Monday, March 25, 2013

The Fed is Blowing Yet Another Stock Market Bubble

If the stock market's record run-up in the face of our continued economic weakness has left you bewildered, you're not crazy. Though the economy continues to struggle, Wall St. is thriving.

Since the second quarter of 2006, there have been only two quarters in which GDP was at least 4%. And over the last ten years, the average U.S. economic growth rate has been below 2 percent.

Inflation-adjusted wages fell 0.4% in 2012, following a 0.5% decline in 2011. Simply put, wages aren't keeping up with inflation. This is hurting demand and, ultimately, the greater economy.

Yet, despite all of this, the stock market is booming.

In the strange world of Wall St., the stock market thrives even as the economy remains anemic. Go figure.

The Dow Jones recently soared above 14,000, setting an all time high in the process. Yet, the Dow is simply an average of thirty large, publicly traded companies. Thirty companies in a sea of thousands do not accurately represent the vast U.S. economy.

The S&P 500 index recently began trading above 1,500 for the first time since December 12, 2007, just months before the implosion of big Wall St. banks sent the major averages crashing to decade lows.

Despite continual weakness in the economy and consumer spending (which accounts for about 70 percent of GDP), the stock market is booming. How can this be?

You can thank the Federal Reserve, which is pumping $85 billion per month of thin-air money into the markets. Quite simply, this bull market is being fueled by all the funny money being spun out of the Fed's printing press. Hundreds of billions in new money has been flowing into the stock market, which is pushing the averages to new highs.

This stock market run-up is nothing more than an illusion of economic well-being created by the Fed. It is entirely lacking in fundamentals.

The Fed is engaged in an aggressive bond-buying policy, in which it has been purchasing $85 billion in Treasuries and mortgage bonds each month in an attempt to lower long-term interest rates and spur the economy.

Before this year even began, the Fed had already expanded its balance sheet by nearly $3 trillion buying these assets in recent years.

Yet, the central bank is not finished. There are still hundreds of billions of these purchases to come and that money will continue to flow into equities, likely pushing the markets even higher.

At the current pace of $85 billion per month, the Fed's bond purchases will result in another trillion-plus dollars of freshly created money flowing into the financial and equities markets over the course of 2013. Such massive injections of liquidity into the economy have been, and will continue to be, quite favorable for equities.

This is why the market has been steadily increasing, despite the numerous factors arrayed against it — weak earnings, political tensions in Washington and a European recession. While this may seem incomprehensible, it is the result of massive sums of money flowing into the financial markets from quantitative easing. Wall St. has to send that money somewhere, and Treasury yields are at record lows.

Considering the historically low rates of return for Treasuries — which don't even keep up with inflation — it's easy to understand why all that money is instead flowing into the equities markets.

The biggest banks are getting enormous sums of money through the Federal Reserve as virtually zero interest. They are then able to invest hundreds of billions of essentially free money in the stock market and collect massive returns. This results in pure profit, which is one hell of a business model.

Though it's been widely reported that U.S. corporations are sitting on a record $2 trillion in cash, it may actually be as much as $5 trillion. Companies have been using some of that cash to buy up and reduce the total number of shares outstanding. Coupled with the roughly $2.8 billion in Fed money flowing into the financial markets every single day, there is an extraordinary amount of money chasing fewer shares.

So, the current stock market averages are quite misleading. They are simply a reflection of our continually irrational, bubble economics. Most critically, the vast majority of Americans are not benefiting from this stock market boom, which has seen the Dow jump 119 percent since bottoming in March 2009.

Unfortunately, the gains from this surging stock market have been flowing mainly to richer Americans. Roughly 80 percent of stocks are held by the richest 10 percent of households.

Quite predictably, middle-class Americans, having lost faith in the markets, sold their stocks over the past few years and have not benefitted from the rebound. During 2012, Americans dumped $204 billion in stocks, according to a report from the Federal Reserve.

Retail investors have been leaving the stock markets in droves for the past few years. In each of the last three years, individual investors have withdrawn more than $150 billion from U.S. stock mutual funds and ETFs. This means that millions of individual investors have missed the current market boom.

