Dear President-elect Obama

A Letter to President-elect Barack Obama

We have just finished the worst market showing in over 21 years.  Had the last week of the month not been the single best week in history, it would have been the worst October in over 100 years.  We were all saved by the bell.  Instead of our regular monthly letter I have chosen to share with you our letter to President-elect Obama.  Our normal format will return next month.

Kendall J. Anderson, CFA    Printer Friendly Version

November 5, 2008

Senator Barack Obama                                                                                              713 Hart Senate Office Building                                                                           Washington, DC  20510

Dear President-elect Obama,

First I need to send my sincere congratulations to you on your winning of the minds, hearts and votes of so many Americans.  I truly want to share in Senator McCain's words, "And I call on all Americans, as I have often in this campaign, to not despair of our present difficulties but to believe always in the promise and greatness of America, because nothing is inevitable here.  Americans never quit.  We never surrender.  We never hide from history, we make history."  And you, sir, have made history.

You have a tremendous job ahead of you, and as a citizen and an investment advisor to hundreds of individual citizens throughout our country, I felt moved to share with you my thoughts on a few of the economic problems you must face.  My hope is that you will step up to the job and make decisions for the good of all Americans. I am sure this will be a difficult task, as your Congress as well as each individual representative will believe you should answer only to them.  You have lived with the sunshine as well as the storms created by the media, and at times you probably felt that you were being treated unfairly.  Believe me when I tell you: you've seen nothing yet.  My advice to you is: have faith in yourself and your advisors.  Use your abilities to see all sides of each problem to make your decisions, right or wrong.  Be humble when your decisions are right, and be willing to accept when they are wrong and change course if necessary.

You are inheriting an economy with greater problems than those inherited by your predecessor, President Bush, eight years ago.  Through 2007 a bubble in the housing market fueled our economy.  The rising valuation allowed individuals to convert this paper profit to cash through home equity loans and refinancing.  This alone increased GDP by 3% in 2005, 2% in 2006 and further in 2007.  As of this year, the net withdrawals have fallen to almost nothing.  Without the excess cash and spending, our GDP will have to make up this 3%, which is an impossible task.

This reduction in cash withdrawals would have placed a large number of people into a depression; however, where there is a will, there is a way to defer the problems further: credit cards.  Greg Weldon (www.weldononline.com) provides a wealth of data that may be useful to you in the future.  According to his research, for the twelve months including and prior to September, consumer credit via credit cards expanded by $61 billion, while mortgage equity withdrawals declined by 95%. Credit card debt continued to accelerate at an annualized rate of 98.4% through the period ending October 15^th.  This money is not created out of the blue.  The funds for these revolving loans come from our nation's Commercial Banks, the same banks that are reeling under the weight of non-performing home loans. 

Credit cards may be the only choice for many people to maintain a standard of living that they can no longer afford.  But we must remember that it takes two sides of these loans for the balances to get out of hand.  We must think seriously before passing judgment in an attempt to help.  Sometimes the best help is to do nothing.  The lender and the borrower should feel the pain of loss, not the taxpayer.

This brings us to one of the greatest problems you must face, which is that of a huge budget deficit that you will only be able to increase.  As it stands today, the deficit will be above $500 billion when you take office, and I believe this is a very conservative estimate.  As we look into the near future we see the ranks of the nation's unemployed increasing to over 8%.  Although home prices are not falling as fast as they previously have, they are not increasing.  As of now it is estimated that over 20% of all homeowners owe more on their home than the current market price. 

And that isn't all of it. Last month the stock market decline reduced global wealth by $16 trillion, a staggering number. You can easily see that tax revenues will not be anywhere close to current estimates. Your new Congress is discussing a second bailout plan of up to $300 billion which, if you support, will elevate you to, as PIMCO's bond guru Bill Gross coined, the "Trillion Dollar Man."  You would be the first President to run a $1 trillion deficit for a year. I wish I could tell you not to allow it to happen, but alas, it is not my decision.

I know that I am not the one to teach you about economics, and that you will find and appoint your own trusted advisors.  But I would like to remind you that one way to look at GDP is through the eyes of consumption.  Consumer spending + Investments + Government Spending = Gross Domestic Product (C+I+G=GDP).  As our consumers unwind their debt, either through a reduction in their standard of living or through bankruptcy, our nation's producers will reduce their own capital investments for lack of demand.  The only way out of this is through increased government spending.  Without growth in GDP, there will be no growth in tax revenue, which is a serious problem in regards to the various programs and goals you have set.

This brings us to a discussion on taxes.  Many Americans understand that goals established during a campaign may need to be changed due to new circumstances.

The tax policy you proposed throughout your campaign called for  a tax cut for 95% of Americans.  My understanding is that the payment for these cuts would come from increased taxes on a select group of people.  I'm sure you've heard it said that the tax increases on this group will "kill the goose that laid the golden egg." I may agree that our current goose has put on a little too much fat and would be better served were he placed on a diet. But as you contemplate the size of the diet, remember that jobs are created by the same people you are proposing to tax more.  We need these jobs at our nation's corporations to increase revenues and to see the C in our equation increase.  These corporations are also the main provider of I in our equation.  Our country already has the second highest corporate tax rate in the world, and our largest employers are global companies.  Given a choice for expansion, they would be prudent to build outside of America where their costs would be lower.  We should provide incentives for expansion on our shores to benefit our people.  Increasing taxes may be necessary to trim the fat, but please don't starve our golden geese to death.

