Thoughts for Memorial Day

It is foolish and wrong to mourn the men who died. Rather we should thank God that such men lived. — General George S. Patton

Perform, then, this one act of remembrance before this Day passes - Remember there is an army of defense and advance that never dies and never surrenders, but is increasingly recruited from the eternal sources of the American spirit and from the generations of American youth. - W.J. Cameron

True heroism is remarkably sober, very undramatic. It is not the urge to surpass all others at whatever cost, but the urge to serve others at whatever cost. - Arthur Ashe

Cadillac Taxes

Speaking of new laws taking effect, there has been a rumor going around that for next year's tax season, a provision of the recently passed health care bill will kick in and people will be forced to pay income tax on their health insurance. "Starting in 2011," one email reads, "your W-2 tax form will be increased to show the value of whatever health insurance you are given by the company.... You will be required to pay taxes on a large sum of money that you have never seen."

The good news is, that's not entirely true. The tax is actually being levied on so-called Cadillac health care plans, ones that cost more than $23,000 per year. Although we rarely see the cost of our employer-provided health plans, the average cost of a plan for a family is about $13,400. For plans that exceed that $23,000 cost, the tax is 40 percent on the amount over the limit; so if your health care plan costs $25,000, the tax is 40 percent of $2,000, or $800.

And the tax is supposed to be paid by the insurance company, not the employer or you. But we can rest assured that any hit insurers are forced to take would be passed along to consumers before too long.

Consumer Protections

We'll conclude our look at the pending financial reform bill with some of the consumer protections that have been included. One provision that looks rather toothless is that shareholders would be able to conduct a nonbinding vote on executive compensation for any corporations in which they hold stock. That doesn't look likely to have much of an effect, but there is also a provision calling for companies to have executive compensation set by independent directors, which might have some impact, depending on who those directors are.

There's also the creation of a federal regulator to oversee consumer issues in areas such as mortgages and checking accounts. One corner of the economy in which such a regulator might make a difference is in the shady world of payday loans, with their interest rates that can reach several hundred percent on an annual basis. The Senate bill puts this regulator under the Federal Reserve, while in the House version, the regulator would be independent. It's hard to see what the end difference would be, but since both versions call for the regulator, it's almost certain to happen.

Perhaps most significant are the investor protections being discussed. The guiding principle is that banks and other financial institutions should retain some of the risk for the products they sell, rather than pushing it all off on investors. This would keep them from selling off the such things as baskets of subprime mortgages without keeping part of the securities (and risk) for themselves. There are also provisions curtailing some of the problems we've seen with rating agencies, including allowing investors to sue them. These are all things that, if they work, you won't see much evidence of them - if disaster happens again, you know they will have failed.

The New Banking Restrictions

To continue our discussion of the impending financial regulatory bill, there are several provisions that would limit the types of trading that banks could do - and presumably save them from themselves. Primary among these are the limits on trading derivatives, those securitized vehicles that can be very far removed from the original issues, to the point of being almost unrelated. These had gone largely unregulated before, so this would be the first federal oversight they receive. Derivatives would now be traded on public exchanges, removing some of the more shadowy elements that had grown up around them, and most of them would need to be insured, removing the possibility of huge losses.

The Senate version also calls for banks to be prohibited from buying and selling derivatives. A call for a complete ban on the infamous credit default swaps did not make it through to the final bill. The Senate bill also included a rule (the so-called Volcker Rule) prohibiting banks from putting investors' money into things like hedge funds. That wasn't in the House version, but since President Obama publicly called for such a rule after the House version passed, it's likely to survive into the final bill.

The purpose of all this is to refocus the business of commercial banks back to their core functions. The major banks shouldn't be too hamstrung by these rules, but one notable sidelight is that Goldman Sachs and Morgan Stanley reincorporated from investment banks to bank holding companies back during the financial meltdown, and they would have a horrible time complying with the Volcker Rule; it will be interesting to see how they're forced to react to it.

The Future of "Too Big to Fail"

Continuing our discussion of the financial reform bill passed by the Senate, some of the most talked-about aspects are the "Too Big to Fail" provisions. These arose out of the feeling that during the recent banking meltdown, we were stuck between a rock and a hard place: Several banks weren't going to survive without major assistance from the federal government, but as the Lehman Brothers collapse demonstrated, letting them fail could have disastrous effects on the economy.

