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Analyzing the Margin of Safety

noreply@blogger.com (MWS) — Fri, 08 Apr 2011 04:19:00 +0000

To value investors and pure Graham & Doddist disciples, the concept of margin of safety is the central concept to the principles of investing. Simply defined, it refers to the purchase of a security at a discount to it's estimated intrinsic value.

This apparently simple concept is so important because there is one concept of risk that does not receive the attention it so rightly deserves among economists and the investment community at large; uncertainty! A wise investor knows his bounds and recognizes there are known unknowns and unknown unknowns. By that I mean there are risks we understand, but cannot specifically quantify and in the case of the latter risks we cannot identify at all.

These known and unknown risks are the reason why demanding a discount to your estimate of value (margin of safety) is such an important concept in investing. But the question arises and is rarely addressed; "just how do you quantify a proper margin of safety?".

In my opinion putting the same discount to every security isn't correct.The result will be missed opportunities or false signals because risk is falsely accounted for. However, your humble author has fallen off the toilet and conceived his version of the flux capacitor. To properly account for the level of discount 6 risks should be quantified.

Systematic
Financing
Operational
Stock Classification
Sensitivity of Growth Estimates
Source of Returns

1) Systematic risk contains known and unknown risks. Investors know markets fluctuate and go through cycles. Investors also know shocks can occur that could never have been predicted. The discount for this type of risk is purely subjective and should be severe, for example 20%.

2) Financing risk must be analyzed from several perspectives to come to an adequate quantification of this discount. We must however apply a cap on the discount that can contribute to the overall margin of safety. I propose 40%.

Debt in particular poses a risk to equity investors because equity is in a subordinated position and can be adversely affected and even wiped out from too much leverage. The type of debt financing should be considered:

No Debt: no discount
Hedge Units: both interest and principal repayments covered by cash flows and cash levels, 5% discount
Speculative Units:interest payments are covered by cash flows and cash levels, but principal repayments rely on growth estimates and/or further debt issuance, 15% discount
Ponzi Units: Neither interest and principal payments are covered by cash flows and rely completely on new debt issuance and abnormal growth, 30% discount

Financing risk can also come from the equity financing.Two types are worth considering:

New equity is issued to fuel growth opportunities. Current investors risk dilution if returns do not exceed the cost of capital, 5% discount
New equity is issued to cover operating expenses or debt costs, 10% discount

Of course, one assumption to this last point is that the company is a going concern and is experiencing temporary hardship, otherwise there would be no practical value.

3) Operational risks refer to indicators that the business is in decline or subject to fraud. Again, this should be capped, say 20%. Indicators include:

Consistently high accrual ratios, where accrual earnings are large relative to cash flows, 5% discount
Declining cash flow growth or highly volatile cash flows, 5% discount
Increasing number of days of normal accounts receivable outstanding, 5% discount
Increasing number of days of normal inventory outstanding, 5% discount

4) Stock classification risk refers to what kind of stock you are considering investment into:

Cyclical: riskier, demands a greater discount
Defensive: lower risk, lower required discount
Growth:riskier due to risk that the growth trend discontinues
Value: riskier as a result of the possibility of being a value trap, meaning it sells at a discount because of negative expectations

5) The risk inherent in growth estimates is seldom addressed. Let's face it, we as analysts cannot accurately predict how fast a company grows. Therefore, we should test how sensitive our valuation is to our estimates. The more sensitive, the greater the discount should contribute to the margin of safety.

6) The expected source of returns is another risk that should be considered. Dividend paying stocks have an assured source of returns (assuming the stock pays a constant payout). Not to say there isn't risk that dividends are cut or discontinued, which should also be considered. Non-dividend paying stocks pose a greater risk because they depend on some other investor paying a greater price in the future. Even sound, growing companies do not guarantee that the stock will appreciate. As a result a discount should be required for non-dividend paying stocks.

The % discount examples I used were intuitive, commonsensical, but entirely subjective. There is no exact quantification for the margin of safety, but my point is that there is a more grounded way of arriving at one.

Furthermore, this list is not comprehensive or exhaustive regarding existing risks, but are risks I consider to be the ones worth paying most attention to.

On Fair Compensation

noreply@blogger.com (MWS) — Fri, 25 Mar 2011 02:15:00 +0000

I just finished watching Charles Ferguson's "Inside Job", which is an insightful documentary about the financial crisis. I recommend everyone to watch. The film discussed most worthy topics:

Those who were the architects of the modern financial and regulatory environment are the ones who are still in those positions
The crisis was a result of a failure to regulate and corrupt, conflicted free-market ideologies
Executives like Dick Fuld of Lehman fame were never prosecuted for perpetrating fraud and retained all of their compensation
Conflicts of interest are not properly accounted for
A standard of care such as a fiduciary responsibility towards clients is largely missing amongst trader
The economics profession is clouded with conflicts of interest and has a curriculum that pushes the agenda of the architects of the system, like Larry Summers
Inequality has been on the rise as a result of misguided policies and unfair compensation structures

I agree with every conclusion presented in Inside Job. It got me thinking about the topic of compensation. There is no disputing the unfairness inherent in executive bonus structure. But I've an idea that would fairly level the field, if properly enforced [sic].

Defined contribution plans with safe harbor provisions reduce discrimination in discretionary profit sharing contributions by disallowing the plan to become top-heavy as a result of large contributions to key employees, owners and highly compensated employees. Formulas are adopted that prevent this this top-heavy situation from occurring and the result is lower compensated employees receive profit sharing contributions, reducing inequality in the plan. Even if there is no safe harbor provision, if the plan becomes top-heavy then the profits will need to be reallocated to correct the imbalance. These are ERISA guidelines.

In this structure owners and key personnel who in all likelihood have earned their share of profits are still rewarded fairly for their work, but the scales aren't tipped dramatically out of favor. This could be a framework to build upon in terms of fairly compensating workers of all levels. After all, profits are earned from collective efforts of all the employees within an organization.

Other considerations must be included. I'm in favor of performance based compensation, whether they are set by reaching short and long term goals, reaching ROI thresholds, etc. However, conflicts of interest are inherent in this type of compensation structure because most often more risk is sought after by those bonus seeking agents. Simply by objectifying the way these performance incentives are measured some of the conflicts can be weeded out.

For example, a ROI target may be set with a bonus attached for reaching it. If additional measures were included that adjusted for risk taking (taking on leverage, investing in low quality but high return investments, engaging in non-value added M&A, etc.) and also accrual accounting quality measures that prevent execs from claiming bonuses if quality measures deteriorate (earnings and ROI increase but cash flows tell a different story).

Of course, this only works in the imaginary world where regulators enforce laws according to a code of ethics and policies. Unfortunately we live in a world of regulatory capture and short-term gains. I feel that no meaningful reform will be undertaken until the systemic pain becomes so great that short-term gain opportunities even disappear.

How Junk Bonds Fuel Equity Valuations

noreply@blogger.com (MWS) — Wed, 09 Feb 2011 16:41:00 +0000

I'm a faithful reader of Mike Shedlock's blog, his insights are almost always spot on. I would like to add to his 4 reason for How The Junk Bond Bubble Supports Rising Equity Prices.

Mish's reasons are:

Companies that cannot get financing go out of business.

In March of 2009 many corporations poised to go under because they could not get financing had exceptionally low stock market valuations. Even GE was on that list. Those stocks rose many multiples after Bernanke managed to revive the junk bond market.

When companies issue long-term debt at lower and lower yields, their interest expense drops.

The entire atmosphere of chasing yields lower is a sign of increased speculation across the board. One should expect stock prices to at least be firm in such conditions.

What Mish is really addressing is that increasing junk bond issuances and decreasing junk bond yields lead to higher valuations because of:

Increased cash flow to equity holders
Lower cost of equity capital

1. Increased cash flow to equity holders

Analysts often value companies using projected cash flows and although there are many variations of cash flows to use, a popular measure is known as Free Cash Flow to the Equity (FCFE).

FCFE = Operating Cash Flow - Capital Expenditures + Net Borrowing

So it stands to reason that if the junk bond market will continue to be accessible, then analysts will project FCFE to increase because of the ability to replace borrowing at lower rates. Analysts love to present bullish cases so assuming this song and dance will continue forever is not unrealistic.

2. Lower cost of equity capital

One means of estimating the cost of capital is to use the "Bond Plus Premium" approach. Granted, this isn't as common as some other methods, but essentially the most recent bond issue yield for a company is added to an equity risk premium. If the bond market is generous towards issuers, then their cost of equity capital will be lower.

Therefore, if analysts project increasing cash flows and decreasing cost of equity capital, their valuations will be higher than they would be without a generous junk bond market and equities will rise as a result of bullish valuations.

As an addendum, the above is mostly applied to lower quality, small capitalization names that are generally accepted as high risk. However, there are spill over affects. As lower quality companies gain access to capital, projects get funded that otherwise would not have which permeates through the economy and leads to overall higher growth. This is why low quality, small cap, high beta names typically lead the cycle in a bull run, which no question is how this cyclical rally has played out so far.

The above data is from Morningstar. Notice how much better the Russell 2000 has performed over the past year (red circle) vs. the S&P 500. This is expected in terms of asset allocation performance through the cycle. I believe we're past the midpoint in this cycle and that Large Cap stocks will start to outperform "relatively". Indeed, YTD performance indicates this has already begun.

Accounting for Equity Investments

noreply@blogger.com (MWS) — Tue, 01 Feb 2011 22:07:00 +0000

In light of the recent decade of wild volatility and poor returns for US investors, I have a small thought experiment. As currently structured, common stock encourages wild speculation in a casino like environment. This should not be the purpose of investment. Instead, common stock are a means of capital formation and participation in the subsequent growth. Along the way this noble idea has become lost. Now equity investment can hardly be called that at all as high frequency traders rapidly buy and sell seasoned issues several times before you can even blink your eyes.

This situation is deleterious to growth, expectations about the future and subject to excessive emotion, both positive and negative which has real affects on the mindset of consumers, investors and businesses. I propose changing the way equity investments are accounted for can radically change the way capital is formed and directed, hopefully for the better.

I propose changing the recording of common stock: instead of recognizing investments in financial assets (generally under 20% with no significant control or influence), stock investments should be recorded in a manner similar to the equity method for ownership in the 0% to 20% range.

In this way, you're investment is recorded as your initial investment and then each year that investment would grow by your proportional share of net earnings(deficit) less any dividends received. The main difference between this and the equity method however would be the exclusion of accounting for the amortization of the excess over book value of PP&E on purchase and accounting for upstream and downstream transactions because they just don't apply.

Hypothetical example:
ABC Co.

Beg. Equity        $141,000,000

Net Income            $100,000,000
Dividends               $ 75,000,000
End Equity          $166,000,000
WACSO 18,500,000
Beg BVS $7.62
End BVS               $8.97
DPS                      $4.054

You make a $10,000 investment, recorded in your brokerage statement as:

Name          Value              Shares
ABC           $10,000          1,312.336

At the end of the period your account would change to:

Name          Value              Shares
ABC           $11,775.56     1,312.336
Cash           $ 5,320.28

This example illustrates a small/mid cap company (if it traded at 10 times earnings). The company earns a very high return on equity at 65%. Notice the value per share of the company is the book value per share (BVS) and your number of shares is determined by dividing your investment by the BVS.

As an investor with the accounting recorded in the equity method manner you share in these large returns proportionately rather than being subject to the whims of the market.In this respect, the market can only grow so much as profits grow and new savings are directed to fund IPO's or secondary offerings. The change in accounting may eliminate the risk of bubbles in equities as a result of a speculative frenzy where share prices are bid up with the intent to sell to the next greater fool, but it does not however eliminate the risk that capital becomes mis-allocated or that companies manipulate their financial statements to boost earnings (which if pervasive enough, could lead to a bubble).

Observations:

Even if a company misses earnings, for instance earnings fall 20%. The company may still have positive earnings that adds shareholder value.
Because the price affect from the earnings game is removed, executives no longer have to focus on short-term performance as much in efforts to keep the stock price elevated.
Share repurchases no longer risk the same mis-allocation of capital from buying shares back at elevated, overvalued prices.
Overall market volatility is dramatically reduced. Even though shares may trade continuously on the whole, earnings are only quarterly.
Planning for retirement becomes easier to forecast because earnings growth has had a fairly consistent average over the course of history for the S&P 500.
Relatively, bonds increase in riskiness because they still have a component of price risk. Overall that should be a net benefit to society because too much debt becomes unsustainable at a certain threshold and the benefit of issuing debt over equity becomes less attractive because investors (creditors) have less relative safety.
Investors still in need of capital appreciation but have high risk aversion can achieve their goal in large companies with consistent cash flows and stable book values.
The one negative consequence I can dream up from this is that small/micro cap companies transitioning from venture capital fund raising to IPO will be that much riskier on a relative basis. However, this could also in effect make the allocation of capital that much more efficient.

I'm certain there are many other observations worthy of mention, but for now they slip my mind. All of the above is fine in theory, but in theory is different than in practice. So, let's consider how the equity method of accounting would have stacked up had it been in practice.

For instance, let's look at Microsoft (MSFT), a large cap AAA rated company. The total stock return over the past 3 years is -3.54%, but let's find out what the total return from my equity method style would be for a $10,000 investment on 6/2007:

          6/2007           6/2008         6/2009    6/2010
BVS    $3.15             $3.83           $4.40           $5.17
DPS    $0.39             $0.43           $0.50           $0.52

Value        $10,000         $12,158.73      $13,986.25      $16.412.70
Shares       3,174.60
Cash*       $0                  $1,365.08        $2,952.38        $3,238.10
Total Return    35.24%    27.94%    29.32%
*dividends from 2007 were not earned from the $10,000 investment

Average Annual Total Return: 30.80%
Standard Deviation of Total Returns: 3.88%

Returns would have been even greater had dividends been reinvested instead of sitting idle in cash. In comparison, the standard deviation from 2007 - 2010 for MSFT stock was 52.44%!

