Secondly, GM has lost about $69 per share in the last 3 years. That loss is very valuable. It may be a record for any American corporation. Someone will want that corporate shell when all the assets are stripped away. That someone will want it for the loss.

On a different scale, assume you could buy a $690,000 tax loss for $7500. Every 75 cents buys $69 of tax loss.

Would you be interested? I know I would.

Microsoft (MSFT) should buy the GM shell. Can you imagine the uproar? The GM tax loss for the last 4 years is almost $32 billion. I did the math based on Microsoft’s recent earnings and taxes, and the GM tax loss would save MSFT around $9 billion in taxes. At today’s close, GM has a total market value of less than $500 million.

I’m skeptical but it’s an interesting thought.

He begins by making the case that there is not now any real sign of inflation:

First things first. It’s important to realize that there’s no hint of inflationary pressures in the economy right now. Consumer prices are lower now than they were a year ago, and wage increases have stalled in the face of high unemployment. Deflation, not inflation, is the clear and present danger.

So if prices aren’t rising, why the inflation worries? Some claim that the Federal Reserve is printing lots of money, which must be inflationary, while others claim that budget deficits will eventually force the U.S. government to inflate away its debt.

The first story is just wrong. The second could be right, but isn’t.

It is true that right now deflation is the bigger of the two risks. Debt destruction, of which now we are experiencing in proportions not seen since the 1930’s, is highly deflationary.  The Fed, to stem this deflation risk, has been dumping trillions of dollars into the system to offset the negative money multiplier that is caused by credit contraction in hopes that enough of it will spill out into the system to keep prices from going down.  Fans of Todd Harrison and Keven Depew at Minyanville have heard this risk described as “our wishbone word” - which is to say that there are countervailing pressures of deflation from which the cure could be highly inflationary.

But then Krugman makes this odd statement:

Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices.

But these aren’t ordinary times. Banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all.

The potential error in his thinking is that he seems to be saying that there are no underlying motivations by the Fed to get banks to start lending more. As explained by Ben Bernake himself one of the prime motivators in putting such liquidity into the system is to unfreeze the credit markets. Of course the other big reason is to ramp up the yield curve (on the backs of savers I might add) to bail out the banks through the artificially increasing their earnings power with low costs of funds and high term lending rates. More importantly, however, is that the Fed will eventually have to pull this liquidity out of the system as soon as money velocity picks up.  And, as Shakespeare would say, therein lies the rub.

If the Fed’s intention is to provide banks with the liquidity they need to both make loans and have a steep yield curve a contraction of the monetary base runs counter to those objectives.  The successful timing of the monetary contraction will be highly politicized as well since an early contraction will choke off an already tenuous future recovery that, heaven forbid, will have vast political implications for the ruling party.  Also, since monetary policy is a blunt tool at best, most economists are concerned that the magnitude  of an eventual monetary tightening will be wrong in one direction or another. Having been a close Fed watcher for a few decades myself it seems more likely than not that the Fed can’t live up to the task and things will end badly. I hope I’m wrong.

Here’s where Krugman falls completely off the rails as he asks:

All of this raises the question: If inflation isn’t a real risk, why all the claims that it is?

This is a true departure for any sense of intellectual honesty.  It may be true that there is not now inflationary pressure but there is always a risk of inflation when fiat money is involved.

Krugman’s conclusion, then,  is couched in a rhetorical straw man:

But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.

First, those economist screaming the loudest about the current deficits were also the voices that gave serious objections to Bush policies.  Then there is the matter of scale.  Even those economists that held out that deficits running in the range of 4% of GDP are tolerable I can think of none that ever held out that deficits of the magnitude that Obama proposes would be  unless we entered another world war and it was a necessity for non-economic objectives .  Maybe I’m wrong, but I probably read as much contemporary macro-economic analysis as Krugman.  I don’t find his argument at all true. The most ironic part is, however, that it was the Keynesians of Krugman’s ilk that were screaming from the rooftops about the profligate deficits of the Bush administration when  they were running at 3% of GDP - which is a far cry from the 30% that is on the table right now.

And if Krugman doesn’t think that inflation is an issue perhaps he should spend a little time looking at the bond market where people put their money where there mouth is.  The rate on the 10 year Treasury has gone from 2% a few moths ago to 3.7% this week.  As a result the greenback is crashing against most other currencies with both the Euro and Japanese Yen recently hitting six month highs.  Now, maybe that didn’t mean much a few years ago when the U.S. economy was much more insular, but in a global economy a weak dollar means significantly higher import costs.  We can already see in the price of oil. Which at some point will do serious damage to economic growth.