So how do we combat that? There was some discussion of limiting the sheer size of financial institutions, but that didn't end up in the Senate bill. The Senate version now calls for these institutions to pay back the costs of any bailout after the fact - which is in many ways what we saw after the last bailout. The House version has a little more teeth, creating a $150 billion fund - filled by a tax on banks and other financial institutions - that would be available to pay for any needed bailouts.

Just as the FDIC has the power to close troubled banks, the bill would give the government the power to liquidate, in an orderly fashion, other institutions such as investment banks. It would also be able to impose emergency regulations on these institutions. These provisions might have helped with a more orderly unwinding of Lehman Brothers, and might have ended up costing the government less when it intervened with other large banks. This sort of language is in both the House and Senate bills, and thus seems likely to become the law of the land.

The Financial Reform Bill

The Senate passed its financial reform bill toward the end of last week, making it very likely that some form of this legislation will soon become the law of the land. Over the next few days, we'll take a look at some of the provisions that the Senate passed and talk about how they might affect your own financial life.

First of all, here's what's going to happen next: Since the Senate bill was different from the one the House of Representatives had passed back in December, a House-Senate committee will now hammer out a compromise bill somewhere between the two. President Obama is said to want a compromise bill to sign by July 4th. If the recent health-care bill is any indication, the final bill will likely be closer to the Senate's version than the House's.

Much of the bill is concerned with the banking sector and derivatives trading and "Too Big to Fail" concerns, which won't likely have any direct impact on financial consumers. But there are some consumer items as well, such as forcing institutions to retain some of the risk from complex mortgage-backed securities, rather than pushing all that risk into the investors' hands. (That may not sound like a consumer issue, but many of these products ended up in the hands of unwary pension funds and the like during the housing bubble.) We'll take a closer look at some of these provisions during the upcoming week.

Bank Robbers Order Takeout

This week's tale from the "Bank robbers sure are stupid" file comes to us from up in Fairfield, Connecticut, where a man named Albert Bailey and his 16-year-old sidekick hatched a plot to rob a branch of the People's United Bank. Their foolproof plan: They called the branch on the phone and demanded that a bag containing $100,000 in cash be left on the floor of the bank. They said they'd drop by in ten minutes to pick up the loot.

The bank obliged, and shortly after the phone call, the teenager walked into the bank and scooped up the bag of cash. As he was getting in Bailey's car, police advanced upon him with guns drawn and made the arrest. Let's hope the hapless robbers weren't too surprised to see them.

"I would classify these individuals as not too bright," a Fairfield police spokesman told the Connecticut Post. "They should have spent more time in school rather than trying to rob a bank. They didn't expect the police to be in the takeout line."

Changing Inflation

The Bureau of Labor Statistics released its monthly consumer price index yesterday, and prices actually fell by 0.1 percent in April. Core inflation, though, remained steady in April, leaving the 12-month inflation rate at 0.9 percent, the lowest it's been since 1966.

The broader figure would seem to suggest we're in some danger of deflation, but it's probably better in some respects to focus on the core inflation number. Why? The big difference between the two is that core inflation strips out energy costs, which are much more volatile, often for reasons that have nothing to do with larger economic issues. For instance, the biggest factor in April's downward CPI movement was that the cost of gasoline dropped by 2.4 percent in a single month. That was probably just a natural result of overheated gasoline prices; they've risen 38 percent in the past year.

Of course, we still have to pay for gas, so if you're concerned about how the inflation rate affects your pocketbook, you should keep an eye on the consumer price index. For the effects on the larger economy, and for where inflation is really headed, you probably want core inflation.

Bears Turning Into Bulls

You may recall the investigation ofGoldman Sachs a month or so ago, involving a hedge fund trader who helped Goldman assemble a basket of poorly performing mortgages. Goldman sold the mortgages to its unsuspecting clients, the hedge fund manager took a short position, betting against the declining mortgages, and everybody won. Everybody except the clients, that is.

