Credit Crunch - Now how do we fix the Solution ?

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

"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

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....

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

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

Thomas Lynch

More Supporting Materials...

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

Supporting Materials

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)