Friday, April 29, 2011

"Student Loans, Rising - Credit Card Debt, Falling"

Sydney M. Williams

Thought of the Day
“Student Loans, Rising – Credit Card Debt, Falling”
April 29, 2011

A possible silver lining extruding from the dark cloud of debt that hangs above the American consumer is the fact that student loans now exceed credit card debt. While that is obviously bad news for students and recent graduates, one could argue that the former represents an investment, while the latter is a manifestation of sating one’s current personal wishes. Perhaps?

Credit card debt and mortgage debt have declined in the past couple of years. The decline in mortgage debt is a function of forces pulling in opposite directions. On the one side, we have thousands of homeowners walking away from their houses. A year ago Realty Trac estimated that 900,000 homes were listed as having been foreclosed. The numbers have likely risen since. On the other hand, each year about 1.2 million Americans become potential homeowners. The consequence is that total mortgage debt has declined modestly from $14.6 trillion in 2008 to $13.9 trillion as of June 2010, a decline of 4.8%. The decline in credit card debt has been more precipitous. According to an article in USA Today last August 27, credit card debt, at the end of June 2007, was at the lowest level in eight years – $495 billion versus $572 billion a year earlier, a decline of 13.5%. Total revolving consumer debt amounted to $828 billion.

In contrast, student loan debt, according to the publishers of, rose to $850 billion. The Project on Student Debt estimates that total student debt is just under a trillion dollars. Both organizations agree that student loans now exceed credit card debt for the first time ever.

There are a number of explanations for this trend:
        ●Since 1978, according to, tuition at U.S. colleges has risen over 900%, 650 basis points above inflation. In contrast, home prices are up only 50 basis points above the CPI during those years.

        ●Home equity loans, which had been used by parents of students, are no longer available.

        ●The job market has been such that many parents of students have lost their jobs, and has made the job search for graduates more difficult.

        ●The weak economy spurred growth at community colleges – 96% of whose students take out loans.

Too much debt is never a good thing, no matter its purpose. But debt incurred in order to increase one’s income makes more sense than debt taken on to satisfy one’s whims. However, questions have been raised as to whether the rapid growth in tuition has created a value commensurate with its costs. In his book, How the University Works, Marc Bousquet points out that if a university student is enrolled in four courses that, on average, only one will be taught by a fully qualified professor, the reverse of forty years ago before the explosive growth in tuition began. During the same time, the proportion of administrators has skyrocketed and the number of tenure-track faculty has declined. The Department of Education has estimated that by 2014 there will be more administrators than instructors at American four-year nonprofit universities – creating a bloated bureaucracy not unlike our government.

In 2009, forty-four percent of all U.S. undergraduates were in community colleges. Between the fall of 2007 and 2009 enrollment increased 17% to about 13 million, which includes about 5 million non-credit students. For-profit colleges have become the fastest growing segment of higher education in America. Ninety-six percent of their students take on debt and, after fifteen years, 40% are in default – a statistic that again raises the question as to the value received for the money expended. Those questions lead inexorably to the conclusion that value received does not match costs. Reinforcing that opinion is a calculation from the Department of Education that only 40% of student loans are in active repayment.

As taxpayers we have an interest in this scenario. Estimates assume about 30% of outstanding student debt is securitized, with the federal government on the hook for most of it, either directly or indirectly. Defaults look very possible.

Access to education is one of the principal benefits of being an American. Unfortunately the public has been sold on a misconception that four years of college leads directly to financial security. It often does, and certainly statistics show that the college educated have higher incomes and less unemployment. But it is not a guarantee. And, as the numbers show, many people have been sold a bill of goods – borrowing money which too often has gone to college administrators, not educators, and has not provided the expected job. Over the last four or five decades while the numbers of college educated have increased, there has been a decline in skilled labor. Despite record unemployment, high-paying jobs requiring specific skills have gone begging. We are turning into a bar-belled society – the college educated on one end and the ill-educated (often illegal immigrants) on the other. What has been lost has been skilled artisans.

Nevertheless, in my opinion, an increase in student loan debt and a decline in credit card debt suggests the country is headed in the right direction. Self-improvement makes more sense than self-aggrandizement, even when the benefits are not immediately visible.

Thursday, April 28, 2011

"East is East and West is West"

Sydney M. Williams

Thought of the Day
“East is East and West is West”
April 28, 2011
In 1990, China’s GDP was less than 10% of the United States; in 2010, it was 40%. China reflects not only a rising Asia, but surging economies in the developing world. Between 1990 and 2007, China’s economic growth compounded at 13.3%; Vietnam’s at 15.1%; Macau and Cambodia at 11.5% and 11.3% respectively; Brazil’s growth compounded at 10.2% and Chile’s at 8.3%; Malaysia at 8.6%, South Korea at 7.9% and India at 6.8%. Even Russia, notwithstanding the problems the country has with its oligarchs, grew its economy during those years at 4.9%. In contrast (and as a warning to the U.S.,) Japan’s economy, the one “developed” nation in the region, compounded at 2.2% during those 17 years.

The developed countries in the West have not kept pace. The size of their economies is one reason – rapid growth from a small base is easier done than from a large base – but as important is the fact the state-controlled economies (mercantilist economies) in Asia have been more free-wheeling and more aggressive, with less regulation, than their counterparts in Europe and the U.S., countries where wealth transfers and social programs play bigger roles. With wealth come societal concerns and responsibilities about the poor and the environment. As productivity improves and hours spent working for the necessities of life diminish, it leaves more time for leisure activities. The U.S., between the years 1990-2007, grew its economy at a Compounded Annual Growth Rate (CAGR) of 5.3%; the UK at 6.2%, Germany at 4.3% and France at 4.0%.

In terms of per capita GDP growth between 1990 and 2007, China, with a CAGR of 12.37% ranked 4th out of 220 countries; in contrast, the U.S. ranked 123rd with a CAGR of 4.17%. On the other hand, China still has a long way to go in terms of per capita GDP. Based on data from the United Nations Statistics Division, GDP per capita in China, at the end of 2010, was $3,011 versus $45,047 in the United States.

Tuesday’s Financial Times had an article, referring to Latin America, with a misleading headline: “China is now Region’s Biggest Partner.” China’s trade with Latin America soared from $8 billion in 1999 to $130 billion in 2009 – a sixteen fold increase in ten years. Nevertheless, bilateral U.S. trade with the region was $489 billion (largely because of Mexico,) more than three and a half times that of China. However, China is now the largest trading partner of Brazil and Chile – two of the regions fastest growing economies. It is almost certainly a harbinger of things to come.

There has been much said and written about China overtaking the United States as the world’s largest economy. Barring an unforeseeable event, it seems inevitable. If China grows its economy over the next 15 years at a 10% CAGR and the U.S. does at 3% –discounts to both their historical rates – China will overtake the U.S. by 2025. Small changes in growth assumptions make for big differences in outcomes. For example, if the U.S. manages to grow its economy at 4% instead of 3% it would add another $4 trillion to U.S. GDP in 2025.

China is not without potential problems. Rapid growth and the high costs of commodities are causing inflation problems. The results of a national census, conducted last year, were released yesterday. It confirms that the population is rapidly aging – almost a guarantee that future growth will slow. The percent of the population over 60 increased three percentage points to 13.3% – within spitting distance of the United States at 17%. At the same time the percent of the population fourteen and younger declined from 22.9% to 16.6%. The ratio of old to young has risen from 45% to 80%. (In comparison, 22% of the U.S. population is under 18.)

With economic growth will come increasing responsibility to help maintain peace in the Pacific region – a function that has largely fallen to the U.S. Bad guys and bad countries have not been outlawed and Asia, as we know because of North Korea, is no different. China’s defense spending will increase and is necessary, but will not contribute to economic growth with the same multiplier that growing one’s industrial base does.

Countries, like companies, mature. They are born; they go through periods of robust adolescence and persistent growth. Countries and companies must continuously evolve; otherwise they grow old and die. Thirty-five years ago China had a rebirth. Its economic aggression is not unlike that of Apple thirty years ago taking on an aging IBM, or like Google or Facebook battling traditional media today. It is not so different from the hedge fund that fifteen or twenty years ago competed for assets against traditional mutual funds, or even like our firm, which competes in an arena against giant brokerage firms.

The United States must recognize that its twenty-odd years of unilateral hegemony are being challenged. We cannot (and should not) stop progress. But we should take up the challenge and begin competing more aggressively in the global world in which we live. As a mature and wealthy society, we have a responsibility to ensure that the elderly, poor and sick are taken care of. But to compete, we cannot lose sight of those traits that made this country great and rich: a government that inspires individual performance, encourages entrepreneurship, values education and welcomes immigrants.

Rudyard Kipling begins and ends his ballad, “The East and West,” with the following refrain, a refrain that hints at both risk and reward:

“But there is neither East nor West, border, nor breed, nor birth,
When two strong men stand face to face, tho’ they come from the ends of the earth.”

Over the next couple of decades, China’s growth will rise to match that of the United States. South Korea will persist in its growth. India, Indonesia and Vietnam will continue to emerge as developing nations. It will not be a smooth ascension. Inevitably, economies will fall into recession and possibly worse. If history is any guide, there will be clashes, but hopefully, with China assuming more responsibility and with a continued U.S. presence in the region, any military action will be limited. The internet and globalization have made the world smaller. Europe, if it can get its act together, would become a third area of economic power and influence. There are a lot of “ifs”, but the possibilities and the potential are there.

Wednesday, April 27, 2011

"The Fed Opens Up - Maybe?"

Sydney M. Williams

Thought of the Day
“The Fed Opens Up – Maybe?”
April 27, 2011

Today, at 2:15PM, Fed Chairman Ben Bernanke will hold his first press conference as Chairman of the Federal Reserve. The idea, I guess, is to remove some of the mystery from the Fed’s operations. Whether that is a good idea and how open the Chairman chooses to be remain to be seen. As Laszlo Birinyi mentioned in a piece yesterday, the last time the Fed made a change to information dissemination was in February 1994 when they decided to disclose any change in policy immediately. That they now do, but the minutes of the meetings are released with a lag time of two or three weeks, presumably allowing for the purification that a scrubbing of the data allows.

