Double Journey

This article by CNN said pretty much the same thing I concluded this weekend, the stimulus, because of all the borrowing that the government will have to do to fund it, will likely have the effect of raising interest rates.  Of course, if it happens, it will occur at the absolute worse time for the economy.  But economics cares very little about the desires of humans.

However, what was even more surprising to me was how much debt some other countries have on their balance sheets.  What I find particularly funny though is that other countries bad planning is used as justification for the United States to do the same thing.  I am not sure if I feel comfortable being bucketed in the same class as some of the other countries who could not live within their own means.  The U.S. should be a leader, not like everyone else.

In a very expected move, the Fed decided to cut interest rates all the way to 0.25%.  They have essentially made it free to borrow money from the Federal Reserve.  Somehow, they have forgotten what got us here, cheap money.  Not only did they do that, but they pledged to buy all sorts of assets including Mortgage backed securities and U.S. Treasuries.  This now empties the gun of all the things the Fed has done, at least all the things that we can rationally expect.  God forbid if they come up with something more.

The saddest part of this all is that this is not going to work.  In fact, it will make the situation worse and prolong our problems.  Now, I have no doubt that we will see a small bump in the market.  In the short term, all this free money will have some positive effect on the economy.  But printing money never solved any problems and it will not solve this one.  How do I know?

The problem right now is not that there is not enough money out there.   The problem is that nobody trust the markets.  I am the Fed’s target.  They want people like me to start deploying the capital I have on the sidelines.  I have no skin in the game right now.   I do not own a house and I have lots of cash on the side.  It will not help to move the economy for people upside down in their house to just stay upside down in their house.  They need new demand to come to the market.  However, there is no chance that someone like me, someone who has had as much patience as I have till now, to come into the market anytime soon.

You see, I cannot get involved with a market that just wildly swings about.   The 5% move to the upside we saw today was just ludicrous.  Sane markets do not behave like this.  One of my larger positions in in UYG, the Double Long Financials.  It was up 20% today.  You would think I would be jumping up and down with joy but I am not.  As fast as it came today, it can go just as fast the other way, and there is no way for someone like me, someone who cannot sit in front of the computer all day, to safely get into this market.

All the Fed is doing is making it more difficult to trade.  They fired all their bullets early in the game and we still have a few innings left.  Now what happens when the next wave of bad news crosses the wires.  Believe me, there is more bad news coming, I have NO doubt about that.  There are more foreclosures and more job losses coming, more than most people expect.  The fed cannot cut rates anymore nor can they really buy any other asset class that will make any difference.  The dollar rally is now shot to hell and soon, foreign countries are going to lose interest in treasuries.  Then what?  Maybe the fed can just throw the gun.

The government is trying to do their best to create a plan to get us out of the mess that they put us in.  Still, nothing is passed yet so there may yet still be hope that they do the right thing which would be to do nothing.  I just find it very ironic that just six months ago, both Bush and Paulson told the American People we had no problems, and now we are suddenly on the precipice look straight at Doomsday.  It was a lie six months ago and its a lie today.  At least they are consistent.

The saddest part of the whole thing is that they obviously didn’t see it coming.  I mean seriously, how could you not.  They created this mess through their own actions.  Let us look back and see exactly how this happened.

In 1999, the government decides that  it would be a great idea if everyone could afford to buy a home.  This is an idiotic notion but it sounds good politically so the American people eat it up.  To enable this “plan” the government allows Freddie and Fannie to lend money to people with less than worthy credit.  Isn’t that nice?  Isn’t it great that we can enable the “American Dream” by allowing people to own things they can’t really afford?  This of course masks an even bigger problem.  These are Govermented Sponsored Enterprises.  This gives them an implicit backing of the government making people believe the government won’t let them fail.  Even worse, people get jobs there by political appointment, further insulating them from scrutiny.  But this is only one of many idiotic things that the government does.

In 2001, we have 9/11.  Fearing a massive recession, the government takes it upon itself to shore up confidence and lower interest rates to an insanely low level.  Rates basically go to 0 percent making the cost of captial very very cheap.  People can now get very low percentage mortgages.   Add this to the above, and you get people who shouldn’t be getting loans able to take how huge loans for very cheap.

