Keystone Kops Cuff the Middle Class; Will GOP Bail It Out?

Among Barack Obama’s many failures none is more stunning than his purported effort to reduce income inequality, which he calls “the defining issue of our time.” While the nefarious 1% prospers (and pays 35% of U.S. income taxes), the bottom 90% struggles. You know the bleak statistics – anemic GDP growth, stagnant real wages, the poverty rate at recessionary levels, record-high income inequality, median household income 8% lower than in 2007.

The Obama Mansion Boom

But to really appreciate how well the affluentials are doing, you need more than numbers. You need to visit my neighborhood and behold the building boom that is under way. It’s a Wall Street bedroom community where the housing stock consists largely of what John Kenneth Galbraith derisively but accurately called “Stock Broker Tudors” built during the 1920s bull market.

Back in 2009, when Barack Obama was inaugurated, the homes in my neighborhood were quite serviceable—no sagging rooflines, no cracked windows held together with masking tape, no broken-down porches, no 1979 Buicks sitting on cinder blocks in the front yard. According to Zillow, most of them are worth $1 million to $3.5 million. Nevertheless homeowners have decided they simply must upgrade to something bigger and better. Taking advantage of rising stock prices and super-low interest rates, they have improved and expanded and built and demolished and rebuilt. You’re not really cool in my neighborhood unless you have a dumpster in the driveway and a Porta-Potty for construction workers in the front yard. I count, within just a few blocks of my house, no less than 17 major construction projects started or completed in the last three years, specifically:

  • One giant new house, somewhat reminiscent of Versailles, is being built on a large lot with a splendid view of Manhattan.
  •  Nine houses have been substantially expanded and renovated, sometimes more than once.
  • Seven houses were either torn down and replaced or totally rebuilt inside and out—always with a big increase in square footage. A famous TV newscaster bought a sizeable older home for $2.2 million, tore it down, and built a palatial white colonial with 23 windows facing the street, as well as a separate three-car garage and an infinity pool in the back. A private equity partner bought a large, stately colonial for $3.75 million, rebuilt it from foundation to roof, increased square-footage 30%, and added a 3-car garage, elaborate new driveway, and multi-tiered terrace leading to the front door.

After you build or rebuild your mansion, you need to decorate it for Christmas with wreaths—lots of them. One for every window and door. The neighborhood record is 17 wreaths; two houses tied for second with 14.

Keystone XL: Out of Excuses

Democrats talk a good game about promoting “good paying middle class jobs” but invariably defer to enviromaniacs who oppose economic development having anything to do with dreaded carbon. Andrew Cuomo banned fracking despite its good environmental record in neighboring Pennsylvania. Obama promises to veto the Keystone XL Pipeline even though he has run out of excuses for doing so. It was painful to watch a hapless Senator Coons of Delaware debate the issue with Senator Hoeving of North Dakota on FoxNews Sunday. Coons spouted empty platitudes about ”An energy policy that includes growing good jobs, American innovation and infrastructure, energy independence, and that doesn’t hurt our environment.” Senator Hoeven, smarter and better-prepared, showed that building the Keystone XL Pipeline is a no-brainer from every point of view—economic, environmental, safety, and geo-political:

  •  It will create 42,000 well-paid jobs. No, they are not “permanent” jobs but then, as George Will pointed out, the only permanent jobs are in government.
  • After six years of study the State Department has concluded the Pipeline will not damage the environment.
  • Six state governments have approved it.
  • Pipelines are safer than moving oil by rail—which should concern Senator Coons because his state will see a surge of rail traffic once a new offloading complex is completed in Delaware City, Delaware. (Memo to the Senator: an oil train explosion in Quebec flattened a town and killed 47 people.)
  • The oil moved by the Pipeline is no dirtier than oil produced in California or oil we now import from Venezuela.
  • Oil imports from Canada reduce U.S. dependence on OPEC.
  • It makes diplomatic sense to treat our ally, Canada, at least as well as we treat Venezuela.
  • Having made a huge investment in their oil sands projects, Canadian companies will find one way or another to ship product to market, so banning the pipeline will have zero effect on carbon emissions.

An Opportunity for Republicans to Stick up for the Middle Class

Fortunately the average construction worker is not as dumb as Senator Coons or President Obama or Paul Krugman or Senator Elizabeth Warren. He or she knows that environmental elitists have total contempt for the average worker who needs to make a living in the real world, not the never-never land of the enviro-maniacs, where pipelines are “bad” but giant windmills that slice up birds and solar farms that destroy thousands of acres of natural habitat are “good.”

By supporting sensible development of fossil fuels, Republicans can demonstrate in 2016 that they care more about the prosperity of the middle class than Democrats beholden to rich enviro-maniacs. But only if they nominate an economically literate, politically adroit candidate who demonstrates real empathy for average workers. Republicans did not nominate such candidates in 2008 or 2012. (McCain’s economic platform did not extend beyond opposition to Congressional earmarks; Mitt 47% Romney, incredibly, never gave a coherent speech outlining his economic platform.) Let’s hope the GOP doesn’t make that mistake again in 2016.

Copyright Thomas Doerflinger 2015. All Rights Reserved.

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The Big Money Loves Tech & Healthcare, Not Industrials and Consumer

I like to check out the biggest holdings of the major mutual funds, for two reasons.   It shows which names are already loved by the Street and at risk of becoming less loved, and vice versa. Second, the guys and gals at the big fund complexes are smart and very well informed; managements of the companies they own or might own are in their offices regularly, and analysts and salesmen are constantly phoning with the latest company tidbits and industry insights. If a couple of funds have a major position in a name, it tells me the fundamentals are probably solid.

