Beam Reach Financials

Credit Crunch - Now how do we fix the Solution ?

2009-01-20T20:20:00.024-05:00

In October 2008, we considered that the credit crunch is the solution, not the problem, or to be more specific, that the current, "Credit Crisis" is:

The source (the world's commercial banks)

of the problem (massive and consistently understated inflation)

correcting itself through market forces (banks limiting credit due to good old-fashioned concerns about the value of collateral and borrowers ability to repay).

Since then we've heard pundits explain how our free markets have failed, regulation was insufficient, and that 'speculators' threaten us all. I'll punt on the question of the regulatory regime and focus on how (if at all), market forces have failed and if so, how we're to go about 'fixing' the solution to our inflationary problem (I know, you say we don't have an inflationary problem anymore, but that's the point).

First let's revisit the base case for today's market environment. In October we put forward some expectations:

Long US Dollar (USDX/UUP) - As deflationary pressures continue
Long Volatility (VIX) - Until the global unwinding is complete
Short Commodities (DBC) - As the economy dampens global demand and the purchase of these assets with borrowed funds slows
Long US Equities (SPY)/Short World Equities (VGTSX/VT) - As US companies outperform their global peers, enhanced by the stronger dollar and 'flight to quality' appeal.

Then, and now, these capture the underlying trend in the markets, rising 7.6% since then (nearly 23% annualized). Until the structural drivers of this trend change we can expect more of the same, but what would those structural changes look like - what is the fix for the solution?

First, let's briefly look at some charts that illustrate again the unreal growth in US consumer credit, juxtaposed against savings (from the NY Times Debt Trap series):

Here's a dramatic post from Reuters, courtesy of FT Alphaville, that shows how private sector debt has risen three times faster than the economy since 1975.

John Kemp notes,

"This created a dangerous interdependence between GDP growth (which could only be sustained by massive borrowing and rapid increases in the volume of debt) and the debt stock (which could only be serviced if the economy continued its swift and uninterrupted expansion)".

We're left with a "Balance Sheet Recession", and (again, courtesy of FT Alphaville), Nomura's economist Richard Koo draws comparisons with Japan's, "lost decade", concluding that in balance sheet recessions monetary policy is largely useless:

So stimulus is our fix for the solution - but certainly easier said than done if it is to be both politically palatable and efficient/effective/timely enough to boost GDP, facilitate the service of existing debt and establish a floor on asset prices.

Free markets haven't failed, they're correcting a dangerous and unsustainable debt driven inflation. They're doing so despite the strong political, commercial and central bank opposition and real human costs. Stimulus plans on the table may hold the answer to restoring real growth, but for now the underlying market trend continues, and we can continue to expect:

US Dollar strength
Panic Level Volatility
Weak Commodities
US Equities to outperform Global Equities

Quotes relevant to investing

2008-10-28T19:16:00.001-04:00

"Nothing in the world can take the place of Persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent. The slogan 'Press On' has solved and always will solve the problems of the human race."

Calvin Coolidge

Stimulus II: Deleverage America

2008-10-22T19:08:00.015-04:00

Earlier this week, I described a base case, that the credit crunch is the solution, not the problem. You can find the details here but the key premise is:

The current "credit crisis" is in fact the source (commercial banks) of the problem (inflation caused by M3 supply growth) correcting itself through market forces (reversal through the refusal to extend as much new credit) due to fundamental questions about the underlying collateral (e.g. houses).

Our focus has been on the monetary side of the equation. Recently we've seen more and more (politically charged) focus on a new economic stimulus package that would form the core of additional fiscal policy.

A policy suggestion:

The stronger dollar, and resurgent US equities we've forecast indeed need support from both monetary and fiscal policy. A tax cut (as opposed to further rebates, expanded government infrastructure programs or anything else) is the most efficient way of providing fiscal stimulus, but if the government were to think strategically the tax cuts would further strengthen the dollar by encouraging the de-leveraging of America. That would mean not only:

- Reducing the total tax burden on US individuals and businesses

But also:

- Providing incentives to reduce legacy household debt by making those payments tax-deductible

- Ending the insane corporate tax preferences for debt over equity

History's shown that whatever you tax you get less of. We've taxed equity more than debt for a long time, and now find ourselves with too much debt and too little equity. Reform of the tax policy to encourage the opposite will carry forward the small beginnings of momentum we're seeing and steer America toward greater prosperity.

Overall recommendations for this environment continue to outperform and remain:

Long volatility (VIX)
Long US Dollar (USDX/UUP)
Long US Equities (SPY)
Short World Equities Ex-US (especially the Euro zone) (VGTSX/VT)
Short Commodities (DBC)

Still more supporting materials....

2008-10-22T18:51:00.004-04:00

And this (courtesy of Larry Kudlow and scottgrannis.blogspot.com), which shows a strongly correlated view showing that 2 year CDS is predicting a dramatic rise in the S&P500.

Quote Relevant to Investing

2008-10-21T18:59:00.001-04:00

"A man must keep his mouth open a long while before a roast pigeon flies into it"

Thomas Lynch

More Supporting Materials...

2008-10-21T18:53:00.002-04:00

And this shows the divergence in oil prices (in dollars/euros/gold) during the 'naughts...

Supporting Materials

2008-10-21T18:46:00.001-04:00

Some of the friendly feedback on Seeking Alpha prompts me to post these, which show both the tremendous variation in CPI measures from 1980 to now....