“Transparency” became a buzzword during the 2008 elections. But somehow the concept became lost. The country, as David Brooks wrote yesterday in the New York Times, lacks faith in its institutions: “The country is anxious, pessimistic, ashamed, helpless and defensive.” People feel confused. For example, Mr. Brooks adds: “Sixty-three percent of Americans oppose raising the debt ceiling; similar majorities oppose measures to make that sort of thing necessary.” It could be that the Administration, Congress and the Fed decided they had little to lose in asking Mr. Bernanke to try his hand at instilling confidence. If that is the case, the Chairman has his work cut out.

The recession ended two years ago, according to the National Bureau of Economic Research (NBER,) with the second quarter of 2009. Thus we are in the 8th quarter of recovery; yet, apart from the fourth quarter of 2009, GDP growth has been feeble. Unemployment, while improving recently, remains high at 8.8%. In the past year, the dollar has declined 15%, while rising energy prices and food inflation have hurt the poorest of our citizens.

There are questions that should be asked at the press conference: If the Fed’s mandate is to provide stable prices and full employment, how do you explain today’s asset inflation and high unemployment numbers? With gasoline prices up thirty percent in the last year and with food prices rising, why do you ignore their potential inflationary impact? As James Grant pointed out in his most recent newsletter, “QE1 failed to deliver vibrant growth or full employment” and since QE2 was implemented, stocks and commodities have risen, the dollar has declined; Treasury bond yields are higher and economic growth has been anemic. Will there be a QE3 and what will its purpose be? Can you remove the training wheels from the bicycle (ending QE2) without the vehicle wobbling? Why have you let banks that were too big to fail in 2008 become bigger? Why are the banks that benefitted from tax payers’ bailouts not encouraged, through tax incentives, to lend more aggressively to small businesses and start-ups, instead of to private equity or for M&A, activities that are often job killers, not job creators? How do you justify keeping short rates so low that seniors are suffering, leaving them with two unattractive choices: eating into their capital or speculating in the equity markets?

The Federal Reserve is two years shy of celebrating its 100th birthday. It was created in 1913; the impetus was the panic of 1907. Its responsibilities have expanded over the years. Its main duties today are to promote sustainable economic growth, maintain full employment and provide stable prices – goals that can be at odds with one another.

What we experienced in 2007-2009 was a balance sheet recession – too much debt, too freely offered, spent inflating house prices. In the aftermath of the credit collapse, households and non-financial businesses, deprived of liquidity, adjusted their habits, increasing savings and reducing spending. Government, of necessity (at least initially,) did the opposite, increasing both borrowings and spending. We have reached a point where the Fed must consider reverse engineering what they have wrought, but doing it in such a way so as not to catapult us back into recession. Otherwise, the cure risks becoming worse than the disease.

The Fed’s press conference offers the opportunity to bring more openness to what is an institution shrouded in mystery. My concerns, though, are two-fold: The Street may misinterpret his words and second, the time horizon of investors is short, while the policy needs of the country demand perspective, patience and longer time frames. Despite the series of questions I raised earlier, I worry: will Mr. Bernanke, in opening himself to the clutches of the press, fall victim to the peripatetic nature of its reporters, or will he be able to hold his ground?

Tuesday, April 26, 2011

"Retirement Assets Growing - But Not Enough"

Sydney M. Williams

Thought of the Day
“Retirement Assets Growing – But Not Enough”
April 26, 2011

An article a week ago in “Money Management Executive” mentioned that 401(k) plans exceeded $3 trillion at the close of last year, with 70% of the assets in equities. The author of the report on which the article was based, Bob Wuelfing, president of RG Wuelfing & Associates writes that last year’s stock and bond performance “helped push total retirement market assets over $16 trillion by year-end 2010.”

The numbers sound and are big, but they don’t come close to what is needed to allow baby boomers a comfortable retirement. First a few statistics:

          * The current workforce in the U.S. is approximately 155 million, which includes 13.5 million unemployed, according to the Bureau of labor Statistics (BLS.)
          * About 25 million are employed in the public sector, including the military.
          * The BLS indicates that 20% of current workers in the private sector – about 23 million – have defined benefit programs and that 80% of non-military public employees (18.4 million) are so covered.
          * About 75 million workers participate in more than 536,000 401(k) plans.
          * Approximately 15 million workers have no retirement plans.
          * The Illinois Manufacturing Extension Center suggests that 69 million workers are over the age of or 48% of the workforce.
          * There are about 79 million baby boomers, including those retired and not working.
          * There are 43 million Americans over the age of 65.
          * Global financial assets are about $175 trillion, of which $60 trillion is in the U.S.

Defined benefit plans were largely a result of the unionization of workers. As unions’ influence in the private sector waned in the 1970s and as companies became increasingly cost conscious, the transition toward defined contribution plans began. In the opposite corner, as states’ and local government workers unionized beginning in the 1960s, defined benefit plans proliferated. Unfortunately, unions, with approval of states’ legislatures, guaranteed unrealistic returns. The Pew Center on the States issued a report yesterday indicating that state-administered pension plans, healthcare and other post-employment benefits are facing a collective trillion dollar deficit. (Granted, the survey was based on numbers from 2009, close to the bottom of the market, but even if the numbers today suggest a deficit of half a trillion dollars, the number is large enough to cause heartache for states and financial pain for taxpayers.)

Defined benefit plans relied on unrealistic growth rates in the underlying assets – usually assuming discount rates of six to eight percent. They also harkened back to a time when large companies were continuously adding to their employee roles, which like Social Security, meant that contributions from younger members were being used to pay off current retirees – a Ponzi-like scheme. Defined contribution plans, on the other hand, depend on personal savings. The employee takes responsibility for the amount of money he antes up and to how it is invested.

The world in which we now live is far different from that of a generation ago. There are today about 100 million workers and some percentage of the 43 million retired Americans who must depend on their own investments to supplement Social Security. Stock market returns over the past twenty years have averaged about 6%, plus about 1.5% in dividends. However, compounded annual returns over the past ten years have been 0.7%.

The question is: what level of financial assets is needed to assure a reasonably comfortable retirement. A rule of thumb is to take your annual needs and multiply that number by 25 or 20, depending on whether one believes in a four or five percent return; for example an income of $50,000 requires financial assets valued between $1 million and $1.25 million. (A million dollars per baby boomer is 30% larger than the entire U.S.’s capital markets.)

Defined contribution plans are a permanent fixture in our lives. Nevertheless, neither the government nor the individuals who must save seem to appreciate the urgency of the situation. Consumers still appear more intent on consuming than in saving or investing. And government seems more interested in discouraging investing and favors taxing small businesses (at least those that report more than $250,000 in income as individual filers) rather than encouraging those businesses to invest and to hire. A comfortable retirement depends upon a rising savings rate and expanding financial markets. Government policy and regulation appear to be lined up against such an outcome.

Over the next eighteen years almost 80 million baby boomers will reach retirement age, joining the millions already there. The government does not have the resources to take care of them. Social Security has reached the point where outflows exceed inflows. Most people have inadequate savings. Home prices, the largest asset for many of these people, have been falling for five years. The capital markets are inadequate to handle the amount of savings necessary, while regulation is chasing more and more public companies and markets offshore. The President, campaigning around the country, demeans those with assets as “millionaires and billionaires” on whom more taxes should be levied, thereby discouraging aspiring young investors. We are facing a crisis. It is approaching fast and Washington is not paying attention.

Monday, April 25, 2011

"The Glencore IPO - End of the Commodity Boom?"

Sydney M. Williams

Thought of the Day
“The Glencore IPO – End of the Commodity Boom?”
April 25, 2011

A friend recently suggested that the Glencore IPO may mark the end of the commodity cycle. Tops of markets are often marked by watershed events. With oil, silver and gold trading at or near record levels could the ten year run in commodities be coming to a close just as investment bankers – those trustworthy souls! – are about to take public one of the world’s largest commodity traders?

Over the past eleven years we have seen two stock market peaks – March 2000 and October 2007. In 1999, 289 internet IPOs raised $24.66 billion, versus 42 in 1998, which raised $1.96 billion. During that period there were a number of deals that, alone, symbolized that the inmates had taken over the asylum. One of the best examples was VA Linux Systems. The company went public on December 9, 1999, almost three months to the day before the peak in the NASDAQ. The stock was priced at $30.00; it opened at $299.00, traded as high as $320.00 before closing at $239.25, a 698% gain on the first day of trading – a record that still stands. A year later, on December 8, 2000 the stock closed at $8.49, and on July 24, 2002 (near the trough in the market), the stock traded at $.54. Today, the value of a share of VA Linux Systems (now incorporated into GeekNet) is worth about $2.50.

Despite distant rumblings of impending doom in mid 2007, complacency ruled most markets. Private equity was in its heyday. Blackstone held assets approaching $80 billion, quadruple what they had been in 2001, so management chose to take advantage of market conditions and go public. With investment bankers placing a $40 billion valuation on the company, it would be offered at 17X the previous year’s income of $2.3 billion. Steven Schwarzman, CEO, was expected to earn $677 million and own a stake valued at $7.5 billion. Co-founder Peter Peterson sold stock valued at $1.88 billion. (Insiders sold $2.33 billion worth of stock on the offering.) Big numbers even for an industry used to big numbers! In a somewhat less than prescient comment at the time, Anton Schutz, manager of the Burnham Financial Services Fund, said, “It’s going to be highly sought after.” It was – for a few minutes. The stock was priced at 29 and traded as high as 35. By December it was trading in the low 20s and by February 2009, the stock traded under $4.00. On Friday it closed at $19.31 – 33% below where it was priced almost four years ago.