Clearly the accounting method for stocks makes a great deal of difference. In the equity method style outlined above owners share proportionally with the equity growth of the company in addition to any dividends that may be received. This is similar to how an investor who makes a significant investment, say 30% ownership, would account for his own investment. In this manner, volatility in returns are dramatically reduced and returns themselves are much higher and much more consistent. Why then should we succumb to the extra and unnecessary risk of the market?

The Power of Dividends

noreply@blogger.com (MWS) — Wed, 19 Jan 2011 21:17:00 +0000

Most investors consider capital appreciation from price returns when considering investments, but dividends through thick and thin are more important than most investors realize. Starting in 1950, let's consider the S&P 500 Index price returns only as compared to the total return index (dividends reinvested) with a $10,000 initial investment.

1/1950 - 12/2010

Price Return Total Return

7.17% 10.92%

$635,626 $5,018,869

1/1950 - 1/1960

Price Return Total Return

12.65% 18.26%

$32,916 $53,496

1/1960 - 1/1970

Price Return Total Return

4.34% 7.73%

$15,289 $21,053

1/1970 - 1/1980

Price Return Total Return

2.99% 7.25%

$13,427 $20,137

1/1980 - 1/1990

Price Return Total Return

11.17% 16.03%

$28,826 $44,225

1/1990 - 1/2000

Price Return Total Return

15.53% 18.42%

$42,374 $54,246

1/2000 - 1/2010

Price Return Total Return

-2.58% -0.80%

$7,701 $9,224

The advantage from the compounding effect from reinvesting dividends is clearly evident even during impressive bull markets where price appreciation takes center stage.While it's misleading to say excellent returns cannot be achieved from investing strategies that pursue capital appreciation only (non-dividend paying stocks) investors are losing out on the opportunity to reinvest cash flows from dividends.

Compounding is the first benefit, but even without the compounding the fact that dividends provide a certain return for investors (at a point in time) is another large benefit, especially in volatile times. Put aside the theoretical arguments from Modigliani-Miller dividend irrelevance theory or the common argument that companies with high earnings growth should retain their earnings instead of paying a portion of it to shareholders and consider the assurance returns from dividend yield provides.

Suppose you invest in stock A with a dividend yield of 3% at $10 per share. Assuming the dividend remains constant over the course of the year ($0.30 annually) and that the stock price falls twenty cents after one year. Your price return is 2%, but you're average dividend yield is 3.06% resulting in a total return of 1.06%. That's nice but in the short-run returns from dividends only offer marginal protection from adverse price moves. Now take the same scenario with the same assumptions and extend it out ten years. The price has generally gone nowhere after ten years sitting at $9.80 per share, but thanks to the dividend yield you're average annual return over the period has been 2.85%. Had you also reinvested those dividends and if the returns on reinvested dividends were greater than 3%, you're return would have been greater.

Returning to the historical examples from before, look closely at the 2000 - 2010 decade that resulted in losses spanning an entire decade. One factor to keep in mind is that many companies in the S&P 500 have shifted from dividend payments to share buybacks over this course of time, so dividend yields have been lower than otherwise. Also, due to the financial crisis financial companies accounting for a large chunk of the S&P 500 Index slashed dividends to zero in some cases. The point is a manager using discretion in favoring dividend paying stocks over the repurchase mania policy over the past decade may have eked out positive returns as a result of higher average yield.

Dividends are certainly more boring that emotion catching growth stocks, but is that such a bad thing?

Are P/E Ratios As Mean Reverting As The Investment Community Would Have You Believe?

noreply@blogger.com (MWS) — Sat, 15 Jan 2011 17:41:00 +0000

Reader Warning! this post contains highly technical statistical jargon and witchcraftery, continue reading at your own peril!

The answer to the questions posed in my title is not as simple as you might think. However, I think it is an academic topic that gets less attention than deserved. Most serious thinkers focus on stock price and returns alone and the majority of studies support that stock market prices do follow a random walk. By random walk I mean that there are no mean reversion properties and the next best price estimate is the previous price plus an unpredictable white noise.

There is however evidence of mean reverting properties observable in P/E ratios for the S&P 500, specifically where the earnings are a ten year moving average. Without getting into too much detail, the conclusion was that there is mean reversion, but there are breaks in the series where the mean actually changes after a period of time and that it is only true over longer periods of time. If you're curious to know more there is a great study you can access titled "An Empirical Analysis of Mean Reversion of the S&P 500's P/E".

This is good news if you're an index investor and you know how to use time series data in such a way that you can adjust for the breaks where the mean changes, but what about for individual stocks?

I've started a study so far using an autoregressive(1) time series model to predict P/E's. An autoregressive(1) model uses the prior period independent variable to predict the current variable using ordinary least squares regression. So far the results suggest that there is a large degree of dependence for long periods of time and quite interestingly there also appears to be breaks in the regression. What I mean by that is that at certain intervals the variance appears to change.

Intuitively variance changes at different intervals make sense because as multiples expand momentum is likely building. I've compiled quarterly P/E multiples using 7 year average earnings for Terra Nitrogen Company, L.P. symbol TNH. [disclosure: I hold a position in TNH] Chart 1:


Chart 1

Can you see what I refer to when I say there appears to be breaks where the variance changes?

0 - 10 P/E Interval: very tight fit, no apparent serial correlation, low variance.
10 - 40 P/E Interval: good fit, no apparent serial correlation, the variance in the error terms seems to have increased with what looks like one outlier data point.
40 - 90 P/E Interval: poor fit, large variance, very little predictive function.

The next step is to split the data into three separate regressions similar to what I listed in the bullet points. I expect that will confirm my observations.

So what does this all mean?

In a nutshell, P/E multiples in this case beget higher multiples i.e. dependence or clustering between the 0 - 40 interval. After that point the dependence breaks down and the next P/E becomes considerably less predictable.

This is the point where mean reversion is expected to take hold. Using the complete regression series the mean reverting level is 19.85.

Of course this is only the beginning of what looks to be a promising inquiry into the nature of how P/E multiples work in the short, intermediate and long term. Still, there is much work left to do, much of which is beyond my capabilities, mainly as a result of a lack of appropriate statistical software, not due to statistical know how. Below is a list of what I still need to do beyond what I have already accomplished:

Test for serial correlation in the AR1 model; if any of the error terms are significant then a new model will need to be constructed, possibly an AR2 or log transformed model.
Test for stationarity in the complete regression and at the separate regression intervals.
Test for conditional heteroskedasticity.
Create a model that captures the negative linear relationship where reversion to the mean is expected.
Test this for several different stocks across market cap ranges and different sectors and structures.

My expectation is that some stocks will have similar behavior as TNH but that others will have stronger mean reverting properties with less of a breakdown in the relationship after a certain interval. TNH P/E's have gone to extreme upper levels and so it makes sense that the dependence would break down; this might not hold with other stocks.

The ultimate conclusion from this inquiry so far is that mean reversion, if present, would take much longer to realize than what most investors might expect and that multiples can reach levels far beyond what might be expected with persistence. A model that captures these assumptions and manages the risk is the ideal goal of this study.

2011 Commentary

noreply@blogger.com (MWS) — Mon, 10 Jan 2011 18:10:00 +0000

Fed Fund Rates: FFR are likely to remain in the +/- 0 to .25% band. There are several reasons for this extremely accommodating policy:

Just like with Greenspan and Japan in the 90's, a slow motion recapitalization of banks can be accomplished by suppressing short-term interest rates. This creates an artificially steep curve which allows banks to earn essentially risk-free spreads via purchases on the intermediate/long end of the curve or via loans. Bank balance sheets are still not fully repaired, evident by large excess reserves. They only seem good due to suspension of mark-to-market accounting.

With growth below potential output and unemployment high the Fed is explicitly trying to depreciate the dollar vs. other currencies with low interest rate policy, thereby reducing demand for dollars. The goal is stimulate exports and subsequently growth. Until growth returns to its potential don't expect the Fed to ease much on FFR.

Inflation is not apparent in a broad sense, it is only evident in specific areas like health care, education and commodities. Without signals of broad inflation in consumer prices inflation is unlikely to be a concern to the Fed in terms of raising rates.

Bond Rates: Rates at the short end of the treasury curve will likely remain very low, especially for t-bills. Rates on the longer end of the treasury curve are rising from low levels for now and this trend could continue in the first half of 2011. There is substantial resistance at the 20 year trend-line.

There are several reason rates at the long end will stay contained in their long term bullish trend-line:

growth is below potential and inflation is tame, therefore in real terms rates on the long end become relatively attractive near the ceiling of the long-term trend-line.

the ultra-low rates at the short end offer incentive to pick up a great spread by buying long term treasuries after a selloff, especially for banks and investors who can finance them with short-term credit (which is unlikely to rise substantially).

Equities are not being embraced by mom and pop. Instead they are flowing to bonds. This makes sense as boomers near retirement and reallocate from equities to bonds in the wake of a crisis. Furthermore government bonds represent a very small percent of retail overall portfolio holdings which means there is pent up demand from boomers looking for relative safety in long treasuries.

the safety trade is on when there is uncertainty, and there is plenty of it out there with the PIIGS, commercial real estate, state and local governments and China's sustainability and considerable excess capacity (more on this later).

Corporate bonds continue their heroic appreciation. One has to wonder how long investors will accept investment grade rates at historically low spreads to treasuries on new issues and such low YTM on OTC offerings. Certainly mom and pop like the safety and continue to flow to investment grade and high yield as evident in persistently positive bond mutual fund flows. The risk trade is on in terms of corporate bonds with investors searching for yield. Unfortunately, once the music stops investors chasing high yield always reap the consequences.

TIPS offer a strangely attractive risk/reward profile. Even though the outlook does not suggest meaningful inflation is on the way any time soon (see below) outright deflation at this point in time isn't expected. With the pullback over the past month in TIPS they look attractive on a relative basis. Small increases in the CPI will make them a safe reliable investment theme into the future with the added protection if meaningful inflation does catch on. If outright deflation does occur, losses will be limited because of the inherent floor in TIPS (but not the TIPS funds, but even the funds should perform relatively better in the case of outright collapse).

In general, the first half of 2011 is in a low and rising yield market action for bonds. This risk/reward scenario is the least favorable of any for bonds; stay cautious and wait for a reversal of this trend, i.e. a pullback or keep maturity ultra-short.

Inflation:

Inflation is primarily driven by a several important factors:

1. Credit growth

2. Deficit spending in unproductive sectors

3. Wages rising

4. Excess business investment, i.e. excess capacity

5. Dollar depreciation

Credit growth is perhaps the most important driver of inflation. Considering that credit dwarfs base money (created by the Fed) and directs capital spending, the fact that credit has consistently been contracting in the private sector is a significant drag on the economy in terms of both growth and inflation.

Deficit spending, especially in unproductive sectors typically leads to inflation. Indeed we are seeing signs of this particularly in health care and education where a large bulk of the spending is directed. Both of these sectors have and continue to outpace inflation in the broad economy by a very large margin.

Wages, as measured by average hourly income has risen at significantly low rates. The average workweek remains at historic lows and workers seem to be more content with having a job than receiving raises. The good news is private payrolls are starting to increase along with the average workweek, albeit at a small pace and seasonal factors could be at play. The bad news is states and localities will be cutting back.

Overall business capacity is still below prior recession levels and industrial production remains below levels from ten years ago. Needless to say any worries from prices heating up as a result of over-investment is some time into the future.

Low interest rates and QEII encourage dollar debasement. This in turn leads to higher commodity prices. Unfortunately this does not bode well for corporate America with a limited ability to pass on the costs to consumers in the form of price increases. At some point, corporations will either have to eat costs, thinning margins and profits or risk alienating their demand through price increases. Furthermore the strain at the gas pump and grocery store will eat into disposable income and growth expectations. It should be noted that China is exerting considerable upward pressure on commodity prices through their infrastructure policies (more on this later).

Employment & Growth (private sector): Signs of life in the jobs market are returning but far below trend of normal recovery in employment after recession. The average workweek remains low and employers are expected to fill those hours before meaningful hiring would take place. The first few months of 2011 will be very telling in terms of the recent employment gains and whether or not they were due to seasonal factors.Of course, jobs aren't available without growth and productivity. Why this is important? The main drivers of growth in any economy are...

1. Investment

2. Productivity

3. Technology

Investment since the recession has almost exclusively been directed towards inventory restocking. While an important and necessary its effects on growth are mostly transitory and have mostly been realized. Corporations have been reluctant to spend on new capital expenditures or projects in any meaningful way because they still have large excess capacity. Furthermore, they are sitting on large reserves of cash. Some could argue that will be directed towards capex, but the recent trend in M&A suggests otherwise. Not that M&A is necessarily bad, but studies have shown that the return on the investment and "synergies" are far below what is forecasted. Bottom line, less bang for the buck.However, due to 2011 tax incentives look for above normal capex at some point before year end to take advantage of accelerated depreciation.

Since the recession productivity has soared. With aggregate hours so low this was to be expected. However, we're coming to a point where unless more investment is made to fuel growth, productivity will start to decelerate as a result of aggregate hours rising. However, as mentioned above additional capex is expected and payroll tax cuts should fuel growth this year.

Technology is the wild card; it's contribution to growth can be enormous. While our computers are getting smarter and handheld devices making us more efficient, one has to wonder what will be the next technological revolution to spur long-term growth? The new growth theory asserts that economies can grow forever as long as technological development continues unabated. However, with nothing new on the horizon potential growth may be far below what economic models predict.

Stocks:

Stocks have had a remarkable rally (approximately 80% from the lows). However, the current market action suggests unfavorable future returns. What is meant by market action?

1. Valuation - as measured by the cyclically adjusted P/E (CAPE), 10 yr avg EPS

2. Sentiment - as measured by the American Association of Individual Investors

3. Momentum - as measured by RSI or Bollinger Bands

Stocks are overvalued, with a CAPE of 23.3; the average is 16.38

Investors are generally bullish at 51.6% bulls, the average is 39%

Momentum in the S&P 500 is close to overbought with an RSI of 75; 80 is considered overbought

It should fully be understood that just because these measures indicate future returns in the long run will be unfavorable it does not mean that the CAPE cannot go higher, that investors cannot become more bullish and that the market cannot become more overbought.

