, most of which they used to purchase student loans and commercial mortgages. The loans were set up so that Christy and Susan would keep 100 percent of any gains on the deals, while the Fed and the Treasury (read: the taxpayer) would eat 90 percent of the losses. Given out as part of a bailout program ostensibly designed to help ordinary people by kick-starting consumer lending, the deals were a classic heads-I-win, tails-you-lose investment.”

-snip-

“The impetus for this sudden manic expansion of the bailouts was a masterful bluff by Wall Street executives. Once the money started flowing from the Federal Reserve, the executives began moaning to their buddies at the Fed, claiming that they were suddenly afraid of investing in anything — student loans, car notes, you name it — unless their profits were guaranteed by the state.”

In short, between 1987 and 2008 the Fed went from paragon to a joke, along with America. I’ve long agreed with Ron Paul that when the Fed took its extraordinary actions in 2008 it needed to be accountable, to be audited. But only now am I beginning to wonder if we do need to abolish it and start over.

Corporate America thinks that China is the future, the place to make a fortune. They are dead wrong. China strongly prefers that Chinese, not foreigners, make money in China. The country’s usual practice is to require foreign firms to transfer valuable technology to Chinese partners, and then make life difficult for the foreign firm if not take over its business.

While some high profile US companies like Apple (AAPL) and Coke (KO) do well in China, at least for now, they are exceptions. Most firms looking to produce in China should remember this: casinos need some lucky winners to lure in the suckers.

China rolled out its trade policy in the Nineties when it established a modern aviation industry at the expense of McDonnell Douglas (remember them?). It’s a story worth recalling because the McDonnell disaster – or smashing victory, from China’s viewpoint – has been the template for the China “trade” ever since.

The McDonnell Douglas Disaster

When the US and China renewed their contacts in the Seventies, China coveted a world class aircraft industry. China’s own aviation technology was horrendously backward then. They even made airplanes out of steel.

Under Deng and then Li Peng, the Chinese planned to catch up. They would play the Western firms off against each other and get them to hand over to China a century’s worth of aviation know-how for the chance – just the chance – to compete for the “limitless” Chinese market.

Neither Airbus nor Boeing caved, even though each was afraid that the other might give up enough to get an inside track in China. There was a third, weaker player, though, which would give the Chinese what they asked for in exchange for one last shot at corporate survival: McDonnell Douglas, whose storied history had included the world’s first real commercial airliner, the DC-3, and the F-15, which for decades helped assure America’s air superiority.

McDonnell had already fallen behind Boeing to a weak number two position in the US when McDonnell Douglas China began producing airliners in 1985. Through the Eighties and early Nineties China dangled the possibility of big sales that McDonnell could make to Chinese customers. The deal between McDonnell and its Chinese joint venture partner went through several iterations as negotiations continued.

In the end McDonnell Douglas China produced a total of 35 planes between 1985 and 1994. And China got what it wanted: McDonnell taught the Chinese to build advanced commercial airplanes. Considering the amount of sales McDonnell got out of the venture, that deal was an absolute steal for China.

China had no compunction about squeezing McDonnell ruthlessly for even stiffer terms, though. China demanded, and got, a $5 million side letter under which McDonnell exported to China in 1994 a number of machine tools that fell under the category of sensitive military technology. Under the export license granted by the Commerce and State Departments, the tools were to be used to make only civil aircraft at Shanghai, but, in an episode one might characterize as James Bond meets Keystone Kops, things turned out rather differently. (Then again, who were we kidding when we exported such things to anyone other than a longtime ally?)

The tools ended up in factories located 800 miles southwest of Shanghai. The tools were so large they would not fit through factory doors; buildings had to be built around them. Not the sort of item that is easily misplaced. The Chinese went to that trouble for a reason.

According to a federal indictment handed up in 1999, McDonnell knew that China National Aero Import Export Corporation (CATIC) would divert the machine tools purchased from McDonnell to plants producing advanced weapons such as Silkworm missiles. A CATIC division pleaded no contest to charges of violating US export laws in 2001.