It’s not about politics.  It’s about standards of living, retirement income, and avoiding the cruelist tax of all that is inflation.  I don’t pretend to know if or when inflation will become a problem.  To to dismiss its risk as nothing but politcs denies the reality of the long term over the ideology of the present.  What we should fear is not so much the fear of inflation but the Keynesian’s who dishonestly attempt to disuade our concern to promote a politicl agenda that could have disaterous effects down the road.

Anyhow, there were a couple of bits that caught my attention today for all of those that are waiving “green shoots” around.  The first was the “good news” about productivity increasing a better than expected .08% for April.  But the reality needs to be more highly scrutinized. As Tyler Durden put it.

In the latest edition, the green shoots crowd are jumping on the release of productivity numbers by the BLS Thursday - nonfarm productivity is up 0.8%, above consensus numbers at 0.6% after going down 0.4% the previous quarter. However, it’s a bad picture when the main driver is due to hours worked dropping 9% and output only dropping 8.2% (poof, productivity gains!).

There are many ways to read this; some may view this as a necessary purge of the fat in our labor economy while others are likely to be alarmed at the increasing weakness of business demand.

The next bit is from Ed Harrison who lends us some perspeective on GDP calulations:

Recovery does not mean recovery

My final thought on the statistics here has to do with starting from a lower base. Before the Great Depression in 1929, the U.S. had nominal GDP of $103.6 billion. By 1933, this had dropped to $56.4 billion due to deflation and a decrease in production. Over the next four year, GDP growth soared. It was 17.0% in 1934,11.1% in 1935, 14.3% in 1936 and 9.7% in 1937. That’s some serious growth, right? Well, GDP was only $91.9 billion in 1937, a full 11.3% lower than it had been 8 years earlier. In fact, it wasn’t until 1941 that we attained the nominal production output of 1929.

What this should illustrate is that working from a lower base makes an increase in GDP comparatively easier than when working from a higher base. Yes, it was a powerful recovery, but it did NOT get the United States back to the same productive level for many years. In that sense, recovery does not mean recovery immediately.

So, even theough we have to respect the market rally we also need to be careful of all the happy talk.  And if you watch Mad Money you need to be all the more careful.

As you can see, since early March, Corporate Investment Grade (subjective, but I digress) spreads have come in substantially from 6% to 4.78% as of yesterday’s close. It goes without saying that this isn’t a small move in spreads. Spreads are back to levels seen in October 2008. They’re improving, however still way above levels seen during normal economic-recovery scenarios. High Yield spreads have had an even greater compression from 18.86% down to 13.23%. They’re also improving, but way above normal recovery levels.

What this is essentially telling us is that — while we’re no longer in an economic death spiral — we’re not set to experience your typical economic recovery, either. Given spreads are back to their October 2008 levels (which also happens to be when the s— hit the fan in equity land), how they act from here is very important.

The pickings in higher yielding corporate bonds has gotten slim - at least by my criteria. That doesn’t meant that they’ll stay that way but we need to watch it.

he Federal Reserve plans to deliver results of stress tests on U.S. banks to executives today that may show about 10 companies need additional capital to weather a deeper recession, people familiar with the matter said.

Banks are formulating plans for filling their capital requirements, much of which would likely come from conversions of preferred shares, the people said. Many of the 19 lenders under review and the government are set to discuss publicly the examinations after markets close May 7, the people said.

But here’s the disturbing part:

The 19 firms include Citigroup, Bank of America, Goldman Sachs, GMAC LLC, MetLife Inc., Fifth Third Bancorp and Regions Financial Corp. The banks in the test hold two-thirds of the assets and more than half of the loans in the U.S. banking system, according to a Fed study released April 24.

We could hope, probably fruitlessly, that the way do get rid of this concentration would be for banks to divest themselves of assets thereby reducing this concentration.  That is, howvever, wishful thinking.

Allan Metzler has penned a good piece on the inflation of the ’70s and how it relates to inflation today.

I do not doubt their knowledge or technical ability. What I doubt is the commitment of the administration and the autonomy of the Federal Reserve. Mr. Volcker was a very independent chairman. But under Mr. Bernanke, the Fed has sacrificed its independence and become the monetary arm of the Treasury: bailing out A.I.G., taking on illiquid securities from Bear Stearns and promising to provide as much as $700 billion of reserves to buy mortgages.

Independent central banks don’t do what this Fed has done. They leave such fiscal action to the legislative branch. By that same token, Mr. Volcker’s Fed had to avoid financing the large (for that time) Reagan budget deficits to be able to bring down inflation. The central bank was made independent expressly so that it could refuse to finance deficits. But is there a political consensus that the much larger Obama deficits will not pressure the Fed to expand reserves to buy Treasury bonds?