I looked at the top 10 holdings of 18 large-cap growth funds run by Vanguard, Fidelity, T. Rowe, and Gabelli—173 positions in all because the funds owned some bonds and foreign stocks. Here are the takeaways:

  • The most popular sectors by far are tech (49 positions, or 28% of the total of 173) and healthcare (44 or 25%). So over half of all the positions were in these two sectors.
  • The most popular stock was Apple, the top holding of 8 of the 18 funds; in all 9 funds own it. Other popular tech stocks are Google (9 funds own it), Microsoft (6 funds), and Facebook (7 funds). Qualcomm is a bit unloved with just one fund owning it. Intel is not a top 10 holding of any of the funds; neither is IBM.
  • Popular healthcare names include Biogen IDEC (6 funds), JNJ (5 funds) and Gilead (5 funds). “Big pharma,” broadly defined, is popular, with Roche, Lily, Merck, Pfizer, Novartis, AbbVie, Bristol Myers and Amgen collectively accounting for 21 of the 173 positions.
  • Financials are not popular; the favored bank is Wells Fargo (6 funds own it) followed by JP Morgan (3 funds).
  • The industrial sector is un-loved; together 3M, Honeywell, GE and Danaher account for just 7 positions of the 173.
  • Also unloved are staples stocks; P&G, PepsiCo, and Coca-Cola are each top holdings of one fund. (To me, this makes sense; the stocks are expensive and earnings are not growing much.)
  • Retailers are not particularly popular, but three funds do like the auto parts space (Advanced Auto, Genuine Parts, Autozone) and three funds count Home Depot among their top holdings. TJX and Starbucks are also represented.
  • Other names owned in size by the funds include Crown Castle (wireless infrastructure), Zoetis (animal health), Disney, McKesson, Marsh and McLennan, Thermo Fisher, Nike, CVS, and United Health.
  • A few funds own the credit card companies, Visa and MasterCard; however their popularity seems to be fading.

I own 16 of the stocks owned in size by these funds, so I can’t say I disagree with their views. That said, healthcare looks rather over-owned and in some cases quite expensive, though I agree it is the sector with the best earnings and revenue momentum. Don’t forget that blockbuster new drugs usually replace drugs already on the market, and healthcare does have exposure to the strong dollar and weak overseas economies. On the other hand, industrial stocks seem too unpopular. The XLI climbed just 6.2% over the last year versus 10.3% for the S&P 500, even though the U.S. economy is accelerating and many industrial companies are producing quite respectable EPS growth despite the strong dollar. (Admittedly the collapse in energy prices is a new headwind for some industrial stocks, albeit positive for others.) I think it is bullish for consumer durables such as restaurants, retailers and apparel that they are not popular holdings even though both revenue and margins should benefit from lower oil prices.

Copyright Thomas Doerflinger 2015. All Rights Reserved.


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Cotton, Capitalism and Poverty Reduction

“Dyed in Blood: A Harvard historian shows how every stage of the industrialization of cotton rested on violence.”

So reads the headline in last Sunday’s New York Times Book Review, regarding Sven Beckert’s volume, Empire of Cotton. The book is part of a new and important historiographical school—the history of capitalism—and also exemplifies a popular genre, the global history of a commodity. With Madeira wine, tobacco, sugar, coffee and mahogany already claimed (consumed?) by other historians, Professor Beckert wrote an informative if biased account of the global history of cotton. He reminds us early and often about the nefarious drawbacks of global capitalism — “the realities of slavery, expropriation, and colonialism” (p. xviii), “slavery, colonial domination, militarized trade, and land expropriations” (p. 60), “the many spoils of imperial expansion” (p. 81), “the newly global, dynamic, and violent form of capitalism” (p. 84), “the onslaught of European merchant capital” (p. 131) and—just in case you didn’t get the message—“a vast and impenetrable machine, a painfully efficient mechanism for profit and power” (p. 135). Like George W. Bush, professor Beckert doesn’t do nuance.

From War Capitalism to Industrial Capitalism

Beckert calls the first phase of his narrative “war capitalism” —a term I like because Britain did indeed fight a seemingly un-ending series of wars with the Dutch and French in the 17th, 18th and early 19th centuries. The line between warfare and commerce was thin. In this period most of the world’s cotton was grown and spun into thread in India’s countryside, then woven into cloth that was beautifully hand printed with colorful designs—paisley, chintz, madras, etc.. Not only was cotton lighter and less scratchy than woolens or linens; it held dyes better. The British East India Company muscled its way into India and set up “factories” (trading posts) that exported the cloth to England. From there some of the cloth was sold domestically, some was reexported to North America and Europe, and some was shipped to West Africa and bartered for slaves in the despicable “Guinea trade.” About half of the cargoes sent to Africa from London and Liverpool consisted of cotton cloth; the other half was metal, guns, alcoholic beverages, and cowry shells (used as currency in West Africa).

In the later eighteenth century “war capitalism” gave way to “industrial capitalism” thanks to two historic developments. A brilliant series of British inventors and industrialists figured out how to mechanize the spinning and weaving of cotton, dramatically increasing labor productivity. Meanwhile, across the Atlantic, Eli Whitney invented the cotton gin, igniting a boom in the planting of cotton in the American South. This was a moral and social disaster because planters in Virginia and Maryland—who owned more slaves than they could employ profitably in the declining tobacco sector—were able to sell their slaves in the cotton frontier (Georgia, Alabama, Mississippi, Louisiana, etc.) rather than set them free, as was gradually occurring in the North. Many black families were broken up as slave traders marched “coffles” of enslaved African Americans hundreds of miles southward to slave markets in New Orleans and other cities.