Both those situations lend credence to the old Wall Street adage that says: “When the smart money dries up, it’s time to chase the dumb money.” The question for investors is: in Glencore, will dumb money be replacing smart money?

Glencore is a Swiss-based commodity trader whose roots go back to Marc Rich, an American who has been credited with building the global spot market for crude oil in the 1970s. Because of countries with which he dealt – Iran, Cuba, and Libya – his activities sparked interest on the part of U.S. authorities. In the early 1980s Mr. Rich was indicted in the U.S. for tax evasion, but was never extradited and chose to stay in Switzerland. (President Clinton pardoned him in 2001.) Mr. Rich sold his share of the firm (Marc Rich & Co.) to current management in the mid 1990s; they renamed the company Glencore, short for “global energy commodity resources.” This offering, of approximately $10 billion in shares – about $8 billion in new stock and around $2 billion for existing shareholders (for “tax purposes”) – would value the business at $60 billion – about 15X last year’s net income. The shares would be listed in London and Zurich. The stated purpose for the offering is to enable the company to use its shares for acquisition – in particular, the purchase of mining companies. Joseph Schuster, founder of Chicago-based IPOX Capital Management was quoted last week in as saying, “The market gurus always know things better…that [they believe] the valuation will be worse down the road.” However, he also points out that, unlike the Blackstone situation, the company’s board members and executive directors (management) are subject to a five-year lock up, in terms of future stock sales.

So, does this offering suggest that commodity prices are topping? Like most things in life, I don’t know, but I suspect not yet. Other than the price of silver (up 173% in the past year and 19% in the past two weeks), there seems to be no mania. Commodity prices have been strong. Global demand, a weak dollar and low interest rates have created an environment friendly to commodities. In my opinion, today’s commodity markets bear little resemblance to equities in the late 1990s, and I suspect that it is unlikely we will repeat the credit crisis of three years ago. Today’s hard commodity prices, adjusted for inflation, are lower than they were thirty years ago.

But, we also know that ten years into a commodity Bull Market, we are not at the beginning of this cycle. Could there be a consequential correction? Of course. A change in any of the above conditions – a global economic slowdown, a strengthening dollar, or a rise in interest rates could precipitate a decline in commodity prices. Caveat emptor, was a saying associated with real estate when I bought my first house forty five years ago. It applies to any deal of this size and of this significance.

Thursday, April 21, 2011

"Federalism is Still Alive"

Sydney M. Williams
Thought of the Day
“Federalism is Still Alive”
April 21, 2011

The Republican’s sweep in last November’s election will have a long term affect. They now control twenty-six state legislatures – with the most seats since 1928 – versus fifteen legislatures for the Democrats. (Eight are split and one – Nebraska – is nonpartisan.) In Minnesota, they won the Senate for the first time ever. In Alabama, they took control of both Houses for the first time since reconstruction.

The importance of controlling the legislatures at this time is because of every-ten-year redistricting – a process based on the census and required by the Constitution. The census determines which states pick up Congressional seats and which lose them. Redistricting falls to the state legislatures. The election of Republicans and financially responsible Democratic governors and state legislatures has also brought into office a group that is more fiscally conservative. Well publicized state deficits in Wisconsin and Ohio, for example, have created monumental battles between deficit hawks and union leaders. These states are following the lead established by governors elected earlier, like Mitch Daniels (Indiana) and Chris Christie (New Jersey.) Even newly elected, traditionally liberal Democrats, like Andrew Cuomo (New York) and Jerry Brown (California) are acting, for now, as fiscally responsible governors.

Meredith Whitney, famous for predicting, in November 2007, Citigroup’s dividend cut, forecast during a “Sixty Minutes” segment last December that there would be up to “50-100 sizeable defaults in the municipal bond market.” Her statements accelerated a trend in withdrawals from muni-bond funds – $14 billion came out between December 22 and February 2 of this year. (To put that number in perspective, only $47.3 billion municipal bonds were issued during the first quarter.)

States continue under enormous pressure, driven by unfunded pension and healthcare plans. Public employee unions are fighting for survival. Depressed housing prices, high unemployment and a still-struggling economy have limited tax collections. Ms. Whitney may be proven correct, but two factors appear to be working against her call. The first is that most states must comply with some form of a balanced budget. The second is that municipal bond issuance is running at the lowest rate in eleven years.

According to the National Conference of State Legislatures, forty-four states require that the governor submit a balanced budget, forty-one require that their legislatures pass a balanced budget and thirty-eight preclude the ability to carry a deficit from one year into the next. Every state in the union, with the exception of Vermont, falls into one or more of those three categories. Thirty states (including California!) must adhere to all three requirements. Budget battles have provided grist for the press mills. Governor Scott Walker of Wisconsin has become a lightening rod for public union dissension – deflecting attention from the outspoken governor of New Jersey, Chris Christie. Wisconsin’s constitution requires the governor to submit a balanced budget and requires the legislature to pass one, as does New Jersey’s.

The second point is the dramatic drop in municipal bond issuance. According to the Securities Industry and Financial Markets Association (SIFMA), municipal bond issuance this year ($47.3 in the first quarter) is at an eleven year low, running at 11% of the annual rate for 2010. Unlike the federal government, states cannot print money and most are required by law to operate balanced budgets, unlike their profligate cousins in Washington. The fourth quarter of last year saw record issuance ($133.6 billion), in part because the Build America Bond program was coming to an end. However, the decline in issuance is more fundamental. Yesterday, Michael Corkery and Jeanette Neumann writing in the Wall Street Journal quoted Thomas Doe of Municipal Market Advisors: “the decline in issuance is a reflection of states managing through a crisis in a very prudent way.” CNNMoney, on March 21, quoted Ebby Gerry head of municipal fixed income at UBS: “The new political atmosphere that has emerged in the wake of the November elections has contributed to the decline in muni issuance.”

Reflecting this slow return to fiscal sanity on the part of state governments, the municipal bond market has recovered from its January lows. As a proxy for the market, the iShares S&P National Municipal Bond Fund (MUB) has bounced back from a January low of 96.26 to 100.80 yesterday.

Renewed confidence on the part of state governors and legislatures was manifested this week when Arizona’s legislature approved a measure to permit out-of-state insurers to sell health policies to small group and individual policy holders in Arizona, an obvious way to lower costs by increasing competition. It remains to be seen if Governor Brewer will sign the measure and whether the Obama administration will take legal action against its implementation. But the bill is sensible and long overdue.

The path the states are blazing is one visible to the federal government and one we all should hope they note. The state’s actions reflect a hopeful sign that the increasing concentration of power in Washington is being challenged by rejuvenated states and that the concept of federalism and state’s rights lives on.

Wednesday, April 20, 2011

"Complacency in Bond Land"

Sydney M. Williams

Thought of the Day
“Complacency in Bond Land”
April 20, 2011

The Treasury market has been subject to a series of jolts over the past couple of months, yet thus far calm has reigned. (The yield on the Ten-Year has risen by five basis points thus far this year, suggesting prices are virtually unchanged.) Last month, Bill Gross of PIMCO, the manager of the world’s largest bond fund, said that he had taken his holdings of Treasuries to zero. Commodity prices have been rising – the CBOE is up 11.3% since December 31 – hinting at the prospect of future inflation. On Sunday, Zhou Xiaochuan, the Governor of the People’s Bank of China, sounding like a persistent seller, spoke at Tsinghua University: “Foreign exchange reserves have exceeded the reasonable levels that we actually need.” On June 30, it is expected that the Federal Reserve will cease buying U.S. Treasuries, ending ten months of quantitative easing (QE2.) Despite being a seller in January, China, with $1.15 trillion in holdings, is still the world’s largest foreign owner of U.S. Treasuries.

And, then, on Monday, Standard & Poor’s lowered their long-term outlook for U.S Treasury Bonds from Stable to Negative. The bond market yawned. That shot across the bow may prove to be a positive omen; for it may encourage productive talks to reduce the deficits. I hope so. When markets ignore bad news, market commentators, metaphorically, say they are “climbing a wall of worry” and that the action bodes well for continued strength. Treasuries rallied on Monday and did so again yesterday, complying with some sort of perverse logic: if it’s bad news, it must be good.

Upward pressure on bond yields poses serious threats to the still-struggling economy and to government deficits. The housing sector remains stuck at levels 75% below the peaks in 2006, despite attractive mortgage rates. Yesterday, the Federal Reserve, in a statement that might have been issued by the Onion News Network, said that they were seeking comment on a proposed rule under Regulation Z that “would require creditors to determine a consumer’s ability to repay a mortgage before making the loan.” Tougher loan terms, as sensible as they obviously are, limit construction. Higher interest rates will limit affordability. With total debt, including inter-agency debt, approaching 100% of GDP, higher interest costs – when they arrive (and they will) – will increase the deficit, already at 11% of GDP – three times higher than it was four years ago.

If China continues to gradually sell U.S. Treasuries (and with PIMCO out of the market for the time being), it may take higher rates to attract new buyers. (Japan, which has been a buyer, has its own problems.) And, if the Fed does suspend QE2 at the end of June, who will become the marginal buyer of Treasuries?

Nevertheless, there remains a lot of liquidity. Many banks released reserves in the quarter just ended. Cash on corporate balance sheets, in spite of record buy-backs and record M&A, remains near 50 year highs. Household savings rates have jumped from zero three years ago to 5% of income today.

However, given the explosion in government deficits, the U.S. national savings rate is lower than it was before the crisis. In fact, according to Daniel Gros writing in the New York Times on February 8, the net savings rate in the U.S. has turned negative, with only Greece and Portugal in Europe in a similar situation. (A negative national savings rate implies that the country is eating into its capital stock, instead of adding to it, putting that country at the mercy of international capital markets.)

It’s beginning to seem to me that, while the Fed may take a breather after June 30, they may not be in a position to aggressively reduce their balance sheet without causing disruption to the bond market and/or economy. Of course, the longer they persist the more difficult it will be to un-wind, and at some point the training wheels must be removed from the bicycle.