What these measures do make clear is that the risk/reward profile for being "all in" right now is high. A pullback might, especially of 20% or more might change the attractiveness of stocks.

High quality large cap stocks have not participated in the rally to the extent that small cap, low quality and high beta names have. If there were a relative play in stocks today, the high quality large cap sector would probably provide the best long-term risk/reward profile.

Quick Notes on Global Markets:

China is overheating. During the crisis they set forth a stimulus package worth 14% of GDP, far larger than any other country. In 2009 and 2010 lending skyrocketed at 30% per year mostly funding real estate and infrastructure projects. The result is largely empty cities. For instance, the city of Ordos was built for 1.5 million inhabitants and the city remains largely vacant. The second largest shopping mall, "The South China Mall" is nearly empty. Private bad debts are mounting but hot money inflows and accommodating monetary policy are keeping the party alive. In Beijing housing prices reached 22 times average income; they only reached 9 in Japan's bubble and 6.4 in the US. Overall that level is around 8 in China. With such large misallocation of capital and excess capacity inflation is now a serious concern. The central bank has already been increasing reserve ratios and it is anticipated rate hikes will be coming to control the inflation. This could be the pin that pricks the bubble. If China does slow down, expect commodities to crash. The Reserve Bank of Australia estimates China accounts for 2/3 of global demand for iron ore, 1/3 of global aluminum demand and 45% of demand for coal. Much of this has been a direct result of stimulus and hot money inflows. If there is a banking crisis, China may have to commit its large US dollar reserves to shoring up its banking system. Unless the affect of "flight to safety" to US dollars is greater than the effect of less demand from China for dollars, a rise in interest rates could result in the US. Support for the above claims regarding China can be found at ContrarianEdge.

Canada & Australia are at the crests of their respective housing bubbles. During the crisis government policies were able to keep the bubbles going because they had not reached the extent of speculative mania the US had. Instead, they sacrificed significant recessions for the "kick the can down the road" policy. Once their housing bubbles burst expect more drag on global growth and therefore US growth.

Europe has only put a band-aid to their banking and sovereign debt crises. There is no political uniformity and efforts so far have been short-term and non-resolute. Bond holders will eventually have to take haircuts and restructurings will eventually be needed. Instead, efforts have so far only protected bond investors at the crippling expense of taxpayers. Germany will be the decider of fate as they eventually grow tires of supporting EU nations and protecting bond investors.

Asset Allocation:

Exposure should be limited to ultra-short maturity bonds, TIPS and floating rate bonds. Stock exposure should be minimal, but if necessary stick to "blue chip" stocks. International exposure should be avoided almost entirely. Due to the risks of a China slowdown or hard landing commodities should be avoided even though a speculative blow-off may occur in the interim similar to 2008. Gold may still continue to outperform. This is a direct result of investors flocking to the safety of gold in fearful and uncertain times. In terms of DJIA/Gold ratio, gold has only reached its mean value from secular lows. Mean reverting assets rarely reach their mean and stop. If history repeats gold has plenty of room to run. Finally, avoid municipal bonds until the problem has come front and center and there is a consensus view that state and local governments are in trouble. Even though most municipal bonds are not in danger of default, contagion from weaker issues and general fear will likely pressure municipal yields broadly for a good part of the year. Bottom line, more attractive yields in municipals will be expected later this year.

These are predictions only and in reality events could unfold in a manner completely different than what I have presented. Please consult your investment professional before making investment decisions as a result of my commentary above.

Positive Economic Developments...Could It Be?

noreply@blogger.com (MWS) — Fri, 05 Feb 2010 15:09:00 +0000

Today the employment report was released. Raise your drinks, the unemployment rate dropped from 10% to 9.7%! For a change, I actually have positive data to report. The drop in unemployment is not due to the unemployed person leaving the labor force. The labor force actually grew by 111,000.

Private Sector Job Growth?

Normally, this would be associated with an increase in the unemployment rate, because someone not in the labor force enters again when they start looking for work (still unemployed mind you). Which raises a question; is private sector job growth returning?

The answer is an awkward yes. Awkward because state and local governments are playing a tug of war game with the federal government. Currently, more job losses are occurring in aggregate government jobs. Uncle Sam does plan to hire some approximately 2 million workers for the census, but state and local level layoffs should intensify. On net, government jobs should add significantly to employment over the next few months. After that, many will be left with no jobs, since the census hiring is temporary in nature.

Unemployed person dropped by a whopping 430,000! Part time workers (for economic reasons) declined too, by 849,000, a very positive development. Average weekly hours ticked up slightly as well, but has been essentially flat at 33.2 to 33.3 for some months.

Overall, this jobs report gives hints of hiring returning to the private sector. At some point, unemployed persons not counted in the labor force will start "returning" and add to the unemployed persons, which will effectively increase the unemployment rate. Will there be enough jobs to absorb this large body of labor? If there is not a stampede back into the labor force, then maybe.

Over the next couple of months the unemployment rate will continue to tick down as a result of the census hiring. It won't be permanent. Lastly, don't confuse the performance of the economy with performance of the stock market, they do not have to be related, a painful lesson for many to learn. Improving employment should however give a nice tailwind to the markets...for now.

Update 2/11/2010 - some other (much more well read and respected) bloggers have brought to attention an adjustment to the latest employment report better known as a "population" control effect". They cited this as the reason for the unemployment rate dropping. Well, I looked over the effect and the change has no affect on the rate, but removing the effect in the calculation there would have been even more employed persons. Therefore, though in calculating the unemployment rate the effect was meaningless, the absolute levels would have been more favorable without it.

Comments are welcome as to others interpretations.

The Small Business Economy (or lack there of)

noreply@blogger.com (MWS) — Wed, 25 Nov 2009 15:20:00 +0000

Small business is an incredibly important driver of growth & jobs in our economy. For evidence, just visit the SBA FAQ section:

Small firms:

• Represent 99.7 percent of all employer firms.
• Employ just over half of all private sector employees.

• Pay 44 percent of total U.S. private payroll.
• Have generated 64 percent of net new jobs over the past 15 years.
• Create more than half of the nonfarm private gross domestic product (GDP).
• Hire 40 percent of high tech workers (such as scientists, engineers, and computer programmers).
• Are 52 percent home-based and 2 percent franchises.
• Made up 97.3 percent of all identified exporters and produced 30.2 percent of the known export value in FY 2007.
• Produce 13 times more patents per employee than large patenting firms; these patents are twice as likely as large firm patents to be among the one percent most cited.

Source: U.S. Dept. of Commerce, Bureau of the Census and International Trade Admin.; Advocacy-funded research by Kathryn Kobe, 2007 (www.sba.gov/advo/research/rs299tot.pdf) and CHI Research, 2003 (www.sba.gov/advo/research/rs225tot.pdf); U.S. Dept. of Labor, Bureau of Labor Statistics.

I placed in bold the most noteworthy statistics. I actually propose that small businesses represent a much greater share than 44 percent of total private payroll simply by reason of the large inequality of income between Joe Shmo working for mom n pop and Tony Tiger earning egregious bonuses at a premier investment bank. Continuing on...

8. How are small businesses financed?

Commercial banks and other depository institutions are the largest lenders of debt capital to small businesses. They accounted for almost 65 percent of total traditional credit to small businesses in 2003. (This includes credit lines and loans for nonresidential mortgages, vehicles, equipment, and leases.) Credit cards account for much of the growth in small business lending over the past few years. For more information, see Advocacy’s annual publication, Small Business Lending in the United States (www.sba.gov/advo/research/lending.html).

Keep the above point firmly in mind as we'll come back and explore how lending to small business is panning out in today's economy.

9. How do regulations affect small firms?

Very small firms with fewer than 20 employees annually spend 45 percent more per employee than larger firms to comply with federal regulations. These very small firms spend four and a half times as much per employee to comply with environmental regulations and 67 percent more per employee on tax compliance than their larger counterparts. For data broken out by industry, see www.sba.gov/advo/research/rs264tot.pdf.

Notes: e = Advocacy estimate.Bankruptcies include nonemployer firms. For a discussion of methodology, see Brian Headd, 2005 (www.sba.gov/advo/research/rs258tot.pdf).
Source: U.S. Dept. of Commerce, Bureau of the Census; Administrative Office of the U.S. Courts; U.S. Dept. of Labor, Employment and Training Administration.

Now before I comment and expand on the above, recently while on the road I was tuned into AM 1420, a local talk radio station here in Cleveland. A brief news report was running and the name of the source escapes me, but the topic was that small business loans were reported to be increasing. If true, the probability for jobs and growth (not too mention the possibility of a bubble reemergence) in the economy have just improved.

I've scanned the landscape of recent headlines to answer this all important question...my findings:

Small Business Loans: $10 Billion Evaporates

Eight months after President Obama began prodding the nation's banks to increase their small business lending, the loan numbers continue to move in the opposite direction.
The 22 banks that got the most help from the Treasury's bailout programs cut their small business loan balances by a collective $10.5 billion over the past six months, according to a government report released Monday.
Three of the 22 banks make no small business loans at all. Of the remaining 19 banks, 15 have reduced their small business loan balance since April, when the Treasury department began requiring the biggest banks receiving Troubled Asset Relief Program (TARP) funding to report monthly on their small business lending.
Over the six months that the reporting requirement has been in effect, the banks have cut their collective small business lending by 4%. Their cumulative balance stood at $258.7 billion as of Sept. 30, according to a Treasury Department report.
The bank with the biggest lending drop was Wells Fargo (WFC, Fortune 500), which cut its loan balances by $3 billion. However, Wells Fargo also remains by far the biggest small business lender, with $73.8 billion lent out to small companies. No other bank comes close to that tally.
Some banks are unapologetic about their cutbacks. Small business defaults are soaring, and banks are under pressure to shore up their balance sheets and reduce their exposure to risky loans. Two key small business lenders, CIT Group and Advanta, filed for bankruptcy this month.
But other banks downplay their dwindling loan numbers.
JPMorgan Chase (JPM, Fortune 500) made headlines last week by announcing that it would increase its small business lending by $4 billion this year. But there's no sign of an increase so far in the reports the bank has been filing to the Treasury. JPMorgan's small business lending total has declined every month since April, falling 2.5% over the period. As of Sept. 30, the balance stood at $25.4 billion, down $664 million from six months ago.

The above article is actually over a week old, but illustrated small business loans are in tight supply. There's also a revealing story about a couple who struggled to get loans from the SBA, even with mountains of stimulus programs poured in worth a read.

In an even more revealing piece on CNN Money: No Lending, No Recovery

In an ominous sign for the recovery, bank loans are drying up faster than ever.
Loan balances at commercial banks fell at the fastest clip in at least 25 years in the third quarter, the Federal Deposit Insurance Corp. said Tuesday.
Outstanding loans have fallen every quarter since last fall, when the collapse of Lehman Brothers and other big financial firms turned a recession into a full-fledged financial crisis.
But the third quarter decline was the sharpest yet, leaving banks' balance sheets 7% smaller than they were at this time a year ago.
The falloff in bank lending is fueling worries that a taxpayer-financed economic recovery could run out of gas as borrowers scrounge for credit. The concern is particularly acute for the small businesses that account for much of U.S. job creation.
"There are people with legitimate projects out there who cannot get loans, and we can't sustain a real recovery without access to credit," said Brian Olasov, a managing director at law firm McKenna Long & Aldridge who focuses on real estate finance.

The lending pullback comes even as the biggest institutions such as Bank of America (BAC, Fortune 500), Citi (C, Fortune 500) and JPMorgan Chase (JPM, Fortune 500) enjoy generous government subsidies -- including the Federal Reserve's decision to hold down short-term interest rates, which cuts bank funding costs.
At the same time, they have been talking up their lending activities.
Bank of America, for instance, boasted last month in its third-quarter financial results that it "extended $183.7 billion in credit during the quarter." But it ended the quarter with fewer loans than it started with, as loans fell by $28 billion.
Similarly, JPMorgan Chase said in its third-quarter report that it "continues to help consumers and communities in this challenging economy." But its loan book shrank 4% during the quarter and 14% over the past year.
Meanwhile, banks are funneling more of the low-cost funds they get thanks to the federal deposit guarantee into securities. Bank holdings of Treasurys soared 49% in the latest quarter, the FDIC said.
The banks are pulling back on lending after the U.S. enjoyed a decades-long credit expansion, fueled in part by bank loans and in part by the growth of securities markets.
Since investors fled the market for privately issued mortgage debt in 2007, once-thriving securities markets have shriveled.
Companies issued $753 billion worth of securities backed by car loans, credit card borrowings and other so-called asset backed securities in 2006. That number shrank to $139 billion last year, according to the Securities Industry Financial Markets Association, and totaled $118 billion through the third quarter of 2009.
The collapse of securities issuance limits borrowers' options and could steer more opportunities to the banks. But they are busy cleaning up after soured residential and commercial loans.
Loans charged off as uncollectible nearly doubled from a year ago in the third quarter, to $136 billion, the FDIC said.
Meanwhile, consumers are coming off a debt binge of their own and trying to mend their own tattered balance sheets.
"The consumer is cutting back as the banks are trying to hack down their loan books," said Dan Seiver, a finance professor at San Diego State. "It's not surprising, but it's not good news for the creditworthy small business that can't get money to expand."
That banks are shrinking their balance sheets at a time when the economy is sputtering and consumers are strapped is no surprise, Olasov said. He said the lending slowdown offers a sobering reminder of banks' limitations.
"The choice for the banks is very stark," he said. "You can either repair your balance sheet or you can build your loan portfolio, but you can't do both at the same time."

There you have it, commercial banks, the largest venue for credit to small business is cutting their loans in that category. Not only that, the consumer demand for additional credit is kaput. Indeed, Richard Koo in a recent speech has made it painfully clear that consumer demand for credit (or lack there of) can have material affects on the economy, but is often ignored.

With small businesses financing severely tightened it's hard to imagine where growth and jobs are going to come from. I could not find one single source citing growth in small business lending, so that radio pitch was likely a misrepresentation.

