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Today's Commentary: 01.18.06
The "On-the-Other Hand" Economy

You want what all investors want. But just as all investors differ in temperament, some looking for rolling momentum for their cash, markets that look for the stratosphere, while still others look for protection from gathering storms, we are essentially the same. What brings investors together from across all boundaries is the undying pursuit of the investment that leaves their money largely unscathed. In return for the trouble, we'd all like a little yield.

So what should anyone with those goals make of December's weak but obvious inversion of the yield curve? An inverted yield curve happens when the yield of a shorter term fixed income note or bill begins to exceed that of a longer term offering. It usually signifies a lack of confidence for the economic outlook in the coming months. It has been saddled with the curse of predicting recessionary times in the offing.

Some stats bear this out but not conclusively. One economist reported that the predicted recessionary downturn was avoided 38% of the time in the five largest economies over the last sixty years. On the other hand, flattened curves between the 3 month and ten year Treasury did foretell a significant downturn almost 100% of the time.

Yet another economist pointed out that you need to look much further back that just a shorter term note and even shorter term bill all the way to the federal fund's target rate. If that were the benchmark for an inverted curve however, we would still have a little bit more flattening to go before we reach inverted. The 10-year Treasury is hanging around the 4.40% mark as of this writing and the target rate mentioned earlier is a full 15 basis points or 0.15% less.

It is a close-but-no-cigar situation that can be easily overcome if a few more pieces of the puzzle fall into place.

First piece of the puzzle is Alan Greenspan. He disagrees that the inverted or flattened curve is a good indicator of anything much at all. He failed to pay it heed back in 1999 as the curve inverted just as the equity markets heated up. That event went almost unnoticed because of the bad news it portends. Irrational exuberance was the feeling of the moment.

The lesson to be learned from that was one of timing. Market watchers and mavens tend to be an impatient lot. Predicting something requires that it materialize in the very near future. Which is why, when the outgoing Federal Reserve Chief weighs in on the subject - remember his conundrum? - one can expect the slowdown and possibly a recessionary one will happen in the next six months.

While we are on the subject of Greenspan and co., you might as well be aware of the F.O.M.C. braking system. Never very good at stopping once it builds even the slightest acceleration, expect the brakes that Bernanke will need to apply by this fall to be too late to stop any movement to the downside. The Fed just can't stop on a dime.

A flat to inverted yield curve dries up the mortgage and lending markets. Unable to attract the kind of investors needed to keep the money flowing at a reasonable profit, this second piece of the puzzle forces banks to simply tighten. That kind of a squeeze will hurt the small cap companies, which in turn will squeeze anything above them.

The net effect of this will be lower inflation through banking controls. An additional net effect will be a flight to high yileds with high risk. More corporate bonds will be looking more attractive as some are moved into junk status by the change in financial markets.

The third piece of the puzzle is more of an international phenomenon. There is prevailing belief that if the rates are low here at home, investors looking to park cash will find another marketplace that seems reasonably safe and invest there. But the trend towards one country, and one as large as the U.S. going it alone on the economic front in a downturn have become less likely as the world contarcts inot one giant economy.

Global long term rates are down among all of the great importers. This creates a conundrum for the world's greatest exporters. The Middle East, China and Russia are all facing a global market place that is increasingly reacting in tandem with each other.

While bond markets have always been roiled with unease and tension abroad, the Iranian noise may be just enough to start the slow tumble. Add to that a slight bump in the producer's price index, slower retai; sales in December, oil price still rising and if you look at the bad omen of both oil and gold rising in tandem, fixed income investors are downright nervous. In any case, the increased search for risk free government securities may be the ultimate vote for paying attention to what the other hand may be telling us.

Today's Commentary: 01.15.06
Truth Be Told

Seems reasonable enough to request that we be honest with each other. Seems equally as reasonable that we accept the general misgivings about human nature and forgive some of those shortcomings. Those mistakes are often quantified as "white lies" or fibs or unintentional fabrications are often expected in some places but are no less an affront to our sense of decency. But when do we reach the breaking point, the moment when you finally grasp the truth about a person, place or thing, you are forever changed. You become suspicious and distrustful and those reactions are warranted.

So if someone like J T Frey were president, how would the non-fiction author of his life with the highly fictionalized recollection of events explain the recent White House report on the 2006 budget deficit?

Granted, it would take some doing to put a former drug user in the highest office in the land, and there is no telling what knee jerk reaction someone like Mr. Frey might have when confronted with a recession, a terrorist attack, a war in a foreign land, and a hurricane all within the first five years in office, and this smacks of just a parlor game, but it might be fun to hypothesize.

The deceitful mind has been researched and documented since before there was commerce. So we have a fairly good idea how someone like Mr. Frey might react should he be confronted with the simple question of why. Why are the deficits up yet again? Why are you making promises to halve the deficit by 2009 when some of us believe there a no good reasons why they should exist in the first place? And why did you spend the surplus you inherited when you took office, cut taxes more than they needed to be cut, and still, in the face of another estimated $400 billion shortfall, want to cut another $90 billion?

