$5 Billion to GMAC

Its no secret that I have some concerns (if not outright opposition) to the massive, ill planned auto industry bailout. However, it now seems evident that the US government is going to take all necessary steps to keep these lumbering beasts alive (at least in the short run). Therefore, because we, the taxpayer, can not stop the inflow of capital to these companies despite their inability to provide Congress with any real plan regarding how they will re-shape their business models to become more competitive and capital efficient, we must look to where the invested capital will be best employed in a manner that benefits not only the auto-makers, but the economy as a whole (where the evaporated capital/total capital invested ratio will be lowest).

I would argue a $5 billion purchase of senior preferred equity in GMAC is a lesser of two evils. At least we know that a portion of this capital will be used by GMAC to provide financing to a "broader spectrum of U.S. customers." Furthermore, GMAC has said it will lower its credit criteria to include retail financing for customers with a credit bureau score of 621 or above (this is compared to a 700 criteria pre-capital infusion) and offer 0% financing for up to 5 years on some GM cars and trucks. This improvement in credit availability and terms may be a first step in creating some increased demand (albeit it very small given the macro pressure on the US consumer) in GM automobiles, and it is certainly more efficient than giving the money directly to GM, where despite two presentations to Congress, we still have no idea where it would end up.

GE's Credit Rating at Risk

The Standard and Poors rating service says there is a probability of 33% that they will downgrade GE's AAA rating within the next two years. A GE spokesman, speaking on the matter, admits that if they are unable to meet their short-term financial plan rating cuts will come. According the Standard and Poors, GE has has about $10 billion in cash that could be funneled into the capital unit, on top of the $5 billion already contributed this month. Doing this will shore up the capital unit's balance sheet and hold off a rating cut at least in the short-term.

Unemployment Insurance Weekly Claims Report

In the week ending Dec. 13, the advance figure for seasonally adjusted initial claims was 554,000, a decrease of 21,000 from the previous week's revised figure of 575,000. The 4-week moving average was 543,750, an increase of 2,750 from the previous week's revised average of 541,000.

The advance number for seasonally adjusted insured unemployment during the week ending Dec. 6 was 4,384,000, a decrease of 47,000 from the preceding week's revised level of 4,431,000.

FOMC Establishs Target Range for Federal Funds Rate of 0 to 1/4 Percent

The final primary monetary policy move is made:

http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm

Even More Deflationary Concerns

The CPI Index fell by a record 1.7% in November (largest monthly decline since the Labor Dept. began compiling the figure in 1947). The steep drop in the index was the result of a 17% decrease in energy prices and broad downward pressure on AD. The core CPI remained unchanged over October. Furthermore, the CPI rose 1.1% on a year-over-year basis in November, which is below the 1.5% to 2% range thought to be targeted by the Fed.

More Deflationary Concerns

A major guage of economic health in manufacturing in New York State hit a record low in December, a Federal Reserve report (one of the earliest monthly indicators of what is to come for U.S. factory conditions) demonstrated, additionally noting a record drop in a key price gauge exemplifying slipping demand. Furthermore indications from additional reports have showed overall industrial output slid in November.

The New York Fed's "Empire State" general business conditions index fell to minus 25.76 in December, versus minus 25.43 in November. Economists polled by Reuters had expected a December reading of minus 27.25.

The series of reports precede government releases concerning consumer price data for November, which economists expect to indicate prices falling for the third time in four months. This alone should indicate that in the near term, deflation, not inflation, should be the biggest worry and that printing money and spending are becoming increasingly necessary as the US appears to be in the early stages of deflationary trends in prices and wages.

Bernie Madoff Arrested Over Alleged $50 Billion Ponzi Scheme

Bernie Madoff, a former chairman of the Nasdaq stock market, has been arrested and charged with running a multi-billion dollar hedge fund pyramid-selling scheme in New York.

Below: A 2001 Barron's article outlining Madoff's consistent success:

Don't Ask, Don't Tell
Bernie Madoff is so secretive, he even asks
investors to keep mum
By ERIN E. ARVEDLUND

Bernie Madoff might as well hang that sign on his secretive hedge-fund empire. Even adoring investors can't explain his enviably steady gains. Two years ago, at a hedge-fund conference in New York, attendees were asked to name some of their favorite and most-respected hedge-fund managers. Neither George Soros nor Julian Robertson merited a single mention. But one manager received lavish praise: Bernard Madoff.

