Let me first begin with the end and go straight to the conclusion of this letter:

1. 1. If you are an investor:

• Choose your levels in your asset classes, sectors, and securities
• Enter your trades
• Turn off your TV for the next year until after the Presidential elections

1. 2. If you are a speculator:

• Buy every book you can on John Maynard Keynes with a focus on his years as a speculator (as an economist he walked his talk)
• Get ready to meaningfully trade for the next year and a half

1. 3. If you are neither of the above then you have much larger concerns



This was, to say the least, an interesting summer.  As many of you know, I endeavor each year to take the month of August off.  But, being the slow learner that I sometimes am, after the past seven plus years I began noticing that the markets almost always exhibited extraordinary volatility during August.  Therefore my antennae were especially attuned this year to any market disturbance.

My family and I had originally intended to go to Barcelona.  My wife had the home there ready to rent, the kids read the Frommers guides, and we all watched the videos.  But, about a week beforehand it didn’t feel right.  So we cancelled it.  One week later the ECB began rumbling again and it continues to today.

We are now heading, again, straight into another storm.  While I could list the litany of issues that concern me, I am more worried about them occurring at once.  Howard Marks of Oaktree aptly said:

“Markets usually do a pretty good job of coping with problems one at a time. When one arises, analysts analyze and investors reach conclusions and calmly adjust their portfolios. But when there’s a confluence of negative events, the markets can become overwhelmed and lose their cool. Things that might be tolerable individually combine into an unfathomable mess whose extent and ramifications seem beyond analysis. Market crises are chaotic, not orderly, and the multiplicity and simultaneity of contributing causes play a big part in making them so.” (*Thanks to John Mauldin for this quote)

At SoHo we are preparing for the worst. As we did in 2008, we have done the following:

1. We have lined up additional custodians. We are prepared to move your accounts immediately if needed and have already begun shifting some of you from some of the weaker custodial hands we are concerned about (you’ll recall that in 2008 we were trading custodians almost as fast as we were trading securities).
2. We have prepared your investment portfolios. We have positioned the portfolios defensively to withstand the shocks we foresee coming.
3. We are encouraging you to have the necessary cash at hand. Even though we are positioning the investment portfolios defensively, you need to be mindful of where your cash is, and who it is with.  In some cases, we do not have access to those accounts to assist you.  We are speaking with each of you in our wealth management practice area to make certain that you have the cash levels necessary to ride out a potential credit crisis.  If you haven’t already, please contact us at 866-294-7913 x201, or email Alfred Mai amai@sohocap.com to schedule a call and review with one of our analysts.

Like Odysseus riding through the Sirens, as your crew we know the ship will be secure, we have the entire crew ready, but our biggest concern now is your personal well being.  The next year and a half may be brutally volatile and you may be tempted to respond as such.

As this is my first letter/email following the summer break, I’d like to take a somewhat different tack from other market letters.  I personally don’t see the need to highlight any further my concern about the crisis.  You’ll be subjected to enough of that over the next year and a half.

Unlike 2008, this crisis we can see coming and we are all mentally adjusting for its onset.  Yet, I have noticed a surreal backdrop this time:  We are all comfortable with just how negative it could be.  Whereas in 2007 we were all gleefully participating in the market’s rally while ignoring the obvious signs of crisis, today we are now ready.  It is almost as if we are slowly tracking up a roller coaster with a building sense of anticipation for the severe drop to come.  We have now somehow adjusted to the potential significance of this crisis.  Just several years ago the disappearance of Bear Stearns and Lehman (forget simply “failing”) were unfathomable and not something anyone had expected.  Now, any institution may be fair game again and we realize that.

One of the books that had a profound impact on my summer reading (a list of all the books I read that I thought you might like I have at the end of this letter) was Lords of Finance: The Bankers Who Broke the World by Liaquat Ahamed (again, many thanks to the client who so strongly recommended it to me).  In my humble opinion, we are in a similar market environment reminiscent to me of post WWI Europe, where the die has clearly been set against us and the future is almost inevitable.

I thought it might be worthwhile instead to play devil’s advocate and really ask ourselves, why after the worst crisis since the Great Depression are we here again so quickly?

I would argue that we now have the confluence of three great events.  One, a true credit crisis in Europe, that in and of its own, should be everyone’s only focus.  Two, a painfully lingering recession in America; and, three (why stop at two) we have an election cycle coming; and so we created one here as well.

Let me ask: Is this in fact the next Great Depression?  Reinhart and Rogoff in their terrific book This Time is Different (which is economic sarcasm as they show how we have seen this all before) describe it as the “Second Great Contraction.”

I would suggest another theory.  Following WWI Europe destroyed its manufacturing capacity, incurred exorbitant debt, and wiped out a generation of workers.  Who benefitted?  The United States.  We entered the war late, lent the money, and built what Europe no longer had the capacity to build.  As the Treaty of Versailles created the environment for WWII, the vicious cycle of destruction started again. We entered the war late, lent the money, and built what Europe no longer had the capacity to build.  Look back at any economic chart of that time and notice the substantial growth of GDP; and the advent of the Baby Boomer.

In each case, the world wars irrevocably devastated Europe.  The first begat a treaty of usurious debt re-payments, which then led to the Depression (some argue that it wasn’t the Crash that caused it but rather an Austrian bank failure), and we then had World War II.

Contrast that post WWI environment against the United States today.  We have wiped out a generation of workers, we have borrowed enormous sums of money, and we no longer manufacture much of anything anymore.

Of the estimated 20+% unemployed today…is there any real chance that anyone will come back to work?  Bank of America is now assessing the viability of laying off 40,000 workers!  (http://online.wsj.com/article/SB10001424053111904103404576559062120847764.html); where will these workers go?  There is no financial services firm to go to for their next job!

