The Law of Unintended Consequences: The Worst Mistake in Decades

By JEFFREY SICA

Image by AFP/Getty Images via @daylife

 Jeff discusses the concept of unintended consequences as it relates to decisions made by the Fed.

The law of unintended consequences has long existed dating back to at least Adam Smith but was popularized in the twentieth century by sociologist Robert K. Merton. In his theory, Merton stated that often unanticipated consequences or unforeseen consequences are outcomes that are not the outcomes intended by a purposeful action. In some cases, the law of unintended consequences could create a perverse effect contrary to what was originally intended and ultimately making the problem worse.
 In the economic downturn of 2008, the central bank undertook a series of what they considered “positive initiatives” to stimulate the economy. Fed Chairman Ben Bernanke defended his position by saying that the policy of “quantitative easing” (bond purchasing), will “stimulate the economy and create jobs”.  In other words, stimulate the economy by printing massive amounts of money.
 The unintended consequence of these initiatives will prove to be catastrophic in the long term. The cause of this unanticipated consequence is something Merton called the “relevance paradox”, where decision makers think they know their areas of ignorance regarding an issue, obtain the necessary information to fill that ignorance void but intentionally neglect other areas as its relevance is not obvious to them. This is exactly the case with our central bank.

 To clarify, Ben Bernanke has intentionally ignored the short term consequenceof his QE initiative through a justification of the potential long term positive effect.  In recent testimony before capitol hill, Bernanke stated, “while indicators on spending and production have been encouraging on balance, the job market has improved only slowly” adding, “it will be several years before the job rate is back to normal”, despite some positive signs that cropped up in January. Bernanke has chosen to ignore the negative “job market” consequences by stating that it will recover in a few years and focus on the minor positive. He continues to forge ahead while ignoring the relevance of negatives such as a surge in inflation in commodities, precious metals, and most importantly oil due to the systematic devaluation (destruction of the U S dollar) as well as the world wide chaos which has been ignited by inflation and rising food prices.

 The unintended consequence of these Fed actions will result in the only economic condition worse than inflation, which is “stagflation”, in which the inflation rate is high and the economic growth rate is low. What will make this condition considerably adverse is the inverse relationship between the U S dollar and oil prices. Oil prices have historically increased as the value of the dollar decreases. Oil prices can exceed their 2008  high of $148 .00 per barrel  especially considering the fact that with oil prices at a historic high in 2008, the value of the U S dollar  was considerably higher. The unintended consequence of a “weak dollar” which is supposed to spur exports and stimulate our economy is more inflation and greater upside pressure on commodities and oil than we saw in 2008.

 Merton believed that the ultimate flaw of mankind is hubris – our belief that we could fully control the world around us and that we put our immediate interest before our long term interests. Ben Bernanke and the central bank are guilty of “hubris”, as they continue to put their immediate interests before that of the nation’s long term interest. Their actions will force us to live with “unintended consequences” for decades to come.
 To quote French novelist and Nobel Prize winner, Albert Camus, “the evil in the world almost always comes of ignorance, and good intentions may do as much harm as malevolence if they lack understanding”. In our financial lives it is imperative to invest with the foreknowledge that we may have to endure many “unintended consequences” inflicted on us by a “well intentioned” government to achieve our financial success.
 Reason is our only defense. To quote Ayn Rand, “From the smallest necessity to the highest religious abstraction, from the wheel to the skyscraper, everything we have comes from one attribute of man … the function of his reasoning mind”.

Blissful Ignorance: Why the Financial Markets are Ignoring the Crisis in Egypt



There is little acknowledgement

of the trouble that lies ahead

when relying on a philosophy

of “blissful ignorance” in regards

 to Egypt and its impact on the economy.

The phrase “ignorance is bliss” is a passage from a Thomas Gray poem “Ode on a Distant Prospect of Eton College” (1742). The complete phrase, “Where ignorance is bliss, ‘tis folly to be wise” has often been interpreted as “what you don’t know can’t hurt you”. Unfortunately, using this proverb as the approach by which the United States deals with situations in the Mideast is a dangerous and destructive philosophy.