Complacency in any market should be seen as flashing amber. It does not suggest that volatility levels will increase or that markets will sell off, but caution seems warranted. It is also worth recalling that following the end of QE1 (end of the first quarter 2010) until the announcement last August 27th of QE2, the risk trade was shunned. The CRB fell 24% and the S&P 500 fell 13%.

Sometimes bad news is bad news. While I viewed Standard and Poor’s change in the long-term outlook for U.S. Treasury Bonds as a warning, the bond market took the news stoically – and complacently. Perhaps they are right. Perhaps factionalism in Washington will be replaced with accord. Perhaps…

Tuesday, April 19, 2011

"Ask Not, What is Good for the Country? Ask Instead, What is Good for my Re-election?"

Sydney M. Williams
Thought of the Day
“Ask Not, What is Good for the Country?
Ask Instead, What is Good for my Re-election?”
April 19, 2011

Yesterday, in revising the long-term outlook for the U.S. from stable to negative, Standard & Poor’s wrote that the government has “very large budget deficits and rising government indebtedness.” They added that “the path to addressing these is not clear to us.” Nor is it clear to the American people. On Sunday, Senator Tom Coburn (R-OK) said political leaders must stand up for what is right and be prepared to lose their seats. There is, in Washington however, a dearth of lambs willing to be sacrificed. The ‘pain’, we are told, should be shared…except for those in Congress.

While I hesitate to grant praise on a rating agency after the deplorable role they played in the recent credit crisis, I believe that what S&P did yesterday was a good thing, if only that it puts Congress and the White House on notice. S&P did say that they viewed President Obama’s and Congressman Ryan’s proposals “as the starting point aimed at broader engagement, which could (emphasis mine) result in substantial and lasting U.S. government fiscal consolidation.” As Hamlet might murmur, in an aside: “’Tis a consummation devoutly to be wished.” However, S&P concludes, in less poetic prose: “That said, we see the path to agreement as challenging because the gap between the Parties remains wide.” Hamlet would have nodded: “Ay, there’s the rub.”

The economy continues its plodding, but steady ascent. Last year’s fourth quarter GDP was revised down from 3.1% to 2.8%, but still above the third quarter’s 2.6% growth. Given higher gasoline and food prices, a number of economists have lowered projections for the quarter just ended by about 100 basis points to 1.5%. However, people are always fiddling with these estimates. The IMF cut estimates last fall, raised them in January and recently cut them. The Federal Reserve raised their estimates in February, only to cut them a week or so ago. Economists are always fine-tuning their numbers, trying to get accurate something they rarely do.

From my perspective, not being burdened with a degree in economics, I worry more about the trend than the details. And it appears that the economy is sluggishly, though reluctantly, moving ahead. Leading indicators, as determined by the Economic Cycle Research Institute (ECRI), continues to suggest positive momentum, in spite of higher gasoline and food prices and despite inflationary pressures in China, from whom we imported goods valued last year at $365 billion – a big number, but only about 2.5% of GDP. Retail sales persist positively and non-farm payrolls, again somewhat anemic, have been positive.

The important thing is that an improving economy, left unmolested, will throw off increased revenues to the state. The problem is that relief will be temporary and risks masking the spreading of a growing cancer – the inability on the part of Washington to rein in spending.

Washington, or at least the President, is in re-election mode. (The Republicans are in total disarray. When Donald Trump shows up as the leading candidate – a blowhard with a mop of hair that must make his barber cringe – as he did in one recent poll, one can only conclude that the GOP has a death wish.) The risk, as I see it, is that a recovering economy will generate revenues that will surprise positively, lessening the immediacy of the debt crisis, essentially kicking that bucket into the next Presidential cycle.

The American people, according to most polls, reflect a dichotomy. On the one hand, they recognize that the persistent spending spree of Congress is unsustainable. On the other hand, they indicate they want no change in the services Congress provides – a perfect manifestation of those lines from a post-World War I song, “How ‘ya gonna keep ‘em down on the farm? (After they’ve seen Paree.”) It is an attitude that should concern us, for it only postpones the inevitable. The country’s remarkable growth is because of the willingness of a few creative people to take risk. A coddled citizenry may feel comfortable, but almost certainly, in time, will be consigned to reduced circumstance.

How far we have traveled since that cold day on January 20th, fifty years ago, when President Kennedy asked the citizens of this country to think less about what they receive from government and more about what they can provide the country! Today we have a host of political leaders who promise the world and suggest that any pain must be shared… except by themselves.

Monday, April 18, 2011

"A Confederacy of Dunces"

Sydney M. Williams

Thought of the Day
“A Confederacy of Dunces”
April 18, 2011

At dinner recently, a friend asked, “Do you think the younger [she is in her late 80s] generation would be capable of the sacrifices we made during the Depression and World War II?” While the consensus was no, I suggested they would, because man is adaptable in almost infinite ways. But such change derives from necessity, not from choice. We were speaking, of course, of the financial damage caused by credit crisis and the sense that in Washington and Wall Street there appears no sense of shame and no willingness to accept blame.

Washington and Wall Street attract smart, talented people, but included among them are those who are ethically challenged. Society encourages an attitude of measuring attainment exclusively through financial attainment (i.e. Madonna’s song of 1985, “Material Girl”,) whereas, in reality, there are myriad ways of measuring success – the most important being personal happiness, often dependent upon financial well-being, but not always.

As Charles Ferguson, in his Academy Award-winning film “Inside Job” and Joseph Stiglitz, in his recent article in Vanity Fair, suggested people from virtually all walks of life got caught up in the frenzy of the housing bubble – academics as well as Wall Street types. So indicting a few when millions were culpable may seem extreme. But I am not sure. The bad guys were not the ones acting from emotion, but rather the calculating ones in Washington who promised what could not be delivered (including a good home at a low monthly cost) and those on Wall Street who created and sold products making such leverage easy and affordable, at least for the moment.

Victory, the old saying goes, has a thousand fathers. Defeat is an orphan. When the housing bubble was in full bloom, millions were being made by Wall Street traders; politicians were glowing with re-election campaign coffers overflowing and with happy constituents who were buying houses in unprecedented numbers, and regulators were relaxing. Among the more amusing (and totally misleading) scenes in Ferguson’s award winning documentary are the interviews with Representative Barney Frank (Mr. Fannie Mae) of Massachusetts who is quick to find fault with those with whom he used to cavort. Likewise, according to John Kay, writing in the weekend edition of the Financial Times, bankers have been revising their view of the past, shifting responsibility onto the government. If bankers should be indicted, and I believe they should, so should those in Washington who flagrantly used the system for their own purposes – mainly to fund their re-election efforts, people like Mr. Frank, Senator Charles Schumer of New York and former Connecticut Senator Chris Dodd.

Last week the Senate issued a report, after two years of gathering, reading and analyzing 5900 pages of e-mails and documents from a host of investment banks that detail their attempts to profit from the booming mortgage market. The report recommends a number of “fixes” – examining mortgage related securities for legal violations and evaluating risky lending procedures. However, there are no expectations that any indictments will be forthcoming. The Angelides Commission’s report, issued in January, brought no indictments. Goldman Sachs settled a suit with the S.E.C. for $550 million, without admitting or denying guilt. Shareholders of Goldman of course, not the executives responsible for the damage, anted up the money. In a public company, it is the shareholders, who have entrusted their capital to management, who become responsible for the sins of a few rogue traders and bankers. (Through the whole sad saga, shareholders have been punished the most – forgoing dividends, paying the fines and living with depressed stock prices – despite being the least culpable.)

In a detailed report in last Thursday’s New York Times on the failure of a number of banks and the loss of billions of dollars in the 2007-2008 credit crisis, Gretchen Morgenson, pointed out that thus far “no senior executives have been charged or imprisoned…This stands in stark contrast to the failure of many savings and loan institutions in the late 1980s when 1100 cases were referred to prosecutors resulting in 800 bank officials going to jail.” In the wake of accounting scandals in the late 1990s, executives from Enron, WorldCom, Tyco and others did jail time. Ms. Morgenson suggests the lack of adequate supervision by regulators, such as the S.E.C., the Office of Thrift Supervision, the Federal Reserve and the Office of the Comptroller of the Currency may have played a role. The Office of Thrift Supervision, for example, from the summer of 2007 to the end of 2008 oversaw banks with $355 billion in assets fail. Yet, as Gretchen Morgenson writes, “The thrift supervisor…has not referred a single case to the Justice Department since 2000.” Washington and the world of banking have become too close. That confederacy, instead of being weakened as one might expect, appears to have strengthened.

It is my belief that almost everyone was to blame for the crisis – bankers, mortgage brokers, politicians and consumers. The desire to believe in a fairyland of ever-rising home prices and a world in which piling on debt would never hurt grew out of a culture that glorified a belief in ever improving lifestyles. The meltdown collapsed that dream. Our political leaders, in denying the severity of the financial situation and using the lure of ‘hope,’ are attempting to resurrect that vision.

We can and should be optimistic as regards the future, but we must first address our problems with realism. Letting the scoundrels go unpunished, be they Wall Street types, politicians or regulators, is a function of denial. Nobody, except the bad guys, benefits.

Because so many of us are consumed with the present, we have a hard time focusing on serious, long term issues, such as the size of our debt, or our competitive place in the world. We see this attitude in many aspects of our lives. Our public education system reflects this narcistic view. In an article in Saturday’s New York Times, Jennifer Medina writes of California where the state just passed a law mandating the teaching of gay history. Is this what we have become? A country more focused on advancing some political agenda than on teaching the basics of math, science and English? Is that the way to compete with Asia in the 21st Century?

In 1980, John Kennedy Toole wrote a book entitled A Confederacy of Dunces. I don’t mean to suggest we are a nation of Ignatiuses (though some on Wall Street and many in Washington bear some resemblance,) but we certainly could use a Myrna.