After the 1994 machine tools purchase, McDonnell Douglas China sputtered; nothing came of the “firm” order for 20 more planes McDonnell announced at the 1995 Paris Air Show. The paltry sales from the joint venture proved far too few to make a difference to McDonnell. Boeing acquired McDonnell – or what was left of it — in 1996. Even then China had the gall to protest the merger, saying it didn’t want a Boeing-McDonnell combination that would “exert market power” over the aviation industry.

The McDonnell Treatment as Standard Chinese Policy

The Chinese have used similar tactics ever since McDonnell got sold; no need for them to change a winning game plan.  Some headlines from just the last three months:

• Train Makers Rail Against China’s High Speed Designs WSJ, November 17.  A virtual rerun of the McDonnell saga. China “invites” Japanese and European companies, into its high speed rail market, apparently misappropriates their technology, then gives the big contracts to domestic manufacturers.

• China Clones, then Sells Russian Fighter Jets WSJ, December 4

• China Wins in Wind Power, By Its Own Rules NYT, December 14. Foreign wind power generation equipment makers with plants in China slowly getting squeezed out of the market after having given their know-how to Chinese companies.

• Then there’s the White House Fact Sheet on Commercial Relations (h/t Taylor Marsh) prepared for Hu’s state visit. It is a list of deals that will supposedly make money for Americans in China. The great bulk of them are agreements to transfer US technology to China in exchange for sales in China. Our President naively or cynically trumpets these deals as accomplishments for the United States. Just how do we expect those to turn out?

Some readers have told me that foreign companies “should transfer technology to China as a condition of market access, otherwise it is neocolonialism.” On the other hand, China is now the world’s largest economy when measured by purchasing power parity. It is itself arguably a colonial power by virtue of its Southern Hemisphere mineral reserve purchases. And China aspires, not just to power, but pre-eminence as it angles for the yuan to get reserve currency status. Why should China still receive the coddling customarily given to weak developing countries?

The Lesson for Investors

For investors the lesson is simple. Companies that manufacture in China risk their intellectual property and even their whole business. While China looks like a wonderful customer on the surface, in reality the Chinese play a very long game and the short term profits China offers to foreign suppliers can come with nasty surprises on the tail end. The “market access” they offer in exchange for technology transfer can prove to be as elusive as that green light Gatsby could never reach.

The NYT article details just how much trouble wind energy equipment makers got into when they went to China because they “just had to be there.” No, they didn’t. As McDonnell and countless others have learned, it may well be that “there’s no there, there.” Except if you are Chinese.

Disclosure: Avoiding companies that manufacture in China in favor of natural resource companies that sell to China.

Moody’s will consider lowering its credit outlook on US Treasurys due to the Obama/ Republican tax cut deal. If the agency decides to lower the outlook, that will open the possibility of actually cutting the rating below Aaa within 12-18 months, the rating agency said December 12.

Not so long ago, Treasurys stood above all other credits, even other sovereign credits, as the closest thing to an absolutely, unquestionably, risk free asset. Even with all our well publicized troubles, it was shocking, if not surprising, to see Moody’s discuss the possibility of a US ratings downgrade publicly.

American Leadership Still in Denial Abut Nation’s Decline

Back in early 2009 I asked why anyone thought the United States could subsidize weak banks, stimulate the economy, and maintain the status of the dollar. Oh, and fight two foreign wars? Maybe we can’t, Moody’s now seems to be saying.

After writing that post I saw this article by former IMF economist Desmond Lachman (he’s now with AEI, the Republican-leaning think tank) who had seen several currency crises first-hand.  Lachman compared the denial we operate in to that of “Argentina in its worst moments.” He concluded by saying, “In the twilight of my career, when I am hopefully wiser than before, I have come to regret how the IMF and the U.S. Treasury all too often lectured leaders in emerging markets on how to ‘get their house in order’ — without the slightest thought that the United States might fare no better when facing a major economic crisis.” If the tax deal is any indication, we don’t seem to have gotten better at facing reality since Lachman’s article appeared.

Moreover, while investor types certainly read the recent Moody’s announcement,  the announcement didn’t seem to get all that much media play. More denial.

