Janet Yellen, Stock Picker; I buy more Protalix

Apparently Janet Yellen believes she can pick stocks. Or at least tell people to dump their "smaller" social Internet stocks and biotechnology companies.

So there was a sale today as the ever gullible dumped stocks they picked up when some other idiot told them to buy them in the past.

I am okay with my portfolio right now, particularly my healthcare and biotechnology stocks. I believe some of my companies like Gilead, Amgen, Biogen and Celgene will report increased earnings during the remainder of 2014 and beyond, so I don't ponder their daily volatility much.

I have a number of smaller positions in riskier companies that need good Phase III clinical results and then FDA approval to get their wares to market. I was tempted to buy more today, but ever-cautious, I only picked up one:

Protalix Biotherapeutics (PLX). I doubled my tiny amount of PLX, raising it to just above 1% of my portfolio.

One of my main criteria for picking up small, risky biotechs is that market capitalization indicates that success is not priced in, at least not too much.

If you want, you are welcome to look at my portfolio positions. In most cases there are links to my coverage (analyst conference summaries and articles) of the stocks. My list is not a set of recommendations, I am just being transparent because I am a financial writer.

P.S. Janet Yellen and I have one thing in common: we both have undergraduate degrees from Brown University. Mine was in Political Science. I took two economics courses at Brown, microeconomics and macroeconomics. I started studying the Federal Reserve then, and even then I knew that some of what I was being fed was bullshit.

ECB Good, Federal Reserve Bad

Today the European Central Bank (ECB) announced it was raising its interest rates from 1% to 1.25%. Given that the European economy, particularly the economies of Greece, Italy, Spain, Portugal, and Ireland, are supposed to be in poor shape, that may seem like a dramatic tightening of the screws. It is not. Interest rates are still very low in Europe. Any shortage of credit, or of takers, is not due to interest rates being too high. 1.25% should provide good support to further economic expansion.

In contrast in the United States of America the Federal Reserve Board (the Fed) recently left its benchmark interest rate at zero. That is right, 0%. I admit I would like to borrow some money at 0% interest, but the Fed alone lends to its member banks. The same people who charge you 15% to 35% interest on credit cards. This unprecedented low American interest rate did not make much sense even during the Panic of 2008. 0.25% or 0.5% would have been just as supportive to the economy and the banking system.

We are now in a pretty ordinary recession, except the prices of certain commodities have spiked due to global demand and limited supplies. The Fed's public argument is that the low rates are because a lot of Americans are out of work. One thing I know, the Fed does not care about the type of Americans who are out of work, unless they are banking CEOs. They are keeping interest rates low for the benefit of the banks, of the federal government (it keeps interest on the national debt low), and for large corporations that can currently borrow vast sums of money at huge rates. In my role as analyst I have not seen much corporate borrowing used for industrial or work force expansion. It is typically used to buy back stocks or mergers.

The dangers of these unprecedented low interest rates are so clear that even a few Fed board members have pointed them out. They can lead both to inflation and to more asset bubbles. We certainly already have a gold and silver bubble. Bubbles were the problem in the first place. New bubbles do not a sound economy make.

Meanwhile, ordinary savers are suffering from low interest rates. Retired people are having to eat their principle because they are getting almost no interest from CDs and bonds. The Fed says there is no inflation, but if your main discretionary expenses are gas and food, there is a lot of inflation. Other recessions were not met with such low rates.

Since 1952 the Fed had set interest rates below 2% for only a few brief periods, before 2008. [See Federal Reserve rate history] Given that the Fed should manage for the long term (not acting like Wall Street traders who can't see beyond the current quarter), the Fed's rate should already be at 2%.

Given that (at least in free market theory) private loan rates should be set by supply and demand, that should not budge rates for housing. Anyway, low interest rates have failed to provide an incentive for people to buy homes. Homes are seen as a bad investment; people want easy money, not assets that are taxed yearly (with real estate taxes) and need to be repaired regularly.

The Fed are cowards. They don't want to tick off Wall Street or Congress (Republicans want low rates for their business friends, Democrats because they don't understand economics). 2% is very supportive of economic expansion. If we had already gotten there gradually (or were near there like the ECB is now), then further gradual adjustments could be made, up or down, depending on the genuine need for credit for economic expansion, or on the danger of inflation.

If I were the President (fat chance) I'd fire the bums on the Federal Reserve and hire some people who can actually do the job.

Data: ECB interest rate press release April 7, 2011

2010 Economic Analysis & Forecast

For once I am basically in agreement with most mainstream economists on what is ahead in 2011.

We are still in the virtuous cycle ramp that follows an economic downturn. Most of the differences between economists are about the strength of the ramp and what particular sectors will lead and lag the economy as a whole. Wild cards include possible actions by the Federal government, the Federal Reserve, and bankers in China and Europe. Double wild cards include natural catastrophes and military incidents.

Leading the trend both globally and in the United States will be manufacturing. This could be more than a bounce-back in the U.S. because it is an increasingly attractive place to do manufacturing now that wages are closer to the global norm. People forget that losing factories to China has not destroyed as many jobs in the past century as advances in information technology and automation have destroyed. I expect increased demand in the U.S. and globally for U.S. products, and the beginnings of a round of capital investment in new and expanded U.S. manufacturing facilities.

Lagging the trend will be the housing and general construction market, which in turn creates demand for wood products, metals, and etc. However, there is very, very little new housing stock in existence right now, in a nation that typically adds over 3 million people each year. Also, a lot of people are overcrowded. College and high school graduates from the past few years are dying to get a job and move away from mom & pop. Even if people who gain employment enter the housing rental market (instead of buying houses), this will make landlords happy and more willing to buy up existing housing stocks. I don't expect a price boom in 2011, but building new houses (and apartments) is going to start looking attractive in some specific markets as the year goes on. If banks gain confidence, we could get back to a normal balance between buyers and sellers by the end of the year. However, predicting timing is difficult because the decisions are driven by diverse buyers' mental states.

Bonds should fall (resulting in higher interest rates), but that is dependent on Fed action and risk assessments by bond holders. The stock market should rise because return on investment, at least in the next few years, should be a lot better than investments in bonds or real estate. In the stock market, however, it will be more important to look for companies with long-term growth prospects, rather than just growth due to bouncing back from the recession.

The national debt is going to grow by leaps and bounds because even strong economic growth won't generate enough tax revenue to cover the spendthrift ways of the Democratic Party and Republican Party. The 2011 budget is already shot and 2012 is an election year, so expect the new Congress of 2013 to contend with a tidal wave of debt.

Jobs should be more plentiful in 2011, but employers will still be able to pick the best workers and offer relatively low wages. This is good (for the economy, not for the unemployed) because low-productivity workers are a drag on businesses. Good workers help generate the profits that are needed to expand, and which eventually force companies to hire and try to train less reliable workers. The unemployment rate should drop by a percent or two, but will remain brutally high for the least employable citizens.