Once “industrial capitalism” took hold in the 19th century, a powerful trans-Atlantic dynamic developed. Slaves on southern plantations produced cotton that was exported from New Orleans and Mobile either directly to Liverpool or to New York merchants who in turn sent it on to Liverpool (reserving some cotton for factories in the northeastern U.S.). Merchants and bankers in New York, Liverpool and London financed the production and shipment of cotton, thus effectively financing the westward expansion of slavery. By the 1850s over half of total U.S. exports were cotton. England’s notorious “dark satanic” mills, which used waterpower and the newfangled machinery to turn bails of cotton into bolts of cloth, came to symbolize the Industrial Revolution. In Beckert’s telling workers in England and America were violently coerced into working in these cacophonous brick factories.

Ignoring Poverty Reduction

Beckert’s book has many virtues. I love its global vista; you can’t understand cotton from the perspective of a single region, be it India, Britain, Africa or North America. And he tells some parts of the tale – such as the gradual mechanization of the English cotton production in the 18th century– exceedingly well.

Unfortunately the book is marred by its leftist bias and disregard of straightforward economic relationships. For example, we hear a great deal about the production of cotton fabric but almost nothing about its consumption. Millions of consumers, roughly half of them women, benefited from the availability of affordable cotton cloth. The tactic employed by historians to dismiss the rise in living standards generated by capitalist productivity gains is condescending invocation of “consumerism,” as though an impoverished woman who could finally afford to own a comfortable cotton dress was comparable to a suburban housewife buying her 10th pair of shoes at the mall. But Beckert pretty much ignores the rise in living standards, and associated alleviation of poverty, stemming from the expansion of the cotton industry.

Another problem is the Euro-centric treatment of manufacturing in India. We learn on page 34 that European demand for cotton cloth—which was promoted and satisfied by the British East India Company—“clearly benefited” Indian weavers. We learn further that “This ‘factory’ system, with its continuing dependence on local traders and local capital, persisted for roughly two centuries.” Obviously an industrial system that benefited thousands of Indian weavers and traders over two centuries merits more than a couple of pages. Precisely how many workers were involved and how much did they benefit from the creation of a global market for their product? Very relevant and important questions, but answering them would confound Beckert’s anti-capitalist narrative.

New England Textile Workers—Attracted, not “Coerced”

Still more problematic is Professor Beckert’s conflation of New England’s early cotton factories with the “dark satanic mills” in the British midlands, which in many cases employed indigent refugees from England’s orphanages and poor houses. Things were radically different in New England, which unlike Britain had a labor shortage, not a surplus of desperately poor people. (Nearly every British visitor to ante-bellum America remarked on the absence of poor white people.) There is abundant historical evidence about how entrepreneurs staffed New England’s textile mills—both factory records and the writings of the workers themselves. As historian Thomas Dublin has written in a standard work on New England’s mill workers:

“According to the conventional view, women in the early Lowell mills were young, single women attracted from the surrounding New England countryside. They entered and left the mills frequently, working for repeated short stretches in the years before marriage. While in Lowell they resided in company boardinghouses, erected by the textile corporations and managed by boardinghouse keepers. . . . This description is basically correct and uncontroversial.…”

For our purposes, the operative word here is “attracted,” which is the precise opposite of the “coercion” Beckert alleges. Impecunious but respectable unmarried women living on hardscrabble New England farms were “attracted” to factory work by decent living conditions, acceptable working conditions and fairly good wages. For example, Thomas Dublin dissects the finances of one Mary Hall, whose earnings, net of charges for room and board, “must have enabled Hall to support herself quite well.” Factory girls could afford more fashionable clothes than the drab homespun worn on the farm. With the support of factory managements, some workers created a newspaper, The Lowell Offering, which helped to create a spirit of sisterhood among the workers. The factories offered flexible employment opportunities and a measure of independence—not oppression—to unmarried women. Later in the ante bellum period they were supplanted by Irish immigrants, whose living standards were much higher in America than they would have been, had they remained in Ireland.

The Seductive Charms of Rural Poverty

An obvious question—relevant to 18th century England, 19th century America or 20th century China—that capitalism’s critics fail to ask, let alone answer, is: “If factory work was so awful, why did so many people migrate from farms to factories?” To the impressionable outsider the simple rural village seems far more salubrious and appealing than a crowded, dirty factory town. But the rural poor knew better. They lived dreary lives of hard work, long hours, low pay and social isolation. Historian Joyce Appleby provides insight in her excellent book on early 19th century America, which is based in part on over two hundred autobiographies:

“Contemporaries looked on factory work as benign when compared to the farming life. Chauncy Jerome, one of the trail blazers of the clock industry, painted a particularly grim picture of what life held for him after his blacksmith father died in 1804: ‘There being no manufacturing of any account in the country, the poor boys were obliged to let themselves to the farmers, and it was extremely difficult to find a place to live where they would treat a poor boy like a human being.’ John Thompson echoes Jerome’s lament when he explained that he ‘did not want to work for the farmers thereabout, for they worked late and early and their work was too hard for me.’ James Riley recalled that the farmers he worked for were loath to release him for schooling despite his apprenticeship agreement.”

Factories Provide an Escape from Poverty

The reality that Professor Beckert and many other historians do not care to confront is that the alternative to rising manufacturing productivity orchestrated by greedy capitalists was—in a context of rising population and finite land—acute and intensifying rural poverty, malnutrition, starvation, and disease. For example, the percentage of people in China with an income of less than $1.25 per day is 6.3% versus 24.7% in India. Why so much higher in India, even though it boasts so many brilliant engineers and entrepreneurs and had a head start over China in creating a modern economy after World War II? A key reason is that China developed a vibrant labor-intensive manufacturing sector producing everything from toys to clothing to smart phones to computers. India has failed to do so, in large part because of burdensome over-regulation of manufacturing firms by corrupt and capricious government bureaucrats. (See my January 14, 2014 post for details.)