 

The most egregious U.S. foreign policy mistake of the last 50 years was Jimmy Carter’s decision to demand the Shah of Iran to step down, together with turning power over to the Ayatollah Khomeini. Carter’s ignorance as to who would fill the “power vacuum” was specifically what led to the grave situation we have in Iran today. President Mahmoud Ahmadinejad presides over one of the most perilous regimes the world has ever known — who exist for the purpose of destroying Israel and the United States.

In the recent Egyptian crisis, the mass protests endure, demanding an end to President Hosni Mubarak’s 30 year rule. It has become apparent that the result will be a “power vacuum” similar to the one created in Iran 30 years ago.

As much of the world applauds the possibility of a Western democracy, it’s important to acknowledge that few “revolutions” succeed without years and sometimes decades of extreme conflict — especially when such polar opposite parties are positioning for power. Organizations such as THE MUSLIM BROTHERHOOD have goals which harbor establishing SHARIA law throughout the world through world domination and Jihad. The Muslim Brotherhood has been banned from Egypt and will without question fight to fill “the power vacuum” to achieve its ultimate goal.
The Dow ended last week up 2.3% and the SP gaining 2.7% with the Nasdaq composite gaining 3.1% after stocks like JDSU (NYSE:JDSU), Aetna Inc. (NYSE:AET), Tyson foods (NYSE:TSN), all beat earnings estimates and conveyed a positive outlook for  the future.

The markets are paying very little attention to Egypt, instead focusing on what they view to be a continuation of the recent recovery. There is little acknowledgement of the trouble that lies ahead when relying on a philosophy of “blissful ignorance” in regards to Egypt and its impact on the economy.

1-The protests, although large in size, have been relatively peaceful giving investors the feeling that the transition to a democracy will be smooth and without consequence. Who can forget the image of the tank commander embracing one of the protestors? The United States has been sending charter flights to evacuate tourists and the press, leaving Egypt with very few objective journalists to talk about what’s actually happening. We are left to rely on a small number of correspondents for our information.

2-The Obama administration while expressing a need for political reform and having Mubarek step down, seemingly ignores the possibility of an “unfriendly regime” interceding. There is no mention of the threat of having Egypt become a “second Iran”. With a population of approximately 80 million each in Egypt and Iran, the combined opposition will be about 50% of the U.S. population, about 20 times the population of Israel, and can cause a shift to the dominant hostile presence in the Mideast.

3-The Obama administration is not acknowledging the talks held between the banned Muslim Brotherhood and Egypt’s Vice President Omar Suleiman. These talks involve massive concessions to the Muslim Brotherhood as an attempt to prevent a violent uprising. However, these efforts have a high probability of failure, greatly increasing the potential of violence in the region.

4-Investors believe the uprising is a result of the Egyptian people’s desire to become a democracy; however, it’s really food inflation which is the ultimate cause. Fitch Ratings determined food inflation in Egypt to be at 18% and Egyptians blame this on the Mubarek administration. Furthermore, the weak currency policy in both the U.S. and China has resulted in massive inflation, spreading throughout the world — including the US. Inflation will be the single biggest threat to the U.S. economy, the equity markets and the world economy.

Most of the economic and geopolitical  calamities we’ve faced as a nation have been the result of engaging in a policy of “blissful ignorance“, by ignoring “what is” for what we want things to be. The U.S. as a freedom loving democracy wants nothing more than to have our enemies retreat through concessions and eventually become our friends. What could be better than Egypt with its vast resources and Suez Canal to become “just like us”? This will not happen overnight in Egypt and we must have a realistic understanding of the long road ahead.

It is imperative that we abandon our “blissful ignorance” when it comes to the economy and understand the consequences of the inflation which we have played a big role in causing. We must recognize the potential of a massive security threat involving the potential of having “two Irans” as opposed to one.

To contend with difficult times like these, it is not “folly to be wise” and to quote Ronald Reagan, “We cannot play innocents abroad in a world that is not innocent”.

               

Thank You,

Jeffrey C. Sica

President

Sica Wealth Management, LLC

67 East Park Place, 1st Floor

Morristown, NJ. 07960

Tel  973-975-0730

Main  973-975-0750

Fax  973-889-1010

And The Loser Is ... Why Financials Will Be The Worst Performing Sector Of The Next Decade ... Again

It’s the much anticipated time of the year when the entertainment industry honors their own achievements by presenting the world with the nominations for the Academy Awards. These awards showcase the best of Hollywood, with critically acclaimed movies like “THE KINGS SPEECH” – leading the ballots with a staggering 12 nominations.

