"No emergency can justify a return to inflation. Inflation can provide neither the weapons a nation needs to defend its independence nor the capital goods required for any project. It does not cure unsatisfactory conditions. It merely helps the rulers whose policies brought about the catastrophe to exculpate themselves"
Ludwig von Mises

I am not sure one could have possibly summarized all of my concerns in one concise sentence better than von Mises did in the above quote...And while, in my view, it applies perfectly to the actions of the "trigger happy" Fed during the last several weeks, let's not forget that it has been actually written almost four decades ago.

It isn't at all difficult to notice that Fed's actions have brought a healthy dose of optimism and hope into the financial sector. And on the surface this optimism is easy to justify- lower rates lead to higher assets values on the balance sheet, lower headline write downs, higher liquidity and higher investor confidence. As Lawrence Summers, a former top US Treasury official, said last week "Moral hazard and market confidence are different sides of the same thing. Sustaining confidence and preventing panics is itself a source of stability. It also econonomizes on capital and can encourage desirable risk taking".

And while I agree with him in principle, I also think that this kind of logic is what got us in into the mess we are in the first place. It is true that in the in the short term, both monetary and fiscal stimulus are likely to lead to higher level of nominal GDP, earnings and potentially stock prices. But what I question is the logic and long term benefit of such a frequent and radical government intervention into a market economy... The only thing that it could possibly do is fuel more inflation and misallocate capital from the efficient use to an ineffective waste...

This chart has been a great predictor so far to what Bernanke is up to...

source: clevelandfed.org

"To be upset over what you don't have is to waste what you do have."
Ken S. Keyes, Jr.,

Poor Patriots...I hope that can bounce back from this upset and pull of a perfect season next year, but I guess as far a SuperBowl prediction goes we are up to continuation of the last week's rally in the next week or two... But here are a few interesting links to consider before pulling all stops out though and an interesting investing idea at the end of the message:

On recession from ECRI:

"The Economic Cycle Research Institute, a New York-based independent forecasting group, said its Weekly Leading Index fell to 131.1 in the week to January 25 from 135.7 in the prior week, revised down from 135.8. The WLI fell due to higher jobless claims, weaker housing activity and lower stock prices, said Lakshman Achuthan, managing director at ECRI. The index's annualized growth rate plunged to minus 7.1 percent from minus 6.0 percent. "WLI growth has dropped back to the six-year low seen in early January," Achuthan said. "While the economy and employment did continue to grow through the end of 2007, the window of opportunity to avert a U.S. recession is about to slam shut."

On why the mortgage refinancing revival could be just another short term blip on the way into a recession, as you might have guessed again- inflation matters:

"Then there's the concern that low short-term rates could eventually bring higher prices." Inflation is very bad for mortgage rates," Green says. While mortgage rates might follow the Fed's lead and fall over the next few months, there's a possibility later of rampant inflation and rising mortgage rates. "By the time the changes make their way through the economy, we might find that the Fed did too much," Green says."

Now the last million dollar question- who thinks that non residential construction could possibly hold up as well as it has in the last year? I personally thought that correction in CRE is long overdue- GS seem to agree:

"Commercial real estate prices may fall 21 percent to 26 percent from current levels, resulting in writedowns for banks of about $20 billion, Goldman Sachs said today in a report. Home price declines will probably drive defaults in non- traditional loans such as Alt-As, which often include limited or no income documentation, resulting in $40 billion in markdowns, the analysts added."

And now two graphs to complete the "optimistic" picture; first one on payrolls- dipping negative does not bode well for the economy in the next 6 months:

source: DallasFed and BLS

And to finish it off here is a promised investment concept- I wish we could buy the US Gross National Debt futures as I think with another $400B red ink likely to be budgeted for the next year, this could be the only sure-thing investment out there right now :)

Stay safe out there,
skepticalcapitalist@gmail.com

P.S. I am looking into the Solar sector for some "real" potential opportunities, here are some of the names that look interesting SPWR, JASO and STP.

