The Obama bull market is here!

Posted by Shyam Moondra

The stock market has gone up over 20% since it hit the bottom in early March. As a rule of thumb, that's considered the beginning of a bull market and not a bear-market rally as some analysts suggest. While 20% gain in less than a month may seem excessive, this up move should be viewed in conjunction with the excessive market decline of over 55% from the peak set in October of 2007. During most of 2008, the market behaved as if the sky was going to fall and we will have a repeat of the depression of the 1930's, which never materialized. In essence, during 2008, the market was besieged with fear and it simply overreacted.

It's hard to not stipulate a bullish scenario for the stocks in coming weeks and months, given the following government actions and market trends:

1. The monetary policy is the most expansive we have witnessed in decades. The money supply is growing at a rapid clip and interest rates are the lowest we have seen in recent history. The bountiful money will unquestionably expand the economy.
2. The Obama administration's aggressive policies on the fiscal front are also positive for the economy. The stimulus package and the proposed budget plan include lower taxes for the middle class and significant increases in government expenditures. These actions will create new jobs, revitalize the sagging construction industry, and increase consumer confidence. Because of the provisions in the stimulus package and the budget, we can expect a reduced rate of home foreclosures and increased rate of home buying, made possible by tax credits for home purchases, attractive home prices and the lowest mortgage rates ever (stimulating refinance market which puts more money in the pockets of homeowners). The latest monthly housing report showed an increase in the home sales for the first time in months, which confirms that we may have hit the bottom in the housing sector.
3. The credit market is stabilizing and we will see a continued improvement in that area in the coming weeks and months. The TARP, FED's credit-window facilities, and the proposed $1 trillion plan to remove the toxic assets from the books of the banks will steadily bring normalcy to the financial markets. The fear of systemic failure of the financial system, which sunk the markets by 55%, is behind us, and, therefore, it's natural for the market to recover a big chunk of that loss in the short-run. The recent signs of stabilization in the housing sector bodes well for these toxic mortgage-based securities to start appreciating in value and thus help speed up the process of normalization in the credit market.
4. Consumer confidence seems to be gaining, as is evident from the recent data on retail sales. The consumers are already seeing a slight increase in their paychecks, thanks to the stimulus package; more money in consumers' pocket will boost their confidence in coming months and they will start spending again.

President Obama deserves credit for providing strong leadership on all fronts; his plans are intellectually well thought out and he is attacking the problems through a multi-pronged approach that will bear the fruits sooner than many critics think. For the first time since the Clinton presidency, it is becoming clear that a smart and a strong leader can indeed make a big difference.

Of course, things are not going to go up in a straight line. We will have some hiccups along the way, but the die is cast and we are on our way to renewed prosperity again. The biggest issue in my mind is the rekindling of inflation. As the economy becomes stronger, we will see a spike in commodity prices. Easy money and sharply increased government expenditures will set the stage for inflationary spiral. Therefore, the next challenge for the FED will be to manage interest rates in a way so as to ensure continued economic expansion while keeping inflationary expectations in check. That means the interest rates will have to start going up gradually beginning in 2010. The Obama administration will also have to come up with a plan to address the bulging budget deficits and ballooning national debt. Decreasing government expenditures (e.g., eliminating waste and contracting abuses in the defense department) and increasing taxes on the super rich and closing down corporate tax loopholes (when companies like Goldman Sachs that use their offshore subsidiaries in tax-haven territories to escape taxes and pay only 10% in taxes, they unfairly put the tax burden on the American people).

I believe the stock market is slated to recover at least half of the losses incurred in 2008 rather quickly, which will bring the Dow Jones Industrial Average to around 10,000 by the end of this year. Further gains in 2010 and beyond will depend on how skillfully the FED manages the interest rates and money supply and how successful President Obama is in bringing down the budget deficit. By the end of President Obama's second term, it's not inconceivable to see Dow Jones Industrial Average of 18,000.