The Federal Reserve should have already raised interest rates to the 2% level, but I expect them to keep rates near 0% for the entire year, because they have a proven record of irresponsibility and incompetence. Or perhaps I should say they are competent at serving their fellow bankers, but not at their mission of maintaining relatively even economic growth. Why say rates should rise even with continuing high unemployment? Because any rate under 4% will support economic growth, and having to raise rates rapidly later on will lead to bad decision making or even panic.

People at every level are looking for opportunities, and 2012 will be a good year for many.

Federal Reserve Behind the Curve?

A wise investor always keeps in mind the spectrum of risk. For any given investment there is a spectrum of likelihoods, including unforeseeable events that could bring an upside or downside. With bonds, of course, you have a lot less complexity than with stocks, and with Federal bonds you have less complexity than with corporate bonds. Typically, however, while bonds limit some downside risks, they also limit the upside.

The economy (whether defined as the United States or as global) has an astonishing number of variables at play at any given moment. The decision makers at the Federal Reserve have considerable experience in the banking sector, but typically have little experience in manufacturing or, for instance, in the black market economy (which is mainly services performed by individuals who do not report their income to the government). Their collective record for steering the economy in the past two decades is dreadful; if they were drivers, they would have had their licenses taken away.

The history of the United States, and other nations, is replete with instances of false booms based on excessive credit and speculation. Real economic growth does require a degree of credit, but it is mainly based on savings and profits that are then redirected to new growth opportunities. Americans are now saving, which is good. They should save considerably more, but in aggregate won't be able to until employment returns to "normal" levels. Judging from price-to-earnings (P/E) ratios, American businesses are generating profits and mostly don't need much in the way of credit to keep up a modest pace of expansion.

Today's Federal Reserve statement (September 21, 2010) gives the impression that the economy is still growing, but at a slower pace than earlier in the year. Of course. Aside from the inventory restocking bounce that always follows a recession, we had a lot of reluctance to anticipate growing demand because of the "double dip" howling of the wolfpack. But there was no double dip, not even during the Euro freeze.

Growth is growth, and it will speed up and slow down from month to month and sector to sector. What the Federal Reserve won't admit is that its zero-interest rate policy is not doing much more for the economy than, say, a 2% interest rate policy would do. It is helping the banks (recall that the Fed does not represent the people, but is all too much like a bank collusion mechanism), but they aren't lending much. When they do lend, it is often on credit cards at ridiculously high interest rates. Which at least encourage consumers to save rather than spend.

The fed could easily start raising interest rates now, showing some confidence, and normalising the situation. At 0.25% today, maybe 0.5% after the holidays, working towards whatever is appropriate by the end of 2011, probably at least 2%. If the recovery is slower than I expect, rates should still go up gradually to at least 1.5%, which is very, very accomodative.

The Federal Reserve can't make a recovery. That will be built by the people themselves, as it always has been. There is a lot of work that needs doing, notably repairing millions of homes that have been damaged by thieves and neglect during the past 3 years. Schools are overcrowded due to teacher layoffs. American services and manufacturing are becoming more competitive with China because of rapidly increasing wages in China. This does require capital as well as person-power; the banks could play a part.

We know what the banks will do. When it stops raining, they will start handing out their supply of umbrellas.

Today's Federal Reserve decision to leave interest rates near 0% may be politically popular, and popular with Wall Street banks, but it is not a responsible decision given the data available.

Virtuous Economic Cycle Components

After a severe recession there are going to be some very damaged sectors of an economy. They don't all spring back at once. Some lead, some lag the general upturn. While past upturns offer patterns that may be repeated, the economy is a complex beast, so it is not surprising if details differ in each cycle.



In 2009 the stock market indexes hit bottom, then had a good climb. In 2010 so far we have been up and down a number of times, ending around flat today after a good start to September. Not knowing history, one might theorize that the stock market should have a damping effect on economic cycles (not dipping as deeply, not rising as quickly). This would be because a common theory is that stocks are about future value. So stock prices should take into account long-term returns, which should in turn take into account the cycles of growth and recession that characterize capitalist economies.


But, in just one for-instance, in early 2009 the stock market averages dipped far more, as a percentage, than GDP. Same in the 2001 crash. But in 2001 the fall came mainly because leading up to 2000 investors forgot to take into account that the profitability of the companies' would drop when a recession took hold. The Federal Reserve failed in its duty to dampen a bubble because big egos mistakenly believed, and told the mass of investors, that cycles were over, to be replaced by more-or-less steady economic growth.


At its bottom in 2009 the stock market was suffering from the opposite delusion: that the economy would never recover. I would argue that in 2007, with the exception of the banking sector, most stocks had in fact priced in the entire economic cycle. The commodity sector had not, and of course housing prices and loans against housing had not. Many people lost all or much of their retirement investments not because they had invested badly, but because they panicked and sold near the bottom.


The big price swings in stocks are because they are auction markets. They are efficient at matching buyers with sellers, but they overprice and underprice securities when there is a deficit of one party or the other.


Today housing, both used housing stock and the building of new housing, is still weak. There are still some pockets of vacuum where people pretend there are loans that will be repaid; there is still turbulence. But the economy can suffer a fair amount of turbulence without crashing.


Demand continues to pick up despite the fact that we are no longer seeing net stimulus from the government sector. Some sectors of the economy are showing strength, notably agriculture and export-oriented industry. Those who are employed are much more confident of keeping their jobs than they were a year ago. They also, on the whole, have paid down their debts and are in a much better position to shop more without getting themselves into trouble. So I would expect that as the employed spend more retailers will be encouraged to do more hiring.


That is the thing about the virtuous part of the cycle. More hiring means more retail sales, and less of a drain on government for unemployment compensation and the like. More retail sales means more manufacturing. And in turn more hiring.


In 2011 we can expect people who have huddled together in houses and apartments to save money to begin to feel secure enough to venture out on their own. That means more rental income (if not increased rents or housing prices, at first) and, after all these many years, the absorption of excess housing stock.


All these processes take time. The stock market is an important part of this cycle. People spend more when their stocks are up. Those who own stocks represent a disproportionate part of the spending equation. If investors are so cautious that stocks take another dive, that will slow down the natural upswing. If the market moves up smartly in the near term, that will accelerate the recovery.

Bonds, Danger! Bonds, Danger!

I have touched on this topic before, but this is a good time to repeat my warning.

Bonds are usually thought of as safe. That is the wrong way to think of bonds right now (except for very short term bonds, say less than 2 years).

