Merry Christmas

Just would like to wish everyone a Merry Christmas and a prosperous New Year. I think that 2010 will have some ups and downs and unfortunately, I think we are going to enter a period of stagflation until we address the fundamental issues that prevent this country from being truly competitive.

The single most important issue is that we need to stop relying on foreign energy and need to return our balance of payments to a sustainable level. There is a very simple approach to economics that basically can determine the wealth of a country by taking wealth created, add it to wealth already in existence, subtract wealth consumed and adjust for wealth imported/exported.

Now the basic formula can get complicated depending on how you measure wealth and whether wealth can be created out of nothing (i.e. housing bubble). However, what is clear is that the amount of wealth exported in trade for an item that is almost immediately consumed such as oil has a negative impact on the wealth of the nation. It is the most obvious and potentially most easily fixed drain on the nation's wealth. Use of more natural gas and coal while we develop alternative energy resources will lead to retained wealth and more jobs. It may not be the most economical solution for any one individual or business, but as a nation it needs to be our number 1 priority.

Musings

If you think about things that drive the economy, it pretty much comes down to the way people feel about those things. Generally speaking, the total amount of resources and products available and the the number of people changes gradually over time. However, if a particular product is considered desirable, it suddenly demands a higher price. Conversely, if something that was desirable goes out of favor or is considered too expensive, it suddenly is in an oversupply situation.

This is in fact the primary cause of economic bubbles. If you consider housing, as long as enough people felt that they could get more for their home in a few years than they were paying for it today, the housing market was "hot". It was when prices stagnated for a period of time and started to decrease that all of a sudden people found themselves in homes they couldn't afford. You can talk about sub-prime mortgages and overbuilding as well as excessive speculation but the reason that the market came to a screeching halt was that people no longer believed that housing prices would go up.

It would take more time and data than I currently have to prove this here but I believe there is plenty of proof available. You can consider anything the is "hot" and pretty much know that at some time it will "cool" off. The contraian investors use this concept fairly successfully and if they have the time and resources to wait long enough, they will almost always be right eventually. The only real problem is the timing. Say you feel the stock market is "too hot" right now and want to short it. First, you have to be right about it being "too hot" and second you have to be able to wait out the increases.

By most historical measures, the market is not really overvalued. Of course you may question if those measures are still valid, but generally, the times people start to believe that the rules have changed, they have been wrong. There is no reason to believe that they are right now. Of course they may be, but then again, a few years ago there were some who believed the DOW was going to 30,000.

If you go back to some of the earliest recorded bubbles, you find that the Tulip bubble of the 1600s clearly demonstrates how a commodity price is dictated by people's fancy. Of course knowing what the next hot thing is going to be and when it is going to go cold is the trick.

Creating jobs

The simple fundamental issue that will determine how strong the economy is next year is the number of jobs created. The recent recession caused the elimination of many jobs that will never be replaced because they have been converted to technology or partially eliminated by better productivity via technological improvements. Further, because of the amount of overbuilding that took place due to the cheap credit and housing boom, it will take awhile before new construction returns to peak levels.

In order to stimulate jobs, we need to do three things. The first is to promote energy efficiency programs that stimulate remodeling and installation of renewable energy and conversion to domestic energy sources on old residential and commercial real estate. This level of effort will create construction jobs, energy jobs and to the extent we can use domestic products, manufacturing jobs.

The second thing is to truly start to work on infrastructure repair. We have many opportunities to improve roads, bridges, transportation facilities and other public structures. This work is actually necessary and has to be done before the actual structures start to collapse. Doing it on an expedited basis can jump start the economy and provide millions of jobs.

The third thing is to make sure the business environment does not discourage hiring in this country. One thing would be to reform the tax basis to one base on a tax on consumption. Another thing would be to eliminate health care costs as a concern. The actual pay given to an employee is no longer the most significant factor in hiring. It is the associated costs.

Furture profitability

One would like to think that someone involved in the Financial world would have rudimentary math skills. However, I hear comments that effectively convince me otherwise. Today I heard a commentator on a business channel say while companies had achieved profitability by cost cutting, the market was pricing in a 25% profit increase next year and she didn't believe sales would increase by that amount.

Now, maybe she didn't mean to express it quite like that but clearly if you have reduced costs and therefore productivity, you can achieve substantial increases in profits with relatively small increases in sales.

For example, lets say that a company is in retail and normally marks up goods 100%. It doesn't achieve a 50% profit rates because the cost of running the business eats up a significant percentage. Lets say that the profit rate is actually 10%, so for every dollar of sales, 50% goes to procure the goods and 40% goes to the cost of running the business. Now saw the total business sales are a billion dollars so profit would be 100 million. Now if sales increase by 10%, the question is would associated costs have to increase also? Probably not since the retailer would be reluctant to increase costs without a greater impetus. So theoretically the 100 million in increase sales would produce 50 million profit. Now that would increase profits by a full 50% but of course, some increases in variable costs would occur so lets assume half of the business cost is variable and, such as overtime and would increase proportionately. So profits would increase by 30 million leading to a 30% increase in profit on a 10% increase in sales.

Shorting Stocks

What would the price of investments be if the only stocks being traded were ones actually in existence? If you consider the mathematics of stock shorting, it enables a speculator to sell stock he or she doesn't actually own. Yes, the stock sold is technical a real stock since the share has to be borrowed and delivered, however, the borrowed stock takes on a double identity, one share being held in an investment account and the same share being sold on a "temporary" basis to another investor.

Ultimately, all shares shorted have to be bought and I suppose those who short stocks argue this balances things out. Maybe it does, but the allowance of short selling adds a lot of volatility to the stock market that otherwise wouldn't exist. Traders love this, and the question that has to be asked is whether the stock market is designed for the Traders or as a place for companies to raise capital by selling stakes in their company.

Lets consider short selling for a second. If a significant number of people feel that a company is overvalued, or possibly simply notice that based on the number of shares being traded, more shares on the sell side could start a price drop, then they will short the shares. The shares being shorted add supply without adding any demand. Now, you hear short sellers say they help find weak companies and expose them. Maybe, but if the company is that weak, maybe the owners of the stock should be the ones selling it. Also, remember that after the shorts drive the price down they buy the stock back at a reduced price and often artificially cause a rebound. It is certainly possible that the stock had weak fundamentals, but there are plenty of examples where despite any fundamental analysis, stocks get driven down by short sellers and then rebound as the shorts cover, often returning to the original or perhaps better price point. All that was accomplished was that some traders made money while investors potentially were scared out of a position at a loss. This is the ultimate goal of a short seller, to ignite a selling frenzy that hammers the stock price.

There are ways to bet on the future of a stock via calls and puts but short selling is the only way to potentially impact the stock directly without actually owning it.

Recovery actions

As the current administration approaches the end of its first year, it seems to have grasped the key elements to economic recovery. There is still a lot of skepticism about this but in the areas that matter I believe they understand the fundamental needs to foster a true recovery.

First, having avoided economic collapse by infusing capital into the banks, it is time for the Government to consider removing that money from the economy. Now, despite what many would like you to believe, the amount of money in circulation has not actually increased, since the reserve requirements imposed on the banks led to a significant reduction in available money. Of course the banks need to be cautious in reintroducing liquidity into the economy and the Government needs to make sure that capital requirements don't allow the reckless behavior of the last few years.

Second, we need to pursue the ongoing replacement of foreign energy sources with renewable or native alternatives. The lure of cheap oil has left us in a position where we face significant export imbalances. This change in the form of numerous initiatives will expand over time and while it will face challenges as foreign oil will go down in price, we need to make sure our policies equalize the playing field. One way to assure this is to determine a price below which alternative energy is uneconomical, and make sure that imported energy costs at least that much. This could be accomplished via a tax that would also help reduce the deficit. Now the tax shouldn't be designed to drive energy prices higher than required to continue economic recovery, but it clearly can help in the transition from oil to cleaner and more available energy. Also, Cap and Trade will lead to greater use of alternative energy and lead to installation of new technology and jobs. Also, providing tax incentives for home renovations to install more efficient or alternative energy will further reduce our addiction to foreign oil.

Third, we need to replace the jobs lost due to secular changes in the economy. The two most significant changes are related to reduced need for construction and the technological changes that are eliminating entry level jobs. If we can inspire a greater amount of renovation to convert existing housing to be more energy efficient that will absorb a large number of construction skills. Also, if we are going to convert the economy to a greater use of items like Natural Gas and Alternative Energy, these infrastructure changes will create many jobs. The jobs being lost to technology, need to be replaced by an increase in health care and manufacturing opportunities. As we convert energy from foreign to domestic, we will see energy costs come down. If we can combine this with some improvements in our tax system, we can stimulate increased in manufacturing. Also as we improve health care to cover all Americans we should see opportunities in health care jobs. Of course, these jobs need to be in fields that supplement our Doctors and Nurses.