Folks on Wall Street know Bernie Madoff well. His brokerage firm, Madoff Securities, helped kick-start the Nasdaq Stock Market in the early 1970s and is now one of the top three market makers in Nasdaq stocks. Madoff Securities is also the third-largest firm matching buyers and sellers of New York Stock Exchange-listed securities. Charles Schwab, Fidelity Investments and a slew of discount brokerages all send trades through Madoff. Some folks on Wall Street think there's more to how Madoff generates his enviable stream of investment returns than meets the eye. Madoff calls these claims "ridiculous." But what few on the Street know is that Bernie Madoff also manages $6 billion-to-$7 billion for wealthy individuals.

That's enough to rank Madoff's operation among the world's three largest hedge funds, according to a May 2001 report in MAR Hedge, a trade publication. What's more, these private accounts, have produced compound average annual returns of 15% for more than a decade. Remarkably, some of the larger, billion-dollar Madoff-run funds have never had a down year. When Barron's asked Madoff Friday how he accomplishes this, he said, "It's a proprietary strategy. I can't go into it in great detail." Nor were the firms that market Madoff's funds forthcoming when ontacted earlier. "It's a private fund. And so our inclination has been not to discuss its returns," says Jeffrey Tucker, partner and co-founder of Fairfield Greenwich, a New York City-based hedge-fund marketer. "Why Barron's would have any interest in this fund I don't know."

One of Fairfield Greenwich's most sought-after funds is Fairfield Sentry Limited. Managed by Bernie Madoff, Fairfield Sentry has assets of $3.3 billion. A Madoff hedge-fund offering memorandums describes his strategy this way: "Typically, a position will consist of the ownership of 30-35 S&P 100 stocks, most correlated to that index, the sale of out-of-the-money calls on the index and the purchase of out-of-the-money puts on the index. The sale of the calls is designed to increase the rate of return, while allowing upward movement of the stock portfolio to the strike price of the calls. The puts, funded in large part by the sale of the calls, limit the portfolio's downside." Among options traders, that's known as the "split-strike conversion" strategy. In layman's terms, it means Madoff invests primarily in the largest stocks in the S&P 100 index -- names like General Electric , Intel and Coca-Cola. At the same time, he buys and sells options against those stocks. For example, Madoff might purchase shares of GE and sell a call option on a comparable number of shares -- that is, an option to buy the shares at a fixed price at a future date. At the same time, he would buy a put option on the stock, which gives him the right to sell shares at a fixed price at a future date.

The strategy, in effect, creates a boundary on a stock, limiting its upside while at the same time protecting against a sharp decline in the share price. When done correctly, this so-called market-neutral strategy produces positive returns no matter which way the market goes. Using this split-strike conversion strategy, Fairfield Sentry Limited has had only four down months since inception in 1989. In 1990, Fairfield Sentry was up 27%. In the ensuing decade, it returned no less than 11% in any year, and sometimes as high as 18%. Last year, Fairfield Sentry returned 11.55% and so far in 2001, the fund is up 3.52%. Those returns have been so consistent that some on the Street have begun speculating that Madoff's market-making operation subsidizes and smooths his hedge-fund returns.

How might Madoff Securities do this? Access to such a huge capital base could allow Madoff to make much larger bets -- with very little risk -- than it could otherwise. It would work like this: Madoff Securities stands in the middle of a tremendous river of orders, which means that its traders have advance knowledge, if only by a few seconds, of what big customers are buying and selling. By hopping on the bandwagon, the market maker could effectively lock in profits. In such a case, throwing a little cash back to the hedge funds would be no big deal. When Barron's ran that scenario by Madoff, he dismissed it as "ridiculous." Still, some on Wall Street remain skeptical about how Madoff achieves such stunning double-digit returns using options alone. The recent MAR Hedge report, for example, cited more than a dozen hedge fund professionals, including current and former Madoff traders, who questioned why no one had been able to duplicate Madoff's returns using this strategy. Likewise, three option strategists at major investment banks told Barron's they couldn't understand how Madoff churns out such numbers. Adds a former Madoff investor: "Anybody who's a seasoned hedge- fund investor knows the split-strike conversion is not the whole story. To take it at face value is a bit naïve."

Madoff dismisses such skepticism. "Whoever tried to reverse-engineer, he didn't do a good job. If he did, these numbers would not be unusual." Curiously, he charges no fees for his money-management services. Nor does he take a cut of the 1.5% fees marketers like Fairfield Greenwich charge investors each year. Why not? "We're perfectly happy to just earn commissions on the trades," he says. Perhaps so. But consider the sheer scope of the money Madoff would appear to be leaving on the table. A typical hedge fund charges 1% of assets annually, plus 20% of profits. On a $6 billion fund generating 15% annual returns, that adds up to $240 million a year.