The truth is, the stock market is not an accurate measure of the health and strength of the economy. In reality, Wall St. is a pretty poor measure of the economy’s condition since it is simply a bet on the future performances of a select group of companies listed on a few stock exchanges.

Furthermore, as previously noted, the majority of Americans don’t have any direct investments in the stock market.

According to the June 2012 Fed survey, just 15.1% of American families had any stock holdings in 2010, down from a peak of 21.3% in the 2001 survey. And just 8.7% of families had direct ownership of pooled investment funds (mostly mutual funds) in 2010.

Clearly, the ballooning stock market is not a reflection of the financial well-being of the vast majority of Americans. Most of them aren't even investors. The markets are simply Wall Street's betting games.

Undoubtedly, the 2008 financial crash scared million of individual (or retail) investors out of the markets. However, even six years prior to the crash, more than four out of five U.S. households had no individual stock holdings.

In its 2002 study, the Mutual Fund Industry group, Investment Company Institute, found that only 21 million households (less than 20%) owned individual stocks outside an employee sponsored retirement plan. Employees in such plans are typically invested in mutual funds that give them no voting control.

So, Wall St. is not a true reflection of how the average American worker, or the average family, is faring.

Many U.S. corporations have been making money by cutting costs and laying off workers, not by increasing revenues. This increase in efficiency and productivity has resulted in corporate profits reaching all-time highs (as it turns out, workers who fear losing their jobs work longer and harder). And that's been putting even more downward pressure on jobs and wages, resulting in weaker economic growth and lingering recessionary effects.

So what's been good for U.S. corporations hasn't been good for American workers or their families.

And then there's the whole issue of Wall Street's manipulation and control of the equities markets.

By some estimates, "high frequency trading" is responsible for close to 70% of all volume in US markets. Computers can track hot stocks and immediately buy up all available shares. Since volume moves markets, massive purchases of millions of shares push prices higher, allowing computer algorithms to quickly sell those shares at higher prices. Millions of shares can also be dumped in just milli-seconds. That pushes share prices lower, allowing the computers to quickly swoop in and repurchase the shares at a lower price.

The radical, erratic movements of the stock market over many years can accurately be described as schizophrenic.

The markets are totally manipulated and, unfortunately, there will be a lot of losers because of this.

At the first sign that the Fed plans to withdraw its monumental levels of liquidity from the markets, they will go into free fall. Just the mere rumors or grumblings of the Fed's intention to change course could trigger panic selling.

Ultimately, this will not end well. It never does. We've seen the markets implode numerous times. The Fed's bond-buying program will conclude at some point. While individual investors, pension funds, mutual funds and the overall economy stand to lose big time, Wall St. traders will be the first ones to the exits, with their profits intact.

In fact, there is evidence that this exodus is already underway.

All bubbles eventually burst, and this one will be a whopper.

Monday, March 11, 2013

When Will China's Bubble Burst?

China's rise to the status of economic powerhouse has been nothing short of breathtaking. For most of the past century, China was still an impoverished Third World nation.

However, the Asian giant has averaged a 10 percent growth rate over the past 30 years and it is now the world's fastest-growing major economy. In 2010, that spectacular growth culminated in China vaulting past Japan to become the world's second largest economy (by nominal GDP), behind the U.S.

In the process, China also became the world's biggest car market, which is remarkable considering that almost everyone there rode bicycles just 20 years ago. Car ownership rocketed from just 1 million in 1977 to 75 million in 2011.

China's emergence as the world's second biggest economy was a historic shift, one that can rightly be described as a sea change. From out of nowhere, China became a major player on the world stage. It's arrival was bold, rapid and pronounced.

To provide a sense of the magnitude of China's growth, consider this: In 2007, China's gross domestic product stood at $3.38 trillion. By 2010, it had reached $5.87 trillion. That's just amazing.

In 2010, China surpassed the US as the world's biggest energy consumer and, in the process, it also became the world's second biggest greenhouse gas polluter (also following the US). The UN reported that Chinese emissions nearly doubled from 1994 to 2002.

China's energy demand has increased exceptionally fast; just 10 years earlier, its energy consumption was half that of the US.

All of these developments were astonishing in their own right. But they were small in comparison to what is projected to soon occur.