"Pain is inevitable. Suffering is optional"
M. Kathleen Casey

Here is another opinion why financial sector might not be quite out of the woods yet... Some of the graphs from today's Loan Officer Survey look quite convincingly scary. It is likely that Commercial Real Estate could be the next source of trouble for the financial sector and economy in general...

Lending terms have tightened dramatically:

"About 80 percent of domestic banks reported tightening their lending standards on commercial real estate loans over the past three months, a notable increase from the October survey. The net fraction of domestic banks reporting tighter lending standards on these loans was the highest since this question was introduced in 1990. About 55 percent of foreign banks--up from about 40 percent in the October survey--indicated that they had tightened their lending standards on such loans. Concerning loan demand, about 45 percent of both domestic and foreign respondents, on net, reported weaker demand for commercial real estate loans over the past three months."

Outlook for Loan Quality in 2008 is very negative- I highly doubt all of the bad news on the CRE front are priced in into the market

"A set of special questions asked banks about their expectations for delinquencies and charge-offs on loans to businesses and households in 2008 under the assumption that economic activity progresses in line with consensus forecasts. On balance, the responses indicate that large majorities of domestic and foreign banks expect a deterioration in loan quality in 2008. Regarding loans to businesses, between about 75 percent and 85 percent of domestic and foreign banks expect a deterioration in the quality of their C&I and commercial real estate loan portfolios. About 15 percent of domestic and 20 percent of foreign respondents expect a substantial deterioration in the quality of their commercial real estate portfolios. Concerning residential real estate loans, between about 70 percent and 80 percent of domestic respondents expect the quality of their prime, nontraditional, and subprime residential mortgage loans, as well as of their revolving home equity loans, to deteriorate in 2008. Finally, about 70 percent of domestic respondents expect a deterioration in the quality of both credit card and other consumer loans."

And finally when looking at the graphs here please note how similar conditions in 2007-08 look to 2000-01...

So to sum it up into simple investing terms- it is quite possible that rebound in real estate and financials is overdone - so SKF and SRS present an interesting short term opportunity. Also, the severe drop followed by rebound pattern seems to be in play in the Solar Energy sector. I added several ideas to my long portfolio at the open this morning- SPWR, JASO and STP... Will look for a quick double digit return similar to that of the dry shippers (DRYS, DSX, GNK) last week...But will also sell on any real weakness...

Trade safe and cheers, Vad
Skepticalcapitalist@gmail.com

"Every man prefers belief to the exercise of judgment"
Seneca

Hopefully the number of recession non believers is once again on the decline which is in itself a bullish sign. Intrade is showing a 75% probability will get there, so once we get over a 90% threshold it might be a good time to buy :)

Quick notes on the latest news- ISM numbers were simply ugly this morning, but the worst part is the noted inflation pressures are becoming a concern to the survey participants. Headline inflation is not as dangerous as a the potential shift in inflation expectations...It's getting scarier out there each day...

"The New Orders Index contracted to 43.5 percent, the lowest since October 2001. The Employment Index contracted to 43.9 percent, the lowest since February 2002. The Prices Index decreased to 70.7 percent in January, indicating a slight slowing in price increases for January. According to the new NMI, only three non-manufacturing industries reported growth in January. Members' comments in January indicate that weakness in the economy coupled with increased costs have negatively affected their business. Members have also indicated that they are experiencing inflationary pressures. The overall indication in January is that non-manufacturing has come to the end of a long-term period of growth and has contracted for the month of January."

"Nothing exists except atoms and empty space; everything else is simply an opinion" Democritus

Was today's rally a sign of things to come or was it simply a short term blip on the path to another low? The answer is not quite clear and really depends on who you ask...