Accordingly, as we now have seen the construction, financial services, and manufacturing capacity of the U.S. economy decimated…are those jobs really going to come back?  Or have we, like Europe in WWI and WWII, wiped out our manufacturing capacity, lost a generation of workers, and found ourselves now the borrower?  The answer is intuitively clear.  I have attached a slightly more “optimistic view from Simon Johnson of the IMF: http://economix.blogs.nytimes.com/2011/08/18/a-second-great-depression-or-worse/

Add to that horrible economic picture our flawed political process.  Many commentators argued that we need look no further than the S&P downgrade of the U.S. debt to compare ourselves against other political systems.  Fareed Zakaria had a notable blog post and television segment on August 21, 2011 (http://globalpublicsquare.blogs.cnn.com/category/gps-episodes/) wherein he suggested a parliamentary system might be better for the reform we need.

For those of you who know me, I regrettably have my fair share of political scar tissue.  From that I have learned quite clearly that the political process is devoid of any rational thought.  It is a separate and different ecosystem.  That said, we are now entering an election cycle and that process is now beginning.  As Rahm Emanuel taught the Republicans so well when President Obama was elected:  “You never let a serious crisis go to waste. And what I mean by that it’s an opportunity to do things you think you could not do before.”

Somewhere in the Republican political math it was concluded that the debt ceiling would be the crisis to create.

I agree with Gary Becker’s analysis in The Wall Street Journal (http://online.wsj.com/article/SB10001424053111904199404576536930606933332.html) regarding market systems in comparison to the government, but I don’t feel that this was a passive failure.  The data points to this being a political “crisis” engineered to create a sentiment level for a new majority in the Senate and maybe even the Oval Office.  President Obama was careful in his recent speech to use previously acceptable republican measures to present as a solution.  As logical as some of his suggestions may be, he will face the logic of an election cycle (http://online.wsj.com/article/SB10001424053111903895904576544584252374732.html)

I regrettably believe that the politics will drive the agenda, and we will fall perilously close to the brink again.  Recently, Mike Lofgren wrote a chilling piece in Truthout (http://www.truth-out.org/goodbye-all-reflections-gop-operative-who-left-cult/1314907779) that highlighted the GOPs ambitions.  If executed, left in its wake will be any semblance of a recovery in the next 12-18 months.  This GOP strategy is dangerous, and some would argue unbelievably irrational, against the backdrop of a collapsing European banking system and a U.S. recession.  But we have a precedent as we all saw what they did with regards to S&P’s warnings.

Let’s look at some of the scenarios, or rather ask, who will be first?

• Does Germany refuse to come up with an agreeable plan for the ECB and EU to survive?  If not, does the contagion come here, and if so to what degree?
• Will a lack of political will to address the housing/jobs market here in the United States continue for at least another 12+ months until we have a new President?
• Is the Republican Party so focused on winning the Senate and Presidency that they will sacrifice anything to get it?  Including the middle class?

All of this paints a rather sordid picture of the future.  Or does it?  Using our analogy to Odysseus, we have done everything we can to make sure that your portfolios are safe, we have the right crew for the ship and it is in good condition, but where do we go?

Does this mean there is no investment that is safe?  Or, is it as simple as looking at who lent us the money?  Today, our world has shifted to a clear paradigm of creditor and debtor nations.  Ray Dalio of Bridgewater, the world’s largest hedge fund with over $120 billion in assets, did an excellent job of explaining this in Bloomberg magazine:

Dalio divides the world into two groups.  Here’s how he describes the first, developed debtor nations (the U.S, Greece, Spain, and Italy, for example):

• They spent years overspending, financed by their government’s borrowing
• They are in the process of deleveraging debt
• As a result, they are being forced to lower their debt relative to their income levels, constrain spending levels and make improvements in the job market
• Some are worse off than others. Greece, Spain and Italy, for example, can’t print money to pay off their debts. To make up for slow credit growth, they will have decade-long depressions and debt defaults.
• The U.S. is trading like a country in decline

The second are emerging creditor countries (Brazil, India and China, for example). Here’s what’s happening there:

• They are leveraging up
• They will account for 70% of global GDP in 15 to 20 years versus 47% now. Read: They will be tomorrow’s economic leaders.
• Some, such as India and China, have currencies and monetary policy linked to those in the U.S. They are experiencing inflation because their interest rates are too low. They will have to unlink from the U.S. or face intolerable conditions.
• They are trading more like blue chips

It is easy as Americans to fall into the trap of a US-centric view.  Yet, there are places globally where there is growth, it just isn’t here.  As investors we have to distill the noise of our “local” national economy that is in a massive deleveraging cycle that will take years to adjust and we need to re-allocate to growth.

At a sovereign level this trend is apparent in multiple forms.  Despite our nation’s public statements to the contrary, it is clear to all that the US’ policy is one of inflating itself out of this problem.  As Henny Sender wrote in the Financial Times (http://www.ft.com/intl/cms/s/0/7484ec1c-cfce-11e0-a1de-00144feabdc0.html#axzz1XUxnWs4k ):

Given the assumption that the dollar will depreciate and that the US government will issue far more debt to inflate its way out of its fiscal hole, investors from abroad are likely to seek to purchase more hard assets and fewer financial investments.

Is this just China’s view?  Or are there other nations viewing the problem the same way?  The press has not really followed an intriguing Venezuelan story.  Hugo Chavez, in his “hedge” against “Libya-like risk” is requesting to move all of his physical gold out of England!

http://www.bloomberg.com/news/2011-08-18/chavez-emptying-bank-of-england-vault-as-venezuela-brings-back-gold-hoard.html

Venezuelan President Hugo Chavez ordered the central bank to repatriate $11 billion of gold reserves held in developed nations’ institutions such as the Bank of England as prices for the metal rise to a record.

Venezuela, which holds 211 tons of its 365 tons of gold reserves in U.S., European, Canadian and Swiss banks, will progressively return the bars to its central bank’s vault, Chavez said yesterday. JPMorgan Chase & Co. (JPM), Barclays Plc (BARC), and Standard Chartered Plc (STAN) also hold Venezuelan gold, he said.

“We’ve held 99 tons of gold at the Bank of England since 1980. I agree with bringing that home,” Chavez said yesterday on state television. “It’s a healthy decision.”

