A. Gary Shilling's: Insight

A.
Gary Shilling s INSIGHT

Economic Research and Investment Strategy Volume XXVIII, Number 10 October 2012
In This Issue
The Grand Disconnect 1 A Grand Disconnect has opened between weakening economies worldwide and optimistic investors, hooked on continuing massive monetary and fiscal stimuli. The U.K. and the eurozone are in recession, the U.S. economy is in or close to decline and a hard landing is unfolding in China. Yet most investors seem totally unconcerned. Instead, many yearn for conditions so troubled that central banks and governments will be spurred to more ease. This risk on attitude and low interest rates also are pushing investors further out the risk spectrum than they realize. Near total reliance on monetary and fiscal stimuli, with little regard for fundamental economic performance, is a new phenomenon. Until quite recently, faith in government action was strong but coupled with the belief it would soon re-establish rapid economic growth. Many hoped for a magic fiscal or monetary bullet. But slow and now faltering global economic growth indicates that huge monetary and fiscal efforts are being more than offset by the gigantic deleveraging in the private sector. To restore normal global growth will simply take time, the five-to-seven years for deleveraging to be completed. With emphasis now on the opiate of government stimuli, more and more is needed to keep investment addicts satisfied. Recent market actions suggest that QE3 is a classic case of buy the rumor, sell the news. This Grand Disconnect is profoundly unhealthy and a reconnection is inevitable. W e see a shock causing financial markets to nosedive and reconnect with faltering global economies. Candidates include the U.S. economy going off the fiscal cliff, the likely hard landing in China, energy price spikes due to Middle East turmoil, S&P 500 operating earnings dropping or the global fallout of a collapsed Euro bank. Investment Themes Summing Up Commentary How To Slash Hospital Waiting Time 22 23 32
The Grand Disconnect

A Grand Disconnect has developed between weak and weakening economies worldwide and optimistic investors, hooked on continuing massive monetary and fiscal stimuli. The U.K. and the eurozone are in recession, the U.S. economy is in or close to decline and a hard landing is unfolding in China. Softness in these three paramount areas is dragging down the rest of the world s economies. So Bad, It s Good Yet most investors seem totally unconcerned over the unfolding global recession. In fact, the globe s economies and financial markets have become so dependent on monetary and fiscal bailouts and investors so enamored by them that they seem to have forgotten the dire circumstances that continue to precipitate these stimuli. Many market participants yearn for conditions that are so troubled that central banks and governments will be spurred to more ease. Oh, goodie, goodie, they seem to say, the economies are so weak that the Fed or the European Central Bank or the Chinese government must act, with positive implications for stocks. Conditions are so bad that it s good for my equity portfolio. On September 7, the U.S. employment numbers for August were announced and they were very weak. Payrolls rose only 96,000 from July, the fourth sub-100,000 rise in the last five months (Chart 1) and far below the 200,000 or so needed to keep up with population growth and potential new job-seekers. July s rise was revised down significantly by 22,000 and June s by 19,000 after a previous reduction of 16,000. Real annual rate GDP growth was also just revised down from 1.7% to 1.3%. Among GDP components, consumer spending on durable and nondurable goods as well as services, investment in structures, equipment and software, exports and imports, and federal defense and nondefense spending were all revised down. The unemployment rate dropped from 8.3% to 8.1% in August, but only because discouraged unemployed people gave up looking for work and dropped out of the labor force. Those leaving the labor force included 195,000 who lost their jobs and 226,000 who were already unemployed. Those not in the labor force
INSIGHT (ISSN 0899-6393) goes to press by the third business day of the month. 2012 A. Gary Shilling & Co., Inc., 500 Morris Avenue, Springfield, NJ 07081-1020. Telephone: 973-467-0070. Fax: 973-467-1943. E-mail: insight@agaryshilling.com. Web: www.agaryshilling.com. President: A. Gary Shilling. Editor: Fred T. Rossi. Research Associates: Colin Hatton and Luke Henninger. All rights reserved. No part of this publication may be reproduced or redistributed without the written permission of A. Gary Shilling & Co. Material contained in this report is based upon information we consider reliable. The accuracy or completeness is not guaranteed and should not be relied upon as such. This is not a solicitation of any order to buy or sell. A. Gary Shilling & Co., Inc., its affiliates or its directors and employees may from time to time have a long or short position in any security, option or futures contract of the issue(s) mentioned in this report.
October 2012 August 2012
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but desiring jobs jumped by 437,000 to 7.0 million, or 2.9% of the population, the highest in this lackluster recovery from the Great Recession. Employment is still 4.7 million below the pre-recession peak. The economic recovery officially began over three years ago in June 2009, and in past upswings, the unemployment rate often rose as rapid job creation attracted many new job-seekers. Interestingly, this time, job openings are rising although still well below prerecession heights (Chart 2). Nevertheless, lack of needed skills, choosy employers in an uncertain world and labor immobility have restrained the growth in new hires. That weak U.S. employment report convinced investors that the Fed would embark on Quantitative Easing 3, as hinted earlier by Chairman Bernanke. And when the Fed announced QE3 on September 13, the S&P 500 climbed 1.6% A Shift of Emphasis
CHART 1 Nonfarm Payroll Employment

monthly change; thousands
Last Point 8/12: 96
600 400 200 0 -200 -400 -600 -800 -1000 2007 2008 2009 2010 2011 2012 600 400 200 0 -200 -400 -600 -800 -1000
Source: Bureau of Labor Statistics
CHART 2 Job Openings and Hires

thousands
Last Points 7/12: hires 4,229; openings 3,664
6000 5500 5000 4500 4000 3500 3000 6000 5500 5000 4500 4000 3500
3000 Near total reliance on monetary and 2500 2500 fiscal stimuli, with little regard for 2000 2000 fundamental economic performance Dec-00 Aug-02 Apr-04 Dec-05 Aug-07 Apr-09 Dec-10 except hoping it s weak enough to spur Hires more government action is a new Job Openings phenomenon. Until quite recently, faith Source: Bureau of Labor Statistics in government action was strong but coupled with the belief it would soon reestablish rapid economic growth. Earlier, in radio, TV and would restore normal global growth, we argued, was time, print interviews on the economies and financial markets the five-to-seven years it would take for deleveraging to be here and abroad, we ve invariably been asked, What completed. monetary or fiscal actions will restore rapid economic growth soon? The belief was that some magic bullet would This search and hope for a magic bullet now seems to be restore growth to the salad days of the 1980s and 1990s. abandoned. Does it mean that many now agree with us that
We always replied that there was no magic bullet. The immense monetary and fiscal stimuli, as measured by the $1 trillion-plus annual federal government deficits and the $3.3 trillion in quantitative easing to date and $1.5 trillion excess bank reserves at the Fed as well as other government actions probably made the economy and financial markets better off than otherwise. Nevertheless, the slow and now faltering global economic growth indicated that these huge efforts were being more than offset by the gigantic deleveraging in the private sector. The only thing that
2 A. Gary Shilling's INSIGHT
there is none? In any event, emphasis is now almost solely on the opiate of government stimuli, and more and more is probably needed to keep investment addicts satisfied. Chronologically, the announcements by the Fed and ECB discussed earlier had less and less effect on the S&P 500. And recent market actions suggest that QE3 is a classic case of buy the rumor, sell the news. But what more can be done? The Fed s QE3 commitment to purchase $40 billion in mortgage-backed securities per month is open-ended, and scheduled to last until the current
October 2012
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8.1% unemployment rate drops to the Fed target range of probably 5% to 6% and job creation is robust. That will probably take a number of years. Meanwhile, excess bank reserves will continue to leap. At the same time, the ECB s purchase of short-term sovereigns from troubled eurozone governments will push up its alreadyexploded assets (Chart 3). Inevitable The Grand Disconnect between slipping global economies and robust equities, driven by never-ending monetary and fiscal stimuli, is profoundly unhealthy and a reconnection is inevitable. Of course, there is that slim, remote, inconsequential, trivial probability that our forecast of deleveraging, of continuing global economic weakness and of recession is dead wrong, and that all the government stimuli and other forces will revive economies enough to justify current investor enthusiasm. We doubt it, however, as a review of the current state of worldwide economic affairs suggests. Sluggish America
CHART 3 Total European Central Bank Assets

billion
Last Point 9/21/12: 3,050
3200 3000 2800 2600 2400 2200 2000 1800 1600 1400 1200 1000 Jan-07 Dec-07 Dec-08 Nov-09 Nov-10 Oct-11 3200 3000 2800 2600 2400 2200 2000 1800 1600 1400 1200 1000
Source: European Central Bank
CHART 4 Inventories-to-Sales Ratio

seasonally-adjusted
Last Points 7/12: mfg. 1.27; retail 1.39; whlsale 1.21
1.65 1.60 1.55 1.50 1.45 1.40 1.35 1.30 1.25 1.20 1.15 1.10 Jan-07 1.65 1.60 1.55 1.50 1.45 1.40 1.35 1.30 1.25 1.20 1.15 1.10
Nov-07 Sep-08 Jul-09 May-10 Mar-11 Jan-12 The U.S. economy is sluggish at best Manufacturing and may already be in recession. We Retail won t know for sure for months, Wholesale quarters, even years from now when all Source: U.S. Department of Commerce the data revisions are in. Even though earlier post-World War II recessions and prices (Chart 5) that commenced in 2006. were much shallower on average than the 2007-2009 slump, their recoveries were decidedly more robust. Many believe housing activity has bottomed, but few think it will revive enough to drive the economy any time soon. As discussed in previous Insights, in the past, four cylinders In contrast, we continue to believe that single-family house fired in the recoveries to get the economic car out of the prices remain vulnerable due to excess vacant units, which recessionary ditch. This time, only one fired. The we number at 1.5 million over and above normal working elimination of excess inventories gave the usual spur to the levels, as detailed in past Insights. economy even before modest rebuilding, as more and
more sales came from new production and less and less from liquidation of old inventories (Chart 4). The second economic spur, housing activity, usually revives robustly, even before recoveries start, as the Fed reverses gears from credit restraint to ease once it sees a recession in clear prospect, and interest rates throughout the spectrum fall. Low rates, however, have not revived housing this time in the wake of the collapse in construction
October 2012
Third, employment normally revives rapidly after recessions, especially those before the 1990-1991 decline when many more were employed in manufacturing and called back to their previous jobs soon after the economic downturn and excess inventory liquidation were over (Chart 6). Globalization and the shift away from manufacturing jobs have tempered employment recoveries since then, but the revival from the Great Recession decline has been very weak in light of the huge drop in jobs, as noted earlier.
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Wages and Incomes American business in the last three years of recovery has had little ability to raise prices, and sales volume growth here and abroad has been minimal. So the route to higher profits has been through cost-cutting, especially labor costs, which are the biggest containable category for most firms. Note the leap in corporate profits share of national income to a postwar record (Chart 7), but as usual, employee compensation s share was the mirror image. Not only has cost-cutting restrained job creation but also wages and salaries. Real wages are moving lower. Real median household income in 2011 was down 9% from its 1999 peak and 8% since the Great Recession started in 2007 as income polarization persists (Chart 8). Indeed, even with declining real wages and median income, consumers are working off their huge debt loads (Chart 9), although a major part of the decline is due to debt charge-offs and writedowns. The household saving rate has been volatile due to the effects of the earlier tax rebates and cuts, but is trending up after falling from 12% in the early 1980s to less than 1% (Chart 10). Young Americans who have seen their parents and other older people in recent years lose their jobs and homes and delay retirement are cutting their spending, increasing saving and preparing for their own retirements. Chronic Saving
70%
CHART 5 Case-Shiller 10-City House Price Index

seasonally-adjusted
Last Point 7/12: 154.9
240 220 200 180 160 140 120 100 80 60 Jan-87 240 220 200 180 160 140 120 100 80 60 Jan-12
Mar-91
May-95
Jul-99
Sep-03
Nov-07
Source: Standard & Poor's
CHART 6 Payroll Employment During Recessions and Recoveries

peak employment month=100
101 100 99 98 97 96 95 94 93 0 10 20 30 40 50 Months from Employment Peak Avg. Recession 1947-82 1990-91 Recession 2001 Recession 2007-09 Recession T 90-91 T 01 T Avg 101 100 99 98 97 96 95 94 93
T 07-09
T=official NBER trough
Source: Bureau of Labor Statistics
CHART 7 Corporate Profits and Employee Compensation