But for whatever it's worth, my slightly bearish view has not changed in any significant way since last Thursday, despite some screaming from bulls that things might be looking a bit healthier in the short term...What's more even today's 200 point rally on the Dow has not triggered a usual emotional "take my short losses and go full speed long" reaction... It felt quite weak right from the start- it wasn't led by usual "blue chip" names but rather in many way resembled a "quant fiasco" scene from August/September 2007 when "typical" shorts went up and "typical" longs went down. So it might not be a good time for a "rally monkey party" quite yet... :)

But first a quick catch up with some important news and developments for the last 3 business days- MoneyGram bailout deal has entered the final phase- and the simple fact that Thomas Lee and Co is actually following through with it should be considered a good sign (on the surface), as it should theoreticallt indicate their confidence that the bottom in sub prime is near or may be has even been reeached. But on the other hand some of the details behind the transaction are quite startling and seem to put the bullish logic into question?

"The nonvoting preferred stock received at the closing will have an initial interest rate of 20%, which will increase over time up to a maximum of 22%...The committed debt from affiliates of Goldman Sachs provides for 13.25% senior second lien notes with a 10-year term, and is not callable by the Company for 5 years. The interest rate on the $200 million of additional senior debt is expected to be no more than LIBOR plus 625 basis points"

"The convertible voting preferred stock will pay a cash dividend of 10% or may accrue dividends at a rate of 12.5% in lieu of paying in cash. The Company expects it is likely that dividends will be accrued and not paid in cash for at least 4 years"

Look at the interest rates on both preferred stock and convertible debt? What's up with that 20% and 13.25% interest? How about LIBOR + 625BP on senior debt? Some serious repricing of risk is underway ladies and gentlemen, and hopefully the time of silly risk premiums is over...But how about actual losses?

"Through February 11, 2008, the Company sold a total of approximately $1.8 billion of investment portfolio securities, resulting in a realized loss of approximately $380 million, which was an incremental $220 million from the unrealized losses related to its investment portfolio securities at November 30, 2007. These amounts include the results of the $1.3 billion sale previously disclosed on January 14, 2008"

This again feels very troubling- losses that MGI seems to be taking on its investments (not enough detail to quantify exactly what the pricing is) could actually be higher than the Citadel/E-Trade deal suggested- let's not forget that ETFC "fire sale" was widely used as "a virtual floor" by many analysts who valued mortgage related portfolios of various financial companies...More write offs to come?

And to finish tonight on a good note to make sure that no one get too excited about another :)potential rally attempt tomorrow. Still think that write off announcements are nearing end? Or that private equity is going to make a quick come back and support the market valuations and investment bank earnings like it did last year? How about a quick reality check on prices and yields of some of the outstanding LBO related debt out there courtesy of WSJ:

source- WSJ.com

According to Markit, the LCDX Index -- which tracks credit-default swaps on such loans (measuring the risk of default), has dropped to an all-time low of 90 of late. CLOs are indeed a cause for concern. Not, perhaps, in a subprime-RMBS-AAA-noteholders-wiped-out way, but more in the way that all banks are vulnerable right now to further writedowns and capital constraints," notes Sam Jones in FT's Alphaville blog.

I'll be back with more updates tomorrow- but for now stay safe
Cheers, Vad at skepticalcapitalist@gmail.com

You remember when Greenspan has said in his book that Fed in effect has lost control over the long term rates? I wonder if some of the most recent developments in the credit market confirm his point of view. Consider this- Fed cut rates 125BP in the month of January and jumbo mortgage rates went up?

"Companies are paying more to borrow now than before the Fed reduced its benchmark rate by 1.25 percentage point over nine days in January, based on data compiled by Merrill Lynch & Co. Rates on so-called jumbo mortgages, those above $417,000, have increased in the past month, making it tougher to sell properties and risking further price declines" Bloomberg reported

It seems that even Fed governors are acknowledging that their cuts did not make the intended impact due to the tightening loan standards, rising inflation expectations and continued declines in the value of the underlying collateral.

``The increase in credit spreads has sort of worked against our policy,'' San Francisco Fed President Janet Yellen told reporters at her bank yesterday. ``The fact that the spreads went up so dramatically really resulted in an effective tightening of financial conditions that our cuts were partly meant to address.''