The lessons of Long-Term Capital Management's collapse are that investors need, or should want, transparency in their money manager's investment strategy. But Madoff's investors rave about his performance -- even though they don't understand how he does it. "Even knowledgeable people can't really tell you what he's doing," one very satisfied investor told Barron's. "People who have all the trade confirmations and statements still can't define it very well. The only thing I know is that he's often in cash" when volatility levels get extreme. This investor declined to be quoted by name. Why? Because Madoff politely requests that his investors not reveal that he runs their money. "What Madoff told us was, 'If you invest with me, you must never tell anyone that you're invested with me. It's no one's business what goes on here,'" says an investment manager who took over a pool of assets that included an investment in a Madoff fund. "When he couldn't explain how they were up or down in a particular month," he added, "I pulled the money out."

Automotive Bailout: Demand & Politics

As noted previously, the problems in Detroit stem from a lack of competitive consumer demand exacerbated by cumbersome labor costs and retiree benefit payments. Interestingly, many of the covenants of the "Automotive Bailout Bill" seek to enforce the creation of smaller, more fuel efficient cars by Detroit (despite their best selling and most competitive vehicles being trucks). Robert Z. Lawrence points out that without legislative action to direct or alter consumer demand, such requirements may simply lead the Big 3 back to bankruptcy down the road, by producing cars that no one wants (Americans like SUVs when gasoline is cheap).

On the topic of the recent stall of the Bill in the Senate, Robert Reich provides insight into motives and realities in the political arena.

More Defualts Ahead?

The following chart (from Calculated Risk) depicts household real estate assets and mortgage debt as a percent of GDP:
If a lag exists between the decline in the assets value, the recognition of such a decline, and the decision or need (as a result of the economic downturn that itself has lagged behind the real estate problems) to default, will we see as sharp a downturn in the red line in the next few months?

Validity of the Tax Multiplier Argument Against Above Average NAIRU

Over the course of the past few days the debate over what strategies need be employed in an effort to close a reasonable fraction of the GDP gap that is predicted to occur in 2009(about $900 billion below normal growth path) has intensified. Perhaps as a result of the recent unemployment report (including U-6 at 12%), or perhaps as more is revealed about the Obama Administration's planned infrastructure spending, and more likely a combination of the two. As always, much of the clash surrounds selecting the appropriate model(s) as a backdrop for strategic decision-making, with focus on the tax and spending multipliers.

As noted previously, economists Susan Woodward and Robert Hall have identified five general stimulus-inducing strategies including further expansion by the Fed, income tax cuts with rebates, tax cuts that reduce the prices of consumer goods temporarily, tax cuts that reduce the cost of labor to businesses, and an increase in purchases of goods and services by state and local governments. While I've been consistently in support of continued and expanded government spending, and not quite convinced tax cuts will prove as successful in this environment, Woodward and Hall have expanded their argument to suggest that the spending multiplier is merely 1 for 1, perhaps a fraction of the tax multiplier, leading to the notion by some that the focus should be on tax cuts (most likely in the form of cuts in payroll taxes). This view is counter to the traditional Kenseyian model.

The two suggest, after viewing spending increases from World War II and the Korean War, that the government spending multiplier is about one: A dollar of government spending raises GDP by about a dollar. As noted economist Greg Mankiw points out:

"By contrast, recent research by Christina Romer and David Romer looks at tax changes and concludes that the tax multiplier is about three: A dollar of tax cuts raises GDP by about three dollars. According to that model, taught even in my favorite textbook, spending multipliers necessarily exceed tax multipliers.How can these empirical results be reconciled? One hypothesis is that that compared with spending increases, tax cuts produce a bigger boost in investment demand. Suppose, for example, that tax cuts are not lump-sum but instead take the form of cuts in payroll taxes. This tax cut would reduce the cost of labor and, if labor and capital are complements, increase the demand for capital goods. Thus, the tax cut stimulates demand not only by increasing disposable income and consumption spending (the textbook Keynesian channel) but also by incentivizing more investment spending. A similar result might obtain if the tax cut included, say, an investment tax credit."

I take issue with the notion that the tax multiplier is greater than the spending multiplier, or that tax cuts will be more effective than government spending in stimulating GDP, in the current economic environment. First, as Nobel Memorial Prize in Economic Sciences recipient Paul Krugman points out, significant flaws exist within Hall's and Woodward's argument: specifically avoidance/denail of certain historical realities which understate the findings. Secondly, in this recessionary environment of steep unemployment, significant downward pressure on labor costs already exists. Would further downward forces on the cost of labor truly encourage increased hours, re-hiring, or less firing? Doesn't the spate of downsizing reflect the businesses need to align current revenues with current costs? I'd happily concede that such a tax cut would decrease the cost of labor further, but I'm not convinced the newly employed or re-employed would immediately begin consuming, as opposed to saving and paying down debt. As for the spur in capital investment by businesses that is suggested, one need look no further than where a majority of the TARP money has been positioned: short-term treasuries now yielding .005%.