Copyright Thomas Doerflinger 2015. All Rights Reserved.

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Stocks Are Expensive, Offer Mediocre Risk / Reward

Using $124 S&P 500 EPS for 2015, the forward PE of the market is 16.8x, which seems reasonable compared to the 17.1x average PE since 1989. Unfortunately this comparison is misleading for two reasons:

  •  The average since 1989 is inflated by the tech bubble of the late 1990s.
  • It is also inflated by recessionary periods when earnings were depressed and investors looked forward to strong earnings growth as the economy recovered. That is not the case today, six years into an expansion. Profit margins are high; revenue growth is tepid. Profits rose 7% in 2014 and will rise around 5% in 2015, impeded by weak energy earnings.

How expensive are stocks, taking those two factors into account? Based on history, “very expensive.” Consider:

Since Q1 1989, using quarter-end price and our proprietary data on “pro forma EPS” (which exclude unusual gains and losses) we have the forward PE ratio for 104 quarters. As noted, the average is 17.1x. But let’s exclude the tech bubble (1997-2000) and six recessionary years (1991-92, 2001-02, and 2008-09). That leaves us with PE’s for 64 non-bubble/non -recession quarters, comparable to where we are today in the economic cycle. Of those 64 quarters, only four had higher PE ratios than the current 16.8x. The mean and median for the 64 quarters are only 14.8x.

The Fed Is “Behind the Curve”

The counter-argument is that interest rates have never been this low. What’s not to like about stocks offering a 2% yield and mid-single digit earnings growth when the 10-year treasury yields 2.2%? I have championed that argument in many reports on “dividend fountains” since the dark days of 2009, and it still has merit. Maybe PE’s will indeed remain lofty in a low-yield world.

But maybe not. Risks are rising. It makes no sense for Fed funds to be at zero as we enter the seventh year of an economic expansion that is clearly accelerating—see GDP, employment, unemployment, industrial production, ISM’s, etc. We are rapidly moving toward “full employment” – particularly given that Obamacare, the EPA’s war on fossil fuels and other policies have damaged the supply side of the economy. As we saw with the “taper tantrum,” Fed tightening may well cause indigestion in the domestic and international bond markets, producing unexpected defaults and global turbulence. After all, the ultra-low Fed funds rate of the early 1990s (down to 3%) and 2003-04 (down to 1%) caused destructive asset bubbles, so why shouldn’t a protracted zero rate regime have similar effects?

Adding to the risk are slow global growth and general economic mismanagement in Europe (excluding the UK), Japan, and many emerging markets. How long will Europeans accept 10% unemployment before they vote for extreme parties on the Left and Right? A bearish near-term scenario I laid out on December 16 has so far failed to materialize, as the Fed spread easy-money-talk foam on the global economic runway. But the Fed cannot do that forever.

I will freely admit that stocks still look like the best game in town. But it is important to avoid complacency, anticipate greater volatility, recognize that equity returns may be modest over the next few years, and accumulate cash now if you need liquidity. Don’t extrapolate the past two years.  We are no longer in early 2013 when the economic expansion was two years younger and the forward PE was 14.0x, not 16.8x.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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Enviro-colonialism in New York

Liberals have unlimited capacity to compartmentalize issues and ignore their obvious interconnections. It would not be surprising to see The New York Times decry wage stagnation on Monday and income inequality on Tuesday; bemoan the low incomes of African Americans on Wednesday; attack carbon spewing coal-fired utility plants on Thursday; and then congratulate Andrew Cuomo for banning fracking on Friday. Never mind that fracking in New York would create high-paying blue-collar jobs in a depressed region, thereby raising median wages, reducing inequality and creating more jobs for African Americans—not to mention expanding output of natural gas which is “cleaner” than coal and raises real incomes by reducing utility bills.

Andrew Cuomo pretends he knows nothing about fracking and so left the decision to his health commissioner. Only Andrew believes that. His report banning fracking is a model of biased, illogical “analysis.” It cites “environmental impacts and health outcomes” potentially associated with fracking, such as:

  • Air impacts that could affect respiratory health
  • Climate change impacts due to methane emissions
  • Drinking water impacts
  • Potential surface spills that could contaminate soil and water
  • Surface-water contamination resulting from inadequate wastewater treatment
  • Earthquakes
  • (This is the weirdest) Community impacts from “boom-town economic effects” such as increased traffic, road damage, noise, and stress.

These are issues worth considering. It would be great if we had many years of experience drilling thousands of hydro-fracking wells, to evaluate the health risks associated with fracking and determine how we can reduce them. But of course we do have such experience—in Texas, Oklahoma, Colorado, North Dakota, Ohio and nearby Pennsylvania. The report presents no hard evidence that fracking created significant health risks in these states. Even the EPA, sworn enemy of fossil fuels, has signed off on fracking.

And then one must ask, “compared to what?” We know that windmills slice up birds and create a racket that gives the neighbors headaches. Solar farms destroy thousands of acres of habitat and require lots of water to keep clean. Both wind and solar are expensive and require unpopular, disruptive power lines to transfer electricity from the source to the city. No energy source is perfect, including fracking and including all the alternatives.

Third, the report cites potential methane emissions (which can be minimized with careful management) but ignores the climate virtues of producing more natural gas to supplant coal.

Fourth, the report ignores the beneficial effects on health and overall well-being bestowed by stronger economic growth, more job creation, higher personal incomes and reduced poverty. This is a favorite tactic of environmentalists—measure health effects of pollution or pollution reduction while ignoring the beneficial economic effects of cheap energy, which in turn have positive implications for the health of average citizens. Poverty and high unemployment are not conducive to better health.