Furthermore small firms bear the brunt of costs in additional compliance regulation. With health care reforms on the way along with additional financial services regulation and consumer protection laws in the pipeline, one can infer compliance costs will continue to rise further choking the entrepreneur. Price Waterhouse Cooper performed a study and found health care costs would increase considerably, a large source of burden to small business owners, the results:

An analysis by the Price Waterhouse Coopers firm concluded that the legislation would raise the health care costs for most American by an average 18 percent. Once the plan is phased in by 2019, a typical family of four would pay an additional $4,000 per year for insurance coverage. When combined with existing inflation, costs would double from today’s $12,300 annual average to $25,900. From that 111 percent increase, $9,600 is due to existing factors the legislation doesn’t correct, and $4,000 is because of additional costs created by the legislation. Premiums for single persons would rise from an average of $4,600 a year to $9,600. After all is said and done, the report said that 25 million Americans will remain uninsured.

Finally, I found the fact that banks are increasing their treasury purchases quite interesting. As readers know I am mildly bullish even on long bonds for the time being. Hugh Hendry of Ecclectica Asset management shares similar viewpoints:

However, where will the demand for all of this additional government debt come from? Let us review the Fed's Z1 numbers. The US has household wealth of some $67trn. Of that, $20trn is accounted for by real estate and is perhaps out of bounds for our purposes. But $8trn is held in the form of private pensions and insurance funds. And yet, remarkably, these institutions presently allocate just $630bn to Treasuries et al. Households have a further $22trn in time deposits and other financial assets. But again they own just $500bn of Treasuries, and commercial banks own a tiny $130bn or, 1% of their total asset base of $12trn.

Consider that in 1952, at the very end of the supernova bond bull market formed from the ashes of the Great Depression and the Liberty Bonds that financed the Second World War, US banks held 40% of their gross assets in Treasuries. That is a potential $5trn of demand from this one source alone, albeit spread out over a number of years. And again, the Japan experience lends support. Japanese financial institutions have quadrupled the percentage of their assets held in JGBs. Furthermore, their households have lifted their government bond weightings five-fold over the last ten years. Should the same pattern repeat itself stateside, American households would need to buy another $2.5trn, but again, over ten years.

Putting Perspective On Today's Money & Money Relation [& The Hoo-Haw About Inflation]

noreply@blogger.com (MWS) — Thu, 22 Oct 2009 18:25:00 +0000

There are two things that drive me Mel Gibson insane:

Constantly hearing companies' earnings are "better than expected"
That serious inflation and/or hyper-inflation are destined in our future

Out of sheer annoyance I'll not speak of the first issue. However on the second, yes, one day in our eventual future inflation will be a problem. But just like Prechter was years early on predicting deflation, the loud majority constantly calling for the return of inflation and demise of the dollar are far ahead of reality on their predictions. I attacked (granted, out of great respect) Marc Faber once before when I heard More Calls for Hyper-Inflation. Since then Faber has become more realistic in his prediction; that is he has conceded this could be a decade in the making and I agree.

So now I want to pick up on a concept I started on in Debt, Wealth & Keynesianism. This time let's get more nitty-gritty with definitions of forms of money (media of exchange).

Traditional Money Source:
Commodity Money: This is money in the most traditional sense - gold, silver, copper, etc.
Money Substitutes: Historically certificates used as claims on commodity money, i.e. banknotes
Fiat Money: Federal Reserve notes, Euros i.e. "legal tender" (backed by nothing but faith)
Credit Money: loans, bonds, etc.

Alternative Quasi-Money Source:
Derivative Money: Swaps, CDS, etc.

There will no doubt be controversy surrounding the above categories, but it's critically important to consider all of them in our money system. Many do not consider credit money as calculated in the money supply. Those who don't are only considering it's legal status as a claim to payment for future goods and services or simply just do not understand monetary theory. Indeed, credit money is the dominant form of money in our system. To explain why in more detail, I defer to Steve Keen's Roving Cavalier's Of Credit:

The Data versus the Money Multiplier Model
Two hypotheses about the nature of money can be derived from the money multiplier model:

1. The creation of credit money should happen after the creation of government money. In the model, the banking system can’t create credit until it receives new deposits from the public (that in turn originate from the government) and therefore finds itself with excess reserves that it can lend out. Since the lending, depositing and relending process takes time, there should be a substantial time lag between an injection of new government-created money and the growth of credit money.

2. The amount of money in the economy should exceed the amount of debt, with the difference representing the government’s initial creation of money. In the example above, the total of all bank deposits tapers towards $10,000, the total of loans converges to $9,000, and the difference is $1,000, which is the amount of initial government money injected into the system. Therefore the ratio of Debt to Money should be less than one, and close to (1-Reserve Ratio): in the example above, D/M=0.9, which is 1 minus the reserve ratio of 10% or 0.1.

Both these hypotheses are strongly contradicted by the data.
Testing the first hypothesis takes some sophisticated data analysis, which was done by two leading neoclassical economists in 1990.[3] If the hypothesis were true, changes in M0 should precede changes in M2. The time pattern of the data should look like the graph below: an initial injection of government “fiat” money, followed by a gradual creation of a much larger amount of credit money:

Their empirical conclusion was just the opposite: rather than fiat money being created first and credit money following with a lag, the sequence was reversed: credit money was created first, and fiat money was then created about a year later:

“There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly. (p. 11)

The difference in the behavior of M1 and M2 suggests that the difference of these aggregates (M2 minus M1) should be considered… The difference of M2 – M1 leads the cycle by even more than M2, with the lead being about three quarters.” (p. 12)

Thus rather than credit money being created with a lag after government money, the data shows that credit money is created first, up to a year before there are changes in base money. This contradicts the money multiplier model of how credit and debt are created: rather than fiat money being needed to “seed” the credit creation process, credit is created first and then after that, base money changes.

It doesn’t take sophisticated statistics to show that the second prediction is wrong—all you have to do is look at the ratio of private debt to money. The theoretical prediction has never been right—rather than the money stock exceeding debt, debt has always exceeded the money supply—and the degree of divergence has grown over time.(there are attenuating factors that might affect the prediction—the public hoarding cash should make the ratio less than shown here, while non-banks would make it larger—but the gap between prediction and reality is just too large for the theory to be taken seriously).

...
This first major paper on this approach, “The Endogenous Money Stock” by the non-orthodox economist Basil Moore, was published almost thirty years ago.[4] Basil’s essential point was quite simple. The standard money multiplier model’s assumption that banks wait passively for deposits before starting to lend is false. Rather than bankers sitting back passively, waiting for depositors to give them excess reserves that they can then on-lend,

“In the real world, banks extend credit, creating deposits in the process, and look for reserves later”.[5]

Thus loans come first—simultaneously creating deposits—and at a later stage the reserves are found. The main mechanism behind this are the “lines of credit” that major corporations have arranged with banks that enable them to expand their loans from whatever they are now up to a specified limit.
If a firm accesses its line of credit to, for example, buy a new piece of machinery, then its debt to the bank rises by the price of the machine, and the deposit account of the machine’s manufacturer rises by the same amount. If the bank that issued the line of credit was already at its own limit in terms of its reserve requirements, then it will borrow that amount, either from the Federal Reserve or from other sources.

If the entire banking system is at its reserve requirement limit, then the Federal Reserve has three choices:

refuse to issue new reserves and cause a credit crunch;
create new reserves; or
relax the reserve ratio.
Since the main role of the Federal Reserve is to try to ensure the smooth functioning of the credit system, option one is out—so it either adds Base Money to the system, or relaxes the reserve requirements, or both.
Thus causation in money creation runs in the opposite direction to that of the money multiplier model: the credit money dog wags the fiat money tail. Both the actual level of money in the system, and the component of it that is created by the government, are controlled by the commercial system itself, and not by the Federal Reserve.

That should be plenty to form a foundation for my argument, but I encourage all to read Keen's post in its entirety.

Those who are calling for out of control inflation refer to the base money. As Keen points out, the "credit money dog wags the fiat money tail". The chart of debt money to money stock measures doesn't truly capture the essence of how much more credit money exists than fiat money because the M2 & M3 stock measures surely contain deposits from debt money source. To illustrate this more completely one must consider the right inputs.

Total Private Debt (Q2 2009) vs. Base Money (10/21/2009)

From the illustration above it is clear to see How Central Banks Lost Power, reinforcing Keen's findings. Total private debt is many magnitudes greater than base money. True, the financial sector's debt takes a large chunk of that, but even removing that source there is still a large divergence. In fact previously heralded figures like Greenspan cheered their loss of 'control' by advocating the positives of securitization, derivatives and other sophisticated products of financial engineering. Securitization and derivatives add another complicated layer to the money supply. The advent of packaging up loans into a securities frees up lending for banks, allowing them to continue to make loans without posting additional capital.

David Roche defined the leverage derivatives create very process in his book 'New Monetarism'.

Just what form has this new cheap money taken? Why derivatives of course!

It's true, the top 5 banks are levered to the teeth in derivatives. Furthermore, derivatives increase traditional lending capabilities. From the OCC:

Surprise surprise! Our favorite headline commercial banks on the receiving end of generous taxpayer bailouts have enormous amounts of capital at risk tied to derivative contracts, the vast majority of which are tied to interest rates. Why so much risk?

We've seen the 'evil side' of derivatives already. Do you really believe that 'committing' a few trillion to banks when they hold over $200 trillion in derivative exposure alone is really going to solve the crisis?

So what we're deducing from these facts above are:

Traditional credit money is many times the base money in the system and indeed the 'credit money dog wags the fiat money tail'
The process of securitisation amplified leverage by use of bypassing traditional capital requirements in the lending process.
Derivatives are enormous in notional value and exceed all other measures of "money" by unimaginable amounts. Even worse, these holdings are concentrated (in the US at least) in the hands of 5 TBTF commercial banks.

Taking it a step further:

When credit money far exceeds base money the means of supporting payments for the obligations reduces, sometimes severely. This is especially true when credit is supported by asset prices. When asset prices tank, there is no longer support for the debt. The global economy has undergone a great period of ponzi financing that is unraveling and will continue to unravel for many years until a) debt conversions/forgiveness have been agreed upon b) defaults have reduced debt outstanding enough to inspire confidence in lending/borrowing again c) a long agonizing period of repayment is undergone d) a combination of a, b & c.
The advent of securitisation put an already fraudulent credit system on steroids and created greater incentive to take on much higher risk than was warranted in lending. Securitisation is now dead and the source of large new credit creation with it.
What happens when derivative bets go wrong? We've already seen what happens; unprecedented bailouts that are akin to band aids for treatment of deep lacerations. I suppose we have not yet finished this chapter of the crisis so long as such large notional values still loom.

To counter all of my arguments above, inflationists will claim the Fed will keep printing and the government will keep spending in perpetuity or until the system is "cured".

The above graph shows the private debt/federal debt relation. Despite epic increases in federal borrowing there is still a very wide margin. At some point the market will place a cease and desist on the government's madness via higher long rates (sending the economy into another crash). Furthermore, it is the very economy that the government is desperately trying to stimulate that must pay the piper for this excessive federal debt binge, which will choke the priate sector.

As for the Fed and Treasury's valiant effort, all they have to show for it are total adjusted reserves now at $1,017.06! Do tell, if banks are so healthy and have received so much free money, why does this figure continue to rise?

The demand to borrow amongst consumers and ability to lend by banks are inclined to engage in providence. As outlined above, these conditions which manifest such attitudes are likely to continue for a time until credit money/GDP are more in line. The chart below illustrates just that:

I know what's coming next. The inflationists will say, but look! Total debt continues to increase. Two things, GDP was contracting in the first quarter of 2009 and as it is the denominator it will create a higher ratio, and two, government debt increases have increased faster than private credit contraction. But have you read everything I've laid out above! Inflationists are missing the boat because they have misinterpreted the mechanism by which money is extended in our economy. The large portion of government spending (from borrowing) is going to two sources:

To banks via bail outs
Transfer payments to the unfortunate

Is main street benefiting from money barreled down the throats of banks? I think not. Total net lending of -241.1 billion in the second quarter is testament to that z.1 and lending is the main mechanism by which money reaches the economy. Meanwhile JP Morgan and Goldman make record profits trading, a more risky venue for generating revenues. The mechanism is broken and now the only mechanism alive is a never ending game of speculate and steal (from the tax-payer) when it blows up.

On transfer payments, I'd assume the majority would opt to have their jobs back instead of receiving a percentage of their former pay. Indeed, many may have afforded lifestyles that only their former incomes could maintain. This time, the public is not buying the perpetual bubble solution to preceding crises.

Lastly, look back on all of the famous crashes and depressions of the past and see what they have in common; speculative bubbles financed by leverage. [1929 great depression, south sea bubble, tulip mania, Japan's decade (going on two) of deflation and property bust, the "great recession" of 2008/2009] More examples are out there and the extent of the crisis all differ, but the crisis mechanism remains the same triggered by the same ponzi financing.

In summary, why is the relation of credit money to base money and its huge multiple so significant? Because debt can be defaulted on, especially when the means to pay it are in scarce supply in relation and the mechanism to extend new credits is broken. Balance must be restored and a new system must rise to take its place.

Relative Pricing & Risk

noreply@blogger.com (MWS) — Tue, 29 Sep 2009 02:16:00 +0000

It seemed every day the bottom was just about to fall out of the S&P 500 over the summer. This never happened. Instead risk taking has returned in the form of egregious multiple expansion. The logic behind the risk taking is actually not so crazy when one puts it in retrospect to interest rates.

The Low Interest Rate Conundrum

The 10 year yield (TBY) = 3.03%

S&P 500 forward earning yield (FEY) = 3.89% (based on S&P earnings (FE) estimates of $41.49, as reported)

Assuming the inverse of the treasury bond yield approximates a good multiple on the market, the S&P 500 fair value on a relative basis of forward earnings would be roughly $1,245. (fair value price/FE = 1/TBY, or FVP/41.49 = 30.3). At 1,066, this actually implies the S&P 500 is undervalued at -0.16 taking the ratio of FVP/Current Price. The model has precedence, Prudential Financial - Topical Study #58, January 6, 2003 (sorry no link):

A spectacular thing occurs when investors expect the earnings yield in stocks to be greater than interest on bonds; they favor the stocks. However, there are conditions that must be met to keep fueling the rally:

Bond interest rates must keep falling, otherwise as the market reaches for the sky, the yield it gives falls with the rise in price. The relative attractiveness will not keep without lower rates.
Earnings must keep up, expectations must rise or at least keep surprising (even if based on grossly deflated estimates).