I am bit surprised by a solution that is presented as the logical solution though? - cutting rates even lower... If you someone still believes that Fed isn't blowing up any new bubbles read this article from WSJ

"A typical mortgage here -- which is pegged to the prime rate which, in turn, is tied to the base rate -- now carries interest of about 3.1%. But compared with Hong Kong's inflation rate of about 3.8%, which is hovering at a more-than-nine-year high, that looks especially inviting, creating a so-called negative real interest rate...Andrew Fung, head of investment and insurance for Hang Seng Bank in Hong Kong, calls the property market here one of two "certain investments" -- along with the appreciation of China's currency, the yuan -- in an uncertain economic environment. Underlying the property-buying enthusiasm: fast-rising wage increases, unemployment near its record low and bank deposits growing at about 20% a year."

Any time some says a word "certain investment" I think it's about time to head for exits...

Stay safe and ignore the noise Vad

"Don't think you're on the right road just because it's a well-beaten path"
Author Unknown

I guess I have neglected to state my opinion on many of the questions of the week at the SLO-2- so here is a short summary of my thoughts for what's its worth...

First on the YHOO/MSFT deal- let's cut through the BS- in my opinion -Yahoo's business model is fundamentally broken and thus whoever ends up buying it is likely to overpay- period. To me YHOO has always been a company that had some great ideas and products, but without solid execution- great ideas are simply a day dream as someone once said...

I am not sure one needs to look any further than a summary of Yahoo's acquisitions profiled at WSJ last week, to quickly see why this stock declined to $19 a share in the first place. Earnings growth in the last few years has been anemic at best and outright negative at worst. And with EV/EBITDA ratio of almost 30 times, the standalone valuation (even after adjusting for value of certain investments) simply seems unreasonable. It is true that company generates roughly $1.5B in cash each year and advertising revenue from most of company owned properties continue to grow but is enough to justify $40B market cap?

Now back to some of the investments themselves- here are some of examples of why the decline to $19 a share wasn't so unreasonable...In 1999 Yhoo bought Geocities for roughly $3B trying to corner the Social Networking market- what is it worth now? I doubt very much if anything at all. Facebook and MySpace have simply outplayed them in every direction...

What's next- Broadcast.com- $4.3B of shareholder value- vanished- the web site has been simply shut down...How about search? Inktomi and Overture- $2B+ more- this time not quite "gone with the wind", but unlikely worth full 4 times the annual income of the entire company. How about well publicized "Panama" investment? I don't know what the total $ amount spent was, but it is now almost a certainty that the platform has failed to live up to all the hyped expectation, with affiliate advertising revenues actually declining y-o-y...So all-in-all an astounding 10+ years worth of earnings- could now be considered almost worthless...

To be fair, one does need to mention some of the investments that on the surface seem to have been more succesful- with the best example being probably Alibaba.com. Yhoo's current stake in the Chinese company is worth several billion dollars, but it is not yet clear to me how could the company recognize all the "headline" value from this investment without a significant discount, plus given the "frothiness" of the Chinese markets in general, future upside there could be hard to come by...

It is also true that several of Yahoo web properties like Yahoo Finance and Yahoo Mail represent some of the most valuable real estate on the web, period, but in my humble opinion- they have a terrible job so far monetizing these assets in any significant way. Earnings growth is simply not there any more-forget all the "one time" investment and adjustments stories- after a certain point they simply become too recurring to be considered "one time". It is very hard to see where will the growth come from?

What's more, as a vivid Yahoo user myself - I can tell you that the quality of the content is not getting any better or actually might be even getting worse- it seems like the recent cost cuts are impacting it very negatively. For example, in my experience, Yahoo Finance web site in the last 12 months has been plagued with constant glitches, when prices and various multiples are simply not showing up at all for prolonged periods of time, or are simply corrupted; Finance message boards became pretty much worthless with spammers overrunning and outnumbering the legitimate users; Yahoo Mail, while certainly very popular, simply has too much solid competition to be a real earnings growth engine in the future- plus it's virtually free and thus is not likely to deliver significant value on it's own anyway...