Innovation now takes hold.  Financial engineering allowed financial institutions to take all these mortgages, package them up, and sell them off as securities.  They supposedly are able to create very “safe” assets by slicing and dicing them in a myriad of ways.  Of course, this also makes the security very hard to understand and greatly obscures who really owns what.  But becasue banks can do this, they no longer really care about making good loans.  There motives now move from making good loans, because they will eventually have to collect on these loans, to making as many loans as possible so that they can make these new fangled securities.  They don’t care if the payer never pays the money back becasue they already sold off the mortgage.  Of course this isn’t the governments fault, so I’ll give them a pass on this one.

Now the SEC gets involved.  There have historically been regulations that only allow banks to take on so much debt when compared to assets.  This limits their ability to use too much leverage.  Of course you remember how leverage works.   It allows you to greatly multiply your gains AND losses.  Of course, when it seems like housing prices can only go straight up, and people are making money hand over fist, the banks lobby to be allowed to use more leverage so they can make insane amounts of money.  Of course when things go south, they go south in a hurry too, which is exactly what we are seeing.  These banks were able to take huge positions on assets they don’t have, and thus make a situation that threatens the entire financial market.

So there you have it.  Giving way too much easy and cheap money to people who shouldn’t have it and have no accountability for when things go wrong.  Doesn’t that sound exactly what Paulson is asking for when he asks for $700 billion with no restrictions, no oversight and no accountability? How on earth does anyone think that will end up OK?  It of course won’t.  What will happen is that they will pass some form of bailout.  It won’t at all do what they want it to do.  In fact, its pretty easy to see some of the awful effects it will have.

At the very least, the dollar is going to go into the tank.  Inflation is inevitable.  We already owe way too much money to the rest of the world.  Now the government is going to essentially print money to pay for this plan.   This will have very negative effect.  Inflation is one of the worse things that can happen from an economic perspective.  This will also drag out the housing problems we are having now as markets will take longer to correct.  This is just prolonging the pain.  This will increase moral hazard thus creating a crisis even bigger the next time.

How do you play this?  Despite my earlier advice that the dollar was going up in the short term (thanks to a years of getting hammered and the rest of the world also slowing down) the dollar will fall.  Commodities now have a ways to go up, despite their highs.   So sell the dollar, buy commodities, and short the market.

A quick financial lesson. While this post may not seem relevant to me telling my back story, almost everything I talk about will be based on this concept, so pay attention. If you want to be rich, one of the most important things you will ever learn is the power of compound interest. This concept is best learned through example.

Let’s say you decide to invest in a Roth IRA, my favorite investment vehicle. You decide to start one today and invest the maximum $4,000 every year. You invest it wisely in an index fund that follows the total stock market which has historically returned 10% a year. In 40 years, your $4,000 a year, ($160,000 in principal payments) turns into $1,947,407.24, All of it tax free.

Now imagine if you were a good little saver and have saved the last 4 years. With a modest gain over the last few years you have $17,000 in your account. With the same investment strategy above you now have at the end of 40 years 2,716,814.59, All of it tax free. That is almost $800,000 difference for saving a little bit earlier. That $17,000 turned into $800,000!

Still not convinced? How about this? You do the above strategy from the ages of 25-35 and then stop. So for 10 years you invest $4,000 and then nothing after that. By the age of 65 you will have an account worth $1,223,633,58. Your $40K turned into $1.2 Million.

Or instead, you do nothing from the age of 25-35 and instead save from the age of 35-65 with the same strategy. Your final balance will be $723,773,70. Your $120K turned into $720K. Not bad until you consider that that’s a half-million dollar difference from the previous example of $1.2 Million! And you put in 1/3 the amount in principal and saved 3x as long!

The lesson? Save early, save often. I can’t stress this enough to my young friends. I know it is hard to save money now, but in the long run, it makes a BIG difference. This concept applies outside of finance as well. Doing the right things today, can pay big rewards tomorrow. You should always have an eye on the future and understand that small differences today, can have big repercussions in the future. This applies to you choosing what school to go to, what job to take, whether or not you should buy that new TV, pretty much everything you can think of. The younger you are, the more important this concept is. Understanding this at a very young age, helped me to get where I am today as I will explain shortly.