Rosenberg Confirms a Gloomy Outlook

Merrill Lynch's chief North American economist, David Rosenberg, said on CNBC's Squawk Box this morning that it is likely GDP will contract in all four quarters of 2009. Rosenberg also argued that U6 unemployment, a broader measure of unemployment than the one presented in the financial press, is around 12%.

Furthermore, he joined the ranks of those dismissing inflationary concerns related to expanded monetary and fiscal policy (this argument sounds familiar). Like many other economists he referenced Japan's massive monetary and fiscal policy moves, which did not lead to significant inflation in that nation.

M&A and the Inherent Disconnect: A Contraction of Multiples

In their latest report outlining future Mergers & Acquisitions activity independent research firm, Bernstein Research, forecasts that total M&A volume, including private equity and strategic deals, will decline by 25% in 2009 from the previous year. The United States' largest investment banks bank holding companies, including Goldman and Morgan, have become increasingly reliant on the revenues generated through M&A advisory (fueled by the 2006-2007 LBO boom). This suggests that a significant decrease in M&A activity could put additional strain on these firms, and the financial services industry as a whole (as if they didn't have enough problems).

Most people point to the tightening of the credit markets as the main factor leading to the current, as well expected decrease in M&A deal volume. While this is true, and the so called "freezing" of the credit markets has certainly had an adverse affect on M&A deal volume there is also another factor at work (somewhat connected to the credit environment of course), and as we enter 2009 it is likely to be as, or even more influential than the condition of the debt markets.

There is an inherent and growing gap between seller and buyer valuation expectations. At one end of the spectrum exist sellers with valuation expectations that have thus far remained fairly static despite desolate economic conditions, a decreasing availability of debt, etc. These sellers are still basing their valuation expectations off of the multiples seen in 2006 and 2007 (multiples fueled by massive leverage, 5x and up, as well as a sense of economic optimism). The problem with this is that at the other end of the spectrum are buyers who no longer have the ability, access, or willingness to employ the type of leverage that supports the aforementioned multiples (with senior debt multiplies likely to further contact as we enter 2009, maybe 2x-2.25x). Furthermore, these buyers are (especially in the case of financial buyers e.g. the PE guys) becoming increasingly more risk adverse and conservative with the valuations they place on target businesses. It seems likely as we enter 2009 this gap will continue to widen, and bridging it will become increasingly difficult.

Focusing on the Future

The economic recovery from the most recent economic recession (which ended in 2001) was the slowest recovery since WWII and below the historical average. At some point during 2009 it is anticipated that the economy is likely to hit its lowest point for this recessionary cycle. Just like it was "officially" suggested that the US experienced contraction almost a year after it truly began, it is not likely that we will "officially" know when the economy hit its "trough" and starts to improve until months after it occurs. Trying to time the economic bottom will be as difficult as timing the stock market bottom. As investors all we can do is try to position ourselves to benefit from the recovery when it happens. In that endeavor, historical experiences may be more reliable than they were in identifying the recession.

Fiscal Spending and Inflation

With the United States facing the worse economic climate since the Great Depression (pardon my use of the most overused and annoying phrase of 2008, although "credit crisis," "Wall St. vs. Main St.," "toxic assets," and "too big to fail" are formidable contenders) there is little dispute among economists that the Obama administration will have to employ some degree of fiscal stimulus in order to promote economic growth. The type and size of the package remains a debate with suggestions ranging from giant infrastructure projects to smaller green initiatives, and a combination thereof. However, there are still some naysayers that argue that such a broad fiscal spending policy will flood the economy with money, and ultimately result in significant inflationary pressure.

First, I would remind this aforementioned group that we are in the midst of one of the most deflationary economic environments in modern history (real estate values plummeting, commodity prices under significant downward pressure, re-pricing of financial assets, etc).

Secondly, we should consider the role of non-traditional monetary policy (aka quantitative easing) as a provider of stimulus.