Chavez, whose government depends on oil for 95 percent of its export revenue, is looking to diversify Venezuela’s cash reserves from U.S. and European banks to include investments in emerging markets including Brazil, China, India, Russia and South Africa, central bank President Nelson Merentes said yesterday. The world’s 15th-largest holder of gold is bringing back its gold after a 28 percent rally in the price this year.

Can you imagine the logistics of moving that amount of physical gold?  If you have the time, there are some great insurance stories (quick conclusion…it’s not insurable!), and transport issues surrounding this that you should research on Google.  Goldfinger 2 anyone?

At SoHo we are implementing a tilt towards hard assets in our portfolios and we will accomplish through a) our existing portfolio construction and b) through dedicated strategies.  As when we had a large energy bias, this one is also an exposure we don’t like, given that its premise is a negative one.  But we’d be remiss if we didn’t acknowledge it.

I was able, in some of this chaos to find themes that intrigued me and afforded me some optimism.  One, which was tragically ironic, was Steve Job’s announcement.  It gave me significant pause as I recalled his professional career.  When you reflect back on all he accomplished with the personal computer, and technological and cinematic innovation, who better to be the Henry Ford of our generation?

Look at the massive change he created.  I love using the Flip camera story (made obsolete by the iPhone), or the pre-cursor to Twitter (made obsolete by the iPod), as examples of how technological innovation can bring massive change and disruption.  Take a moment and look at the past few months:  Egypt, Libya, Syria, and the U.K.?  In the old days, a totalitarian regime could simply annihilate the opposition through brutal violent force.  What has changed?  Technology.

In the past, the war began with the technique to immediately knock out command and control centers, airdrop a bunch of leaflets over the populace, announce over the radio that you were in charge, and your armies could roll in.  Today, all it takes is one text message to tell everyone where the tanks are.

Technology begat us flash drives and flash memory.  The market has given us flash crashes and now we have political flash mobs.

Any student of economics knows that fundamental change is never a smooth statistical progression.  It involves enormously volatile, and sometimes chaotic, violent, change.  This change is now in front of us.  Marc Andreesen did an excellent job in this recent op-ed of highlighting the extraordinary opportunity in software (http://online.wsj.com/article/SB10001424053111903480904576512250915629460.html)

I took comfort in Reinhart and Rogoff this summer, as we have been here before.  Key to our success will be our recognition of what is in front of us for the next 12-18 months, and realistically and pragmatically preparing for it.  I ask you to consider, what if Europe finally fixed its problems with some of the rational solutions that have been presented by the Dutch?  What if the U.S. developed the political will to a) agree and b) develop a plan?

Just like that, we could begin the process of recovery without the vitriol.

To balance the somewhat negative tone of this letter’s beginnings, I conclude here with a video that I think subtly contradicts Ms. Stein’s quote at the beginning.  We have it within us to fix this.  Lost Generation:  http://www.youtube.com/watch?v=42E2fAWM6rA

With warm regards,

Frank T. Troise

Senior Portfolio Manager

The Summer “August” Reading List

With my iPad and Kindle application, I am cruising through books now even faster than just the Amazon Kindle!  As always, please send me suggestions for any materials/books you feel of note.  Your input and suggestions are always greatly appreciated!

Lords of Finance: The Bankers Who Broke the World, by Liaquat Ahamed

On China, by Henry Kissinger

Diffusion of Innovations, by Everett M. Rogers

The Great Stagnation, by Tyler Cowen

This Time is Different, by Reinhart and Rogoff

Little Bets, by Peter Sims

Inside Steve’s Brain, by Leander Kahney

The Pixar Touch, by David A. Price

1939, Countdown to War, by Richard Overy

In the Garden of Beasts, by Erik Larsen

The Tower Treasure , by Franklin W. Dixon (Spencer’s pick for me, his dad!)

From The New York Times:

Retirement funds aren’t required to offer you a cash-equivalent investment option.

http://nyti.ms/rpdBbd

Many of you know that I have become fascinated about pre-World War II Germany and the rise of Hitler. Part of the catalyst for this recently was The Lords of Finance. I hope you had a chance to buy it, as all it took to create the Great Depression was the failure of one Austrian bank! What chance do we have if the ECB collapses?

Yet, in markets such as these, I am not worried (yet) about any systemic risk…at least not now.

However, I am worried about the demagogic vitriol the major networks are spouting and how terrifying this is for the average investor. All the media is creating now is an irrational frenzy that is inevitably causing today’s Boomer to fall even deeper and darker hole. With frustration boiling over the news media (http://www.youtube.com/watch?v=wpfXjGrRGI4&feature=youtube_gdata_player Dylan Ratigan rant), it seems inevitable that a climate of irresponsibility is taking over. How many of us continued to be shocked and saddened by the riots in London? This from the society we consider a close friend of the United States? http://www.stratfor.com/analysis/20110812-agenda-george-friedman-crisis-political-economy

These events prove terrifying and unsettling. At the same time, they create investing opportunities. How many of us heard people who wished they “bought in 2008/2009″ and didn’t? Fortunes were made by the patient. Noted billionaire Wilbur Ross was quoted in Bloomberg this week: “Has the world really gotten 10, 12, 15 percent worse in the last 48 hours? I don’t think so,” Ross said. “Buying stocks at today’s prices over a couple of years’ time period will prove to be a uniquely rewarding experience.”