For the rest of the year, there are plenty of attractive investment opportunities. The technology sector has been lagging and thus could do well in the coming months (HP, GOOG, AMZN, AAPL, RIMM, BIDU, IBM, MSFT, CSCO, etc.). The financial sector has been beaten down sharply, so it will recover just as fast (JPM, WFC, BAC, C, etc.). Some of the other industrial companies that look very attractive are MON, CAT, CMI, FDX, UPS, AA, CE, DOW, BA, HON, GE, MMM, VFC, TJX, etc. (Disclosure: The blogger owns most of these stocks).

New political math: Obama = 1/Reagan

Posted by Shyam Moondra

The 1980's defied the classical Phillips Curve of the economic theory (inverse relationship between the rate of unemployment and the rate of inflation) and had both high inflation and high unemployment. In 1980, when Ronald Reagan was elected as the president of the United States, he formulated his economic policy based on his conservative philosophy of smaller government and lower taxes or what came to be known as supply-side economics or trickle-down economics (or as his opponent in Republican primary election, George H. W. Bush, called as the "voo-doo" economics). The idea was that people could keep more of what they earned which would induce them to work harder, and that would, in turn, lead to more saving and investment, stimulating overall economic growth. While the Reagan tax cuts benefited mainly wealthier Americans, the economic theory behind the aggressive tax cuts argued that benefits would trickle down to lower-income people as well because higher investment would lead to new job opportunities and higher wages. At the same time, Reagan feared that the U. S. had neglected its military in the wake of the Vietnam War, so he pushed for big increases in defense spending. The tax cuts and increased defense spending made a big hole in the budget. Reagan mistakenly believed that huge budget deficit and sharply increased national debt will force Congress to cut non-military spending, but in a Democrat-controlled Congress that part of Reagan's economic plan never materialized and Reagan's legacy included huge budget deficit and huge national debt. It took President Bill Clinton, a Democrat, two presidential terms to balance the budget by increasing taxes on wealthy Americans, reducing growth in defense spending, and modernizing welfare programs.

Now, President Barack Obama, a Democrat, is faced with the worst economic crisis of the century with declining economic growth, increasing joblessness, and falling prices. However, Obama is relying on increased government spending and lower taxes for the middle-class, in the belief that massive new government spending will instantly create new jobs and lower taxes will induce middle-class consumers to spend more, thereby giving a big boost to the sagging economy. This trickle-up approach, which is exactly the inverse of Reagan's trickle-down approach, will bring a modest gain for low-income and middle-class people who lost considerable ground during the presidency of George W. Bush (2001-2008). However, this massive government spending and reduced tax revenues will make a bigger hole in the budget and the big Bush deficit and debt will become even more big. The Obama's calculation is that huge deficit and debt will force Democrat-controlled Congress to increase taxes on wealthy Americans and cut defense spending. Of course, Republican Reagan stood no chance of getting his proposed non-military spending cuts approved by Democrat-controlled Congress but Democrat Obama has a pretty good chance of getting his proposed tax increases on the rich passed by Democratic Congress.

So what we have is an inverse of Reagan economic policy, i.e., Obama = 1/Reagan. One could also argue that Obama is trying to accomplish what Reagan and Clinton did together, the former left a big budget deficit and Clinton turned that into a surplus by increasing taxes on the richest.

The million-dollar question that still remains to be answered is would the Obama plan lead to trickle-up prosperity or it will stifle economic growth and lead to trickle-down misery. Hopefully, the present economic crisis will provide a definitive answer to that question.

Some comments on the U.S. foreign policy

Posted by Shyam Moondra

Swiss Bank Laws:
I think the U.S. government should insist on more comprehensive changes to Swiss banking laws than what has been offered by Switzerland. Switzerland's bank secrecy laws have encouraged drug traffickers, money launderers, wealthy tax cheaters, and corrupt politicians to stash away large sums of money in Swiss bank accounts. In many of the developing countries, for example in Africa, Asia, and South America, politicians are known to have stolen public funds and financial aid money and deposited in secret Swiss bank accounts. Switzerland is thus aiding and conspiring with these corrupt and criminal people around the world to steal public money that should have been used to fight poverty and hunger in many of these impoverished countries. It has been widely reported that former and current Pakistani leaders and military officers and Palestinian leaders have stolen funds from the U.S. aid money and deposited in secret Swiss bank accounts. Even people like Vladimir Putin are rumored to have secret bank accounts in Switzerland. I think the U.S. and other industrialized nations should insist on dismantling the Swiss secrecy laws and put a stop to the breeding corruption worldwide. If Switzerland does not cooperate, the U.S. must threaten to shut down the operations of the Swiss banks in the U.S. and pass laws to make it difficult for Swiss banks to do business anywhere in the world.