Bonds are the most dangerous financial investment you can own today. It does not matter whether they are U.S. treasury bonds, corporate bonds, or municipal bonds. The general danger does not lie in possible defaults, though of course individual bond issuers could go bankrupt and default.

Many investors, including individuals whose investments come from 401k and IRA accounts, had little or no experience with bonds prior to the Panic of 2008. Typically, after taking significant losses in the stock market or in real-estate investments, individuals and sometimes even large entities like pension funds wanted some place to park their cash. They were advised to buy bonds. This advice was self-serving by brokers, who could take fees for buying the bonds, but would not get fees if they left the money in the form of cash.

Under normal circumstances bonds play a ballast-like role in investment portfolios. Normally they do not fluctuate in value as much as stocks and produced a decent long-term rate of return that is higher than you would get on a CD of similar term. Returns for a given length of time vary mainly according to the perceived risk of the entity doing the issuing, so the U.S. Government pays the lowest interest, solid corporations a middling interest rate, and weaker entities pay "junk bond" interest rates. Short term rates are usually much lower than long term rates, but the differential is affected by the outlook for inflation.

Underlying interest rates are typically set by the Federal Reserve, but even the Fed cannot fight market forces forever. Right now real short to medium term interest rates on Federal debt don't even cover the loss of principal from the effects of inflation. The Federal Reserve is keeping interest rates artificially low to help revive the economy and to keep the interest on the federal debt a relatively low percentage of the federal budget.

But the danger in bonds is not in the low interest rates they are paying today. It is not even in the fact that people who were 100% in bonds in 2009 lost out on a major stock market rally. And what I am going to point to should not be a problem with balanced portfolios that include appropriate ratios of bonds with stocks or other investments.

But if you are 100% in bonds, you had best get out, or largely out, while you still can, before everyone realizes what is happening.

Bond interest rates are highly likely to rise. And they may rise rapidly once they start rising, regardless of how the Fed tries to fight market forces.

If your broker put you in bonds or bond funds, you might think that higher interest rates is a good thing. After all, you have been getting about 2% interest (maybe 3.5% if you are all in long term bonds) for a couple of years now; that seems more like being a chump than an investor. Surely it is better for bonds to be at say, 6%? Isn't that a pretty nice return on a safe investment, as opposed to chewing your nails about stocks or real estate or commodity prices?

The problem comes when you (or your broker, or bond fund manager) tries to sell your 3% bonds to buy 6% bonds (note how I have made the math easy!). Say both bonds terminate the same year, say 2020. Who wants to buy a bond that is going to make 3% interest for another 20 years when they could buy a new bond at 6%? Only one kind of trader: the kind that will get a deep discount on the bond. Like say a 30% discount. Because for a thousand dollar bond, principal plus (simple) interest at 6% for ten years givens you a total of $1600. Pay a thousand, get $600. But your old bond will pay only $300 interest over the remaining ten years. So to be worth the same amount of money, the buyer would only pay $700 for the bond itself (getting, in the end, $1000 principal and $300 interest for $700; making the same $600). You, who foolishly were in 100% long bonds, suddenly have lost 30% of your life savings just because interest rates have gone up.

And they will go up, unless we are hit by a global Depression that makes the Panic of 2008 look like an ice-cream party. The indebtedness of the Federal government keeps ballooning, and that is, so far, while paying low interest rates. You know those penalty interest rates credit card companies like to charge their most unfortunate, weakest customers? That is the direction we are probably headed in, if taxes are not increased and expenses reduced to quickly balance the budget. The economy is reviving, but that won't increase government tax revenues fast enough to make up for reckless spending and ballooning debt payments.

No one in their right mind should be loaning the United States of America money at under 10% these days, to compensate for the default and inflation risk. Now that you have thought about it, I'm sure that you as a rational individual would not do that. But tens of millions of Americans depend on mutual funds, brokers, and financial advisers to manage their investments, and they are being told to keep their money in federal bond funds. It is bad advice brought to you by the same pack of jackals and fools who brought you the Panic of 2008. It is up to you to stop playing the fool and to warn your friends.

Most publicly traded American corporations are much sounder than the federal government right now, and so should be able to issue bonds at less than the government rates. But when federal bond rates go up, they become comparisons for all bonds. That will likely force corporate bond rates up as well, causing their principal value to weaken. So if you can get out of corporate bonds before the crisis, do it.

Alice in Wall Street Land

Today it was announced that the government of China tightened up on lending by increasing the reserve requirements of banks.

Stocks fell in most of the world and in the United States.

And yet we should be celebrating that the Chinese government, unlike the American government, has at least a vague sense of sound capitalist economics. We really don't want the Chinese economy to overheat and then crash. We want to see sustainable growth. Even with that goal, we would expect to see more cyclic activity than is desirable.

China has become the engine of the world economy. Just as Great Britain was in the 19th century and the U.S.A. was in the 20th century. What is good for China is good for the world. China is one of the largest national markets for many of the stocks I own or follow like Marvell Technologies (MRVL) and Microchip (MCHP). Even my biotechnology companies are selling rapidly increasing volumes of their products to Chinese end markets.

The rest of the world, particularly the United States, needs to catch up to China in this cycle. It helps us if China taps the breaks a bit. We need to improve our competitiveness and absorb our own excess capacity.

Selling stock because China tightens its credit policies, this early in a recovery cycle, is just stupid.

Professionals on Wall Street may have a lot of competitive advantages over individual investors, but on the whole they are a narrow-minded, stupid and cowardly lot. It's hard to match the top 10% of Wall Street guys, but beating the average is not very tough if you do your homework, analyse situations carefully, and don't get emotional.

Choosing individual stocks is still where the competitive advantage is for smaller investors. It does not take very much research to know more about a particular company than most brokers and professional traders. You can even beat computerized trading programs simply by taking a long view; they aren't programmed to understand companies or markets, they seldom trade well on time frames of over a week.

Markets should be cheering the Chinese government. Investors should be pressuring the Federal Reserve to raise interest rates to a defined point like 0.25% or $0.50% to signal that credit generation will not be allowed to get out of hand in this cycle, the way it was in the last two cycles.

To The Federal Reserve: Start Raising Interest Rates

The Federal Reserve should have set its "federal funds" rate at 0.25% at its last meeting. Unless there is a marked reversal in the economy, it should raise the rate to 1% in steps.

Confidence in the Federal Reserve is near zero at this point. We have had two major asset bubbles in less than a decade. While there were other reasons for the bubbles, the main reason the bubbles grew to catastrophic proportions was the failure of the Federal Reserve to raise rates quickly in response to the bubbles. True, there should have been better oversight of the mortgage industry and the derivatives based on it. But when an economy as a whole inflates unreasonably, it is the money supply and interest rates that need to be controlled.