So, to sum all of the above- standalone YHOO is not GOOG or EBAY and not even an AMZN, and their pre Microsoft offer price reflected the true value of the company... In my opinion Yahoo's management has made a fundamental strategic mistake of trying to be all things to all people and never really chose to specialze in anything...

They've tried to beat EBAY and AMZN in e-commerce and failed... The tried to corner the Social Networking space with Geocities- and lost to Facebook and MySpace...Same thing in search -GOOG has simply ate their lunch...Now both Yahoo Mail and Yahoo Finance are likely to stay under pressure and without substantial additional investment and focused management attention, they might just lose there again to the likes of GOOG and MSFT...

That brings us back to the fundamental question - is MSFT really getting anywhere close to a good deal by offering a whopping 60% premium for a company with a fundamentally broken or undefined business model? The answer to this question in my opinion is again relatively simple- even if MSFT is serious in their intent of eliminating a $1B+ in costs- the deal might be at best an "ok" proposition to MSFT's shareholders. One would expect that eliminating duplicate development resources deployed to Search engine development etc could help justify some of the premium, but $1B is probably worth $10B or so at best (an NPV at 10% WACC), given all the costs and time it is likely to take to capture the savings...

I also do think that MSFT's management is more competent and shareholder friendly and thus could justify some additional valuation upside. But given the complexity of the Yahoo structure (Alibaba, Yahoo Japan investments etc), heavy reliance on synergies to make this deal accretive to MSFT (by the way why would Yahoo's shareholders should receive these synergies upfront instead of MSFT's anyway?) and the enormous pressure from the Wall Street on MSFT to increase the bid (again no financial justification whatsoever)- this deal is not good for MSFT's shareholders and thus the decline in MSFT's price, assuming the deal closes at the announced price or higher, to me is definitely justified...The question is now simply -at what point will this punishment become unreasonable? I think that if MSFT sticks to the original price or pulls out- stock should react positively, in all other cases- more declines could be in store.

So take it for what's it worth and remember this is an opinion only...

P.S. I am not trying intentionally to be skeptical, may be just a little more objective then most of the Main Street Press :)
www.skepticalcapitalist.com

So here is the ScepticalCapitalist's take on what the primary goal of "rational" investor short selling strategy should be- it is simply called risk mitigation or hedging. I personally believe that it is a very prudent practice for an average investor to allocate a healthy portion of their portfolio- usually no more than 30-40% percent of their "long" holdings to a well diversified group of small short positions. These stocks are intended to serve a primary goal of cushioning portfolio gains in the event of a severe market decline like the one experienced over the last several months.

Assuming that you also you shorted the right stocks (usually on the downtrend already and highly leveraged), this 30-40% position could potentially cushion the majority of your "long" losses even though the actual dollars committed to the "shorts" are 2.5 times smaller, because "weak" stocks tend to "fall off the cliff" much faster than the blue chip names... Yes, it is also true that during the "bull market" your "short" positions could exhibit a small drag on your upside, but it is likely to be small if executed correctly and will reduce the overall volatility of you portfolio.

Now here are some of the simple rules I personally use when picking short positions:

Rule 1- I do not short stocks based purely on valuation- period!
Shorting based on "valuation only" usually means that the stock you are shorting has been going up for a while, and thus you are very likely going to end fighting against a momentum driven crowd that could "stay irrational for longer than you can stay solvent".

Rule 2- I do not short stocks that do not have debt!
Again logic here is very simple- by selling stock short I am in effect saying that there is something fundamentally wrong with company's business model, rather than simply saying that the stock is too expensive. And without pressure of interest payments company can stay afloat for a while, even if the business itself is worthless. Plus there is another upside from focusing on stocks with debt- during bear markets stocks with a heavy debt load decline multiple times faster than the "debt free" ones.

Rule 3- I also only short on the downtrend and in general like for the short candidates to have a short ratio of over 7%.
I found that if I am the only one who thinks that the company is broken- I am usually wrong. Plus buying on the downtrend helps to avoid fighting against the "momentum crowd".

Rule 4- I prefer to short stocks that have negative or declining cash flows, low margin and reasonably low growth expectations.

