30. August 2010 by Abraham.

Apparently central banks noticed that companies are hoarding cash.  At its August meeting, the FOMC decided to add cash to the financial system by reinvesting the proceeds from maturing mortgage backed securities (MBS) into Treasury securities.  This seems to have accomplished two things: (1) it reinforced the broad assessment that economic recovery is pretty weak and (2) it seems to have pushed several companies into acquisition mode (witness the bidding war over 3Par).

Unfortunately the numbers indicate that the money the Fed is putting out is not really enough to stop the momentum of debt-deflation (the weight of servicing existing debt levels with a decreasing private labor force and shrinking real asset values).  However, the Fed chairman has said in a very straight forward manner that the Fed will do everything in its power to stop deflation from taking hold (as a side note, I think that goal is a very noble intention).  The Fed’s real power is to print money… and money growth that exceeds economic growth is almost always has an inflationary affect on prices.  Interestingly enough, the inflation that is occurring now seems to be the price of government bonds and the price of the dollar relative to trading partners’ currency;  crazy, right - the Fed prints money and gives it to banks, the banks buy Treasury securities (pushing up the price of government bonds), the government hires more people and extends unemployment benefits, total demand for oil and imported manufactured goods increases (thanks almost entirely to government handouts (easy to see in the BEA data)), surplus countries (oil exporters, China (via investment in Japanese bonds), and Japan) turn around and buy treasuries and other dollar denominated assets driving up the price of the dollar.  A strong dollar encourages more imports and gives the Fed leeway to print more money, and the cycle continues.

So, monetary policy momentum and the actions of all the major players indicate that the Fed should keep printing money if we want to spur domestic and global economic activity (even if that activity is global production feeding US consumption).  The Fed looks ready to oblige.  Only one thing might stop them: politics.  Despite the fact that the average American household is insolvent, their poor understanding of history and economics prevents them from seeing that inflation (and substantial inflation at that) will help them.  As such there is a political movement afoot, and gaining strength, that is interested in a variety of deflationary policies (ranging from balancing federal budget to returning to the gold standard).  If that political movement gains real power, watch out.

I’ve just finished reading “An Analysis and History of Inflation” by Don Paarlberg.  In the book he analyzes 15 of histories great inflations, from the inflation that afflicted Rome in the second century to US inflation in the 1970’s.  Some key takeaways from his analysis are that (1) large inflation is always better than large deflation (2) inflation is often correlated with real economic growth (3) inflation can be a very effective method of transferring wealth from the rich to the masses (4) the course and degree of inflation are almost always dictated by the political powers at the time.  With that said, I recommend keeping a very close eye on the actions of our elected representatives and reacting accordingly.

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31. July 2010 by Abraham.

Sometimes it’s worth asking a simple question when trying to answer to a complicated question.  The complicated question is “is deflation likely to appear over the next couple of years?”  Answering that question by looking at data and studying history quickly clouds the issue.  The simple question is “Do I think things (labor, consumables, durable goods) will cost more or cost less in the future?”  My answer to that simple question is “they will probably cost the same or less than their cost today.”

As such, I will tend to save my cash rather than spend it.  I expect to be able to purchase more stuff (consumables, homes, stocks, etc…) in the future with dollars I hold today.

And it’s not just me.  The data from most OECD nations shows that households and corporations are holding on to their cash.  It’s understood that households are trying to repair their balance sheets.  But even so, when people to choose to pay down liabilities over acquiring new assets it means that they don’t foresee substantial asset price appreciation.  For corporations it indicates that they think that prices will be lower in the future. 

When people expect no price appreciation of assets and falling prices of consumables, that’s a deflationary expectation.  That’s why substantial deflation will likely take hold around the developed world over the next couple of years.

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11. July 2010 by Abraham.

This morning I discovered that the Bureau of Economic Analysis has a charting tool for their data. 

 Check out the chart below, generated right on the BEA website (click for larger image):

The green line, disposable personal income, is the line politicians focus on most.  If that line is going up then, in aggregate, people have more money on a year over year basis.  That line is going up and politicians are doing their best to cheer-lead the recovery.  But let’s look just a little deeper at what’s going on.  The green line (disposable income) is equal to the blue line (total personal income) minus the yellow line (taxes).  So its plain to see that the gains in disposable income are due to a fall off in tax payments (and hence our $1.5T federal deficit).