Friday, April 15, 2011

"NATO - A Paper Tiger? A Tool of the U.N.?"

Sydney M. Williams

Thought of the Day
“NATO – A Paper Tiger? A Tool of the U.N.?”
Apr 15, 2011

The North Atlantic Treaty Organization (NATO), an intergovernmental organization created to provide mutual defense for its members was formed in 1949 with twelve member states. Its purpose was to address the fear that the Soviet Union, in the aftermath of World War II, may try to move west. Lord Ismay, its first Secretary General, famously stated its goal: “to keep the Russians out, the Americans in and the German’s down.” From the beginning it was largely American, in terms of its funding and composition. In 1951, General Eisenhower became the organization’s first Supreme Commander. (In the military structure of NATO, a U.S. military officer is always commander-in-chief of NATO forces; so that U.S. troops never serve under the control of a foreign power.)

In 1954, in a cagey move, the Soviet Union suggested it join NATO, a suggestion which was rejected by a wary Western Europe sensing this would be equivalent to letting the fox into the hen house. West Germany joined the alliance the next year. In the same year, the Warsaw Pact was formed by the Soviet Union to offset NATO’s growing presence. With the fall of the Berlin Wall in 1989, NATO began to refocus itself, permitting former enemies (members of the Warsaw Pact) to join. By 2009 NATO consisted of twenty-eight members – becoming, in essence, an organization in search of a purpose.

Following the collapse of the Iron Curtain, NATO became involved in humanitarian efforts in Bosnia (too late to prevent the massacres at Srebrenica and Markale) and in Kosovo, where NATO airstrikes caused the fall of President Slobodan Milosevic and prevented the killing and exiling of Kosovo Albanian refugees.

Libya is now a testing ground for NATO. United States’ led airstrikes, under a U.N. resolution, provided protection for civilians threatened by Moammar Gadhafi’s troops who were threatening the city of Benghazi in eastern Libya. However, within a few days, the U.S. handed responsibility to NATO. Claims by the United States that its planes were no longer taking part in airstrikes were apparently false.

The ensuing weeks have shown the difficulty NATO has without U.S. direct leadership. Germany and Turkey have been urging withdrawal. The UK and France have lobbied for increased efforts, and have called for the removal of Gadhafi from power – an action not covered by the U.N. resolution. Additionally, Libya has shown the difficulty of engaging in a military conflict where we have no national interests. Henry Kissinger and James Baker recently wrote in the Washington Post: “Our values compel us to alleviate human suffering.” However, they also issued a warning: “our country should [intervene] militarily only when a national interest is at stake.” They added: “The goals must be clear.” But how does one reconcile the use of military force solely on humanitarian grounds with the inevitable collateral damage our own bombs inflict? (Benghazi was saved – at least for now – but the western city of Misurata was shelled yesterday and thirteen people were killed.)

The U.S. has now joined the camp of the UK and France. Yesterday Secretary of State Hilary Clinton said that the goal in Libya is regime change. This morning President Obama, UK Prime Minister David Cameron and French President Nicolas Sarkozy write in the New York Times: “Our duty and mandate under U.N. Security Council Resolution 1973 is to protect civilians and we are doing that [except for those in Misurata.] It is not to remove Qaddafi by force. But it is impossible to imagine a future for Libya with Qaddafi in power…So long as Qaddafi is in power, NATO must maintain its operations.” The President recommending violating a U.N. resolution? One can only imagine the fire-breathing from the press and Congress had President Bush penned those words!

On Thursday evening, U.S. television viewers were treated to a view of Colonel Gadhafi standing in an open car, pumping his fist in the air, as he paraded through the streets of Tripoli – the capital of a country engrossed in a civil war, a scene unimaginable for the President of the United States – a country at peace. It was not the picture of a man who was planning on quietly retiring anytime soon.

At best, it appears that NATO has achieved a stalemate in Libya. At worst (and more realistically,) it seems that Gadhafi’s forces are reclaiming lost ground. Airstrikes against Libya began four weeks ago, a month after the conflict began. During those two months, innumerable Libyans have been killed and made homeless. We like to believe – and it may well be true – that early strikes against Gadhafi’s forces saved thousands of lives in Benghazi. But it does not seem that Gadhafi is about to step down, nor does it appear that the rebels are winning. In fact, they appear to be losing. Perhaps a divided state will result? No one knows. When we look back with the perspective of time, will NATO have accomplished much? In a speech at the Brookings Institute in June 2000, General Wesley Clark, the former Supreme Allied Commander, Europe and who directed the NATO airstrikes against Serbian President Milosevic’s troops, said “when you use force, it has to work.”

There is little point, at this time, arguing as to whether we should have responded to the Libyan crisis earlier or whether we should have looked the other way. (In a sense, the choices were on of a Morton’s Fork – neither one good.) We did. I do not agree with John McCain who believes we should militarily intensify our mission. If there is to be a quagmire, leave it to the Europeans. But, that being the case, neither should we up the rhetoric as the Secretary of State and President are doing. It is interesting to consider that among our least militaristic presidents were those like Washington, Grant and Eisenhower, men who had served our nation as leaders in combat. Better than most, they understood the consequences of war.

Despite its superior technology and military power, but with its internal squabbles and lack of real purpose, it makes one wonder – has NATO become a paper tiger? Or, does the fault lie with the U.N., from whom it takes its orders?

Thursday, April 14, 2011

"A Speech on the Deficit? - The 2012 Campaign Begins!"

Sydney M. Williams

Thought of the Day
“A Speech on the Deficit? – The 2012 Campaign Begins!”
April 14, 2011

This was not a speech about a budget deficit that is throttling opportunity. It was the opening gambit for the President’s re-election bid announced last week. The first half of the forty-five minute talk was devoted to bashing Representative Paul Ryan’s deficit reduction proposal issued last week. The Washington Post said: “In the speech he used as many words to attack the GOP proposal as to lay out his own.” They went on: “Even as he savaged the GOP proposal, Obama was less specific about his own.” The New York Times echoed that sentiment: “Mr. Obama spoke in strikingly partisan tones.” The speech was a “blistering critique of the Republican approach.” As a speech on the budget, it was unserious at a serious moment – as a campaign opener, it was an odd venue.

There are very few observers of the Washington scene who do not feel that the deficit situation, if left untended, will wrack critical damage on our economy and interest costs. A year ago Mr. Obama appointed a deficit commission. They issued a report in December with eleven of the eighteen members in agreement. The President, at the time, never accepted their recommendations. Nor did he say anything in his State of the Union message. When he issued his 2012 $3.7 trillion budget on February 12, nothing was said about the findings of the deficit commission. And, again last night he ignored their findings. A “gang” of six senators (Kent Conrad, D-ND; Richard Durbin, D-IL; Mark Warner, D-VA; Tom Coburn, R-OK; Saxby Chambliss, R-GA, and Mike Crapo, R-ID) have been meeting quietly to prepare a bi-partisan proposal. The President did not seek their advice before the speech. He has now asked for a third bi-partisan group (to be composed of four senators and four representatives from each party and chaired by Vice President – who appeared to sleep through yesterday afternoon’s speech) to meet by May and report their findings by the end of June – about the time the debt ceiling will be breached. Good luck to that!

The President’s proposal allegedly cuts $4 trillion from the budget over twelve years – a two year extension from earlier proposals. Three trillion would be from spending cuts and $1 trillion would be achieved through tax increases. His proposal assumes that the Affordable Care Act, which looks to become the biggest entitlement ever, will save the country half a billion dollars – part of his $3 trillion in savings. (As an aside, now that questions are being raised as to the reality of the $38 billion cuts in the 2011 budget, are we to believe the $4 trillion from Mr. Obama, or the $6 trillion from the GOP?) Even if the numbers are correct, the combined federal budgets over the next dozen years will constitute about $200 trillion; so whether the cuts are six trillion or four trillion, we should view the proposals with reservation.

This was the speech of a candidate addressing a small base of ardent, left-wing supporters who have felt he has given up too much to the Right. He knocked the Bush tax cuts for “millionaires and billionaires,” claiming that each person, on average, is benefitting by $250,000 annually. He did not talk about tax reform, a subject he has broached before, but oddly omitted this time.

There is a lot of misinformation floating around about taxes. The top 1% of all tax payers today pays 38% of all income taxes. The bottom 50% pays 3%. When George Bush took office, before he lowered taxes, the top 1% paid 34%. In 1980, the marginal tax rate on the highest earners was 70%. In 1981, it was cut to 50% and then lowered again in 1986 to 30%. The share of income tax revenues collected from the top one-half of one percent of earners rose from 14% to 22%. The way to get more money from high earners is to reduce the marginal rate and eliminate (or sharply curtail) deductions. The same thing would be true for corporations. Simplifying the tax code, a recommendation the President has made in the past, makes sense.

The President has had four opportunities to seriously address the budget deficits – in December when the deficit commission reported its findings, during his State of the Union, when he issued his 2012 budget in February and yesterday afternoon. Each time he punted. I am sure that he does understand the serious nature of the problem we face. Certainly he is pandering to his base, but more importantly he reflects his vision of the future which includes a far more intrusive government. The President wants to raise government’s share of GDP from the 19% to 21%, which has been the case for the past forty years, to 22%-24%. So, in a way, I am pleased he made the speech he did. “It was,” as Daniel Henninger wrote in today’s Wall Street Journal, “a useful speech. A defining moment.”

Paul Ryan made a genuine start on a path toward budget reform. One does not have to accept his proposal to agree that it took courage to initiate the discussion. Entitlements can no longer be treated as the “third rail” of politics. No one wants to dismantle them, but they need to be put on a sound fiscal foundation. Instead of responding in a non-partisan, “above the fray” manner, the President chose to throw down the gauntlet, giving the American people a clear choice as to which road they choose to follow – one that provides more power to states and the people, or one that endows increasing power in the hands of the President and our representatives in Washington. He also provided us a sense of the rhetoric we can expect until the 2012 elections are finally held on November 6 of that year. It is going to be a long eighteen months.