It is a night that everyone in the entertainment industry strives to be a part of. It is an honor to be given the opportunity to stand behind the podium and give an incoherent speech, which is far too long to be crammed into the allotted time, only to be cut-off by music or a commercial. It is those few brief moments when the world takes notice and entertainers can say, (as Sally Field did in her 1984 acceptance speech for her second Oscar, for the movie “PLACES IN THE HEART), “you like me, you really like me”.

In addition to the Oscars, there have also been nominations for the 31^st annual Razzies award. The Razzies are the polar opposite of the Oscars in so much as the audience chooses who are the absolute worst actors, actresses and movies of the year. There is an official show, however, most of the recipients are far too embarrassed to receive their awards or deliver speeches like “you didn’t like me, you really didn’t like me”.

In the coming year, we will see one sector perform so poorly that if they were movies, they would certainly receive the dreaded “Razzie” award. The first and worst performance of all, will come from the industry that investors love to hate — THE FINANCIAL SECTOR.

 Although rallying 162% from the market low of March, 2009, the financial sector is still off 51.9% from its October, 2007 market peak. This performance credits the Financial Sector with the worst performing sector of the decade award.

Industry wide revenues are off 17% since 2007 with recent figures flat or declining. Bank of America (NYSE:BAC) reported a 1.24 billion dollar loss its second consecutive, unprofitable period. The Securities and Exchange Commission charged Merrill Lynch, now owned by BAC, with securities fraud, for misusing customer order information. Merrill agreed to pay 10 million to settle the charges, further tarnishing the credibility and trust of customers.

Financials face new regulations which will greatly reduce profit margins in the years to come. The vast majority of what could be considered earnings has been mostly exaggerated, due to money being moved in and out of reserves. The impact of bad loans has yet to be disclosed by financial institutions and will only accelerate over time. This is further exacerbated with the exorbitant amounts of commercial real estate owned by banks and so they will begin to sell at a discount.

The Investment Razzie for the “worst“ supporting cast  was Citigroup (NYSE:C), who hid its massive leverage attached to risky loans by using complicated derivates and listing their balance sheet exposure as short term debt. In the months leading up to the crisis, Citigroup neither confessed nor admitted that their underlying exposure was “becoming a concern”. Instead, they gave investors the false impression that they had minimal exposure to risky loans and held sufficient insurance to protect investors from a drop in the value of the underlying securities in their general portfolio. Investors lost over 90%of their investment while Citigroup accepted a tax payer funded bailout of 25 billion dollars.

Some other memorably bad performances include: NYSE:WFC, NYSE:AIG, NYSE:JPM, NYSE:UBS, NYSE:GS.

The aftermath of the financial crisis of 2008 will be felt in the banking industry for years to come, making them the worst performing sector of the next decade as well as the last. They like so many “bad actors” will be type cast in the role of “villain” in their horrific and disingenuous performance.

In an industry which played such a historic role in the foundation of our country, it is very disheartening to see the depth to which these onetime “stars” have sunk, leaving many investors to walk down “the boulevard of broken dreams“. This “stroll” will be taken with much less of their investment assets than they would have had if only the banks would have acted with integrity.

In the final scene, financial institutions will realize that no attempt to “recast” themselves as the hero will prevail, considering investors will forever remember this performance as defining who they are and for the damage they’ve done. The Investment “Razzie” may actually be too high of an honor for this performance.

True Grit – Investing With A Vengeance

 This year Hollywood is ending the year with a vengeance amidst the remake of the 1969 classic, TRUE GRIT, which starred the original Hollywood bad ass, John Wayne. This exceptional remake is quite a divergence from the standard no plot, special effect extravaganzas, starring former Disney Channel celebrities we’ve grown accustomed to at this time of the year. The movie centers on 14 year old Matte Ross, (played by Hailee Steinfeld), who hires U.S. Marshal “Rooster” Cogburn, (played by Jeff Bridges), to find her father’s murderer and have him brought to justice. It is a movie that has virtually no special effects, manicured stars, illicit humor or any of the other so called successful ingredients of a Hollywood blockbuster — yet it had a very good opening weekend. This early success defies the logic of many movie critics who claim that revenge-themed westerns can no longer succeed in Hollywood as they once did. This may be proof that movie goers are getting a little tired of the same old “tricks” and want to be “entertained” and not just  “distracted”.