Once again self explanatory- negative cash flow in combination with debt means trouble. Low margin means lower room for any (even short term) error. And lower than average growth expectations help with potential "buy out attractiveness"- acquirers usually seek "growth" rather than "turnaround" opportunities.

Rule 5- I also usually avoid shorting stocks in biotech and other "high end" research and development heavy sectors.

As I found again in my own experience- unless you have some kind of special insight on the research subject/technology- you are simply betting on an outcome instead of making an intelligent investment decision.

Even in the current volatile market it is possible to find some companies that I consider attractive short candidates. You can find some of them in my profile on MSN's web site. But anyway, I hope some of the above information is helpful for some curios investors out there. So please next time you hear another "disgruntled" manager complaining about "evil" short sellers, please ignore the noise and remember, that while "making money on other people's pain" is usually a great discussion point for populist politicians, the reality is a lot more simple- short selling helps to avoid larger bubbles in the market, and thus could potentially save many investors some serious pain when these bubbles eventually burst.

However, cruel it might sound, it is often more productive to let "bad" companies simply disappear, instead of wasting more productive capital on inefficient and destructive business concepts that are destined to collapse eventually anyway.

"Sickness is simply the vengeance of nature for the violation of her laws"
Charles Simmons

Please feel free to visit my blog or e-mail me your comments at skepticalcapitalist@gmail.com

"Keep on going, and the chances are that you will stumble on something, perhaps when you are least expecting it. I never heard of anyone ever stumbling on something sitting down"
Charles F. Kettering

One of the fundamental ideas of this investment contest is supposed to be sharing ideas and thoughts on how the individual investors can make money. Today I wanted to share some of my most thoughts on the process that can help an average investor to protect some of their hard earned gains during the bear markets- it is called "short selling".

Let's begin with a quick definition of short selling from Investopedia for those who are not familiar with a concept:

"The Basics -When an investor goes long on an investment, it means he/she has bought a stock believing its price will rise in the future. Conversely, when an investor goes short, he is anticipating a decrease in share price... Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered. That may sound confusing, but it's actually a simple concept... When you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money. "

Now let's get into the actual discussion... Every few weeks or so, the Media seems to pick a new story about some "evil" hedge fund manager that is trying to bankrupt another "great" company by engaging in a very "questionable" practice of short selling. Recently in a bazaar twist bond insurer MBIA has written a letter to the Senate in effect blaming the hedge manager Bill Ackman for some of the troubles that bond insurers have gotten themselves into.

"MBIA wrote that the House Subcommittee on Capital Markets should work with the Securities and Exchange Commission to "curtail (short sellers') unscrupulous and dangerous market manipulation activities... Short sellers like Bill Ackman, founder of hedge fund Pershing Square Capital Management, have worked hard to undermine market confidence in the bond insurers, wrote MBIA, whose shares have fallen more than 80 percent since the start of 2007"

I mean- no offense to the management of MBI, but do they seriously think that their stock price declines because of the short sellers, rather than because of the fundamental issues with their business model? What a joke! I think these guys need to grow up, stop crying and instead focus their efforts on trying to figure out how to save their companies and reputations from what now looks to be a string of serious, potential deadly errors in strategic and business judgment...

I personally believe that "short selling " is not only ethical and legal, but also a very necessary financial transaction, that not only helps to keep markets from being irrational for prolonged periods of time, but also makes sure that incompetent management's mess ups do not go unpunished for too long, by bringing a healthy dose of fear into their often unreasonably "greedy" and "self" centered actions...

But now let's get back to the initial target of our discussion- learning how an average investor can and should benefit from selling short. First, let me start by saying that I do not think that an average investor should use short sales as a primary tool of making money. That would be a pure speculation rather than investing. You odds of beating the market in the long haul with a 100% "short only" portfolio are quite slim. The main reasons for that are quite simple:

1. While your upside is effectively capped at 100%, your downside is theoretically unlimited.
2. In the long term stocks prices go up- period. The "doom and gloom" theories are always short term in nature, as it is simply impossible for prices to go down forever because of the simple little fact called- inflation. While the "real" stock prices could possibly go down for a long period of time, "nominal" prices will always go up in a lock step with inflation...