Wednesday, April 13, 2011

"Demonizing the Wealthy"

Sydney M. Williams

Thought of the Day
“Demonizing the Wealthy”
April 13, 2011

Demonizing the rich has become recreation for the populist mind. In yet another condemnation of the “rich”, the current issue of Vanity Fair has an article entitled, in a bastardization of Abraham Lincoln’s Gettysburg Address, “Of the 1%, by the 1% for the 1%.” The article is written by Joseph Stiglitz, professor of economics at Columbia and a Nobel winner.

There is no question that the income gap has been widening, as has the wealth gap. An article in the February 21, 2000 issue of U.S. News and World Report reported that the income from the richest five percent of families in 1979 was ten times that of the poorest twenty percent. Twenty years later that multiple had enlarged to nineteen times. It as ironic, though, that while we applaud the success of our children and friends, we become upset when that success translates into wealth.

The widening income and wealth gaps have two components – the gap between CEO pay and average worker compensation, and the explosive growth in entrepreneurship over the past several years. In 1980 the typical CEO took home 42 times what his average worker did. That ratio peaked in 2000 at 525 times – thanks to the munificent offerings of options during a roaring bull market. (The bull market masked the dilution those options were imposing on existing shareholders, so never drew the criticism it deserved.) During the decade of the 2000s that ratio gradually fell, unsurprisingly as managements discovered that options were less attractive in down or flat markets. By 2008, the average CEO’s pay for the 292 S&P 500 companies surveyed averaged $9.25 million, or a still-too-high 319 multiple of their average employee’s wage. I have long thought that many of those who run public companies treat them as personal ATMs rather than focusing on benefitting their shareholders. When I first entered this business, returns to labor were generally subordinate to returns to capital. (Labor then meant factory workers.) That was a time when most stocks were owned directly by individuals, rather than institutions. Today, capital is advantaged by labor; by this I mean the labor performed by CEOs.

But, the world is changing. Large companies continue to lose ground as the nation’s primary employers. According to a website, during the past decade the share of U.S. workers employed by large companies (those with over 500 employees) declined from 34% to 26%. Small business owners are increasing their dominance as the nation’s premier employers.

In 2009, according to The Hill, more entrepreneurs launched businesses than at any time in the last fourteen years. This is a double edged sword; for the risk of bankruptcy is high, but private businesses are also the best path to wealth. Many of these start-ups are in the service economy, a sector where wages tend to be lower – accentuating the trends toward widening income and wealth gaps. There has also been an almost three-fold increase in the number of self-employed, from 2.5% of the workforce in 1993 to 7% today – a function of businesses downsizing and a growing sense of being one’s own boss. These are not trends that are likely to reverse any time soon. In fact we should applaud the initiative shown by fledging entrepreneurs, for those are the ones likely to keep our country on the cutting edge of innovation. There will be, as there always have been, failures, but the characteristics of success – intelligence, drive, hard work and perseverance – are the same today, as they were 200 years ago, at the start of the Industrial Revolution.

Professor Stiglitz suggests a conspiracy – lax enforcement of anti-trust laws, manipulation of the financial system, regulators turning blind eyes, and a small coterie of people from CEOs to US Senators to executive-branch policy makers – that essentially presents a closed system. Such risks should always be taken seriously. Both the French and Russian revolutions were in large part revolts against concentration of wealth and power. Today’s situation does not come close to those examples, nor does it to the restrictive period in the United States during the last part of the 19th Century through the mid part of the 20th Century. During those years WASPs from the Northeast controlled much of banking, industry and Washington. In fact, our country has given rise to growing numbers of entrepreneurs building businesses that no one could conceive a couple of decades ago. How can one criticize such creativity, or the wealth it creates?

The more important questions are the ones of the future. Manufacturing companies have improved their productivity out of necessity in an environment in which competition – for employees and markets – is global. It is generally expected that S&P 500 earnings this year will exceed the record set in 2007, but they will do it with 8 million fewer employees. Would those who criticize wealth and income disparities prefer our manufacturing sector to employ more people and be unprofitable? Business is undergoing radical and dynamic change, with a combination of technology and global forces causing that change. We are in a transitional period when a few innovators will succeed, while the majority, those who cling to the past, will not. It may not be ideal, but it is the world as it is.

Government can play a role. In fact it already is. Stephen Moore, writing recently in the Wall Street Journal, stated: “Today, in America, there are nearly twice as many people working for the government (22.5 million) than in all manufacturing (11.5 million.”) Fifty years ago those numbers were reversed. More important, though, government can provide the foundation for better education. One of the saddest examples of the lack of opportunity are the barriers erected by teacher’s unions to hamper the expansion of charter schools, voucher programs and keeping teachers based on seniority, not merit. It is dispiriting to watch thousands of children participate in a lottery system for a limited number of places in charter schools. If these schools are as bad as the unions and “liberal” politicians say they are, why do the lotteries attract so many? Why did it take a “conservative” Republican John Boehner, during the recent budget meetings, to negotiate the funding of a popular voucher program in Washington, DC that a “liberal” President Obama had axed in 2009? Government cannot, however, legislate equal outcomes and remain a democracy. Free trade and a modernization of the immigration system are other areas in which the government can be (and should be) more proactive.

As a society, do we want to discourage entrepreneurship? Do we want to stifle creativity? I have long had problems with what seem to me gross overpayments to managers of large public companies, for their compensation comes from the shareholders who have been, in too many cases, ill treated. But to the extent that the income gap derives from entrepreneurs, I say God bless them. We all have equal rights, but intelligence, aspiration and a willingness to work hard cannot be guaranteed. All youth look to the future. The best we can do is provide opportunity. A dynamic economy favors the young and creative. When wealth follows success, it is a thing to rejoice, not demonize.

Tuesday, April 12, 2011

"More Tarnished Heroes"

Sydney M. Williams

Thought of the Day
"More Tarnished Heroes"
April 12, 2011

Last week I wrote a piece in which I expressed my dismay that Warren Buffett had let down his admirers when he failed to mention that his lieutenant, David Sokol had, in buying Lubrizol stock a week before recommending the company to Mr. Buffett, violated the standards that Berkshire Hathaway had implemented regarding “insider” trading.

Perhaps it is indicative of the times or, more likely, it reflects my age and a reduced willingness to compromise, but two recent incidents reflect badly, in my opinion, on two other people I have always regarded highly – JP Morgan CEO, Jamie Dimon and General David Petraeus.

Mr. Dimon guided his firm through the shoals of the financial crisis better than any other major bank leader. According to an article written by Roger Lowenstein last December for the New York Times magazine, JP Morgan, unlike most of its competitors, remained profitable throughout the meltdown. Of course, without government assistance in late 2008, JP Morgan may not have survived – but, in that case, without governmental assistance it is unlikely our credit markets would have survived. In his interview with Mr. Lowenstein, Jamie Dimon claimed he would like to see JP Morgan (with assets in excess of $2 trillion – and nine percent of all US deposits) become even bigger, by expanding globally. “Too big to fail risks becoming “too big to save.”

Banks have always had inherent conflicts of interests, in that the needs of clients can intersect with the demands of the corporation. In Monday’s New York Times, Louise Story explains the consequences of this conflict in discussing a lawsuit brought against JP Morgan by some of their clients. In June 2007 a Morgan unit placed $500 million of client money into notes issued by a SIV (Structured Investment Vehicle) named Sigma. The investors allegedly were told their investments were safe. According to Ms. Story, two months later executives from other departments within the bank made CEO Jamie Dimon, among others, aware of their rising concern regarding SIVs in general, including Sigma. In her article, Ms. Story writes that the bank’s chief risk officer suggested that “JP Morgan needed to protect its own position and not worry about what its clients were invested in.” Apparently all of this was known to Mr. Dimon.

The lawsuit implies that the bank made $1.9 billion from fees and the purchase of assets from the SIV at greatly reduced prices – assets sold to them by mangers of JP Morgan Asset Management on behalf of their clients. The suit further suggests that those clients recouped only $30 million of the $500 million they had invested.

Banks have erected “Chinese Walls” to prevent the flow of information from one department to another, so as to avoid even the appearance of conflict. But the banks senior management, including Jamie Dimon stands astride all departments, so they breach the “Wall.” His decision to protect his bank at the expense of his clients says something about the man and speaks volumes about the wisdom a dozen years ago to dismantle Glass-Steagall.

(It is worth noting that insiders at JP Morgan own less than one percent of the stock, so one can conclude they were principally interested in protecting their jobs. In the seven years Mr. Dimon has been CEO of JP Morgan, the stock has risen 20% - in line with the S&P 500. The dividend, though, was cut 95% in early 2009 and is still 75% below where it was in late 2008. Mr. Dimon and his managers, however, have extracted hundreds of millions of dollars in compensation.) Mr. Dimon, in failing to look after the bank’s clients, did the wrong thing.

General David Petraeus has been widely – and deservedly – acclaimed for his success in the Iraq surge and for his handling of a difficult situation in Afghanistan. As the U.S.’s commander in Afghanistan, he has a responsibility to protect his troops the best he can even while deploying them in “harm’s way.” However, even the best people can fall victim to political correctness.

On March 20, a failed and emotionally disturbed Florida pastor, Terry Jones, burned a Quran after a mock trial in which he found Islam responsible for 9/11. (In the United States, the burning of any book, no matter how inappropriate, including the Quran or the Bible is not against the law.) Two weeks later deadly riots in Kandahar left 22 dead over a three day period. As Dorothy Rabinowitz wrote in last Thursday’s Wall Street Journal, General Petraeus “delivered an impassioned rebuke of the publicity-hungry Florida pastor” who had burned the Quran. The act was, in the general’s words “hateful, extremely distasteful and enormously intolerant.” It was dangerous to his troops. But, as Ms. Rabinowitz writes, “nowhere in any of that condemnation was it possible to find a mention of the merciless savage [retribution] that had taken place in the name of devotion to God and the Quran.”