Using TARP

It seems that many analysts and commentators are so caught up in their own political views that they have a lot of trouble with the facts. For example, their is a lot of misunderstanding about the TARP funds.

There are very clear rules concerning reappropriation of funds once used. As has been clearly stated by the administration and as is required by law, funds once used and returned, are returned to the US Treasury. The net result of that is clearly one of reducing the deficit. However, funds appropriated and not used are still available for use.

When the Administration talks about using TARP funds, it is not talking about using funds returned by the banks but about using funds that were appropriated and not used. Now, these monies are available for use and always were. Certainly, it is appropriate to use them in the time period and for the purpose appropriated. If the administration asks for and gets an extension of the times period authorized for use or if it can get the congress to change the rules regarding use, these are legal uses. Clearly, one may object to using these funds but what I find disturbing is when commentators on national TV shows don't seem to understand what they are talking about.

Dollar thoughts

It seems that all you hear about is the fact that the US Dollar is under pressure and because of the Fed policies is inevitably sinking in value leading to increased inflation and higher import prices. Now, during the worst of the financial crisis there was a run up in the value of the dollar and as financial markets have improved we have seen the dollar fall from those levels to levels of about a year ago.

Now, if you are a supporter of a strong dollar, this may be unacceptable but ultimately the value of a currency needs to be equated to other currencies based on value for goods produced. For example, at one time due to the types of industries and productivity involved, an American hour of labor may have been appropriately valued higher than it was elsewhere in the world. Of course, business is designed to maximize value and when you see jobs migrating from one country to another country, it is an indication that the cost of labor in the first country is no longer properly value rated.

So how does this get corrected? The most likely method is via currency revaluations. Now, either the currency of the first country has to lose value or the second country's currency has to gain value in relation to each other. This balancing is the result of supply and demand as the labor costs of the first country go down in response to oversupply or the labor costs of the second country rise due to under supply. These changes in cost are more easily accomplished by currency adjustments since it doesn't actually require that individual salaries be adjusted.

Is this a bad thing? Well, it is an economic event that is required to balance world economies. If you believe in free markets this is simply something that results from economic conditions. The problem normally arises when Governments attempt to influence the market forces.

Military intervention

When you consider the various nations of the world and their people, we find a tremendous diversity. Each nation has a culture, that it may or may not share with neighboring nations, but usually, each nation has multiple culture's which taken as a whole form the overall national identity.

Now these sub-cultures, so to speak, are often not very harmonious. In fact we often find one of those cultures becoming dominant and attempting to subjugate or destroy adherents of the other cultures.

Of course, a country looking at a different country observes the conflicts and may or may not have an interest in which of the sub cultures become dominant, either because they share the views of that group or it is in their own best interests.

Over the centuries of human history this had led to multiple wars and incidents between sovereign nations. It has also led to many civil wars and incidents as one group wrests dominance from another.

The question that has to be addressed is when is one country able to legitimately interfere in the affairs of another country. Now, this obviously depends on the degree of interference we are talking about. For example, it is clearly acceptable to state opinions in almost all situations. For example, to simply express an opinion that a particular nation should allow more rights for a minority group and to expose them to the court of world opinion may upset the target but is clearly withing normal intercourse. Using the same example, if a nations engages in clear discrimination against a subset of its population, one may also use economic sanctions or by supplying one side in a dispute aid may be used as a way to ameliorate the situation. This type of action should be carefully considered, but while it may cause significant distress in the target nation, it is normally an action that may be taken without actual physical intervention.

Direct physical intervention, either by use of blockades or introduction of forces into another country is in fact an act of war. Sometimes it is justified because one faction has requested support to help it end an insurgency. However, today's insurgency may be tomorrow's government. When one nation intervenes in this way it should only be done when the intervening nation can show that it faces a clear and present danger from the situation.

It is not enough to argue that a situation may develop into a future danger, since using that argument one could justify nearly any intervention.

On Line Sales

While it is still less than 10% overall, the growth in on-line retail sales has two significant impacts. First it increases profitability since on-line sales offer significant productivity improvements. Second, partly because of those improvements, it reduces employment in retail.

Now, from the overall economic impact, the amount of merchandise being sold is not impacted whether it is sold on-line or in a traditional store. However, as America has stopped being a producer of goods and more of a middleman, selling foreign made goods to American consumers, this may be a significant issue.

It requires watching.

Retail Sales

Having posted in a few days due to the Thanksgiving Holiday and the fact that I was travelling. Hope the holiday was good for everyone.

I think we all know that people see or interpret events based on their paradigm. A paradigm is basically the way we see the world. If you were to believe the world was flat, you would interpret everything in accordance with that. Things that didn't fit into that belief system would have to be explained away or you would have to adjust your paradigm.

Now, I spent a fair amount of time at Malls and stores last week. It was clear that there were many, many people out shopping. My own observation was that most people were carrying shopping bags or packages indicating they were spending money. Now, watching the analysts talk about the results indicated the following. More people were shopping this year than last and they spent more money overall but less per person. At the same time, on-line shopping was up significantly, although it still represents a small but growing percentage of total retail.

Interestingly, the factoid that most of the analysts seemed to pick up on was that the average person spent less on average. If you own a store and total sales are up, even if by a small percentage, I'm not sure if the amount each person spends is important to you. I'm sure the ideal state is to sell all you inventory to a single customer, but selling all you inventory would be the more important event.

As I watched the analysts, discuss what it means that individual buyers were spending less individually, it soon seemed that the fact that after a terrible year for job losses and asset valuations, the total sales were up, even if only slightly, indicates a remarkable turnaround from the dire predictions of just a few months ago.

As I've been saying, we need to understand that the economy has contracted and needs to retrace growth. I would have expected sales to be down. Now last year was a bad year, but the period following Thanksgiving last year was simply terrible. Stores have adjusted with reduced costs and reduced inventories. If they have the same or slightly lower sales than last year they will be quite profitable.

Now, perhaps my paradigm is getting in the way, but I think we had a very successful start to the holiday shopping season and see no reason it won't continue. Now, that doesn't mean we will see the levels of two years ago, but I think retailer's are in great shape to profit.

Recovery trends.

How bad are things in the country today? You still have people who talk like the economy is completely dependant on Government stimulus and that when the stimulus ends it will collapse or have the second dip.

Now, the question that no one seems able to answer is how effective the stimulus actually was. If it is indeed propping up the economy, it would have had to be quite effective. However, much of it is still unspent and in other ways it was poorly targeted and potentially ineffective.

Now, clearly adding a great deal of money to the economy, even if done inefficiently will have some impact. However, was it enough to create all the economic activity we are now seeing? I'm not sure if there is any way to actually measure this, but it certainly doesn't seem so. We see that companies have reduced costs to return to profitability at lower revenue levels. We also see a rise in foreign demand that has helped the economy. Consumer spending, while not what it was is showing some signs of strength and we are starting to see some stability in housing.

The other factor is that the stimulus infused into the economy is not going to be withdrawn. It is there and will stop at some point but it will actually end much more gradually than many seem to think. Much of the stimulus went to prop up shortfalls in state government budgets and as economic activity picks up the increased taxes will eliminate the need for the stimulus.

Now, how strong will the recovery be? I think it will be stronger than many believe as a number of trends help the US economy more than most analysts predict. First, as we develop local and renewable energy sources the balance of trade will be better as we need less foreign oil. This will be gradual of course, but each increment of improvement will help to keep energy costs down and improve the balance of trade. Second, the dollar which has returned to levels it was at about two years ago, will probably weaken a bit more and make manufacturing more competitive in this country, especially with reduced energy costs. Finally, the changes in health care will lead to lower costs for small business and will also lead to lower rates of increase in health care costs.

As these trends progress, we will see them build on each other and the recovery will strengthen.

Thanksgiving thoughts.

One may wonder as we approach Thanksgiving Day if the country in general has much to be thankful for. We are still in the throes of an economic crisis although it is starting to improve. The actions we took to ease the crisis have increased our deficit and combined with the high unemployment rate and reduction in business activity, the deficit was increased even more so due to the loss of tax revenues. We are still engaged in Iraq and Afghanistan and have thousands of young Americans at risk. We see a rising economic threat in China and we see a rogue country like Iran on the verge of developing Nuclear Weapon capability.

So, what is there to be thankful for? Of course each of us has our own individual situation and most of us can probably find many good things in our lives to be thankful for. However, as a Nation, what is there?