Lastly, we must consider the non-accelerating inflation rate of unemployment (NAIRU), which is commonly believed to be in the 5%-6% range. The Keynesian argument as it relates to the NAIRU is that when the unemployment rate is above the NAIRU (i.e above 5%-6%), inflation will rise and as a result the unemployment rate decreases (reference the Phillips Curve.) In contrast, when the unemployment rate is below the NAIRU (i.e. below 5%-6%) inflation will fall and as a result the unemployment rate increases (again reference the Philips Curve). There is very little debate that in the short-run we will see economic conditions get worse and the unemployment rate continue to climb from its already lofty 6.7% (with some economists even forecasting a peak at 10% unemployment). As a result we will continue to experience increased deflationary pressure. After we reach a peak in unemployment (possibly 5pp above the NAIRU) the upward inflation and downward unemployment adjustment that will follow, and in turn bring the measures in line with the NAIRU, is likely to be very slow, further dismissing rapid inflation concerns.

Come on Down to Uncle Sam's House of Loans

As negotiations between the White House and Congress appear to be nearing completion on an inevitable automotive rescue plan, debate concerning the $15 billion dollar bill primarily concerns wording and semantics. The Democratic counter offer to the White House, which has voiced concens about Detroit's ability to survive even if supplied with an infusion of federal cash, addresses issues that the first draft had with promoting future viability and competitiveness. Additionally, the most recent draft grants the government the right to acquire preferred shares of the companies equal to 20% of the amount loaned (Ford is also seeking an additional line of credit).

The automotive rescue bill gained further traction following last weeks unemployment report, as the US economy lost an additinoal 530,000 jobs in November and more emphasis was placed on "saving" 350,000 industry jobs and the percieved millions that depend on it. The White House, however, remained hesitant without gurantees that taxpayer dollars would be paid back, that the automakers would reorganize and become competitive (something they have no been for some time), and that proposals of detailed plans concerning cost cutting and business overhauls would be submitted by March 31st 2009.

Perhaps of most interest, a presidentially appointed "car czar" would be created to oversee the restructuring in Detroit. The designated car cheif would would authorize and directly disburse bridge loans or lines of credit, report periodically to congress, and could even force the automakers into bankruptcy if guidlines werent followed, or restructuing progress was ineffective. At this point it looks as if the ol' Car Czar may not be a single position, but either way the name and idea evoke an image of used car dealership commercial.

No credit? Bad Credit? No viable business plan or competitiveness? Excessive, prohibitive labor costs and nothing that addresses the single most important issue (demand)? Well come on down to Uncle Sam's Lot "O" Loans: where the Car Czar will get you the $15 bailout you need today!

As I've noted before, the government must continue to spend, but it cannot spend blindly. What (viable, strong assets) is just as important as when (ASAP). My biggest question from the highlights of the automotive bill, is how does any of this drive demand? Afterall, it is a lack of demand now, and into the forseeable future, along with stiff competition from those with stronger business fundamentals (cost structure) that has landed Detroit in this position.

I think it's time the government started acting like a Porchse dealer and screen their customers financial viability, and less like a used car salesman.

Nobel Prize Winning Economist Predicts 10% US Unemployment

2008 Nobel economics prize winner Paul Krugman said today that unless a "very effective" stimulus program is developed, the US unemployment rate could reach 10 percent.

"We could easily be looking at a world economy that is depressed until 2011 and
maybe beyond".

Krugman's modest estimate is that the US economy needs a $600 billion stimulus program on top of all the initiatives already presented by the Treasury Department. This number, which Krugman admits might have to increase, would equate to 4% of GDP. Krugman, like the new Obama administration, believes much of the plan should focus on infrastructure development "because that at least will leave us with things of value afterwards".

Full Story

Woodward & Hall: Options for Stimulating the Economy

Economists Susan Woodward and Robert Hall have identified five general stimulus-inducing strategies that should be considered in closing a reasonable fraction of the GDP gap that is predicuted to occur in 2009 (about $900 billion below normal growth path). The strategies include:

• Further expansion by the Fed
• Income tax cuts with rebates, as earlier this year
• Tax cuts that reduce the prices of consumer goods temporarily
• Tax cuts that reduce the cost of labor to businesses
• Increase in purchases of goods and services by state and local governments

Two of the five I noted would be very beneficial in a previous post.

Living in the Left Bin

The following chart presents a histogram of returns of the S&P500 since annual returns were tracked beginning in 1825. Each block represents a full year and each column is a bin of returns within a specific range. 2008 is the black square at the far left alongside 1931.