Policy towards Pakistan:
The key to defeating Al Quaeda and Taliban lies in our policy towards Pakistan. Pakistan has been a half-hearted partner in this matter. They have used terrorism as a policy tool against India while pretending to be helpful to us in the fight against terror so that they could collect billions of dollars of our aid money. They have been playing a shrewd game of collecting the aid but doing as little as possible. The result is that the terrorists have only become stronger. I think we need a major shift in our policy towards Pakistan. We should announce a complete cessation of all financial and military aid to Pakistan. Then we should lay out measurable benchmarks that they will have to meet before we restart aid in incremental manner. The benchmarks would be: they must dismantle terrorist camps and infrastructure within their territory, they must close-down their religious schools that are a breeding place for terrorists-to-be, they must pass banking laws to trace the money and stop channels (e.g., drug trafficking) that feed money to terrorists, and they must ban terrorist organizations and prosecute the known terrorists as demanded by India. We should also insist that they put their intelligence agency ISI under the firm control of the civilian government and direct their military resources towards fighting terrorism in the Northern provinces rather than position them against India. We should continue to attack potential terrorists on Pakistani soil even without the permission of the Pakistani government; self-defense against cross-border attacks by terrorists on NATO forces in Afghanistan provides a valid legal basis for doing that. Also, we need to have a secret strategic plan to seize their nuclear arsenals and destroy their WMD labs and infrastructure, if Pakistan's domestic situation deteriorates to the point that we face the danger of these WMDs falling in the wrong hands.

Policy towards Russia:
From the day Barack Obama was elected as the president, Russia has been shrewdly playing tough and behaving aggressively as a follow-on to their invasion of the tiny neighbor Georgia. Now they are even talking about placing Russian bombers on Cuban soil. Even in the face of this bluster, the reality is that with the crashing oil prices Russia is actually on the defensive and they are craving for Obama's attention. Therefore, I don't think we should make any unnecessary concessions. We should hang tough on our missile shield plan unless they make concessions on Iran and else where. We should insist on more democracy and freedom of press in Russia before we shoot for close relations with them. The Russian leaders are not trust-worthy - Prime Minister Putin is a typical cold-warrior in the KGB mode. I think President Obama should put Russia on the back-burner for now and not make any hasty decisions simply because they are testing the novice Obama by all this tough talk of placing bombers in Cuba or directing ballistic nuclear missiles towards Europe. We should, however, negotiate a new arms-control treaty with Russia, if it is in our self-interest.

Policy towards Cuba:
We need to reassess our relations with Cuba, which is no longer a Soviet puppet or threat to us. Carrying on a cold war era policy towards one of our smallest and poorest neighbors is laughable. We need to tone down our harsh policy towards Cuba and help them with their economic development. A stable and prosperous Cuba is in our interest. We should encourage people-to-people contacts and allow travel and business deals between the two countries. Over time, they will have more democracy (we started our relations with China on that basis in the 1970's, so why not treat Cuba the same way?).

Policy towards Israel:
Israel's continuing expansion of settlements in occupied territories is illegal and a big obstacle in achieving comprehensive peace in the Middle-East. Just like with Pakistan, we need to set some benchmarks for Israel to meet for us to continue our financial and military aid to them. It's a tough decision but a necessary and fair decision to achieve lasting peace in that region. Israel must go back to pre-1987 war borders and give up all of the territories they seized in that war, with some minor adjustments to provide contiguous borders, and in return, all of Israel's neighbors must recognize Israel and establish diplomatic relations with Israel. I don't think Israel will see a need to make any concessions to achieve real peace unless they have something big to lose and that big thing is the close relations with us and our financial aid to them. In Israel's calculation, if they can maintain status-quo for another fifty years and yet keep getting billions of dollars of the U.S. aid every year, it's the best outcome for them. I don't think there will be lasting peace in the Middle-East unless there is some fundamental change in our policy towards Israel to induce them to long for peace.

