Larry Summers’ Bad Bet

We interrupt our regular programming to speak out in favor of Larry Summers; he is the perfect candidate to replace Ben Bernanke.

Poor Larry… The critics are on his case. One called him a “high IQ moron.”

No one likes to kick a man when he’s down. Unless the man on the ground is Larry Summers…

More on that in a minute…

First, a quick look at the markets. As expected, the Fed is fully, squarely, 1,000% committed to EZ money.

Why?

Because huge public policy disasters do not stop until they’ve gone all the way to the end. Like a real bear market… a forest fire… or a love affair… it has to burn itself out.

A New Kind of Money

Look, as we’ve been explaining over the last few days, in 1971, the US federal government took the world’s money in a new direction. It went back to credit-based money… rather than money based on gold bullion.

Credit-based money allowed an almost infinite stretch in the amount of, well, credit. From 150% before the switch to over 350% today… total debt as a percentage of US GDP has gone wild.

Gold is limited. Credit is not. With this new “credit card” in their pockets, people could spend money that they hadn’t made yet… money they may never make. They realized, too, that they could spend the earnings of their children and grandchildren far into the future!

A credit-based system works well in small, primitive societies. In some tribes studied by anthropologists, credit can be subtle and extensive. A man can make a mistake or a decision. All of his descendants, for generations, may bear the burden of it.

But in a small tribe, people can keep track of credits and debits. They know the creditors. They know the debtors. They know what a piece of meat is worth… or a bride.

But what’s a dollar worth? This is a credit-based system. But no one is too sure what the credits are worth. You say you have a US T-bond that matures in 2020? What is that worth? You say it will fund your retirement?

Are you sure?

The Argentine government has promised to make a payment on a US dollar bond in 2015. That obligation is part of a sophisticated derivative instrument… which is one of the key assets of Hedge Fund A. It borrowed the money to buy the derivative from Bank B. Now Hedge Fund A’s debt to Bank B is a critical part of Bank B’s capital.

But what happens if the Argentines don’t pay?

You see, the collateral in a credit system is debt. And when debt goes bad, the system cracks up. The only thing that can stop the crack-up is a gush of more credit.

That’s what happened in 2008-2009. But this kind of fix is only temporary… and always disastrous. Because it just stretches out the web of unsustainable credit connections even further.

And you – the holder of this credit-based money (check your wallet) – never know what your holdings are worth… or when they might become worthless.

That’s why ancient man, at the dawn of civilization, came up with a better idea: money based on precious metals.

When you have a gold coin in your hand, you don’t care if Argentina pays or not. Your dimwit neighbor can’t pay his mortgage? Too bad for him! Your government can’t keep the money flowing to zombies? Too bad for the zombies!

Larry Summers: The Right Man to Lead the Fed

But let’s turn back to Larry Summers – former dazzling academic… former US Treasury secretary… former president of Harvard… former director of the US National Economic Council… and now candidate to replace Ben Shalom Bernanke as the nation’s No. 1 money man.

On the surface, Summers has the right qualifications. He has no idea how an economy really works. Nor does he have any interest in finding out. He has never… as far as we were able to determine… had a job in the business or commercial world. Instead, he has passed his entire career giving bad advice in academia or government.

Here is Robert Scheer criticizing Summers for the wrong reasons in The Nation:

Former US Treasury Secretary Lawrence Summers, the guy who tops the list of those responsible for sabotaging the world’s economy, is lobbying to be the next chairman of the Federal Reserve. But no, it makes perfect sense, since Summers has long succeeded spectacularly by failing.

Summers was one of the key players during the Clinton years in creating the mortgage derivative bubble that ended up costing tens of millions of Americans their homes and life savings. This is the genius who, as Clinton’s Treasury secretary, supported the banking lobby’s successful effort to make the sale of unregulated bundles of mortgage securities and the phony insurance swaps that backed them perfectly legal and totally unmonitored. Those are the toxic bundles that the Federal Reserve is still unloading from the banks at a cost of trillions of dollars.

Summers opined that “the parties to these kinds of contracts are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies.”

Summers didn’t understand how a credit-based economy works. In fact, he didn’t seem to understand interest rates. Bloomburg recounts:

During the financial crisis, Harvard lost nearly $1 billion because of some unusual and ill-judged interest rate swaps that Summers implemented in the early 2000s during his troubled tenure as the university’s president.