The Dollar’s Reserve Currency Status At Risk

We’re blowing up the dollar based international monetary system, which underpins the prosperity we used to take for granted, and Washington doesn’t seem to care. Someone needs to remember that with the dollar as a reserve currency, foreign central banks hold Treasurys as a reserve asset (like, say, gold) to back their own respective currencies. But as we cheapen our credit, we fail in our responsibility to maintain Treasurys as unimpeachable, gilt-edged instruments.

While any number of analysts say that US credit is safe because we have lower debt to GDP ratios than, say, Italy or Japan, that argument misses the point in my view. If you want to have a reserve currency, your debt has be so sound, no one thinks to worry about it. That soundness used to be part of the reason why foreign central banks hold trillions of dollars. As that soundness erodes at least some pronounced selling could make sense for managers of foreign official portfolios. Somewhat better than the other guy is not nearly good enough. And once we lose our pride of place, getting it back will take a very long time.

Some analysts speculate that our economic “leadership” is actually looking for an exit strategy where we let go the burden of carrying the reserve currency, and allow it to be replaced by a composite of several currencies, something like the IMF’s Special Drawing Rights. I have three problems with this strategy, if that is what Washington is trying to do.

First of all, in such a system, countries not all that friendly to us would likely get much more say in how things get done in the world – China, Russia, possibly some of the Persian Gulf states. Do we really want that? The second problem is that by its fiscal irresponsibility, our country would presumably be negotiating the new monetary world order from a position of weakness. No longer can we say, as the late Treasury Secretary John Connolly did, that “It’s our [current account] deficit, but it’s your problem.” The third problem is that if we continue to let things drift, we risk a crisis as Lachman points out. In which case we wouldn’t be “negotiating” very much, things would be taken from us with little given in return.

Meanwhile, China keeps doing bilateral trade deals with other countries in which trade gets settled in renminbi and the dollar gets bypassed altogether. In addition to reducing the dollar’s primacy in international trade, such arrangements reduce the needs of other countries to hold dollars, making official foreign sales of Treaurys more likely at some point.

One suspects that the troubles in the Euro zone are one reason Treasurys look good by comparison, at least for now. That, and the way dollar selling got overdone earlier this autumn. Eventually, though, Euroland will resolve its troubles (for better or for worse), and then we’ll get another turn in the spotlight. If foreigners then become less willing to hold dollars, how long will we be able to pay for imported oil (or microchips, for that matter) with dollars we print so casually?

No one knows. But taking the dollar’s unique status for granted would seem to be unwise.

Moody’s Sounds the Alarm and Still Doesn’t Seem to Get It

How ironic then, that Moody’s, while sounding its alarm on Treasury credit quality, remained blind to the implications of that alarm when it released its US economic forecast. (I know, the forecast was released on the 8^th, four days before the announcement on the Treasury outlook.  But in a December 6 analysis Moody’s did raise the possibility that the tax cut deal could affect US creditworthiness – which was newsworthy enough in my view—even though as of that date Moody’s was not ready to warn about a change in outlook).

Moody’s economist Mark Zandi ran the numbers and decided that, yes the tax cuts will goose the economy – and even assure the kind of recovery we’ve been waiting for. But while his company’s credit analyst Stephen Hess had started to open America’s credit rating to question, Zandi didn’t think to tell us what would happen to our economy if other countries started to doubt our credit more seriously too.

The Federal Reserve’s monetary policies have no doubt been a positive factor for the stock market. We’re barely a month into QE2 and already there is talk of unlimited QEs to come, if necessary to inflate the economy. But little has been said about about the ugly consequences for the poor, not just here, but worldwide and those retirees on a fixed income due to steep increases in commodity prices.

The past six months has seen one of the sharpest rises in commodity prices in history while at the same time interest rates have been pushed lower and lower so that even retirees with some savings, which most tend to invest conservatively in shorter term instruments, have seen their incomes drop considerably. Can any advisor tell their elderly clients that they must pull their money out of short term bonds and CDs, the traditional refuge, and put it into the Russell 2000? But even this assumes they have some discretionary money to invest. How about those who are locked into fixed payments via Social Security and perhaps a fixed pension payment?