China, wary of the troubled US economy, has already “canceled America’s credit card” by cutting down purchases of debt, a US congressman said Thursday.

China has the world’s largest foreign reserves, believed to be mostly in dollars, along with around 800 billion dollars in US Treasury bonds, more than any other country.

But Treasury Department data shows that investors in China have sharply curtailed their purchases of bonds in January and February.

Read the whole thing.

The trade is to short Treasuries - if you haven’t already.  Keep in mind, however,  that the Fed has some tricks up thier sleeve that might cause downward pressure on rates in the near term.  In the long term though, I still think the the trade makes sense.

The real innovation, however, is in its ability to work things out “on the fly”, according to its British inventor, Dr Stephen Wolfram. If you ask it to compare the height of Mount Everest to the length of the Golden Gate Bridge, it will tell you. Or ask what the weather was like in London on the day John F Kennedy was assassinated, it will cross-check and provide the answer. Ask it about D sharp major, it will play the scale. Type in “10 flips for four heads” and it will guess that you need to know the probability of coin-tossing. If you want to know when the next solar eclipse over Chicago is, or the exact current location of the International Space Station, it can work it out.

Dr Wolfram, an award-winning physicist who is based in America, added that the information is “curated”, meaning it is assessed first by experts. This means that the weaknesses of sites such as Wikipedia, where doubts are cast on the information because anyone can contribute, are taken out. It is based on his best-selling Mathematica software, a standard tool for scientists, engineers and academics for crunching complex maths.

I hope this works out as pitched.  I have nothing against Google for sure but with all of the research I do it seems like this will be a massive time saver.

From an investment perspective I wouldn’t put my shorts on Google because of this - yet.  But there may come the day.  It’s worth keeping an eye on.

There’s a lot of optimism out there.  Personally I really appreciated a break from endless bad news - or at least less bad news than what we had for the first three months.  Or maybe I’ve just become numb to it all and the market’s continued upside sprint gives hope that the world is not coming to an end.  That said, there still lies enough uncertainty that I vacillate between cautions optimism and guarded pessimism. So let’s look at where we are.

The Fifth Inning

Part of the optimism has come from the latest GDP report that showed a bump in consumer spending for Q1.  That, however, could prove to be a false start therefore I think it serves us to wait a bit before doing an end-zone dance.

The first quarter GDP numbers were stunningly bad showing the economy contracting at an annual rate of 6.1%.  The consensus view was a milder -4.3% but economists missed the huge inventory correction which accounted for roughly 3.4% of the contraction.  That’s actually good news inasmuch as businesses are adjusting their balance sheets more rapidly than what was expected. In the mean time personal spending increased by 2.2% - which many took as a sign of the beginning of the end.  Regarding that, I don’t know if we can take that as a real sign of progress.  Personal spending was so dampened in the prior quarter due to credit constraints on durable goods that this bump could be nothing but a bit of pent up demand being released.  It’s hard to tell for sure - even though some retailers have reported modestly higher sales - but one quarter does not a trend make.  Furthermore, it appears that most of the spending happened in February while March turned back down.

As noted above, however, the sharp reduction in inventories bodes well for an uptick in manufacturing.  Now this certainly won’t be true across all sectors and industries - like automotive, which still has huge levels of unsold cars on lots across the country.  In contrast, while listening to Intel’s conference call, they projected that a bottom has been reached in the PC market and demand was showing signs of picking up. This general trend in IT looks more positive than most sectors.  From a cyclical standpoint this makes a lot of sense inasmuch as when businesses run into hard times they look for ways to increase efficiencies through technology.

Now, don’t get me wrong.  Not a single indicator, besides the perhaps anomalous blip in consumer spending, was positive. When economists talk about “green shoots” what they are really talking about is an upturn in the 2nd derivative.  In other words, a slowdown in the rate of deterioration.  If your interested in knowing more about that I blogged about it a few days ago and you can find it here.

Calculated Risk has a good take on where we are in the business cycle and particular attention should be paid to residential real estate.  I don’t think we’ve come close to a bottom yet and that has everything to do with consumer spending.  The good news is that, according to Mike Shedlock, low interest rates will help those with variable rate mortgages thus, at least, won’t make foreclosures worse in the near future.

Speaking of interest rates, no matter what the Fed is doing to keep long term rates down there seems to be more external forces than they are willing to deal with.  The 10 year bond has increased it’s yield from just over 2.5% to 3.17% since the Fed announced its quantitative easing in March.  At the same time the good news is that high yield commercial bonds spreads are narrowing quite significantly as credit starts to flow again in the capital markets.