as a % of national income
Last Points 2Q 2012: corp. profits 13.9%; employee comp. 62.1%
15% 14% 13% 12% 64% 11% 62% 10% 60% 58% 56% 1947-I 9% 8% 7% 1959-III 1972-I 1984-III 1997-I 2009-III Compensation of Employees - left axis Corp. Profits with IVA and CCAdj - right axis
As we ve discussed in detail in past Insights, the debt repayment and saving rate rose will probably persist for years. The recent volatility of stocks, with two of only five declines of over 40% since 1900 occurring since 2000 (Chart 11), had destroyed the belief that portfolio gains will make saving from current income unnecessary. Indeed, individual investors continue to withdraw money from U.S. domestic equity funds (Chart 12), even after accounting for the
68% 66%
Source: Bureau of Economic Analysis
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October 2012
51% 50%
Lowest and Second Quintile
counter flows into exchange-traded funds (Chart 13). So far this year, investors have pulled $137 billion from U.S. equity mutual funds but only offset it with $89 billion purchases of ETFs. With home equity withdrawn and falling house prices, home equity of the average mortgagor has dropped from almost 50% of their abode s value in the early 1980s to 20.5% and 24% are under water, with the mortgage principal exceeding the house s value. So this source of funding for oversized spending has evaporated. As covered in our August 2012 Insight, we believe that the earlier mini-U.S. consumer spending splurge in excess of income growth (Chart 14) is over, and that households are beginning to retrench. With no other economic sector able to sustain economic growth, a moderate recession is now under way or about to start. Concrete evidence is found in the three consecutive months April, May and June of declining retail sales (Chart 15), the first decline for three months in a row since OctoberNovember-December 2008 in the midst of the Great Recession. Declines of three or more consecutive months have occurred 29 times since data began in 1947. In 27 of the 29, the economy was in a recession or within three months of its start. A rebound after three months of decline, such as occurred in July and August, is typical and did not reduce the high likelihood of a recession. More Weakness Other indicators of U.S. economic weakness include small business optimism, which remains at recessionary levels and deteriorating big business sentiment. Industrial production also dropped sharply in August, with declines in manufacturing, mining and utilities. Furthermore, new orders for durable goods went off the cliff with a huge 13.2% drop in August from July and 6.7% from August 2011.
October 2012
Highest Quintile
CHART 8 Share of Aggregate Income

by income quintile
Last Points: 2011
52% 12% 11% 24% 10% 9% 8% 20% 7% 6% 5% 16% 4% 3% 14% 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 4th Quintile 5th Quintile (Highest) 18% 22% 26% Third and Fourth Quintile
49% 48% 47% 46% 45% 44% 43% 42%
1st Quintile (lowest) 2nd Quintile 3rd Quintile
Source: Census Bureau
CHART 9 Household Debt (consumer plus mortgage)

as a % of disposable personal income
Last Point 2Q 2012: 108.9%
130% 120% 110% 100% 90% 80% 70% 60% 50% 40% 30% 1952-I 130% 120% 110% 100% 90% 80% 70% 60% 50% 40% 30% 2012-I
1964-I
1976-I
1988-I
2000-I
Source: Federal Reserve
CHART 10
seasonally-adjusted annual rate
Last Point 8/12: 3.7%
16 14 12 10 8 6 4 2 0 Jan-59 16 14 12 10 8 6 4 2 0 Jan-67 Jan-75 Jan-83 Jan-91 Jan-99 Jan-07
U.S. Personal Saving Rate
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Inventories Weakness in durable goods orders will probably be reflected in higher producer inventories, and rising inventories are always linked to economic declines. When orders and sales drop, manufacturers, wholesalers and retailers cannot initially tell whether it s a random fluctuation or the beginning of a significant downturn. So they don t slash their own orders and production quickly and inventories mount. That s already the case with retailers and wholesalers, and will probably back up to manufacturers soon. Getting rid of unwanted inventories constitutes a significant part of the decline in economic activity in recessions. Notice (Chart 16) that in post-World War II recessions, it has accounted for 21.1% of the decline in real GDP in the 1957-1958 recession up to 126.4% in the 1960-1961 slump. Interestingly, there is no clear declining trend despite the fact that services, which by definition are consumed as produced and have no inventory component, are an ever-rising share of GDP while inventory-related goods share falls (Chart 17). The U.S. economy, then, is weakening and may already be in recession. You wouldn t know it, however, from the recent strength in the stock market. QE3 On September 13, the Fed announced QE3. Subsequent reports indicate that it took Chairman Bernanke considerable one-on-one discussions and cajoling to get all but one policymaker to agree to the open-ended purchase of $40 billion of federal agency mortgage-backed securities per month until unemployment rates return to the Fed s range for the normal unemployment rate, 5% to 6.3%. Those policymakers don t see the current 8.1% rate dropping into that range until the end of 2014. By then, the Fed would have bought
CHART 11 S&P 500 Declines Over 40%
Peak Date Peak Level Trough Date Trough Level Sept. 1929 Feb. 1937 Jan. 11, 1973 31.30 18.11 120.24 June 1932 Apr. 1942 Oct. 3, 1974 Oct. 9, 2002 Mar. 9, 2009 4.77 7.84 62.28 776.76 676.53
% Decline 84.8% 56.7% 48.2% 49.1% 56.8%
Mar. 24, 2000 1527.46 Oct. 9, 2007 1565.15
CHART 12 Net Domestic Equity Mutual Fund Flows

monthly; $ billion
Last Point 8/12: -15.5
20 20
10
10
-10 -20
-10 -20
-30 -40
-30 -40
-50 2007 2008 2009 2010 2011 2012
-50
Source: Investment Company Institute
CHART 13 U.S. Domestic Equity Fund Flows

$ millions
2008 2009 2010 2011 Net Mutual Fund Flows -148,195 -28,076 -94,881 -134,418 Net ETF Flows Total 115,696 -248 38,369 47,580
2012* -52,322 22,736 -29,586
-32,499 -28,324 -56,512 -86,838
* through June 2012
Source: Investment Company Institute and ETF Industry Association
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October 2012
around $1,060 billion of these securities issued by Fannie Mae, Freddie Mac and other government-sponsored enterprises, compared with the $1.75 trillion it purchased in QE1 and $850 billion in QE2. Since there were $2,258 billion of these agency securities outstanding as of the second quarter, the Fed would have bought 46% of them by the end of 2014. And the central bank would own them all, a very disruptive prospect for credit markets, if it took another 2.5 years to reach the Fed's unemployment rate target range in mid-2017. In this year so far, the Fed has bought in the open market $360 billion of Treasurys maturing in 7 to 30 years, the equivalent of 65% of the $556 billion gross issuance of such obligations. The prospect that the Fed will own them all if it sticks to its current plan isn t all that far-fetched. As we ve been noting for some months, at the rate that private sector deleveraging is taking place (Chart 18), it will take another five to seven years to return to norm in 2017 to 2019. Chronic Unemployment The deleveraging started with the financial crisis in 2008, so now we re almost five years into it. Another five to seven years would total about a decade, the normal length of recovery after a major financial crisis, according to Carmen Reinhardt and Kenneth Rogoff s book, This Time Is Different: Eight Centuries of Financial Folly. Meanwhile, our forecast of a continuation of about 2% annual average real GDP growth implies high and rising unemployment rates. Chart 19 shows the trade-off in the postWorld War II era between the yearover-year change in real GDP by quarters and the year-over-year change in the unemployment rate. Obviously, all the data points don t lie on our fitted curve but the fit is good, as indicated by the 0.69 R2. Reading off
October 2012
CHART 14 Personal Consumption and Disposable Personal Income

June 2009=100
Last Points 8/12: PCE 113.8; DPI 111.5
114 112 110 108 106 104 102 100 98 96 94 Jan-07 114 112 110 108 106 104 102 100 98 96 94 Nov-07 Sep-08 Jul-09 May-10 Mar-11 Jan-12
Personal Consumption Expenditures Disposable Personal Income
CHART 15
month/month % change; seasonally-adjusted annual rate
Last Points 8/12: total 11.2%; ex autos 9.9%
20% 20%
Retail Sales
15%
15%
10%
10%
5%
5%
0%
0%
-5%
-5%
-10% Aug-10
-10% Jan-11 Jul-11 Jan-12 Jul-12
Total Retail and Food Service Sales Retail and Food Service Sales ex. Autos
Source: Census Bureau
CHART 16 Inventories In Recessions
Recession 1948-1949 1953-1954 1957-1958 1960-1961 1969-1970 1973-1975 1980 1981-1982 1990-1991 2001 2007-2009
Real GDP Peak-to-Trough Decline % Due to Inventories -1.8% 112.5% -2.6% 29.8% -3.7% 21.1% -1.6% 126.4% -0.6% 115.7% -3.2% 45.8% -2.2% 47.2% -2.7% 31.2% -1.4% 49.2% -0.3% 64.2% -4.7% 31.7%
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the curve, a 2% real GDP growth implies a chronic rise in the unemployment rate by a bit over one percentage point per year. In other words, the current 8.1% rate would rise to 9.1% in August 2013, to 10.2% in August 2014, to 11.3% in August 2015, etc. Obviously, no government, left, right or center, can tolerate high and chronically rising unemployment, so continuing slow growth will continue to pressure Washington for job creation with the resulting high federal deficits. In any event, our forecast of persistently slow economic growth and high unemployment indicates that the Fed could end up owning all the outstanding agency securities and then some, if it sticks to its plan, a highly unlikely outcome. So QE3 isn t really openended, with our forecast. With its September 13 QE3 announcement, the Fed also said it would continue through year s end Operation Twist, its program of buying long-term Treasurys while selling shortterm government securities. It will also continue to reinvest its maturing mortgage-related securities, so its total holding of long-term securities will rise about $85 billion per month through year s end. Furthermore, the policy committee extended its 0-0.25% range for the short-term federal funds rate it controls by six months, at least through mid-2015. Why? Why did Bernanke push through QE3? Sure, the Fed has a dual mandate to promote full employment as well as price stability, but QE3 on top of Operation Twist, QE2 and QE1 and all the Wall Street rescue measures the Fed took in 2008 have pushed the central bank deep into the realm of fiscal policy, compromising its fiercelydefended independence. Also, the openended and unprecedented nature of QE3 might suggest that Bernanke has lost control.
CHART 17 Goods and Services

as a share of GDP
Last Points 2Q 2012: goods 28.2%; services 64.7%
70% 65% 60% 55% 50% 45% 40% 35% 30% 25% 1947 70% 65% 60% 55% 50% 45% 40% 35% 30% 25% 1959 Goods Services 1971 1983 1995 2007
CHART 18 Ratio of Sector Cumulative Debt and Equity Issuance to GDP

Last Points: 2Q 2012
140% 140%
120%
120%
100% 80%
100% 80%
60%
60%
40% 20%
40% 20%
0% 1952
1958
1964
1970
1976
1982
1988
1994
2000
2006
0% 2012
Nonfinancial Corporate Household State and Local
Federal Government Financial
CHART 19 Year/Year Change in Unemployment Rate as a Function of the Year/Year Change in Real GDP
1Q 1949-2Q 2012
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October 2012
Furthermore, the effectiveness of previous quantitative easing is questionable, so why do more? Despite the $3.3 trillion of long-term securities the Fed has bought so far, economic growth is marginal at best and unemployment remains very high. Of course, we ll never know what would have happened otherwise. An old history professor of ours used to say that there are no ifs in history. History isn t a controlled experiment where you can change one baffle in the maze, run the rats through again and see which way they turn this time. In his August 31 Jackson Hole speech, made before the September 13 QE 3 announcement, Bernanke defended the Fed s aggressive policy. He stated the asset purchases so far reduced the yield on 10-year Treasury notes by 0.8% to 1.2% and said, These effects are economically meaningful. He also noted the rise in stocks during those quantitative easings (Chart 20). And Bernanke said that a Fed study that found that QE1 and QE2 had raised output by 3% and increased private payrolls by 2 million from what would have occurred otherwise while mitigating deflationary risks. Well, maybe so, but what we know for certain is that the Fed s asset purchases have had limited effect on the normal financing process. Sure, when the Fed buys Treasurys or mortgage-backed securities, the seller has the resulting money to spend or invest elsewhere. Meanwhile, he deposits the funds in a bank, which increases the bank s reserves at the Fed. In normal times, these funds are lent and re-lent by banks in the fractional reserve system, and the net result is that every dollar of reserves turns into about $70 of M2 money supply. But currently, banks are reluctant to lend except to the most creditworthy borrowers who aren t much interested in borrowing, despite negative real interest rates (Chart 21). So, since August 2008, before quantitative easing
October 2012
CHART 20 S&P 500 and Quantitative Easing

Last Point 10/3/12: 1,451
1600 1500 1400 1300 1200 1100 1000 900 800 700 600 Jan-07
QE1 +42% QE2 +24%
Greece 1 Euro Crisis /Fiscal Cliff Greece 2 / Fed. Debt Ceiling
1600 1500 1400

QE3
1300 1200
Op. Twist +20%
1100 1000 900 800 700 600
Oct-07
Aug-08
May-09
Mar-10
Dec-10
Oct-11
Jul-12
Source: Thomson Reuters and A. Gary Shilling & Co.
CHART 21 Real and Nominal Federal Funds Target Rate

Last Points: nominal 10/3/12 0.125%; real 8/31/12 -1.45%
6% 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% Jan-07 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% May-08 Nominal Target Rate Real (Nominal less yr/yr change in CPI) Target Rate Sep-09 Feb-11 Jun-12
Source: Federal Reserve, Bureau of Labor Statistics and A. Gary Shilling & Co.
CHART 22 M2 Money Supply and Total Bank Reserves