Acts such as those committed by the nut in Florida are reprehensible and indefensible, but that act does not compare to the heinous bombings, beheadings and mutilations of innocent people by extremists, no matter their heritage. General Petraeus’ failure to condemn such retaliations in language he reserved for the Florida pastor is an insult to concerned people everywhere, and especially to the victims of 9/11 and their families.

What these incidents demonstrate is that men are fallible. While all three – Warren Buffett, Jamie Dimon and General David Petraeus – have been tarnished, they remain unusually accomplished and respected men. Perhaps it should be reassuring to learn they are as human as the rest of us, but I find myself disappointed.

Monday, April 11, 2011

"The 2012 Budget - A Day of Reckoning Dawns"

Sydney M. Williams

Thought of the Day
“The 2012 Budget – A Day of Reckoning Dawns”
April 11, 2011

Whether you love him or hate him, you have to admit Republican Representative of Wisconsin Paul Ryan has been the first politician, since the fiscal and budget crisis developed, to place his hand on the third rail of politics – entitlement reform. (I say the first since then, because George W. Bush did attempt Social Security reform in March 2005, but was almost immediately foiled by his own party.) As Draconian as some claim Mr. Ryan’s proposal is, it only projects a balanced budget in 2040. Thirty years, frankly, is not good enough. On the other hand, the CBO (the Congressional Budget Office) has projected that the Obama budget left untouched would, in eleven years, add $12.2 trillion to the $13.5 trillion we had at the end of fiscal year 2010 (since the end of September 2010, we have added another $700 billion,) almost assuredly generating a credit downgrade on U.S. government debt.

While the federal government avoided a shut-down at the 11th hour Friday night, the fight over the deficit ceiling and the 2012 budget have yet to be fully joined.

The battle will not just be about numbers. It is about the sort of a society we want. Extremists from both ends of the political spectrum have served to divert attention from these more important questions. Fiscally, conservatives do not want to see the impoverished go hungry, without medical care, unclothed or un-housed. Neither David Koch nor Charles Krauthammer is uncaring or miserly. Most fiscal liberals understand that there are limits to government largesse, and that entitlement programs, in their current form, are unsustainable. As much as I disagree with Paul Krugman and feel he is politically – not sensibly – motivated, he is neither stupid nor na├»ve. The situation has become more polarized, in part, because the dialog has been one of inmates in control of the asylum – a plight fanned by a press desperate to sell content and by bloggers desperate to attract eyeballs. The good news is that, as Erskine Bowles (co-head of the President’s Deficit Committee) said, “The period of denial is over.” The bad news is that the President has thus far chosen to ignore the recommendations of that committee. (That may change when the President belatedly addresses the nation on Wednesday evening.)

Congress has been reluctant to say no to those that ask – whether the request is for corporate or individual tax breaks, or whether it is to fund a project that will help a fellow congressional member be re-elected. There are limits as to what well-intentioned men and women can do – and the limits are largely financial. Taxes can only be assessed on earnings. Too much of government’s focus, over the past several years, has been on what government can provide, and not on, as President Kennedy asked, what people can do for the country. Paul Ryan, in the preamble to his recommendation, states that our debt is an “existential threat.” Both parties have been guilty of raising expectations as to what government can do, which is a prime reason, in my opinion, as to why Congressional term limits are imperative to honest, efficient and effective government.

The hole we are in is one of our own digging. With the exception of the Ronald Reagan years, the decades since President Lyndon Johnson and his policies of “guns and butter,” (Great Society programs, while waging a land war in Southeast Asia) have seen politicians consistently promising more than they could honestly deliver. In the mid 1970s, outlays as a percent of GDP rose to 20%-22% from the 16%-19% of the early post war years. That period ended with the 2009 budget year. A combination of the financial crisis and the new administration’s social programs (“a crisis is a terrible thing to waste”) increased outlays to 25% of GDP in 2009, the highest percent since World War II, and 23.8% in 2010, the highest since 1946. Despite reductions in marginal tax rates in the 1960s and 1980s, federal tax receipts continued to rise, though at a lesser rate than spending. The financial meltdown and the recession combined to produce tax receipts in 2009 and 2010 that were the lowest percentage of GDP since 1950 .

Individuals and businesses (except those financial firms deemed “too big to fail”) live under the threat of bankruptcy. States, by law, must balance their budgets. The threat of bankruptcy brings a discipline, a characteristic absent from Washington and also, unfortunately, missing among those banks that operate with the expectation they will be bailed out should trouble arise. According to polls quoted over the weekend by Robert Samuelson, in a column in Investor’s Business Daily, about two thirds of Americans want more public spending on education, healthcare and Social Security, but the same numbers of Americans feel that deficits and taxes are too high. This disparate attitude is a consequence of government promising what it cannot deliver.

Paul Ryan also addressed the tax issue, urging Congress to lower the marginal rates for both corporations and individuals, while eliminating a number of deductions – in fact simplifying the tax code – a recommendation the President has made as well. The left has attacked the recommendation to reduce rates, as they pertain to individuals, as a giveaway to the rich, but that masks the truth. What has been a giveaway to the rich have been the myriad deductions, credits and write-offs available under the existing system. Otherwise, why would Warren Buffett pay less in taxes than his secretary? Reducing the marginal rates, broadening the base and eliminating many popular iconic deductions, such as mortgage interest and limiting the deductibility of charitable contribution to some percent of total income would generate more revenues from the wealthy. With taxes, it is not the rate that is important, it is the actual receipts.

Honesty has been missing. Politicians must be honest as to the real costs of the programs they propose. The American people must be equally honest in what they want from government. If they decide they want government to play a bigger role in their lives they must be willing to pay for it. If they want to pay less, they must understand they are going to get less. There is no free lunch. It’s not complicated. Washington has lied to us for so long that this make-believe “Land of Nod” where we now dwell has become reality in our minds. Waking up has been painful.

Whatever action does get taken, between Congress and the President, must restore the confidence of the American people (pessimism doesn’t work, as Jimmy Carter discovered), and it must help drive economic growth. The fastest way out of the current morass is for the economy to expand and private sector employment to pick up. Increased tax receipts will follow.

Thursday, April 7, 2011

"Say It Ain't So, Warren"

Sydney M. Williams

Thought of the Day
“Say It Ain’t So, Warren”
April 7, 2011

While the Weezer’s 1990s song “Say it Ain’t So” is what most people remember, the line originated in 1920 when a small boy allegedly called out to White Sox left fielder “Shoeless” Joe Jackson, as he was leaving a Chicago court where he had admitted to participating in a scheme to throw the 1919 World Series in which Chicago played Cincinnati. Jackson, who still holds the sixth highest batting average at .408, was a hero to the young. Leaving the courthouse in the custody of a sheriff, a young boy called out: “Say it ain’t so, Joe.” Jackson responded, “Yes, kid, I’m afraid it is.” If only Warren Buffett had been as forthcoming in the David Sokol scandal.

Mr. Buffett, because of his own strict, and publically expressed, high standards, operates in a self-imposed fishbowl. His investment prowess is matched by what we all believed was the integrity of his operations. In recent days, in the wake of the Sokol scandal, the press has reminded their readers of the Berkshire memo, “Insider Trading Policies and Procedures,” sent last May to his senior executives, but in place for ten years. His annual letter to shareholders is filled with homilies expressing sentiments such as: “It takes twenty years to build a reputation and five minutes to ruin it. If you think about that you will do things differently;” “Only when the tide goes out do you discover who’s been swimming naked,” and “It’s better to hang out with people better than you. Pick out associates whose behavior is better than yours and you’ll drift in that direction.”

Warren Buffett is an icon. The business and investment community have virtually deified the man; that glorification may have infected him with hubris. He seems to have risen above most mortals, into a sphere where no matter what he does, his actions will always be considered not only legal, but within the bounds of his own high ethical standards.

While the resignation of David Sokol, one of Mr. Buffett’s most important lieutenants, last week was a surprise, the shock was that there was no sense of shame or remorse that Mr. Sokol, while perhaps not breaking the law, certainly seems to have violated the intent of Mr. Buffett’s memo regarding insider trading. That memo, according to yesterday’s Wall Street Journal, specifically bars “certain Berkshire officials” from trading in public companies “that may be involved in a significant transaction with Berkshire.” The Journal reported: “Mr. Sokol certified having reviewed the policy, according to a person familiar with the matter.” It turns out Mr. Sokol bought $10 million of Lubrizol stock about a week before suggesting to Mr. Buffett that he look at the company.

In the press release issued at the time of David Sokol’s resignation, Warren Buffett stated, “I had not asked for his resignation, and it came as a surprise to me.” He added, “Dave’s contributions have been extraordinary.” In terms of Mr. Sokol’s stock purchase, Mr. Buffett said: “In our first talk about Lubrizol, Dave mentioned that he owned stock in the company. It was a passing remark and I did not ask him about the date of his purchase or the extent of his holdings.” Mr. Sokol committed a sin of omission in failing to disclose details of his recent purchase. Alexander Green, Investment Director of the Oxford Club, once wrote, “Sins of commission are easy to identify. But sins of omission? That’s trickier.” In this case, it’s not very tricky.

David Sokol, in a CNBC interview last Thursday following his resignation, insisted he had behaved legally and honorably and that he had no influence over which companies Buffett invested in. Reading back issues of Mr. Buffett’s annual letter, and noting the praise he regularly heaped on Mr. Sokol, it is hard to believe that David Sokol “had no influence.” A reputation, as Mr. Buffett once reminded us, can be destroyed in a few minutes.

