Fact, Fiction, Fantasy and Foolishness

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We all know the facts: the economy is weak, job growth is anemic, a whiff of panic is in the air and the powers that be have little to offer in the way of solutions, except for more of the same failed policies.

We also know that Treasury Secretary Timothy Geithner's recent Op-Ed piece in The New York Times, in which he extols the current "economic recovery," should be #1 on the best seller list - category "Fiction" - or, at the very least, be included in creative writing classes at the nation's colleges and universities this fall.

And it is apparent to all, except for the academics that populate the Obama administration and the Federal Reserve Board that low interest rates, free money, ongoing bailouts and obeisance to political constituencies solve nothing. Wasn't it Benjamin Franklin who said that the definition of insanity is doing the same thing over and over again and expecting different results?

In the White House fantasy world, providing $20 billion or so for the hiring of new teachers is a good thing. Except they didn't account for one thing: many districts which received this federal largesse decided not to hire teachers at all; rather they socked the money away in rainy day funds as they know the economy is about to roll over once again. "Oops, we never thought of that."

In the Federal Reserve Board Fantasy World, jawboning that interest rates will stay low forever and increasing purchases of virtually every debt security on the face of the earth are supposed to increase loan activity and business investment. Instead the Fed has created the third asset bubble in a decade (neat trick!) as market participants fully take advantage of the greatest interest rate arbitrage game since the invention of the wheel. "Oops, we never thought of that."

Meanwhile, we hear the same old tired arguments from the same old "experts." Economist Paul Krugman recently chastised the Fed for "dithering," "fecklessness," and "ponderous slowness," and exhorted the Fed to "buy more long-term and private debt," "push down long-term interest rates by its intention to keep short-term rates low," and to "raise its medium-term target for inflation, making it less attractive for businesses to simply sit on their cash." Note to Mr. Krugman: the Fed has been pursuing the first two items for quite some time now with nothing to show for it except a liquidity trap, and businesses will continue to sit on their cash as long as uncertainties about taxes, regulations and a weak economy continue - no matter what "targets" the Fed conjures up.

And this past Sunday, Roger Lowenstein (author of When Genius Failed and The End of Wall Street) wrote one of the most disingenuous whoppers we've seen in a long time - published by the New York Times, of course. Mr. Lowenstein seems to think that stocks are cheap because their "earnings yield" of 8.5% is much more attractive than the 2.58% yield on bonds (we assume he was referring to the 10-Year U.S. Treasury). Talk about comparing apples to oranges! Problem is that the real dividend yields on the S&P 500 and the Dow Jones Industrial Average are 2.16% and 2.77% respectively (at the close of business on August 27, 2010) - hmmm, not much difference from his above-mentioned bond yield.

Additionally, Lowenstein makes the case that stocks are cheap because current P/Es are historically low. He writes that the S&P 500 index is trading at only 12 times expected earnings. How quaint. What he neglects to mention is that the current P/E is 15.8, which is considerably higher than the theoretical - and not yet achieved - future P/E he cites. Furthermore, Mr. Lowenstein conveniently neglects to mention that current equity P/Es appear relatively low because most companies have slashed their work forces, cut back on research and development, ratcheted down production and are hoarding cash because of tax, regulatory and general economic uncertainties.

In short, stocks are not cheap, no matter how Mr. Lowenstein wants to spin it. But why let facts get in the way of fantasy?

So a red flag is being raised here. Chase yield or inflated commodities, stocks and other asset classes if you wish, but practicing the Greater Fool Theory never works. Just when you think some other poor benighted soul will come along and buy your over-priced securities from you, the whole house of cards might just collapse, leaving you in the same position you were back in 2000 and 2008. Don't people ever learn? How foolish.

Mr. Morris wrote the attached for the clients of his firm, Steven Morris Consulting. 

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