$ billion; seasonally-adjusted
Reserves 97.5 1626.5 1529.0
10500
M2
1800 1600 1400 1200
10000
Aug. 08 Aug. 12
7743 10058 2315
9500 9000
Difference
1000 800 600
8500 8000
400 7500 7000 Jan-07 200 0 Nov-07 Sep-08 Jul-09 May-10 Mar-11 Jan-12
M2 Money Supply - Left Axis St. Louis Adjusted Reserves - Right Axis
Source: St. Louis Federal Reserve
Telephone: 973-467-0070
but when the Fed started to expand bank reserves, they ve risen $1.5 trillion while M2 has increased $2.3 trillion (Chart 22). That s a 1.5 multiplier, far below the normal 70. Another way of looking at this is to note the piling up of excess reserves, the difference between total and required bank reserves at the Fed, which now total about $1.5 trillion. Credibility And Withdrawal Another issue that might have given Bernanke pause in pursuing QE3 is strains on the Fed s credibility. In his Jackson Hole speech, he said a potential cost of additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed s ability to exit smoothly from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might increase the risk of a costly unanchoring of inflation expectations, leading in turn to financial and economic instability. This strikes us as a serious threat. Bernanke has stated that the Fed could easily get rid of excess reserves by agreeing, in a 15-minute policy committee phone call, to sell securities from its vast $2.8 trillion portfolio. But let s put the economy five to seven years down the road when deleveraging is completed and real growth moves from about 2% per year to its long-run trend of 3.0% to 3.5%. Even then, it would take at least several years to utilize excess capacity and labor, as indicated by the Commerce Department s output gap (Chart 23). This gap is calculated from the difference between current real GDP growth and growth potential of the economy, as estimated by Department economists. In any event, when Wall Street gets the slightest hint that the Fed is thinking about removing the excess liquidity, interest rates will leap and the danger of an economic relapse will seem very real.
CHART 23
as a share of potential GDP
Last Point 2Q 2012: -6.01%
8% 6% 4% 2% 0% -2% -4% -6% -8% -10% 1949-I 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% 1961-I 1973-I 1985-I 1997-I 2009-I
Output Gap
CHART 24 10- and 30-Year Treasury Bonds

Last Points 10/3/12: 10-yr. 1.62%; 30-yr. 2.82%
5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% Jan-07 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% Oct-07 Jul-08 May-09 Mar-10 Dec-10 Sep-11 Jul-12
10-Year Treasury Yield 30-Year Treasury Yield
Source: Thomson Reuters
CHART 25 Spanish and Italian 10-Year Government Bond Yields

Last Points 10/3/12: Spain 5.806%; Italy 5.099%
8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 Jan-07 8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 Oct-07 Spain Italy Jul-08 Apr-09 Jan-10 Nov-10 Aug-11 May-12
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October 2012
Political pressure on the Fed might be intense, charging it with taking away the punch bowl before the party even gets started. Echoes of 1937-1938?
CHART 26 Reuters/Jefferies Commodity Research Bureau Index

Last Point 10/4/12: 306.6
500 450 400 500 450 400 350 300 250 200 150 100 Jan-08 Jan-10 Jan-12
No doubt, historians in the crowd would 350 recall the 1937-1938 recession. It s 300 hard to believe, but in 1936, with the economy a long way from full recovery 250 after the 1929-1933 collapse and 200 deflation sill prevailing, the Fed and 150 FDR worried about a return of rapid inflation. So they tightened monetary 100 and fiscal policy. Real GNP dropped Jan-00 Jan-02 Jan-04 Jan-06 11.4% in what was dubbed the Roosevelt Source: Jefferies Depression, less than the 36.2% fall in the Great Depression but more than twice as much as the 4.7% decline in GDP in the recent Great Recession. remain negative. Maintaining credibility in the Fed is obviously paramount for a number of reasons. For one, it allows the Fed to buy huge quantities of Treasurys without being accused of financing the Treasury deficit, even if indirectly. In the October 2010-September 2011 fiscal year, the Fed bought Treasurys equal to 77% of all those issued by the Treasury, and in this year to date, $360 billion of Treasurys maturing in 7 to 30 years, the equivalent of 65% of the $556 billion gross issuance. Still, these indirect purchases are quite different than buying them directly since the sales by the Treasury and the purchases by the Fed are both conducted in open markets where investors price credibility. So far, faith in the Fed and the Treasury has not prevented Treasury yields from declining substantially (Chart 24). In Europe, the ECB has bought the sovereign debts of troubled countries and plans to buy more, as discussed earlier. Still, the credibility of Spain and Italy is so low that their yields have leaped (Chart 25). Financial credibility was also a very serious problem for the German Weimar republic where the central bank bragged that its prized possessions were two of the world s fastest currency printing presses! The Fed s Objectives Obviously, Bernanke & Co. felt that all these negatives will be more than offset by the positives of QE3. By buying mortgage-related securities, they hope to further drive down mortgage rates to encourage refinancing and induce home buying. But mortgage rates, along with other interest rates, have already declined tremendously without obvious significant impacts on housing activity. Many other factors
October 2012
and Co.
Lending standards have gone from almost nonexistent to stringent in the last few years, and many lack the nownecessary credit scores and downpayments. The unemployed and those whose jobs are in jeopardy clearly are out of the home-buying picture, regardless of mortgage rate levels. So too are those who are underwater on their mortgages. And the desirability of homeownership has reversed for many who now realize, for the first time since the 1930s, that house prices can and do fall. Bernanke also hopes that those who sell mortgage-backed securities to the Fed under QE3 will use the proceeds to buy real estate, stocks and other financial investments, pushing up their prices. This will make them feel wealthier so households and businesses will spend, invest and hire more people. This is a Main Street policy, he said after the Fed s September policy meeting. What we are about here is trying to get jobs going. But note that in the sequence we just described, there are five steps between the Fed s purchase of securities and job creation, and one or more may fail to be taken. We believe this was largely true with earlier quantitative easing, despite Bernanke s model results. Stocks rose for a while in each instance. So did commodities (Chart 26). But higher gasoline and grocery costs squeezed consumer purchasing power, and employment gains remain subdued. Higher food and energy costs hurt the poor the most, ironically, folks that the Fed and the Administration care about. In 2010, the latest data, the bottom fifth of households by income devoted 27% of the spending on food and energy with the top fifth spent only 18%.
Telephone: 973-467-0070
11
Homeowner Effects Homebuyers certainly did not show the enthusiastic response to earlier quantitative easing that stockholders did, as shown by comparing the two price responses. This is significant since households with large stock portfolios tend to have higher incomes, and their spending is not affected significantly by portfolio value fluctuations. Chart 27 shows the concentration of stock ownership among high-income households. Those in the top 10% by income have average stock portfolios that were 52 times the equity ownerships of the bottom 20% in 2010, the latest data. In the top 20% of households by income, 87% own stocks. In contrast, lower-income households are much more likely to spend more if the value of their assets roses, but only 13% of the bottom fifth by income own stocks. Nevertheless, 37% of the lowest fifth owned their abodes, and homeownership is much more evenly distributed by income group (Chart 28). The average home value of the top 10% was only 5.3 times that of the lowest 20% in 2010. Some 69% of households owned homes compared to 50% that owned stocks, and the median value of homes was $170,000 compared to $29,000 median stockholding.
CHART 27 Median Value of Direct and Indirect* Stock Holdings

by income class; thousands of dollars
All families percent of income Less than 20 20-39.9 40-59.9 60-79.9 80-89.9 90-100
1998 25.0 5.0 9.5 12.0 19.0 45.1 135.0
2001 35.0 7.0 9.0 15.0 31.0 64.9 250.0
2004 32.9 8.0 9.6 15.0 26.5 56.0 202.4
2007 34.0 6.0 8.1 18.0 33.0 64.2 221.0
2010 29.0 5.1 7.3 12.0 21.3 58.4 266.5
* indirect holdings are mutual funds, retirement accounts and other marginal assets Source: Federal Reserve Survey of Consumer Finance
CHART 28
by income class; thousands of dollars
Median Value of Primary residence
All families percent of income Less than 20 20-39.9 40-59.9 60-79.9 80-89.9 90-100
1998 115.8 63.8 86.9 98.5 127.4 158.7 260.7
2001 131.0 69.2 85.2 101.2 138.5 186.4 319.5
2004 175.7 76.9 109.8 148.3 192.2 247.1 494.2
2007 200.0 100.0 120.0 150.0 215.0 300.0 500.0
2010 170.0 89.0 110.0 135.0 175.0 250.0 475.0
In any event, the relationship of real wealth on consumer spending is weak with a correlation of only 57% going back to 1952. The relationship to after-tax income is much stronger, 75%, but with corporate cost-cutting and the limping economy, growth in disposable (after-tax) income has been minimal of late. So if government policy intends to encourage household spending by spurring their asset values, it s much more effective to push up house prices than equity values. The problem for the Fed in doing so is that monetary policy is a very blunt instrument. The central bank can only move interest rates up or down and buy or sell Treasury and federal agency securities. It s up to the markets to determine any follow-on effects on other asset purchase spending effects, etc. Sure, QE3 does involve home mortgage security purchases, but that s as specific as the Fed can get and, as noted earlier, the effects of previous
Source: Federal Reserve Survey of Consumer Finance
buying of mortgage-related securities on housing activity have been limited. Focused Fiscal Policy In contrast, fiscal policy can be very focused. If Congress and the Administration want to help the unemployed, they can increase unemployment benefit payments and extend the time over which they can be received. But at present, fiscal policy is on hold, given the huge size of ongoing federal deficits, political gridlock in Washington and the upcoming November election. This is likely another reason the Fed adopted QE3 the pressure to do something in Washington amidst a faltering economy. The Fed at present is the only game in town, and it probably wants to demonstrate that it feels the country s
October 2012
Telephone: 973-467-0070
pain and is not hiding in its marble headquarters in Washington. Furthermore, unlike a number of us, Bernanke does not believe that the Great Recession left many unemployed who lack the skills needed for available jobs the structurally-unemployed carpenters and plumbers laid off when residential construction collapsed who can t easily shift to software engineering. In his Jackson Hole speech, Bernanke said, Although the recent recession was usually deep, I see little evidence of substantial structural changes in [unemployment] in recent years. So, as far as he s concerned, all that s needed to eliminate excess joblessness is more aggregated demand, not massive retraining for those who are retrainable. Plosser Agrees
10%
3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% Jan-03
CHART 29 10-Year Treasury - TIPS Spread and Yield

Last Points 10/3/12: 2.47; yield -0.83
3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% Jan-05 Jan-07 Dec-08 Dec-10
10 Year Treasury - TIPS Spread 10 Year TIPS Yield
CHART 30 Japanese Real and Nominal Overnight Rates

Last Points 8/12: real 0.6%; nominal 0.1%
10%
Federal Reserve Bank of Philadelphia 8% 8% President Charles Plosser agrees with us 6% 6% on the ineffectiveness of QE3 in reducing unemployment. He stated in 4% 4% a September 25 speech: We are unlikely 2% 2% to see much benefit to growth or to employment from further asset 0% 0% purchases. Conveying the idea that -2% -2% such action will have a substantive impact -4% -4% on labor markets and the speed of the Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 recovery risks the Fed s credibility . I Nominal Overnight Rate opposed the [policy] Committee s Real Overnight Rate (nominal rate less yr/yr change in CPI) actions in September because I believe Source: Bank of Japan that increasing monetary policy accommodation is neither appropriate nor likely to be effective in the current environment. Every Inflation has remained near the [policy] Committee s 2% monetary policy action has costs and benefits, and my objective and inflation expectations have remained stable. assessment is that the potential costs and risks associated Indeed, the spread between the yield on 10-year Treasury with these actions outweigh the potential meager benefits. Inflation-Protected Securities and 10-year Treasury notes After the speech, he told reporters, It doesn t make sense to say that there is a particular unemployment rate that we can achieve. The problem with the labor market is there are many things that affect employment and unemployment that are beyond the control of the Fed such as technology, education attainment and tax rates. Bernanke also pursued QE3 because he sees little evidence of inflation, and indeed, the Fed s favorite measure, the consumer expenditures deflator excluding food and energy, rose 1.6% in August from a year earlier, below the Fed s target of 2.0%. In his Jackson Hole speech, he noted,
October 2012
(Chart 29) suggests that investors aren't worried about serious inflation in the next decade. Deflation Fears Indeed, the Fed is much more worried about deflation than inflation, and in his Jackson Hole speech, Bernanke said that central bank security purchases were mitigating deflationary risks, as quoted earlier. In deflation, even zero nominal interest rates are positive in real terms, as seen repeatedly in Japan (Chart 30). To create negative real rates, as at present (Chart 31), the Fed during deflation can t reduce the fed funds rate below zero although recently,
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short-term Treasury (Chart 32), German and Danish government security yields have dropped into negative territory. Investors were so zealous to hold them that they were willing to pay for the privilege. In any event, in time of economic weakness, the Fed wants negative real rates, as at present, to encourage borrowers to borrow. In inflation-adjusted terms, lenders are paying borrowers to take the filthy lucre away. Furthermore, in deflation, the fed funds rate is likely to remain close to zero, as at present. But the Fed would like it to be far enough in positive territory that it can cut it significantly in future times of economic weakness in order to stimulate the economy. Finally, the Fed fears that deflation, if it becomes chronic as we continue to forecast, will spawn deflationary expectations. Declining prices will encourage buyers to wait for still-lower prices. Their restraint sires excess inventories and unutilized capacity, which pushes prices lower. That confirms expectations and convinces prospective purchasers to wait for stilllower prices. A self-feeding, downward spiral of prices and economic activity results. Interestingly, this has not occurred in Japan during its two-decade-long deflationary depression. Even though consumer prices have been falling more often than rising since 1990 (Chart 33), deflationary expectations have not developed. Of course, the Japanese culture does differ from the American, so the Fed s worry over deflationary expectations may be valid. Help The Treasury It s interesting that some observers believe the Fed wants inflation and negative real rates to reduce the burden of the Treasury s huge debt (Chart 34) by paying its holders negative real returns. This is called financial repression. We doubt this sinister
CHART 31
effective fed funds - year/year change in CPI
Last Point 8/12: -1.57%
10% 8% 6% 4% 2% 0% -2% -4% -6% Jan-55 10% 8% 6% 4% 2% 0% -2% -4% -6% May-63 Sep-71 Jan-80 May-88 Sep-96 Jan-05
Real Effective Federal Funds Rate
Source: Federal Reserve and Bureau of Labor Statistics
CHART 32 U.S. 1-Month Treasury Bill Yield