While Mr. Sokol’s timely purchase of Lubrizol may have conformed to laws governing insider trading (I am not qualified to pass judgment on that aspect), they certainly appear to have violated the rules Mr. Buffett imposed on his senior managers. What Mr. Sokol did certainly does not pass the “smell” test. Questions that persist include: Why didn’t Mr. Buffett elicit details about David Sokol’s purchase? And why didn’t he ask him to sell his stock in the open market prior to the announcement of the deal? The latter would have been an easy out for both parties. In 2007, David Sokol self-published a 127-page business guide. In it he wrote, “Integrity is merely doing what is right, even when no one is looking.” He should have taken his own advice. Thus the blame lies primarily with him, for not being forthcoming; unfortunately, however, the tarnished image will cling to that investment genius and paragon of corporate ethics, Warren Buffett.

What is particularly dismaying to those of us who have so long admired the man from Omaha is discovering that he is as human as the rest of us. It is akin to that moment in childhood when we learn we did not arrive in the beak of a stork, nor were we the result of Immaculate Conception; we realized our birth was a result of old fashioned copulation. Just as the scales of childish beliefs fell from our eyes so many years ago, they have done so again.

Wednesday, April 6, 2011

"Eric Holder - It's Time to Go"

Sydney M. Williams

Thought of the Day
“Eric Holder – It’s Time to Go”
April 6, 2011

There was a pettiness in the tone of the Attorney General Eric Holder, when on Monday he spun the reversal of how and where to prosecute terrorists. The Justice Department has now opted for the venue initially selected by the Bush administration – military tribunals at Guantanamo Bay, instead of civilian courts in the United States, the initial choice of the Obama administration. Mr. Holder claimed that the decision the administration had come to, and that he was explaining, was wrongheaded. It emanated from a Congress, he explained, determined to thwart his own view that civilian courts within the U.S. were the preferred venue. Congress’ interference, Mr. Holder arrogantly inferred, flew in the face of his superior knowledge: “The reality is, I know this case in ways that members of Congress do not…So, do I know better than them? Yes.” It was a remarkable statement from an appointed official to a group of elected legislators who had unanimously voted for his appointment just over two years ago.

The job of Attorney General combines two roles: that of legal advisor to the president and as the nation’s chief law enforcement officer. The office was established in 1789 (Edmund Randolph of Virginia, George Washington’s neighbor, served as the nation’s first Attorney General.) It was not until 1870 that a Department of Justice was established to support the AG in the discharge of his duties. Historically most, but not all, Attorney Generals have been personally close to the President. The closest, obviously, was Robert Kennedy who served his brother in 1961-1963. Eric Holder and Barack Obama had a relationship, as Mr. Holder served as legal advisor to then Senator Obama is his campaign for the Presidency in 2008.

Many of Mr. Holder’s actions have been controversial. In 1999, as Deputy Attorney General he was the prime mover in getting President Clinton to grant clemency to 16 members of two violent Puerto Rican nationalist organizations (including the notorious FALN), over recommendations from the FBI, federal prosecutors and victims of their crimes. His decision, in late 2009, to treat the Christmas Day bomber Umar Abdulmutallab as a criminal defendant rather than turn him over to the U.S. military as an enemy combatant was bizarre. In early 2010, Eric Holder pledged that the Obama administration would try 9/11 mastermind Khalid Sheikh Mohammed and four conspirators in a New York City court. That decision was met with bilateral opposition, led by Senator Charles “Nose to the Polls” Schumer and Mayor Bloomberg. After Major Nidal Malik Hasan shot and killed thirteen service personnel at Fort Hood on November 5, 2009, Eric Holder, in testimony before Congress, a few months later, refused to suggest religion might have played a role in the shootings. This denial was despite Major Hasan’s shouting “Allah Akbar” as he fired his pistol, and despite knowledge of a speech Major Hasan gave in 2007 in which he claimed the War on Terror was in reality a War on Islam. This is taking the concept of political correctness to the realms of Neverland.

Early on as Attorney General, in a bid for openness, Mr. Holder reversed the Freedom of Information Act (FOIA) guidelines that had been tightened by Bush Attorney General John Ashcroft following 9/11, guidelines that many felt were too restrictive. However, in doing so, he has been accused of politicizing compliance, providing same-day turn-around for politically connected civil rights groups, while employing delaying tactics for requests by conservative organizations.

As the nation’s first Black Attorney General, Eric Holder was placed in the sensitive position of handling the civil suit originally brought by the Bush administration against the New Black Panther Party for voter intimidation during the 2008 election. Two members of the party had stood outside a Pennsylvania polling station in paramilitary uniforms, one carrying a Billy club, shouting racial epithets at white voters. Upon Mr. Holder’s assumption of office, the charges were dropped for lack of evidence. However, former members of the Department of Justice, including J. Christian Adams who resigned over the issue, have claimed that the real reason had to do with an unwillingness to prosecute minorities for civil rights violations. In a revealing statement, Mr. Holder later said: “When you compare what people endured in the South in the 60s to try to get the right to vote for African Americans, to compare what people subjected to that with what happened in Philadelphia…I think does a great disservice to people who put their lives on the line for my people.” He is right; the situations are not the same. There is no question that the position Mr. Holder found himself in was difficult. For decades minorities, especially Blacks, were denied basic rights at polling booths and in everyday life; nevertheless, that does not justify prejudice of any sort from any perspective, especially from an Attorney General whose foremost responsibility is to uphold the law.

Eric Holder, born in Barbados, is an academically brilliant man; he is a graduate of New York’s Stuyvesant High School, Columbia and Columbia Law School. But his judgment has been questionable and, more important he has permitted ideology derail the enforcement of the nation’s laws. His speech on Monday was defensive and hostile – not the characteristics we should want in an Attorney General. The lead editorial in yesterday’s New York Times said the Attorney General was “right to sound bitter about the decision [to use military tribunals, instead of civil courts].” I disagree. It is time for Eric Holder to go.

Tuesday, April 5, 2011

"Inflation, the Economy and the Stock Market - What, Me Worry!"

Sydney M. Williams

Thought of the Day
“Inflation, the Economy and the Stock Market – What, Me Worry!”
April 5, 2011

According to the National Bureau of Economic Research, the agency which determines the timing of recessions and recoveries, the current recovery began in the third quarter of 2009. At the time, unemployment stood at 9.8% and gasoline prices at $2.45. Today, eighteen months later, unemployment has declined to 8.8%, but with part time and marginally attached workers included, the total number swells to 24.3 million people, or 15.8% of a workforce of a 153.4 million. Today, gasoline prices average $3.65 a gallon, 49% above where they were eighteen months ago. Corn and soybean prices, over the same period, have risen 54% and 64% respectively. And cotton has risen 225% since the recession ended. Yet we are told by Washington there is no inflation. Equities, as measured by the S&P 500, are higher by 28% since the recession ended.

The American economy is a colossus, two and a half times that of China, the world’s second largest economy, and roughly equal to the combined economies of China, Japan and Germany. Ours, however, is a service economy, with the consumer representing about 70% of economic output; yet our very size means that manufacturing (about 12.5% of GDP) continues to place us as the world’s largest manufacturer with close to 21% of all global manufacturing output in terms of constant dollars, according to the National Association of Manufacturers.

Our manufacturing might is being threatened from within and without. As Stephen Moore pointed out in last Friday’s Wall Street Journal, we have become a nation of takers, not makers, with double the number of employees in government (22.5 million) versus those in manufacturing (11.5 million) – a trend that has been worsening. China, the world’s second largest manufacturer – and some claim the leader – is able to compete on wages and, as our largest creditor, will have a say in the interest rates we pay. A weak dollar has thus far benefitted exports, though nothing beats innovation. (A corollary of a weak dollar, it must be remembered, is higher prices for imported goods.) However, continuing holdups by the Administration and Congress on three pending trade agreements with Colombia, Panama and South Korea are not bolstering the case for exports. Also, rising interest rates – an inevitability it seems to me – may attract dollar buyers. In fact, rates have already risen. The Wall Street Journal reported yesterday that last week U.S. Treasuries “endured the longest losing streak in more than two decades.” (The end of quantitative easing means the Fed steps away from the market for Treasuries, so natural buyers – of which there have been a deficit – will determine prices and yields.)

The economy is chugging along, but at a relatively feeble pace. The lead editorial in yesterday’s New York Times (in reference to last week’s job gains of 216,000) pointed out: “At a comparable point in the recovery from other severe recessions, the economy was adding about 400,000 jobs a month.” Left unsaid was that our workforce is larger today, so true comparables would require higher employment numbers. The reluctance to commit to the recovery can be seen in persistent shuttered stores. Walking home last evening up Third Avenue, I counted seventeen blocked up stores along the sixteen blocks before turning west on 64th Street – better than two years ago, but worse than usual at this point in recovery. The willingness to commit to long term leases is just not there.

Despite rising prices of necessary goods – food, energy and clothing – official government statistics show inflation to be about 2%, dramatically below the 14% rates in 1980 when food and energy were included in the calculation for inflation. In his most recent “Investment Outlook”, Bill Gross of PIMCO writes of the dilemma of entitlement costs on government coffers. He suggests that a depreciated dollar (and higher inflation) may be their answer – a practice perhaps already begun.

Yet, through this maze consisting of an economy struggling to stay upright, a depreciating dollar and the rising costs of essentials, the stock market moves blissfully along, now approaching its recovery highs attained in mid-February. From its low on March 9, 2009, the S&P 500 has doubled, but, as important, the Index has risen 28% since Fed Chairman Ben Bernanke gave a speech introducing quantitative easing on August 27, 2010; that rise has been accompanied by a dramatic lowering of daily volatility – until last month.

It is not that stocks seem overvalued. They are not. But neither are they excessively inexpensive. As Laszlo Birinyi wrote in a Strategy Bulletin yesterday, “old fashioned stock picking” should be the choice for investors. Of course, that makes life more difficult for those who prefer surfing (buying or shorting ETFs, baskets or indices) to the hard work of analyzing an individual company. Extended markets place a premium on stock selection, as the low hanging fruit has been picked. If not a time to be worried, this is a time to proceed with caution.