The IMF dropped a major bombshell in 2011 when it forecast that China’s economy will surpass that of America in real terms in 2016.

Such an outcome would be a positively stunning development. But as amazing as China's emergence has been, it has not come without serious challenges.

China has considerable problems that it needs to confront. With a population of 1.3 billion people, the country outnumbers the US by a billion citizens. The need to provide energy for all of those people is transforming world energy markets and increasing the global demand for fossil fuels, including oil and coal. With 20 percent of the global population, China's enormous demand will continue to drive energy costs well into the future.

According to Fatih Birol, the chief economist at the IEA, China's surging appetite for energy will require a massive and rapid infrastructure build out. China will need to construct some 1,000 gigawatts of new power-generation capacity over the next 15 years — about equal to the current total electricity-generation capacity in the US.

That is simply amazing. The US achieved its current energy capacity over a period of many decades. Yet, China's growth has occurred at hyper-speed. This is already having enormous impacts on the planet, ecologically and environmentally.

Though the US has just five percent of the global population, it uses 25 percent of the world's oil. But America now has a huge competitor for vital energy resources, and one with very deep pockets. The irony is that America's robust appetite for Chinese exports helps to pay for China's massive purchases of foreign oil.

Yet, China's problems go far beyond its demand for energy resources, much of which come from foreign sources.

China needs to generate 15 million jobs needed annually—roughly the population of Ecuador or Cambodia—to employ new entrants into the national job market. That is a spectacular challenge.

China's incredibly rapid growth was built on manufacturing and exporting. But with the global economy slowing, the demand for Chinese goods has also slowed. In order to maintain its growth, China will eventually have to boost domestic demand and switch from its export-driven model to a consumption economy. That will be a challenge for a thrifty nation more inclined toward saving.

Moreover, one billion of China's citizens are still peasants. It has one-fifth of the world's population and it has to feed that mass of humanity. Yet, much of its landscape is an ecological wasteland and an environmental disaster area. That poses an enormous challenge.

Dust storms have been steadily worsening in China over recent decades due to heavy tree-cutting. The environmental damage in China is extensive. More than a quarter of the country's landmass has been turned into desert as a result of erosion and logging, and acid rain has damaged a quarter of Chinese soil.

According to the World Bank, China is home to 16 of the world's 20 most polluted cities. Three hundred thousand Chinese citizens die prematurely each year due to respiratory illness, and the life expectancy of a traffic cop in Beijing is approximately 40 years due to the horrid air quality.

These problems are poised to worsen as China attempts to provide energy to its continually developing economy and absolutely massive population.

So, while some are heralding the 21st Century as the 'Chinese Century', and predicting that China will supplant the US as the world's dominant power, I, for one, remain unconvinced.

Yes, the US has its own enormous challenges and finally appears to be bumping up against the limits to growth. While the US is the world's biggest debtor nation, China is the world's largest creditor nation and owns approximately 20.8% of all foreign-owned US Treasury securities.

Nonetheless, China will eventually face even greater environmental and agricultural challenges, which could derail all of those exuberant projections of its rise to global supremacy.

Yet, long before China is forced to fully confront its horrendous environmental degradation, which will make feeding 1.3 billion humans even harder than it would otherwise be, it will likely be derailed by the largest housing bubble in human history.

China has built entire cities with no one in them. Seriously.

According to Gillem Tulloch, a Hong Kong based financial analyst, China is building somewhere between 12 and 24 new cities every single year. We're not talking about developments, communities or neighborhoods — but entire cities. This means that 1-2 new cities are being constructed each and every month in China.

Think about that for a moment. It's hard to comprehend.

These are known as "ghost cities" and their skylines are adorned with massive apartment buildings that sit empty. The emerging Chinese middle class is buying up multiple properties — in addition to their primary residences — with the belief that real estate is the best investment. Banks offer paltry interest rates and the stock market is too volatile. Property prices, on the other hand, have always gone up and they've always beaten inflation.

Sound familiar?

Real estate has been an enormous driver of growth in recent years, accounting for as much as 20 or 30 percent of the entire economy, according to some estimates. And it's not just apartments and houses; it's shopping malls and towering office buildings. But far too many of them sit empty.

The idea seems to be, "If you build it, they will come."