The Board of Governors of the Federal Reserve current policy is to "maintain the target range for the federal funds rate at 0 to 1/4 percent." [See August 12, 2009 Federal Reserve meeting release]

One of the causes of the crash of 2008 was inadequate consumer savings. Because most consumers had little of no savings, when credit was reduced they had little or no ability to keep consuming.

Since the Fed lowered interest rates to deal with the crash it should have prevented, those who did save by putting deposits in CDs and saving accounts have been severly punished. True, they may be happy that they were not invested in stocks or speculating in real estate, but as time passes the punishment becomes more real. It must be particularly gauling to get a notice that you credit card interest rate has been raised to over 20% from the same bank at the same time your CD renewal rate is lowered to 0.5%.

There is something obviously corrupt, and diverging from free market pricing doctrines, when the Fed is lending to banks (at the discount rate) without charging interest, and the banks are turning around and charging over 20% interest to the citizens of the United State.

But if you can, forget about justice for a moment. Consider the economic implications of the Fed's current policy. Money costs nothing to those borrowing directly from the Fed. What are the chances that free money will be allocated in an economically efficient manner? Zero, the same as the interest rate.

The biggest problem, however, is that the Fed is signaling that it does not care about inflation. With global supplies of oil, grain, and other basic commodities likely to tighten quickly once the global economy starts expanding, the danger of inflation from commodities alone is high. In addition, the Federal deficit and debt are huge indicators of potential inflation.

It is unlikely that a Fed funds rate of 1% would derail a recovery, even if such a rate had been announced in August. Putting 1% gradually into place is no danger at all. The danger is that the Fed will, yet again, get behind the curve and then be forced to overreact. The even greater danger is that the Fed will get behind the curve and then fail to ever catch up without causing a crash, as happened in 1999 and 2007.

Even if the economic recover is gradual, there is no reason to have rates below 3% by the end of 2010. High interest rates reward savings. That is not just putting money in a savings account. That is thrift, doing things efficiently, doing without waste or luxury. High interest rates also punish borrowing, which is associated with economic inefficiency and waste.

You can let the Federal Reserve know what you think at Federal Reserve Feedback.

The Oil Price Oscillator

Most Americans have noticed gasoline prices have been jacked up for the summer driving season. Those who read the financial pages know there is a glut of oil and gasoline available. If the corporations that set pricing keep prices up, and demand remains low, the glut will still be there in September.

But if there is an economic recovery, either in the U.S. or globally, the current glut will work down to normal levels and then to shortages. Prices will get jacked up further at the pump. And that, in turn, should moderate any economic upswing. It might even bring consumer consumption of everything but gasoline crashing back down.

It is very possible that we are in a period of oil prices being the primary oscillator for the economy. That is, when oil prices are up, the economy will slow, stall, and then decline. Oil prices will then fall by a greater percentage than the economy as a whole. Which only allows the economy to repeat the cycle.

This is a limits-to-growth scenario. It assumes the economy can only grow so much without more oil as an input, because the price of oil determines how much of the economic pie is left for everything else.

Over time, oil prices should become less of a controlling factor. We have already seen some of this. The shift from low mile-per-gallon SUVs to smaller cars and hybrids is just one example of how the shift could take place in the long run.

Some economists and analysts will get out their spread sheets and try to make numeric predictions about exactly how oil and gasoline prices will affect the economy in the short run. When dealing with something as complex as the economy, using a rule of thumb is more honest than pretending you can predict with finer granularity. There are too many other factors affecting the macroeconomy, ranging from how the Federal Reserve sets interest rates to billions of one time decisions by individuals that are small in themselves but in aggregate create macroeconomic trends.

Have We Hit Bottom Yet?

What every investor wants to know: have we hit bottom yet? Business people want to know that too. Should we lay off more people, buy that new ERP software, or cut that dividend?

Smart people will use a cover your bets approach. We have already seen a number of worst-case scenarios starting in 2007.

Typically, in the post-Depression recessions, the stock market averages started recovering before the rest of the economy. Stock markets are believed to be forward looking. But that may not be the case this time.

There are a number of differences between this recession and prior post-New Deal down cycles, and a number of similarities. Sorting them out may not tell them if we are at a bottom yet, but they can help us understand how to get our footing once there is a bottom.

Fortunately, many major corporations were cash rich going into this downturn, and are well-positioned to weather anything thrown at them short of the collapse of civilization. Some are taking advantage of their cash positions to buy assets cheap, which is what I believe investors with cash coming in should be doing right now.

Most people who are losing their jobs are getting unemployment compensation. More than any other New Deal reform, this tends to put the brakes on recessions.

The big obvious problems, of course, are banks and housing. The Federal Reserve System was set up to deal with banking credit cycle issues. Unfortunately the Fed is run by people, and in particular it was run for a long time by a certifiable idiot, Alan Greenspan. Alan drank the Free Markets are God kool-aid. If free markets were not sometimes a problem, we would not have needed the Federal Reserve in the first place. Free markets are not magic. They have their own mechanics, and don't care too much about human beings.

It is a tribute to the resiliancy of capitalism, the safety valves and safety nets of socialism that have been grafted onto it in the United States, and the good sense of most business persons that the crew of the likes of Alan Greenspan, Robert Rubin, Bill Clinton, George W. Bush, et al, actually did so little damage to our economy.

I am glad the American people, as a whole, started saving more money in 2008. Even though it hurt the holiday shopping season, even though it hurt the auction prices of some of my stocks. It was the right thing to do. Shopping on credit that has to be paid at high rates of interest is no way to run a family economic unit, and no way to run an economy. Lowered household debt as we go into 2010 will mean people will be paying less interest, and have more actual money of their own to shop with. I just hope we all remember this lesson.

Housing remains an interesting dilemma. As far as I can tell, there is no longer a surplus of housing in the U.S. as a whole, though some areas remain overbuilt, like the central California valley. If the banking system starts functioning in a healthy manner, surplus of houses for sale right now will shrink throughout 2009. In 2010 new home construction will become necessary in at least some areas. That in itself should get the economy back to normal.

But I don't feel the bottom under my feet yet. One more part of the down cycle has not really kicked in, and it could force us further out into the stormy seas. This is the bankruptcy cascade. Businesses can fall like houses of cards when this cycle starts. A business that seems solvent, with plenty of receivables to use to cover its payables, can be put in jeapardy if its receivables disappear in customer bankruptcies.

On the other hand, this is also a healthy, important part of business consolidation. Week, poorly managed businesses with insufficient profit margins or cash reserves get punished. Well-capitalized companies get a licking, for sure, but they can then pick up any paying customers of the losers and enter a new expansion cycle.

This is a stock pickers market. If you are in index funds, you are a fool. The only stocks worth buying now are those with large cash reserves built from profitable business practices. Those cash reserves stand for conservative management. They represent past profits, and they are the ticket to future profits.