Stock and commodity markets are manipulated - we need regulatory reforms

Posted by Shyam Moondra

It's a well-known fact that increased volatility in stock and commodity markets is primarily due to manipulation by investment banks and hedge funds through their frantic computerized trading. Jim Cramer, a TV business commentator, once posted a video on his website explaining how he, as a former hedge fund manager, used to throw $25 millions or so and move a particular stock up or down as he wished. The investment banks and hedge funds short sell a stock to push it down (often spread false rumors about the targeted company to aid the process of bringing it down) while also trading in options. Then just before the monthly options are to expire, they start covering their short positions and push the stock up. In the process, they may lose some money in trading stocks but they make proportionately more money in options and thus come out ahead. Sometimes they move a particular stock up or down to make the options they wrote worthless and thus pocket the premium the buyers paid. They repeat the process every month in many targeted stocks and make money at the expense of small investors. Some of these big players also use what is known as "pump-and-dump" strategy in which they take substantial long position in a company, usually a lesser-known small-cap company, and then publish inflated views or research reports about those companies that help move the stock price up ("pumping"), enabling them to sell their holding at a profit ("dumping"). Some times these big players also use their research departments to make money in their trades. As an example, Goldman Sachs' research department was touting that oil was headed to $200 per barrel while at the same time they reportedly held long positions in oil. It's also reported that some investment banks were selling mortgage-based securities to others while at the same time they were short selling those securities.

The stock markets were created to help companies raise capital so that they could build new factories and hire more workers and the stock prices moved based on the companies' fundamentals. Now the markets move up and down in a yo-yo fashion without any underlying change in fundamentals. The increased volatility caused by manipulation in the markets has turned the markets into gambling casinos, hurting our overall economic system.

We urgently need new regulations to stop market manipulation by the investment banks and hedge funds. The government could take a number of actions such as:

1. Ban naked short selling, limit short positions to 1% of outstanding shares at any given point in time and reinstate the "up tick" rule for short selling.
2. Regulate hedge funds like any other mutual fund. Their CEOs and other officers must pay taxes at the regular rates as opposed to at the capital gains rate as they do now.
3. Investment banks and hedge funds must be required to hold stocks they buy for a certain specified period before they can sell those stocks.
4. Change the margin rules so investment banks and hedge funds are limited to leverage of no more than 10:1 (in the recent past they have had leverages of up to 40:1).
5. The investment banks must not be allowed to own research business. Currently, they have arm's length relationship between their trading and research departments which is not enough.
6. Pass tough laws to discourage "pumping-and-dumping" so that big players can't make money at the expense of unsuspecting small investors.
7. Strengthen SEC resources to investigate and enforce the laws vigorously to stop market manipulation. The CEOs of the companies that are found to violate any of the new regulations must be given mandatory jail terms and their companies must be fined heavily to discourage them from manipulating the markets.
8. Change the tax laws to stop investment banks and hedge funds from escaping from paying their fair share of income taxes. In a recent quarter, Goldman Sachs paid only 10% in taxes because they executed their trades through a complex web of off-shore subsidiaries and hedge funds that made it possible for them to reduce their tax levies. It's time we close all these tax loopholes.

Economic recovery may be erratic but it's on right track

Posted by Shyam Moondra

President Barack Obama has been in the oval office for only a few weeks but he has moved at a lightning speed on several fronts simultaneously. While his actions may not be perfect, he seems to have a good intellectual grasp of how the various pieces of the puzzle fit together. Undoubtedly, some critics on the other side of the political divide would say that he is on a wrong track. However, given the awful results of the George Bush presidency, it's hard to support the Republican ideological viewpoint that doing anything differently from what President George Bush did automatically puts you on a wrong track.

