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Recessions, Government Intervention and Investment Strategy

Imagine a world where economic cycles repeat again and again facing booms, busts, rebounds, expansions, recessions and depressions. Because the repeated world appears to be intact, it is time to ask a few questions. Will President Bush’s Troubled Asset Relief Program (TARP) and President Obama’s American Recovery and Reinvestment Act work to pump up economic demand, as John Maynard Keynes (the father of modern Macro Economics) predicted? Analysts at Credit Suisse are believers. They say few people realize how powerful quantitative easing (QE) really is and that the combination of fiscal and monetary strategies when combined, are beating back recessions.

Both Republicans and Democratic administrations have used fiscal policy to pump up government spending and monetary policy to reduce interest rates in an effort to stimulate economy recovery. But is this Keynesian revolution working as it was predicted in the 1930’s? That is, should the government be regulating the economic cycle at all? Let’s take a brief look at the U.S. government intervention during its downturns.

A brief historical review:
 During the late 1920’s, margin accounts were the rage in America. By 1928 individual investors were making fast and easy money by using 10-to-1 leveraged brokerage accounts. As the stock market soared, so did easy wealth. But when the market turned down, the leveraged crowds were buried in debt. Banks failed. People lost their homes, their businesses, their jobs, and their standard of high living. As banks failed the economy went into a tailspin. The President of the United States at the time, Herbert Hoover, a Republican, tried to stimulate the weak economy by establishing federal programs to reduce growing unemployment. Hoover’s advisors suggested several strategic options. Hoover chose (1) to authorize the forced migration of some 500,000 Mexicans and Mexican-Americans back to Mexico in an effort to make jobs more plentiful for others. This campaign continued under the Roosevelt administration-through 1937. Hoover also chose to raise tariffs on imported goods, so U.S. made goods would be more attractive to domestic consumers. He also chose to set up a monthly income safety-net for older Americans. However this proposal was defeated by conservatives in Congress who were against higher taxation.

 It was President Roosevelt, (1933) who ultimately had the votes to set up a Hoover-styled program for the senior citizens. They call it social security. Roosevelt also had the votes to establish several other massive work programs designed to bring down unemployment. President Roosevelt referred to his massive stimulus program as the New Deal. But it didn’t work. So a second stimulus program, called New Deal ll was initiated. This two-step program finally appeared to turn the economy around. However, a recent UCLA study suggests that Roosevelt’s policies prolonged the Great Depression by 7 years by focusing, as Hoover had done, on anti-competition policies, rather than allowing the free markets to work. Fast forward to… 2010.

In the final days of his eight year administration President George W. Bush established the Troubled Asset Relief Program (TARP) to save the banking industry from complete collapse. Like the 10-to-1 leveraged crowds of the 1920s, the banks were failing because their own investment departments had become caught up in 60-to-1 leveraged schemes. The investments of choice were mortgage-backed derivates. Bush’s TARP program sent some $245 billion to beleaguered U.S. banks. While some $169 billion of TARP money has been repaid, $76 billion has yet to be repaid, suggesting many banks, mostly regional, are so small in nature that they remain weak.

Less than one month after his inauguration, President Barack Obama signed a $787 billion economic stimulus package into law. The stimulus package provides relief for unemployment benefits, education, health care and infrastructure. The efficiency and utility of the stimulus package has many critics. Meanwhile, this month, the Federal Reserve Board said, “they would restart QE (think New Deal II) (quantitative easing) IF the economic outlook were to “worsen appreciably”. The Fed’s willingness to promote a quasi-New Deal II program suggests that economic-deflation needs to be taken seriously. However there are many signs a recovery is beginning to take hold. The general consensus in 2010 is that QE1 did not do the trick and therefore QE2 will not work either. However, many analysts believe that a combination of fiscal spending and quantitative easing will eventually work for the following five reasons.

QE works via five routes:
(1) Quantitative easing pushes up asset prices. Because real bond yields are artificially low, it forces bond holders to make asset allocation decisions. To do nothing assures the safety strategist of a guaranteed loss because bonds, net after tax and inflation, produce a negative return.

(2) As asset prices rise, investors holding stocks feel the benefits of a wealth effect. Consumers buy and corporations build since it becomes too expensive to buy the stock of growth companies.

 (3) Lower bond yields/credit spreads makes housing more affordable. At some point the low cost mortgage market is going to reach a tipping point such that buyers are compelled to take advantage of a higher standard of living; bigger home, better neighborhood.

(4) Lower bond yields give governments more discretion. To illustrate, the federal government has renewed $32 billion for unemployment and $26 billion for state and local governments. This is money that is available because the cost of government borrowing is low.

(5) Quantitative easing produces a weaker currency. Lowering yields from holding U.S. Treasury debt instruments makes foreign debt look more attractive. The result is a weaker dollar which in effect, increases the competitiveness of U.S. goods and services.
Summary:
 It will take time for quantitative easing to work. The wildly leveraged and unmonitored schemes of the nation’s largest banks put this nation’s economy (and the world’s economy) in peril. In the aftermath, with 10-year bonds yielding a negative return on account of taxes and inflation, investors are now being forced into the equity market. Clearly this is a set up for stocks. This is government intervention; classic Keynesian economics. Don’t fight the Fed since both parties are using the Keynesian strategy. As Federal Reserve policy begins to work, analysts believe strongly that quantitative easing II will not be necessary. We shall see. Credit Suisse analysts still put a target price on the S&P 500 at some 1220 by year end.

Contact Us to learn more about working with Vaughn Woods Financial Group.

Best Regards,

Vaughn L. Woods, CFP®, M.B.A.

*Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views off Delta Equity Services Corp. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0096

*Marketedge.com, Pershing NetExchange Pro, Bloomberg, Credit Suisse, Briefing.com

The following sources were used to research and write this newsletter:
 Marketedge.com, Pershing NetExchange Pro, Bloomberg, Credit Suisse, Briefing.com, Standard & Poors
 Credit Suisse Research, August 16, 2010
http://www.bloomberg.com/markets/
 http://en.wikipedia.org/wiki/Obama_inauguration
 http://www.federalreserve.gov/bankinforeg/tarpinfo.htm
http://newsroom.ucla.edu/portal/ucla/FDR-s-Policies-Prolonged-Depression-5409.aspx