First, despite the current hostile activities, in most ways the Nation's defense has never been more secure. Yes, there is the threat of terrorism and we need to remain vigilant, but there is no real military threat to the country as a whole.

Second, most Americans still have a higher standard of living than almost all of the world's inhabitants. The issues we face will be challenging but we should never forget the great wealth and potential of this nation. We have the capability to solve our problems, we merely need to develop the resolve. We always have in the past and I believe we will again.

Third, we are on the verge of providing health care to all Americans. We need to be smart about it but I can't imagine anyone who thinks we shouldn't do it. Without addressing the issues on the implementation of this, we will find a way to pay for it and we will join the rest of the developed world in improving health care access.

Fourth, most (not all) of the racially divisive issues of the country's history are behind us. Yes, there are still pockets of segregation and it will never go away completely, but society as a whole treats all our citizens equally. We have also made great strides in gender equality.

Fifth, we seem to have grasped the need to protect the climate and improve the environment. There is a long way to go, but I believe the tide has turned and more and more we will see improvements in how we treat the world we live in.

Finally, we still enjoy the benefits of freedom that our country was founded upon. There are some who think our freedom's are being threatened and we need those people to keep the system honest. There is a constant challenge related to freedom which is best expressed by the old adage that states, your freedom to swing your fist stops where my nose begins. We can have freedom and individuality while respecting the rights of others.

I believe all Americans should keep some of these things in mind this Thanksgiving and enjoy this very American holiday.

Valuations

Recently the estimate for earnings for the S&P 500 was raised to $80 for 2010. This estimate projects earning growth over the year, meaning profits will be better in the second half of 2010 than in the first half.

If you use a P/E ration of 15, this earnings forecast equates to an 1200 level on the S&P. Now 15 is a little low and in effect represents a 5.33 rate of return. If you consider what you can get in short term bonds, this is a significant risk premium. However, be that as it may, it clearly shows that if you accept this earnings forecast, the current S&P levels still have a 10% upside.

Of course, the speed at which the economy grows, either based on domestic demand or export demand and the speed at which the world economy does or does not grow will play a significant role in whether these earnings are on target or not. Still, while there are always those people who argue that "this time is different" and articulately spell out there reasons, it generally turns out that this time is very much like all the other times.

It is a bit odd that some of the same people who argue that the economy is too weak and that unemployment will drag the economy down, also argue that we have great danger of inflation because of the supposed increase in the money supply. However, so much money was effectively eliminated from the system as assets values collapsed that until we see some increase in real estate the money supply is actually not very much increased at all.

Generally, this recovery, like most recoveries that preceded it will start off slowly and have fits and starts until the point that the growth rockets fully ignite. I believe the fuses have been lit and while I don't think we should or will see significant new housing, I believe that existing home values will start to rise and energy efficient renovations will be one of the driving forces for new jobs.

Picking stocks

There are many uncertainties in what is going to happen in the future. Because of this, investors like to analyse every piece of data to try to determine the best way to profit. Now, of course information is power, but the more important old saw may very well be that a little information is a dangerous thing.

As we see companies report profits or we see data such as monthly jobless claims, the reactions are often very swift and very violent at times. However, if you look at the same data in a long term series, it sometimes shows a very different scenario.

Clearly each company in an industry has some impact on the industry as a whole. But if you consider two companies that both report earnings one may do well while the other may not. Further, the two companies may give us very different projections based on how they see the market they are in. It certainly says a lot more if both of them do well or both do badly, but we do have to realize that in the current environment competition has increased and consumers are more selective. You need to offer the better value and perhaps be in the better location to succeed.

Similarly with much of the economic data. We still have many companies failing because they were unable to adjust to the changing economic climate. Other companies are grabbing their market share. However, a failed company will fire 100% of their employees while a company that grabs share will never hire all of the losing companies employees. Generally they can absorb much of the business with slack in their own company and only after they do that will they hire some of those that lost their positions.

This will lead to more new claims and less hires but it is greatly increasing the productivity of the survivors. So as the economy improves, it will be a while before it has absorbed all of the slack in the workplace in most industries. This will result in greater productivity numbers and greater profitability, the trick is simply to invest in the survivors.

Society's future

Any number of things may happen in the next year or so and because of the uncertainty created by that any predictions can be difficult. It is how the society responds to these events that determines success or failure.

Now when you talk about success or failure, the terms are somewhat meaningless unless you define them. Clearly each individual needs to decide what the terms mean to them but what is harder is what they mean to the society as a whole. The reason that becomes difficult because the overall society benefit is sometimes contrary to the benefit of part of that society.

If you ignore the problem of individual interests for a bit, you could probably get broad agreement on the following goals:

Educational opportunities for everyone.
Health Care for everyone.
Full employment.
National Security against foreign aggression
Clean air
Affordable energy
Good transportation systems

Now this list is certainly not all inclusive but it covers quite a bit. Now, in each of these areas the big arguments often become an argument between the haves and the have nots.

If you have a job, you don't want to pay higher taxes in order to get someone else a job. The immediate impact of that is that you are poorer. Now, ultimately, having more people employed creates greater demand and in some way the increased economic activity will probably have a positive impact on you at some point, either a better raise or more security or possibly increase house valuations, but that long term impact is vague and the short term impact is vivid.

As a society we have to decide if we can get past the short term self interest and take the actions needed for long term success.

Cost cutting

In the latest round of earnings from retailer's some analysts noted that the decrease in the cost lines was less than it had been. This led to some comments that profitability was in jeopardy because you can't cut cost indefinitely, and that the top line revenues had to increase.

Now mathematically speaking, the statement about cost cutting is clearly accurate in that it has a clear bottom limit. However, if you substitute the idea of efficiency for cost cutting, there would probably still be plenty of room for further efficiencies and I'm sure they will continue. Especially in retail, where better use of online advertisements and sales will reduce the cost of brick and mortar and to at least some extent the need for printed materials, as well as leading to improved inventory control and the need to carry less inventory, there is plenty of room for cost cutting in the future.

However, cost cuts once implemented do not go away. Now, if you want to see profit grow, ideally a combination of efficiency improvements and increased sales would be optimal. However, if you have reduced your costs by 85% and seen revenue declines of 90%, you have increased profitability, not only in the current period but also into the future.

I continue to maintain that we are in the middle of an ongoing technological revolution (maybe that is a bit strong) in many American businesses, where the trend to more technology and less employees is growing. This is clearly not a good thing for employment, but it is a good thing for profitability. We need to develop additional growth industries in order to address the unemployment issue, but, if you are a commercial enterprise, you are discovering ways to become more and more profitable without the need for increased personnel.

Its not a short term thing.

Nostalgia

There are some people who really seem to want to live in the 1930s. Perhaps they look at the old newsreels and feel fondly about the small town values they seem to portray, the lack of modern conveniences and the general good time feeling you see in a movie such as "Its a Wonderful Life".

Now I didn't live in that period, but from what I can tell, the people who did live during that period didn't really like it very much. Now, this was my parents generation, and as they aged, they did sometimes decry what had happened to the society related to morals and general changes. However, with very few exceptions, they certainly didn't want to return to the depression. In fact they developed habits that were designed to assure they would never have to live like that again.

Now, we have had another bad recession. This recession was clearly linked to a tremendous drop in real estate valuations. Of course, the drop was more dramatic in places where prices had escalated far out of proportion to sustainable demand, California, Nevada, Florida, Arizona. This is of course the very definition of a bubble and the bubble did burst.

Now, some look at this and have decided that the American economy and the way of life it has created is profligate and people need to be punished. Of course, many people have lost a lot, but in reality, some of these people who lost their homes, which they couldn't have afforded in a normal situation, are not really that much worse off then they would have been anyway. Those who own houses and haven't lost them, are somewhat restricted in how much they can borrow against their equity, but if they are still employed, they are not materially worse off.

Yes, there were many real and paper losses, but the losses are not going to be permanent. To some extent, the hand wringing over the Government policies to ease the pain and the dire predictions related to the debt we are running up, have some validity, but really as the economy recovers and the tax basis increases, we will see this level become less problematic as we see increases in tax revenues.

Investing morality.

There are some people who seem to think that there is a moral element in finance. You often hear these folks talk about how "other" people have taken on too much debt, or that the profits or goods they are enjoying are based on unsound economic activities and are too risky. Last week I heard a TV analyst talk about how he is on the sidelines during the current run up in the market, and implied that he will miss the downside. Of course, one would think it would be smarter to simply sell on the way down and pocket profits.

Yes, there is risk in the market and there is a chance that riskier investments will lose money. Of course there is also the chance that they will make money. A few months ago there was a lot of consternation over how the buy and hold investor was not making any money. Of course this depends on the point you started and the point you are at.