This picture is painted in relative terms of course. In absolute terms the market is overvalued (fundamentally). An overvalued market price can be corrected by bond rates rising, earnings expectations not being met and/or by prices simply falling.

Psychology plays an important role in this re-risking as well. Bullishness has been growing all summer and investors have all bought their magic beans that they are told will sprout green shoots. So expectations are increasingly becoming optimistic. The higher are you expectations the easier they burst when not met.

The TBY has been on a tear, recently and expectations for the future economy remain bizarrely bullish. On a relative basis, the TBY is so low it is implying the market can go higher to $1,245 keeping the TBY constant. Companies are managing earnings expectations by the lowering the bar so far they almost can't miss.

Any rational person would look at the absolute overvaluation and say, this rally is kaput. However, markets can stay irrational longer than you can stay solvent.

Reforming The Economy

noreply@blogger.com (MWS) — Tue, 22 Sep 2009 18:49:00 +0000

Despite a huge stock market rally and some indicators turning up in the economy, many prominent bloggers, economists and investors remain bearish. Some names on that list include Nouriel Roubini, Bill Gross, David Rosenberg, Mike Shedlock, John Mauldin, Paul Tudor Jones, Paul Krugman, Nassim Taleb and Steve Keen to name a few.

Why?

If I was to take a stab at this it would be to say (except for the two Keynesians noted above) that it is because the risks in the economy have not structurally been changed.

Predominant Risks:

excessive leverage
moral hazard
conflicts of interest
complex regulation
complex and misaligned tax code
interventionism
lack of credible transparency

Without addressing these inherent risks even a resemblance of stability will not be obtained. Of course, this is just a starter list. A round table of think tank arm chair economists surely could build a more comprehensive list. Let's address these out of order.

The non-republic, republic:

The past century has seen a growing trend in the overall involvement of our government...interventionism. This needs to be put in check before a currency crisis occurs at some unknown future date from out of control spending. Here are some simple solutions.

Restoring the republic:

Lobbyists have no place in Washington. Their presence distributes unfair subsidies to industries and corporations at tax payer expense, creates " "-opolies which often raise prices and reduce competition. It also represents the wrong constituent. Corporations are not constituents, citizens are. Lobbying brings misrepresentation of interests to Washington, since profits are the interests of corporations while rights and liberties are the interest of citizens. If lobbying is banned then...
The term for house representatives should be increased from 2 years to at least 4 years. It's amazing to me the conflict of interest between terms and agendas are not brought to attention more often. With lobbying erased and terms extended the focus on short term agendas and re-election would be reduced and allow for more strategic, long-term objectives as goals for representatives. More specific and objective research could be sought after in drafting bills where the representative actually writes it! Of course seeking expert advice of non-interested parties would be welcome in research from senators (absent lobbyists this could be done).
As crazy as this may sound, I believe Americans to be truly underrepresented in the house. The number of representatives used to be regularly increased to match population increases and this has not been done in over a century. With more representatives two things will be accomplished. 1) the ease of rushing bills through the floor should be reduced. No doubt the first stimulus may not have passed as quickly as it did with more waffling. 2) more time with constituents, on planning legislation and focus on topics will be afforded for and hopefully better quality bills will result.
The true purpose of the government is to uphold contract law and property rights of the individuals it represents.

The republic; can we keep it? Not if the structure of congress remains as is.

Banking and Monetary System Reform:

We live in a credit based economy that has reached an absolute peak in private sector leverage, largely a result of a fraudulent banking system and an improper role of the central bank. These proposals are based on Steve Keen's assumptions that credit is created by banks before reserves are supplied (by the Fed or depositors).

Fractional-reserve banking is fraudulent, even in name. Steve Keen concludes reserves are a mere mirage and that our current banking system is more like a zero-reserve system. This needs to be addressed immediately. Perpetual credit creation from thin air is inflationary and is the cause of the boom-bust cycle. The bust come when incomes and/or asset prices can no longer support the credit being serviced or when the pool of greater fools runs out and lending slows or stops. Bank runs are inevitable.
Given the fraudulent, destabilizing and inflationary bias of fractional-reserve banking, a system of full-reserve banking should be adopted. Rarely in history has this actually been practiced, but two known successful examples can easily be traced: 1) Bank of Amsterdam 2) GoldMoney.com
Full-reserve banking, in theory needs no lender of last resort. Therefore, the role of the central bank would be altered in a material way. This role creates powerful moral hazards we are all witnesses and victims too. 1) it's lender of last resort powers would be stripped. 2) it's ability to set interest rates would be stripped. Interest rates would be set between investors, borrowers, savers and lenders. 3) it's powers to print money would be stripped. 4) The FRS powers for acting as regulator and overseer of banks and their (now 100%) reserve requirements would remain, but this new reserve level would be permanent. 5) Though demonstrably the FRS has failed in times past as a regulator of lending standards (i.e. fraud), with the conflicts of interests stripped out, the FRS should be able to carry out this task more responsibly.
The FDIC should have no implicit guarantees from the government and should operate as a fully private institution. Of course, with full-reserve banking the institution would most likely fail from lack of a market. Banks and individuals could make their own decisions as to whether they would pay for (seemingly unnecessary) insurance of this nature.
Control of the currency is a much more complicated subject. The powers are vested in congress officially, but to trust congress with this right is suspect almost as much as the FRS. I propose a bi-metal currency backed by gold and silver, authenticated by banks (now with oversight from an non-conflicted FRS).

Debt & Equity Incentives:

Unfortunately not only is our society's monetary system credit based, but every incentive is also given to issue more debt than equity.

Tax deductions are given for interest payments on debt out of pre-tax income.
Dividends paid to equity investors are double-taxed; once to the corporation out of income and once to the investor as dividend income.

Conclusion, tax incentives skew the capital structure of the economy to favor debt investments. An equity based capital structure is much more stable in the long run. Without the incentives for debt based capital a natural balance more heavily weighted towards equity financing would likely emerge.

Remove tax deductions for interest payments.
Lower tax rates on dividends for equity investments.
Lower tax rates paid on interest earned on fixed income investments.

Commercial & Investment Banking:

Those who claim it was a lack of regulation that led to the crisis are misinforming you. The banking and securities industries are two of the most complex and heavily regulated industries in modern society. It was the failure to set intelligent regulation that was, of course, heavily lobbied by the banking sector against, that enabled much of the crisis.

The SEC, the regulatory body responsible for investment bank oversight, severely loosened net capital requirements for the major investment banks in a corrupt showcase of crony-capitalism. The result was highly levered firms invested in high risk assets. Net capital requirements should be strict, as these firms manage other people's money and should have a fiduciary obligation to act in their client's best interest. This should be true for any firm that holds deposits of any kind.
Though controversial even among conservatives, the repeal of the Glass-Steagal act was in my opinion material. The conflicts of interest created when commercial and investment banking activities are conjoined are great and should not be allowed.
Exchanges should not subsidize principals to provide "liquidity". If there is an attractive market with profit potential investors will provide ample liquidity. Also, any trading practice that encourages front-running should be banned (flash trading).
Not exactly a construct of the banking industry, but securities related nonetheless, rating agencies have a government sponsored monopoly (is there any other kind? debatable point) and should be paid by investors, not issuers.
I'm not an expert on commodity markets nor derivative markets, but surely some attention from more qualified individuals could shed light on that. Specifically, the opening of the commodities markets to speculative investors such as oh say pension funds, who have been known to dabble in oil futures in large amounts I'll say. The CFMA would need serious reformation.

Accounting:

The advent of the off-balance sheet item is a monster I'm amazed is still a legitimate practice.
Mark to market, not mark to fantasy
Dubious line items such as "other items" with little disclosure in footnotes would be a welcome reform to added accounting transparency. While at it, more descriptive line item disclosure would be very welcome addition to today's accounting standards.

Tax Code:

Utterly incomprehensible and too complex. Simplification is a must; I am no tax expert. The issue of debt vs. equity incentive was already discussed.

Labor is an economy's most valuable resource. It defines value in all commodities of exchange by its productive capacity. Give back spending/saving power to the economy and dramatically reduce all individual and corporate income taxes. Income taxes should be lower than dividend and capital gain taxes.
If tax burdens must be implemented to support necessary government functions, then labor and capital should not be the primary source of tax revenue for governments. Instead rent, here considered as the price paid for the use of land, should be a major source of tax revenues. The tax code heavily favors landlords and encourages speculation in real estate, we all know the outcome. In theory, taxing rents should not affect land prices in a material way.

Interventionism:

Our government has so many departments I doubt they can even account for them all. Needless to say, services that can be profitably and legally provided through private enterprise should be. Waste in our government is out of control and the size and responsibility must be downsized and restructured. In capitalism...

Institutions are allowed to fail through the courts if necessary.
The welfare state should only be afforded to the (truly) disabled. Citizens believing they have an intrinsic right to government services they are capable of obtaining of their own free will is not a principle of a capitalistic society. The ongoing health care debate is a prime example of that. Is it any wonder obesity in America has become a serious problem given the excessive role of our government in health and insurance industries? Americans have not the proper incentive to care for themselves in this status quo.
Mercantalist policies should be avoided unless to protect from hazard (such as imports that prove fatal from chemicals of manufacture). This includes severely limiting quotas, subsidies and tariffs on trade domestically and internationally.
Competition should be freely embraced. Say, that might be a swell idea for insurance companies that are afforded state monopolies.

Conclusion:

I started with the issue of "the republic" and of course the monetary reforms because they are the most instrumental problems in America today. The future however, predicts these changes will not be addressed until it is too late. Why? because liabilities, both our indebtedness to other sovereigns and our own domestic entitlement liabilities will prove to be too great at some point and some form of default (inflation or otherwise) will occur, most likely not for many years down the road.

Since 2007 when the crisis emerged, all of these factors listed above are still inherent in the system. If nothing has been changed to prevent these complexities from triggering another crisis, why then should one expect them not to occur? Money has been thrown at the problem creating more moral hazard in typical kick the can down the road fashion.

Student Loans: The Non-Issue, Issue

noreply@blogger.com (MWS) — Sat, 19 Sep 2009 13:11:00 +0000

It surprises me that so little attention has been given to recent college graduates and student loan performance. First, some background on how students have fared from the National Center for Education Statistics:

Enrollments:

Enrollment in degree-granting institutions increased by 14 percent between 1987 and 1997. Between 1997 and 2007, enrollment increased at a faster rate (26 percent), from 14.5 million to 18.2 million. Much of the growth between 1997 and 2007 was in full-time enrollment; the number of full-time students rose 34 percent, while the number of part-time students rose 15 percent. During the same time period, the number of females rose 29 percent, compared to an increase of 22 percent in the number of males. Enrollment increases can be affected both by population growth and by rising rates of enrollment. Between 1997 and 2007, the number of 18- to 24-year-olds increased from 25.5 million to 29.5 million, an increase of 16 percent, and the percentage of 18- to 24-year-olds enrolled in college remained relatively stable (37 percent in 1997 and 39 percent in 2007).

Average Income:

Cost of Education:

For the 2007–08 academic year, annual prices for undergraduate tuition, room, and board were estimated to be $11,578 at public institutions and $29,915 at private institutions. Between 1997–98 and 2007–08, prices for undergraduate tuition, room, and board at public institutions rose by 30 percent, and prices at private institutions rose by 23 percent, after adjustment for inflation.

All Institutions: from 1980 to 2007-08 the cost of education has risen by a multiple of 5.25. Since 2000 costs have risen by a multiple of 1.42 while men saw their incomes decline by 7.8% over the same time period. Is that value added education?

Indeed, college graduates are finding the wonder jobs they expected after 4 hard and costly years of education are not there, which is quite evident in the latest employment report:

Highlights in orange rectangles are mine. If you are between 20 and 35 this recession is hitting you hard, specifically if you are between 20 - 24.

A severely lagging, but telling sign student loan defaults are set to rise and continue to rise is from the Federal Student Aid:

The cohort default rate is the percentage of borrowers who enter repayment in a fiscal year and default by the end of the next fiscal year.

The Department issues default rates according to the fiscal year that borrowers entered repayment. For example, the fiscal year 2007 default rate is based on students that entered repayment between 10/1/2006 and 9/30/2007. The Department publishes default rates approximately two years after the fiscal year that students enter repayment.

The trend of defaults turned sharply up even before the recession started. This could be confirmed again back in April when defaults soared:

The situation is mirrored in the smaller private student-loan market. In 2008, SLM Corp. also known as Sallie Mae, wrote off 3.4% of its private loans that were already considered troubled, according to its latest annual report -- more than double the figure in 2006. Student Loan Corp., a unit of Citigroup Inc., wrote off 2.3% of those loans in 2008, compared with 1.5% a year earlier.
"The volume of people in trouble is definitely increasing," says Deanne Loonin, a staff attorney at the Boston-based National Consumer Law Center who counsels low-income consumers on student loans and other debt issues.

Lenders say they are hearing more pleas for help as the unemployment rate worsens and debt levels soar among graduates.

Sarah Kostecki, a 24-year-old sales associate in New York, graduated last year from DePaul University with a major in international studies and $87,000 in debt, translating to monthly payments of $685, the vast majority of which are private loans.

The payments represent more than a third of her take-home pay, and to help her make ends meet, her grandparents are giving her $200 a month toward her debt this year. Beginning in January, she'll be on her own, and she worries about falling behind.
"It feels like I'm being punished for having gone to school," Ms. Kostecki says. She has contemplated some of the options offered by private loan companies, such as temporary interest-only payments. But after two years, her payments would jump by almost $200 a month on top of what she's paying now, she says. "I don't want that."

The article goes on to explain various deferment and forbearance schemes that essentially kick the can down the road for most borrowers but exacerbate the problem when it comes due.

Sallie Mae releases quarterly results of their private loan portfolios.