The notion that an economic boom would trouble western New York is particularly absurd. The population of Broome County (home of Binghamton) declined from 221,815 in 1970 to 200,600 in 2010. I seriously doubt a fracking boom that boosted the population 10% back up to the 1970 level would upset the citizens of this economically depressed county. As for the impact on tourism, the Southern Tier already has many natural gas wells, most of them tucked away in the expansive fields and forests of a beautiful and thinly populated agricultural region. Let each individual town decide whether it wants to put up with the disruption and prosperity of a fracking boom.

Enviro-colonialism . . .

What we have here is a rich urban and suburban enviro-gentry imposing its prejudices and misconceptions on poorer, less powerful rural folks. Consider the figures on median household income and poverty rates (2009-13) for the two regions:

  • Three counties in the “southern tier” (Broome, Chemung, Chenango): median household income averages $39,193 and the share of people below the poverty level is 16.2%, on average for the three counties.
  •  Three counties in the New York City suburbs (Westchester, Nassau, Bergen): median household income averages $87,810 and the poverty rate averages 7.6%

So—even leaving aside the super-rich precincts of New York City—the affluent anti-fracking counties are more than twice as rich and have less than half the poverty of the poor counties denied jobs and prosperity by King Andrew’s edict. No wonder inequality is rising and wages are stagnating. If you want to prosper, go west to Texas and Oklahoma—which is precisely what workers are doing. Between 2000 and 2010 New York State’s population rose 2.1% and New Jersey’s 4.5%, while population growth was 20.6% in Texas and 8.7% in Oklahoma.

. . . could Split the Democratic Coalition

 It’s not just King Andrew. Elizabeth Warren attacks fossil fuels while opining “if we commit ourselves to clean energy and energy efficiency now, in the long run we can reduce price swings and lower our overall costs.” As Keynes said, in the long run we are all dead. Right now the cost of heating houses in New England is about to soar because inadequate pipelines prevent cheap natural gas from reaching Senator Warren’s constituents. This is no big deal for wealthy professionals like Senator Warren; it matters a lot to average workers. Will she oppose the Keystone XL Pipeline?

And it’s not just energy. Democrats seem to be lining up behind the Reverend Al Sharpton against “racist cops.” They are attacking CIA patriots who (with the oversight of Congressional Democrats including Nancy Pelosi and Dianne Feinstein) water-boarded Islamic terrorists in order to protect Americans and eventually kill Osama Bin Laden.

 Hopefully Republicans can find a candidate who—unlike Mitt Romney in 2012—will adroitly expose and exploit the rift between Democrats’ enviro-gentry and average workers of all ethnicities, genders, races, income levels, sexual preferences etc. The anti-capitalist environmental extremism of the Obama era has been a disaster for average workers—while the affluent have prospered.

Copyright Thomas Doerflinger 2014. All Rights Reserved.


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Emerging Market Masochism

I had lunch in midtown with my friend Fred, a veteran Street salesman, who handed me a glossy brochure from an emerging market fund manager who had visited his office. The pitch was (Surprise!) emerging markets have underperformed, investors are “underweight” EM relative to the MSCI global index, the markets look cheap, and it’s time to buy.

It’s not just dedicated fund managers who like EM. One of the biggest and best wealth managers is telling clients to have a total equity allocation of 34.5%, of which 6% should be in EM. They also want you to have 4% in commodities, which are highly correlated with EM. Therefore more than a quarter of your “risk assets” are in EM or EM-correlated commodities. [(6+4)/(34.5+4)=0.26]

I have a big problem with EM, which I described a year ago (see “Emerging Market for Cowards,” Jan 5, 2014). U.S. equities are risky enough and periodically drop more than 20%. When you buy EM stocks, you are embracing several new layers of risk, which are auto-correlated, and which you don’t need to accept to get exposure to the economic growth in emerging markets.

Four Big Risks

Because emerging economies are financially risky, their currencies periodically plunge. Most of them run current account surpluses; i.e., they borrow from abroad. This is fine so long as the money is spent on productive assets such as factories, but often it goes for consumer goods, presidential palaces, boondoggle infrastructure, weapons, or (in the case of Russia) apartments in London and Manhattan. Much of the borrowing is in dollars, so if the EM currency declines the effective debt burden increases dramatically. To defend its currency, the country raises interest rates and slashes government spending; a severe recession ensues. (See Russia, 2015.)

It gets worse. Many (not all) emerging markets rely on commodity exports and so are hurt by weak commodity prices, which are inversely correlated with the dollar – strong dollar, weak commodity prices. So U.S. investors in EM get hit with the double whammy of weak EM currencies and weak EM economies.

Third, corporate governance, which sometimes sucks in the U.S., is even more problematic and opaque in emerging markets, for three reasons: weaker standards of corporate governance, more government corruption, and the difficulty U.S. investors have in monitoring far-away companies operating in an alien business culture.

Then there is economic policy, which is bad enough in the U.S. (see Obama, Barack). EM economic policies are often hostile to capitalists because they are socialistic (India, Brazil), exceptionally incompetent (India, Argentina), corrupt (Russia, India, China, Turkey), or distorted by political instability (Thailand, Middle East).

Bad Timing

Because they are so risky, you need a huge “risk premium” (i.e., very low valuation) to justify investing in emerging markets. That means buying after a crash. Unfortunately that is not when Wall Street will tout EM; brokers will wait until the markets have recovered and they can tell clients “If you had owned EM over the past year, you would have done better than owning boring U.S. stocks. But there’s still time to diversify into EM, which will cut the volatility of your portfolio.”