And now, please forgive me for being so bold, but I would like to discuss your new advisors.  I am sure you will search far and wide to bring in those who you believe will provide you with the best advice available, independent of their political persuasion.  However, advice is what they give, and you are the one who has to make the decision.  My concern is with those economic advisors who are, for the most part, drawn from the field of academics. Coming from Chicago, your peers from the "Chicago School" may be at the top of the list.  However, their firm belief that all people are rational and only seek to maximize personal self-interest is highly flawed, and without this assumption, their equations lose meaning. Also, a reminder: without their equations, there would have been no basis for the financial engineering needed to create mortgaged back securities and the ultimate fiasco caused, in part, by the sub-prime mortgage mess. 

I would suggest leaving the city and locating a few individuals who are firm believers in the school of behavioral finance or those practicing professionals who understand the value of a dollar and how to share this understanding with others.  I have heard you talk about Warren Buffet and Paul Volcker.  Both would be wonderful, not only because they are tried and tested, but because their wisdom and understanding of their fellow man has grown over time. Yes, they may be up in years, but in the field of economics, this is a real positive.  No matter who you choose, test not only their knowledge of the current schools of economics, but also their common sense.  Given a choice, I say you should err towards one with common sense and independence over one with a Nobel Prize or equivalent. 

Our Federal Reserve's balance sheet has expanded from $500 billion to almost $2 trillion in the last few months as it and it's counterparts in the US Treasury have diligently attempted to free up the markets and add liquidity.  It will take time for this to work through our system, and while we wait I'm sure you will be told, or maybe even scolded, by some that this action will lead to a terrible bout of inflation and therefore every American will suffer.  This may happen, but without the actions taken to grease the wheels of our economy, the opposite will happen: deflation, a far more serious problem that would devastate our citizens.   Support as you can the re-inflation of our economy.  Interest rates will go up, and they may go up during the later years of your term, which is something that you, I am sure, would not like to see.  But trying to let things unfold as they are is not the proper course for the whole of society. 

Problems at home will of course also impact our relationship with other countries around the world.  While celebrating your first day as President Elect, other countries will be undergoing severe financial stress and, true to their own beliefs, may blame you as well as the rest of us for these problems. Ukraine, Pakistan, Hungary, Argentina and many of the smaller emerging economies are on the verge of bankruptcy.  So far the IMF has provided some help, but it will not be enough.  You will be approached to give more of our tax dollars to support the world.  It may be extremely hard, but tread softly with these requests for help and do what is necessary to protect Americans.  Our ability to be the world's military and financial savior has been stretched farther than at any time in history, and we may need to give some relief to ourselves first.

Your first year in office may be one you will want to forget.  We are surely in a recession which will extend well into next year.  This recession is a consumer-led recession, a type of recession not experienced for 27 years.  It will seem brutal as banks and consumers de-leverage their personal balance sheets.  Banks will lower the amount of funds available to consumers and consumers will reduce spending and start saving.  Both of these actions will prolong the recession.

Don't despair. These actions are what will ultimately save us.  Our economy grew quite well for decades with a consumer-spending rate of 65%.  Over the past few years it has hovered around 70%.  Our economy also grew quite well for decades with a savings rate of 5% or more.  Over the past few years it has been negative.  Our economy's normal rate of unemployment was 6% for decades and our economy still grew quite well.  What we need to do is re-learn how to save. 

Many people are saving through their employer's 401K plans.  During good times, when the market is rising, everyone is happy and continue to add to their savings.  But we have seen what happens when the markets go through their periodic depression stage.  The same academics I referred to earlier in this letter have convinced the Department of Labor that individuals, such as those investing in 401K's are rational investors who do not need the help or advice of a financial advisor.  This has been tested in the past few months and many of these same 401K investors panicked and sold at the worst possible time while reducing their level of contributions.  These plans should be encouraged and opportunities for individuals to receive advice from qualified financial advisors should be made available.  Our social security system needs relief, and the best approach is to give incentives for individuals to save.  There have been discussions of allowing easy access for individuals to withdraw funds from their 401K without penalties.  It may sound like a good idea for freeing up some cash for the struggling consumer, but I urge you to resist this.

The last couple of weeks we have seen the market for security prices rise from the largest sell-off in twenty-one years.  Markets are forward looking, and this small but very important beginning may be the direct result of your election, or it may just be that people have finally come to their senses.  In any case, you have a oratorical gift that allows you to instill confidence in your audience, and your audience has now grown to include many of those who did not choose you as their President, as well as all of those who did. Use your gift wisely, place all of Americans first, and I am sure you will be rewarded and respected.

Sincerely,

Kendall J. Anderson, CFA