You would, faced with such daunting questions, turn the mongering press over to your new press secretary, Oprah. Oprah steps in and suggests that these problems would have been handled the same way by any president that was in office at the time of these events. The Scott McClellan like Oprah would no doubt echo the Congressional Budget Office's report that cutting spending would not be enough to achieve financial sustainability and the president feels the need to cut taxes further would further stimulate the economy.

She would also be quick to point out that the budget deficit was actually decreasing until Hurricane Katrina came along. This part would be right but in a convoluted sort of way. Much of the deficit reduction that was reported last year came from a recovering stock market and tax bills on corporations.

The tax windfall credited to that reduction to $319 billion last year was a stand alone event and not likely to be repeated. Some of the money came from a tax repatriation of corporate overseas profits, of which the government took a much smaller tax share in return for bringing the money home. The rest came from the reduced capital gains tax which allowed some long term gains in the markets to be taken without too much tax damage.

The disaster that occurred in New Orleans and the surrounding area was horrific but the cost of such disasters is what what the framers of the constitution intended the government to pay for when they wrote the document. Which is why we have a need for some surpluses.

In fact, the CBO, the nonpartisan arm of Congress suggested that any attempt at solving the problem with basic spending cuts would immediately be offset by new spending needs.

In other words, the government, according to the report, will be faced with new spending problems such as aging boomers, the first of which begin to retire this year, and health care costs that have no visible ceiling to stop them start to take their toll on the country and its empty coffers.

Mr. Frey as president has an advantage: the support of his Congressional majority, whose effort to keep cutting taxes in light of this grim economic future, one that we can rest assured has a few more emergencies worth hundreds of billions of dollars that the budget can't handle. They seems very DoubleDay-ish in their support.

In an election year, much like the year following the publication of a book, anything that can be done to support the reasoning behind even more tax cuts, Washington's non-fiction turned fiction, is glossed over, excused and otherwise referred to as inspired.

Truth be told, as long as tax revenues head in the opposite direction of government spending (those outlays now make up almost 20% of GDP and have done so for the last three years while tax revenues have fallen 3.5% from their 2001 level of 19.8%), the Congressional support of tax cuts seems like a "turn of a blind eye". In an election year, when approval ratings are down, giving away what you need desperately to cover the basics doesn't seem like a very smart idea.

In the name of share holders everywhere, Christopher Cox is going to insist that these generous companies parade these outrageous pay packages in front of anyone willing to look at the corporate culture of celebrity.

Perhaps Mr. Cox is a fan of the new wave of horror films such as "Hostel". The movie, which has been reviewed as torturous to watch but entertaining in its own frightening sort of way, shows the dangers of too much graphic detail. The film involves the interrupted travel of two carefree men who are, for the majority of the movie, tortured at the hostel they checked into just for the fun of it. We don't look at these films in horror and disgust and there is little likelihood we will do so when we find out just what these execs have been paid.

Mr. Cox has the best interest of the shareholders in mind when he seeks more disclosure. Executive pay has gotten out of hand in the last ten years despite what might be perceived as questionable performance of the companies they run. In corporate America, celebrity sells shares and celebrity pay is warranted as well. When the company is doing so well that accolades of wealth are the only compensation that can be awarded, many of us don't really mind that much.

Corporate compensation hit its zenith during the divorce proceedings between Jack Welch, former CEO of General Electric, and his wife. Finding out just how much reward Mr. Welch received for his efforts at GE was not enough to cause a shareholder uprising. While Mr. Cox's efforts are noble, history has proved the disclosure works in the opposite way.

One need look no further than professional sports for answers. Each new player contract that is reported at new atmospheric levels forces athletes with similar skills to want an increasingly bigger portion of the gate receipts for their talent as well. It spirals out of control a little further each year. Fans watch in amazement and then, they pony up the additional cash needed to pay for tickets as a result. Has the game improved with each new salary increase? Is the experience better because you paid for even though you might be getting a diminished performance despite the higher payroll?

CEO's have done essentially the same thing. Each time a compensation package is revealed, similarly talented chief execs want to be compensated the same way. Disclosure actually increases pay packages. And shareholders buy into the idea even if it takes more and more earnings just to cover one man's paycheck. What they expect is better performance but the results, or earnings, the way a company gauges success, are not always aligned with the boss's paycheck.

With the distance between the chief's pay and worker's compensation now at 400-1, it would seem like a good time to address the situation. The problem of how to do it and still retain the best talent for the shareholder dollar remains. Efforts to curb abuses, including using taxes have only made companies more clever in how they compensate the company chief.

Possibly the easiest way to control the problem of CEO pay and still compensate a CEO for their efforts would be to put a percentage cap on pay as it relates to earnings. The SEC could mandate that companies comply with a minimum salary and a piece of the pie. It could be as little as 1% but not more than 3%. No stock, no options, no grants, no perks. Just enough to create the incentive to grow the business and shareholder value while increasing their pay package.

Shareholders would be able to, at a glance, determine what the top dog was paid just by looking at the balance sheet. A $100 million dollar profit means that the CEO took home a million dollars for his efforts in addition to his salary. It could be called profit paying and would be as transparent as anything the SEC is likely to expose for us in the coming months.

Past commentary can be found here

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