That hedge fund manager, John Paulson, is back in the news, because his fund recently released details of its latest purchases. And the news is that he's now on the recovery side of the housing market, buying a stake in Atlanta-based homebuilder Beazer Homes. One report said Paulson told his clients that he expects home prices rising by 3 to 5 percent this year, and 8 to 12 percent next year.

That's not to say Paulson has any special insight into the housing market, just because he made one successful bet on its demise a few years ago. But it's highly unlikely that this move accompanies any of the sort of under-the-table deals like the Goldman Sachs affair. And it takes a lot for people to change their stripes, so when a famous housing bear becomes a bull, it's worth paying attention to.

Getting It Wrong

We tend to think of Wall Street as attracting the best and the brightest, with the shiniest rocket-science tools at their disposal. Well, perhaps the crash of 2008 removed that notion for many of us, but now the Harvard Business Review is reporting on a simpler matter that the Street has been getting consistently wrong for a long time now.

We talk a lot about quarterly earnings reports, and the Wall Street estimates of those, but analysts also predict longer-term earnings, making five-year projections. And they get them very wrong. Over the past 25 years, analysts' estimates of long-term earnings have been an astonishing 100 percent too high.

The general consensus is for long-term earnings averaging around 10 to 12 percent a year, whereas in reality they tend to be more like 6 percent. The only time the analysts' estimates hit the mark is in the very highest-growth years. A shorter-term horizon didn't help any: The results were the same for three-year earnings as they were for five-year.

The State of the Hedge Fund

Despite the continuing turbulence in the markets, many investors are showing an increased appetite for risk: Hedge funds gained a solid $7.6 billion in new investments in March, according to figures released last week. Total assets in hedge funds are at their highest level since late 2008, at $1.64 trillion.

The most popular style of hedge fund at this moment is the event-driven fund. Event-driven funds try to exploit price inefficiencies created by specific events affecting corporations, such as bankruptcies, mergers, restructurings or private equity investments. These funds took in the most money of any of the hedge fund groups in March.

Even so, these somewhat secretive vehicles, which generally come with the allure of fabulous returns, have hardly been setting the world on fire. The same report showed that event-driven funds have returned 4.7 percent in the year to date. The S&P 500 has returned 1.9 percent year-to-date, so those hedge funds are delivering marginally better performance for a lot more risk.

The Big Plunge

So what happened last week to cause the Dow to fall nearly 1000 points in the space of about 15 minutes? The first theory was that it was all based on a typo: CNBC reported that a trader at Citigroup put in an order to sell several million shares, but accidentally requested the sale of several billion instead. The massive number of shares flooding the market then supposedly caused the momentary panic.

In addition to the so-called “fat finger” theory, there are other speculations:

* Excessive trading in Procter & Gamble – which temporarily lost 37 percent of its value – caused the drop. One theory has it that the billion-share “fat fingers” trade was in P&G.

* Some kind of hackers or terrorists got into the New York Stock Exchange computers. SEC chief Mary Schapiro officially denied this rumor.

* The E-Mini S&P 500 futures market caused the plunge. These are highly liquid options contracts based on the S&P 500, and are basically bets on the value of where the S&P will be in June. A Nasdaq official has said that speculation in E-Minis was “one factor” in the crash.

The real cause could be some combination of these, or something else altogether. No matter what triggered the drop, though, the important thing is what happened afterward. Traders recognized that the market was suddenly undervalued, and began buying up shares as fast as they could. The sudden plunge was certainly newsworthy, but in the larger scheme of things, what is most significant is that the market corrected itself quickly.

Inside the Trade Deficit

America's trade deficit widened in March, according to figures released yesterday: Imports increased by $188 billion, while exports increased by $147.9 billion. That's the headline news, but there are a couple of important factors lurking underneath those numbers.

1) Exports actually increased at a faster pace than imports did. Exports rose by 3.2 percent and imports rose by 3.1 percent, but since we already imported more than we exported, the raw import figure was a little bigger, and the trade deficit still widened a little.

2) The margin for imports is explained entirely by the rise in the price of oil. March brought us the highest crude oil prices we'd seen in almost two years, as well as a surge in demand. And of course, most of the oil we consume is foreign. If you take oil out of the equation, the trade deficit actually dropped between February and March.