Rather than trying to play this complicated, risky game, normal investors who are not closely monitoring the elections and economic performance of India, Brazil, Russia, Argentina and Turkey should simply purchase U.S. or European multinationals, along with an occasional high-quality EM stock such as Samsung. These companies produce what developing nations need, whether it is iPhones, Nike running shoes, Diageo whiskey, Philip Morris cigarettes, Monsanto seeds, Boeing aircraft, or Schlumberger oil services. Leave the currency risk to the Treasury Departments of these companies.

Copyright Thomas Doerflinger 2014. All Rights Reserved



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Deflation Fears will Weigh on Stocks for the Next Few Weeks, Creating Opportunities

Why are stocks selling off when economists tell us declining oil prices are wonderful? Answer: full valuations, investor complacency, financial blow-ups from plunging oil prices, and fears of global deflation.

Investor Complacency

A couple of years ago you could still find some bears in the Barron’s survey of stock market strategists. No longer. They are all fairly bullish on both earnings and valuation, expecting 2015 SPX EPS of $127 (too high by about $3.00 given the drop in oil prices) and a trailing PE at year-end 2015 of 17.5x (versus 16.2x in the middle of the last cycle, i.e., Q1 2005-Q2 2007). Strategists’ average year-end 2015 target is 2200.

Another sign of complacency is investor positioning. According to the WSJ, the number of trades handled by TD Ameritrade climbed 14% in the year ending September 2014. E*Trade’s margin loans outstanding climbed 31% in the past year; at Schwab they climbed 20%.

Lower Oil Prices: Good for Consumers, Bad for Speculators

In retrospect, it is clear oil prices collapsed due to weak global growth (see below), increasing energy efficiency, and abundant new supply. But that’s all hindsight. From January 2012 to July 2014 the XLE rose 37%, and many investors expected the strength to continue. They snapped up energy-related junk bonds, which comprise 16% of the High Yield Index. Now speculators are scrambling to sell stocks and bonds in markets made less liquid by Dodd Frank.

Weak Global Growth

Much of this selling has little to do with longer-term economic prospects. That said, there is enough bad news to convince skittish investors that weak oil prices show global growth is grinding to a halt, despite obvious strength in the U.S. (see Q3 earnings, Q2 and Q3 GDP, employment, retail sales, industrial production). The gloomy global trends:

  • Europe is barely growing, due to a dysfunctional Euro-land; structural flaws in Italy and France; weak demographics; stagnant export markets; and Germany’s allergy to fiscal stimulus.
  • Japan is stagnant despite a weak Yen and super-stimulative monetary policy.
  • China is slowing sharply as its credit-fed real estate / infrastructure boom fades. Debating 7.4% versus 7.1% growth is absurd; try 5%.
  • Many emerging markets (e.g. Russia, Nigeria, Brazil, Argentina, Venezuela) are weak due to mismanagement, weak commodity prices, and a strong dollar that hikes the burden of dollar-denominated debt.

Can the U.S. “Decouple?”– Lessons from 1998

I hear commentators opine the U.S. cannot decouple from economic weakness in the Rest of the World. This is largely false, as recent trends attest. Exports will be hurt by weak demand and a strong dollar, and domestic commodity producers will struggle. That will certainly take a toll on S&P profits, which are nominal. However, domestic demand is healthy and low inflation means a lower GDP deflator—both positive for real GDP. A Republican Congress is a plus for business confidence. And it’s positive to “rebalance” the U.S. economy by slowing the oil booms in Texas and North Dakota (booms inevitably lead to inefficiencies) while other regions benefit from low energy prices.

In 1998 S&P profits rose at just a low-single pace, due to global deflation and Russian default. (Oil prices dropped 55% in the two years ending December 1998.) However, U.S. real GDP rose 4.4% in 1998 and stock prices were strong (albeit very volatile). So I think the U.S. can grow nicely next year. And don’t forget that a strong dollar will boost growth somewhat  in Europe and Japan.

Deflationary Tremors Will Weigh on U.S. Equities

Obviously the market shocks from plunging energy prices will precede the longer-term benefit. Currently we have a negative feed-back loop where investors interpret lower energy prices as bearish evidence of global deflation rather than the bullish result of improving oil field technology. With Russia raising rates to 17% to defend the Rouble the bad news is far from over; recall that a Russian default sparked the financial panic of October 1998, when Lehman Brothers had a near-death experience.

We have yet to see the full financial damage caused by weak oil for companies, banks, hedge funds, and countries. Who will take a hit if Russia or Venezuela defaults? (On a more bullish note, tougher regulation means Wall Street is far less financially over-extended than in 1997-98 when banks were competing to see who could lend the most to the wunderkinds at Long Term Capital Management, the giant hedge fund that blew up in the autumn of 1998.)

Make a List and Check It Twice

The first potentially positive signpost for equity investors will come in the second half of January when Q4 earnings results are released. Analysts will likely slash their 2015 estimates for energy companies when they hear grim guidance. On the other hand, analysts will also raise estimates for many weak-oil winners. Now is the time to make a shopping list of high quality domestic companies that stand to benefit from cheap energy via lower costs and/or stronger consumer spending. It is too early to bottom-fish among the “losers” because there is more bad news to come.

Copyright Thomas Doerflinger 2014. All Rights Reserved

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From the Greatest Generation to the Weakest (and Dumbest)

If Diane Feinstein and John McCain had been governing the U.S. during World War II, today we would be speaking German and worshipping the divine Shinto Emperor. Instead Americans look back with heartfelt gratitude at “the Greatest Generation” of men and women who defeated the Nazis and Japanese. Here are a few of the encomiums to Tom Brokaw’s influential book, The Greatest Generation:

“Mr. Brokaw has composed a sweeping tribute to Americans who saved the world: the citizen heroes and heroines who, during World War II, put themselves on the line. . . . We who followed this generation have lived in the midst of greatness.” The Washington Times

“Brokaw’s ‘greatest generation’ produced greatness in its own way and, in doing so, made the ordinary extraordinary.” The Boston Globe

“A generation of remarkable Americans—our better angels”   Ken Burns

“A moving, admittedly patriotic, testament to brave men and women who quite literally saved our skins.” Daily Press (Newport News, Va.)