Continued in part two "My rules for short selling"...

"Stubbornness does have its helpful features. You always know what you are going to be thinking tomorrow" Glen Beaman

It is simply amazing sometimes to observe how fast the public opinion swings from one direction to another. Several months ago no one really cared about recession or believed it was actually coming. Now you can hear people speak about it openly at the grocery check out line. And while this "casual recession chat" usually is a positive sign that signals that the majority of damage has been priced in into stock prices already, the stubborn denial of the Federal Reserve to accept the fact that inflation threat is real and that the "wishy-washy" projections of declining prices just won't materialize, is simply troubling...

I can't comprehend how could anyone deny that inflation has been trending UP not DOWN for a while now, and is actually showing signs of accelerating rather than slowing? US, UK, Japan and EU inflation is at multi year highs? Chinese inflation is at 11 year high? 65% y-o-y increase in prices of Iron Ore? 20% increases in rental rates for Rigs? Come on Ben - give me a break. How many times a year will they have to adjust the forecast? My guess on where the GDP growth and inflation are going to end up in 2008 is as good or may be even better than Fed's :)

But I am very glad that once in a while we can all read a reasonable commentary from a respected economist that actually makes sense:

Although it is too soon to tell whether the United States has entered a recession, there is mounting evidence that a recession has in fact begun. Key measures of economic activity stopped growing in December and January or actually began to decline. The collapse of house prices and the crisis in the credit markets continue to depress the real economy.

If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. The recessions that began in 1991 and 2001 lasted only eight months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.

But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.

Please visit the WSJ to read the whole thing - I think it's a great read...

Percent change, past 12 months Aug Sep Oct Nov Dec Jan
CPI* 2.0 2.8 3.5 4.3 4.1 4.3
CPI less food and energy* 2.1 2.1 2.2 2.3 2.4 2.5
16% trimmed-mean CPI 2.4 2.5 2.7 2.8 2.8 3.0
Median CPI 2.9 3.0 3.0 3.1 3.1 3.2

Source: http://www.clevelandfed.org/research/inflation/us-inflation/mcpi.cfm

To all those interested - this is sorta how I look in the real life... May be a bit less angry and more skeptical :)

I've been quiet for several days now because of my move to a new employer (Private equity world here I come :) And while the market has rallied strongly in the last several days- I haven't actually closed any of my short positions. I didn't do it for two main reasons- one- I simply didn't have an opportunity to sit down and assess the damage properly :) and two- I am still convinced that we are in for a rough ride in the months to come and thus my shorts are likely to rebound...

Some quick notes...

• Inflation is simply out of control and I find it simply outrageous that a Fed governor Kohn can state nonsense like this with a straight face:

"On inflation, Mr Kohn indicated that price pressures were moving up the Fed's list of concerns. He said higher energy prices, higher import prices and higher commodity prices "may be passing through a bit to core consumer prices"..."I expect the run-up in headline inflation to be reversed and core inflation to edge lower over the next few years."
What a bazaar and simply dangerous attitude...

• Think real estate related write downs are over? Why do you think the banks haven't really rallied much and some of the players that in effect define current real estate market like FRE and FNM actually declined?

How about some graphical evidence that things aren't that pretty and that it might be a bit early to call an "all clear" for most banks- the fact is- most ABX indexes hit a new all time low today!

Source: Markit

More to come tomorrow, for now stay safe and cheers.

P.S. I'll look to establish some fresh shorts when the DOW index hits 12,800 or so...

Skepticalcapitalist@gmail.com

I think it is way too early to claim that the worst is over for the mortgage backed securities market. Yesterday's disclosure from Thornburg Mortgage (TMA) that it was forced to pay $300M in new margin calls, in my opinion is simply the first warning bell of what's might be another spiral of write downs and thus more dilution to come in the financial sector...

