Time to Get Defensive

It will not be surpising to see US equities pullback 2 to 3 percent from here, and then push higher to a new rally high near the end of August. This will help to pull in the public money as the insiders continue to sell, distributing their stock and taking their gains.

But from what we are seeing, September and October look to be particularly 'risky' months this year, and now might be a good time to become more defensive in those accounts that are not agile, like 401k's.

What is 'defensive?' Cash is good, and short term government bonds of less than 2 years duration. No need to get fancy if you are an investor.

This is not a prediction or a recommendation. This is what we are doing for ourselves and some friends.

If the market can hold support through November, then we will reconsider.

The Banks Must Be Restrained and the Financial System Reformed...

As Simon Johnson points out in his essay previously cited here, the reform required to support a sustainable recovery will not happen while the financial oligarchs control the government, the media, and the banks. Ken Rogoff reaches the brink of a similar conclusion.

The lengths and ways to which Americans go to avoid their reality grows increasingly surreal. Most economists and thought leaders prefer to lose themselves in non-controversial details, traditional team politics, and of course the spinning of propaganda in support of their patrons or prospective employers in the think tanks, institutes, and corporate enclaves.

In a way who can blame them? I am finding it increasingly difficult to watch financial television these days, because the speakers are so cruelly deformed, devoid of humanity, pale figures washed in the strident din and flickering torches of a concrete stadium hosting a desperate rally as the night closes in.

Truth is becoming such an increasingly scarce commodity in 'the fog of numbers,' so that one might think that a war is fast approaching.

And so it is, that events may unfold as they have done so many times before. As the ancient maps would say as they marked the boundary of the unknown, "Here there be monsters."

In 1940 the American essayist and poet Archibald Macleish wrote a book titled "The Irresponsibles."

Indeed.

Project Syndicate
The Confidence Game
by Kenneth Rogoff

CAMBRIDGE – Next month marks the one year anniversary of the collapse of the venerable American investment bank, Lehman Brothers. The fall of Lehman marked the onset of a global recession and financial crisis the likes of which the world has not seen since the Great Depression of the 1930’s. After one year, trillions of dollars in public monies, and much soul searching in the world’s policy community, have we learned the right lessons? I fear not.

The overwhelming consensus in the policy community is that if only the government had bailed out Lehman, the whole thing would have been a hiccup and not a heart attack. Famous investors and leading policymakers alike have opined that in our ultra-interconnected global economy, a big financial institution like Lehman can never be allowed to fail. No matter how badly it mismanages its business – Lehman essentially transformed itself into a real estate holding company totally dependent on a continuing US housing bubble – the creditors of a big financial institution should always get repaid. Otherwise, confidence in the system will be undermined, and chaos will break loose.

Having reached the epiphany that financial restructuring must be avoided at all costs, the governments of the world have in turn cast a huge safety net over banks (and whole countries in Eastern Europe), woven from taxpayer dollars.

Unfortunately, the conventional post-mortem on Lehman is wishful thinking. It basically says that no matter how huge the housing bubble, how deep a credit hole the United States (and many other countries) had dug, and how convoluted the global financial system, we could have just grown our way out of trouble. Patch up Lehman, move on, keep drafting off of China’s energy, and nothing bad ever need have happened.

The fact is global imbalances in debt and asset prices had been building up to a crescendo for years, and had reached the point where there was no easy way out. The United States was showing all the warning signs of a deep financial crisis long in advance of Lehman, as Carmen Reinhart and I document in our forthcoming book This Time is Different: Eight Centuries of Financial Folly .

Housing prices had doubled in a short period, spurring American consumers to drop any thought of saving money. Policymakers, including the US Federal Reserve, had simply let the 2000s growth party go on for too long. Drunk with profits, the banking and insurance industry had leveraged itself to the sky. Investment banks had transformed their business in ways their managers and boards clearly did not understand. (And willfully so he should add - Jesse)

It was not just Lehman Brothers. The entire financial system was totally unprepared to deal with the inevitable collapse of the housing and credit bubbles. The system had reached a point where it had to be bailed out and restructured. And there is no realistic political or legal scenario where such a bailout could have been executed without some blood on the streets. Hence, the fall of a large bank or investment bank was inevitable as a catalyst to action.

The problem with letting Lehman go under was not the concept but the execution. The government should have moved in aggressively to cushion the workout of Lehman’s complex derivative book, even if this meant creative legal interpretations or pushing through new laws governing the financial system. Admittedly, it is hard to do these things overnight, but there was plenty of warning. The six months prior to Lehman saw a slow freezing up of global credit and incipient recessions in the US and Europe. Yet little was done to prepare. (Why was nothing done? Why is nothing being done even today to prepare for the next wave of defaults one might ask? - Jesse)

So what is the game plan now? There is talk of regulating the financial sector, but governments are afraid to shake confidence. There is recognition that the housing bubble collapse has to be absorbed, but no stomach for acknowledging the years of slow growth in consumption that this will imply.

There is acknowledgement that the US China trade relationship needs to be rebalanced, but little imagination on how to proceed. Deep down, our leaders and policymakers have convinced themselves that for all its flaws, the old system was better than anything we are going to think of, and that simply restoring confidence will fix everything, at least for as long as they remain in office.

The right lesson from Lehman should be that the global financial system needs major changes in regulation and governance. The current safety net approach may work in the short term but will ultimately lead to ballooning and unsustainable government debts, particularly in the US and Europe.

Asia may be willing to sponsor the west for now, but not in perpetuity. Eventually Asia will find alternatives in part by deepening its own debt markets. Within a few years, western governments will have to sharply raise taxes, inflate, partially default, or some combination of all three. As painful as it may seem, it would be far better to start bringing fundamentals in line now. Restoring confidence has been helpful and important. But ultimately we need a system of global financial regulation and governance that merits our faith.

Remember, Remember, the Twelfth of November (1999)

"On November 12, 1999, President Clinton signed the Gramm-Leach-Bliley Act
(GLB) into law. This landmark legislation does much to unravel the influence of
the Glass-Steagall Act on the United States' financial system. Now banks and
other providers of financial services have far greater freedom to compete
against each other. No doubt, the legislation will prompt an altering of the
financial landscape in this country."

John Krainer, Federal Reserve Bank of San Francisco Economic Review,
2000

Federal Reserve August 12 Statement

The following is the Federal Open Market Committee statement following its August policy meeting:

Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Conditions in financial markets have improved further in recent weeks. Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.

Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability. (So much for the "V" recovery - Jesse)

The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time. (Dream on - Jesse)

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year.

In addition, the Federal Reserve is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.