At SoHo we received a unique and unexpected benefit this week from Mr. Bernanke as he drastically lowered rates until 2013. We had held short maturities for some time now and were pleasantly surprised to receive a “gain” from Fed policy. Now that T-bills are a new form of cash currency (can they fit in one’s wallet?), how long before the bond market validates our other key thesis: Inflation has to occur, either a) as a matter of policy or b) the markets will unleash it. (http://www.nytimes.com/2011/08/12/business/sometimes-inflation-is-not-evil.html?_r=1)

This week’s auction of 30-year Treasuries was all the confirmation we needed.

http://www.ft.com/intl/cms/s/0/63bf4174-c165-11e0-b8c2-00144feabdc0.html#axzz1Urb8NkEj

Financial Times, 2:06pm Thursday 11th August 2011 US stocks surge as Treasury yields soar

Cash-rich investors choose crazy Treasury returns

http://www.ft.com/intl/cms/s/0/d5733486-c42d0in0-ad9a-00144feabdc0.html

Now, my wife sometimes teases me that I do not listen that well. But when the Federal Reserve (and Treasury) do not want you buying US Treasuries, when the world’s largest money manager (and who started in fixed income) Larry Fink is also saying that bonds are not a good investment (the bond guys says to buy stocks http://online.barrons.com/article/SB50001424052702303960104576498463368504044.html#articleTabs_panel_article%3D1), and corporate insiders are now buying their company stocks (Insiders Buying at Highest Rate Since March 2009 as Stocks Drop 8/11/11 BloombergSixty-six insiders at 50 companies bought shares between Aug. 3 and Aug. 9, the most since the five days ended March 9, 2009, when the benchmark index for U.S. equities reached a 12- year low, according to data compiled by Bloomberg.), that’s usually a “sign;” even for someone as deaf as me.

At SoHo we haven’t lost sight of the larger issue. Our country today is faced with an enormous problem that it has yet to grapple with. But the signs of the stress are beginning to permeate through (http://www.nytimes.com/2011/08/13/us/13bankruptcy.html rhose island pension bankruptcy).

We do not believe in a US economic recovery and we have positioned ourselves accordingly; and we do not believe that US Treasuries represent an investment, and therefore we do not own them.

We believe that over the next 2-3 years there is the opportunity vis-à-vis our friends at the Fed, to own risk assets again. Let’s do so and then look at bonds again in 2014-2015. Until then, it may be worthwhile to go to Brazil! (http://www.nytimes.com/2011/08/13/world/americas/13brazil.html land of the $35 martini)

Source: http://www.bloomberg.com/news/2011-08-11/insiders-buying-stock-at-highest-rate-since-march-09-as-s-p-500-drops-18-.html

Aug. 11 (Bloomberg) — More executives at Standard & Poor’s 500 Index companies are buying their stock than any time since the depths of the credit crisis after valuations plunged 25 percent below their five-decade average.

Sixty-six insiders at 50 companies bought shares between Aug. 3 and Aug. 9, the most since the five days ended March 9, 2009, when the benchmark index for U.S. equities reached a 12- year low, according to data compiled by Bloomberg. Morgan Stanley Chief Executive Officer James Gorman and two other managers purchased 175,000 shares of the New York-based bank as the shares fell to the lowest level since March 2009, according to filings with the U.S. Securities and Exchange Commission.

Almost $3 trillion has been erased from U.S. equity values in the last three weeks as signs the economy is slowing and S&P’s downgrade of the government’s AAA credit rating left the benchmark gauge for U.S. shares within 30 points of a bear market. Some analysts say insider buying is bullish because executives have the best information about their prospects.

“Nobody knows a company better than the people running it,” Shawn Price, who manages $2.4 billion at Navellier & Associates Inc. in Reno, Nevada, said in a telephone interview. “It’s a positive sign that they are committing their personal capital.”

Stocks Drop

CEOs, directors and senior officers bought stock as the S&P 500 fell 18 percent from this year’s high on April 29 on concern about Europe’s debt crisis and the political battle over the U.S. debt ceiling. The index is trading at 12.3 times earnings in the past year, compared with its average since 1954 of 16.4, data compiled by Bloomberg show.

Gorman’s purchase of 100,000 shares was his first since joining Morgan Stanley in 2006 and the biggest stock acquisition among the firm’s executives in more than four years, according to Princeton, New Jersey-based InsiderScore.com, which analyzes insider transactions. Chief Financial Officer Ruth Porat and Paul J. Taubman, co-head of the firm’s investment bank, also bought stock.

Morgan Stanley fell 19 percent from July 21 through Aug. 4, the day of Gorman’s purchase. It has lost 17 percent since, falling to $16.45 yesterday, the lowest level since January 2009, data compiled by Bloomberg show.

General Motors Co. CEO Dan Akerson purchased $250,500 in shares of the automaker on Aug. 9, a day before the stock fell 6.3 percent to $23.92, the lowest level since its November initial public offering and down 35 percent for 2011. Akerson bought 10,000 shares for $25.05 each, bringing his total to 103,600, Detroit-based GM said in a regulatory filing.

MEMC Electronic

CEO Ahmad Chatila and five other officers at MEMC Electronic Materials Inc., which has a price-earnings ratio of 8.4, bought a combined 468,057 shares of the silicon-wafer maker on Aug. 5, when the stock sank to the lowest level since October 2002, regulatory filings showed. Shares of the St. Peters, Missouri-based company rallied 19 percent to $5.93 on Aug. 9, when the transactions were disclosed.

Robert Hugin, the chairman and CEO of Summit, New Jersey- based Celgene Corp., bought shares of the maker of blood-cancer drugs for the first time since at least 2003, according to data compiled by InsiderScore. Hugin acquired 10,000 shares on Aug. 8, when the stock fell to a five-month low, while Chief Financial Officer Jackie Fouse bought shares three times this month, according to SEC filings. The stock climbed 4.2 percent on Aug. 9 and closed at $51.85 yesterday, down 12 percent for the year, data compiled by Bloomberg show.

Insiders Buying

A total of 919 insiders bought stock among all publicly listed U.S. companies between Aug. 1 and yesterday, data compiled by InsiderScore show. That compares with a monthly average of 1,065 transactions in data going back to January 2004. About 1,390 insiders bought during the first 10 days of March 2009, InsiderScore data show.

Executives at 14 S&P 500 companies sold shares between Aug. 3 and Aug. 9, according to Bloomberg data, bringing the ratio of those with buyers and those with sellers to 7 to 2. Since the beginning of 2004, there have been on average 3.08 companies in the S&P 500 with sellers for every company with buyers, according to InsiderScore.

“It’s a fire sale and the insiders are stepping up to buy at these prices,” Daniel Genter, who oversees about $3.7 billion as president of Los Angeles-based RNC Genter Capital Management, said in a telephone interview. “The insiders are saying that the lower valuation is unreasonable because they believe the earnings power of their companies is likely to go up.”