Never before, economic fortunes crumbled worldwide in such a short period. Low interest rates of the 1990s fueled the housing market prompted by innovative products such as sub-prime mortgages, mortgage-based securities, and credit default-swaps. The business was so lucrative that financial institutions around the world jumped on the bandwagon without ever bothering to fully assess the enormous risks involved and made a fortune. But when the FED started increasing interest rates to tame the fears of inflation, the house of cards began to crumble. Reduced demand for housing led to rapid decline in home prices that, in turn, led to the floodgate of defaults and foreclosures. The financial institutions that grabbed the mortgage-securities began to see the values of those securities evaporate and they were forced to report huge losses bringing them closure to bankruptcy.

The Obama administration moved swiftly to address the issues in a top-down as well as bottom-up fashion (as I suggested in "Combine top-down and bottom-up approaches to deal with the credit crunch," The Moondra Post, September 30, 2008) by offering assistance to the financial institutions through TARP and FED credit facilities as well as providing help to the homeowners to stay in their homes. The stimulus package, recently passed by Congress, includes tax credits for home buyers that should help reinvigorate the housing market. The Obama's proposed budget includes income-tax reductions for 95% of the taxpayers that will induce them to spend more, thereby boosting the economy. The budget also includes massive spending for infrastructure projects that would instantly create new construction jobs. In addition, the proposed budget includes long-term investments in alternative energy technologies (that will create new high-paying jobs and reduce our dependence on imported oil), health care (that will reduce health care costs), and education (that will increase our competitiveness in the world), The Obama administration's multi-pronged approach to the economic collapse is well thought out and it will yield positive results over time. While it's true that the budget proposal has many pork-barrel wasteful spending appropriations, overall, it has many more positive elements that are necessary under the present dire circumstances.

Not to forget the last piece of the puzzle, the regulatory reforms. Lack of regulations and oversight led to the collapse of the financial system. So it's not surprising that the Obama administration is aggressively moving to bring the regulatory regime to the twenty-first century. We need to regulate investment banks and hedge funds, monitor and regulate computerized trading to eliminate market manipulation (ban naked short selling, limit short selling to 1% of outstanding shares, require institutions to hold stocks they buy for a certain minimum period before they can sell those stocks, and limit trading in derivatives such as options), and impose strict capital requirements on all financial institutions (no more 40:1 leverage used by many investment banks and hedge funds).

The increased spending to jump-start the economy will certainly add to our budget deficit and national debt in the near-term. That's why President Obama is already looking beyond the near-term and he has proposed to reduce government expenditures (e.g., changes in defense contract procedures and health care reforms will save billions of dollars) and increase taxes on the richest (who prospered handsomely during the Bush years and now must give up some of those gains). It took President Bush eight years to turn a budget surplus into a huge deficit, so it's reasonable to expect that it will take a concerted effort by the Obama administration over the next several years before we see a budget surplus again.

In spite of the above dramatic initiatives, we are continuing to see unemployment on the rise and corporate profits on the decline, but the actions taken by the governments around the world create just the right conditions for an economic recovery. Lower interest rates, increased government expenditures, lower taxes for the middle-class, and regulatory reforms will boost the global economy soon. These conditions are ideal for the financial markets, so President Obama was right in his recent observation that long-term investors should start buying dirt-cheap stocks. The current average PE ratio of S&P 500 index of 12, while not as low as 6 of July 1932 and 7 of July 1982, is much lower than the latest 25-year average of 21 and 50-year average of 18. The decline in the average PE ratio from the recent peak of 44 set in 2002 is the worst since the depression of the 1930's. The conditions today are, however, very different than those in the 1980's when we had double-digit inflation and double-digit interest rates. Today, we have annual inflation rate of about 2% and fed funds rate of 0.5%. Therefore, the stocks are indeed very cheap with a huge upside potential.

Aside from the differences in policy directions, there is a stark difference in mostly reactive mode of operation of the Bush Administration and a pro-active comprehensive approach of the Obama administration. President Bush had no long-term vision and he never believed in a deep governmental involvement in free-market economy. President Obama works off a well-thought out strategic vision bringing in the full weight of the government to make his initiatives yield the results quickly. If President Obama continues to show vigor and remains a hands-on chief executive as he has been so far, chances are we will begin to see the results of his stimulus package and the proposed budget plan as early as in the second-half of 2009 and by 2010 we should be well on our way to recovery and renewed prosperity.