Since the late 1990s, the market has gone up to 1500 twice and down well below 1000 twice. If you have been investing money regularly over that period without withdrawal, you probably don't have much of a return. Of course if you started investing 20 years ago, in the late 1980s, you are doing quite well right now. In fact if the market returns to and passes its prior highs, you are still potentially going to do well.

Now clearly, if you have been a little more active and invested more at the bottoms and took some out near the tops you have made quite a bit of money. Simply put, the risk of investing in the stock market is very dependant upon timing. If you have a long enough investment window, it is likely that you will do OK. If you need to take the money out at an inopportune time, you have significant risk and probably should make sure that money is protected.

There is no morality involved in investing. You can of course use your own morality or beliefs to dictate how you invest, but financial decisions don't really care. If you borrowed a ton of money in 1990, bought tech stocks, sold near the top, bought real estate, sold near the top and then bought gold, you would be a very rich person today. The fact that you did it using borrowed money wouldn't really have much to do with it.

ARMs

As long as interest rates remain as low as they are, a number of fears that get expressed frequently are not really major concerns. The first of these is the concern related to resets on Adjustable Rate Mortgages. Yes, these often came with teaser rates that were significantly below market at the time and many of them are going to reset in the near future. However, if the current reset rate is as low as the teaser rate was, what exactly is the impact?

Now, if the ARM had negative equity provisions or other exotic factors, yes there might be an impact. However, one would like to think that financial institutions, who have mortgages that are current, would be smart enough not to force them into delinquency at no benefit to anyone.

Extending current terms or agreeing to modify these mortgages would be easy enough and clearly more profitable in both the short term and the long term then imposing terms that simply create additional foreclosures, unless, the market goes up significantly.

One of the things we are going to see in the next few years is a tremendous explosion in asset valuations held by banks. It doesn't require that real estate recover to the levels it had at the peak, merely that it increase from the lows. Many of these assets were written off as toxic with effectively no residual value to the banks. However, as the real estate market stabilizes and these assets increase in value, we will see banks start to look healthier.

Oil

There are many who think that the demand for oil is an indicator of the health of the economy. This was a reasonable link in prior years but following the tremendous increase in oil prices a year ago, I believe there has been a fundamental change in the way Americans will use foreign oil.

Americans have started to drive less, use more energy efficient products and start to increase the use of domestic and renewable resources. Now, these changes are not going to look very dramatic. However, you have to realize that an awful lot of economic impacts are at the margins. Often the bulk of data is in fact relatively irrelevant to price changes, it is the rate of change or marginal data that has an impact.

Consider a basic supply and demand scenario. If the supply of an item is at 100 and the demand is also at 100, you have equilibrium. At that level there will be a price set. Now if you reduce the demand by 5%, meaning that 95% of the demand stays unchanged, you go into an oversupply situation. This will lead to a reduction in prices and the theory says that the price decrease will either increase demand or drive suppliers out of the market until we reach a new equilibrium.

The market reacts to these marginal changes depending upon the elasticity of supply and demand. Now, to expand a bit on the theory, you have to consider cyclical demand swings versus secular demand swings. Cyclical demand goes up and down based on relatively short term economic conditions. Those who are linking oil to economic health are using it as a cyclical indicator and it certainly is to some extent. However, if I am right and the secular forces are pointing to a long term decrease in oil use, the cyclical increase will be blunted by the secular decrease.

Now, the question that has to be addressed is whether the secular trend is strong enough to overcome short term cyclical demand. Of course we also are seeing increases in cyclical supply and I believe a misguided secular increase in supply as technology shows new potential oil sources.

Short selling

When people discuss short sellers, they sometimes argue that they serve a "policeman" like function in the economy, pointing out companies that have significant problems earlier than others would. Now this may have some validity but it is basically the same argument that you could make about bank robbers, they point out the banks with the worst security.

Short sellers do it for the money. I'm not saying this is a bad thing, profit motivation is what drives capitalism after all, but lets understand that no one sells a stock short as a public duty. They do it to make money.

There can be many arguments related to whether short selling is a good practice. There is however one thing that has to be carefully watched. As we have seen the development of funds that are in many ways not subject to regulation that manage large amounts of money we increase the possibility of individual stock manipulation.

Now, if hedge fund managers as a group take the same position on a stock we can see significant moves. Buying and selling real shares has a impact that moves with the fundamentals of a stock. However, if you have significant short selling in a stock, the simple fact is that you increase the number of shares being sold, beyond the actual number of shares owned. Yes at some point the short sellers have to cover their positions, but in the meantime, it exerts a downward pressure that wouldn't exist if there were no shares available.

Clearly, this can be played and I have no doubt that is is played on a regular basis. Society has to decide if that sort of behavior is what we want to see in our market exchanges.

Health Care

While the country continues to move to some form of universal health care, you continue to hear fear mongers and well to do conservatives decry the reform as a form of socialism or even sometimes communism.

One of the things that a society needs to decide is what exactly does each participant get in return for abiding by the societal rules. If you consider modern society, each member of the society does their part by following rules, paying taxes, and participating in our representative government. Our basic national documents state that each individual has certain inalienable rights. One of these is the right to life.

Now, as health care has progressed, we have seen life expectancy expand. However, clearly access to care and especially preventive care is of utmost importance to such life expectancy. A significant number of our fellow citizens do not have access to this care. The dividing line is not simply between rich and poor. Oddly, the poor tend to have access via Government programs already. Those who don't have this care tend to be our lower middle class citizens or in some instances our blue collar workforce who are not employed by major corporations.

We have evolved into a system where health care and employment or wealth are linked. Now, if there is some justification for why an employee at an auto manufacturer, or other large corporation should get better health care than a construction worker or day laborer I would be curious as to what it is.

Often I hear analysts claim that Americans with health care are happy with it and don't want to see changes. Of course, that is similar to saying people who have anything of value are happy with it. The question that Americans have to answer is do they want to deny their fellows the same care? Another question to ask is do they want to leave their future access to care up to chance that they will remain employed?

The current state of health care is simply unfair and expensive. If you are wealthy or secure in your employment, you are one of the haves. Whether you are there because you are deserving or lucky is really irrelevant. We need, as a society, to extend health care to all.

Market valuation

There is currently a high degree of nervousness over the short term direction of the stock market. Now, of course, the market direction is generally questionable on a short term basis, but there is a clear sense right now that despite the rise in market prices the economy's condition does not justify current prices.

Now, many analysts base this opinion on the rise in the market since the March lows. To use the March lows as the basis of the increase, you have to assume that valuations in March were accurate. Clearly the drop that occurred between October 2008 and March 2009 was the result of extreme fear. If you consider the market prices using a different starting point, say January 2009, you get a different picture. The S&P was about 933 in January so what we have seen is a rise of about 14% this year. If you go back one year, you see the S&P last November was also near 930 so we have a 12 month increase of 14% as well. Is this increase unjustified?

If the Stock Market is predicting economic conditions to come, it would indicate that current predictions are about 15% better than they were at the end of last year or a year ago. Considering the problems that had been uncovered and the Lehman bankruptcy, it was a very uncertain future for the economy. The stock market was predicting a very rough period accompanied by drops in valuations and high job loss. This was an accurate prediction. Now as those events unfolded, the market continued to drop and in March was effectively predicting Armageddon. However, the financial collapse did not happen and whether due to the tremendous stimulus or the natural business cycle, the economy bottomed and started to improve.

So how bad is the current valuations? Do things look 15% better than they did a year ago? I think most people would agree that they do. In fact, if the market was predicting Armageddon in March it is not unreasonable to argue that things today look infinitely better than they did in March. However, March is simply a terrible comparison point and outside of providing a wonderful buying opportunity was an abnormality.

So if you compare current valuations to a year ago of look at YTD returns, the 15% increase coming off what was already a down period is by no means outrageous. It all depends on where you start your comparison.

Jobs

As we consider the job issue, the growth in jobs will not be in the areas where we have just lost millions of jobs. Clearly, as the economy grows, there will be some fractional return of jobs, but it will not be at the same rate as the job losses were on the way down.

Clearly, if you are a business, faced with the degree of uncertainty the current economy is faced with, will only hire new people considered essential. This is a good thing for long term business stability but will result in an increase in unemployment for the foreseeable future unless we can promote new job growth areas.

As I've said before the best strategy to do this would be to greatly expand both our domestic and renewable energy efforts and to reform taxes and health care to eliminate the unfair advantages of doing business overseas. Our current system of employer provided health care has increased the cost of each employee to the point that each hire is in some ways critical.