Last Point 10/3/12: 0.09%
0.18% 0.16% 0.14% 0.12% 0.10% 0.08% 0.06% 0.04% 0.02% 0.00% -0.02% Jan-11 Mar-11May-11Aug-11 Oct-11 Dec-11 Mar-12May-12Aug-12 0.18% 0.16% 0.14% 0.12% 0.10% 0.08% 0.06% 0.04% 0.02% 0.00% -0.02%
CHART 33 Japanese Money Supply and Prices

year/year % change
Last Points 8/12: CPI -0.5%; M2 2.4%
14% 12% 10% 8% 6% 4% 2% 0% -2% -4% Jan-90 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11
Yr/Yr Change in CPI Yr/Yr Change in M2 Money Supply
Source: Bank of Japan and Statistics Bureau of Japan
Telephone: 973-467-0070
October 2012
motivation on the part of the Fed, and put the financial repression notion in the same area of those who believe the Fed is hyping its balance sheet and bank reserves to generate serious inflation in order to slash the real value of federal debt, again at the expense of government security owners. Distortions Although we don t see sinister motives on the part of the Fed, that doesn t mean its actions haven t had distorting effects on the economy. Near-zero interest rates have created an unusual array of winners and losers. At a zero federal funds rate, the Fed can t cut it further in reaction to economic weakness. If deflation unfolds, it can t push real rates negative in order to stimulate borrowing. Furthermore, the lack of response to near-zero interest rates by lenders and borrowers is what pushed the Fed, and earlier the Bank of Japan, into the new world of quantitative easing. This and other non-interest rate actions taken previously also has pushed the Fed uncomfortably close to fiscal policy and threatened its independence, as noted earlier.
CHART 34 Net Federal Debt Outstanding

as a % of GDP
Last Point 2011: 67.7%
110% 100% 90% 80% 70% 60% 50% 40% 30% 20% 1945 110% 100% 90% 80% 70% 60% 50% 40% 30% 20% 1955 1965 1975 1985 1995 2005
Source: Office of Management and Budget
CHART 35 Federal Government Net Interest Payments

Last Points 2011: interest/GDP 1.54%; interest/expenditures 6.38%
3.5% 16%
3.0%
14%
12% 2.5% 10% 2.0% 8% 1.5%
6%
1.0% 1948
4% 1958 1968 1978 1988 1998 2008
Net Interest / GDP - left axis
As discussed earlier, we doubt that the Fed in any way acted to ease the problems of the federal debt and deficit. Nevertheless, low interest rates do keep the cost of financing the debt low (Chart 35), even as it leaps. We wouldn t suggest, of course, that these low financing costs encourage Congress and the Administration to delay dealing with the mushrooming federal debt. Regardless, after deducting its own operating expenses, the Fed returns the interest it receives on the holding of Treasurys and agency securities to the Treasury, helping to offset the deficit. Bernanke noted in a recent speech that, in the past three years, the Fed has remitted $200 billion to the Treasury. Central banking is a neat game. The Fed creates money out of thin air, uses it to buy securities and then sends the interest, after expenses, back to the government. Can we get in on it? Central bank rates close to zero also promoted the strange phenomenon of negative returns on short-term government
October 2012
Net Interest / Federal Govt Expenditures - right axis
* net interest = interest payments to debt held by the public Source: Office of Management and Budget
securities, as discussed earlier. Then there is the recent negative 0.75% yield on 10-year TIPS. Of course, TIPS returns are adjusted for inflation. If annual inflation over the next decade turns out to be 2.5%, as forecast by the spread between 10-year TIPS and 10-year Treasury notes, the return on the TIPS would be just a bit below 2.5% annually. Borrower Beneficiaries The federal government, of course, isn t the only borrower benefiting from low interest costs and negative real rates. Residential mortgagors, if they can qualify for loans, obviously are getting a break with 30-year rates at 3.4%. Investment-grade corporations have been able to issue debt and refinance at low rates, and many are doing so. In July, $75 billion were issued, a record for any July, at 3.2%
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average yields, a record low and compared with an average 7.2% over the last 30 days. In the third quarter as a whole, $257 billion were issued, 64% more than a year earlier. To be sure, low corporate bond yields are partly due to individual investors disdain for stocks and love of bonds, and investment-grade corporates also have safe haven appeal. Low interest costs as well as its tax deductibility make it attractive to issue bonds instead of equity. Some entities are issuing century bonds. Last year, MIT, Norfolk Southern, Berkshire Hathaway, P&G, Robobank Nederland, Coca-Cola and Motorola all locked up borrowing that doesn t mature for 100 years. In August 2011, the University of Southern California issued $300 million in century bonds with a 5.25% coupon yield, compared with 3.4% yield at the time on much shorter 30-year Treasurys. The relatively small premium for another 70 years suggests that buyers of that issue agree with us in not fearing inflation for many years. Another winner from low interest rates, and especially QE3, is agency securities. On the day QE3 was announced, September 13, Fannie Mae mortgagebacked securities with a 3% interest rate coupon jumped 1-10/32 points, outperforming the 10-year Treasury note by 1-4/36 points. Normally, the performance difference in a trading day is less than 5/32 point. The Fed s $40 billion per month purchase of agency debt under QE3 is the equivalent of a major part of the normal $140 billion monthly issuance. Dividends Dividend-paying stocks have also benefited from low interest rates, despite average yields over S&P 500 stocks of only 2.1% (Chart 36). Furthermore, the collapse in stocks in 2008 and the fact that the S&P 500 index showed zero net gain from 1998 through 2011 and no gain in 2011 alone have steered many institutional and individual investors to
CHART 36 S&P 500 Dividend Yield and Payout Ratio

1947 to present
Last Points 2Q 2012: payout ratio 31.7%; dividend yield 2.08%
100% 90% 80% 70% 5% 60% 4% 50% 40% 30% 20% 1947Q1 3% 8% 7%
6%
2%
1% 1957Q1 1967Q1 1977Q1 1987Q1 1997Q1 2007Q1
Dividend Payout Ratio - left axis Dividend Yield - right axis
Source: Standard & Poor's
CHART 37 Six-Month CD and Money Market Fund Yields

Last Points 10/3/12: money market 0.06%; CD 0.35%
6% 6%
5%
5%
4%
4%
3%
3%
2%
2%
1%
1%
0% Oct-06
0% Jul-07 May-08 Mar-09 Dec-09 Oct-10 Jul-11 May-12 Avg. 7 Day Annual Yield on Money Market Funds Annual Yield on Six-Month Certificate of Deposits
Source: Crane Data, Bloomberg and Federal Reserve
CHART 38 Minimum Balance Required to Avoid a Fee

non-interest checking
Last Point 2012: $723
$800 $700 $600 $500 $400 $300 $200 $100 $0 2007 2008 2009 2010 2011 2012 $800 $700 $600 $500 $400 $300 $200 $100 $0
Source: Bankrate
Telephone: 973-467-0070
October 2012
stocks that pay high, sustainable and increasing dividends as well as to bonds. They want income here and now as opposed to pie-in-the-sky capital appreciation out in the wild blue yonder. Investors are putting increasing pressure on corporate managements to pay dividends, and in August, S&P 500 companies paid out a record $34 billion. This pressure is also reflected in stock buybacks. Although they aren t always completed since 1985, 25% weren t the times of actual purchases is uncertain and buybacks sometimes simply offset new issuances to employees, S&P 500 companies have announced $429 billion in equity buybacks for 2012, down, however, from $555 billion last year. Companies such as Microsoft and WalMart that no longer have growth stock images are under heavy pressure to pay dividends. Wal-Mart s dividends have risen 5.3 times in the past decade and the dividend yield is now an average 2.1% while the stock price has only risen 50% in that time.
CHART 39 Total Money Market Fund Assets

$ trillion
Last Point 9/20/12: 2.58
4.0 3.8 3.6 3.4 3.2 3.0 2.8 2.6 2.4 Jan-08 4.0 3.8 3.6 3.4 3.2 3.0 2.8 2.6 2.4 Dec-08 Dec-09 Nov-10 Nov-11
Source: Investment Company Institute
CHART 40 M2 Money Velocity and FDIC-Insured Deposits

Last Points 2Q 2012: deposits 8.4%; velocity 1.58
25% 1.5
20%
1.6
1.7 15% 1.8 10% 1.9 5% 2.0
Interestingly, the total return on dividend0% 2.1 paying stocks beat nonpayers in every -5% 2.2 year since 2000 except 2003 and 2009. Mar-86 Mar-91 Mar-96 Mar-01 Mar-06 Mar-11 If $10,000 had been invested in FDIC Insured Deposits (year/year % change) - left axis nondividend-paying stocks in 1979, it M2 Velocity of Money - right axis (inverted) would have been worth $250,000 in Source: FDIC and St. Louis Federal Reserve 2010, but the same amount in dividendpayers would have risen to $413,000. and thrifts, facing low interest earnings, have increased the Part of this superior result, of course, is the compounding size of the required balance on checking accounts that pay of re-invested dividends. no interest to $723, on average, up 23% in the last year (Chart 38). The average fee on non-interest checking The Losers accounts jumped 25% to $5.48 per month, also a record. The percentage of non-interest checking accounts that are It amazes us that in his Jackson Hole speech, and elsewhere free of charges dropped form 76% in 2009 to 45% in 2011 as far as we know, Chairman Bernanke emphasized the to 39% today. Banks are also reacting to new federal beneficiaries of low interest rates but never even mentioned restrictions on debit card and overdraft charges and fees the losers. Neither, to our knowledge, have any key that will reduce their annual revenues by $10 billion. On Administration official or member of Congress. But nearcorporate cash deposits over $50 million, Bank of New zero interest rates are causing considerable distortions and York Mellon began charging a fee in August 2011. outright harm to many. Think about savers who are receiving trivial returns on their bank and money market accounts (Chart 37) that would be negative if fund managers weren t waiving fees. Furthermore, free checking accounts are fading. Banks
October 2012
Furthermore, many savers are deserting money market funds (Chart 39) for the safety of FDIC-insured accounts (Chart 40). This chart also has M2 velocity of money, the ratio of M2 to GDP in inverted form to show that the
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money is just sitting in accounts, despite next to no returns in nominal terms and distinctly negative returns in real terms. In Europe, the ECB in July announced that it would cut its deposit rate for banks to zero and benchmark lending rate to 0.75% (Chart 41). With rates this low, managers of money market funds totaling $60 billion have closed their funds to new investors. Many were already offering returns well under 1%. Will Americans be discouraged by low interest rate returns and save less, or save more to reach lifetime goals? We believe the latter, which is one more reason why we expect the household saving rate to climb back to double digits. At the same time, low interest returns in conjunction with volatile stocks and huge losses on owneroccupied houses are forcing many vastly-undersaved postwar babies to work well beyond their expected retirements. Sure, better health for seniors and increasing life spans are also factors, but the percentages of men and women over 65 and in the labor force are rising rapidly (Chart 42). And as seniors retain their jobs, there are fewer openings for younger people and less advancement for those in between.
CHART 41 Central Bank Rates