The net result is rising commodity prices, while affecting everyone, has a particularly adverse effect on those on fixed incomes. According to the latest Bureau of Labor Statistics the average consumer unit, spends 12.4% of their income for food shown very well here at Visualeconomics.  Now two important things to consider here – these results are based on prices over a year old and notice that the number is based on an average family income of nearly $63,000. Must be the banker salaries skewing the income numbers because I know plenty of families that exist on much less. The result is that even before the recent skyrocketing of commodity prices some families were already spending in excess of 25% pf their income on food.

Now let’s talk about about rising energy prices, which affect everything from home heating oil, elctricity cost, and perhaps most importantly gasoline prices.  Wholesale gasoline prices are up more than 25% since mid August. Not only does this have a more direct impact upon poorer and fixed income consumers, but also indirectly as these fuel costs are translated into higher costs for nearly everything farmed, produced and transported.

There is also the indirect costs to our economy of increased health care expenses since as food costs go up, those who can least afford it switch to less healthy foods, encouraged to do so by our government. In a recent Newsweek article it addresses the social divide we now have in this country based on food.

We haven’t even began to talk about the ramifications on the poorer economies of the world where often food can eat up 50% or more of their budget. The UN’s Food and Agriculture Organization is predicting the food import bill could surpass one trillion dollars for the poorer countries. Here is a FAO food price index chart showing the dramatic increase in food prices. If you remember, it wasn’t long ago that there were riots in many parts of the world over food. Guess what, the prices are higher now. Is it long before we start seeing them again and pictures on the nightly news of people starving?

Here in our country, the big debate is about extending tax cuts. What about the the most regressive tax of all, higher food and energy prices for the people who can least afford them. Who is lobbying for them?

Some influential commentators say that as the Government gets more desperate to shore up its finances, it will confiscate private gold holdings. Just like  it did in 1933.

After all, the argument runs, the Feds already did this, so there is precedent. And if Fort Knox really is running on empty (Ron Paul among others wants an audit to find out), the US needs money even more badly than it is willing to admit.

So, why wouldn’t the Feds go for the gold? First, I don’t think Obama wants to; I’ll explain why below. More importantly, Americans just don’t own a lot of gold, and so there isn’t much for the Government to confiscate.

Do US Private Citizens Own Enough Gold to Bother Confiscating?

To see why their isn’t much bullion in private US hands (actual figures on US private gold ownership are hard to come by) just look at how different things are from the way they were in 1933. Until that time, the US gold coins circulated in the ordinary course of business.

Gold coins were used as money, along with silver coins, and yes, paper. But then the dollar really was good as gold. You could bring a $10 bill to the bank and emerge with a $10 gold piece if you cared to. When Roosevelt confiscated gold, he confiscated a form of money that lots of people used, every day. Of course there was plenty around.

These days money in the form of gold or silver is something Americans barely relate to. Some Americans bought precious metals during the price runup of the 1970s, but Paul Volcker seemingly restored the soundness of the dollar then, and gold fell off the investing public’s radar screen for a good twenty years.

Here’s another reason to suppose that if the Government came for citizens’ gold, it would have slim pickings. Gold dealers have reported to the press that they can get supply only from wholesale sources, such as official mints. Individuals are not selling it. And the few times that I have been in the market, I have heard the same thing. The dealers are getting buy orders from the public, but not offers to sell even at today’s record prices. So far, anyway.

Is this a reflection of low private holdings or a belief among bullion owners (as opposed to ETF holders, maybe) that metals are only heading higher? My guess, is some of both. So while ETFs like GLD, SGOL, and SLV have become popular, private bullion ownership has likely not become a mass phenomenon, yet.

Obama is Quite Investor Friendly

The second reason I don’t expect gold confiscation is that, despite his reputation, Obama governs as a moderate if not a Republican in drag. We’re all reading about how the current Republican tide has (or will) force President Obama to “move more to the center.” But in truth Obama already made his hard right turn, back in August 2008.

As Yves Smith graciously allowed me to note here, candidate Obama condoned the August 2008 amendments to the Foreign Intelligence Surveillance Act (FISA). The FISA amendments made it easier for the government to monitor citizens’ electronic communications without a warrant and even granted Bush-era wiretappers retroactive immunity from prosecution. Having bolstered his “anti terrorist” credentials, Obama then signed on to the TARP bill in September 2008. You can’t be more business friendly –or at least, investor and big bank friendly — than that.