Sallie Mae references the "favorable" trend of forbearance in their presentation. However, what's favorable about this is that it shadowed reality for awhile, avoiding charge-offs of any significance in 2008. In 2009 the story has changed and the trend of delinquencies and charge-offs is accelerating while forbearance decelerating (because eventually the can gets to heavy to kick down any further). There is no indication this trend will slow as more and more college graduates continue to enter the labor force in a bleak economy and as previous graduates run out of options for making ends meet.

While I'm no expert on bankruptcy laws I do know student loans are next to impossible to discharge, so these debts will haunt graduates (and in many cases their parents who are also struggling to pay for their students education) for some time into the future. While college graduates do earn significantly more than high school only earners, the net benefit has been declining over the past decade. And now that boomers are now recognizing they are woefully underfunded for retirement, these graduates now have more added competition with more experience.

In conclusion, one has to wonder why this topic receives so little attention? Investors and financial institutions will be slowly bleeding losses on private student loans for some time to come and gen X & Y will have serious constraints on the contribution they can afford to growth in our economy despite their education advantages. Yet another headwind our economy faces in the wake (is it truly the wake yet?) of the most massive credit binge in history.

Gold Bugs Beware!

noreply@blogger.com (MWS) — Fri, 18 Sep 2009 22:03:00 +0000

Gold has certainly been in the spotlight as of late. Since July it has rallied approximately 100 points. Gold bugs have proclaimed the long awaited push to 1,500+ has now begun. Maybe so, but I know of some guys who may not like that idea; IMF Approves Sale of 403.3 Metric Tons From It's Gold Stockpile:

The International Monetary Fund’s executive board said it approved gold sales of 403.3 metric tons and pledged to ensure against “disruptions” in the gold market.
The IMF said it would “stand ready to sell gold directly to central banks.” The sales could also be conducted in the open market in a “phased manner” over time, the Washington- based lender said in an e-mailed statement.

"disruptions"? If gold truly is on its way to the moon, this IMF action will only delay the inevitable. Of course in the short term depending on the aggressiveness this could have an impact that would disappoint the dollar collapse believers. The truth is, as outlined here before, gold performs spectacularly in the face of high uncertainty. The fact gold has soared throughout this global stock market rally signals something is amiss. Investors must not be convinced of a great recovery and are hedging accordingly. Global central bank "QE" shenanigans don't hurt either.

Musings Over "Recovery"

noreply@blogger.com (MWS) — Sun, 13 Sep 2009 22:48:00 +0000

It's been awhile since I've commented in depth and comprehensively on the state of the economy here. No doubt headlines in the mainstream media have been generous in making the assumption that the economy is returning to growth, albeit on a slow trajectory. The most recent bit of data being the OECD's composite leading indicators that "point to broad economic recovery". While the index is to be respected as it has had a fairly good track record in its predictive ability, there's more than meets the eye. I discussed the Conference Board's Index (here) once before and warned that it should be respected, but again questions still lingered as to the long term sustainability of "green shoots".

Before getting very "HD" (High Definition) into an analysis of why the growing optimism of recovery might be set up for severe disappointment, let's visit a great economic thinker's thoughts on conditions to be expected in a deflationary environment, which I contend we are not out of the woods on yet. From Ludwig Von Mises' "Human Action":

Credit Inflation (pg. 569):

Conditions are different (than money proper inflation) under a credit expansion which by first affects the loan market. In this case the inflationary are multiplied by the consequences of capital malinvestment and overconsumption. Overbidding one another in the struggle for a greater share in the limited supply of capital goods and labor, the entrepreneurs push prices to a height at which they can remain only as long as the credit expansion foes on at an accelerated pace. A sharp drop in the prices of all commodities and services is unavoidable as soon as the further inflow of additional fiduciary media stops.

Now that we know an extended period of credit inflation inevitably leads to deflation once the flow of additional money is shut off and not refueled, we can accept that we have great potential in today's environment for still being in deflation. I would add that popular delusions and the madness of crowds (reference to Charles Mackay) certainly is a necessary condition to set off a credit boom which eventually leads to a deflationary bust.

Mises outlines a few conditions one might expect during a deflationary credit contraction (p566-569):

Banks, frightened by their adverse experience in the crisis brought about by credit expansion, are intent upon increasing the reserves held against their liabilities and therefore restrict the amount of circulation credit.
The crisis has resulted in the bankruptcy of banks which granted circulation credit and that the annihilation of the fiduciary media issued by these banks reduces the supply of credit on the loan market.
Now, it is true that even with no restrictions in the supply of money proper and fiduciary media available, the depression brings about a cash-induced tendency toward an increase in the purchasing power of the monetary unit. Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money (in the broader sense) and the demand for money (in the broader sense) for cash holdings. This may be properly called deflation.

Keeping these theoretical concepts in mind, let's put them into context of today's economic environment.

Market Watch recently reported the total of 2009 bank failures has now reached 92. As the crisis progresses, experts like Chris Whalen expects hundreds if not 1,000+ bank failures (there are more than 8,000 small banks that hold only about 20% of total bank assets). Failures on this scale are not consistent with economic growth looking forward. The fringe banks are not alone in their troubles. Despite massive government and FRS support and bailouts even the large oligopoly of banks are reluctant to lend. Evidence can most clearly be ascertained of this from two sources:

(1)
Reserve Balances with Federal Reserve Banks:

The most recent value on 09-09-2009 was recorded at $859 billion of reserves, the vast majority of which are excess reserves, that is reserves voluntarily held at Federal Reserve Banks.

(2)
The July Senior Loan Officer Opinion Survey On Bank Lending Practices:

(revealing charts here)

In the July survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households, although the net percentages of banks that tightened declined compared with the April survey.² Demand for loans continued to weaken across all major categories except for prime residential mortgages. The fractions of domestic banks reporting additional weakening in demand in this survey were slightly lower than those in the April survey for C&I loans and home equity lines of credit, approximately the same for commercial real estate (CRE) and nontraditional residential mortgages, and slightly higher for consumer loans.

In response to a special question, domestic banks pointed to decreased loan demand and deteriorating credit quality as the most important reasons for declines in C&I lending this year. In response to a second special question, most banks reported that they expected their lending standards across all loan categories would remain tighter than their average levels over the past decade until at least the second half of 2010; for below-investment-grade firms and nonprime households, the expected timing is later, with many banks reporting that standards for such borrowers will remain tighter than average for the foreseeable future.

I encourage all to click on the link to pdf charts which show lending standards and demand. The demand charts are especially revealing...there little demand and it continues to decline.

Points 1. & 2. have now been satisfied considering the above information. In June the second quarter flow of funds report was released. I will not break it down for you in detail as Martin Weiss has already done an outstanding job of that. For much more Hard Evidence of Continuing Debt Collapse please visit his analysis.

As for point 3. one needs only look to the spike in savings rate, flawed as its calculation may be, the trend is indistinguishable.

Of course, rising savings rates are not deflationary per-say, but they are when wages and incomes are stagnant or declining and spending falling. Consider a recent gallop poll on spending:

Survey Methods:

Results are based on telephone interviews with more than 260,000 national adults, aged 18 and older, conducted January 2008-June 2009, as part of Gallup Daily tracking. For results based on the total sample of national adults, one can say with 95% confidence that the maximum margin of sampling error is ±1 percentage point.

For 2009 data, each generation consists of no fewer than 4,000 interviews. For 2008 data, each generation consists of no fewer than 10,000 interviews. The margin of error for each generation in 2008 and 2009 is ±1 percentage point.

I would assume these polls to be fairly reliable. The bottom line is the consumer is not as thrifty as in times past even in the face of huge government transfer payments, low interest rates for qualified borrowers and lower prices as indicated (by the very flawed) CPI. The poll has some great findings into the demographics issue as well. I would not expect a sudden revival in the consumerism America has enjoyed so recklessly in decades past. Indeed, Record Plunge in U.S. Consumer Credit Signals weakened Spending:

A record $21.6 billion drop in borrowing by Americans added to evidence that consumer spending will be slow to recover as banks and credit-card companies tighten lending standards and households pay down debt.
Consumer credit fell by 10 percent at an annual rate in July to $2.5 trillion, according to a Federal Reserve report released yesterday in Washington. The drop was more than five times larger than economists forecast. Credit fell for a sixth month, the longest series of declines since 1991.

Point 3. looks to be satisfied.

Now let's look to the corporate sector:

Junk Default Rate Rises to 11.5% in August-Moody's:

Moody's Investors Service said the global speculative-grade default rate rose to 11.5 percent in August, the highest level since 1991, as the economic recession took hold.
A total of 15 Moody's-rated corporate debt issuers defaulted last month, 11 of them in North America and four in Europe, taking the year-to-date total to 205 companies, Moody's said in a report on Wednesday.

The ratings agency, meanwhile, cut its forecast for Europe's peak junk default rate, while raising its forecasts for peak U.S. and global rates.

Moody's now expects the European rate to peak at 11.4 percent in the fourth quarter -- the sixth consecutive month that it has reduced its estimate from 12 percent in August, 15 percent in July and as high as 22.5 percent in March.

For the United States, Moody's raised its peak rate forecast to 13.2 percent in the fourth quarter, versus last month's estimate of 12.7 percent, reversing direction after reducing the estimate for at least the previous four months.

Moody's predicted that the global junk default rate would peak at 12.6 percent in the fourth quarter and decline sharply to 4.3 percent by August 2010.

That compares with a 1991 peak of 12.2 percent.

The global forecast is based on an estimated peak in the U.S. unemployment rate at 10 percent in 2010, said Kenneth Emery, director of corporate default research.

"If the U.S. unemployment rate were to increase substantially above 10 percent in the coming year, then default rates would likely be significantly higher," he added.

Surely an economy about to recover to growth would not experience these abnormally high default rates. Hmmm, something is amiss.

Revenue & Earnings:

The S&P Earnings Estimates commentary unfortunately did not come with hard data on sales. So I took an average of the individual issue along with the corresponding operating and as reported figures:

I hid much of the data in the spreadsheet for easy viewing. Unfortunately the font is small. Trusting the average provides a good indication of the overall trend, there is no growth inherent in representative corporate America.

Actual Q2 data:

495 issues (99.51% mkt val) reported: preliminary Operating EPS declined 18.3%, with As Reported up 5.8%.
Again Q3 will be less bad, -9% vs -18% for Q2, -39% for Q1 and the only negative qtr for Q4,'08.

For year 2009 forward earnings estimates (including Q1 & Q2 actuals):

Operating: $54.09 - forward P/E at 1,044 of 19.30

As Reported: $39.35 - forward P/E at 1,044 of 26.53

Are these attractive valuations? Considering all of the data reported above from the beginning of this post is revenue growth in the near future realistic?

For more commentary on the S&P 500 let's visit on some Breakfast's with Dave (Rosenberg) of Gluskin Scheff.

September 9, 2009

With earnings AND revenues down over 20% YoY, it can hardly be said that the fundamentals are very constructive. Current quarter EPS estimates are also down 30% from where they started the year.

Dave must have actual data and confirms revenues are worse than my average taken above.

September 10, 2009

Companies have not really been beating their earnings estimates — only the very final estimates heading into the reporting quarter. For example, the consensus view for 3Q EPS at the start of the year was $21.00, last we saw the estimates were down to just over $14.00. But there is a deeply rooted belief that earnings are coming in better than expected. This is a psychology that is difficult to break. It is completely unknown (for some reason) that corporate revenues are running at a -25% YoY rate, which compares to the -10% we saw at the worst part of the 2001-02 bear market and the -3% trend at the most negative point in 1991.

September 11, 2009

On the incredible multiple expansion of the rally from the March 2009 lows;

In summary, corporate America is not seeing the growth in profits and revenues (more like cliff diving) to support a robust recovery and a soaring stock market.

Dave has some continued thoughts on the labor market:

The problem is not so much with firings any more; it’s more about a complete lack of new hiring. The NFIB index that measures job openings fell again in August — from 9.0 to a 27-year low of 8.0. Challenger hiring plans collapsed 24% in August to a three-month low. Someone obviously forgot to tell the folks at Manpower that the recession was over because its employment plan index for the U.S. just broke below the worst levels of the last three economic downturns. The JOLTS data from the Bureau of Labor Statistics also showed that job openings plunged 121,000 in July and we now officially, for the first time on record, have six unemployed people competing for every possible job opening out there. No wonder organic wages and
salaries are deflating a record YoY rate of nearly 5%.

The U.S. Census Bureau just reported that Americans’ household income last year took the sharpest drop since the government began keeping records in 1947. Median household income sank 3.6% to $50,303, after adjusting for inflation, during the first full year of the recession. At that level, median income is now down to its lowest level since 1997 — a decade’s worth of gains wiped out in just one year. Those that think we are going to see the return of the U.S. consumer into the dealer showrooms and malls on any sustained or meaningful basis for the next several years are dreaming in Technicolor.

That does not bode well for growth outside of any statistical means. And now, a final take from Mises (p. 569):

Prices of the factors of production - both material and human - have reached an excessive height in the boom period. They ust come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. Thus any attempt of the government or the labor unions to prevent or to delay this adjustment prolongs stagnation.

This paragraph sets one up to ask, with wages and salaries having deflated 5% yoy and commodity prices as represented by the $CRB Index nearly 50% lower than a year ago; have the structure of prices and wages adjusted to the real state of the economy?

It's tough to say in the face of such severe declines as we've seen that it's not. But with so much government interference one has to ask, why should the process be over now?

Also of great importance are the structural imbalances that remain. Consumers still remain over indebted and unemployment is expected to continue to rise. Bad assets are still on bank balance sheets and how much is any ones guess. What is known is that this economic downturn has created more structural bad assets as delinquencies on mortgages and commercial real estate continue to escalate at a fast pace. Also looming are Alt-A and Option-Arm resets that begin to escalate in Q3 2009. With headwinds such as these, the prospects of recovery seem doubtful despite the positive leading indicators and a tiny uptick in housing permits and sales.