But there's a big problem with that assumption: Though China has a rapidly growing middle class, one billion of its citizens still live as peasants.

The typical new Chinese condo is 1,100 square feet and costs between $100,000-$150,000. However, the typical two-income Chinese couple in their 30s makes approximately $7,000 or $8,000 a year. That just doesn't add up.

In some places, it's even worse. A typical apartment in Shanghai costs about 45 times the average resident's annual salary.

China is building the wrong kind of housing. It isn't creating affordable dwellings for its massive population of impoverished citizens. And desperately poor people don't shop at malls either. Most people in China live on about $2 a day.

When this enormous real estate bubble bursts, it will have massive reverberations throughout the world — not just in China.

About 50 million Chinese workers are employed as construction workers. When the bubble bursts, they'll all suddenly be out of work. That would pose a staggering social problem for the government.

Already, numerous construction projects throughout China have been abandoned. Many developers have run out of money and abruptly pulled out of existing ventures in midstream. That, in turn, is slowing the Chinese economy. Lots of loans are going sour. If this builds up a head of steam, it could cripple the economy.

How might this affect the US?

The Chinese government has spent some $2 trillion to build these 'ghost cities' as a means of maintaining its economic growth.

Imagine if the Chinese government has to use its US currency reserves to solve its own financial and economic crises. Imagine if it has to sell off its US Treasuries to fill the void?

If the Chinese bubble bursts, it would affect all US companies that sell commodities to China — particularly the variety that go into construction, such as steel, most of which goes to China at present.

I first wrote about the Chinese real estate bubble three years ago, when I questioned whether China's growth is an illusion. At that time, millionaire hedge fund manager James Chanos said the following about China: “Bubbles are best identified by credit excesses, not valuation excesses. And there’s no bigger credit excess than in China.”

Chanos, the founder and President of Kynikos Associates, has spent significant time evaluating and analyzing the Chinese economy and its property bubble. Back in 2010, Chanos warned that the bubble will likely burst and run its course in late 2010 or in 2011.

Because that hasn't occurred yet doesn't mean Chanos was wrong. He was just early. The pressures in the system have only grown considerably over the last two years, meaning that when this bubble does finally burst, it will be felt all around the world.

There's an awful lot of foreign investment money tied up in China. At the first outward signs of distress, everyone will want to escape intact. But with everyone simultaneously heading to the exits, not everyone will fit through the door.

The losses would be catastrophic.

Friday, March 08, 2013

Why the Official Unemployment Rate is so Deceiving

The government wants you to disbelieve your lying eyes and accept that our nation's unemployment problem (or, crisis) is actually improving. The jobs problem has been so awful over the past five years that the government desperately needs the illusion of good economic news, and none could be better than promoting the notion that more people are working now than last month or last year.

The problem with this story is that it's all nonsense.

It's not that the government is lying outright; it's that it is cherry-picking the data. It's telling the story in a way that makes things seem much better than they are in reality. By looking at one set of numbers while ignoring other critical ones, you end up with a very different, and more upbeat, picture.

But to do so is highly misleading.

The Federal government counts a person who is self-employed and earns $100 a year as "employed" and it also counts a person who works one hour a week as "employed."

As a result, the only meaningful metric is full-time employment.

To be counted as officially unemployed, a person must have actively looked for work some time in the past month. If you have not looked for work in the past month, for whatever reason, you are not counted as unemployed.

The government uses two different numbers to express unemployment. These are known as the U-3 and U-6 unemployment figures.

U-3 is the 'official' unemployment rate. It measures people without jobs who have actively looked for work within the past four weeks.

However, U-3 does not include so-called "discouraged workers", or those who have stopped looking for work because current economic conditions make them believe that no work is available for them. It also excludes so-called "marginally attached workers", or those who "would like" and are able to work, but have not looked for work recently.

On the other hand, U-6 includes all of the above, plus part-time workers who want full-time work, but cannot find such employment due to economic circumstances.

Under the U-3 definition, the official unemployment rate was 7.7% in February. By this definition, there were 12 million people who said they had looked for a job without success.

But there were also 6.8 million people who said they wanted a job but weren’t even looking, perhaps because they were so discouraged. This may be due to a lack of transportation, a lack of childcare, illness, or some other reason.