From that day forward it should have been obvious to all that Obama’s “change” slogan was but a talking point. He introduced Robert Rubin proteges Geithner and Summers  as key members of his economic team shortly after his election. Then he largely dismantled his enthusiastic army of volunteers, Obama for America (OFA). During his campaign Obama turned out OFA members at will in every state for phone banking, door to door canvassing, and donations. That power kept Republicans awake at night in 2008. Now, not so much.

Once in office Obama continued his moderate bent. His stimulus plan consisted mostly of Republican style tax cuts. Obama’s health plan will force citizens to buy insurance from private insurance companies – how “anti business” is that? And the rest of his Republican Lite Administration, is well, history. Also it’s worth noting how much Obama actually holds his liberal allies in contempt, seemingly not much less than the “real” Republicans do. Obama thinks he can forget key campaign promises (Exhibit A: the public option) because his supporters will vote for him rather than a Republican no matter what he does.

I can only assume that business keeps chanting the “Obama is a radical” mantra in order to keep Obama in line, to keep him from even thinking about “change,” and to gin up Republican campaign contributions. But is this man out to take your gold? Hardly. I don’t think his people even understand the stuff. Otherwise, why would they continue to debase the dollar, and ignore the message gold and silver prices are sending? Was anyone surprised that gold hit 1,298 after the Fed hinted at more possible QE September 21?

Advice for Investors

So I remain a long term dollar bear, and a bull on precious metals. If I’m right, it’s safe to store most of your bullion in the US, though maybe not all of that at a bank. The main worry here, is the outside chance that banks might close temporarily in the event of a run on the dollar. But in that case, you would still own your bullion. You would need, however, to have some real, non paper money in another safe place where you could get it in an emergency. Non-bank depositories such as First State of Delaware and Brink’s are now trying to fill such needs and might be worth a look. I have no connection with either.

Disclosures: Long GLD, SLV, gold bullion

You read it right. It can’t.

Of course there has been some growth in GDP over the past year.  All that government stimulus was going to goose the numbers at least a little, and inventory restocking started to look good for a couple of quarters. But if you look at the major components of GDP you can see why only the cheerleaders think that this supposed recovery is either powerful or self sustaining.

By definition, GDP is the sum of Consumption by individuals, Investment by businesses in plant, equipment, and inventory, Government spending, plus Exports minus Imports. Economists write this as Y = C+I+G+X-M.  Note to the math challenged: you have just read the only equation in this article.

Both Drivers of Consumption Are Weak

Since consumption accounts for 70% or so of GDP, let’s look at it first. Consumers fund consumption out of income and wealth. Income not spent, by definition, is saved. Obviously the wealth of most consumers has taken a hit and is not about to recover any time soon. The S&P is still down 29% from its 2007 high.

Moreover, for most people the family home is the principal asset and home prices have not really budged from the bottom at this point. I am far from the only person to have said that home prices can’t recover until we work off the huge “shadow inventory” of delinquent mortgages, homes in foreclosure, borrowers with adjustable rate mortgages that have not yet reset, and homes owned by people who would sell if a price rebound allowed them to take their money out.

On the income side, most people depend on jobs, and the employment outlook remains poor. Total non-farm employment has grown all of 600,000 since December 2009 low of 129.6 million. Which is worse than it looks, because we need something like 200,000 new jobs per month just to keep up with population growth.

Offshoring Has Weakened our Ability to Recover, When Compared with Previous Recessions

In my view off shoring is a major culprit here, and it really shows up in the last twenty years of employment numbers. About 22.7 million jobs got created during the Clinton Administration. Only 8 million got created under Bush and the recession erased all of those. And yes, a big portion of the jobs created under Bush were in residential construction, a sector not expected to lead us out of recovery this time. But my point is, less jobs got created under Bush than Clinton, largely because US corporations are less and less eager to hire Americans even when business turns up. No one sees that trend reversing unless the government steps in.