This year in the equity markets investors experienced what many would characterize as a “blockbuster” year with over 10% returns on the S&P 500 and upward of 17% in the NASDAQ composite. The hero, although not a former Disney Channel star, was Ben Bernanke who took center stage after being given the role of saving the world through his own special brand of “special effects” — quantitative easing. Here our headliner, Bernanke, creates “money out of nothing”, inflating everything since 2008 from stocks and bonds, to Gold up 89%, crude up 107%, copper up 230%, sugar up 154%, soybeans, wheat, corn and coffee – all up over 50%. All this in typical Hollywood fashion, trying to get us to believe that the “special effects” are in fact, reality and the economy is really improving. Also starring in this “blockbuster” market year is President Barack Obama who decided to “play the part” of supporting actor and sign an extension of the “Bush Tax Cuts”. This two year extension not to raise taxes, brought relief to those that the President referred to as “the villains” or what we prefer to refer to as the “job creators” or “investors“. This “performance” brought him concessions during the lame duck session which will increase our federal deficit by almost 1 trillion dollars, making his award winning performance “Oscar worthy”. Investors were successfully “distracted” by the special effects as they recaptured virtually “all” of their market losses since the market decline of 2008 — most unaware of what was happening “back stage” as our federal deficit grew to 14 trillion dollars.

 In the year ahead, it is highly unlikely that the same old “special effects” of 2010 will produce similar results in 2011. Ben Bernanke cannot use another round of QE without completely undermining the confidence of investors worldwide. The bond market bubble is beginning to burst and although a further round of QE could prolong that from happening, it will create a much greater bubble in the future. It is only by embracing certain facts and looking past the “distraction” to the reality, which will allow investors to achieve the “blockbuster” returns they are seeking.

1. Inflation is Here – Commodity prices especially oil will continue to surge, therefore stocks like EXXON (XOM), Schlumberger (SLB), National Oilwell (NOV) and ETFS like IEO (ishares Dow Jones Oil and Gas exp) and IEZ (ishares Dow Jones Serv) or companies like Reynolds (RAI), Dupont (DD), Archer Daniels Midland (ADM), or Powershares DB Agriculture (DBA) will benefit from higher agricultural prices.
2. Income is dead – Investing for income is a waste of time, considering bond prices will continue to decline. Stay invested in short term bonds and buy quality dividend paying stocks like Kimberly Clark (KMB), Kraft (KFT) and Duke Energy (DUK).
3. Municipal and local municipal bonds will see historic defaults due to high levels of leverage. As a result, it would be prudent to greatly reduce municipal bond holdings.
4. Precious Metals will continue to advance.
5. The direction of the market will be determined by whether or not we see an improvement in unemployment.

Mattie Ross, “True Grit’s” 14 years old main character, chose the “tough as nails” U.S. Marshal “Rooster” Cogburn, to find her father’s killer because in her words, “he was true Grit”. He wasn’t your typical hero but he knew the terrain and had no fear when it came to accomplishing what he set out to do. Mattie Ross was described as having “steel in her spine” and a face that “couldn’t hide her broken heart “. In the challenging year ahead, we too must have “true grit” in enduring the economic challenges which lie ahead of us. We too must have “steel in our spine” even when some of our investments leave us broken-hearted. This will be a volatile year and we must look past the “special effects” and “distractions” which inflated this market, to a more “true” foundation. In the end, like Mattie, we will accomplish exactly what we set out to do.

Thank You,
Jeffrey C. Sica
President
Sica Wealth Management, LLC

QUANTUM PHYSICS AND THE ECONOMY – How the Bond Market ‘BUBBLE’ Affects the Overall Global Economy

This year the Nobel Prize in Physics was awarded to Andre Geim and Konstantin Novoselov from the University of Manchester in the UK for the discovery of a completely new material named Graphene. This new substance when extracted from graphite such as “found in a common pencil“, and is stabilized and mixed with certain plastics can be transformed into Graphene conductors believed to be the fastest conductors of electricity known to man — substantially faster than today’s silicon transistors. This amazing discovery could lead to faster, more efficient computers as well as other sorts of high frequency communication devices. This advance in the field of Quantum Physics brings to light an often ignored aspect of investment strategy —  the relevance of the interdependence of asset classes in achieving investment results. To continue with our Graphene example, it is the interdependence between the Graphene and the plastics that transform them into conductors of electricity — not simply one isolated element.