I'll be looking at more concrete evidence in the future. SHOW ME THE MONEY! I want to see broad increases in sales and upticks in temporary workers. I want to see trust and transparency in our financial institutions and diminishing involvement from government. Once data points like these begin to emerge I'll declare the next great bull market. Until then, deflation remains in my view intact. That's not to say markets cannot diverge from fundamentals for much longer than most think; a word of caution.

Not covered in this report are global aspects such as China's massive stimulus efforts (another credit induced boom), global currencies and devaluative monetary policies, and global trade. No definitive conclusion should be made without analysis of these aspects as well. For the sake of not turning this post into a novel, we'll unfortunately dis-include them.

Liberty Analytics Performance Update

noreply@blogger.com (MWS) — Tue, 01 Sep 2009 13:22:00 +0000

It's been 11 months since the inception of Liberty Analytics' first strategy:

The Intrinsic Wealth Strategy:

Capital appreciation and income will be the main objective here, and would be suitable for conservative to moderate investors alike. Equities will not be as overweight in this portfolio, but as aforementioned, strict guidelines will be applied as to the margin of safety rule, and financial soundness of the issuers is a core requisite. Options and short strategies will not be employed in this strategy. Bonds and other fixed income securities will also find a regular weighting in this portfolio, including cash. Economic outlook will still bare significance as to the weighting of the portfolio. Value and income defines this strategy.

Since Inception (October 2008) the strategy has returned 3.13%.

Results of Strategy:

The timing of inception for this strategy worked out quite well since the September to November crash resulted in many quality equities at substantial discount. The initial drop off and leveling out was a result of investing in equities that found their bottom in November ahead of the March lows.

March was the start of this now much larger than anticipated correction equity markets are seeing globally. Your humble manager had severely underestimated the power this rally has had. The result was to sell equity exposure in hindsight too early as multiple expansion soared and continues to soar beyond top and bottom line growth. After reducing equity exposure, other investments with negative correlations to the SPX were entered into. The decision was early, but good yield and income has been earned since then and in August as the rally has slowed these investments have started to pay off.

The primary view of Liberty Analytics is that this rally has born no relationship to fundamentals. Indeed with stocks leading the rally such as Citigroup and AIG which are only solvent courtesy of the US taxpayer, our caution is not without warrant. There are still very large headwinds facing the over leveraged consumer and time and saving are the appropriate remedies.

Despite our less than optimistic outlook on the economy, we at Liberty Analytics will concede "the bottom" may be in, but than again it may not. This autumn will be quite telling and from the now current extreme bullish sentiment we'll be looking for a correction. In the face of this there are several investments of interest we are looking to and will start slowly increasing equity exposure with an emphasis on companies that have still shown growth in the face of adversity and are high yielding in earnings and especially dividends. Patience is a virtue.

Conclusion

The past year has been extraordinarily challenging for even the most experienced and successful managers. With rock star funds like Fidelity Magellan down nearly 23% yoy despite successful participation in this rally, Liberty Analytics is proud of its humble 3.13% return yoy with minor volatility in the overall portfolio. We are optimistic despite our overall bearish view that select opportunities will begin to emerge this autumn if a correction takes place.

Money Stock & The Economy

noreply@blogger.com (MWS) — Sun, 30 Aug 2009 23:50:00 +0000

Steve Keen is a Australian economist at the University of Western Sydney and author of "Steve Keen's Debt Watch" blog. He was one of the few economists to predict the crisis correctly and continues to be bearish on the economy. What is different about Keen from other economists is his treatment of money and credit in analyzing the economy. He recognizes that the larger the absolute total debt in an economy becomes the larger is its contribution to growth (or contraction). His analysis now determines that there are serious deleveraging headwinds facing many of the world's largest economies.

In other words, there exists large deflationary factors looming that could take years to unwind as credit is adjusted to serviceable levels. What recently caught my brain is his most recent post: Debtwatch 38 - The GFC Pothole or Mountain? He references am empirical study from Kydland and Prescott that proves what Keen has been saying all along; that credit money is created before base money, with a lag of up to a year.

“There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M 1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.

The difference in the behavior of M1 and M2 suggests that the difference of these aggregates (M2 minus M1) should be considered. … The difference of M2-M1 leads the cycle by even more than M2, with the lead being about three quarters.

The fact that the transaction component of real cash balances (M 1) moves contemporaneously with the cycle while the much larger nontransaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory. Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.”

Taking this idea a bit further into today's world, let's see how the M2 - M1 difference has worked as a leading economic indicator.

First, no one indicator is perfect and can be conclusive on its own. In addition to Fed actions and deposit flows were massive fiscal stimulus packages and taxpayer funded subsidies. Simultaneously, a look at the 1Q09' flow of funds report shows the credit side of things, with all but the financial and public sector in massive delveraging mode. However, looking at this data as if it was in a vacuum one could conclude that with the dramatic changes in M2 - M1 has had quicker than 3 quarter lead time if one were to compare it to the SPX, a good proxy for social mood and possibly monetary stimulus.

Indeed, using a Pearson coefficient equation, a -0.4 is extracted using monthly changes in the SPX over the same period as the M2 - M1 monthly changes. This suggests the M2 - M1 change is more close to real time than three quarters. However, using statistics based from normal distributions has proven anything but reliable. The point here is to consider the possibility of a relationship between these two data points and what has been presented here would only serve as a starting point.

What I've shown is not statistically significant. Glancing at the chart you can see the decrease in the flow of money from 3/08 to 6/08 lead the September massacre in the SPX. After that point the M2 - M1 % changes become volatile, again leading the market in a moderate negative correlation. Extrapolating a specific lead time from this would be difficult and uncertain, but June and July M2 - M1 decreases sure do start looking interesting for September.

FASB Grows Marbles - Pros & Cons

noreply@blogger.com (MWS) — Thu, 23 Jul 2009 16:28:00 +0000

The treatment of securities and loans on balance sheets is not a simple matter. Investors wish for transparency and owners reject recording losses, but welcome the upside pro-cyclical features...go figure.

In my own opinion, a middle ground needs to be reached on the fair market value rule. The concept of mark-to-market is investor friendly and transparent so long as you can trust the firm is marking prices honestly. However, FASB is proposing fluctuations in those securities, whether gains/losses are realized or not, flow to the income statement. This is true for securities classified as hedges as well.

While I applaud FASB's new found post-pubescent courage, their treatment leaves me wanting. "Fair value" marks change constantly and often erratically. While these changes should be clearly marked on the books as compared to cost, having in many cases unrealized gains/losses flow to the income statement is erroneous, even when labeled as "comprehensive income". Not only will this add more volatility to earnings, but also less predictability, especially for companies with large securities held on their books. Gains/losses should be recorded when they are realized.On the subject of recording fair market value on the balance sheet and income statement, Bloomberg reports:

The scope of the FASB’s initiative, which has received almost no attention in the press, is massive. All financial assets would have to be recorded at fair value on the balance sheet each quarter, under the board’s tentative plan.

This would mean an end to asset classifications such as held for investment, held to maturity and held for sale, along with their differing balance-sheet treatments. Most loans, for example, probably would be presented on the balance sheet at cost, with a line item below showing accumulated change in fair value, and then a net fair-value figure below that. For lenders, rule changes could mean faster recognition of loan losses, resulting in lower earnings and book values.

The board said financial instruments on the liabilities side of the balance sheet also would have to be recorded at fair-market values, though there could be exceptions for a company’s own debt or a bank’s customer deposits.
...
While balance sheets might be simplified, income statements would acquire new complexities. Some gains and losses would count in net income. These would include changes in the values of all equity securities and almost all derivatives. Interest payments, dividends and credit losses would go in net, too, as would realized gains and losses. So would fluctuations in all debt instruments with derivatives embedded in their structures.

Other items, including fair-value fluctuations on certain loans and debt securities, would get steered to a section called comprehensive income, which would appear for the first time on the face of the income statement, below net income. Comprehensive income now appears on a company’s equity statement.

Another quirk is that the FASB doesn’t intend to require per-share figures for comprehensive income. Only net income would appear on a per-share basis. My guess is that means Wall Street securities analysts would be less likely to publish quarterly earnings estimates using comprehensive income.

Imagining the Impact

Think how the saga at CIT Group Inc. might have unfolded if loans already were being marked at market values. The commercial lender, which is struggling to stay out of bankruptcy, said in a footnote to its last annual report that its loans as of Dec. 31 were worth $8.3 billion less than its balance sheet showed. The difference was greater than CIT’s reported shareholder equity. That tells you the company probably was insolvent months ago, only its book value didn’t show it.

Gold & Deflation

noreply@blogger.com (MWS) — Wed, 22 Jul 2009 19:38:00 +0000

While not agreeing with this author's definition of deflation, his arguments and historical references are informative. I understand his logic in using the CPI index to track deflation (CPI flawed as it is), he falsely actually defines deflation as such.

His conclusions about gold are incredible though and I agree completely. That is, high levels of uncertainty, lack of confidence and credit deterioration all contribute to gold demand. This is true for inflation or deflation. The 23 pages are well worth your read, especially for the history lesson.

Written in 96', he noted the bubble like characteristics even then....this credit bubble has not yet finished bursting.

Behavior of Gold Under Inflation

Leading Indicators Turning Up, Bullish?

noreply@blogger.com (MWS) — Tue, 21 Jul 2009 01:14:00 +0000

Astute investors are considering the recent data out on The Conference Board Leading Economic Index:

LEADING INDICATORS. Seven of the ten indicators that make up The Conference Board LEI for the U.S. increased in June. The positive contributors – beginning with the largest positive contributor – were interest rate spread, building permits, stock prices, weekly initial claims (inverted), average weekly manufacturing hours, index of supplier deliveries (vendor performance), and manufacturers' new orders for consumer goods and materials*. The negative contributors – beginning with the largest negative contributor – were real money supply*, manufacturers' new orders for nondefense capital goods*, and index of consumer expectations.

The Conference Board Leading Economic Index™ (LEI) for the U.S. increased 0.7 percent.

Based on revised data, this index increased 1.3 percent in May and increased 1.0 percent in April. During the six-month span through June, the leading economic index increased 2.0 percent, with five out of ten components advancing (diffusion index, six-month span equals 50 percent).

A quick look at the chart above begs one large question:

The LEI declined 5 of the first 6 months in 2006, but no recession followed

I'm well aware of the predictive ability, but skeptics do joke that the index has predicted 9 of the last 6 recessions. The index is not perfect, but commands some respect. Let's break down the contributors I highlighted in red:

Interest Rate Spread - This is the largest contributor to the index and no one can doubt the significance of such a steep yield curve (difference between the 10 vs 2 yr treasury yields) in predicting economic upturns. Why?

Expectations of higher growth
Expectations of higher inflation (not a positive)
Banks earn profitable spreads, encourages lending

With regards to the first point, it can happen, but only as a result of a statistical anomaly in calculating GDP. Inflation fears have been growing rapidly since the beginning of 09', so no surprise there. As for the third, well....Bank Fail To Make Adequate Loan Loss Provisions Moody's Says:

July 20 (Bloomberg) -- Banks have failed to make adequate provision for the losses on loans and securities they face before the end of next year, Moody’s Investors Service said.

U.S. banks may incur about $470 billion of losses and writedowns by the end of 2010, which may cause the banks to be unprofitable in the period, the ratings company said in a report published today.

“Large loan losses have yet to be recognized in the banking system,” Moody’s said. “We expect to see rising provisioning needs well into 2010.”

Banks and financial firms worldwide have reported losses and writedowns of $1.5 trillion since the credit crisis began in 2007, according to data compiled by Bloomberg. New York-based Citigroup Inc. has reported $112 billion of writedowns, more than any other firm, the data show.

Any economic recovery is likely to be “weak and bumpy hook-shaped,” Moody’s said. Banks will also be challenged in an environment where government support is replaced by tighter regulation, the report said. Higher credit and funding costs may force a re-pricing of credit, Moody’s added.

“The fundamentals of financial institutions are still traveling on a downward slope,” Moody’s said. “No-one should consider recent improvements as assurance that the current rebound can be sustained.”

It's safe to say banks are constrained to lend and consumers are mostly unwilling to borrow.

Building Permits - In the bust of the biggest housing boom ever, increases in building permits can be viewed of as a negative considering the huge overhang of inventory that needs to be worked off, not to mention CRE's impending bust. For more on this please read 7 Reasons Why Housing Isn't Bottoming Yet.

Stock Prices - The rally in stocks has been impressive and its no wonder they're showing up in the LEI. However, this rally is guilty until proven innocent.

Weekly Initial Unemployment Claims - The contribution to the LEI from this statistic might be explained by emergency unemployment compensation (EUC). Mish had a great post on this, let's revisit:

Around the country, the number of people exhausting their benefits is piling up. By the end of September, more than 500,000 people will exhaust their benefits checks, with the biggest groups in Pennsylvania, California and Texas, according to estimates by the National Employment Law Project, an advocacy group for low-wage workers based in New York City. That number will nearly triple by the end of the year, the group said.

As Mish explains in his post, EUC is NOT included in the continuing claims. He also has some interesting commentary from David Rosenberg within the post regarding seasonal adjustments in the claims and slow downs in layoffs related to auto workers affecting the weekly claims, I encourage all to go and read the post. To summarize, Rosenberg postulates that with the auto factories shut down, there's no one to lay off when during normal seasonal patterns there would be.

The LEI may prove to be right down the road in 2009, but considering the above points one has to wonder whether this would lead to a real recovery where jobs, profits and sales increase, or whether this would just be a recovery in a statistical sense bearing no resemblance to reality.

The coincident index has remained negative through all of 2009, but rate of decline is slowing. By far the most important contributor to the LEI is the steep yield curve, but considering banks are far from profitable outside of one time gains and accounting shenanigans, how significant is that?

Developing State Budget Crisis

noreply@blogger.com (MWS) — Thu, 16 Jul 2009 15:52:00 +0000

Generally, you may feel all warm and fuzzy inside about the prospects of the economy. After all, Dennis Kneale has officially declared the recession is over and inventory restocking is all the rage (despite still above trend inventory/sales ratios). Banks are reporting large profits again from lucrative proprietary trading desks, churning $100 million trading days. Reflation is indeed on...or is it?