For example, you’d think that Apple’s (AAPL) dazzling new product introductions would create American jobs. Not a chance. As former Intel (INTC) chief Andy Grove says, Apple Computer (AAPL) has 25,000 US workers and ten times as many in other countries. While AAPL keeps key engineering, design, and management people here, the actual work of stamping out Macs, ipods, iphones, and ipads gets done elsewhere. Which is why US computer manufacturing employment sits at 166,000, lower than it was 35 years ago. In my view, this example illustrates the long-term downtrend in the job growth numbers as well as anything possibly could.

Business Investment is in Low Gear

So far we have shown that wealth and employment, the principal consumption drivers, remain weak for long-term, structural reasons. How does the rest of the economy look? Well, business investment in plant and equipment has not moved far from trough levels either. I suspect that the picture is the same here as it is for employment: Increased US demand for goods is less and less likely to result in new US plant and equipment. Think of all the new AAPL factories in Asia.

The other main component of investment is inventory. We have had our spurt in inventory investment, and I don’t see how it continues without a sustained increase in consumer demand. Therefore I don’t expect business spending (investment) to contribute much to GDP either.

Net Exports Actually Subtract from our GDP

As for trade: the first thing to remember is that we import about 12 million barrels of oil per day, a cool billion dollars’ worth. By the definition of GDP  we listed above, that billion (like all imports) gets subtracted from GDP, every single day. That won’t change unless we change our energy policy or a supply problem changes it for us.

The next thing to remember is, that the world trade system is set up so that the US imports far more than it exports, and many other countries depend heavily on US consumption. As former IMF consultant Richard Duncan points out in his book, The Dollar Crisis, the US current account deficit approximately equals the surpluses of all the other countries in the world. Again, this is a structural issue.

I think some change in that structure is inevitable, and it won’t be painless. But until and unless it does change, the international sector will continue to be a considerable net minus for GDP. We aren’t going to grow the economy by exporting to other countries, because on balance, they make a point of selling to us more than they buy from us.

Government Spending Can’t Make up for Private Sector Weakness

What about government spending? While the federal government is doing a fair amount of spending, state and local governments have had to cut back. They can’t print money the way the feds can, and so when state and local tax receipts fall, their spending falls too. Much of the stimulus program has in fact gone to help states and localities. Otherwise the states and localities would have let go  more firefighters, police, and teachers than they already have. So yes, federal spending makes a difference (Economists Alan Blinder and Mark Zandi say that the program prevented 2.7 million public and private job losses), but it is less stimulative than spending totals make it appear. What will the federal government do as the stimulus program winds down?

At some point the President will almost have to propose another stimulus plan. That begs at least three key questions: the program’s structure, whether Congress will enact it, and how it will be funded. I think that a wisely structured and funded stimulus would be helpful in the short to intermediate term, but wouldn’t it be nice if the Administration also tackled the long-term, structural problems? Not very likely, since the Geithner/ Summers team talks as if it faces a “normal” cyclical downturn.

The Fed Can’t Help Much Either

So much for the components of GDP,  on to the Fed. Like many others I expect that on August 10 the Fed will say that it will reinvest the proceeds of its maturing MBS rather than let its balance sheet shrink. But whether I am right or wrong, the Fed can no longer pump up the “real,” non-financial, economy by creating money. Banks don’t want to lend and few creditworthy customers want new loans.

Our economy is stuck and our government is clueless.

The early July pullback in gold to 1190ish has at least some people scratching their heads. My take is this. Gold ran up $100 to its all-time high of $1,268.50 as worried Europeans dumped Euros and bought gold in May. Then the European Central Bank (ECB) signaled that it will protect the Euro, and its own existence, by any means necessary, see this, and this.

And so, the Euro dissolution trade is dead, at least for now. I suspect that traders who bought gold because they feared the end of the euro, are selling gold and buying euros back.

To understand what is going on, look at the ECB’s secondary market purchases of sovereign bonds, which began in early May. I think the purchases may be a decisive element in the measures that have preserved the Euro, at least for now, and also led to gold’s pullback.

Recall that in response to the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) debt crisis the EU put together its bailout package in April. The package had an impressive headline number, $1 trillion in assistance. Many traders thought the headline number was more impressive than the substance. The euro kept falling and gold kept screaming higher.