“…a spell is cast upon the reader reminding us, in our cynical and fragmented age, that with enough collective energy and spirit anything can be accomplished.” Doris Kearns Goodwin

So how, exactly, did the Greatest Generation apply its universally-lauded “collective energy and spirit” to defeat the evil enemies of America and the free world—the Nazis who killed 8 million Jews and other innocents, the Japanese who in the course of conquering much of East Asia slaughtered an estimated 200,000 Chinese in the murderous Rape of Nanking?

Answer: by bombing to smithereens hundreds of thousands of Germans and Japanese, many of them civilians. No “water boarding,” no “close confinement,” no sleep depravation, diaper wearing, or snarling dogs—and no second guessing by hypocritical Congressional Committees. Just hundreds of thousands of enemy soldiers and civilians slaughtered by courageous heroes of the Greatest Generation, now lauded by the likes of The Boston Globe, Ken Burns and Doris Kearns Goodwin. Here are some of the military activities these liberal stalwarts are implicitly praising:

In February 1945 British and U.S. Air Forces dropped more than 3,900 tons of bombs on Dresden, Germany. Death toll of the Dresden Firebombing: 23,000-25,000.

During the War allied forces conducted 363 air raids on Berlin; by 1945 40% of the population had fled. After the War, the U.S. estimated that “strategic bombing” killed 305,000 Germans (the vast majority civilians) and wounded another 780,000. More than 7,000,000 German civilians were made homeless.

The U.S. Air Force dropped thousands of tons of conventional ordinance (mainly firebombs) on Japanese cities in multiple operations stretching over many months. In Operation Meetinghouse (March 1943), 279 B-29s dropped 1,665 tons of firebombs on Tokyo, causing a huge fire that destroyed 16 square miles or 7% of Tokyo. An estimated 84,000 people were killed during the raid and another 41,000 were injured. Similar attacks were directed against Nagoya (destroyed 2 square miles), Osaka (destroyed 8 square miles) and Kobe (destroyed 7 square miles and killed 8000 people). Later in the spring of 1943 there were additional raids on Nagoya (killed 3,866), Tokyo (destroyed 22 square miles), Yokohama (destroyed 7 square miles, killed 1000) and Osaka (destroyed 3.2 square miles, killed 3,960).

In 1945 the U.S. dropped Atomic bombs on Hiroshima and Nagasaki, killing at least 129,000 people.

 Just in case you were not keeping score at home, the civilian casualties enumerated above total well over 500,000. Wikipedia puts the total civilian death toll (not all inflicted by the U.S.) at 1.1 million for Germany and 0.5 million for Japan. That’s in addition to at least 4.3 million German and 2.1 million Japanese military personnel killed in World War II.

How pathetic is it that hypocritical liberals like Tom Brokaw, Doris Goodwin, and The Boston Globe praise “The Greatest Generation” and then attack the CIA heroes who kept America safe after the 9/11 Islamic attack—and did so under close oversight of Congressmen and Senators who are now attacking the CIA? It almost makes you wonder whether a future Republican-controlled Congress could bring charges against President Obama for all those civilians killed as collateral damage of drone attacks on terrorists.

(The above war figures are from Wikipedia; consider giving them a year-end gift if you value the service.)

Copyright Thomas Doerflinger 2014. All Rights Reserved.


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Dems Suffer from ODS (Obamacare Denial Syndrome)

William Galston of the Brookings Institution thinks of himself as a moderate, level-headed Democrat well-versed in the subtle intricacies of public policy. Writing in The Wall Street Journal he admonished, “Democrats, It’s Time to Move On” (past the intra-party wrangling over the unpopularity of Obamacare, recently lamented by Chuck Schumer). Galston opines:

“The American people are sending a large and urgent message to Washington. We want an economy that works for all of us, not just a favored few, and nothing we’ve heard from either party so far convinces us that you know how to get us there.”

Therefore, Galston argues, “we should spend the next two years debating answers to the questions that will define the country’s future”—the usual suspects such as how the information revolution is transforming the labor market, the soaring cost of college, infrastructure spending, promoting basic research, reducing income inequality, etc.

There’s just one problem: Arguably the biggest burden weighing on lower and middle income families is Obamacare, which a mendacious “progressive” policy elite foisted on the little people in the middle class (but not themselves). The policy flaws in this amorphous, labyrinthine legislative blob are legion, but for smaller “Main Street” businesses and their employees the two most egregious are:

  • Small businesses that do not self-insure are obliged to provide the standard one-size-fits-all Obamacare insurance policy, which is usually more expensive and less flexible than what they had before. Obama simply lied when he said, “If you like your plan you can keep your plan. If you like your doctor you can keep your doctor.”
  •  To avoid Obamacare, small businesses have a strong incentive to stay small, under 50 full-time employees, defined as workers working more than 30 hours per week. This brings some of the worst features of Italy’s sclerotic labor market to the U.S.