Today Gilead (GILD) [I own Gilead stock] announced it will buy CV Therapeutics (CVTX). Gilead is your prototypical well-managed company. Even after it buys CV, it will have a huge cash balance. That's the way to do it.

Keep diversified!

Strange Securities Auctions

This column already has several essays about economic, and investment, issues created when prices are set by auctions. The recent financial meltdown has given many real world examples of this, but they are difficult to explain to people who are not familiar with stock and bond pricing, much less derivative pricing. So I have made up an imaginary example that encapsulates, in a dramatic way, a particular type of auction malfunction (if by malfunction we mean pricing that veers from free market ideals).

I'll walk you through the example, then relate that imaginary experience to selected current economic and financial events caused by the lack of liquidity in the markets.

You hear about an auction and it sounds like you might want some of items in it, if the prices are right. The auctioneers will take only cash, so you put together what you have, say $55. You get stuck in traffic, so you arrive late. Outside people are already boasting of what great bargains they won. You hurry in.

The auctioneer, "the next item is a bundle of $1 bills, 100 of them." You think it is a strange item to auction: it is clearly worth $100 [assume these are not bills of value to collectors, or counterfeits, just ordinary $1 bills]. No one makes an offer at first, because everyone says assumes that it will be bid up to just short of $100, so bidding is a waste of time. But the tension builds and you decide why not, and open at $10. At that point the bidding goes quickly up to $29, then stalls. You offer $30. No one else bids against you. You win the $100. You pay $30 for the $100 and have $70 at the end. Meanwhile the auction has ended.

How could that happen (aside from the fact no one would auction off actual money like that)? Everyone else had run out of money. The next richest bidder in the room only had $29. It is your lucky day.

Translating this imaginary excursion closer to reality, now suppose that the item you bid $30 on and won was a mortgage bond worth $100. It really is worth $100, because the mortgage backing the bond is sound and will pay $100 over time. You win the auction not because the bond is worth $30, but because there is not enough cash to efficiently price the auction. Free market ideals have broken down.

Lately, almost no one has wanted to participate in auctions of at least two types of securities, mortgage-related bonds derivative securities and auction-rate securities.

There are two basic reasons there has been little bidding for weeks now: fear and lack of cash to bid with. The kind of institutions that can play this sort of game were all suddenly short of cash, and wanting to auction off what they could for cash, rather than using their precious cash to buy more securities. But no one else knows how to price the securities. For instance, it is difficult to find out which particular houses correspond to which particular mortgage bonds; linking the houses to derivatives is even more complex. So it is not exactly like buying a bag of $1 bills, if you just start buying a bunch of bags without looking in them. It is like buying an unopened bag of $1 bills and moths. It might have $100 of usable bills in it, or it might be all moths, or anywhere in between.

This is a problem for the government bail-out program; is the government going to look in each bag before it uses taxpayer money to buy it, or is it going to guess about the value of huge groups of bags using sampling techniques.

In free market theory prices are supposed to emerge in an efficient manner and result in efficient allocations of resources. Putting aside that there may be (in fact, are) problems with free market economics even when pricing of commodities is efficient, in the real world the conditions necessary for efficient pricing often don't exist.

For an auction to price items efficiently, there need to be a reasonable number of bidders and a reasonable number of items to bid on. If anyone has the power to set prices, prices will be set by that person, not by the market.

Even when there are reasonable numbers of buyers and sellers, because of human nature, prices can get out of whack, as in both bubbles and Depressions. The housing market is an auction market. Two years ago there were relatively few houses compared to bidders, resulting in unrealistic, high pricing. Now the same houses are in abundance compared to bidders, so in many cases sales are either not made (because in effect the people auctioning off their houses have set a minimum bid that no one will meet) or made at well below the real value of the house. The actual cost of construction being a good surrogate for real value for new homes, and that cost adjusted for inflation and physical deterioration being a good surrogate for used homes.

The Federal Reserve has been tasked with making sure their are neither too many nor too few dollars in circulation. When there are too many dollars, they are used freely to create inflation and asset bubbles. When there are too few dollars, people are forced to sell assets at less than their real values. Free market theories pretend that the only real value is the selling price, and it a very real sense that is true. But when selling prices depend on the whim of the Federal Reserve, you might want to ask yourself: what really is true, and what is bull?

Cash is King

The United States of America has a long history of booms financed largely by credit followed by periods of recession and limited credit. You don't have to be an economist to see these trends. You do have to be a calculating, unemotional investor to take advantage of them. Take the Kennedy family. They were doing pretty well during the 1920's, but Joseph Kennedy knew his history and economics. He cashed out well before the crash. Then, in the depth of the Depression, he went on a buying spree with the cash he had. Thus a family of little economic note went from the lower middle class to being one of the richest in America in a single generation. Only then did the political experience of the family, previously of account only in Boston, bloom into a dynasty of national importance.

There is nothing wrong with taking credit under appropriate circumstances. Between 1936 and 2003 buying a house on credit was a sound investment in most of the United States. Taking some credit to ease a business startup can be rewarding too. But even when these general rules applied, there were specific counterexamples. Buying a house in a city whose factories moved to Mexico or China, or even to Alabama, did not work out for a lot of people. Most small businesses fail or limp along.

You would think with the Internet stock bubble of the late 1990's in the rear view mirror that people would have been more cautious about buying McMansions on credit between 2002 and 2006. In the vast majority of cases, while the price of the house was an issue, the two main factors in the personal disasters were buying a house that was too big, and spending too much on luxuries (often fueled by additional loans).

For about a year and a half now we have been seeing the other side of the equation, a contraction of credit. The Federal Reserve was created to minimize the credit cycle, but it did a poor job at that starting when Alan Greenspan took over. Voodoo economics, the theory that markets always reach an equilibrium that has good results for humans, can only partly be blamed. Credit was created off the Federal Reserve's books, so to speak, and like Enron stockholders, the Fed acted like that was none of its business.

In 1928 Al Smith was the Democratic Party candidate for President. Herbert Hoover won by a landslide; he was already a national hero. The Dixie wing of the Democratic Party could not get the voters behind Smith, a Catholic whose only real political difference with Herbert Hoover was that he was for ending Prohibition (of the sale of alcohol). If Al Smith had won the election there would still have been a Great Depression. The Republican Party would have come to power in 1932, and as the credit cycle turned it would have established itself again as the party of Prosperity. History would be very different.

While we are in a credit crunch, cash is king. Unless you want to use your dollars to buy foreign assets, you can buy almost any investment cheap. Stocks, bonds, real estate, you name it.

True, if the U.S. or world economy collapses, you will look like a fool for not holding onto your cash. But if that happens, all bets are off; even cash may not save you. A collapse is not very likely. Parts of our economy, notably agriculture and manufacturing not related to construction, are doing quite well. Unless the Fed or Congress does something really stupid, there will be a bottom and then a liftoff period. No one will really be able to see the bottom until it is a quarter or two behind us.