What You Missed This Weekend

• Layoffs Expected to Decimate Wall Street Ranks
• Fortress, the Hedge Fund, Is Crumbling
• Krugman: US auto industry will probably disappear
• Dow Chemical to slash 5,000 jobs, close 20 plants

Commercial Real Estate - Here We Go Again

Commercial real estate delinquencies are still at a historically low level, but they are increasing rapidly. Philip van Doorn from thestreet.com recently conducted an analysis for banks with total assets greater then $10 billion, to determine which banks are going to face the hardest times if that trend continues. Here is an excerpt:

"According to a recent JPMorgan Chase report on commercial mortgage-backed securities Analyst Alan Todd said that retail delinquencies of 60 days or more were 0.40% in October, increasing from a low of 0.08% in July 2007. Over the same time period, office delinquencies increased to 1.29% from 0.47% and multifamily delinquencies increased to 0.28% from 0.11%. The report also noted commercial property prices had only fallen 11% from their peak, and were expected to fall 30% to 40% "over the next few years."

Doorn's analysis compared the bank's non-performing commercial real estate (CRE) and commercial construction loan holdings (CCL) to the bank's total assets. The complete list can be found below (click the image)

Simple logic leads me to believe that the rate of delinquencies on commercial real estate loans is going to increase significantly. A weak economy decreases demand for goods, companies decrease prices (and cut margins) to spur demand, companies can no longer turn a profit, go out of business and become delinquent on their commercial loans. A very simplified chain of events but it illustrates that banks, especially the ones listed above, should be very worried about their commercial loan holdings.

"The Bailout Paradox" Paradox

Robert Reich, the nation's 22nd Secretary of Labor and a professor at the University of California at Berkeley, presents an interesting take on the Big 3's problems, deeming it "The Bailout Paradox". Specifically, he states:

As a condition of getting a federal bailout, the Big Three are promising, among other things, to cut costs. Among the costs to be cut will be jobs. This is paradoxical, since the reason Congress is considering bailing them out in the first place is to preserve jobs and avoid the social costs of large-scale job loss unnemployment insurance, lost tax revenues, pension payments that have to be picked up by the Pension Benefit Guarantee Corporation, and so forth).

We should take a lesson from the Chrysler bailout of the early 1980s. The ostensible reason Congress voted for it was to preserve Chrysler jobs. Yet once the bailout was underway, in order to generate the money it needed to restructure itself, Chrysler laid off more than a third of its workforce. Most of these jobs never came back.

The paradox of this argument stems from the UAW absurd labor benefits and costs to the automotive companies. Isn't cutting costs (jobs) in order to prevent bankruptcy or total failure (total loss of all jobs) the idea? I'm against an automotive bailout for demand issues, but no matter how you slice it, Detroit needs to reduce its costs related to labor.

Oil and Elasticity

January crude oil prices fell $3.12 yesterday closing at $43.67, which marks an astounding 71% drop from the June high of $150 (welcome back supply and demand fundamentals).

While commodities as a whole have experienced significant downward pressure, particularly in H208, (reference the CRB Commodity Index), few have seen the type of pressure experienced in the oil market. Is it possible that oil prices can continue to fall as we look to 2009?

The answer is YES. In the short term it seems likely that oil will continue to experience downward pressure as a continued and significant decline in demand will outpace relatively inelastic supply movements. Gulf Oil CEO Joe Petrowski even said yesterday that the price of oil could sink to $20 per barrel, and there is a chance gasoline prices could drop as low as $1 per gallon early next year. $20 oil seems a little extreme, but further downward price momentum is certainly possible.

It seems apparent that suppliers of oil, particularly the OPEC nations, are reluctant and slow to adjust output to efficiently align supply with worldwide demand (despite their rhetoric), and who can blame them. They have become comfortable and accustom to receiving huge revenues from oil exportation. These huge revenues have fueled extravagant domestic projects that now rely on these revenues (look at Dubai). As oil exporting nations face a decline in oil prices coupled with their own domestic economic slowdowns in connection with the worldwide crisis they will continue to look to their safety blanket (oil exports) to generate revenue and sustain economic activity. To reiterate, the result is inelasticity of supply in the oil market and in turn downward pressure on oil prices.

Downward Spiral: Unemployment Bound for Double Digits

• Non-farm payrolls: -533k


• Unemployment rate: 6.7%


• Hourly earnings: 0.4%


• Average workweek: 33.5 hours
  

The US economy shed an additional 533,000 jobs during the month of November, the steepest loss since December of 1974 and 57% higher than the median analyst prediction. The recent cuts propelled the unemployment rate to 6.7% as widespread losses impacted factories, financials, retailers, services, hospitality, construction and nearly every corner of the economy.