So the purported recovery seems like an accounting trick to me.  And the real proof of that are red and black lines, wages and government social benefits respectively.  If the economic recovery were self sustaining, wages would head up and government social benefits would head down.  So far, that is not happening.

If the Bush era tax cuts expire as scheduled this year, disposable income would collapse.  No politician will talk about this substantively before the election, but November and December look like they will be very tough months for Congress.

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20. June 2010 by Abraham.

I’ve spent a few weeks considering what to take away from the May 6^th “flash crash”, the hour or so after 2:45pm when the Dow Jones Industrial Average dropped 1000 points and then recovered 700.   

My take away is that most stock market liquidity is provided by market participants with very short time horizons.  The post event inquiries have shown that once the market started to fall, many large automated trading groups shut down their systems to avoid further losses.  Once their systems were shut off, markets for many individual stocks disappeared completely, causing massive price volatility. 

This should be a primary consideration for long term investors – when they buy or sell a stock, it is likely executed against someone asking the question “Can I profit from this trade in the next few days?”  Whereas the long term investor is asking the question “Can I profit from this trade in the next few years?” 

This type of time horizon asymmetry can create massive price distortions – with tremendous benefit or detriment to the long term investor.

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30. May 2010 by Abraham.

For any entity, person, nation, etc… insolvency occurs when creditors believe that there is no chance the entity can pay of its debts. 

The Greek debt crisis has inspired many questions about how close America is to the same predicament.

Let’s look at the numbers:

The chart above shows the ratio of the dollar change in GDP to the dollar change in total dollar denominated debt for two periods; the previous 4 years and previous 10 years of a given date.  The raw GDP data is from the BEA and the raw debt data is from the Fed Z.1 report.

If borrowing were a good thing the ratio would be stable or rising; i.e. for a given number of dollars borrowed, that amount should show up as a permanent increase in the nation’s ability to produce goods and services.  What we actually see is that over time our economy has gotten worse at converting dollars borrowed into structural productivity gains.

A simple linear trend line crosses zero at around 2027.  So what does that zero crossing mean.  It means that adding debt actually lowers GDP… which is certain insolvency.  The exact date creditors lose faith is anyone’s guess but the time frame is almost certainly less than 20 years.

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3. May 2010 by Abraham.

I am pretty sure that America’s financial path forward involves another bout of financial asset and home price deflation followed by printing press driven inflation.  The inflation will have a small impact, in real terms, on the federal debt (because of its relatively short weighted maturity) but will have a huge impact on households, most of which now hold fixed rate long term mortgages.  In aggregate households are weighed down by owing more on their homes than the homes are worth.  This in turn limits private sector investment and worker mobility, both of which are key elements in a growing economy.  The question that now occupies me most is whether the deflationary period occurs in the next 12 months, or whether it is a few years out.

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25. March 2010 by Abraham.

A lot of people seem to ask the question “Why do corporate executives make so much money?”  The simple answer is that they make so much money because corporations make so much money.  When a corporation makes money it has to choose whether to save it, consume it, distribute the money to its employees, or distribute the money to its owners.  The corporation’s board of directors makes this decision.  Often, one or more members of the senior management team sit on the board of directors.  The other members of the board are often executives of other corporations. To me, it seems rather straight forward that since boards of directors are filled almost entirely with corporate executives that the boards make executive biased decisions. 

Is it fair?  Probably not, but it is important to consider the relationship between the corporate entity and its management.  From the corporation’s point of view, the number one priority of its management should be ensuring the corporations growth and survival.  So in some ways it makes sense that executives get a disproportionate share of corporate earnings – they need to show the corporation tremendous loyalty and the corporation rewards them for it. 

The unfair part comes about when a large corporation is in a steady-state condition.  A steady-state condition occurs when the divisions within a corporation can go about their business with little input from senior management.  For example GM in the 60’s, AT&T in the 70’s, IBM in the 80’s, Bank of America in the 90’s and so on.  In those cases, the corporation is churning along making a healthy profit on a constant business model.  In those cases, it can be argued that corporate executives are benefiting more from their circumstances than their skill. 