State Budget Crisis

It's truly blasphemous how little attention this is receiving, but let it be known that green shoots are dying in the summer heat. By autumn seasonal change will begin to take hold setting the stage for the deadly winter cold. To expect the effects of state budget adjustments not to have material effects on the economy is naive to put it nicely. Some highlights:

Budget cuts often are more severe in the second year of a state fiscal crisis, after reserves have been largely depleted
Expenditure cuts and tax increases are poison for the economy, especially during a severe recession
In this recession states have already drawn down much of their available reserves; the available reserves of states with deficits are likely to be depleted in the near future
State budget shortfalls of remaining 2009, 2010 and 2011 are estimated to total between $350 - $370 billion

What this looks like:

Bigger picture, commercial real estate is still deteriorating, total public debt is still outrageous and Fed monetary infusions have only been funneled into the wallets of phat cats at brokerage firms resulting in mini booms aka large rallies (and that's all they are). Now use you imagination and ask yourself "has employment bottomed?", "will consumer spending come roaring back?"

State Budget Problems Worsen

More Calls For Hyper-Inflation. Is It Guaranteed?

noreply@blogger.com (MWS) — Mon, 01 Jun 2009 14:06:00 +0000

The recent decline in the dollar and spike in rates of treasuries have many worried. Let's investigate that further.

Marc Faber is a bright guy and well respected. However, when it comes to his concerns (guarantee) over hyperinflation his equation is too linear: [A + B = C] Where,

A = Rapidly Increasing Monetary Base
B = Federal Deficit Spending
C = Hyperinflation

Reality is much less linear, in fact non-linear. There are other factors in this equation:

D = Bank Excess Reserve Deposits
E = Rising Savings Rate
F = Falling Home Prices
G = Falling CRE Prices
H = Increasing Loan (option-Arm, Alt-A, Prime, C&I), credit card & Corporate Bond Defaults
I = Rising Unemployment

The catalyst that may have sparked Faber's concern might have been S&P US debt downgrade warnings and spikes in US treasury yields. I take these important signals a bit differently. The bond market is issuing a warning to the Fed and US. What is that warning exactly? If this path continues investors will demand higher rates. Since higher rates are poison both to the economy and the US Governments ability to service its bloated debt, you can throw some wild card non-linearities in there as well:

J = Large across the board tax increases

K = Abandon some of the proposed spending plans

L = Abandon Quantitative Easing

The latter two scenarios (K & L) seem least likely. However tax increases (J) are a certain guarantee. Obama is Hell bent on the central planning model. More recently there have been some tax increase proposals; I mentioned some of the more certain taxes while Sitting On The Fences:

Cap & Trade = higher prices related to energy and transportation (roughly $1,600/yr per household)
Taxing the $250k + income earners
Taxing foreign source income (more double taxation)
Soda pop & alcohol taxes

Then of course come the more biting taxes, namely the VAT; Is A National Sales Tax In Our Future?:

A VAT is a tax on the transfer of goods and services that ultimately is borne by the consumer. Highly visible, it would increase the cost of just about everything, from a carton of eggs to a visit with a lawyer. It is also hugely regressive, falling heavily on the poor. But VAT advocates say those negatives could be offset by using the proceeds to pay for health care for every American — a tangible benefit that would be highly valuable to low-income families.

Example:

Take, for instance, a car with a sticker price of $30,000 and a value-added rate of 10%. Ford might buy its steel and other materials for $8,000 plus $800 in a VAT tax. A dealer then pays $25,000 plus a $2,500 tax for the finished vehicle. Ford takes an $800 credit for the tax it already paid and sends $1,700 to the government. A buyer then pays $30,000 for the SUV and $3,000 in taxes. The dealer collects the $3,000, takes a credit for the $2,500 worth of taxes already paid, and sends $500 to tax authorities. Ultimately, the government pockets $3,000, or 10% of the retail price of the car, in taxes.

These tax increases might occur sooner than most realize. Why? Consider the final trump below.

The final trump is something Faber is disregarding. Dollar Hegemony. The US has a monopoly over the world's currency. Right now there is no serious competition entering the global currency environment to step up and challenge the dollar's standing. In the cases of Weimar and Zimbabwe today, the opposite was true, where more important substitute currencies (i.e. the pound, dollar) were already liquid and available. Granted this could change, and China and Russia are certainly both receptive to the idea of a supranational currency, but don't expect that idea to come to fruition any time soon as the idea would be years in the making.

The massive issuance of treasuries, huge projected deficits and QE promises have raised eyebrows from the global community. As stated earlier, the message sent has just been a warning. Surely Geithner knows this as he was laughed at in China jawboning a strong dollar.

All eyes are now fixed on Washington for a response. If their response is to continue on the path as they are now, then rates will skyrocket higher, the dollar will fall more and the economy will suffer an inflationary depression, but not necessarily hyper-inflation. For hyper-inflation to occur, the major holders of dollars (China, Japan, etc.) would have to simultaneously dump their holdings, tanking the value of the dollar, like in Weimar and Zimbabwe. The result in a massive global depression as all trade is tied to the dollar.

China, the largest US creditor, has shown no signs of that yet. Treasuries, Dollar 'Only Game In Town' As China Buys:

The Federal Reserve’s holdings ofTreasuries on behalf of central banks and institutions from China to Norway rose by $68.8 billion, or 3.3 percent, in May, the third most on record, data compiled by Bloomberg show. The Treasury said bidding from foreigners was above average at its $101 billion of note auctions last week.

China will continue to be a buyer of treasuries until they commit to changing their currency peg to the dollar. A reversal of this sort will not occur overnight, but eventually must happen. This buys the US some time.

The likely result I forecast is higher taxes, slower growth (when it returns) and a long muddle through and transformation of the financial world as we know it. How it turns out is anyone's guess.

Finally, for everyone clamoring about the Fed's balance sheet, please see IMF White Paper On The Fed's Skyrocketing Balance Sheet. There's no conclusion as to the deflation/inflation debate so it's open to interpretation. The data collected there is certainly eye opening, especially the data from the Great Depression, which showed the Fed's balance sheet did in fact explode back then as well. What is so important to note is the asset backdrop. While the recent Fed balance sheet explosion is "unprecedented", put it on a relative basis to derivatives:

We discussed “Eight Bubbles” in play worldwide in November 2008 and their approximate scale, based on latest information in 2009, is as follows:
1. Subprime Mortgage linked Loans & Assets (USD 1.5 trillion) within Mortgage backed Assets (USD 5 trillion);
2. China, India, Eastern Europe and other Emerging Market Loans (USD 5 trillion);
3. Commodities (Commodity Derivatives at about USD 13 trillion);
4. Corporate bonds (USD 18 trillion);
5. Commercial (USD 22 trillion) and Residential property (USD 45 trillion);
6. Credit Cards Outstanding Debt (USD 4.5 trillion);
7. Currencies (Foreign Exchange Derivatives at about USD 62 trillion); and
8. Credit Default Swaps (USD 57 trillion) as a subset of all Derivatives (USD 1,405 Trillion).
The relative scale of the world's financial engine is as follows:
1. The entire GDP of the US is about USD 14 trillion and falling.
2. The entire US money supply is also about USD 14 trillion with rising Quantitative Easing in trillions.
3. The GDP of the entire world is USD 45 trillion and falling. USD 1,405 trillion is 31 times world GDP.
4. The real estate of the entire world is valued at about USD 65 trillion.
5. The world stock and bond markets are valued at about USD 70 trillion.
6. The trans-national universal model financial institutions own about USD 150 trillion in derivatives.
7. The population of the whole planet is 6.8 billion people. So the derivatives market represents about USD 206,000 per person on the planet.

Much of these assets are accounted for off balance sheet or with accounting gimmickry. These figures come directly from the Bank of International Settlements. Still fear inflation as the problem?

It now seems the race is on between faith and credit, meaning will faith be lost before credit?

Relative Value

noreply@blogger.com (MWS) — Sat, 30 May 2009 21:22:00 +0000

A quick review of some traditional markets will give us some insight into where the value is hiding.

Stocks

A quick trip to S&P's website will allow you to take a historical look into some price/value relationships of the index.

based from the close of 5/29 of 903.47:

P/E EPS Yield Less Div Yield

EPS TTM 130.75 0.76% -1.62%
EPS 3 yr 18.02 5.55% 3.16%
EPS 5 yr 15.94 6.27% 3.89%
EPS 10 yr 18.56 5.39% 3.00%

P/B = 2 (end Q1)

The dividend yield is currently 2.39%, which means on the ttm basis, the S&P 500 payout is actually over 100%, a clearly unsustainable path. Even the more favorable 5 yr smoothed average is still slightly overvalued.

FINVIZ Screen

I ran a screen out of a possible universe of 6,731 stocks. The criteria were as follows:

Dividend Yield over 2%
P/E under 15
P/B under 2
Current Ratio over 1
Debt to Equity under 1
Sales Growth 5 yrs >0
EPS Growth 5 yrs >0
Return on Equity >10%

The criteria weren't overly conservative but conservative nonetheless. The screen resulted in 97 matches. This is just 1.4% of a large universe, suggesting widespread attractive common stock investments are lacking despite the monumental 40% lower values from the peak in 2007.

Daily Bond Yields and Key Indicators

Data as of 28-MAY-09

Moody's Daily Long-term Corporate Bond Yield Averages

	Utilities	Industrial	Corporate
Aaa	NA	5.75	5.75
Aa	6.41	6.44	6.43
A	6.60	6.94	6.77
Baa	7.83	8.27	8.05
Avg	6.95	6.85	6.90

Moody's Daily Treasury Yield Averages

Short-Term (3-5 yrs)	1.18
Medium-Term (5-10 yrs)	2.78
Long-Term (10+ yrs)	4.31

So called "Aaa" corporates have a fair yield of 5.75% and the highest yielding treasuries are at 4.31%.

The Question Posed

Stocks on a 10 yr smoothed basis offer a "deficit of safety" next to Aaa corporates and long treasuries that looks like this:

S&P EPS Yield 6% deficit of safety to Aaa corporate bonds
S&P EPS Yield 20% margin of safety over long dated treasuries

However, this doesn't take into account dividends. When factoring yields and margin of safety only reinvestible earnings should be considered since that is what determines future earning power. On the adjusted basis

S&P EPS Yield 91% deficit of safety to Aaa corporate bonds
S&P EPS Yield 43% deficit of safety over long dated treasuries

Either case Aaa bonds are clear winners. A word of caution! Rating agencies are an utter failure in model. It is advised that before rushing to buy bonds to study long term earnings records of the companies and to look for adequate earnings to interest coverage (maybe 3x's + at least), conservative capitalization structures, and little indication of "funny" accounting or nonrecurring items. Treasuries still have some attraction vs. stocks, especially if fear returns to markets.

The debate now is whether growth returns. This debate I'l leave to individual investors but my own opinion is there will be little in the department of revenue drivers in the economy for the foreseeable future.

Deflation & Government Bonds

noreply@blogger.com (MWS) — Mon, 25 May 2009 03:13:00 +0000

The central concept of this post assumes that the US is and will remain in a deflationary trend for sine time to come, regardless of outspoken calls of hyper-inflation or severe inflation from many. If deflation ends sooner than expected, than the consequences of the investment thesis described here will end in losses.

During times of deflation there are few investments that prove suitable for long-term investment, but among them are government bonds. The two examples illustrated here are the US during the 1920's through 40's and Japan from the late 80's until the present.

If you were a buy and hold investor in the 1930's and your investment happened to be long dated government bonds, you made money:

The spike in yield in 1932 corresponded to the bottom in the stock market, but US government bonds still proved an excellent investment for many years to come. The DJIA on the other hand, tested the emotions of investors with opportunities and tragedies throughout the same time frame.

The yield curve grew steep from 1930 to 1932, signaling the end of the plunge in markets.

What's most interesting is that the action in the yield curve was dominated by changes in the long end of the curve. In other words, the shortest end of the curve never recovered to normalcy, confirming a new bull market had not yet been sparked, but only short cyclical bull markets within a bear.

Notice the shorter term treasuries didn't recover significantly until the late 40's at the onset of a new secular bull market in stocks and bear market in treasuries. What is even more significant is just how long rates remained very low, a deflationary trend.

US Government bonds remained bullish for a long time despite persistent and large deficits and stimulus programs.

Just as now, US public debt was growing at a rapid pace at the same time.

Before presenting how this compares to today, let's consider Japan's deflation as well.

Richard Koo Presentation Richard Koo Presentation pkedrosky Nomura economist Richard Koo talking about balance sheet recessions.

Publish at Scribd or explore others: Fiction art poetry

Fast forward to slide 15 within that document. Japan spent up huge deficits for nearly 20 years and grew its debt to GDP to now almost 200%, yet an investor in 10 yr JGB would have profited nicely.

Recently, Japan's credit ratings were downgraded, but there was no panic sell off as yields on the 10 year were recently quoted at 1.43% and the yield curve remains normal.

Let's fast forward to today. The situation is not exactly the same for the US, but many similarities co-exist. Recently there has been a large sell off in the long bond as equity markets rallied. Also, similar with the other two examples, the yield curve steepened throughout the equity market sell-offs. In this case, the yield curve has remained steep throughout, a bizarre phenomenon that may be sending a false signal.

The main difference between America post 1929 and Japan post 1990 is the public debt starting point and deficit spending starting point. Referring back to Steve Keen's chart above, you can see the US has a much higher starting point now than in the two preceding cases. Also, the US has large amounts of unfunded liabilities and has been deficit spending for some time. The deficits are expected to grow for 10 years +.

The fear is the US is next in line to lose its triple A rating, and soon. All in all, its a non-event that will trigger a knee jerk reaction in probability.

The question is, will the deflationary trend remain intact sparking investors to seek safety in return and capital of US treasuries? The evidence presented above is compelling and suggests the answer is yes regardless of an equity market bottom. Fundamentals of the economy and the equity markets remain impaired and show no signs of improving, just declining at a slower pace.

On a final note, please read Bob Hoye's recent article Great Depressions Are So Methodical. Bob is a market historian of sorts and has interesting parallels of 1929 to 2008. It sort of hints at another year and a half of severe contraction in the economy and equity markets.