Additionally, 8 million people said they could only find part-time work, even though they preferred full-time work. In some cases, their hours have been cut back involuntarily.

If you count those discouraged workers and the involuntary part-timers as unemployed — the U-6 figure — the unemployment rate jumps to 14.3%. That's nearly twice the official figure. Big difference.

A more accurate measure of our unemployment problem is the size of the labor force. This looks at the number of people, ages 16 and older, who are either working or are actively looking for work, while excluding the disabled and those in the military, prison, or hospital.

Using that measure changes the picture considerably.

In February, the labor force shrank by 130,000, which is why the U-3 rate fell to 7.7%. Yes, if you exclude huge numbers of people, the unemployment figure looks considerably better.

The labor force participation rate actually decreased slightly to 63.5 percent in February, from 63.6 percent in January. That's a return to the low of last summer and matches the woeful rate seen back in 1981.

So, while some are celebrating the unemployment rate's drop to a four-year low, the reality is not nearly so encouraging. It's obvious that unemployment is "improving" only if you pretend that millions of American workers no longer want jobs.

If the participation rate were 66.2% — where it was when the economy fell into recession in December 2007 — the jobless rate would be 10.7%. Again, when you exclude millions of people, the unemployment rate looks a whole lot better than it really is.

The number of people reported as not in the labor force rose to 89.304 million in February from 89.008 million in January, which is a new record. It means that 28 percent of the adult population is no longer contributing to the wealth of the nation through their labor.

That's a stunning statistic.

Because more than 3 million people turn 65 each year, the number of retired people is increasing steadily. That obviously has an impact on the decreasing labor force participation rate. But it is not the sole reason for this alarming tumble. Young workers continue to enter the labor force each and every month.

The critical numbers are all heading in the wrong direction. To make pretend this isn't so is highly deceptive and unhelpful.

By ignoring all of this, the government can celebrate a falling unemployment rate while millions of Americans continue to suffer. Undoubtedly, job creation is largely a function of the private sector. Most Americans aren't pining for more government jobs just to improve the unemployment rate.

However, if the government was held accountable for the true unemployment rate and the declining labor force participation rate, perhaps it would have to work more closely with the business community to improve conditions for job creation — most especially for the small business community.

Friday, March 01, 2013

When Stimulus Doesn't Stimulate

Since 2009, the U.S. has run an average annual deficit of $1.2 trillion. At the same time, the Federal Reserve has expanded its balance sheet by more than $3 trillion. Yet, the economy has only managed to grow at a subpar rate during that period.

Historically, from 1948 until 2012, the annual GDP growth rate in the U.S. averaged 3.22 percent. However, GDP growth has slowed considerably in the last decade. In fact, the average growth rate has been below 2 percent over the last ten years.

The Fed has even held short term rates at a remarkably low level of between 0% and 0.25% since December 2008 and made the unprecedented promise to keep them that low “at least through late 2014.”

What have we got to show for all of these historic interventions? Not much. The economy continues to limp along like a wounded animal. Though you can't prove a negative, perhaps all of these monumental actions averted a full blown depression.

However, the headwinds acting against the U.S. economy have been gathering strength for many years and our share of the global economy has been continually shrinking.

According to the World Bank, U.S. GDP accounted for 31.8 percent of all global economic activity in 2001. That number dropped to 21.6 percent in 2011. That's not just a decline — it's a freefall.

Despite all of the Fed's extraordinary efforts with monetary policy, and despite Congress' aggressive deficit spending, the U.S. economy still surrendered a huge share of global GDP over the past decade.

It's rather amazing that our economic system has held together so well, particularly over the past five years, in the face of all this thin-air money printing and repeated trillion-dollar deficits.

However, these actions are merely acting like duct tape keeping things together. Money-printing and massive deficit spending only offer a temporary respite; they are not long term solutions. They will just create greater long term crises.

Moreover, by forcing near-zero interest rates upon us, the Fed has forced millions of Americans — including retirees — to make big gambles with their life savings. Low rates have driven many people to buy risky assets in the quest for returns high enough to beat inflation.