The most relevant and recent example of asset class interdependence is what investors have been witnessing in the bond market. In the past few weeks, the interest rate on five year treasuries has doubled to 1.9%. The rate on the 10 year jumped to 3.4% from 2.4%. The rate on the 30 year treasury is currently at 4.4%, a full percentage point higher than it was only a few months ago. These higher yields equate to lower bond prices which, in effect, wipe out years of interest, considering there is an inverse relationship between price and yield. Investors looked to bonds as an answer to their fears regarding an uncertain recovery and experienced some of the “best ever” returns — making mutual funds like the Pimco Total Return Fund grow assets to over 250 billion. If the majority of the appreciation in the bond market was the result of investor demand, we could rest easy knowing that the free market would prevail and even a correction could be bearable and, maybe even considered a “buying opportunity”. Unfortunately, this is not the case. Investor demand is not the only reason the bond market has appreciated to this level. The bond market has expanded due to the Federal Reserve’s misguided experiment of “printing money” or “quantitative easing”, which has artificially inflated bond prices. Investors realized that with yield so incredibly low, bonds offered little reward for lots of risk and instead of exiting in an orderly fashion through the main exit, they ran the risk of a continuing stampede through any exit, leaving many investors wondering — what happened?

 One of the significant differences of today’s average investor as opposed to investors of the past few decades is that substantially more of their money is invested in bonds and bond funds than ever before — an estimated 3 trillion dollars. Investors gravitated toward longer maturity bonds in an effort to secure higher coupons since older investors often rely on interest payments to sustain their income. These longer term bonds are most susceptible to loss of principle in a rising interest rate environment. For example, if long term bond yields move to 7%, the loss will be 25%. A 25% decline to an older investor with fewer years to try to recapture the loss is often catastrophic, greatly affecting spending and confidence and in turn affecting the overall economy. Investors who thought they found solace in the higher yielding corporate bonds will also suffer since once treasury yields rise and investors can get similar returns from “higher credit quality“ government bonds, corporate bonds will also come under considerable pressure. This too will have an impact on spending and consumer confidence.

Investors who are under the assumption that the stock market can continue its upward surge if the bond market continues its decline, will  be very disappointed when they find that much of the appreciation resulted from money flowing into dividend paying stocks from investors who were seeking income but couldn’t find what they were looking for in the bond market. Corporate earnings will be exceedingly affected in so much as corporations will not be able to issue long term bonds at low rates to fund their growth — greatly affecting their profits and essentially their stock price. Investors will always gravitate toward assets which give them the greatest return for the least risk. If bond prices continue to fall, the enthusiasm to take on more risk in equity will wane as investors seek similar returns in the higher credit quality treasury bonds. The equity market has been the beneficiary of the interdependence it has developed with the artificially overbought bond market and it will be this correlation which will cause the equity market to decline as the bond market declines. Ben Bernanke has hinted that he’s not opposed to a QE3 which may elevate bond prices in the near term but create an even greater “bubble” in the long term, spurring a considerable inflation threat.

In Quantum Physics as in investment strategy it is often the combination of the simplest elements which create the most spectacular results or the greatest catastrophes. Whether it’s the Graphite in a pencil or stocks and bonds as a part of an investment strategy, it is how those elements interact that make them just plain graphite or the fastest conductor of electricity known to man — or just plain stocks and bonds or the core component of a strategy which ultimately protects and grows what you’ve taken your whole life to accumulate. The method used to take a carbon atom in graphite and make it useful is a process referred to as “stabilization”, once considered to be virtually impossible. In the financial markets of today, many “experts” consider another type of market stabilization to be impossible, however, through diligence and discipline we will ultimately achieve the investment success we strive for and understanding the laws of Quantum Physics will help us get there.