The Housing Division

Where are New Jersey's home prices headed? It depends on where in the state you are. In southern New Jersey, the latest figures show that house prices dropped in the first quarter of 2010 by 2.6 percent from the first quarter of 2009. But in the northern half of the state, home prices were up 2 percent in the same period.

Part of the issue here is not so much that the economy is so widely divergent in the various corners of the state, but that the baseline price was different. The standard comparison in these things is to the same period one year ago. One year ago, in the first quarter of 2009, northern New Jersey was coming to grips with the collapse of the financial sector: Lehman Brothers declared bankruptcy in September 2008, and Citigroup was declared insolvent that November. Many financial professionals who live in the area were thrown out of work. That had a huge impact on the high-end housing market in North Jersey.

That's probably not the only factor at work here. But it's a good reminder that when you're comparing two economic changes, it's important to know not just what's changed but where you started from.

Earnings Wrapup

A few weeks back we were periodically reporting on earnings season and the reports that came out about the various companies. Over the weekend, Paul Lim of the New York Times assembled all those figures, and found that it was a very good season indeed. A whopping 77 percent of the S&P 500 companies have reported earnings that beat the Wall Street estimates. Remember, the historical average is that 61 percent of all companies beat the Street's numbers. Overall, profits for the quarter are on track to come in 56 percent higher than the same quarter in 2009.

And 66 percent of the S&P 500 that have made such reports have had revenue growth exceeding the analysts' estimates, indicating that sales have come back strong. The article does point out that if you take out the financial sector, the rest of the S&P 500 is merely meeting expectations in both of these categories.

The ironic thing is that this news come on the heels of a poor week for the stock market. But even if the market is going through a period of temporary weakness, it's good to know that the fundamentals of the economy look strong.

The Employment Paradox

Friday we got good news and bad news about the unemployment situation. The numbers for April came in, and the U.S. economy added 290,000 jobs, which is the most for any month since March 2006. And that doesn't count any newly hired census workers. At the same time, the unemployment rate rose, from 9.7 percent to 9.9 percent.

How did this happen? The biggest change for the month was the massive increase in the size of the labor force. According to the Bureau of Labor Statistics, an additional 805,000 people entered the labor force in April; a big part of that was 195,000 people re-entering the job market. These are people who were thrown out of work some time ago and had given up on finding a job, but had been encouraged enough by the recovery to officially join the labor force again.

That's one of the paradoxes of the growing economy: It causes the labor force to grow at a pretty rapid rate, meaning job growth has to be unusually strong just to keep pace. As to which number is more important - the number of new jobs created or the unemployment rate - it matters which side of the fence you're on. The job creation is a sign of a healthy economy, but if you're still looking for a job, you probably don't need the competition that's reflected in the unemployment rate.

A Bumpy Ride

A few days ago we talked about the folly of getting overexcited about a single day's gains in the stock market. We saw the flipside of that yesterday, over a period of less than a day, when the Dow Jones average dropped nearly 1000 points in the middle of the day, causing various Internet sites and news organs to go into conniptions. Granted, when the Dow is dropping through the floor, it's hard to look away, but in the end, the markets rebounded and the Dow finished with a disappointing but hardly historical loss of 3.2 percent.

The roller coaster ride was really just a small part of the day. After opening at 10,842, the Dow drifted slowly along much of the day: It was at 10,798 at 1:00, and at 10,712 by 2:00. By 2:30, the downward trend was apparent, with the index at 10,596, for a loss of 1.9 percent on the day.

Then the plunge hit: Just sixteen minutes later, it was down to 9,873. That's a loss of nearly 7 percent of the Dow's value in a quarter of an hour. But the rebound was even more breathtaking - a gain of 602 points in just ten minutes! That's a gain of more than 6 percent of the Dow's value.

In the end, it lost 348 points on the day. It wasn't even the biggest loss of this past week. Just another ho-hum day on Wall Street.

