Late Friday came news that two employees of JP Morgan would soon be indicted in the London Whale episode that cost the bank $6.2 billion. The two employees are suspected of masking the size of the losses through creative valuation of the derivative positions at the center of the losses. The trader for which the scandal is named, Bruno Iksil, is apparently cooperating with authorities and will probably not be charged. JP Morgan itself is in final negotiations with the SEC for a settlement that will amount to a slap on the wrist – and probably a fine – but no senior executives will be charged with anything other than being ignorant.

We also recently received a verdict in the Fabulous Fab Tourre trial in which the Goldman Sachs trader was accused of misleading investors in a mortgage derivative product that was supposedly designed to fail for the benefit of John Paulson. Tourre was found liable on six of seven of the charges of securities law violations brought against him. Goldman Sachs long ago settled its case with the SEC by paying $550 million and admitting to certain mistakes in the marketing material for the security in question. That would be the marketing material used by Tourre to sell the issue to his dupes…er, clients.

So what has really changed since the Great Financial Crisis of 2008? Apparently, not much. Banks are still highly leveraged pools of capital doing risky things that are largely hidden from public view until they blow up. We still have little idea what is on the balance sheets of the Too Big To Fail banks and they are now bigger than when they were deemed too big and important to fail in the first place. The Volcker Rule that was supposed to prevent these banks from taking big risks with depositor funds has yet to be fully implemented and even when it is banks will find plenty of loopholes at their disposal. Yes, there have been changes to capital requirements, but I dare anyone to read all the footnotes to banks financial statements and say with certainty that they are actually meeting the requirements. I sure can’t and I highly doubt regulators can either.

At the peak, financial firms were the largest weighting in the S&P 500 with a share over 20%. Now, almost 6 years removed from the crisis, financials are the second biggest weighting in the index with a share of nearly 17%. That isn’t anywhere near the over 30% that technology represented at the peak of the dot com bubble, so maybe it isn’t a bubble but I don’t think it is good news that the market and the economy are still being led by the financial sector. The financial sector accounts for roughly 30% of corporate profits and while that is down from the peak near 40% it is still far larger than the historical average near 10%. Nearly six years have passed since the near death experience of the US financial system but we aren’t anywhere near solving the problems that led to it.

Another thing that hasn’t changed is investor behavior. Trim Tabs reported recently that inflows to equity mutual funds set a record in July. The previous record, just for the record, was set in early 2000 right before the peak of the dot com mania. The inflow so far this year, about $92 billion, is the most since 2007 when investors put $85 billion to work in the first seven months of the year. It is tempting to see this as good news, that investors are regaining their confidence, but the sad truth is that mutual fund investors are notoriously bad at market timing. They were buyers in 2007 near the highs and sellers in late 2008/early 2009 near the lows. They’ve sold every dip in the market since the bottom in March of 2009. Five consecutive months of outflows near the bottom in mid 2010. Eight consecutive months of outflows around the budget debate and European meltdown of 2011. Ten consecutive months of outflows leading into and immediately after the 2012 election. And now, inflows in six of the seven months of 2013 as the market is hitting all time highs. This might not be a top but history says one could do pretty well by doing the opposite of what the average mutual fund buyer is doing.

Our addiction to debt hasn’t changed either. At the peak in early 2008, individuals owed $13.8 trillion in mortgages and consumer debt. Today that figure is all the way down to….$12.8 trillion. Non-Financial Corporate debt is at an all time high at $12.9 trillion – up from around $10 trillion before the crisis – and recently surpassed individual debt for the fist time ever. And of course, everyone knows the government debt is rising although this year the deficit will for the first time since the crisis be less than $1 trillion annually. The savings rate rose in the wake of the crisis to about 8% but is now trending down again at about 4.5% as individuals seem to once again be counting on rising stock and housing prices rather than doing the hard work of saving.

The reason none of this has changed is that the source of the problem has not been addressed. The Fed has spent the intervening years proclaiming its innocence in the bubble that preceded the 2008 meltdown. As a consequence, there has been little change in their policy approach. Certainly quantitative easing is more creative than just manipulating interest rates but the effects and expectations of the Fed haven’t changed a bit. The Fed and its enablers believe that growth is dependent on credit creation and in that they’ve been successful. What they haven’t been able to do – this time – is to turn that credit into actual economic growth above anything other than the anemic rates we’ve recently witnessed. Along the way, they’ve managed to exacerbate the inequality that was already becoming a problem before the crisis erupted. Inequality itself isn’t necessarily a problem – in fact it is necessary to a degree for overall wealth creation – but it does create a very unstable growth dynamic when taken too far. The Fed is not solving our problems; it is making them worse.

We also haven’t addressed the problems created by the big GSEs, Fannie Mae and Freddie Mac. These institutions are once again cranking out profits and dominate the mortgage finance market. President Obama held a press conference recently to announce that he is going to do something about reducing their footprint but he isn’t the first politician to promise that and he won’t be the first to fail. These institutions continue to be a source of largesse for politicians and now that their profits are going directly to the government’s coffers it is hard to believe that Congress will shut down the money machine (the two will fork over almost $15 billion to the Treasury this quarter).

The stock market has performed wonderfully since the bottom in 2009 and it is tempting to think that we’re back to “normal” but we are far from it. We haven’t addressed the problems that got us into this mess and expecting a different result is Einstein’s definition of insanity. Stocks are once again at valuations that in the past have not been kind to long term investors. The economy continues to perform poorly and while the unemployment rate is down, that is somewhat of an illusion as more and more people drop out of the workforce (for whatever reason). I don’t know what will bring down the house of cards this time but the economy and the markets are acting as if all our problems are solved. Nothing could be further from the truth.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.