(thanks to www.shadowstats.com)

Scripture Relevant to Investing...

2008-10-19T15:12:00.000-04:00

PROVERBS 27:23
"Be diligent to know the state of your flocks, and attend to your herds."

The Credit Crunch is the Solution, not the Problem

2008-10-18T21:18:00.000-04:00

Since roughly October of 2007, the world’s financial institutions have trembled, credit markets have seized, and as the government bailouts arrive the consensus view has developed that the root cause of our recent misery is the greed of over-levered, under-regulated financial institutions helpless in the face of overwhelming losses caused by indefensible gambles on sub-prime mortgage loans for over-valued residential housing.

While reasonable conversations can take place regarding the root cause of mortgage lending standards (e.g. the Community Reinvestment Act in the Carter era), the simple truth is that the true nature of the economic crisis has been obfuscated. Most Americans believe they are in for a severe recession caused by the unwise decisions of bankers. They may not understand they are coming out of a severe recession facilitated by the very government now coming to the rescue.

Theme I: We’ve experienced a much more severe inflation shock than reported.

Let’s keep it simple. When we greatly expand the number of dollars that exist, each of them will be worth less (i.e. prices will rise). The facts are clear:

- Most official measures of the US Dollar money supply show a recent record of minor, very stable growth – all the hallmarks of a concerned steward of stable prices. In fact, in March 2006 the US government stopped reporting “M3” a critical component of the money supply which helps indicate how much money supply growth is attributed to commercial bank lending via institutional deposits, money funds, and Euro dollars, etc. While official monthly money supply measures (M2) show the supply of US Dollars growing in a 4-6% range since 2003/04, private individuals who have continued estimating M3 growth show that the world’s commercial banks have increased the growth rate of dollars by up to 16%.

- That’s OK, you say. The government carefully measures inflation, ensuring that swift and prudent action is taken the minute money supply growth impacts the stability of the prices for this we must buy as part of our daily lives. Now I ask, does that sound like the US federal government to you? The government does continue to measure price inflation, but they have made two significant changes since our last inflation shock in 1980 when Paul Volker killed inflation by raising interest rates. Back then, the rampant, unacceptable inflation rate touched 15% . Of course, this time in the worst of it (2008) we only touched 5 ½ %. …except that we changed how we measure it. If you still measured inflation the way we did in 1990, before the Clinton-era changes, we experienced 9% inflation in 2008. If we measure it the way we did in 1980, we touched 13% - almost to the Volker era highs. You weren’t crazy. Did you get a 13% annual pay raise?

- And the markets weren’t fooled for a minute. Gold (priced in dollars) rose 235% from 2005 through 2008. Oil by 247%. Now, US GDP only rose 11% from 2005-2007, Adjust for the ‘new’ inflation numbers and you find the line you hear in the media. “We’re not quite in a recession yet”. Adjust GDP for something approximating the way we measured inflation in recent history and you see that we’ve been in a rather severe recession for some time now. Ask yourself – hasn’t it felt that way?

- And, as it always does, capital flowed to more hospitable places. It doesn’t matter if you looked at US investment in anything overseas (especially emerging markets), anything not priced in dollars, or if you just flat out look at the currency. The US dollar dropped in value (against a basket of other currencies) by more that 40% from its peak in 2002 to trough in 2007.

Theme II: This time we didn’t need to raise interest rates

In 1980, the Volker fed needed to raise interest rates to extremely high rates to break the back of inflation. I’m sure we can all agree we’d prefer not to incur borrowing costs in excess of 15% - so why do we get to avoid that pain?

In this case, the cause of the problem (the rampant creation of too many dollars by the commercial banking system) seems to have been corrected by the market itself. After peaks in 2008:

- The US Dollar has risen 14% in 2008 from its lows.
- Gold has declined 21% from its highs
- Oil has declined 34% from its highs
- Credit creation by commercial banks has declined from 18% to 2%.

In other words, the current “credit crisis” is in fact the source (commercial banks) of the problem (inflation caused by M3 supply growth) correcting itself (reversing through the refusal to extend credit) through market forces (which question the real value of the collateral e.g. houses) for the loans.

Theme III: The Return of America

So how do we interpret the current state of our economy. The majority of media outlets repeat the standard line that the lack of available credit will negatively impact the earnings potential of US equities. That the best expectations for growth continue to lie in emerging markets. That we are still in for a ‘deep’ recession, not coming out of one.

Phoey! The run up in energy and commodity prices was largely due to these commodities being priced in the free-falling dollar (doubt me? check a chart of oil priced in Euros or gold compared to dollars) . The strengthening in the dollar caused by the fact that commercial financial institutions no longer have the capital to debase the currency represents a massive tax cut for productive US industry. US industry, whose consumers have already seen the worst of a very deep economic recession.

- In terms of momentum there is no better currency in the world.
- There is a flight to the quality of the US, both in terms of currency and equity of commercial and real assets that will be levered for foreign investors by the continuing strength of the dollar.
- For the undervalued US Equities, expect a new era of “going private” and/or the ‘new conglomerates’ as balance sheet cash and real dollar profits are put to work buying over-levered or foreign assets.

As markets adjust from the paradigm of a weak dollar we are:

- Long Volatility (VIX)
- Long US Dollar (USDX)
- Long US Equities (SPY)

- Short World Equities Ex-US (especially the Euro zone) (VGTSX)
- Short Commodities priced in dollars (DBC)
- Short the US Government not having truly independent measurement of monetary statistics.