The General U.S. Crisis of Confidence

Last Tuesday, July 13, 2010, the Wall Street Journal printed a paper written by Amity Shlaes, a senior fellow at the Council on Foreign Relations and author of :"The Forgotten Man:A New History of the Great Depression". The title of the paper was "FDR, Obama and 'Confidence' ". At the time, I did not think much about it. I didn't see it as a more pervasive problem. Then, I read and/or thought about the National Federation of Small Business's survey of optimism just out this week, the Financial Reform bill's far reaching regulatory ecosystem about to be unleashed upon banks and financial institutions just passed the Congress this week, the Obama administration's penchant for attacking businesses, the Federal Reserve's dilemma in managing the country's money supply, the consumer's pull back in spending, the continuing unemployment, the lack of healthy revenue gains for companies reporting Q2 results this quarter, and small investors leaving the stock market in droves. It dawned on my feeble mind that something larger than Timothy Geithner's concern about "a basic sense of confidence to American businesses and families" was going on.

Now why would we take the time to consider this crisis of confidence topic which seems so far from our mandate to give clients who invest with us a decent return? Because we believe the lack of confidence is keeping investors and business and personal consumers of goods and services on the sidelines, and therefore, job growth and corporate profits are not as robust as they might otherwise be. Since increasing corporate profits are what ultimately drives the stock market, the case for the normal 60% allocation to equities is difficult to make. All of which has caused us to review all asset allocations with a view towards increased allocation to income-producing securities held by mutual funds, such as bonds, real estate investment trusts, preferred stocks, convertible bonds, and high dividend-paying stocks. Now that I have articulated the reason for this timely tome, we will turn our attention to some of the reasons for what we think is a national U.S. crisis of confidence.

The 1930s

Let's start with the lessons of history. Ms. Shlaes expertly recounts in her paper the education of Treasury Secretary Henry Morgenthau, Jr. in the 1930s. When President Roosevelt attempted to drive up the price of gold by .21 cents, Morgenthau requested an explanation and received this explanation: that .21 cents is seven times three and three was a lucky number, or so Roosevelt thought. Investors apparently didn't think so and the rally in 1933 petered out because investors lost confidence in their President. Morgenthau came to understand that government consistency and nice treatment of businesses was good for the economy. When the President kept attacking the utility industry, Morgenthau stopped being the "yes" man that Roosevelt hired him to be and started expressing his views more strongly. Morgenthau enlisted the support of John Maynard Keynes, the respected economist of his day, who point blank asked the President, "What's the object of chasing them (businesses) around the lot every other week?" The President did listen to Keynes.  This strengthened Morgenthau 's resolve. When the President authorized the killing of pigs to drive up prices, Morgenthau objected. Ms. Shlaes recounts that the recovery from the 1937-38 depression within the still lingering Great Depression was helped by an expansionary monetary policy ala Keynes. She also writes that a new respect for market confidence grew within the White House. Knowing that businesses would supply the war machinery to fight World War II, Roosevelt called off his assaults on businesses. But by that time, three years of suffering had already been written in the history books. Would the economic malaise of the 30s have been turned around more quickly with a business-friendly President in the White House? Morgenthau should be given some credit, but his education and that of the President came too late to prevent a lot of pain.

Regulatory Uncertainty of the Financial Reform Bill

Friday, July 16, 2010 the Senate passed the Financial Reform legislation on  60-39 vote with the help of three Republicans all of whom gained a compromise in a key piece of the 2,300 page bill. Following President Obama's signature, 243 new formal rules are likely to be promulgated by 11 different agencies, as reported by a Wall Street Journal editorial in Wednesday's edition. Regardless of whether the new regulation count is 243 or some other number, that represents the Lawyer's Relief Act of 2010. It would be difficult to argue that the bill does not create jobs....lawyer jobs. The Washington law firm Davis, Polk & Wardwell estimated that it would take 6 to 18 months to accomplish writing new regulations. Think in terms of thousands of pages for just one of the 11 agencies charged with writing regulations that will take months to understand.     

Aside from business winners and losers as their lobbyists try to shape regulations, the uncertainty over how to run the business will take years to be reduced to a viable level. In the meantime, slower economic growth is almost certain as business leaders would tend to approach business transactions with caution. After all, who wants to be sued by the Federal Government? Is it reasonable to conclude that there will be a reduction in confidence among business leaders?

We need to remember that the promise by Senator Christopher Dodd was that there would be real reform to streamline and modernize the financial system. If so why 11 new agencies, new powers of government, and 2,300 pages to "streamline" the system.  A recent CBS poll found that 86% of Americans believe the government's policies hurt them. Four out of five Americans have little or no confidence that the bill will prevent or significantly reduce a crisis.  Both the Business Roundtable and the US Chamber of Commerce have said that the financial reform bill is just another attack on the free enterprise system. The healthcare and stimulus bills did little to improve confidence. We think the financial reform bill is a confidence-killer and the burden of proof is clearly on government to show the financial system will be fixed.

Small Business Optimism

On Tuesday, July 13, 2010 the National Federation of Independent Businesses published its Small Business Optimism Index. Surprise, surprise, it dropped 3.2 points to 89.0 in June. Approximately 70% of the 3.2 point decline in June was caused by weaker expectations for business conditions and real sales over the next six months. To put this report in perspective, the normal index reading is above 100. Unfortunately, the index has not been above 93 since January 2008 and in the last 23 out of 30 months, the index has been below 90. The June report meant that there was some previous optimism, but in June optimism fell. One of the 10 index components to rise in June, the only one to do so, was whether the time was right to expand the business. It rose 1 point but still was a low 6%. The sales component of the index declined by 4 points due to "widespread price cutting and lower nominal sales." Other items in the index that were in decline in June were tax increases, potential for a VAT, cost of hiring, earnings, and government spending.