Gold Bugs

For much of 2009, financial pundits were worried about the fear of inflation coming back, fueled by the massive deficits our federal government was running. The upside of this was that there were ways for investors to take advantage of inflation, especially by investing in gold. Many investing experts thought that inflation would support gold prices - or conversely that the rise in the price of gold was the result of inflation fears. There were stories to this effect on such respected financial Web sites as TheStreet.com and Seeking Alpha.

Well, we seem to have dodged the inflation bullet (for the moment at least). On the other hand, gold prices have held up lately, despite the waning of the inflation fears. Now, yesterday morning, Bloomberg News featured an interview with the chief economist for the Canadian wealth management firm Gluskin Sheff, talking about the threat of deflation. According to Bloomberg,"Deflation will push gold prices to record highs.... the precious metal will reach $3,000 in the next several years."

So inflation would drive the price of gold higher, and deflation would drive the price of gold higher. It seems the only way for gold to fall is if consumer prices stay exactly the same.

Auditing the Fed

As finance-reform regulation makes its way through Congress, one idea that is getting a lot of traction is the proposal to audit the Federal Reserve. Leaving the political implications aside - and the proposal is getting support from both the right and the left - what would an audit of the Fed look like?

The Fed's independence in setting monetary policy through the use of interest rates would not likely be affected by an audit, if only because there aren't a lot of hidden numbers at work there. When the Fed decides interest rates should be raised (or lowered), it raises them. It's the investments the Fed makes and its relationships with banks both here and abroad that would be examined by an audit - and eventually subject to some sort of political pressure.

The Government Accountability Office, which in most cases can investigate any area of the federal government, is now prohibited from looking into the Fed's monetary policy or the Fed's relationships with other banks. Calling for a Fed audit would change all that. One of the weapons the Fed has been using to stabilize the banking system is purchasing securities, whether from a faltering Bear Stearns or from the Treasury Department itself. The Fed handed out more than $2 trillion worth of emergency loans during the recent banking crisis, without any obligation to disclose in any great detail where that money went. This is primarily what an audit would focus on - if there were any shady deals going on, or money spent in ways that the public would consider misguided. It would also be an opportunity to asses what kind of return the Fed is getting for all its investments.

A Good Day

It's always dangerous to try to read much of anything into one day's worth of movement in the stock market, but sometimes it's fun to take a look at a single day anyway. Especially when we have a day like yesterday, when the Dow rose 143 points, for its biggest one-day gain since February.

The striking thing about yesterday was how broad-based the gains were: 29 of the Dow's 30 components finished the day up. The only loser on the day was Alcoa. Alcoa's problem was that it was overtaken by events, with the Australian government on the verge of passing a levy on mining operations there (Alcoa has major operations in Australia). That's a good day, isn't it? The only way one of the Dow components lost ground was when there was outside news directly affecting that company's bottom line.

Of course, before we get too excited about that, we should remember that it was only last Friday that all 30 components of the Dow were down on the day.

Is 3.2 Percent GDP Growth Enough?

The news on Friday that our GDP grew at 3.2 percent in the first quarter of 2010 has brought out a chorus of voices on what exactly that number means: Is it good? Is it weak? Is it good, but not good enough? "GDP Still Weak," read the headline on the AP story. But how can it still be weak when the previous quarter had given us rip-roaring 5.6 percent growth?

Here are some figures to compare it to:

* Over the past 25 years, the average annual GDP growth rate in the U.S. has been 2.8 percent.

* Since the onset of the Great Depression with the 1929 stock market crash, average GDP growth has been 3.4 percent.

* Before the recovery, the last time we had a growth number this high was in the third quarter of 2007, when GDP grew at 3.6 percent.

So in the historical context, 3.2 percent growth isn't weak at all. The problem is that within the context of an economic recovery from a deep recession, 3.2 percent growth would mean we have along way to go to reach full economic health. Following the recession of 1981-82, for example, we had four successive quarters starting in 1983 where GDP growth was over 8 percent.

There are estimates that it takes roughly 3.5 percent annual GDP growth to knock one percentage point off the unemployment rate. So at our current rate, we could expect unemployment to get down to around 5 percent in around five years. That's much too long for large sections of the country to be out of work. The bottom line is that even though 3.2 percent GDP growth is normal and comfortable, we have not yet reached the economic circumstances where it's enough.