Then in early June, it became clear that the ECB’s purchases of sovereign bonds on the secondary market were part of a continuing program, not a one time event (h/t naked capitalism). The Euro bottomed on June 7. I don’t think this is coincidence. Furthermore, gold, which made an intermediate high of $1,254.50 on June 7, can now be seen to have struggled since then, before finally selling off on July 1.

I would argue, though, that while the ECB punished gold holders in the short-term, ECB bond purchases are a positive for gold in the long-term. The purchases smack of “money printing” and amount to a backdoor aid package for the financially weak PIIGS. They peg the debt of the issuing countries to artificially high prices, and might even allow PIIGS to issue new debt at artificially low rates – assuming the ECB stood ready to buy bonds to support their prices. All of this can only lead to further debasement of the Euro versus gold.

Moreover the rebound in the Euro corresponds to at least a possible topping in the dollar. It almost has to, given the Euro’s large weight in the Dollar Index. (Hopefully this dip in the dollar will not bring to the fore, my longterm concerns about the dollar.) Some analysts suspect the Euro’s bounce mean that the risk trade is back on, and maybe it is for at least a little bit, given this week’s corresponding bounce in stocks.

The European bank stress tests also demonstrate Europe’s determination to save the Euro by propping up both the banks and financially weak PIIGS. The guidelines say that European banks may value Spanish Government bonds at 97% of par, and Greek bonds at 87%. That way the banks can, well, lie about the value of these assets and artificially prop up their equity. Of course, the banks will say that if the bonds will pay off at par (and if the EC can make that happen, they will) who needs to mark the bonds to market?

Allowing Europe’s banks to value the weak sovereign debt at such generous numbers, will also provide incentives for the banks to keep holding these bonds rather than dump them. Therefore the stress test guidelines provide a backdoor subsidy for the debt issuing countries as it would help keep their borrowing rates down. Of course, no one believes that these bonds are worth anywhere near that much.

But, in addition to the subsidy for issuing countries, the stress test guidelines matter because they indicate that Europe is following the US playbook on stress tests and bank bailouts. Last year, US regulators announced stress tests for US banks that would supposedly show that the banks would stay “solvent” under various economic scenarios.

As most readers know, these tests were ludicrously easy. Not many analysts thought that the major banks (with the possible exception of Wells Fargo, WFC) were viable at the time – not without government assistance, at least. But the stress tests provided a fig leaf to justify government help through TARP, the alphabet soup of Fed lending programs, and more lenient accounting treatments for banks’ securities holdings.

The change in bank accounting also marked the US stock market bottom in March 2009. Clearly the Europeans hope that European bank bailouts will make the financial markets happy as well. And in the short to medium term, if the US experience is any guide, the bailouts may enable the Euro bottom to hold (at least when measured against other paper currencies) longer than many people think. Even if, as in the US, European banks will continue to hold their fair share of underwater assets. In other words, short-term measures that kick the can down the road, can have important short-term results, even if they don’t solve long-term problems.

The European moves to bail out their banks tell you something else: not to worry about those reports that the Bank for International Settlements (BIS), is lending to commercial banks and taking gold as security, under repurchase agreements. Some gold traders seemed to fear that if the banks failed to make good on these loans, the BIS would dump the gold collateral on the market. My response: the EU will not let a big European bank fail anytime soon; that’s the whole point of their stress test charade. And if big European banks did start going down, I suspect the demand for gold would soar.

So what’s an investor to do? Chartists note that the June top was not much higher than the previous highs in December 2009, and point to what looks like a double top.  In response to this and the July 1 gold selloffs, gold timing newsletters turned understandably bearish. Of course, the Hulbert Letter holds up this pessimistic timer consensus as a contrarian indicator, and calls it a buy signal (h/t Daily Crux). Still, if you are a long gold, the chart has to concern you.

My thinking is,  if you are a trader and you don’t like gold’s double top (not to mention its closes below the 50 day moving average), why not lighten up? The chart doesn’t tell me that gold is going higher anytime soon. But I wouldn’t sell a core position, because the European move only underscores the long-term weakness of paper money around the world.

Disclosure: long GLD, SGOL