Last Points: 10/3/12
6% 6%
5%
5%
4%
4%
3%
3%
2%
2%
1%
1%
0% Jan-07
0% May-08 Sep-09 Feb-11 Jul-12
U.S. Fed. Funds Target Rate ECB Repo Rate
UK Bank Rate BOJ Call Rate
Source: The central banks
CHART 42 Labor Force Participation Rate for People Over 65

seasonally-adjusted
Last Points 8/12: male 23.2%; female 14.6%
50% 45% 40% 35% 11% 30% 10% 25% 9% 20% 15% 10% Jan-48 8% 7% 6% May-56 Sep-64 Jan-73 May-81 Sep-89 Jan-98 May-06 15% 14% 13% 12%
With the Fed now intending to keep Female - right axis short-term interest rates near zero Source: Bureau of Labor Statistics through 2015, and probably longer as deleveraging keeps the economy financial institutions leveraged themselves up dramatically subdued and unemployment high, what can savers do? as they moved beyond traditional bank spread lending to all Hope for the arrival of deflation, which will push real sorts of exotic and highly profitable activities, including interest rates from negative to positive? special investment vehicles and other off-balance sheet investments, securitization of subprime mortgages, Squeezed Banks proprietary trading and exotic derivatives. But the financial crisis to which these activities contributed immensely has Despite these efforts to increase fees, banks are also resulted in rigorous enforcement of previously looselysuffering from near-zero interest rates. That s even though pursued regulation; new rules, principally the Dodd-Frank they are paying next to nothing on deposits, which continue law that proscribed proprietary trading and other activities; to jump as savers stampede for liquidity and safety. One stockholder pressure to reduce risks; and bank CEO firings serious problem is the relatively flat yield curve, anchored and embarrassments for current financial institution by zero federal funds rates on the short end and pushed managements. Banks are being busted back to less-risky, down for longer maturities, where banks normally lend, by normally low-profit spread lending. declining Treasury yields. This pressure on spread lending couldn t come at a worse time for banks. Starting in the 1970s, banks and other
Male - left axis
Bank yields on assets are in a distinctly downward trend (Chart 43), which will no doubt persist as the Fed continues to keep short rates at zero. U.S. banks also have considerable
October 2012
Telephone: 973-467-0070
exposure to the sovereign debt troubles in Europe. Of their global total exposure, 24% is in the eurozone and it s 44% if the U.K. is included. European banks are in worse danger due to their heavy ownership of the sovereign debt of troubled eurozone countries, as we'll discuss later. Many U.S. banks still have unresolved problems with troubled mortgages that investors who bought them claim were misrepresented as to quality. Zeal For Yield While some investors are pursuing the safe haven of FDIC-insured deposits, others, unsatisfied with low nominal and negative real returns, are moving out on the risk spectrum in their zeal for yield, whether they understand the additional risk they are incurring or not. Bernanke, in his Jackson Hole speech, acknowledged this possibility. Some observers have raised concerns that, by driving longer-term yields lower, nontraditional policies [quantitative easing] could induce an imprudent reach for yield by some investors and thereby threaten financial stability. But he dismissed this threat, saying, We have seen little evidence thus far of unsafe buildup of risk or leverage. We see lots of potentially unsafe buildups. Consider the rush into junk bonds, depressing their yields and spreads vs. Treasurys (Chart 44). So much money has poured into belowinvestment grade debt that it s taken real skill of late to default (Chart 45). In the third quarter, junk-rated companies sold $94 billion in debt compared to $25 billion in the third quarter of 2011. But the global recession will hype defaults even though many low-rated companies have a cushion of safety from prefunded debt. Zeal for yield has pushed the returns on junk municipal bonds to 3.15 percentage points above investment-grade issues, the lowest gap in two year. These bonds are usually issued by quasi-governmental
October 2012
CHART 43
total interest income / earning assets
Last Points 2Q 2012: large banks 3.9%; small banks 4.6%
7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 2005-I 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 2006-I 2007-I 2008-I 2009-I 2010-I 2011-I 2012-I
Yield on Bank Assets
Banks with more than $1 billion in assets Banks with less than $1 billion in assets
Source: FDIC
CHART 44 Junk Bond Yields and Spread vs. Treasurys

Last Points 10/3/12: yield 7.10%; spread 4.68%
25% 25%
20%
20%
15%
15%
10%
10%
5%
5%
0% Jan-07
Oct-07
Aug-08
May-09
Mar-10
Jan-11
Oct-11
0% Aug-12
Junk Bond Spread vs 20 Yr Treasurys Junk Bond Yield
Source: Bianco Research LLC and Bloomberg
CHART 45 High-Yield Bond Default Rates

Last Points 2Q 2012: quarterly 0.37%; moving avg. 1.85%
6.0% 16% 14% 5.0% 12% 4.0% 10% 3.0% 8% 6% 2.0% 4% 1.0% 2% 0.0% 1989 1992 1995 1998 2001 2004 2007 2010 0%
Quarterly Default Rate - left axis 12 Month Moving Average - right axis
Source: Ed Altman and Brenda Kuehne/NYU Salomon Center
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19
bodies to finance schools, nursing homes and other facilities. They depend on the revenues generated, and aren't guaranteed by municipal governments.
CHART 46 Emerging Market and Domestic Stocks

return since 1/3/11
Last Points 10/3/12: MSCI -13.8%; S&P 500 14.1%
20% 15% 20% 15%
Other junk-like securities have appeared 10% 10% to satisfy investors zeal for yield. Closed5% 5% 0% 0% end funds offered by Cornerstone -5% -5% Advisors provide huge distribution -10% -10% yields of about 22% of net asset value. -15% -15% But most of that extraordinary return -20% -20% comes not from savvy investments but, -25% -25% in earlier years, from a return of investor -30% -30% Jan-11 Mar-11May-11Aug-11 Oct-11 Dec-11 Mar-12May-12Aug-12 assets and now from funds raised by MSCI Emerging Markets Index rights offerings to existing shareholders. S&P 500 Index In 2008 and 2009, 93% of total distributions were a return of capital. So Source: MSCI and Thomson Reuters investors simply are sending their own money in and then having most of it debt crises of the late 1990s. The joke at the time was that returned. Nevertheless, some investors who don t read the an emerging market is one you can t emerge from in an prospectus fine print may think distribution yields are emergency! real earnings. And Cornerstone charges 2.5% of assets per year for this round tripping. Commodities No Decoupling As for commodities, we continue to regard them as speculations, not an asset class with a strong upward price Ever since our study of China in 2007, before the Great trend. As discussed in last month s Insight, we re well aware Recession substantiated our view ( The Chinese Middle of all the time-worn reasons that commodity prices just must Class: 110 Million Is Not Enough, Nov. 2007 Insight), go up in the long run, going back to the Rev. Malthus. we ve maintained that decoupling ranks with free lunch in There are only so many tons of minerals in the earth s crust the nonexistent department. Export-led developing countries and they re more and more expensive to recover. There s simply can t grow independently of Europe and the U.S., only so much arable land to grow food for the world s which directly and indirectly buy the vast majority of their exploding population. Diets will be upgraded to contain exports. more meat as countries develop, requiring more crops to feed the animals. More and more people in developing Now, the decoupling theory once again has been disproved. countries will soon be driving cars that take metals to build Just look at how emerging market stocks, anticipating a and energy to propel and cement for the roads they'll travel global slowdown or recession, have underperformed the on. S&P 500 in the last year (Chart 46). But that hasn t slowed down yield-happy investors as they move into sovereign debts of small Eastern European and other countries. Serbia s 51% debt-to-GDP ratio is well below those of Western Europe and its inflation-adjusted Treasury bonds yield exceeds 10%. The average debt-toGDP ratio for the 27-country EU was 83% at the end of the first quarter. Spain s government expects an 85.3% ratio this year and 90.5% in 2013. Hungarian bond yields are down from 10% last year but still run about 7%. In contrast, Barclays Global Treasury Universal index, which is heavily weighted toward large countries, yields 2.7%. An important reason that small markets have large bond yields is because they tend to be illiquid, especially in times of strain. This was seen clearly in the Asian and Russian
Peak Oil Crude oil has been the darling of the commodity-shortage crowd, and when its price rose to $145 per barrel in July 2008, many became convinced that the world would soon run out of oil. As we discussed in Shortages vs. Human Ingenuity (Jan. 2012 Insight), human ingenuity and substitutes have always overcome shortages quickly, regardless of how permanent they appeared. New extracting techniques slash the cost of mineral production. Caterpillar just introduced a mining shovel that lifts 120 tons, the equivalent of five pickup trucks, and Joy Global s new entry is even bigger, 135 tons. Still, the dump trucks they fill require three scoops from
October 2012
Telephone: 973-467-0070
Joy s huge shovel. Agricultural productivity leaps as nations develop better seeds and fertilizers are used on larger fields that utilize efficient mechanized equipment, while improved breeding and medical care reduce the cost of producing meat. The advent of plentiful natural gas from shale, the collapse in U.S. prices and new crude oil finds has shattered the theory of a nearpeak in global energy output. Furthermore, for the last 150 years, during which the U.S. and then Japan rose to become major economies and users of commodities, real prices have been in a declining trend (Chart 47). Sure, the Civil War, World War I and World War II created temporary demand spikes and the oil shocks in the 1970s slashed supply. But the related price spikes were overcome quickly with real commodity prices falling back to their long-term declining trend. U.K.
CHART 47 Real U.S. Commodity Prices

CRB index deflated by CPI
1400 1200 1000 1400 1200 1000
800 600 400 200 0 1774
800 600 400 200 0 1814 1854 1894 1934 1974
Source: Bianco Research, Bureau of Labor Statistics and Historical Statistics of the United States
CHART 48
qtr./qtr. % change; seasonally-adjusted annual rate
Last Point 2Q 2012: -1.8%
6% 4% 2% 0% 6% 4% 2% 0% -2% -4% -6% -8% -10% 2008 2009 2010 2011 2012
U.K. GDP
The U.K. has the same huge gulf between -2% investor enamor over quantitative easing -4% and a weak economy, but only more so. -6% In mid-2010, the then-new Conservative-led government -8% embarked on a noble experiment, leading -10% the fiscal austerity wave among major 2007 countries. It planned huge cuts in government spending of 81 billion by fiscal 2014-2015 with average cuts in government department budgets of 19% over five years. The hope was that reductions in government spending would energize the private sector to the point that it more than made up the cuts, overall economic activity would leap and with it, government tax collections. So the net effect would be a reduction in the government deficit from 10 billion, or 9.4% of GDP, in fiscal 2010-2011 to less than 2 billion, or 1.5% of GDP, in 2015-2016. Most of the planned tax cuts have already taken effect, and the pace of reducing the corporate tax rate has been speeded up. By April 2014, it will be 22%, down from 28% two years ago and the lowest of G-7 nations. But only about 30% of the spending cuts proposed in 2010 for the four years ending in March 2015 have been implemented.
Source: U.K. Office for National Statistics
British Recession Meanwhile, with net exports dropping, a weak construction sector, consumers concentrating on paying down their oversized mortgages rather than spending and the austerity program depressing consumer and business outlays, a recession is well under way and deepening, with the third consecutive drop in real GDP in the second quarter (Chart 48). U.K. manufacturing activity also continues to fall (Chart 49). With the weak economy and delayed government spending cuts, government borrowing in the five months through August is 22% higher than a year earlier, and the government's targets for borrowing and government debt reduction are in question. Nevertheless, investors are concentrated on the Bank of
(continued on page 24)