Is benefiting from circumstances more than skill really that bad or unfair?  That’s a very philosophical question, and most individual’s answers will depend on their situation and their awareness of their circumstances.  Is it fair that I was born at a time and in a place where there are almost no real threats to my person or property?  Maybe, or maybe not, but I’m certainly ok with it.

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7. February 2010 by Abraham.

When people ask me for the solution to our economic problems, I tell them that as a society we have to save more and consume less.  Almost 100 percent of the time, their first response is “If we stop consuming, won’t the economy collapse?”  The simple answer to that question is no, the economy will not collapse.   

Here’s why. 

The chart below shows the how the 4 major components of the economy (consumption, investment, exports, and government) contribute to total GDP. 

Over the last 10 years, consumption has run around 70% and exports have run around -5%.  If the US population cut its consumption to 65% of GDP and focused the cuts on imported goods and services (primarily oil), then GDP, and perhaps more importantly domestic employment, would be unaffected.  So not only does the economy not collapse it doesn’t do anything. 

But it gets better.  If Americans took their savings and invested them in new businesses and new ideas then the economy would expand.  The economy would expand because investment adds to GDP.  Saved money gets put to work, unless people are sticking money in a mattress.  Even money in a bank gets put to work as loans (though I’m not a big fan of banks).  In the best case, money is put to work expanding capacity (like loans to growing businesses), or developing new technologies and new methods (like equity investments in new industries).  

The real loser when US consumption is reduced is the profit of multi-national corporations.  And that, as it seems to me, is the primary reason that most Americans hear that consumption is the only path forward. 

Here is an interesting side note.  Below is a chart of debt to GDP that I used in a previous post.  Notice the rate of debt to GDP growth between 1984 and 1987, and from 2000 on?  Now look at the export line in the components of GDP at the beginning of this post.  You’ll see exports are a negative contributor during those periods.  Coincidence?  No.

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1. February 2010 by Abraham.

The chart below shows the evolution of all US dollar denominated borrowing over the last 5 decades.  It is broken down by borrower type. 

At the end of the third quarter of 2009 the total stood at roughly $53 trillion.  To help understand the scale of that number lets think of the entire borrowing population as a homeowner with a $53 trillion mortgage.  If it were a traditional 30 year mortgage with a 7% interest rate, the required monthly payment would be $352 billion, which is $4.2 trillion per year.  That payment amounts to roughly 29% of GDP and 38% of disposable personal income.  Given traditional borrowing guidelines, dollar borrowers are just about at the limits of reasonable debt service. 

As we look forward the question is whether the current situation is sustainable.  It would be sustainable if debt and GDP grew at approximately the same rate going forward – if the debt doubles, and GDP doubles, and interest rates stay the same, all the payment ratios are still okay, barely. 

The chart below shows ratio of total debt to GDP, the year over year change in GDP, and the year over year change in the debt for the past 5 decades. 

My main observation from this chart is that rarely does GDP growth exceed debt growth.  So the present path of debt financed growth is likely unsustainable.  My second observation is that debt growth is required for GDP growth.  If you accept the premise that debt growth is a requirement for GDP growth, the next test for our economic sustainability is whether dollar debt can exceed its previous high and establish an uptrend.  By the end of summer 2010 the new trend should become apparent. 

Data sources: http://www.federalreserve.gov/releases/z1/Current/z1r-4.pdf http://www.bea.gov/newsreleases/national/pi/2009/pdf/pi1109.pdf

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22. December 2009 by Abraham.

Shown below is a 6 month chart of the iShares FTSE/Xinhua China 25 Index ETF (in blue, right axis) and the SPDR S&P 500 ETF (in white, left axis).

For most of the last 6 months directional movements of the two have been well correlated.  In the last two weeks however the S&P500 is slightly up and the FXI is down 10%. The last time the FXI and S&P500 diverged like this was in August of 2008.  See the 2 year chart below and notice the highlighted region.

Two months later in 2008 both markets suffered severe losses.  Two months from now the White House will release next year’s budget, and congress will take up the issue of the budget and the debt ceiling.  There is a chance that the politics surrounding those issues will destabilize financial markets.

It will be interesting to see how the present divergence resolves – given the intertwined nature of the US and Chinese economies it is difficult for stock market directional divergence to persist.

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