Clearly job growth in domestic and renewable energy, including greater exploitation of natural gas would create jobs in this country. Removing the burden of health care costs from small and large business would certainly make hiring easier. Finally, we need to change our business tax system to go to one based on sales would share the tax burden based on what is sold in this country as opposed to what is produced in this country. This would help reverse the trend to moving jobs overseas.

Long term investment

If you look at any chart of the S&P 500 for any significant period of time, the one thing that stands out is that whether the long term trend is up or down, the line does not move smoothly. Now to define the period of time you are looking at is possibly the most important aspect of an analysis. If you had somehow bought into the S&P in 1960 when it was about $60 you would have experienced a significant increase by now. However, if you only started when it was at 14000, you have lost a third of your money.

So how do you invest to maximize returns on an index that has significant variations. If you follow dollar cost averaging, you would invest a standard amount on a regular basis. This theory says you will of course end up buying at both highs and lows, but if you believe that the trend is ultimately up, you will have a nice return at the end of the day. Of course, this requires a belief in the overall trend and an time period that allows you to weather the deep dips.

A better alternative is to have a strategy that allows you to invest when the market is low and reduce investment when it is high. This of course can be applied to a stock index or it can be applied to individual stocks. Now if you were to follow this strategy, you could restrict purchases to a point when the average falls below a pre-determined point, say the 200 day moving average. Of course in considering this strategy it only works as a long term strategy and is effectively the reverse of a short term trader strategy that buys when it crosses to the upside and sells when it hits it on the way down. it also requires you to believe in the long term upward trend.

Index thoughts.

In many ways it is fairly easy to predict things in the future. Certain trends have a sense of inevitability about them lead to fairly reliable predictions. We don't always see, or understand these trends, but when we do see them and understand them, it makes a future situation inevitable.

However, knowing that is often of very limited use in the short term. It has been clear since at least the 1970s that at some point in the future we will run out of oil. However, that is potentially a distant outcome and if in 1970 you had invested in that outcome, you would have potentially lost a lot of money, and then potentially made a lot of money, with a lot of uncertainty yet to come. The inevitability of oil becoming scarce is not immediate enough to dictate short term behavior.

Similarly, the US economy is going to recover. Whether it has already started to recover, or if recovery will be delayed for a period of time, it will inevitably recover. In the meantime, many investments will have up and down periods.

So, when you listen to economists giving predictions, the reliability of what they predict in the near term is extremely uncertain. Generally, assuming they accept the same data, in the long term their predictions will end up being very similar. It is what is going to happen next month, next year, that is uncertain.

If you can ignore short term fluctuations, you can invest in very long term trends that will ultimately pay off. If you consider the stock market, the simple fact is that over its long history, it has gone up on average approximately 6% per annum. However, this rise is terribly unsystematic with periods of much higher than average growth followed by periods of malaise or decrease. In 1960 the S&P 500 was around 60. It is now around 1050. Of course, we are coming off a period where is has dropped from its highs by 33% and if you had measured it at that point the return would have been somewhat higher. Of course had you measured it at the March lows it would have been worse.

More economic meanderings

Economic recovery is tied to increased income. Probably it is more accurate to say that it is tied to disposable income, since income that is consumed by fixed expenses doesn't have much of an impact. Now, in the years of the housing boom, a lot of "income" was related to increase in house valuation, to the extent that Americans were willing to borrow either directly or indirectly against their home valuations.

When prices stopped going up and in fact reversed course, this income disappeared and the cost of the borrowing remained. This led to a tremendous decrease in disposable income and in fact many Americans found themselves unable to pay fixed expenses let alone have disposable income.

Now, this loss of income characterized by the loss of housing wealth led to the steep recession, joblessness and the decline in the stock market. Of course, not everyone was impacted but certainly enough people were to cause a tremendous reduction in demand across the board. This reduction in demand led to deflation in many areas and may still have that impact.

One of the biggest impacts was the tremendous decline in the money supply. Now, when I say money supply, the amount of money actually created by the Federal Government is only the tip of the iceberg. The money used to make loans multiplies the amount of money in the system since the capital reserves are only a percentage of the amount loaned. If a deposit of $1 allows you to lend $10, you have effectively multiplied the money in use by a factor of 10.

As banks started to lose money and stopped making loans, we saw a tremendous decrease in the money supply and a corresponding decrease in prices. As the Government attempted to combat this by in effect creating money by borrowing and making this new money available, it also raised reserve requirements for banks. The measure of the money supply that includes all the bank lending is referred to as M3 and is no longer published by the US Government. However, it is still estimated by a number of economic sites and is not increasing. It is still tracked in Europe where it has been declining.

If M3 is stagnant or decreasing, the risk is hardly inflation, it is deflation. Of course, there is a simple argument that the banks could increase M3 very quickly by increasing credit. However, it seems unlikely in the current environment that they will do that very quickly.

It would seem that many of the jobs that existed just two years ago are very unlikely to come back in the same areas. However, if we can get domestic and renewable energy projects going, that job growth can help significantly. Further, we should be engaging in much more infrastructure repair than we are. Finally, we need to reduce the cost of doing business in this country, by changing our tax system and reforming health care.

Market Valuation

As we are seeing more earnings data, the S&P 500 is somewhat expensive based on current earnings, but right in line if you think about next year earnings. Now, obviously, next year earnings are an estimate and therefore risky, but as we see most companies beating the estimates on current earnings, the better productivity coupled with any increase in revenue based on improved economic conditions will probably meant that the 2010 estimates are too low.

While we can certainly expect to see hesitancy in the rise of the S&P to levels above 1200, barring some significant unknown economic event, it is a highly probable outcome. Some areas of the economy are still weak and will remain that way for awhile, but these are known risks and as the Government actually takes action to increase jobs, as it will with an election coming up next year, we will see increased demand, increased revenue and increased profitability.

Whether the Government will be smart enough to turn the 2010 stimulated boom into a longer term self sustaining recovery with sustainable growth depends on how fast they increase usage of domestic and renewable resources, reduce the health care cost burden and reform the tax system.

Health costs and employment

While earnings have been improving we have not yet seen a significant increase in hiring. While inevitably, hiring will resume, the simple fact is that man industries that just went through painful layoffs will use that opportunity to implement permanent productivity increases that will result in a smaller need for employees.

Further, we unfortunately have many incentives to outsource jobs to other countries. One of the biggest of these is the excessive health care costs we have in this country. Now, health care reform is partly based on reducing these costs but if we do expand coverage, this will lead to increased demand and that normally leads to increased prices.

Clearly, we need some reforms designed to control cost increases in health care delivery and drug costs in this country. These reductions should not be related to reduction in beneficial health care but should be focused on elimination of waste to include unnecessary tests and procedures. Now, in each case the doctor patient role should not be precluded but we need to eliminate some of the fear of malpractice that leads to doctor's ordering tests that are not medically necessary.

It is certainly not desired to excuse doctors who are negligent, but we do need to reform the process which drives up the cost for malpractice insurance because of a pre-disposition to equate the performance of every conceivable test to good medical practice.

Ethical behavior

If you read Plato you may recall the question he poses concerning a magic ring of invisibility. The question can be summarized as follows, if you could do whatever you wanted to do without the danger of being caught, would you have any reason to be ethical or moral?

The question gets to the root of a human dilemma, is being "good" something that we should do or is the ultimate goal to "take care of number 1"? Now remember, this is pre-christian and the ancient Greek view of the afterlife was not the same as our current views. Further, if you really want to think about the question, getting caught by God would make it irrelevant.

So, giving no real fear of retribution, would most of us behave well, meaning not taking unfair advantage of our fellows. Unfortunately, based on recent headlines and events, it would seem many of the people in the financial industry are clearly on the side that says, get away with whatever you can. Now, I don't mean to pick on the financial world, but we see more examples there where unscrupulous people took advantage of people who for had no way of discovering their wrongdoing.

Of course it is probably unfair to focus on the highly publicized cases, but in an industry that relies on making trades where generally there has to be a winner and a loser, we probably cultivate some of the most cut throat behavior possible. It is also clear that some of the players are going to have an advantage for legitimate reasons. However, how do we control the unscrupulous players?

If you consider the financial world, there have been many safeguards designed in by the markets themselves. However, many of these self-regulating rules are not as effective as they once were as the old methods have changed due to changes in technology. In fact, one big issue that needs to be restored is trust. There are many, many people who simply don't trust the financial industry.

Government has to be part of the answer, but it can't be the complete answer. Government will never be big enough or capable enough to prevent abuse, it is more appropriate for it to punish abusers who get caught.