Best bet in this environment? Stocks and bonds of well-established, profitable companies with global distribution networks. Buy what looks cheapest on a value basis; don't read too much into other people's selling, which is based on their liquidity needs and their fears. Figure this credit squeeze will last a while, which means spreading your conversion of cash into assets over time. Keep in mind that the important bottom is the credit bottom, not the stock market bottom.

And keep diversified.

The Federal Reserve May Have a Hidden Agenda

If I had a seat on the Federal Reserve, I would have voted for a quarter-point increase in rates at the latest meeting. I believe that the low federal rates are not being passed along to consumers partly because of inflationary expectations. In other words, low rates are not helping as much as they normally would to get the economy back in growth mode because they are fueling short term inflation and long-term inflationary expectations. They are helping to prop up the idiots who run the nations major banks by allowing them to borrow at low rates and lend at high rates, but a quarter-point increase would not have cut into that game substantially.

A quarter point rise would have had an immediate positive impact on the dollar, which would have the effect of decreasing the contract price of oil, which in turn would reduce gasoline prices and give consumers some cash (or credit) to buy other items.

Gradual quarter point rises would not hurt the housing market or dampen the economy in any way. Four quarter point rises over the course of one year would only raise interest rates to 3%, which is still extremely accommodating.

The bankers who have been given seats on the Fed presumably know all this. Do they want to keep gasoline prices high? Are they willing to sacrifice the economic health of the middle class and working class to achieve an extra quarter-point differential in bank profitability? Well, yes, after all they are bankers. But I think there is another item that has been on the agenda for decades now. The Federal Reserve statements don't mention it, and neither does the financial press, at least not in the context of interest rate decisions.

Interest rates have an large long-term impact on the size of the national debt and the annual payments on that debt. This is not a new problem, but the size of the national debt has reached a magnitude that it impacts the Federal Reserve's leeway to raise rates. This is the real reason rates have been kept consistently too low for the last two decades.

The national debt as I write stands near $9.37 trillion [See debt clock]. Interest paid on it is an average over different time terms for the debt and different points where the debt was auctioned off. However, choose a nice round number like 1%. Over the course of 10 years most of the bonds representing the debt are turned over, so if my hypothesis is that the Fed is keeping rates on average 1% lower than would be ideal for their basic mission (economic expansion with minimal inflation), we are talking about saving the federal government 1% a year on debt. In round numbers, that is $94 billion a year. Over ten years, you can round up to a trillion dollars.

Now look at a truly bad scenario. What if, to fight inflation, the base rate was raised from 2% to 5%? Over ten years we are talking $3 trillion.

What should have happened during the late 1990'2 was the Fed should not have accommodated Congress, the President, and stock market speculators. The Fed is accommodating a federal budget that keeps taxes low on rich people and corporations, but spends a lot of money that mostly goes into corporate coffers. The War on Terror is great for defense contractors, but it is killing the economy. And the terrorists know it.

American Seniors pay for all this in another way. They tend to have their liquid capital in CDs. Low interest rates set by the Fed hurt senior retirement income disproportionately.

The war on terror should be handed over to the CIA and military special operations groups. Having a lot of soldiers on the ground, like we do in Iraq, is an ineffective waste of taxpayer money.

I believe we are in a situation where we can have better long term prosperity by raising interest rates modestly, cutting federal spending modestly - mainly in the Defense budget, and raising taxes modestly. But given the control of the Federal Reserve by the self-serving banking industry and the weakness of the current President and both major party Presidential candidates, I am not using that scenario to model the future.

I am modeling an ever-expanding national debt that will at some point hit a tipping point and turn the United States into a 2nd rate economic and military power. It happened to England after World War II, it happened to the USSR in the 1970s, and it is going to happen here, the only question is when.

Which, by the way, does not mean I'm pessimistic about my stock portfolio. Many individual corporations will survive this calamity, if necessary by basing themselves in countries that run their economies on a more rational basis. Owning companies that have strong intellectual property and management teams is the best economic bet Americans can make right now.

One Million Opportunities

Last week the headlines screamed that the number of homes foreclosures had passed the million mark [See, for instance, Homes in Foreclosure Top One Million at CNN/Money]

Some see a train wreck the size of the global economy. Smarter people see one million opportunities.

We all know the story of how the opportunities were created. Housing prices started going up after the Internet Stock crash of 2001 because the Federal Reserve set interest rates too low and left them their too long. Stupid people were egged on my news media, real-estate agents (my friend John calls them land pimps), banks and mortgage companies, friends and relatives to believe that housing prices would always go up at 10 to 20% per year. A house was no longer just a place to live in, it was a money machine. Why, it was such a sure thing you could buy a house without a down and be rich in almost no time.

I've seen smarter people who believe a carpenter can raise the dead.

Some people worked and saved and did not fall for the flim-flam. Now they have downs and if they can buy a house at the right price they can eliminate their rental expense. They can build equity the old fashioned, reliable way: by spending less than they make and paying down the mortgage.

It is a good thing. The profligate are punished and the thrifty rewarded.

Not every house in foreclosure is a good buy. You have to ask yourself, what is the real value of this house, and how does that compare to the asking price? Just like stocks. I always ask myself, before buying or selling a stock, what is the market capitalization of the company, and if I were going to buy the whole company, would that be a price I like?

Not everyone should buy a house just because the price is right. It takes energy or money, and sometimes both, to keep up a house. Things go wrong, things wear out. Taxes have to be paid, and they will eat up the original purchase price of the house in the long run. Don't kid yourself, all land in the U.S. is just rented from the government, and taxes are the rental payments.

And people are out there hunting and buying. April used home figures were released today [See April Pending Home Sales Rise As Prices Tumble] and they reflect what I've been hearing anecdotally in California. If a home is for sale and it is priced right, it can sell quickly. People who are trying to sell for imaginary prices, their properties will just sit.

There are scenarios that could make buying homes now look stupid, but they are becoming increasingly unlikely. Buy a home at the right price and ugly scenarios are balanced by some pretty bright ones. Some distressed sellers may sell so cheap that a non-distressed seller to have some equity, aside from a down, pretty quickly.

Most in demand: homes near workplaces or on public transportation routes.

Bottom Fishing Time?

Fans may have noted my absense from Dissecting the Bull for multiple weeks. I was doing a project for Microsoft. I turned it in Monday night. I was so far behind on rest and other requirements that I have not had time to write until now. I did go to a local poetry reading last night and read a poem:

Touching the old skills
Fingering them like tools
The Mind sends forth tendrils
Frosty and interwoven

Which I wrote an amazingly long time ago. But the question for many investors, that I continue to ponder as well, is: time for bottomfishing? That is an old skill, for sure.