October 2012 Telephone: 973-467-0070 A. Gary Shilling's INSIGHT 21
INVESTMENT THEMES
Our Investment Themes section reflects the positions that are in or being considered for our managed portfolios. We may add or delete portfolio positions in the course of the month, but those changes will not be shown in Insight until the following report.
Unresolved eurozone financial woes have spilled into economies there, and a European-wide recession is well underway. With tight economic policy in China and falling exports, the hard landing we forecast is unfolding and being anticipated by falling commodity prices. Huge deficits and gridlock in Washington have curbed sizable U.S. fiscal stimuli. The euphoria over the Fed's QE3 will probably end with a shock, but the response so far is weak. A global 2012 recession seems likely to provide that shock and benefit of our quartet of investment strategies: long Treasury bonds, short stocks, short commodities and long the dollar.
Treasury bonds (favorable) The rally in Treasurys resumed in March as a safe haven in a sea of trouble and in response to slowing economic growth and looming global recession. The likelihood that inflation fears will turn soon to deflation worries also helped. The yield on 30-year Treasurys actually reached our 2.5% target, the 2008 postLehman low, in early June. A 2.0% yield is possible as economic and financial conditions deteriorate. Income-producing securities (favorable) As many investors favor income over problematic capital gains, included are stocks of utilities, drugs and telecoms with high, safe and rising dividends. But all stocks are vulnerable to a likely bear market. Also, investment-grade corporate and municipal bonds and some Master Limited Partnerships are attractive. The dollar vs. the euro and Australian dollar. Also the Dollar Index (favorable) The buck is the world's safe haven. The eurozone financial crisis remains unresolved and the recession there deepens. Australia has become a captive mineral supplier to faltering China. Rental apartments (favorable) have gained favor by those who can't afford home ownership and are discouraged by falling house prices. Their stock prices seem overblown, but direct ownership of rental apartments may still be attractive. Medical Office Buildings (favorable). The aging postwar babies, the 2010 health care law and the migration of physicians from private practice to hospital employment will promote robust, steady growth in this real estate sector. But government regulations can be disruptive. North American energy (favorable) Americans have decided to reduce dependence on imported energy from high-risk foreign areas. We like conventional energy investments including natural gas, on- and off-shore drilling and Canadian oil sands. Natural gas prices appear to have bottomed, and pipelines are attractive. New nuclear facilities may be postponed in the wake of the earthquake and
tsunami in Japan. Renewable energy is problematic since it depends heavily on unpredictable government subsidies amidst federal cost-cutting. Ethanol suffers from droughtsired corn price leaps. Developed country stocks (unfavorable) With a hard landing in China and the resulting negative effects on commodity exporters, a major recession in Europe and a strong dollar, earnings of U.S. multinationals will be hurt. A moderate recession in the U.S. will also damage corporate profits despite more cost-cutting in response. We look for $80 per share in S&P 500 operating earnings over a coming four-quarter period and a bottom P/E of 10. Homebuilders are unattractive if house prices tumble as we forecast. Your house, second home or investment single-family houses aren't attractive. Excess inventories are likely to push prices down another 20% over the next several years. U.S. major and regional banks (unfavorable) Major banks are being bereaved of proprietary trading and other profitable activities and are being busted back to lesslucrative spread lending. Regional banks suffer from weak loan demand and bad real estate loans. Junk securities (unfavorable) Despite recent pre-borrowing from yield-hungry investors, default rates are likely to leap in the global recession we foresee while junk prices drop. Developing country stocks (unfavorable) China is close to a hard landing. She and other emerging exporters are vulnerable to economic weakness in the U.S. and Europe. Commodities (unfavorable) The commodity bubble started to break in early 2011 due to a prospective hard landing in China and the global recession. Copper is already down substantially and excess inventories in China loom. Deletions: The yen remains a safe haven, so we're dropping our unfavorable position for now.
October 2012
Telephone: 973-467-0070
Summing Up
U.S. stock markets rose to near-five-year highs early in September before drifting generally downward towards month s end as eurozone fears reared its ugly head, concerns lingered about the strength of the U.S. economy and China s economy continued to weaken. Spain, in particular its ailing banks and the country s credit rating, was a major area of focus last month, and the economy there continued to fall at a significant pace in the third quarter, in the words of the Bank of Spain. Finishing off a solid third quarter, the Dow Jones Industrial Average, S&P 500 index and Nasdaq all rose last month but completed September off their highs. Overseas markets saw similar performances. The dollar fell last month against the euro and gained slightly vs. the yen. Treasury rates rose slightly last month. If at first you don t succeed, try, try again and again. In the wake of another weak employment report, the Federal Reserve after its September policy meeting announced QE3 its intention to buy $40 billion worth of mortgagebacked bonds each month in an effort to boost the jobs market. The central bank said the purchases would continue for a considerable time after the economic recovery strengthens. The Fed also lowered its expectations for economic growth this year, forecasting GDP growth of 1.7%-2.0%, down from the 1.9%-2.4% estimate it issued in June.
The final revision of second quarter GDP showed a gain of 1.3%, down from the original +1.7% estimate and less than half the fourth quarter 2011 s 4.1% gain. Personal income rose 0.1% in August while spending was up 0.4%, due mainly to higher energy prices, not increased consumer enthusiasm. As a result, the personal saving rate declined to 3.7% from 4.1% in July. Retail sales rose 0.9% in August, the biggest increase in six months and boosted greatly by spending on cars and on gasoline. Car and truck sales weighed in at a 14.5 million unit annual rate, the strongest month since 2009. Ex autos, retail sales were up 0.8%. The jobs picture continued to be weak, with nonfarm payrolls increasing by just 96,000 in August. The national unemployment rate declined to 8.1% from 8.3%, but the drop was the result of people dropping out of the labor force. Revisions showed July s payroll increase was 141,000 (vs. the original 163,000) and June s gain was 45,000 (vs. 64,000 originally reported). Further revisions late in the month showed that job gains in the 12 months through March 2012 were stronger than first estimated, with some 400,000 more jobs being added than first reported. Housing starts rose 2.3% in August, with single-family homes accounting for nearly three-fourths of activity. New home sales fell 0.3% in August from July, but July s data was revised upward to a level that was the highest since April 2010. Sales, though, rose 28% from August 2011. The median price of $256,900 was 17% higher than a year earlier while unsold inventories now stand at a 4.5-months supply. Existing home sales rose 7.8% in August to their highest level since May 2010. The median price of $187,400 was up 9.5% higher than a year earlier.
Consumer prices rose 0.6% in August after being flat for four months. The increase was driven by higher fuel costs (energy prices up 5.6% and gasoline up 9%). CPI is up 1.7% year-over-year. Core CPI rose 0.1% in August (yearThe S&P/Case-Shiller index of property values in 20 cities over year, it s ahead 1.9%). Producer prices rose 1.7% in rose for a fourth month, 1.2% in June, with 16 cities August, led by a 6.4% rise in energy prices and a 13.6% showing a year-over-year gain, led by a 17% advance in increase in gasoline prices. PPI is up 2% year-over-year. Phoenix. The National Association of Home Builders Core PPI was up 0.2% in August (year-over-year, it s ahead confidence index rose two points 2.5%). The core personal to 40 in September the highest consumption deflator, the Fed s INSIDE THE NUMBERS level since June 2006. favorite inflation barometer, has Sept. 2012 Year-to-Date risen just 1.6% from August 2011 % Change* % Change Consumer sentiment rose to 78.3 through August 2012, safely below Dow Jones Industrials +0.6% +7.1% in September from 74.3 in August, the Fed s 2.0% target. S&P 500 +1.9% +11.9% the University of Michigan Nasdaq Composite +4.3% +17.7% reported. The Conference Board s Crude oil prices briefly touched Nikkei Average +1.7% +4.5% index of consumer confidence rose $100 per barrel in mid-September FTSE 100 +1.3% +2.5% to 70.3 in September from 61.3 in Hang Seng -1.6% +5.7% amidst the Libyan consulate attacks August. and widespread protests elsewhere Aug. 31 in the region before sliding back to the lower $90s at month s end.
10-yr. Treasury note $= =$ Sept. 28 1.64 78.03 1.28 1.55% 78.27 1.26
*through Sept. 28
Fred T. Rossi Editor

October 2012
Telephone: 973-467-0070
The Grand Disconnect

(continued from page 21)
65
CHART 49 U.K. Manufacturing Purchasing Managers Index

65
England s quantitative easing and other stimulating programs, and stocks are rising on balance. In July, the central bank hiked its asset purchase program from 325 billion to 385 billion, in view of the weak economy and inflation falling back to the BOE s 2% target and threatening to go lower. The BOE has been the most aggressive of major central banks in expanding its sheet since the global financial crisis commenced (Chart 50).
60
60
55
55
50
50
45 40
45 40
35
35
30 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 May-12
30
Source: Markit Economics
Interestingly, after the BOE s September policy meeting, its governor, Mervyn A. King, said, in defending the decision not to cut its reference rate below the current record low 0.5%, that further reductions could hurt some financial institutions and might be counterproductive. Well, at least one central banker thinks about the effects of near-zero rates on interest receivers! In July, the BOE and the U.K. Treasury started the Funding for Lending Scheme that allows banks and other lenders to borrow from the BOE for a lengthy four years if they lend the money to businesses and households. But money is fungible, so a bank could say it did so but cut lending elsewhere. Besides, cash-heavy British banks are so wary of making more bad loans that they're buying back their own bonds instead. Banks maintain that creditworthy borrowers are lacking, and buying their senior bonds back, even at premiums over issue prices, is a better investment and reduces funding costs. Deleveraging at work! Eurozone As goes the U.S. and U.K., so goes the eurozone. The ECB has been flooding that area with money, in part to push investors into stocks. It has succeeded, with stocks rising in the past year despite the deteriorating economies. Even Greek stocks are up this year, by 15%. With corporate profits flat at best, the stock rallies are hyping price-to-earnings ratios, especially in southern Europe where profits are plummeting. P/Es there are at four-year highs relative to northern European companies. Last year the ECB returned its target
rate to 1%, essentially ignoring its sole mandate to keep inflation under 2%, in view of the financial crisis that has spilled over into the real economy. Then, in late 2011 and early 2012, the ECB lent 1 trillion to 800 member banks at 1% for an unprecedented three years. Those banks in turn used the money to refinance their own debts and to lend to their home countries for deficit financing after all, few others would lend to the Greek, Portuguese, Spanish or Italian governments. Those funds proved insufficient, and subsequently the European Union agreed to recapitalize Spanish banks with 100 billion from its bailout fund, the European Financial Stability Facility, with the Spanish government apparently still on the hook. The ECB persists in the fiction that it can t lend to governments for deficit financing, but it really is. And increasingly, European leaders view the ECB as the only institution with the unlimited resources to keep the bailout
CHART 50 Central Bank Balance Sheets
Bank of England ( billion) Swiss National Bank (CHF billion) Federal Reserve (US$ billion)
May 2007 79.42 105.65 896.13
September* % 2012 Increase 399.51 403.1% 492.54 2,806.19 3,049.54 366.2% 213.1% 161.7%
European Central Bank ( billion) 1,165.36
* Swiss National Bank data is through August 2012; unlike the others, its data is released monthly Source: HM Revenue and Customs
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Telephone: 973-467-0070
October 2012
CHART 51 money flowing. The bank s President, Mario Draghi, more recently said the U.S. and German 10-Year Government Bond Yields ECB, within its mandate. is willing to Last Points 10/3/12: U.S. 1.63%; Germany 1.46% 5.5 5.5 do whatever it takes to preserve the 5.0 5.0 euro and, believe me, it will be enough. 4.5 4.5 Then on September 16, the ECB announced that it would buy sovereign 4.0 4.0 debts of troubled eurozone countries, 3.5 3.5 up to three years maturity, in an 3.0 3.0 unlimited program, as mentioned 2.5 2.5 earlier, as long as they met austerity 2.0 2.0 targets the Outright Monetary 1.5 1.5 Transactions Program (OMTP). Don t 1.0 1.0 Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Nov-10 Aug-11 May-12 you wonder who dreams up the names U.S. for the never-ending list of bailout Germany programs with interesting acronyms? Think, in the U.S. alone, we have TARP, Source: Thomson Reuters TALF, ARRA, CARS, HARP and HAMP, among others. The ECB has is dire. The eurozone financial crisis has spilled over to the EFSM, EFSF and ESM. The Bank of England has APF real economy and will probably result in a recession as deep and FLS. Do you even know what these acronyms stand as the 2008-2009 slump. Back then, eurozone real GDP for? fell 5.7%, more than the 4.7% swoon in the U.S. (Chart 52). Nevertheless, while American real GDP is now slightly ECB Limits above the fourth quarter 2007 peak, eurozone growth was flat in the first quarter before the previous peak was But just as there are limits on the Fed s QE3 even though reached and fell 0.7% in the second quarter at annual rates. it s supposed to be open-ended, there are also limits on the
ECB s open-ended policies, even though it can theoretically expand its assets forever. The credibility of the ECB is ultimately backed by the German balance sheet. So far, investors have put German government bund in the same safe haven category as Treasurys (Chart 51), in sharp contrast to their disdain for Spanish and Italian debt amidst nonstop credit warnings and downgrades. But that faith may be wearing thin. Moody s recently even cut the outlook for stalwart Germany, the Netherlands and Luxembourg from stable to negative. The rating agency cited the risk of Greece leaving the eurozone and the costs of containing the subsequent contagion. In its recent announcement, Moody s said that Germany had reached the limit of its ability to carry the financial costs of bailouts, even with its likely 2012 government deficit equal to only 0.8% of GDP. Germany so far has committed 211 billion in cash and guarantees to eurozone rescue funds. It cited German bank exposure to weak countries, high Dutch household debt and Luxembourg s very high dependence on the financial services industry. According to the IMF, German lenders have the highest exposure in Europe to Spain, $140 billion, of which $46 billion is exposure to banks. On The Ground Back on the real eurozone economic ground, the situation
October 2012
Evidence of the deepening eurozone recession is legion. The unemployment rate for the 17-country bloc continues its steep ascen. In August, the unemployed rose 34,000 to 18.2 million and in the larger EU, 25 million are jobless. In Greece, 55% of those younger than 25 are unemployed, 53% in Spain, 32% in Ireland but only 8% in Germany. As eurozone unemployment rises, consumer confidence and spending, naturally, fall. Consumer confidence was at a 40month low in Europe in September. Sales volume fell 0.2% in July from June and was off 1.7% from a year earlier. Manufacturing activity is falling in the total eurozone and even in France and Germany (Chart 53). So even exportled Germany is succumbing to the downdraft. Japan Japan is no stranger to quantitative easing and has been using it for two decades, as well as using massive government deficits and debt, to try to escape her two-decade-long deflationary depression. The Bank of Japan recently increased its asset purchase program to 80 trillion ($1 trillion) from 70 trillion and extended the program by six months until the end of 2013. Nevertheless, the recovery from the March 2011 earthquake and tsunami appears to be waning. Real GDP growth
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swung violently from negative as a result of that disaster to big recovery gains, but now has settled back to low gains with only a 0.7% rise in the second quarter from the first quarter at annual rates, revised down from the 1.4% earlier estimate. Industrial production fell 1.3% in August from a month earlier after a 1% drop in July. In export-driven Japan, exports dropped 7.4% in July from a year earlier, the second straight monthly fall, due to weak demand from Europe and China. Consumer prices continue to fall. China As noted at the outset of this report, China is using a different strategy than Western lands and Japan in responding to chronic economic weakness. China basically used bank lending, the equivalent of 12% of GDP in 20082009, to revive her economy from the Great Recession. Real GDP growth year-over-year had fallen to 6% in early 2009 (Chart 54), well below the 8% rate needed to accommodate new job entrants. In contrast, the U.S. 2009 fiscal stimulus was half as big 6% in relation to the economy. Much of the money in China went for excess capacity-creating capital spending, real estate speculation and development loans arranged by local governments. They legally can t borrow, but after essentially stealing land from local farmers, they arranged for loans through off-balance sheet vehicles to property developers and they profited by taxing the structures they built. The economy revived quickly but a property bubble and high inflation were undesired consequences, especially leaping food prices in an economy with many people at subsistence income levels. So China reversed gears to slow her exuberant economy, and those efforts have born fruit, probably too much for Chinese leaders tastes. House prices cracked due to tight controls on mortgages and speculative
CHART 52 U.S. and Eurozone Real GDP Since 2007-2009 Recession Peak
peak quarter = 100
Last Points 2Q 2012: EZ 97.6; U.S. 101.7
102 101 100 99 98 97 96 95 94 2007Q4 102 101 100 99 98 97 96 95 94 2008Q4 2009Q4 2010Q4 2011Q4
Eurozone (Q1 2008 Peak) US (Q4 2007 Peak)
Source: eurostat and Bureau of Economic Analysis
CHART 53 German, French and Eurozone Manufacturing PMI