Rising Profits

Earnings per share increased 17 percent among the S&P 500 companies that have released quarterly results since July 11, according to data compiled by Bloomberg. About three-quarters of the companies have topped the average analyst profit forecast, the data show. Sales rose 13 percent during that period.

Insider behavior doesn’t always foreshadow stock moves, according to Michael Yoshikami, chief investment strategist at YCMNet Advisors. Selling by S&P 500 executives reached a record in November as the index was in the midst of a 33 percent rally from July 2 to April 29, 2011. They increased sales in August 2009 when the S&P 500 was halfway through an advance in which it doubled, data compiled by Bloomberg and InsiderScore show.

“It’s not a perfect indicator,” Yoshikami, who manages about $1 billion in Walnut Creek, California, said in a telephone interview. “Insiders can be wrong and get carried away by emotion. Just think about all the technology executives who didn’t sell at the highs because they were overly optimistic.”

The end of earnings season leads to an increase in insider transactions because executives are prevented from buying or selling before announcements, according to Ben Silverman, the Seattle-based research director at InsiderScore. Of the companies in the S&P 500, 427 have reported results since July 11, according to data compiled by Bloomberg.

U.S. laws require executives and directors to disclose stock purchases or sales within two business days. The data don’t include transactions related to options and so-called 10b5-1 programs, which allow executives to cash out a portion of their holdings when stocks reach predetermined prices.

To contact the reporters on this story: Nikolaj Gammeltoft in New York at ngammeltoft@bloomberg.net Lu Wang in New York at lwang8@bloomberg.net

To contact the editor responsible for this story: Michael P. Regan at mregan12@bloomberg.net

Find out more about Bloomberg for iPad: http://m.bloomberg.com/ipad/

The current crisis must be understood as a global event with one overriding theme: the relationship between the political order and economic life.

Source: http://www.stratfor.com/weekly/20110808-global-economic-downturn-crisis-political-economy
By George Friedman

Classical political economists like Adam Smith or David Ricardo never used the term “economy” by itself. They always used the term “political economy.” For classical economists, it was impossible to understand politics without economics or economics without politics. The two fields are certainly different but they are also intimately linked. The use of the term “economy” by itself did not begin until the late 19th century. Smith understood that while an efficient market would emerge from individual choices, those choices were framed by the political system in which they were made, just as the political system was shaped by economic realities. For classical economists, the political and economic systems were intertwined, each dependent on the other for its existence.

The current economic crisis is best understood as a crisis of political economy. Moreover, it has to be understood as a global crisis enveloping the United States, Europe and China that has different details but one overriding theme: the relationship between the political order and economic life. On a global scale, or at least for most of the world’s major economies, there is a crisis of political economy. Let’s consider how it evolved.

Origin of the Crisis

As we all know, the origin of the current financial crisis was the subprime mortgage meltdown in the United States. To be more precise, it originated in a financial system generating paper assets whose value depended on the price of housing. It assumed that the price of homes would always rise and, at the very least, if the price fluctuated the value of the paper could still be determined. Neither proved to be true. The price of housing declined and, worse, the value of the paper assets became indeterminate. This placed the entire American financial system in a state of gridlock and the crisis spilled over into Europe, where many financial institutions had purchased the paper as well.

From the standpoint of economics, this was essentially a financial crisis: who made or lost money and how much. From the standpoint of political economy it raised a different question: the legitimacy of the financial elite. Think of a national system as a series of subsystems — political, economic, military and so on. Then think of the economic system as being divisible into subsystems — various corporate verticals with their own elites, with one of the verticals being the financial system. Obviously, this oversimplifies the situation, but I’m doing that to make a point. One of the systems, the financial system, failed, and this failure was due to decisions made by the financial elite. This created a massive political problem centered not so much on confidence in any particular financial instrument but on the competence and honesty of the financial elite itself. A sense emerged that the financial elite was either stupid or dishonest or both. The idea was that the financial elite had violated all principles of fiduciary, social and moral responsibility in seeking its own personal gain at the expense of society as a whole.

Fair or not, this perception created a massive political crisis. This was the true systemic crisis, compared to which the crisis of the financial institutions was trivial. The question was whether the political system was capable not merely of fixing the crisis but also of holding the perpetrators responsible. Alternatively, if the financial crisis did not involve criminality, how could the political system not have created laws to render such actions criminal? Was the political elite in collusion with the financial elite?

There was a crisis of confidence in the financial system and a crisis of confidence in the political system. The U.S. government’s actions in September 2008 were designed first to deal with the failures of the financial system. Many expected this would be followed by dealing with the failures of the financial elite, but this is perceived not to have happened. Indeed, the perception is that having spent large sums of money to stabilize the financial system, the political elite allowed the financial elite to manage the system to its benefit.

This generated the second crisis — the crisis of the political elite. The Tea Party movement emerged in part as critics of the political elite, focusing on the measures taken to stabilize the system and arguing that it had created a new financial crisis, this time in excessive sovereign debt. The Tea Party’s perception was extreme, but the idea was that the political elite had solved the financial problem both by generating massive debt and by accumulating excessive state power. Its argument was that the political elite used the financial crisis to dramatically increase the power of the state (health care reform was the poster child for this) while mismanaging the financial system through excessive sovereign debt.

The Crisis in Europe

The sovereign debt question also created both a financial crisis and then a political crisis in Europe. While the American financial crisis certainly affected Europe, the European political crisis was deepened by the resulting recession. There had long been a minority in Europe who felt that the European Union had been constructed either to support the financial elite at the expense of the broader population or to strengthen Northern Europe, particularly France and Germany, at the expense of the periphery — or both. What had been a minority view was strengthened by the recession.

The European crisis paralleled the American crisis in that financial institutions were bailed out. But the deeper crisis was that Europe did not act as a single unit to deal with all European banks but instead worked on a national basis, with each nation focused on its own banks and the European Central Bank seeming to favor Northern Europe in general and Germany in particular. This became the theme particularly when the recession generated disproportionate crises in peripheral countries like Greece.