In a normal week I would be writing blogs on AMD and Gilead's analyst conferences, but that would take more energy than I have this morning.

When the tide goes out ... around here lots of people go looking for abalone. I have always considered abolone too beautiful and too rare to grace my barbeque. While taking them should be banned until they become plentiful again, at least Fish and Game has cut back to 4 the number a person can take in one day.

Taking stocks off the bottom is limited only by your available cash and credit. The problem is knowing when there is a bottom. While many signs and portents are visible in the world now - famines and melting glaciers and three-headed snakes - let's look at something we are better at interpreting, the housing market, mortgage crisis, and overall U.S. economy.

The thing about downward spirals is that there are usually two options. One is that the downward action impells more downward action. The other is that balancing forces come into play, breaking the cycle, and perhaps even causing an upward cycle to resume.

I think the bulls and bears both have it right. The bears say that housing prices are continuing to fall, which will continue to make houses worth less than the mortgages on them, which will hurt consumer spending, anyone involved in the banking and mortgage industries, and hence rippling out to the general economy. And the slowing general economy will feed back into the spiral. So bears believe it is not time to buy stocks, in fact if you have not been smart enought to sell off your entire portfolio, you should do so now.

The bulls say that we have passed through a liquidity crisis. The Federal Reserve may have screwed up in the past by allowing the housing bubble to form, but now it has created enough liquidity to restore confidence and allow growth to resume. There is a lot of new and used housing out on the market right now, but housing starts are now below the real level of increasing demand. Because immigrants are still immigrating, young adults are still having children, and increasing population requires increasing housing. Are people being turned down for loans in large numbers? Well, that shows there is pent up demand.

So the overstock of housing on the market will dwindle, then it will drindle rapidly (varying in rate by locality). One man's foreclosure is another man's windfall. Then the new home builders will start upping their building permit applications. Then workers will be hired and demand for cement and lumber will return. The stock market will go up, and people will wish they had bought while it was down. Given that the rest of the economy is pretty sound, so far, that means GNP will start growing again, aggregate consumer spending will go up, and we can start worrying about famines and three-headed snakes instead of the economy.

Of course, you should hedge your bets. The bears might be crowing for a few more months. Then again they might be underestimating the American spirit. I know a lot of people who have tightened their belts in the past 2 years. And the payoff has already begun. With less debt, they have less interest to pay, and more real disposable income.

We won't know when the corner has turned. The statisticians will let us know three months later.

There are no tide tables for the economy. But if you want abalone, you have to go to the tide pools while the tide is out. When the tide comes in, the picnic is over.

Positive Yield Curve

Remember the negative bond yield curve? Negative yield curves are supposed to predict recession, and there is some good reason for that. Now if we are not in a recession we are in what might be called a pause. With only a slight return to normal consumer spending patterns and house sales, however, the pause could turn into a ramp. You have heard enough dire predictions for the rest of 2008; I won't repeat them here, and they remain a possibility.

However, lets look at that yield curve. One place to see it is at CNN-Money. It looks extremely positive to me.

So I would not be surprised to see the economy go back into positive territory in Q2. And if the Federal Reserve, as usual, ramps interest rates too slowly, we could start seeing rapid expansion of the economy, and unwelcome inflation, as early as Q4.

For my analysis of specific companies see my Company List page.

Oil Bubble to Burst?

Noticing that there is a bubble is no big deal. I noticed that there was a stock market bubble in the late 1990's. I noticed that there was a real-estate bubble in the mid 2000's.

And I've noticed that there is an oil bubble that started a couple of years ago.

But calling an end to a bubble is difficult. How do you know when investors are going to collectively realize that all their stocks can't be the next Microsoft?

And given how irrational the Federal Reserve has acted in the past 20 years, even though you could predict that the housing bubble would burst when the Fed raised rates high enough, there was no way to predict when the Fed would get around to acting.

We are in an oil bubble. But that does not mean that the price of oil can't go higher, or that it might not take years instead of months for it to burst.

Consider the counter-argument: the globe has reached peak oil production, but demand is still rising rapidly, so prices will continue to be pushed up.

I believe it is likely that we have reached the vicinity of peak oil production, but Saudi Arabia could flood the global market with oil tomorrow if it desired to, and keep the flood running for at least a couple of decades.

Demand is already being pinched, but converting from oil to other energy sources, or to conservation, is a slow process. Yet it is happening. Talk to any car dealer in the U.S. about what has been selling in 2008, and they will tell you: fuel efficiency. People are sizing down. They are going to size down through all of 2008, and in 2009 Americans will be using a lot less gas.

True, demand in India, China, and other developing countries will increase. But these nations are also rapidly adopting non-oil based energy technologies.

Consider Applied Materials (AMAT) [disclosure:I own this stock]. It sells a line of solar panel factories. That is, it makes all the tools you need to make massive, low cost solar panels. You build a big building and move in one of the factories. You spit out solar panels. Another company paves large sections of the earth with them. Soon all-electric cars will run on the energy from these massive solar installations.

Multiply that example by a thousand other innovative companies and the practical decisions of billions of individual consumers, and you have demand for oil that is drying up. In addition, there is plenty of oil and gas. Do you see people lined up waiting for gas? No. There are no shortages. At least half of the current price of oil is pure speculative fever.

Maybe it is a good thing. Maybe these speculators are doing more to ease global warming than the federal government ever did or ever will do. But if federal taxes had been used to raise gasoline prices to today's level, we would not have a huge federal budget deficit in addition to our other troubles.

I can't say when the bubble will burst. And artificial shortages, like the one caused by the Iraq war, or Enron's gaming, could be created.

Meanwhile real estate is reasonable and stocks are dirt cheap. Food is another matter. We are in that part of the Malthusian cycle when there is not enough food for all the people who have procreated. If you bought sacks of flour last year your return today would be better than most managed stock funds performed.

It is a strange, new world. The pace of change in the 20th century will prove to be nothing compared to changes this century. And one change is coming fast: the end of the Oil Era.

Liquidity Squeeze Is Opportunity

Despite the efforts of the Federal Reserve Bank of the United States and central banks in other nations, we are in a credit squeeze. In historic terms it is not much of a squeeze so far, but it could get worse if the U.S. economy enters a recession or the global economy slows down from its hot growth rate.

Credit is hard to come by, but strangely interest rates are not high and appear to be heading lower. That means cash is king. Many people who, by income or personal wealth measurements, are traditionally in the investor pool, have had to raise cash. They have had to sell what they could, and that has meant a lot of selling of good quality stocks, because those were the only liquid assets available to sell.