After lowering short-term rates to near-zero levels, the Fed has lost one of its primary tools for monetary policy. All it has left is its ability to increase the quantity of money.

At present, the Federal Reserve's quantitative easing program (QE) is the lifeblood of the U.S. economy. Yet, despite all of this unbridled money-printing, the economy still contracted in the fourth quarter. Without QE, the economy would seize up. The Fed's funny money — trillions of dollars created out of thin air — is the only lubricant greasing the wheels this economy right now.

The central bank has been purchasing $85 billion in Treasurys and mortgage bonds each month, and says that it will continue doing so for an indefinite period.

Though the Fed has already expanded its balance sheet by nearly $3 trillion buying Treasurys and mortgage bonds (in an effort to lower long-term interest rates and stimulate the economy), this additional $85 billion per month in bond purchases will result in another trillion-plus dollars of freshly created money flowing into the financial system and equities markets over the course of 2013.

The Fed isn't worried, at this moment, about the trillions of dollars is has been printing because the U.S. economy remains gripped by sluggish growth. Many observers predict that the economy will continue to grow at lackluster 2%, or so. Slow growth usually equals low inflation, which keeps interest rates low.

However, as history shows, all of this unbridled monetary easing eventually leads to a sharp increase in inflation and bond yields. It's just a matter of time.

The Fed is conducting a rather dramatic and desperate experiment right now, hoping it won't backfire and unleash a punishing wave of inflation on the American people. Yet, this unprecedented experiment is already having side effects. Though inflation averaged "just" 2.1% in 2012, which many economists consider mild, at that rate the dollar would lose 21% of its buying power by the end of the decade.

The Fed continues to create oodles of money out of thin air, backed by nothing, without regard to the amount of goods and services in the economy. As history shows, this sort of money/currency inflation ultimately leads to price inflation.

The U.S. monetary base (the supply of money) nearly doubled between 1994 and 2006. But then things got really crazy. It doubled twice more, increasing by an additional 221%, from 2006 to 2011. That can only be described as stunning.

None of this even takes into account the amount of debt the federal government has been incurring as it tries to stimulate demand and fill the void created by a hobbled private sector. The national debt now exceeds $16.6 trillion and will surpass $17 trillion before the year is over.

According to the Bureau of Economic Analysis, U.S. gross domestic product totaled $15.8 trillion in 2012, meaning that our debt is now 105% of our GDP.

The 'Debt Held by the Public', which is all federal debt held by individuals, corporations, state or local governments, foreign governments and other entities outside the United States Government, equals $11.7 trillion at present. That amounts to 74 percent of GDP.

In their book, "This Time It's Different: Eight Centuries of Financial Folly," Carmen Reinhart, a University of Maryland economist, and Harvard professor Kenneth Rogoff find that a 90% ratio of government debt to GDP is a tipping point in economic growth. Beyond that, developed economies have growth rates two percentage points lower, on average, than economies that have not yet crossed the line.

For 800 years "you increase it over and beyond a high threshold, and boom!" write Reinhart and Rogoff.

As their work shows, debt ratios that high cause GDP growth rates to fall. That creates a downward spiral. Slowing growth — or worse, a shrinking economy — only causes debt ratios to increase even further.

Unfortunately, the U.S. has now reached that point of no return.

"Highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked," write Reinhart and Rogoff.

"Sovereign powers saddled with debt loads as large as those of the U.S., Europe, and Japan today are jeopardizing their long-term economic wellbeing."

Since the 2008 financial crash and subsequent Great Recession, the U.S. has added more than $4 trillion in new debt and the Federal Reserve has blown out its balance sheet by more than $3 trillion. Despite these historic and dramatic interventions, the U.S. economy has just muddled along and barely grown.

After contracting in 2009, the U.S. economy expanded 2.8% in 2010, 1.7% in 2011 and 2.2% in 2012. The Congressional Budget Office projects GDP to increase 1.4% this year.

Those weak results are not what one would expect, given all that has been done to bring the economy back to life.

Perhaps the U.S. would still be in the midst of the second Great Depression if not for the massive deficits and money-printing that have ensued. But after all of this spending by Congress, and these stunning monetary interventions by the Fed, it's reasonable to ask:

Is this as good as it gets?