While significant noise exists on a monthly basis for unemployment estimates, the overall trend certainly suggests continued rises in the rate as the recession deepens. Both September and October estimates were revised upwards, and rather significantly. October's job losses were revised to show a cut of 320,000 jobs from a previously reported 240,000, while September's losses were 41% higher than originally reported. Little doubt should exist that November's estimate will experience the same revisions driving the unemployment rate toward, or even over, 7%. When you consider the number of individuals who have "given up" and left the workforce, or that are working part-time (lowest average workweek since tracking began) but want to work full-time, the downward spiral of GDP and unemployment will only be exacerbated. Double digit unemployment is only a few reports away, if it isn't truly here already.

"The only way out is for the government to be extremely aggressive on every front: The Federal Reserve, economic stimulus, help for the automakers, extending out TARP money, everything, because we're now in a self-reinforcing negative cycle, and the only way out is for the government to fill the void," noted Mark Zandi, Moody's Economy.com chief economist.

It's clear that government spending needs to be increased, and done so immediately. Inflation is currently of no concern, crowding out holds little weight, and the Keynesian theory that $1 of government spending is more beneficial than $1 of tax cuts must be revered in the short term. It should be noted that the only employment gains occurred in the government, education and health services.

As Harvard economist Greg Mankiw puts it, "we need to step on the gas."

Update:

The Bureau of Labor Statistics does more than report the headline 6.7% unemployment number (U-3). On page 19 of the November Report, the BLS outlines all measures of unemployment. U-6, total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all marginally attached workers, comes in at a whopping 12.5%.

Enough Said

The $34 billion requested is more than 5 times the total market capitalizations of the three companies combined.

Sweet 16

We are now officially in a recession (like it was a question before) and have been in one since December 2007 according to the National Bureau of Economic Research (NBER). Historically the average recession lasts for 16 months. Therefore, if this recession is average, the economy will turn around in four months. I don't think it takes an economist to determine that this recession will not be over in four months. Will it be over in 2009? Economists are trying to figure that out by comparing this recession to recessions like the ones in 1973-75 and 1981-82 recessions (both which lasted 16 months), or even the Great Depression (43 months long). Their results? Lots of well written papers, but no consensus among experts as to how long this recession will last. It seems that no one historical event is going to provide us with a clear road map of what is to come.

What economists are more certain of is that the rapid economic recovery (and stock market rally) that came after past recessions will be absent after this recession. Newly conservative financial institutions will hold back the recovery as they slowly improve their balance sheets and neglect to make the level of loans necessary to drive a spike in economic growth.

The actions of Congress, the Fed and the Treasury over the next 6 months will not only determine how long the recession lasts, but more importantly how quickly the economy turns around once it is over.

Apples, Oranges, & The Expenditure Method

The chart above has successfully made its rounds across several news media outlets over the past few weeks, capitalizing on the negative public sentiment towards "bailouts" and seemingly inciting outrage wherever it appears. While it does present an informative visual representation of the dollar amounts related to the federal expenditures of 2008($4,616,000,000,000 as of November), it fails to properly classify the "expenses" resulting in an "apples to oranges" comparison.

The chart suggests, or fails not to, that the "2008 Bailout" is a single expense; an enormous cash outflow similar to The Marshall Plan or the Moonshot, rather than as an investment. An argument can be made, of course, that the Louisiana Purchase or NASA's advances were also investments. That each provided significant resources or breakthroughs we enjoy daily (even the Marshall Plan helped develop the current world order). But what was the ROIC on such expenditures? On the Vietnam war?

With the confirmation of a global recessionary economic environment, few would expect significant capital gains (perhaps even positive returns) from the billions of dollars of toxic assets the government has been purchasing in the near term. Fewer still, however, would assume that the assets are utterly worthless and will provide no return, or see no appreciation. Certainly the preferred equity of major banks, with dividends upwards of 10% and an equitable ownership of future revenues can be considered a sound investment. An investment I would happily purchase from the government in the open market, especially when considered against a long-term horizon.

Perhaps more importantly though, the image is often the basis for the "anti-bailout" sentiment; the suggestion that the spending is irresponsible or unreasonable. This argument undoubtedly ignores one of the most basic economic equations, the Expenditure Method of Calculating GDP:

GDP = C + I + G + (X-M)

With consumption(C) and private investment(I) down significantly and falling, and exports (X) shrinking as a result of the strong USD, the only option for avoiding a dramatic decline in GDP and subsequent and significant rise in unemployment, is an increase in government spending. One can argue that the spending is misplaced, but it would certainly be a difficult argument to make that it isn't necessary.

Such spending under normal circumstances may cause inflationary concerns or worries about crowding out the private sector, but with the economy operating well below available resources and as the Fed continues to combat deflation and prepares to take rates below 1%, printing more money has considerable merit. In fact, as Harvard economist Kenneth argues, a touch of moderate inflation may be rather beneficial.