The Fed also announced yesterday that it was creating a lending facility for commercial real estate mortgage backed securities.  I’ve been calling commercial real estate the next shoe to drop in the credit fiasco.  Apparently the Fed agrees and is working to bolster liquidity in that market.  By some estimates the amount of CMBS refunding through the end of the year is near $700 billion.  Combine that with the huge amount of Treasury borrowing that is projected and liquidity is an issue.  In fact, the country’s third largest commercial REIT, General Growth Properties (NASDPK GGWPQ.PK) filed bankruptcy in April because they weren’t able to refinance their debt.

To summarize the state of the economy I’d say we’re roughly half way through the cycle.  I reserve my right to change my position, however, and if I was to make a bet on the over/under on my prediction I’d take the under.

Investment Outlook

From a macro view I think that the broad markets are quite a bit overbought right now.  Many technical analysts set upside resistance for the S&P 500 at 875.  Although, on a intraday basis, we breached that number by 13 points yesterday morning, the market has failed to break it on a print at the close.  The funny thing about technical analysis is that, since so many people use it, it can be a self-fulfilling prophecy. According to a Barron’s survey of institutional investment managers last week  a good majority think that the S&P 500 will see 1,000 by year’s end.  A similar percentage likewise think that we’ll test the March lows before that happens.  Todd Harrison of Minyanville is of that mind as well. He’s calling 2009 “The Year of the W” and given that I think he’s the best prognosticator on the street I have to give his opinions the respect they’re due.  Another great Minyan, Vinny Catalano, thinks that stocks are overvalued  here.

From a fundamental valuation perspective, there are an increasing number of reasons to be more cautious - most notably, the high P/E levels. At current price levels, the S&P 500 operating earnings for this year must come in around $60 to justify an average times P/E of 15 (15 x 60 = 900). While there may be a good case to be made for an average times P/E of 15, it’s hard to deny that these are anything but average times. Fraught with many unresolved problems, I find it hard to buy the average times P/E as being prudent. A number more like 13 or 14 times (thereby producing an S&P 500 fair level of 780 and 840, respectively) seems more appropriate. .

Accordingly, although I don’t have a crystal ball, I think he’s right and so I have stops on most, but not all, of the assets in the portfolio under the heading of asset preservation.

My bias has been to move into longer positions in certain commodities such as copper and natural gas and I’ve taken positions in a couple of tech names - with really strong balance sheets - as well as low-end retailers who should hold up in the event of a downturn.

As I write this the portfolio is up about 5.47% year-to-date against a loss- in the SPX of 3.19%.  I’ll admit that I missed much of the big rally from the March lows but I also missed much of the big bear that preceded it in January and February.  Caution was and still is the order of the day.

But going forward I see there is probably some money to be made as inventories start to be rebuilt.  I’m looking at things that are used as input goods to component manufacturing such as makers of polysilicone used in micro-chip and solar applications.  I also think that companies will be investing in technology process improvements in both the data hardware and software spaces. In every economic downturn surviving companies look to increase operating efficiencies through technology and I don’t suspect that this time will be any different.

As I’ve written before, we’ll really have a better understanding of the end of the downturn when “things that come out of the ground” significantly increase. Everything starts with raw materials.  Right now I like copper mostly due to the massive infrastructure projects on the drawing boards worldwide and it soon might be time to look at aluminum as well.  I still think that infrastructure engineering companies are an interim good bet but many of them have had their run and they’ll back off  providing a better entry point.

Over the longer term I suggest that we all look to how we eventually get very long in both stocks and commodities.  While we may be seeing some deflation right now - which is good for cash - I doubt the Fed’s ability to pull back the money supply in time to choke off eventual inflation.  That may be a year or two out but my best guess, having been a Fed watcher for a few decades, is that the dollar is at risk of being clobbered at some point.  The last thing we want to have is a lot of cash when that happens. But on a cautionary note, I still think gold will prevail in the long term as the best dollar protection, but I’m not ready to go way long in it right now since I think we have some time before the great deleverging is finished and the risk of higher deflation passes.  So if you’re a gold trader that’s fine, but as a core holding I think there’s a better entry point.

I guess the moral of the story is that there still is significant risk out there and the need to balance the downside is equal to need to keep in the game for whatever upside eventually comes about. In order to profit one must be nimble.

If anyone would like to talk about their specific circumstances please don’t hesitate to drop me a line or call. And don’t hesitate to pass this forward to anyone you know who may be interested.  It’s a tough environment and sometimes we need all the help we can get.