For those of us who saw that the housing market would decline at some point (it can hardly be said to have burst like a bubble, so far) and built up cash instead of getting deeply into debt, this is a golden, once-in-a-decade opportunity to get some great buys.

Pick almost any listed stock and do the math. Earnings of 7 to 8% are readily available in companies that are solid and growing; earnings of 5% are readily available in companies that are expected to grow rapidly (say 10% annual growth or more) over the next few years. Dividends of 3 to 4% are easy to find as well. Some stocks are so oversold that buying now should result in 50% to 100% total returns over a two year period.

But no one wants to be the chump who buys today just because a stock is a bargain, when it might be even more of a bargain tomorrow. That is the problem with auction prices: they are usually out of equilibrium.

A good strategy is to spread your buys over 2008. Predicting the bottom for the market is guesswork; for individual stocks there is no telling either.

If you buy in a linear fashion over the year you will get some stocks at rock bottom and all your stocks at less than they should be going for. When liquidity returns and valuations go back to normal, whether than be in Q3 2008 or Q3 2009, you'll be glad of the apparent risks you are taking now.

Earnings reporting season is upon us. I'll be posting regularly on the stocks I follow (see list), analyzing Q4 2007 and guessing at what 2008 will bring.

Don't get too excited about any one stock; always diversify (I have to remind myself of that, as much as anyone). It is a good time to buy a house, too, if you are planning to live in it. Except in a few special markets I don't think housing prices have declined enough to make them attractive to investors, given the exceptionally high real-estate transaction costs.

Don't Count On Another Rate Cut

This week's 0.5% rate cut by the Federal Reserve was appropriate. But I would not count on any further cuts. If economic trends run as I expect, further cuts would send the economy fish-tailing.

Much of the economy is moderately strong, including exports. The fall in new housing construction combined with the uncertainty in the mortgage derivative markets has been slowing the overall growth rate. Everyone has reason to reassess our spending habits, from private equity buyout specialists to minimum wage workers.

Hopefully the Federal Reserve cut, combined with injections of credit in appropriate institutions, will mean that mortgage rates will go a bit lower. They never were high in this decade. The problem was stupid people thought lenders would be happy with eternally low returns on their loans. Once the Fed jacked up interest rates to normal levels the handwriting was on the wall. Yet the financially illiterate did not refinance their low-interest, variable rate loans to long-term fixed-rate loans. Some people who are in default were victims of scams, but most were just spendthrifts.

There is a lot of unsold housing, both new and used, on the market. But there is a great deal of evidence of pent up demand; fear is holding buyers back. Why buy a house or condo now if it will be 10% cheaper in six months? The U.S. population increases so rapidly now that all the housing stock is needed.

Housing prices lost touch with reality around 2004, earlier in some markets. But now that developers have cut back on building (permits issued were remarkably low in August), buyers will start digesting this inventory. Already housing in the Midwest is so cheap that I would not hesitate to move a business there to take advantage of the low costs. But every market is different. San Diego, with its near-perfect weather and ocean access, will probably snap back faster than real estate in the Central Valley of California, where most people live only because they can't afford a coastal home.

With the dollar low imports should continue to boom, meaning more hiring in manufacturing and agriculture. As soon as builders start seeing their inventories dwindle they will up their output, putting demand on lumber and other housing components. Selling furniture and appliances will swing back. Of course this process is one measured in months or quarters, not days.

Unemployment is at reasonable levels despite massive layoffs in the housing sector. So if the housing sector even stabilizes, labor availability will be tight.

Of course, there is always a spread of paths to the future, and you can guess at the probabilities to match to the paths. There is some real probability of a recession, perhaps brought on by more turmoil in financial institutions. But there is a real possibility that this summer was a panic for no good reason, and that the Federal Reserve will regret even the cut it made this week.

The most probable path, in my eye, is a return to moderate economic growth in Q4 followed by strong growth in 2008. Of course as more data comes in the Fed will evaluate it, as we all will. But given the most probable path, I think the Feds should hold interest rates steady for about 6 months. Then they will probably have to raise rates again to keep all the people jumping back into real estate and stock speculation from having too big of a party.

Work smart, spend cautiously, then save, and invest wisely.

Critiquing the Federal Reserve

With hindsight it is easy to critique the interest rate policies of the Federal Reserve. If they had raised rates earlier in the 1990's there may not have been quite so much of a shock from the bursting of the Internet bubble. If they had not sent rates so ridiculously low in 2002 to 2004 then we would not be suffering now from all the turmoil in the housing market. Some folk even think the nation would have not suffered through the Great Depression if the Federal Reserve had been on the ball, both to dampen enthusiasm in the late 1920's and to flood the country with liquidity after the bubble burst.

I was critical of the Federal Reserve for excluding the huge asset class known as stocks from its analysis in the late 1990's. Being the caretaker for the economy as a whole means you should watch every asset class for inflation and every sector for its ability to impact growth both long run and short run.

I was critical of the extremely low interest rates we saw a few years ago. Recall that the recently ended housing boom began with a rise in house values at a time the rest of the economy was in a recession, a strange anomalie. Interest rates did not need to be that low to revive the rest of the economy. Once the prices of houses started to escalate sharply the Federal Reserve should have started a gradual rise in interest rates. This would have smoothed the curve for the class of people who took out adjustable rate mortgages (ARMs). It probably would have prevented prices and the pace of construction from overshooting. It would also have begun fighting non-construction inflation earlier in the economic cycle.

The Fed lately always seems to be compensating, or overcompensating, for earlier mistakes. Jacking up interest rates every consecutive meeting in 2005-2006 might have been necessary to fight inflation, but it created a huge class of people whose re-adjusting ARMs have led to personal despair and widespread anxiety about the housing market.

So where do we go from here? While inflation is a long term danger, the greater danger right now is the readjusting of ARMs. The Fed caused rates for ARMs to be artificially low. They should take some responsibility for the mess.

If I were on the Fed (fat chance) I'd be arguing for two consecutive half-point cuts. This is despite the fact that I'm not an easy money guy. It is an intensive care treatment for victims of the Fed's past mistakes. It would mean that ARMs coming due during this period would reset at much more reasonable levels for the fools that bought the instruments without thinking seriously about the implications.

Then I would pause and watch. If, despite the cuts, the economy moves into a recession or a very-low growth period, more cuts would be warranted. I think it is more likely that following my 1% cut advice the housing market and mortgage markets would stabilize and the economy as a whole would grow at a good pace. If that happened, then quarter point rises once per quarter would be justified to fight long term inflation.

But I'm not the Fed. Based on the past behavior of Fed, I think it will tend to do nothing until it has to do something too fast, and then it will overdo. It will act like a stupid cow, and then it will jerk and stampede. Its job is to smooth things out, but the wrong people (subject to the wrong pressures from the wrong friends) have been assigned to that job.