Bottom line: Obamacare screws millions of middle class families who lost policies they were perfectly happy with, and it screws young workers who can’t get full-time jobs and are forced to stitch together two or three part-time jobs. No wonder the economy is sluggish and the middle class is shrinking. Affluent Americans are sheltered from these effects because they mostly work for large employers who self-insure. Paul Krugman and his Princeton University colleagues love Obamacare—just not for their own families. When they go to sign up for health insurance in 2015, they will see these reassuring words on the website:

“ The Patient Protection and Affordable Care Act (PPACA) was signed into law by President Obama on March 23, 2010. Princeton University believes the active health care plan is a “grandfathered health plan” under the PPACA.” (emphasis in original)

Democrats’ Obamacare Millstone

It’s not surprising that William Galston would like to see Democrats’ “move on” from the policy catastrophe known as Obamacare, but Republicans won’t let them. By attacking Obamacare the GOP can simultaneously advance the interests of the middle class and discredit Democrats as Big Government elitists. Over the next two years a Republican Congress will try to dismantle the law piece by piece—repealing the Medical Device Tax, the Employer Mandate, the Individual Mandate, and on and on. Jeb Henserling, Chairman of the House Finance Committee, suggests that Obamacare be made voluntary, which effectively blows it up.

Democrats are in a box. As a practical matter they can’t abandon Obamacare or permit wholesale changes; the Warren Wing of the Party would never allow it, and neither would President Obama. And, since Obamacare is the son of Hillarycare and Romneycare, Hillary cannot disavow the law. Democrats are stuck with defending an unpopular, dysfunctional law that probably hurts more people than it helps while throwing a “wet blanket” on the U.S. economy. And Obamacare is just one issue alienating white middle class voters from the Democratic Party.  Another is the war on coal, the XL Pipeline, and cheap energy generally.  Still another is Obama’s embrace of the tax-cheating, race hustling Al Sharpton and his ilk.

A litmus test for candidates vying for the 2016 GOP Presidential nomination will be this: Who can most effectively attack Obamacare and put forward a smart alternative that is both politically attractive and economically sensible? (Neither John McCain nor Mitt Romney were articulate on the subject of healthcare or, for that matter, economic opportunity for the middle class.) I have no doubt that Ted Cruz, Rand Paul, Paul Ryan and Chris Christie can do this; I am not so sure about the others.

Copyright Thomas Doerflinger 2014. All Rights Reserved.



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Regulation Matters: Germany’s Green Energy Nightmare

Wall Street lavishly over-analyzes fiscal and especially monetary policy, while largely ignoring the economic impact of regulatory policy, despite its great importance for investors. Actually three disparate groups are guilty of this oversight:

  • The media tends to focus on Washington wars over the level of taxation and government spending, rather than complex regulatory issues.
  • Academic economists battle to promote their pet paradigm—Keynesianism, monetarism, supply side, behavioral economics. These macro models have their uses, but they are laughably simplistic and have little to say about regulation.
  • Wall Street economists and the traders who support them are focused on Fed policy and its implications for bond, stock, and currency markets.

It is not at all surprising that government regulation receives inadequate attention. It is a murky, mind-numbing morass of highly technical rules that cannot be reliably quantified or modeled. There are few deadlines that investors can trade against; regulation dribbles out into the economy rule by complex rule. Even seminal laws such as Obamacare and Dodd-Frank take literally years to be implemented as agencies interpret and effectuate the legislation. Regulation does not make compelling copy for the media, and regulations rarely move stock prices in a discrete and decisive way. On Wall Street any idea that can’t be expressed in one sentence or, better, a single number, tends to be ignored, rather like the fine print on a credit card application.

Germany’s Green Energy Nightmare

As an example, you could listen to hours and hours of learned discourse on Bloomberg or CNBC about the European Central Bank, the Bundesbank, quantitative easing, the level of the Euro, the budget deficits of France and Italy, banks’ balance sheets and myriad other elements of Europe’s macro gridlock, without every hearing mention of Germany’s Green Energy Nightmare. That’s a pity, because it is important in its own right and symptomatic of what ails Europe.

As a recent Financial Times article ably recounts, Chancellor Merkel (who has a PhD in physics) abandoned nuclear energy in the wake of Japan’s Fukushima nuclear disaster. Heavily subsidized “renewables” such as wind and solar were supposed to take nuclear’s place, but so far dirty coal has filled the gap. “Last year,” the FT writes, “German electricity production from lignite, a particularly polluting form of coal, reached its highest level since 1990.” So dependent on coal has Germany become that the Vice Chancellor, Sigmar Gabriel, “made a dramatic appeal to Sweden to help it out of an energy dilemma.” It seems that Sweden controls two lignite mines in Germany, mines that a new and more environmentally correct government in Sweden wants to close. Gabriel pleaded with Sweden to keep the mines open in order to help stave off an energy shortage in Germany.

This is a story of all pain and no gain. Germany is missing its carbon emission targets even as its energy costs soar and the risk of energy shortages looms. Costly kilowatts are not only squeezing the budgets of German consumers, who pay twice as much as America; they hinder hiring by undermining the competitiveness of heavy industries such as aluminum, steel and chemicals, which compete with cheap-energy venues such as Saudi Arabia and the U.S. Since 2007, 11 of 24 aluminum smelters in the EU have shut down. European smelters without cheap long-term energy contracts have production costs of $2230 per ton versus $1940 in the U.S. and $1400 in Saudi Arabia. We are not talking about a decrepit basic industry that is winding down: aerospace relies on aluminum, and autos are shifting to the white metal to cut vehicle weight and reduce emissions. So smelters support important downstream industries such as packaging, auto parts and aerospace. These industries will leave Germany if they do not have a local supply of aluminum.

Germany’s Green Energy Nightmare is hobbling Europe’s putative “locomotive” while the U.S. thrives on “tight oil” and cheap natural gas, which are far cleaner than German coal. Germany’s energy problem would not be too significant if it were an unusual “one off,” but of course it’s not. From top-to-bottom, Europe’s economy is tangled in red tape; just about the only surviving growth industry is regulation itself. But in the whacky world of macroeconomics, as practiced on Wall Street and in academia, regulation doesn’t matter much. It’s all about monetary and fiscal policy.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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