Last Points 9/12: Germany 47.4; France 42.7; eurozone 46.1
65 65
60
60
55 50
55 50
45
45
40
40
35 30 Jan-07
35 30 Nov-07 Sep-08 Jul-09 May-10 Mar-11 Jan-12
Germany France Eurozone
Source: Markit
CHART 54
year/year % change
Last Point 2Q 2012: 7.6%
12% 12%
Chinese GDP
11%
11%
10% 9%
10% 9%
8%
8%
7% 6%
7% 6%
5% 2005 2006 2007 2008 2009 2010 2011 2012
5%
Source: Chinese National Bureau of Statistics
Telephone: 973-467-0070
October 2012
homeownership. Stock markets are usually excellent harbingers of economic activity, and the Shanghai Composite Index, which partially revived in 2009 after its 2007-2008 collapse, has been trending down ever since. This slide probably foretells a hard landing in China, with 5% to 6% real GDP growth rates, well below the 7.5% government target, down from the 8% target for each of the previous eight years. Reserve Requirements The Chinese central bank relies on adjusting reserve requirements to implement monetary policy. From January 2010 to late November 2011, it raised reserve requirements 12 times from 15.5% to 21.5% (Chart 55). In contrast, it only hiked lending rates five times to 6.56% from 5.31% in order to subsidize, with low-interest costs, the inefficient state enterprise borrowers that are crucial to the economy. They employ about a quarter of the workforce and account for 50% of GNP. Note that the Fed hasn t changed reserve requirements in decades and considers them crude, sledgehammer tactics. Reserve requirements limit bank lending since they amount to credit rationing, while higher interest rates still accommodate the most promising investments.
CHART 55 Chinese Reserve Ratio and One-Year Lending Rates

Last Points 10/3/12: reserves 20.0%; loans 6.00%
22% 20% 18% 16% 14% 12% 10% 8% 6% 4% Jan-07 22% 20% 18% 16% 14% 12% 10% 8% 6% 4% May-08 Sep-09 Feb-11 Jun-12
Required Reserve Ratio (major banks) - left axis One Year Lending Rate - right axis
Source: Bloomberg
CHART 56 2011 China Trade by Partner
Total EU (27 countries) U.S. Hong Kong Eurozone* ASEAN Japan Korea India Taiwan
Exports Exports ($ bil.) (% of Total) 1898.6 100.0% 356.0 18.8% 324.5 17.1% 268.0 14.1% 233.0 14.8% 170.1 9.0% 148.3 7.8% 87.9 4.6% 50.5 2.7% 35.1 1.8%
* 2010 data
Imports Imports ($ bil.) (% of Total) 1743.5 100.0% 211.2 12.1% 122.2 7.0% 15.5 0.9% 141.7 10.2% 192.8 11.1% 194.6 11.2% 162.7 9.3% 23.4 1.3% 124.9 7.2%
China s primary dependence on exports for growth is also causing problems as a global slowdown unfolds and worldwide recession looms. Hopes of economic decoupling of China and other Asian lands from the U.S. and Europe have once again surfaced in recent years. And once again, they are being dashed. As shown in Chart 56, almost 20% of Chinese exports went to the EU in 2011, and deepening recessions there have reduced them to 5% this year through August. Chinese exports to the U.S. were close behind those to the EU in 2011 at 17% of the total, and the drop in European-bound Chinese exports has put the U.S. in first place this year. Exports to America were still rising in the second quarter, up 14.4% from a year earlier. Overall Chinese exports are barely growing and well below the earlier 20% to 30% norm. The earlier economic restraints and slipping exports are depressing Chinese economic activity. Industrial production
October 2012
Source: China Customs
growth fell to 8.9% in August from a year earlier, down from the earlier 15% or higher growth rates. The lower GDP growth in the second quarter versus a year earlier, 7.6% due to waning exports and weak real estate, may vastly overstate reality, and official Chinese numbers in general are highly suspect. The HSBC China Manufacturing Purchasing Managers Index has been below 50, indicating actual contraction, for 15 of the last 16 months. Direct foreign investment in China is declining. Industrial company profits dropped 6.2% in August for the fifth month, and the drop accelerated from the 5.4% decline in July and 1.7% in June. Selling prices are falling, demand is slowing and costs are rising with the 20%-25% recent hikes in minimum wages. In the first eight months of 2012, profits slid 2.7% compared with a 28.2% gain a year earlier. Revenues rose 10.2% in the first eight months
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vs. 29.9% in the comparable 2011 period. Avoid Social Unrest Chinese leaders want to avoid a hard landing and the high unemployment and social unrest of the sort that spawned the Tiananmen Square uprising in 1989. High unemployment has gotten numerous Chinese dynasties tossed out, and the leaders of the Mao Dynasty, as we ve dubbed it, know their history. Beijing eased bank lending limits and reserve requirements for smaller banks back in September to help struggling small businesses and offset the stringent restraints on shadow lending. And starting Nov. 30, China s central bank reduced the bank reserve requirements three times, back to 20.5%. The once-in-a-decade change in Chinese leadership later this year is also adding stress to policy decisions. We have no doubt that Chinese leaders will act decisively enough to prevent a prolonged hard landing. But we doubt that Chinese leaders will act quickly enough and be clever enough to prevent a drop in growth to the 5% to 6% range for at least several quarters. The technique they used in 2008-2009 funneling massive loans through the banks for infrastructure and other capital projects will probably not work a second time, even with further substantial reductions in reserve requirements. Also, Chinese banks are reluctant to lend for industrial capacity additions when it is already more than ample as a result of the last lending spree and mounting loan losses. Bank liquidity is ample and weakening loan demand by business suggests subdued investment demand. With attractive infrastructure investments already made, additional ones will take time to develop. Many firms lack profitable investment opportunities. Monetary and Fiscal Stimuli With this reality, it s not surprising that on June 7, China s central bank cut the one-year yuan lending rate to 6.31% from 6.56% and to 6.00% on July 6 while allowing banks to offer loans up to 30% below the benchmark rate. With the two rate cuts and the allowed discount, the cost of a oneyear loan fell more than two percentage points, from 6.56% to 4.2%, in a month. It also appears that the authorities want to go around the reluctant banks and appeal to borrowers directly by making money available at rates low enough to encourage profitable investments. The average return on capital investments has fallen from 11.6% in 2007 to 6.7% last year, barely above the earlier one-year lending rate of 6.6%. We take this as concrete evidence of Chinese leaders concerns over a faltering economy. So did Chinese investors as the
Shanghai Stock index dropped 2.7% over the next two trading sessions after the last rate cut. Chinese leaders appear to believe that further monetary ease will not rekindle economic growth and may spawn another real estate bubble. So they re turning to fiscal measures. The national Development and Reform Commission, a powerful government planning agency, approved 1,555 major investment projects this year through August, a 13% rise from 2011. And, as noted at the outset, in early September, the Chinese government announced $158 billion more in infrastructure projects over four years. Nevertheless, the fact that this amount is only 26% of the $586 billion stimuli in 2008-2009 enacted over two years suggests that the government is wary of overdoing it with undesired consequences, as occurred earlier with the property bubble and inflation. Also, Chinese leaders may be reflecting the reality that more of the same in exporting industries and the capital spending that supports them no longer works and only creates troublesome excess capacity as the big importers, the U.S. and Europe, retrench. As discussed in past Insights, they recognize that they need to boost consumer spending and a domestically-oriented economy to ensure future meaningful growth in China. A recent shift of government emphasis away from supporting export growth and towards domestic needs in South Korea, Thailand, Malaysia and elsewhere indicates that this policy shift is widespread. China And Commodities Despite the initial pop in the prices of commodities such as copper in reaction to monetary and fiscal stimuli in the U.S., Europe, Japan and China, they remain in a downtrend that commenced in early 2011. And we expect commodity prices to continue to drop as the hard landing in China and global recession unfold. The Dow Jones-UBS Commodity Index jumped 15% since the Fed hinted at QE3 on June 6, but is down 1% since QE3 was announced on September 13. Buy the rumor, sell the news? As we ve noted in past Insights, it s probably no coincidence that China s joining the World Trade Organization at the end of 2001 was followed by the commencement of the global commodity price bubble in early 2002. And it has been a bubble, in our judgment, based on the conviction that China would continue to absorb huge shares of the world s industrial and agricultural commodities. The shift of global manufacturing toward China magnified her commodity usage as, for example, iron ore that previously was processed into steel in the U.S. or Europe was sent to China instead.
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October 2012
As a result, China in recent years consumes 42% of annual world production of nonferrous metals such as copper, tin, lead and zinc as well as half of global iron ore output and huge portions of coal and other industrial material. China s oil stockpiles are unknown but probably have leaped. She s also importing soybeans, grains and other agricultural production heavily as diets are upgraded to contain more meat. Chickens and hogs don t convert all of the corn they eat to meat, so more grain is needed than if it s eaten directly by humans. Agricultural producers are influenced by global demand but also by weather-driven supply. Forecasting economies is tough enough, so we ll leave it to others to forecast the weather. Note, however, that in the past, ideal growing weather often follows the bad weather suffered lately, and bumper crops and barn-bursting surpluses often replace hand-wringing shortages in a crop year or two. Evidence of the commodity bubble is rampant. Individual investors are participating through ownership of mining company stocks and Exchange-Traded Funds, some of which own physical commodities. Commodity-oriented mutual funds and ETFs had $50.7 billion in assets at the end of 2011, up from $258 million in 2002. Pension funds and other institutional investors are also aboard, owning physical commodities or substitutes. Many now regard commodities as an asset class like equities and bonds, which we doubt, as mentioned earlier. Excess copper is piling up in and outside Shanghai warehouses, as mentioned at the outset. With easy access to money from government-controlled banks, state-owned Chinese steelmakers have kept producing even though manufacturing activity has declined for over a year. The result is 16 million tons of surplus steel alloy, 15% more than a year ago. This is only adding to a global glut of steel. Reversing Gears With more and more agreeing with our long-held belief that China is in for a hard landing, withdrawing from commodityoriented funds has commenced. In the first seven months of this year, investors yanked $6 billion from commodity mutual funds compared with a $7.8 billion inflow a year earlier. A survey in August found only 2% of investors interested in China-focused commodity funds that typically invest in big Chinese imports such as iron ore, soybeans and rubber. At the beginning of the year, 15.4% were favorably disposed. The end of the commodity bubble is not only negative for commodity prices but also commodity-exporting countries such as Brazil and their currencies as well as suppliers to commodity producers. Australia has, in many ways, become a Chinese colony as they dig up the island continent
October 2012
and export the iron ore, copper, coal, etc. to China. The Australian government planned to erase a $46 billion budget deficit with higher taxes on mineral producers. But with iron ore prices down 24% in August alone, they are about half the level the Australian government planned on. Coal prices are half their 2008 peak. So miners are retrenching and canceling expansion projects, leaving Australia with a potential $10 billion shortfall in tax receipts. Then on October 3, the Australian central bank cut its target rate by 0.25 percentage points to 3.75%, with a cumulative 1.50 percentage point decline since last November. In announcing the cut, Reserve Bank of Australia Governor Glen Stevens said, Growth in China has also slowed, and uncertainty about near-term prospects is greater than it was some months ago. Key commodity prices for Australia remain significantly lower than earlier this year. This reverses his view last June when he said he needed to do some cheerleading on the economy to rebut vocal pessimists. But the Australian economy has slipped meanwhile. Iron ore prices have collapsed, and miners are slashing investments, as mentioned earlier. Australian exports to China equal 5% of GDP, and 60% are shipments of ore. Australian growth slipped to 0.6% in the second quarter from 1.4% in the first, payrolls were unexpectedly cut in August and business confidence is falling. The trade deficit leaped in August and the Australian dollar is falling. In the U.S., Appalachian metallurgical coal prices hit a record $330 per metric ton in early 2011 as Chinese demand soared. But with Chinese imports faltering along with manufacturing activity there, prices are down almost 50% to $170 per metric ton. This and the shift of U.S. electric utilities to cheap, cleaner natural gas is causing production cutbacks, mine closings and layoffs in the U.S. coal industry. Not surprisingly, miners worldwide are cutting capital spending due to production cuts, weak prices and falling profits. Caterpillar recently lowered its profits forecast for the next few years due to weak demand for construction and mining equipment. Global Weakness We ve concentrated in this report on unfolding economic weakness in Europe, the U.S. and China and those three areas, which account for 57% of global GDP, do take the rest of the world with them up and down. And there s growing evidence that s happening on the downside. Purchasing managers indices show that manufacturing continues to fall in Vietnam and Taiwan, and growth is
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slowing in Indonesia. Declines reign in South Korea, Australia, Taiwan and Brazil. Consumers globally are cutting back on the ubiquitous hamburger. In July, McDonald s same-store U.S. sales fell 0.1% and declined 0.6% in Europe and 1.5% in the faster-growing economies in Asia/Pacific, Middle East and Africa. International trade is more volatile than overall economies, in part because it largely involves goods that are more cyclical than services. And trade is definitely slowing. Global air freight volume in July fell 3.2% from a year earlier. FedEx CEO Fred Smith points to economic weakness in Europe and the U.S. as well as in China. Both FedEx and UPS have cut their flights to the U.S. from China, in part due to competition from cheaper ocean shipping. There s less need for fast delivery when sales are slack. But ocean shipping is also falling. In the ports of Long Beach and los Angeles, which handle most of the U.S. ocean trade with Asia, outbound container shipments fell 4.1% in August from a year earlier, the sharpest drop since September 2009. AP Moller-Maersk, the giant Danish shipper that accounts for 15% of global seaborne freight, has cut capacity on Asia-Europe routes by 9% and is reducing ship speeds to save fuel costs. Asia-Europe ocean freight rates fell 30% in the August-September period. The World Trade Organization forecasts world trade in goods to rise just 2.5% this year, down from 5% growth in 2011 and 14% in 2010. And that forecast is probably optimistic in view of weakening global economies. U.S. export growth has accounted for about half of GDP gains in this recovery vs. 12% of growth in the last four decades. The Administration s goal of doubling exports in the five years after the recession ended in June 2009 is obviously suspect. Shocks The Great Disconnect we ve discussed in this report between investors enamored with monetary and fiscal largesse and globally weakening economies is profoundly unhealthy. And in our opinion, the gulf will be closed, sooner or later, one way or another. Of course, it could be eliminated by rapid expansion of economies globally. The past and current massive monetary and fiscal stimuli or other forces might rekindle economic growth. Some point to the recent stabilization of U.S. house prices as the beginning of this economic revival. We doubt it, however. The massive deleveraging in private sectors here and abroad, the unresolved odd couple combination of the Teutonic North and the Club Med South in the eurozone and the needed shift in China from
an export-led to a domestically-driven economy suggest that risk on investments will collapse to meet recessionary and chronically slow growing economies. What will cause the agonizing reappraisal by bullish investors? Probably a shock, as was the case in limited ways with the euphoria over QE1, QE2 and Operation Twist. The first Greek debt crisis in early 2010 ended the QE1 stock rally. The QE2-spawned bull ended with Greece II and the widening European financial and economic woes in early 2011. Operation Twist optimism concluded with the realization that European problems may be unsolvable and with worries over the fiscal cliff in the U.S. The current gap between sliding global economies and stock market euphoria remind us of Wile E. Coyote in the Roadrunner cartoons who runs off the cliff and stands on thin air until he finally realizes there s nothing between him and the valley floor below. A sizable shock may provide investors with that realization. Forecasting specific jolts is hazardous, although we can list several possibilities. A hard landing in China might do the job, with growth slowing to 5% to 6%, especially as the dire ramifications on world trade, commodities demand and prices and commodity producers and their currencies roll out. Increasing numbers are agreeing with us that this is in the cards, and maybe that's behind the recent possible shift from "risk on" positions to "risk off" trades the quartet of long Treasury bonds, short stocks, long the U.S. dollar and short commodities. A fall off the fiscal cliff is another possibility. It s well known that if Congress and the Administration don t act, at the end of this year, the Bush-era tax cuts disappear, the payroll tax on employees goes back to 6.2% from 4.2%, unemployment benefits drop from a 99-week maximum to 26 and the first of $1.2 trillion in federal spending cuts and tax increases over 10 years commences (i.e., "sequestering"), the result of Washington s failure to deal with the longerrun budget deficit last year. The nonpartisan Congressional Budget office estimates that the fiscal cliff will slash 2013 GDP by 4.0% (Chart 57). That in itself constitutes a major recession, even more so coming on top of an already recessionary economy. We ve been assuming that Washington will avoid, or as they did in the summer of 2011, at least temporarily postpone the fiscal cliff even before the election in employment continues to deteriorate. Even the tea party Representatives and Senators want to get re-elected, and telling constituents that austerity is good for their souls doesn t garner many votes. Alternatively, with gridlock in Washington, Congress and the Administration in a lame duck session after the election could postpone the tax increases and spending cuts
October 2012
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temporarily to let the next Congress and Administration deal with the mess. That's what they did last December for three months and then in February for the rest of this year. One way or the other, we doubt seriously that Washington will allow the economy to go off the fiscal cliff. Our old friend, the late Barber Conable, earlier the ranking Republican on the House Ways and Means Committee and later President of the World Bank, told us repeatedly, Congress ultimately does the necessary thing, but only when forced to and as late as possible. Few in Washington are likely to stand on principle and let the economy fall into an abyss.
CHART 57 2013 Effects Of Fiscal Cliff
Tax Increases Expiration of Income Tax Cuts 2001-2012 Expiration of Payroll Tax Cuts Expiration of Other Tax Provisions Payroll Tax Increases (Affordable Care Act) Total Tax Increases Spending Cuts Sequestration - Budget Control Act Expiration of Emergency Unemployment Benefits Reductions in Medicare Physician Payment Rates Total Spending Cuts Other Revenues/Spending Total Fiscal Adjustment
Source: Congressional Budget Office
Change (yr/yr) $ bil. % of GDP $221 1.5% $95 0.6% $65 0.4% $18 0.1% $399 2.6%
$65 $26 $11 $102 $106 $607 0.4% 0.2% 0.1% 0.7% 0.7% 4.0%
We doubt that many American businesspeople and consumers believe the fiscal cliff won t be removed, even though many cite the risks as a rationale for the general uncertainty that is retarding spending and capital investment. Note, however, that removing the fiscal cliff does not add new stimuli to the economy. It simply keeps existing government spending and tax rates intact. An oil price leap, triggered by an Iran-related blow-up in the Middle East, could also shatter investor euphoria. That s what happened with the Arab oil embargo in 1973 and the Iranian revolution in 1979. Sure, the U.S. is becoming less dependent on imported energy and very few oil imports come from the Middle East. But petroleum is fungible and price increases elsewhere will affect the U.S. as well as Europe and China. A huge energy cost spike would be a debilitating tax on already-stressed consumers. Failure of a major European bank would probably spread worldwide and generate a global financial crisis, much as in 2008. Banks are so intertwined through loans, leases, derivatives, etc., as noted earlier, that a shot in Europe would be felt round the world. Major corporate earnings disappoints are another possible shock. Always-optimistic Wall Street analysts believe S&P 500 operating earnings fell slightly year-over-year in the third quarter but that s well known and a 14% year-overyear revival in the fourth quarter is expected. But suppose our forecast is correct and operating earnings drop to $80 per share in a coming four-quarter stretch, due to recessioninduced declines in corporate revenues, a decline in profit
margins from record heights and currency translation losses as the dollar strengthens? That $80 is more than 20% lower than analysts estimates, and would be a big disappointment to many bullish investors. Investor Caution QE1, QE2 and Operation Twist got increasingly larger bangs per Fed buck. But not so with QE3 and recent ECB actions, at least so far. As noted earlier, each successive announcement by the Fed and ECB got less pop in the S&P 500. Since peaking on September 14, the day after the QE3 proclamation, that index has declined on balance, in contrast to gains in comparable days of trading after the three earlier quantitative easings. Treasurys have rallied vs. little change after earlier QEs. It's early into QE3, but does this suggest that investors are getting cautious and wary, that the Fed has gone back to the well one time too often? Are investors anticipating a hard landing in China or one of the other shocks we just outlined? Stay tuned. It should be clear from this report that we beg to differ with the It s so bad, it s good crowd. Conditions are so bad, they re just plain bad. All the immense monetary and fiscal stimuli here and abroad in the last five years have failed to offset the gigantic deleveraging in global private sectors. And they re unlikely to do so until that process is completed in another five to seven years.
October 2012
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31
Commentary
How To Slash Hospital Waiting Time