The financial industry needs to do what it needs to do to reform itself. This has to take into consideration that public trust is important, not just because of the amount of money that retail investors invest, but because public perception will lead to onerous Government intervention, and we know that can't come out well.

Risk taking

Success in any endeavor has many components, including hard work, intelligence, initiative and what may be best characterized as luck. Sometimes you can be successful and only employ one or two of these and if for example you simply stumble into a situation that leads to success. If for example you invested in Micro Soft because you happened to know someone associated with the founders in the early days, you may have made a fortune simply because you knew someone and maybe invested some money as a favor, even if you had no real conviction. This would be similar to someone winning a lottery. However, that sort of thing simply can not be counted on and if it happens, god bless, but a more reliable method is to employ hard work and intelligence.

Now intelligence is to some extent the result of hard work and it can be innate or purchased. By this I mean, you can certainly pay for advisers or sift through various sources of information to acquire intelligence in a particular area. Similarly, you can learn a skill that may enable you to be successful. Obviously, I am not using intelligence here to refer to potential knowledge but to actual knowledge gained.

So ultimately, you can use hard work to garner intelligence. You also have to act on your intelligence. This is initiative. If someone has acquired knowledge that indicates a potential trend or movement but fails to act, it is the same as not having the knowledge at all. This is initiative that may also be characterized as risk taking. The amount of risk that you are willing to tolerate often predicts the potential success you may enjoy.

Now this is where some of the most confusion arises. You often hear that you need to take some risk in order to enjoy significant success. However, just taking risk is not enough. For example, if you note that a particular stock for a well know company has dropped tremendously and buy it thinking it will recover, you have taken risk. If you have not acquired enough knowledge to support that conclusion you are likely to be wrong and lose the money you have invested. Now, not always, but this type of uniformed risk taking is, well very very risky.

However risk coupled with intelligence acquired via hard work can be a tremendously successful combination.

Price pressure

One of the things that seems to have changed is the sensitivity of the consumer for goods and services to changes in price. While obviously, price was always a factor in making decisions about whether to buy something or not, when demand was higher, it wasn't the main factor since many consumers felt the desired product or service might get more expensive or become unavailable if they didn't make a quick decision.

As demand fell off a cliff last year and prices plummeted, consumer's have taken a different attitude, feeling that the product or service will be available and that there is stronger likelihood that it will be cheaper if they wait. This change in sentiment is clearly going to put pressure on businesses and you see things like Coach coming out with a more affordable line of product to cater to the new consumer.

This attitude is also impacting the length of time products remain in use. Where many people felt that they needed to get a new car every few years, many are now postponing that decision and driving slightly older cars. This had led to a shortage in the used car markets. Now, I sometimes see this change characterized as a switch to cheaper products, such as store brands. However, while some of that has happened, it is more accurate that consumers want the products they have been used to buying at a lower price point.

Brands that in the past tried to maintain certain price levels are being put under a lot of pressure to provide consumers with deal. Of course, we have seen how business has been able to restore profitability by cutting costs. I believe it will be quite a while before prices will go back to what they were, since consumers have learned they can demand better value for their dollar.

This is flowing down the supply chain. I hear analysts talking about the risk of inflation as the dollar declines and things like foreign oil go up in price. However, companies that try to pass increased costs through to the consumer are going to have a hard time of it. I believe they will be spurred to find cheaper alternatives or ways to reduce costs in other areas to maintain low prices.

With all the extra capacity we have, inflation is a very unlikely event for at least two years, if not longer. In fact, deflation is still a more likely scenario.

Future economy

It is getting harder and harder for those who think the economy is not actually getting better to find evidence to support that opinion. While there are still issues in the economy related to home mortgages, commercial real estate, and unemployment, business has now factored in those things and adjusted their overall business models to handle a lower level of overall activity.

The companies that did this the best are making profits that exceed the estimates and indicate that they can be successful in the current and future economy. Consumer spending will probably not return to levels that existed during the bubble, but it doesn't need to. In fact, the fact that we have excess capacity and room to grow withing prior limits will limit inflation and put the overall economy on a better footing.

If consumer spending drops 15% and represented 70% of the economy, it would reduce GDP by 10.5%. Now we have seen this reduction and if consumer spending goes from 70% to about 66% of the economy, that difference can easily be made up over time by development of alternative energy and exports.

If you really look at the numbers, we are moving into a healthier economy than we just left and with the change will be able to reduce our balance of payment issues and start to absorb more of our own debt.

There are very healthy long term trends emerging and while we can expect some bumps in the road, the country is far from Armageddon.

Long term growth

In order to achieve long term stable growth in the United States, there are three things that have to happen.

The first of these is that we need to reduce or eliminate our reliance upon foreign oil. The fact that the country has an abundance of its own energy resources and is capable of developing renewable energy sources for the future makes the ongoing drain and uncertainty of foreign oil unacceptable. Further, it drains funds and contributes greatly to our trade imbalance. This has in my opinion already started as we have started to reduce usage of foreign oil via energy efficiency and ongoing conversion efforts, as well as reduced economic activity. However, as economic activity picks up, we need increased use of domestic and renewable energy sources. This would add jobs.

The second thing is that we need to change our method of corporate taxation and move to a consumption tax. By taxing products sold in this country, we will level the playing field from a tax basis, for domestic manufacturers. The increased cost of products should be matched domestically by a reduction in cost as the current taxes are eliminated. A tax like this would go a long way to encouraging the regrowth of domestic manufacturing as our products were put in a better competitive position both domestically and internationally. This would add jobs.

We need to eliminate the deficit and start reducing the National Debt. It doesn't matter if the reduction seems insignificant, any reduction would have the desired effect of strengthening the dollar and controlling inflation. Now, it may seem almost impossible, but I believe the energy and tax reform initiatives will increase revenue significantly as consumer spending rebounds and imported products pay their fair share. This has to be matched by reductions in federal spending. We seriously need to look at the cost of all federal programs and where spending is not mandatory, such as Social Security, make significant reductions. However the best path to balancing the budget rests in economic growth. Reducing our dependence on foreign oil and reforming our business tax system has tremendous potential to spur growth. If we can foster this growth while reducing spending by even modest amounts we can achieve a balanced budget in 5 years.

Half filled glass

When you consider data the old stumper about whether a glass is half empty or half full comes to mind. Of course, the answer to the stumper is that it depends on whether you are filling it up or drinking it. Data in a vacuum only provides you with a point in time. It is the trend that matters.

So when you see that foreclosures are still near record levels, the key point is are they getting worse or are they getting better? Similarly for unemployment, are more people losing their jobs or less people? You can go on and on with this, but in almost every category, the numbers while still not "good" are "better" than they were.

So, going back to the glass analogy, the glass which was being emptied for much of 2008 and early 2009 has now started to be refilled. It may not even be at the halfway level yet, but the level is rising.

Health Care Timeline

I just read a quote about leadership that said leaders take people where they want to go but great leaders take them where they may not want to go but ought to be (Rosalynn Carter). The first instance could be characterized as pure Democracy since in such a situation, the people completely dictate what to do. Most societies, over time, have found this to be an unreliable method to make decisions. If you look at the development of society you almost always find that democracy gives way to some other form of organization most likely because democracies often end up being unable to make tough decisions.

The United States has a representative form of Government. Now since representatives have to get reelected, they have to be responsive to the people they represent, but, for the period of their term they have a chance to take unpopular but correct decisions. However, their willingness to take risk is clearly dependent on how much time is left in their term. If you make an unpopular decision immediately before you are up for reelection you seriously put your future in danger. On the other side, if you have a significant amount of time between the decision and the election, if in fact it was the correct but unpopular decision, you have time in which you may be able to show that it was the right thing to do.

To a large extent the health care reform is subject to this time sensitivity. Realistically, there are some areas of the country where Government involvement in health care is looked at with some favor while there are some areas of the country where it is looked at as a terrible thing. Representatives from these districts have little doubt about what they should do. However, there is a significant part of the country where opinions are not so clear. It is these representatives who hold the outcome of the health reform decision in their hands.

What is most important in these districts where many Democrats won very close elections and where Republicans present a significant challenge to their reelection that it is important to get a health care bill passed this year. They have an election in November and need significant time to show that whatever is passed is the right decision even if many of their constituents don't think so now.

For those who wonder why the time pressure is so intense, this is probably the most significant reason.

Spending

Company after company has been reporting higher earnings and generally higher revenues than expected by the Wall Street Analysts. This is starting to build strong evidence that the economy is not as bad as these analysts think it is.

Now, there are problems in the economy but as I've said before, when someone loses a job or goes through a foreclosure it doesn't necessarily mean that they stop spending. In the case of the foreclosure, if they are still employed, it may mean they have more money to spend.