There are two narratives to the story. One is the German version, which has become the common explanation. It holds that Greece wound up in a sovereign debt crisis because of the irresponsibility of the Greek government in maintaining social welfare programs in excess of what it could fund, and now the Greeks were expecting others, particularly the Germans, to bail them out.

The Greek narrative, which is less noted, was that the Germans rigged the European Union in their favor. Germany is the world’s third-largest exporter, after China and the United States (and closing rapidly on the No. 2 spot). By forming a free trade zone, the Germans created captive markets for their goods. During the prosperity of the first 20 years or so, this was hidden beneath general growth. But once a crisis hit, the inability of Greece to devalue its money — which, as the euro, was controlled by the European Central Bank — and the ability of Germany to continue exporting without any ability of Greece to control those exports exacerbated Greece’s recession, leading to a sovereign debt crisis. Moreover, the regulations generated by Brussels so enhanced the German position that Greece was helpless.

Which narrative is true is not the point. The point is that Europe is facing two political crises generated by economics. One crisis is similar to the American one, which is the belief that Europe’s political elite protected the financial elite. The other is a distinctly European one, a regional crisis in which parts of Europe have come to distrust each other rather vocally. This could become an existential crisis for the European Union.

The Crisis in China

The American and European crises struck hard at China, which, as the world’s largest export economy, is a hostage to external demand, particularly from the United States and Europe. When the United States and Europe went into recession, the Chinese government faced an unemployment crisis. If factories closed, workers would be unemployed, and unemployment in China could lead to massive social instability. The Chinese government had two responses. The first was to keep factories going by encouraging price reductions to the point where profit margins on exports evaporated. The second was to provide unprecedented amounts of credit to enterprises facing default on debts in order to keep them in business.

The strategy worked, of course, but only at the cost of substantial inflation. This led to a second crisis, where workers faced the contraction of already small incomes. The response was to increase incomes, which in turn increased the cost of goods exported once again, making China’s wage rates less competitive, for example, than Mexico’s.

China had previously encouraged entrepreneurs. This was easy when Europe and the United States were booming. Now, the rational move by entrepreneurs was to go offshore or lay off workers, or both. The Chinese government couldn’t afford this, so it began to intrude more and more into the economy. The political elite sought to stabilize the situation — and their own positions — by increasing controls on the financial and other corporate elites.

In different ways, that is what happened in all three places — the United States, Europe and China — at least as first steps. In the United States, the first impulse was to regulate the financial sector, stimulate the economy and increase control over sectors of the economy. In Europe, where there were already substantial controls over the economy, the political elite started to parse how those controls would work and who would benefit more. In China, where the political elite always retained implicit power over the economy, that power was increased. In all three cases, the first impulse was to use political controls.

In all three, this generated resistance. In the United States, the Tea Party was simply the most active and effective manifestation of that resistance. It went beyond them. In Europe, the resistance came from anti-Europeanists (and anti-immigration forces that blamed the European Union’s open border policies for uncontrolled immigration). It also came from political elites of countries like Ireland who were confronting the political elites of other countries. In China, the resistance has come from those being hurt by inflation, both consumers and business interests whose exports are less competitive and profitable.

Not every significant economy is caught in this crisis. Russia went through this crisis years ago and had already tilted toward the political elite’s control over the economy. Brazil and India have not experienced the extremes of China, but then they haven’t had the extreme growth rates of China. But when the United States, Europe and China go into a crisis of this sort, it can reasonably be said that the center of gravity of the world’s economy and most of its military power is in crisis. It is not a trivial moment.

Crisis does not mean collapse. The United States has substantial political legitimacy to draw on. Europe has less but its constituent nations are strong. China’s Communist Party is a formidable entity but it is no longer dealing with a financial crisis. It is dealing with a political crisis over the manner in which the political elite has managed the financial crisis. It is this political crisis that is most dangerous, because as the political elite weakens it loses the ability to manage and control other elites.

It is vital to understand that this is not an ideological challenge. Left-wingers opposing globalization and right-wingers opposing immigration are engaged in the same process — challenging the legitimacy of the elites. Nor is it simply a class issue. The challenge emanates from many areas. The challengers are not yet the majority, but they are not so far away from it as to be discounted. The real problem is that, while the challenge to the elites goes on, the profound differences in the challengers make an alternative political elite difficult to imagine.

The Crisis of Legitimacy

This, then, is the third crisis that can emerge: that the elites become delegitimized and all that there is to replace them is a deeply divided and hostile force, united in hostility to the elites but without any coherent ideology of its own. In the United States this would lead to paralysis. In Europe it would lead to a devolution to the nation-state. In China it would lead to regional fragmentation and conflict.

These are all extreme outcomes and there are many arrestors. But we cannot understand what is going on without understanding two things. The first is that the political economic crisis, if not global, is at least widespread, and uprisings elsewhere have their own roots but are linked in some ways to this crisis. The second is that the crisis is an economic problem that has triggered a political problem, which in turn is making the economic problem worse.

The followers of Adam Smith may believe in an autonomous economic sphere disengaged from politics, but Adam Smith was far more subtle. That’s why he called his greatest book the Wealth of Nations. It was about wealth, but it was also about nations. It was a work of political economy that teaches us a great deal about the moment we are in.

Read more: Global Economic Downturn: A Crisis of Political Economy | STRATFOR

How ironic is it that all of the concerns were with regards to the debt crisis not being resolved, and yet the market sells off today (Tuesday)?

For the past several years our entire thesis has been that a slow US economy was inevitable.  So we have invested that way.  Our economic exposure to the US is low and we are diversified away from any substantive exposure to the US economy.

Let me be clear, we believe the US economy is exhibiting all of the characteristics of a depression, not a recession!  For some light reading, I would strongly recommend that your read Lords of Finance, which was recommended to me by a client to whom I am exceptionally grateful for the suggestion.

BUT, unlike the economies of old, we can allocate capital away (remember, for a time in the Great Depression France’s economy was absolutely fine and rallied!).