Thank You,
Jeffrey C. Sica
President
Sica Wealth Management, LLC

High Net Worth: SPIRIT OF FREEDOM-What the Conflict on the Korean Peninsula Means to the World Economy

High Net Worth: SPIRIT OF FREEDOM-What the Conflict on the Korean Peninsula Means to the World Economy

SPIRIT OF FREEDOM-What the Conflict on the Korean Peninsula Means to the World Economy

She’s a beautiful vessel, about 1,092 feet long , 257 ft wide and 244 ft high. She has an enormous flight deck, 4.5 acres long which could accommodate up to 80 aircraft — each armed with the most sophisticated weaponry known to man. She has a crew of 6,250 brave men and women. Her name is the USS GEORGE WASHINGTON, and she has recently been deployed to the Yellow Sea, west of the Korean Peninsula, to begin joint military exercises with South Korea. In a statement from the US Navy’s seventh fleet, the military exercises are described as a measure to show the United States’ “commitment to regional stability through deterrence.”  In other words, what we are saying to the dictator Kim Jong Il and his “20 something” heir, apparently Kim Jung-un, is that we mean business when it comes to protecting our allies. The mere presence of this symbol of US power should inspire them to back down. It’s impossible to predict what the NORTH will do, since they continually act in a defiant, irresponsible manner — most notably in a recent revelation that there is a uranium enrichment facility in North Korea which could further advance their existing nuclear capabilities.

The most important aspect of this confrontation is how North Korea’s closest ally, China, deals with their recent aggression and insatiable need to advance their nuclear capabilities. China has a long history of using North Korea as a buffer against the US. Since the end of the Korean War, they have been leery of our strong alliance and our military presence in South Korea. They have never welcomed having our warships anywhere near their coastline. Furthermore, they have yet to firmly condemn North Korea on the attack of a South Korean warship which killed 46 sailors last March, the revelations of their nuclear capabilities or the most recent events. Alternatively, China, in a statement from its foreign ministry regarding our military exercises, has chosen to warn the US against “any military acts in our exclusive economic zone without permission.” In other words, China is threatening the US not to come too close to their coastline or face consequences. This statement by China will only serve to encourage the radical Korean dictator and his offspring to further threaten South Korea and defy the US. It should concern the Obama Administration that the strongest stand taken by the Chinese has been against the US protection of our allies, and not against the aggression of a radical dictator.

 The US market fell this week amid concerns that the Korean peninsula conflict will escalate. The bulls have chosen to focus on this conflict as yet another example of “saber rattling” from North Korea, but its consequence could be far greater than ever before, considering a few key factors. FIRST, China has the greatest influence over North Korea and how they handle them will substantially affect the world economy. SECOND, China is the largest foreign holder of US Government debt in the history of our nation, with holdings of nearly 900 billion dollars. This position gives them significant leverage over the US and substantially undermines our ability to negotiate with them when they side against us, as they seem to be doing now. THIRD, China has systematically devalued the juan in response to QE2 creating the dawn of inflation as we are beginning to see now and will soon see in the US. The recent interest rate increase in China has yet to show signs of curbing inflation. If the US and China are unable to come to terms with the conflict in the Korean Peninsula, it is unlikely they will come to terms with stabilizing their currencies — continuing on a path of systematically devaluing  currencies and creating a future threat of inflation while undermining a worldwide economic recovery. Finally, an insane dictator with nuclear weapons that is not kept at bay, by its closest ally and neighbor, is always a threat to the economy and well being of nations throughout the world. China has a responsibility to help stabilize the region and until they do, uncertainty and fear will remain throughout the worldwide financial markets, keeping us in a very defensive position.

The USS GEORGE WASHINGTON has an insignia designed by the ship’s crew, which includes a classic profile of Americas first president, a band of thirteen stars representing the original thirteen colonies and the crossed flags of freedom — all encircled by an unbroken rope representing the solidarity of the crew. The motto of the ship originates from the namesake, George Washington himself, taken from a letter he wrote to a fellow patriot. Washington used the phrase, “THE SPIRIT OF FREEDOM”, to describe the mood of the people during the revolutionary war. Perhaps we should reflect on the words of George Washington when considering the future of our nation, for it is the “Spirit of Freedom” which will motivate us to stand by our allies in times of trouble, when their freedom is at risk. It is the “SPIRIT OF FREEDOM” that will guide us through the challenges which are before us —it can never be taken away.

Thank You,
Jeffrey C. Sica
President
Sica Wealth Management, LLC