In fact the main loss of spending is not really related to either of these two events, it was related to the loss of home equity and the ability to borrow against that equity for large purchases. This and the negative environment and loss of wealth in the stock market, caused many people who were still employed to slow down spending. However, with the exception of large purchases that had previously been financed by using home equity they still have the same disposable income they had previously.

Consumer spending is not dead, it may be reduced, but it is growing again.

Growth

Growth is a relative term. You can consider growth over a long period of time or over a short period of time. In our current environment, you hear many argue that compared to a year ago or sometimes even longer, the results show declines in growth. However, in most cases the short term view is that growth on a month over month basis is up.

How do we reconcile these two things. Well, if you have a company that achieved profitability after negative growth, and it then starts to grow from the new lower base, profitability will also grow. However, if you need to return to prior year levels in order to achieve profitability, than the longer term view is appropriate.

Profitablility

If you invest in an enterprise, what you hope is that the enterprise makes money. You also want your investment to provide returns commensurate with the risk involved. Anyone can but bank Cd's or Treasury Bonds to get a relatively safe return (main risk there being inflation). However, if you invest in equities or another enterprise that carries the risk of failure, you expect a better return if it is successful.

You also would like the potential to see your investment's value grow. In fact, there are many stocks that only provide price appreciation as the possible return since they don't pay dividends. Of course if they are making money and reinvesting the money, you should see the value of your investment grow.

So fundamentally, the most important thing is that the enterprise returns a profit. A secondary consideration would be that the profit increases over time. Now, all of this is relative to where you make your investment. It is fairly rare for investors to be in at the inception of an enterprise. More likely you are considering the future of an ongoing enterprise and trying to decide if its stock is a good investment. Now, if the enterprise used to be much bigger but has contracted and revised its business model, the current enterprise is what you need to consider, not the enterprise that used to exist.

In our current economic situation, many businesses have contracted and reduced costs in order to adjust to the reduction in consumer demand. The fact that consumer demand is less than it was is really irrelevant since to make money you have to be a realist. If you can adjust your business model to be profitable at current demand levels you are a successful business. Over time, the demand may grow back to where it used to be and if it does, the enterprises can grow along with it, but there is no need for that return to happen quickly.

Increased profitability

Companies that made money last quarter will make more money this quarter if the earnings were based on continuing operations. It is ridiculous when I hear people with significant business backgrounds talk about how cost cutting is a one time thing. When you reduce staff, reduce inventory or eliminate facilities it is ongoing, and those costs will not return until you hire people or open new facilities. In fact, normally the cost cuts get better over time as severance payments or costs related to closed facilities go away.

So, the companies that achieved profitability via better efficiency (a nicer word than cost cuts) have only to see revenues stay the same to have an increase in profitability. If there is revenue growth it will greatly increase profitability.

In fact, the next quarter is going to see a shortage of consumer goods develop since retailer's have lowered their expectations and stocked much less inventory. As hot items start to move off the shelves, we will see manufacturers filling rush replacement orders and putting on additional shifts to satisfy this short term demand. Now, this doesn't require great sales increases from last year, since if you are stocked up to a level that expects less sales and get the same sales, you will be short of product.

Businesses are prepared for the worst and they are going to get something better than that. That is going to drive significant earnings improvements similar to what happened during back to school shopping. You don't have to sell more than you did less year, you simply have to sell most of your current inventory.

Predicting the future

In every time of crisis, some adapt and end up being successful and other fail to adapt and fail. The ones who adapt are finding opportunities and working to be successful while the ones that don't adapt complain about how everything is stacked against them.

The opportunities being created by the ones who are adapting the best clearly are in areas that are not clear to most of us. The changes that will come will be significant. Predicting these changes is difficult and like everything else they are dependant upon circumstances that may or may not already exist.

If you simply look at problems facing the United States and the World, you may get a feel for the areas where these innovators will make the biggest contributions. However, some of the changes will be in areas that are not even perceived as current problems. For example, twenty years ago I believe most people would have felt the telephone system that existed was quite adequate. However, now most people can't manage without their cell phones. This is an entire industry that was created without a perceived need for it. You can say it created the demand that it then satisfied.

In fact, most of the most successful innovations and growth industries are not in response to a problem that existed, but a brand new opportunity that we would have had problem imagining at one time. In many of our traditional businesses, the improvements have been significant but not revolutionary. In other industries, the new developments have created significant challenges that they are struggling to overcome. Think about network TV, newspapers, land line phones companies, etc.

So when I hear prognosticators talk about the downfall of the economy and the collapse of our society I have to wonder if they are taking into account the fact that so much is simply unpredictable? I don't think they are and I guess I simply have more faith in the entrepreneurial and innovative spirit that humanity has.

Consumer spending

Understanding the limits of on-air analysis, I am still a bit befuddled by some of the things I hear. The one question that I think I find the most insipid is the discussion concerning whether the consumer is back or not. Well, the consumer has never really left, they just bought less and became more value conscious. This was driven by the loss of equity wealth and that wealth is not coming back quite so quickly.

Consumer spending will now start to trend up from the low levels we saw early this year. However, it is not going to "jump" back to where it was during the bubble. The good news is that it doesn't have to for us to have a vibrant economic recovery.

Companies have adjusted their forecasts to a lower level of sales, have reduced staff and locations and are stocking less inventory. These productivity reductions will mean that they will sell most of their inventory at decent margins. Further, the suppliers have also pared back to provide the lower levels of inventory. Now this contraction in the economy has been accomplished and we will find that the companies will start to grow from its contracted point.

The recovery will not mean that we return to bubble levels, but we don't need to and in fact we shouldn't want to. What we need is to do all the things we are currently doing, reduce consumer debt, revalue assets to affordable levels and provide better value for each dollar spent. These activities will lead to a better fundamental economic base and sustainable growth.

Shoppers

The last few times I was at a local mall, the number of people there has been noticeably higher than just a few months ago. Some of this is probably related to the seasonal issues, such as back to school shopping, but in the early months of this year, the malls resembled ghost towns.

How good an economic indicator is this? Well, you can't have spending unless you have shoppers. The shoppers may be more value oriented but the folks were carrying packages and even more importantly looked sort of happy.

Going back a few months, the people who I did see at malls looked like they were sorry to be there. It almost seemed that they had to be there because there was something they had to get because they really had no other choice. Now the shoppers seemed more relaxed, and happier, chatting, going to the food court and generally creating a familiar buzz that was missing a few months ago.

I think the consumer is coming back, not at the same level as during the bubble but at a higher level than the last nine to twelve months. Considering how the companies have reduced cost, even small growth in revenue will result in significant profitability.

Cost cuts equal Productivity

I keep hearing how companies can't keep cutting costs to improve profitability. Well, from a purely mathematical point of view, I agree that cost cutting has a limit after which we would have liquidation. However, mathematics also tells us that profits can be made at any sales level as long as costs are less.

The cost cuts that business has undertaken, as well as other productivity improvements were designed to allow them to make profit with lower revenue. Once these reductions were obtained, they merely need revenue to stay flat, or increase. However, if revenue is seen to be decreasing further, there can and will be additional cost cuts.

Now one of the outcomes of this is that companies that have heavy leveraged positions are faced with fixed debt payments that can't be easily reduced. Basic accounting talks about fixed vs variable costs and the various permutations thereof and the more costs are variable the easier they are to reduce. Many companies have outsourced a lot of what once were considered core capabilities and in a downturn can simply reduce orders to reduce costs. Personnel are of course generally a variable cost and the high unemployment we are seeing is evidence of that.

So, companies that have kept fixed costs at a reasonable level can cut costs to a very low level to maintain profitability. The companies that had high fixed costs (debt) have either gone bankrupt or may end up there. This is the way weak companies get shaken out of the market and the more adaptable companies get bigger eventually. So, if a company made profits last quarter because of cost cuts, it will most likely make more profits this quarter. The three scenarios we face are revenues got worse, not the most likely scenario, revenues were flat or revenues increased. In the latter two of the scenarios profits will be the same or higher than they were last quarter. In the first scenario, the profitability will depend on additional cost cutting. However, this is the least likely outcome, since clearly economic activity was higher last quarter than it was in the preceding one.

Simple things

The economic recovery we have started is going to build up momentum as soon as we turn the corner on jobs creation. Of course, a certain number of jobs have been cut and they will never come back due to productivity improvements in the form of technological improvements and other factors. So to really get job growth, we have to stimulate new growth industries and reform our tax system to encourage jobs in this country instead of overseas.

I believe renewable and domestic energy as well as the growth in technology offers our best opportunity for significant job growth. I've discussed it before and if you want to have effective stimulus programs, it should be directed to home and industrial energy improvements and conversion to domestic and renewable energy sources.