The President's Attack on the Gulf States

As we all know, on May 27, 2010 President Obama ordered a cessation of deepwater offshore drilling in the Gulf of Mexico. Subsequently, the Gulf States appealed and Federal Judge Martin L.C. Feldman set aside the President's order on June 22, 2010. The US Government appealed to the U.S. Fifth Circuit Court of Appeals in New Orleans, citing time to give the government the opportunity to investigate the causes of the April 20th spill. On July 8, 2010, the Court denied the government's bid to maintain the 6 month moratorium on deepwater offshore drilling while its decision is pending. The Court also denied the government's emergency request to stay the Circuit Court's decision. The Court will rule in August on the appeal. In the meantime, the Interior Secretary Ken Salazar has stated he will issue an order in direct contradiction to the US Circuit Court of Appeals ruling.

Meanwhile, in a blatant attempt to stop offshore drilling another way, President Obama appointed a 7-member commission to study the matter. The problem was the President picked members of the commission that were either directly opposed to offshore drilling or were affiliated with organizations that opposed offshore drilling. Furthermore, none of them had any expertise in drilling or petroleum engineering.  We think the Wall Street Journal editorial said it best when they characterized the President's commission similar to  "putting the Amish in charge of winning the Afghan war." Democrats and Republicans in Congress recognized the stacking and set up their own "independent" 10-member commission.

Louisiana Governor Bobby Jindal, reflecting the view of the oil industry and the Gulf State's economic leaders, said, "The federal government has an entire agency dedicated to monitoring safe drilling. It shouldn't take them six months or longer for a new national commission to ensure safety measures are in place and their laws and regulations are being followed." We think he's right. Most folks know it was negligence on the part of BP and that the vast majority of oil companies involved in deepwater drilling are practicing safety first. Furthermore, most experts already know how BP screwed up.

President Obama may have the country's best interest in mind and we would not want to second guess the President of the United States, but plenty of other folks have, and some folks think this has the smell of a continuing anti-business bias of this government, and an attempt to exert more government control over the oil industry, as has been the case with healthcare and financial institutions. The government's actions do not promote confidence among businessmen, certainly not among oil industry workers. If Treasury Secretary Tim Geithner doesn't learn from the Roosevelt era, we could be in for a long slow recovery. We are betting he won't.

Expiration of the Bush Tax Cuts

All tax cuts that were passed by Congress and President George W. Bush in 2001 and 2003 will expire on December 31st, 2010, and last year there was no doubt that President Obama would do nothing to stop it, even though 130 million middle and low income households will have to cough up $255 billion more in taxes while the wealthy will have to pay an extra $55 billion. However, it's one year later and there has been no economic recovery, there has been no significant new job creation (ignoring for the moment the funny numbers game the government plays), and the Democrats are not as popular as they once were. For various reasons, there is confusion and uncertainty as to whether the President and Congress want to let the Bush tax cuts expire. In the midst of this confusion and uncertainty, how can investors plan? Should stocks be sold in 2010 to get the lower tax rate? Should sales be put on hold? How can investors have confidence in their decision-making when the rules are uncertain?

The Goldman Sachs Decision

In the largest civil settlement ever, Goldman Sachs agreed to pay $550 million to settle charges it mislead clients by selling mortgage securities it knew would go down in value and were secretly designed to benefit John Paulson's hedge fund, a client of Goldman. The SEC in a 3-2 vote proceeded with the case even though the case was said to be weak. What this case seemed to be more about was the same-old attack on businesses. The SEC probably knew it had a weak case and the split in the 3-2 vote was along party lines. After the decision, the SEC was quick to let it be known that it was considering pursuing similar charges against other Wall Street firms. What a confidence builder that is!

The Small Investor Bailout

The Wall Street Journal on Monday presented a story about a couple, Karen and Roger Potyk, who sold the last of their stock mutual funds and decided to invest it all in bonds. What triggered their decision was the May 6 market decline. They had been scaling back for months, but May 6th was the last straw for the Potyks. It seems that they are not alone, if the limited sample in the newspaper can be believed. Financial advisors have long recommended that every portfolio have some exposure to stocks. It may be that investors are not listening. The fear among advisors is that investors are reverting to the behavior of the 70s when stocks were out of favor for a whole decade. The Standard & Poor's index today is at the same level as 12 years ago. The buy-on-the-dips mentality has also suffered. A recent chart put out by Charles Nenner Research shows the S&P 500 gyrating over the next several years with no real gain. In other words, more of the same experience. The market could be smelling that out and we want to outperform and create value for our wealth management clients.

Our Conclusion

Our conclusion is simply a repeat of our introductory comment which was that it is time for a greater allocation to income-producing securities. We made the case in a previous paper, and this simply follows those thoughts. There is ample evidence for this position. Our clients who have a concentrated income-producing asset allocation are up anywhere from 4.5% to 7% as of last week. With low inflation at the moment and no job growth or significant economic growth in sight, we feel more confident that this strategy will be better for the foreseeable future.

Any references and commentary regarding government and administration officials, representatives, economists, investors, corporate officials, shareholders, and any public figures are made with the intent to attempt to interpret the effect of their words and actions and those of any other group of individuals not mentioned solely and exclusively on market behavior and investments, and is not intended to engage the reader in a political or any other similar thought process.

John A. Epeneter, CPA/PFS, CFP®, CFS, CCPS, Master of Science in Financial Planning.   Copyright © July 2010