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Market Commentary

August 2, 2009   David Kotok, Chairman & Chief Investment Officer

Genesis 1:31 says “And God saw every thing that he had made, and, behold, it was very good. And the evening and the morning were the sixth day.“  A few millennia later, we find that the world’s most popular book can be applied metaphorically to the US House of Representatives, as it labors in the creation of clunker-nomics.

The first billion voted by the Congress for the $4500 clunker rebate program was exhausted in 6 days.  Practicing for deity status, the House beheld and determined “it was very good.”  They immediately passed a $2 billion addition.  That bill now goes to the Senate, which will pass something similar, and then to a conference committee to resolve some differences about rules.  We expect additional funding will be forthcoming quickly.  Congress loves to spend and Americans love to receive.

In the spirit of Genesis, Adam and Eve American, otherwise affectionately known as John and Jane Doe, recognize a good deal when they see one.  They had an old clunker worth a few hundred.  Suddenly they can exchange it for $4500 if they buy the new one now.  The rest they can finance at very low interest rates, thanks to the Federal Reserve and the Treasury for extending TARP and other funds so that lenders can offer them liberal terms.  They seized the moment    who can blame them?

This will boost short-term activity in the US.  Neil Soss of Credit Suisse estimates, “Our math suggests that vehicle sales could spike in July, perhaps to a run rate near 12.5 million units (at a seasonally adjusted annual rate) from the 9.6mn average of Q2.”  He adds that “in response to cash-for-clunkers … the personal savings rate will drop sharply in the next months, even as the longer run trend is still headed higher.”  That will ramp up auto production in the 3rd quarter.  Neil concludes, “As a consequence, we are revising up our Q3 real GDP forecast to 2.0% (from 1.3%) and our Q4 forecast to 2.5% (from 2.0%).

Okay.  We know that older and fuel-inefficient cars are supposed to be scrapped.  That is supposed to be an environmental improvement.  And we know that the United Auto Workers like this stimulus, for obvious reasons.  So do the government-owned or government-sponsored auto manufacturers.  The last private firm, Ford, will benefit, too. 

Does the clunker stimulus result in enough gain to offset the net present value of the perpetual cost to finance it?  Fair question?  We think so.  Is there an answer?  Maybe, but the proof is very difficult to establish.  It you are interested in this discussion, invite a few friends over for a beer and talk about it.  But make sure the beer is brewed in America by the United Beer Brewer Workers.  And when you toast, toast Ford and be a patriot.

Did anyone ask how many of these car sales are being “borrowed from the future?”  We didn’t see it in the Congressional commentary.  If it was there, it did not influence the political decision. 

Has anyone looked at what we have done in a macro sense?  We will try.

The United States borrowed 1 billion dollars.  It is unlikely to ever pay it back.  The annual interest will add $50 million to the federal budget each and every year, forever.  We are assuming it is financed today with 30-year Treasury bonds.  The additional $2 billion of borrowed clunker money will add another $100 million in interest.  So clunker-nomics has committed the nation to make this interest payment forever.

Practicing an industrial policy by inserting government into a mixed economy is the new America.  No one measures the exchange of short-term gain being substituted for longer-term taxes or inflation or debt-burdened slower growth.  Those economists who are full believers in expectations analysis argue that the market will immediately adjust prices to reflect this exchange.  Maybe so in the mathematical models that they use to justify that argument.  

We think this expectations analysis fails in the real world.  Adam and Eve American are not economists.  They make their decisions for their individual benefit and in terms they can understand and assess.  They know what a $4500 free gift is.  They understand it.  They do not deal with trillions of dollars; they do not conduct ever-increasing auctions of Treasury notes and bonds; they do not deal in foreign exchange and reserve transfers.  That is not their fault.  The have daily lives to live and they are facing their own struggles. 

So they delegate some of these borrowing and spending decisions to the Congress because they have no other choice.  In the House the long term is limited to the two years until the next election cycle is faced.  So the House will easily exchange $1 billion in spending for $50 million in added budget interest.

Thus we have an asymmetric exchange.  We gratify now; we borrow to do it; we defer the day of reckoning; it grows bigger and bigger but seems to be perpetually deferred.  Every once in a while a crisis unfolds and the system fails, as it did with Lehman Brothers last September.  That triggers a new round of upward ratcheting of this asymmetric system. 

When does it end?  First question without an answer?  Will the end be fire, or ice?  Also, no answer.  What should we do to protect ourselves?  Much harder, but there are some answers.  Diversify worldwide.  Seek a mix of investing to protect wealth.  Lastly, enjoy life and the weekend in the spirit of Genesis.  Rest on the seventh day, if you can.

And remember that God gives you only so many days on the planet but doesn’t count the ones you spend fishing.  We will wink at CNBC viewers on Friday, August 7 from Leen’s Lodge at the annual Shadow Fed fishing retreat, where 35 of us will debate and dissect asymmetric information and deficit finance.  For now, we hope your seventh day is restful for you. 

A further unsettling factor is the large number of companies planning to list for the first time. The ban on new listings was lifted by Beijing in June. The first new listing on the Shanghai exchange in over a year, the Sichuan Expressway, more than tripled upon its debut. This is seen as an indication of the readiness of Chinese investors to speculate.

Going forward, while we would not characterize this year’s advance of the Hong Kong H share market or even that of the Shanghai A share market as having reached bubble proportions, the latter market certainly has become “frothy,” and the risk of a bubble developing is significant.  The Chinese bull market still has legs and probably will continue for some time yet. But the road ahead looks likely to be a more volatile one. In view of the growing risk of a correction in the A-share market that would spill over to the Hong Kong H share market, we have reduced the China overweight positions in Cumberland’s international portfolios back to close to benchmark levels.

David Kotok, Chairman & Chief Investment Officer