Exponential Absurdity

The graph below shows the hypothetical growth of the Big Three's (or Small Three as re-named by Larry Kudlow) government provided finance requirements assuming a growth pattern similar to the one we saw between Detroit's first plea to Congress on 11/23/2008 and their second plea, two weeks later, on 12/02/2008. While this analysis is highly over simplified and based upon a relatively unrealistic and consistent exponential growth rate assumption, its purpose is to serve as a hyperbolical illustration of the depth of the financial and strategic management issues facing these firms.

The fact that an organization's financial requirements can increase by 50% in a two week period, both GM ($12b to $18b) and Ford ($6b to $9b) , serves as an insight into the significant financial and strategic mismanagement issues facing the Big Three.

As Congress contemplates providing the Big Three with the now requested $34b a very simple question arises, and it isn't the now famous, are they too big to fail, but rather are they too big, inefficient, and debt laden (both to traditional debt holders and to their union workers) to save? Regardless, before any money is given to the Big Three the government should insist on evidence of significant discussions and movement towards union policy reform (the only way Detroit can become competitive again) and the presentation of sufficient revised business strategies (not the ones that were presented to Congress yesterday).

Gross Investment Outlook

One of the consistent arguments amongst the loudest of the bulls for calling a bottom and dipping our toes back into the market (made time and time again over the past 8 months) has undoubtedly referenced a perceived undervaluation, or "cheapness", in the equity markets. Technical analysis screams both individual securities and the marketplace(s) are oversold, and perhaps more convincingly, accepted fundamental valuation methodologies often paint the same picture. Certainly fear, volatility, a global recessionary environment and the ever-evolving uncertainties plaguing the credit markets offer explanations for a DOW shedding value and, at times, struggling to find support, but PIMCO's Bill Gross offers an additional take: the fallacy of undervaluation.

Gross first visits the two strongest culprits influencing the undervaluation notion; the Q-Ratio and the P/E ratio. Essentially, the Q-Ratio, which is mean reverting in the long-run, compares the stock market valuation relative to replacement cost of net assets (with a value of 1.0 representing perfect valuation). When Q is above 1.0, market valuations exceed reproduction costs, indicative of overvaluation. When Q is below 1.0, the opposite is true. As Gross notes, "Today's Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation."

P/E, as it turns out, paints the same picture (valuations below historical average):Clearly undervaluation given the above is difficult to dismiss entirely, but Gross points out that such valuations may not account for recent changes that have serious potential to be "not only non-cyclical, but non-secular...[and] likely to be transgenerational."

"My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner. Dow 5,000? We don’t have to
go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well. One only has to recognize that roughly 20% of bank capital is now owned by the U.S. government and that a near proportionate share of profits will flow in that direction as well. Better to own corporate bonds than corporate stocks..."

Economic Weakness Abroad Suggests Continued Strength in the Greenback

A taste of global economic data released today:

• Euro Zone Service PMI was weaker than expected at 42.5


• The U.K. PMI measure fell to 40.1 from 42.4


• Euro Zone retail sales in October fell 0.8% (outpacing expectations to the downside)


• Australia's GDP grew 0.1% Q-O-Q in Q3 (half of the expected growth)


• Thailand's central bank cut rates by 1.0% to 2.75%

This data further emphasizes the decline of global economic activity and reiterates the likelihood of a wide spread easing of monetary policy on a global basis (an easing already pursued in the United States). The introduction of loose global monetary policy coupled with a heightened sense of risk aversion (especially in the emerging markets) will likely lead to an inflow of foreign capital into the United States, resulting in a continuation of the strong performance seen in the USD over the past few months. The downside is the negative affect this will have on US exports and in turn their contribution to GDP in the US (export growth has already decreased from 12.3% in Q2 to 3.4% in Q3 due in part to the USD's performance over that time period). This supports our view that we will continue to experience GDP contraction through H209.

12/04 Update:
ECB cuts by 100 bps and the ECB eases by 75bps leaving the benchmark rates at 2.0% and 2.5% respectively (the days of the European single, inflation focused mandate are quickly fading).

Non-Manufacturing ISM Record Low @ 37.3%

New orders, imperative for future growth, are contracting at an increasing pace, suggesting that the services sector is deteriorating at an accelerating rate. New export orders experienced considerable contraction from October, coming in at 34.5% from 50.0%, likely impacted heavily by the effects of a stronger dollar and weak global demand environment.

Overall some pretty bad news to add to the pile.

http://www.ism.ws/ISMReport/NonMfgROB.cfm?navItemNumber=12943