Inflation, Deflation and Financial Engineering

Stocks finished he week in fine fashion, ignoring the most obvious bad news: Bank of America needs another $20 billion and needs the Fed or Treasury to backstop even more huge potential losses; Citigroup is breaking up from the pressure of bad debts on its books; industrial production for December fell off another 2%, capacity utilization for the same period fell from 75.2% to 73.6%, and, deflation is alive and well, with the CPI dropping another 0.7% in December.

Noting that those aforementioned figures are supplied by corrupt, inept, spendthrift federal government agencies, the real condition is probably worse, though everybody loves the deflation idea. Everybody, that it, except the government and the Federal Reserve, both of whom are hell-bent on re-inflating the economy. They've been trying hard for months, however, to no avail, throwing money at banks and failing financial institutions, auto manufacturers, insurance companies and anybody else who seems in need of an additional $5 billion or more.

It's not working, and it won't. Here's why. Most of the money spent on bailing out banks and other businesses has been carefully squirreled away to enhance reserves, pay down some debt or other or fund continuing operations. For the money to actually result in inflation it needs to be put to new uses, or loaned, i.e., multiplied. Currently, the banks aren't interested in making new loans to anybody. They've been burned too badly by getting too close to that subprime fire, and now they're worried about other loans going bad, like credit cards, equity lines of credit, commercial real estate loans, to say nothing of the massive amounts (more than $2 trillion) of Alt-A and ARM mortgages due to reset in 2009-10.

The Fed, the government and Treasury, if they had an honest bone between them, would do what really would make the economy zip along: cut the payroll tax, institute usury laws (limiting the maximum interest rate chargeable by law) and let the failing banks (and other companies) be sold off in pieces and have new operators start over.

To get an idea of how one-sided and wrong the government help has been, consider that of the $350 billion already doled out via the TARP, all but $15 billion has gone to banks, financial firms and insurance companies (most of that to AIG). Today, electronics chain Circuit City announced that instead of reorganizing, it would liquidate, in effect, changing its bankruptcy status (filed in November) from Chapter 11 to Chapter 7, or, end of story for the company.

So, while the banks are "too big to fail," what about the 34,000 employees that Circuit City will furlough? And the leases that will not be paid on the huge space that each of the 571 stores it plans to close occupies? Those employees are out of work, the landlords are left with empty space. Too big to fail? Consider that at just an average of $23,000 (just a guess), those 34,000 out-of-work Circuit City employees will cause $782,000,000 in wages to go out of circulation over the course of the year. That's money that will not be spent in local economies, on rent, food, mortgages, utilities, gas, car payments, movie tickets, etc. The ripple effects from those 34,000 people being unemployed may be a lot worse than say, Citigroup going belly up, which, despite mountains of handouts from the feds, it did.

The bailouts are a bad idea made worse by the money going in the wrong places, to the wrong people. It's the working class that needs the money, that greases the wheels of the economy, that keeps America rolling. They've gotten nothing. Well, they'll get unemployment insurance (most of them), again, paid for with taxpayer dollars. If they had been bailed out and kept working, they'd be paying taxes, not draining the treasury.

Still, investors seemingly still believe in the big business that is Wall Street and the stock markets, which are dead, or at least dying. Looking over some charts of the Dow and S&P, in particular, there's a real possibility that stocks could decline much further from current levels. Try to wrap your mind around the Dow at 4000 and the S&P holding tight to a valuation of around 450.

The operative time period seems to be right around 1985, when Reagan tax policies began to take hold and the era of Wall Street greed took off in full flight. On January 2nd, 1985, the Dow opened at 1211.57, the S&P began the year trading at 167.20. At the peak in 2007, the dow was over 14,000, the S&P sailed as high as 1550.

Just a back-of-the-envelope calculation would conclude that the 30 stocks comprising the Dow increased in value over the 22+ years from 1985-2007 by a factor of 11.5. The more modest S&P companies only would have grown 9-fold in the same period. Are these companies worth 11 1/2 and 9 times what they were in 1985? Doubtful. Besides that, many of the losers have been taken out of the indices and replaced with more healthy firms. To get an idea, here are just some of the companies which were part of the Dow in 1985, and are no longer there: American Can, Bethlehem Steel, Eastman Kodak, General Foods, Goodyear, Inco, International Harvester, Owens-Illinois Glass, Sears Roebuck & Company, Westinghouse Electric, Woolworth. The entire index is periodically, carefully re-engineered to reflect a growing economy, when, in fact, companies coming into the index are growing by largely eating the remains of the companies being shown the door. Similar changes occur periodically in the S&P and other indices. It's all part of the Wall Street shell game.

So, even if these companies are worth 3-4 times what they were in 1985, which some may be, they are still, as a group, overvalued. Prior to August, 2007, they were massively overvalued. Today, they are only slightly overvalued, maybe by 35-60%. Still, as the year of 2009 drags onward and profits collapse, valuations will come back to reality.

The financial engineering which began in the Reagan years, took off during the Clinton era, soar and crashed in the Bush years, was a highly profitable venture for the insiders and those who traded smartly. Those still chasing profits today are, as they say, out of luck. The 9000 level on the Dow won't be seen again for another 3-5 years, at the earliest. By June, 8000 will look like a long way up. Stocks need to revert to reasonable, sustainable levels. And they will.

Nonetheless, investors saw to it to boost their fortunes (or bury them in more malinvestments) pumping stocks higher on Friday.

Dow 8,281.22, +68.73 (0.84%)
Nasdaq 1,529.33, +17.49 (1.16%)
S&P 500 850.12, +6.38 (0.76%)
NYSE Composite 5,387.50, +39.75 (0.74%)

On the day, advancers beat declining issues, 4020-2505. New lows were ahead of new highs, 163-20, which was less of a margin than yesterday. With no more trading prior to Inauguration Day (Monday is a holiday), stocks may get a temporary boost for a few days, though the news flows of poor corporate earnings are sure to keep any such Obama-rally brief.

Volume on Friday was the best seen in weeks, most likely tied to options expiry.

NYSE Volume 1,617,226,000
Nasdaq Volume 2,273,921,000

Commodity traders also got on the inflation fantasy train on Friday. Oil futures gained $1.11, to $35.97. Gold skyrocketed $33.60, to $839.90, while silver was also a star, gaining 78 cents, to $11.22. We knew silver was a good buy under $11, but we didn't think the payoff would come so soon. We'll be buying more at any price under $10.80, actually hoping it goes lower, because inflation is, at this juncture, a pipe dream.