Of note today…HSBC was eliminating 30,000 jobs!  But, they were hiring 15,000 in the emerging markets!!  (http://news.yahoo.com/hsbc-hire-15-000-emerging-markets-2014-032756352.html).  Suffice it to say…its time to go.

On our end, this is a continuation of the same thesis we have held to…and a great opportunity for us to buy equities…equities in the growing economies!  They are throwing the baby out with the bath water today and investors do not see this for what it is…a terrific buying opportunity.

A lot of bond investors are finding out the hard way how much of the Greek debt crisis was already priced into the U.S. Treasury market. Clearly, a significant amount of risk aversion from Greece, and the PIIGS in general, occurred in April, May and June. Investors sought safe haven in U.S. Treasuries and, in the process, helped to drive down 10-year yields from 3.57% in early April to 2.87% last week. I say “helped” because the Fed had already been pushing Treasury yields down with its $600 billion Quantitative Easing 2 (QE2) program.

The Fed’s massive Treasury-buying arsenal artificially held down interest rates when rates should have been climbing with inflation signs. As a result, U.S. Treasury yields were much lower relative to their historical average against GDP. In fact, it’s not a stretch to say that Treasuries were so overvalued that Treasury buyers needed an outright default in Greece just to hold the unrealistic levels. Unfortunately for these buyers, an outright Greek default doesn’t appear to be in the cards.

Today, Greece’s parliament approved austerity plans to cut its budget and sell assets. As a result, Greece is now eligible for more international aid to avoid default. The news, along with a surprise reading in the Chicago PMI, caused a spike in intermediate-to-long term Treasury bond yields. The 10-year yield jumped from yesterday’s 3.11% closing level to a 3.22% intraday high today. It has since settled to around 3.16%. But that’s still more than ¼ of a percentage point increase in yield since last week (1/4 point rate increase equals about a 2.5% loss of principal).

The Chicago PMI, which measures industrial production in a region dominated by auto manufacturers, jumped to 61.1 in June from 56.6 in May. The increase was larger than expected. The upside surprise indicates that supply disruptions from the earthquake in Japan have eased. If tomorrow’s ISM manufacturing report, which measures industrial activity nationwide, shows a similar increase to the Chicago report, 10-year yields could push through 3.22% rather quickly, especially since the Fed’s QE2 program ended today.

Oil Supplies

Last week, the Obama administration announced it would begin releasing 30 million barrels of oil from the country’s Strategic Petroleum Reserve in August. Several other countries will collectively release an additional 30 million barrels from their reserves as well. What’s interesting is the 60 million barrel announcement didn’t do much to the price of oil. Prices are still around $95 and gasoline prices have come down a measly 7 cents, according to AAA’s national average.

It’s possible the news leaked before the announcement, like when oil was well over $100, or it could be that the market is telling us that economic growth and inflation are about to accelerate enough to keep oil prices at these levels. Whatever the case may be, a 60 million barrel release will not be enough to put a lid on inflation, especially if OPEC counters Obama’s move by reducing production by a similar amount.

In my weekend research reading, I thought this piece by John Mauldin did an excellent job of explaining the market’s concern with regards to Greece:

Bernanke gave another press conference after the FOMC meeting this week. Taking his time to address the situation in Europe, and the increased urgency of the crisis in Greece, Bernanke said US bank exposure to Greece was minimal and only indirect, via positions in large, core-nation banks in Germany and France. Raising a red flag, the bearded academic said that money-market mutual funds had substantial exposure to those same banks and could take a big hit if push came to shove in Europe. “A disorderly Greek default would have significant effects on the US” economy, he added.

About the only thing there was seeming consensus on in Europe was that Greece will eventually default. The question is when. European leaders, along with the IMF, have caved and will give Greece €12 billion to tide them over while they debate on finding €70-100 sometime late next month. By some accounts that amount will have to be a lot more. Meanwhile, the ECB is adamant that Greece cannot be allowed to default.

The whole process is somewhat akin to trying to help someone who is drunk by giving them another bottle of whiskey. Trying to cure a problem of too much debt with even more debt is simply irrational, and everyone but Europe’s leaders can see that. So why are they doing it?

Because if Greece is allowed to go, there is real reason to believe that the problems will spread rather quickly to the rest of peripheral Europe. By the way, it is not just French and German banks that US money markets have exposure to; there are a lot of Spanish banks that have issued commercial paper as well. And my sources told me that many of the state-owned German Landesbanks are essentially insolvent, with massive amounts of sovereign debt. By the way, another source notes that US money-market funds are not rolling over the commercial paper to some of the banks (like Spanish ones), so there is a liquidity squeeze coming to European banks in peripheral countries.

The ECB has taken on some €100 billion of Greek, Irish, and Portuguese debt, if I remember the number right. They have capital of only about €10 billion. They want to take on even more debt from the banks, as the banks are using sovereign debt as collateral. The whole process is a way to paper over the fact that many European banks are essentially insolvent if they have to mark to market their Greek debt.

I think it is a given that in the near future Ireland is going to tell the ECB that the line item on their balance sheet for €60 billion that says “Loans to Ireland to bail out their banks” should be moved from the line that says loans to the line that says capital. They will simply walk away from the debt. “Here are the keys to your banks. What are you going to do with your banks?”

Let’s assume (generously) that there is only a 50% haircut on Greek debt. Add in the Irish debt, assume a smaller haircut on Portugal, at least initially, and you can easily get to €100 billion in losses for the ECB. That makes Lehman look like small potatoes.

The ECB would either be forced to print money to cover the losses or have a massive capital call to ECB members. Germany is 27% (again, from jet-lagged memory), so their portion would be a mere €27 billion. How do you think that will play with the voters in Bavaria? The ECB was not supposed to take on bad debt, according to its original charter. More than one person speculated to me that Germany might simply use that as an excuse to leave the euro. Not by the current set of politicians running the place but the new set that will be elected when things go bad.

And printing? Not all that good for the value of the euro.