My wife has suffered a sore right knee for some time that was diagnosed as a tear in the meniscus, the cartilage that acts as a shock absorber between the thigh bone, or femur, and the shin bone, or tibia. A local orthopedic surgeon recommended a knee arthroscopy, a fairly common procedure that takes about 20 minutes under general anesthesia. The surgeon makes a small cut, fills the knee area with saline to expand the space and inserts a scope about the size of a pencil with a light and tiny video camera to look around. Through another cut, he inserts tiny scissors to trim off the torn edge of the meniscus. Then he withdraws the equipment, the saline is drained, the knee is bandaged and the patient is off to the recovery room. My wife s appointment for arthroscopy as a day patient at a local hospital was for 11:00 a.m., but the night before, they changed it to noon. That should have warned us of a long wait. Still, we arrived early, and after a half hour stay in the general reception area, were sent to the surgery section for another 15-minute delay before being called to check in. They took my wife in, dressed her in a hospital gown on a gurney and hooked her up to a saline IV before I rejoined her. By now, it s about 12:30 p.m., and we re told the surgery is scheduled for 1:00 p.m. But 1:00 comes and goes. Finally, a gregarious male nurse arrives to be sure my wife is the right patient for the planned procedure confirming her name; birth date; regular
medications she takes; no food, drink or medications since last midnight; which knee is to be operated on, etc. His and numerous checks by others as well as the various pre-operation tests made it clear that a tremendous amount of the staff s time and expense is devoted to defensive medicine avoiding simple mistakes that could result in lawsuits. We asked about the long delay and he explained that the surgeon was moving back and forth between two operating rooms, but the scheduling for each was handled and fully booked by a separate computer. So the doublebooked surgeon was positively, absolutely guaranteed to run behind. Can t a real live human being simply override the two computers that don t talk to each other, we asked. No, they operate separately within the system, he told us. This was scary for my wife and me. If such an obvious problem was beyond human control, what about hidden but more critical aspects of the hospital s medical care? We were partially relieved when another male nurse appeared with a magic marker, confirmed with my wife that her right knee was the troubled one and drew a wide circle around it with yes written inside. Low tech but effective. I suspect, however, that the overbooking problem was not poor administration of computers, but the zeal of the surgeon, who did about a dozen knee operations a day, to not waste a second in maximizing his operating time and income. Clearly, our waiting time was valued at zero. These long delays were obviously enhancing our pre-op anxiety, but they finally wheeled my wife into the operating room after 3:00 p.m. I was told that she d be out of the recovery
room in an hour and got worried when I d heard nothing by 5:00. So I demanded action and was allowed to rejoin her in the recovery room. The surgeon also finally responded to my call and told us that all went well with a simple trimming of the meniscus. After verbal and written instructions from him and the nurses, and a further stay in the secondary recovery room, we finally left for home at 6:30. The staff were friendly but said they had no control over the long delays. Nevertheless, should we as patients routinely accept waits that totaled five hours? I have a simple three-step plan that will instantly eliminate unnecessary patient heel-cooling time and do so by using the market mechanism, not more regulation. First, remove half the chairs in waiting rooms. Burn them, trash them, given them to charities. They re gone. Then irritated and standing patients will demand prompt service. Second, take all TV sets out of waiting rooms so patients will have no distractions from the boredom of their long waits and will be further irritated. Third, charge each physician $1,000 for each and every one of his patients who stands for lack of a chair. The result of these three simple steps will no doubt be much greater demand by patients for quick service and a leap in the supply of on-time performance by medical practitioners. Does my plan sound ridiculous? In an era of intense experimentation to deal with exploding medical costs and a very inefficient delivery system, it s worth a try.
If you enjoy reading Gary Shilling's monthly "Commentary," you may be interested in Letting Off Steam, a collection of more than 130 of Gary's "Commentaries" from 1989 through 2003. This 286-page book is available for $20 (shipping included). Call 973-467-0070 to order.
32 A. Gary Shilling's INSIGHT Telephone: 973-467-0070 October 2012

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Gary Shilling s INSIGHT

The Grand Disconnect

October 2012 August 2012

A. Gary Shilling's INSIGHT

CHART 1 Nonfarm Payroll Employment

Source: Bureau of Labor Statistics

CHART 2 Job Openings and Hires

CHART 3 Total European Central Bank Assets

Source: European Central Bank

CHART 4 Inventories-to-Sales Ratio

CHART 5 Case-Shiller 10-City House Price Index

Source: Standard & Poor's

CHART 6 Payroll Employment During Recessions and Recoveries

T=official NBER trough

Source: Bureau of Labor Statistics

CHART 7 Corporate Profits and Employee Compensation

Source: Bureau of Economic Analysis

Lowest and Second Quintile

CHART 8 Share of Aggregate Income

49% 48% 47% 46% 45% 44% 43% 42%

1st Quintile (lowest) 2nd Quintile 3rd Quintile

Source: Census Bureau

CHART 9 Household Debt (consumer plus mortgage)

Source: Federal Reserve

U.S. Personal Saving Rate

Source: Bureau of Economic Analysis

A. Gary Shilling's INSIGHT

CHART 11 S&P 500 Declines Over 40%

% Decline 84.8% 56.7% 48.2% 49.1% 56.8%

Mar. 24, 2000 1527.46 Oct. 9, 2007 1565.15

CHART 12 Net Domestic Equity Mutual Fund Flows

-50 2007 2008 2009 2010 2011 2012

Source: Investment Company Institute

CHART 13 U.S. Domestic Equity Fund Flows

2012* -52,322 22,736 -29,586

-32,499 -28,324 -56,512 -86,838

* through June 2012

Source: Investment Company Institute and ETF Industry Association

CHART 14 Personal Consumption and Disposable Personal Income

Personal Consumption Expenditures Disposable Personal Income

Source: Bureau of Economic Analysis

-10% Jan-11 Jul-11 Jan-12 Jul-12

Source: Census Bureau

CHART 16 Inventories In Recessions

CHART 17 Goods and Services

Source: Bureau of Economic Analysis

CHART 18 Ratio of Sector Cumulative Debt and Equity Issuance to GDP

Nonfinancial Corporate Household State and Local

Federal Government Financial

Source: Federal Reserve

CHART 20 S&P 500 and Quantitative Easing

1600 1500 1400

Op. Twist +20%

1100 1000 900 800 700 600

Source: Thomson Reuters and A. Gary Shilling & Co.

CHART 21 Real and Nominal Federal Funds Target Rate

CHART 22 M2 Money Supply and Total Bank Reserves

1800 1600 1400 1200

7743 10058 2315

1000 800 600

Source: St. Louis Federal Reserve