Interest rate swaps allow borrowers to lock in a fixed interest rate on floating-rate debt, which can be good to hedge against short-term uncertainty. The problem with Harvard was that Summers wanted to lock in interest rates for money that the university hadn’t actually borrowed and wasn’t planning on borrowing for a very long time.

There aren’t a lot of ways to interpret this exotic instrument except as a bet that the future level of interest rates would be higher than the market pricing implied at the time. That bet was wrong, and Harvard lost a billion dollars. Anonymous finance blogger Epicurean Dealmaker puts it well:

“I have rarely encountered a corporate client who feels confident enough about both their absolute funding needs and current and impending market conditions to enter into a forward swap starting more than nine months into the future. Entering into a forward start swap for debt you do not intend to issue up to 20 years in the future sounds like either rank hubris or free money for Wall Street swap desks.”

Hey, anyone can make a mistake. But what sets Summers apart is his readiness to make mistakes on a colossal scale… with other people’s money.

But as far as we can see, that gives him all the qualifications you need to be America’s top banker.

A high IQ moron is just what you need for this kind of work.

You have to be smart enough to talk the talk, pretending that you know what you’re talking about. But you have to be stupid enough to believe it.

You must think you really can improve the financial decisions of 310 million people. And you have to be arrogant enough to contradict all of them – putting your own asinine plans into action even though they will almost certainly bankrupt the entire nation.

Summers is the man for the job!

Regards,

Bill

Market Insight

Should You Buy Stocks at New Highs? 

From the desk of Chris Hunter

 

The S&P 500 has reached a new record nominal high. So has the Dow.

Both indexes have rallied strongly in July. The S&P 500 is up 5%. The Dow is up 4%.

So what to do?

Analysts tell you that buying in at market highs is nothing to worry about. That’s because, going back to 1950, buying the S&P 500 at a new 12-month high and holding for 12 months has been a better strategy than the average buy-and-hold strategy… and a better strategy than buying at new lows.

Here are the figures from True Wealth Systems editor Steve Sjuggerud, who’s bullish on US stocks.

Pretty impressive…

And pretty compelling, if you plan to hold for exactly a 12-month period.

The problem is most investors don’t hold for exactly 12 months. And longer-term returns depend on buying low and selling high.

But stocks are cheap at current levels, say the bulls.

In 2000, just before the dot-com crash, the S&P 500 traded for an average P/E of 30. And in 2007, just before the subprime mortgage meltdown and subsequent stock market crash, the index traded on a P/E of over 20. Today, it’s on a more reasonable P/E of 15.

But this measure looks only at stocks’ forward P/E, which uses forecasted earnings for the next 12 months.

A problem with this valuation method is that forecasted earnings are just best guesses by Wall Street analysts… nearly all of whom are paid to be bullish about stocks and the economy.

If they overshoot, as they so often do, and booked earnings come in lower than forecasted earnings, P/Es will turn out to be higher… and stocks will be more expensive than previously believed.

A second problem is these are estimates of just 12 months of earnings. But long-term investors aren’t buying just 12 months of earnings. They are buying a stream of earnings further out into the future.

That’s why many long-term investors look at the cyclically adjusted  P/E or CAPE. (It’s also known as the Shiller P/E after Yale professor Robert Shiller, who popularized this alternative measure.)

This averages booked inflation-adjusted earnings over 10 years and compares this to the current share price. This means (a) you aren’t dependent on Wall Street’s guesses of future earnings and (b) you aren’t looking at just one year of earnings (which may be unusually high or low).

Are stocks cheap right now on a CAPE basis?

Hardly…

As I said on Wednesday, on a CAPE of 24.6, the S&P 500 is trading at nearly a 50% premium to its average historic valuation.

And it trades on a 233% premium to where it stood in January 1982, at the start of the last secular bull market. (The CAPE back then was just 7.4.)

And looking at P/Es based on 12-month “as reported” earnings doesn’t improve the picture much.

On this basis, the S&P 500 is trading at a 25% premium to average historic valuations. And it is 153% more expensive than it was in January 1982.

Buying into a mature bull market at new highs may work out. But think twice before buying on the belief that stocks are cheap. Calculations using actual booked earnings – whether over the previous 12 months or over the previous 10 years – don’t support the “stocks are cheap” view.

When either of these two measures drops to single digits it will be time to seriously consider buying in.