We had dinner on Monday night at the home of Hervig von Hove of Notz-Stucki Bank, where I was speaking the next morning. There were 16 of us at the table, and these people represented a great deal of money as managers and investors. All very well-informed. We sat outside in perfect weather in the Swiss countryside. Charles Gave sat across from me at the middle of the table, and we talked and debated as the rest asked questions and offered opinions for 3-4 hours. The wine was flowing, and it was a most interesting evening. Now, with that set-up…

I was asked if I still thought the euro was going to parity with the dollar, and I said I did, although I was not sure what the euro would look like in three years, or who would be in it. There was some pushback from people who thought the dollar would be the weaker currency. So I asked for a show of hands as to how many people thought the euro would be higher in one year’s time. There were 6 hands raised, but one gentleman said he was actually abstaining. So I asked how many thought the euro would fall, and we got 12 hands. Yes, that is 19 votes for 16 people. Clearly there were at least three economists in the group who voted both ways!

Then someone asked Charles about the issue. Now, for those who have never had the extreme pleasure of time with Charles, he is a powerful, white-haired French patrician, and one of the better economists I know. Quite a brilliant thinker and not afraid to express his mind forcefully with a voice that sounds like God talking, with about the same assurance (note to self: never again follow Charles on a speaking stage).

“The question is entirely irrelevant” – punctuating the air for added emphasis. “The euro will not exist in a year. The whole thing was dysfunctional from the beginning.”

I suggested that was a tad bearish.

“Not at all. I think it is extremely bullish. The demise of the euro and the return of national currencies will allow for proper allocation of investments and resources. It is the best thing that could happen for the markets.”

I could not get him to commit to exactly how that process of dissolution would look.

“I didn’t create the euro so it is not my responsibility to solve the problem for them.”

But I cannot help but think that any exit by anyone from the euro will be disorderly, giving rise to Bernanke’s “significant effects.” Many European banks are simply not solvent if there are major sovereign defaults. The US banks have sold some $90 billion in credit default swaps on Greek, Irish, and Portuguese debt to European banks. That is supposedly balanced with other purchases of CDS, but my sources say that much of that insurance is from German Landesbanks. Yes, the same ones I mentioned above that are basically insolvent. We are joined at the hip to Europe. A European recession would certainly be felt here. And a credit event could cause the same problem as in 2008, as banks start to refuse to lend to each other again. Ugh.

The potential for a real crisis is far too high for comfort. It would mean another recession for sure, with the US already close to stall speed and global growth slowing. I hate to sound alarmist, but I am worried. Absent a problem in Europe, the US should be fine, if slow. And maybe European leaders can stall the crisis off longer, buying time for banks to move their debt to the ECB and raise capital. We have to really keep our eyes on this.

At some point, Europe needs to realize that the problem with Greece, Portugal, et al. is not illiquidity, but that they are insolvent and have few prospects for economic growth anywhere close to what is needed to solve their problems.

Europe would be better off just taking the money they are giving to Greece and using it to recapitalize their banks. Let Greece go. Give it up. Let them enter a 12-step program or whatever it is that insolvent nations do. That is harsh, but it is also the truth.

But there are very sad things going on. It is not just banks that are losers here. Pharmaceutical companies are starting to refuse to deliver to Greek hospitals, as they are up to two years behind on their payments. It turns out that Greece owes some €6 billion to private businesses like hospitals and simply cannot pay. Those costs are rising, and much of it is to hospitals for medical care supported by the government. They are issuing bonds (shades of California) for the debt in some cases, which sell for a discount of 50%, if they can be sold. And we thought finding €12 billion was a hard thing.

This is not just a Greek problem, it is a concern in many countries that are having financial difficulties.

Now, time for some speculation on my part. For Greece to leave the euro, the politicians would have to make a rather serious decision. That will not happen overnight. The minute there was any speculation or a “secret” meeting of Greek leaders to discuss leaving the euro, the run on the banks would be massive and fast. It would all come down quickly.

To go back to the drachma would require a bank holiday for a week, and it would have to be a surprise move. About the only way for that to happen would be a military coup coupled with a bank holiday and promises to return to elections after the currency issue was solved. The current government does not have the votes or the power to declare a holiday and move to the drachma, or at least they don’t as I read it. Just a thought.

U.S. Treasury buyers last week ignored inflation signs and continued to drive bond prices higher. In May, the Consumer Price Index (CPI) was up 0.2% and the core rate (minus food and energy) was up 0.3%. At a glance that doesn’t look so bad. But when you look past the headlines you can clearly see that inflation is becoming a problem.

For example, the 0.3% core increase was actually the biggest monthly gain since July 2008. On a year-over-year (yoy) basis, consumer prices were up 3.6%, collectively, in May. And May was the seventh consecutive month that yoy prices accelerated (see table below).

Year-over-year consumer price gains for all items

May 2011 +3.6% yoy

April 2011 +3.2% yoy

March 2011 +2.7% yoy

February 2011 +2.1% yoy

January 2011 +1.6% yoy

December 2010 +1.5% yoy

November 2010 +1.1% yoy

Notice how the yoy rate has more than tripled since November 2010.

Despite the evidence that inflation is accelerating, there have been recent signs indicating that the economy is slowing down. As a result, investors have been buying Treasuries and selling stocks to reduce portfolio risk. Greece’s debt crisis has been making U.S. Treasuries look more appealing, too. But what’s interesting is bond guru Bill Gross says the United States is in worse shape than Greece! (Read: US is in even worse shape financially than Greece: Gross)

The bottom line is U.S. Treasuries are wildly overvalued relative to the health of the U.S. economy, thanks to the Fed’s $600 billion dollar QE2 strategy that pushed bond prices beyond appropriate valuations. Even if the economy slows down for a couple of quarters, which appears to be likely (watch video from the Economic Cycle Research Institute), U.S. Treasuries are still significantly over priced.

As a result, this is no time to chase yields further out on the duration front. Things could get very volatile and wild in the weeks ahead in bond land, especially with the Fed’s QE2 program ending this month. The risk one would have to take to get a pitiful 3% or so yield just doesn’t square.