Secondly, we need to change our corporate tax structure to tax items sold in this country no matter where manufactured. This change would level the playing field and reduce incentives to shift employment overseas.

These simple steps would go a very long way in putting a solid foundation under the recovery.

Economic domiance

The United States emerged as the dominant economic power in the world by the end of the 20th century. This was not the case at the end of the 19th since England and Germany were at that time dominant economies. Of course, if you looked at the United States in 1899, it was up and coming and clearly had the potential to become what it did. Of course the fact that Europe went through two devastating wars and the colonies achieved Independence had a lot to do with the emergence, or at least the speed of it, but the United States clearly had much greater potential than England or Germany without colonies.

So the question is, looking forward from 1999 to 2100, will the next dominant economic power be China? The main resource that China possesses in excess is the number of people who live there. Of course, China is a large country with approximately as much land as the United States excluding Alaska, but more of China is inhospitable than is the U.S. as the entire western part of it is mostly arid. Now, those areas may contain tremendous natural resources to be exploited, but in general, the United States seems to have more natural resources than China does.

So will China's large population bring it economic dominance? There is one thing that is certain. Since China has 4 times as many people as the United States, the size of its economy will eventually surpass that of the United States through the normal course of events. China has been growing and creating wealth for its population. As the consumer culture expands in China there will be tremendous opportunities considering the size of the population.

However, does China have the wherewithal to support a standard of living for its population similar to that enjoyed by the West? Well, ultimately, yes and when that happens the economy will be dominant. Of course, India is moving in the same direction and perhaps faster.

So sometime during this century the Asian powers will emerge as the two largest economies. This isn't necessarily a bad thing, especially if American companies and workers can exploit this growth by exporting products there.

Creating jobs

There are a number of things that are so obvious that stating them seems non-sensible until you think about it. If you want to accomplish something you have to be as direct as possible. In the years I spent reviewing costs, I lived by a fairly simple rule, "If you want to reduce costs, you have to reduce costs." Now, the reason this rule is so effective is because in many instances the proposals I would look at would have all sorts of machinations but when you really studied them, they just moved costs around, and didn't reduce them.

So applying this to our current economic situation, if the goal of the stimulus was to create jobs, it should have created jobs. Now, I will admit that I'm not an expert on every aspect of the stimulus, however, I do know that much of the stimulus money ended up funding things that had very little potential to increase jobs. Now, some of this money may be seed money, with the hope that the outcomes will eventually increase jobs, but it would seem that there were plenty of opportunities for direct job creation that could have been implemented.

You hear a lot of arguments from various politicians that the federal government should not try to dictate specific behavior in granting money. However, when you look through the stimulus plan, there is basically no money that can be clearly linked to direct job creation. One of the great mistakes you see in the bill is how much was given to the taxpayers and social security recipients. The assumption had to be that these folks would spend the money, however, in the current economic climate, more of them saved it then spent it and it provided no real stimulus to the economy at all. Second, the extension of unemployment benefits may have been altruistic, but had the money been used to actually employ some of these people, say having them work on infrastructure repair or energy projects, it would have reduced the unemployment rate and possibly forced some of the folks to be more aggressive in taking action.

How many jobs were saved or created by the stimulus? Clearly not enough. Suppose the Government created 1,000,000 direct jobs performing needed projects or funded the states to create these jobs using something similar to a program we had back in the 70s called the Comprehensive Employment and Training Act (C.E.T.A.), and if these temporary jobs with limited benefits cost $50,000 a year, it would have required $50 billion. However, 1,000,000 created jobs has a multiplier impact and a significant number of other jobs would have been created or saved to support the jobs created. Also, instead of getting unemployment benefits, the workers would be paying taxes and feeling a whole lot better about themselves.

The idea being that the best way to create jobs is to actually create them.

Seasonal adjustments

September jobs data like all the other months gets adjusted for what have been seasonal variations. Some of these adjustments are based on historical patterns and while they made sense when initiated, sometimes don't make sense in unusual economic times.

A lot of adjustments related to what has been historical patterns in the auto industry are simply wrong now. How much these distort the figures is open to debate, but the pattern that used to exist where many auto workers were laid off for a period while the plants retooled for the new model year has been disrupted by all the current chaos in the industry.

The question then is point is served by the use of these seasonally adjusted numbers? At one time, it was felt that the raw variations could provide a false impression as to the health of the economy. If you could predict that x thousands of auto workers let go in July would be hired back in September, the spike in unemployment they represented wasn't considered real. It was also of course politically problematic to have unemployment rates shoot up every summer and then drop again.

Statistically, if you were trying to determine the real structural trend, you had to eliminate these cyclical impacts. However, they require constant adjustment and can distort when times become unusual.

Market forecasting

As we go into October, the economy looks poised to continue its recovery. It should be remembered that only six months ago, there was a lot of people who believed that the entire worlds on the brink of a collapse comparable to the Great Depression.

Very few still hold that view (some do) but it simply looks like the economy has taken its lumps and has started to regrow. Business cycles are really very predictable in the macro but not so much in the micro. Now, we are moving into another earnings system and I would think we are going to see improvements over last quarter for most companies. Of course, the companies that have adjusted better will do better than those that did not.

The next three months present some challenges to the extent that there are a large number of professional investors who would like to see a market correction so they could put cash to work at lower valuations than current. Of course a correction could happen, but it would require a significant event to trigger it. One significant danger is the CIT situation and it is unclear if a failure to reorganize CIT would be enough. Another possibility might be some sort of terrorist event and I don't think anyone wants that.

Without a major stimulus the most likely outcome over the next three months is for the market to continue its upward trend, although possibly at a slower pace than the quarter that just passed. However, I still believe the earnings that are going to come this month and the forecasts will point strongly to an S&P level of 1150-1200 and that is about a 10% increase over the quarter.

How are you going to make them pay full price?

One thing that has happened in our consumer economy is that shoppers have gotten use to significant discounts from full price on just about everything. Now, more and more, shoppers, even those that have not suffered a loss in income, are demanding lower prices or greater discounts. Of course this is driven by a simple fact, they can get them and the retailer's need the buyer's much more than the other way around.

With the drop in demand across the board the consumer now has an expectation that everything should be on sale. If the consumer does not think the item is offering sufficient value, they will not buy it until it does. Now discounting in retail is nothing new and if retail has prepared for a slightly slower season, as it should have, we may actually start to see popular items become unavailable.

It is going to take such shortages to make people buy at full retail or even pay a premium. As we get through Halloween and move into the Christmas season, I believe two factors are going to prevent those shortages from materializing. In the first case, stores are most likely overstocking. Forecasting is clearly difficult but this is going to be a better season than last year but not dramatically so. So I expect stock to be widely available. The other factor is simply that the ability to sell on-line makes many items available that would otherwise have not been. Central storage and distribution for on-line retail eliminates a lot of the uneven store inventory that is so difficult for retail.

Economic comparisons

We are quickly moving to a period where economic data for this year will actually be better than it was last year at the same time. After the Lehman collapse and the rapid deterioration of the economy in the last quarter of 2008 and the first quarter of 2009 things got pretty bleak. So, since there has been some improvement, we will enter a period where instead of numbers showing x% below last year, it will be x% above last year.

While this will be refreshing in a sense, it is as meaningless as the bad comparisons were. In the last quarter of 2008 we entered what has to be considered a panic period where an economy that was struggling essentially collapsed as fear prevailed. If you think about what happened, high energy costs and the resulting drop in consumer demand coupled with unsupportable home prices led to declines in real estate prices that caused sub prime mortgage backed securities to become almost worthless. The drop off in home equity and the loss of construction jobs plus the seemingly endless stream of bad economic news caused a dramatic and scary reduction across the board in costs and employment by American industries.

Of course, the reaction created the basis for the earnings we saw last quarter as despite significant declines in total sales cost reductions enabled firms to generate profits. This was the end of the recession, as profits, even at reduced sales provide a foundation for future growth.

Of course whether the Government stimulus had much to do with this is a difficult question. To some extent it prevented some jobs from being eliminated but considering how slowly it has been implemented, much of it is yet to be felt. It certainly had a negligible impact on demand and the demand lost from the drop in home equity will not easily be replaced.

It is more likely that the companies, reacting to the drop in sales have simply entered into a reverse growth mode and scaled back operations sufficiently to be profitable. This is a sustainable act since the cost dropped will only be added back as growth dictates and in fact will most likely be added at a more productive level than they were previously.

Growth needs to be measured month over month to get a picture of what the status of the current economy actually is. Year over year comparisons don't work in the current scenario.