TMA situation to me is significant for several reasons. During the "go-go" days of the subprime boom, Thornburg represented a "gold" standard of conservative underwriting standards in the whole sector. They also only kept the highest quality assets on the balance sheet and thus even when the whole subprime sector caught a fever last summer, TMA was widely believed to be a "thriving oasis" in the subprime desert...

But when the commercial paper market effectively shut down back in August, TMA share price tumbled from high 20s into teens in a matter of days. Being a contrarian investor myself, I sensed fear and thus opportunity, and after carefully studying their balance sheet, I started a position. But to my surprise TMAs share price kept declining daily. So assuming that their portfolio was of high enough quality to sustain some short term losses I bought more... Long story short, it was one expensive lesson and I won't repeat it again...

TMA not only turned out to be one of my two largest losers during the whole contest but also taught me a valuable lesson- in the event of the severe dislocation in financial markets, asset quality is significantly less important than steady and ample access to liquidity. Because of their heavy reliance on the short term financing in a form of commercial paper, TMA was forced to sell some of their best assets at a huge discount to meet margin calls, which triggered more write downs and thus more margin calls...

But after huge write downs and liquidity injections last fall, things seemed to have gotten much better for the troubled lender. They actually managed to report a profit in the most recent quarter and have even paid a dividend again. Stock has rallied strongly just like the rest of the financial sector...Unfortunately, as the most recent announcement from TMA and UBS confirms, it looks like we might be in for another round of the same troubles...

I know there have been a number of reports in the media stating that conditions have improved markedly for the battered financial sector, but I personally question this logic for a number of reasons. First, it is true that rate cuts from Bernanke Fed theoretically increase the value of assets on the balance sheet and thus help the financial sector. These rates cuts also usually lead to lower mortgage rates, but not today and the main reason is -inflation. Mortgage rates actually hit a multi month high this week according to Bankrate.com

If Fed can't read the writing on the wall- I think someone needs to spell it out- "No more rate cuts!!!" I personally think that Fed is either asleep at the wheel or they are just playing some of kind of silly game that I personally just do not understand. We keep hearing a story from most Fed officials that inflation is not really an issue and that headline inflation number excluding food and energy does not matter... And we are talking about 4%+ inflation? This kind of hands-off attitude towards price stability is simply incomprehensible and irresponsible for a head of central bank of a developed country.

The truth of the matter is simple- inflation is always driven by excess liquidity and thus is "always and everywhere a pure monetary phenomenon". So while blaming high inflation onto high oil and food prices is a very convenient cover up for the populist politicians, the truth is much simpler- both housing bubble and oil bubble are a direct result of lax monetary policy- period...All the explanation about the Chinese demand impact etc -are simply overblown- the world has plenty of spare oil production out there and even most recent OPEC's moves where to CUT production- case closed...

Now, going back to the current situation- the excess liquidity generated by silly rate cuts has to end up somewhere, and given the widespread risk aversion, instead of going towards the productive areas of the economy, it is now simply being washed up into the assets that either have no risk- like treasuries, or into the assets that are perceived to be bullet proof to the US recession- like Emerging markets and commodities.

But as a skeptical capitalist I just simply don't buy into the emerging market "decoupling story" or into the "peak oil" theory. To me these are simply the next two big areas of "bubble" trouble and the most recent rate cuts are simply throwing more gasoline on fire. My prediction is that if RTP/BHP merger actually did close (highly unlikely), several years from now it would have the same ending as the AOL/Time Warner merger did...

As far as financial sector recovery goes- my rationale here is again very simple- we have not yet really seen any small regional banks go bankrupt; we have not yet seen commercial real estate related write offs from the large banks; we have not yet seen the LBO related debt write offs and in combination with tightening underwriting standards these write off will likely lead to more equity dilution. Thus buying into the sector is still very premature... What's more, with many players rallying strongly since Fed's January cuts, I think there is a real opportunity out there to actually short some of them...

Anyway, enough rambling for now
My summary advice is still the same- be careful, hedge your downside whenever possible and avoid the "this time is different mentality"...

Please feel free to e-mail me at skepticalcapitalist@gmail.com