Archive for February, 2010

There is an intense debate on Wall Street about whether or not we are heading towards a massive inflationary problem or if we are stuck in a deflationary problem.  Inflation is when prices go up and deflation is when prices go down.

If you are investing money, it is going to be important to get this one right.  So many of the talking heads on CNBC are declaring that we are heading towards extreme inflation.  They cite that the printing of money by the government is causing it.   They also point to this “incredible” rebound we are seeing in the economy.

If you will bear with me, I need to put the KOOL-AID down so that I am not tempted to drink it.  On the surface, it is inflationary when the Government prints enormous amounts of money.  However, the story goes well beyond the printing of money.  I regard these financial hosts as pretty smart people.  I often wonder if these hosts are all told to always be positive no matter what?  After all, they do work for CNBC, which is owned by GE, a publically traded company. 

Here is the evidence of deflation:

The velocity of money – Dig out your economics book. The velocity of money measures the circulation of money throughout the economy.  The velocity of money would need to be running pretty high to potentially create inflation.  Currently it is very low primarily because banks aren’t lending money and consumers aren’t spending money.

A world overloaded with debt – Debt in itself is deflationary.  Deflation is brought on by a debt crisis. 

The money supply – The money supply has been decreasing and not increasing. You would need to see the money supply expanding at a great pace to see inflation.  

The CPI and the PPI – The PPI or Producers Price Index shows whether or not the prices or increasing or decreasing at the producers level.  In other words, are the widgets getting more or less expensive to make?  The CPI or consumer price index shows what is happening to consumer prices. Are they going up (inflationary) or down (deflationary)? 

The latest PPI numbers showed an increase in prices at the consumer level.  When that happens, typically those higher costs get passed onto the consumer and are reflected in the CPI number.  However, the CPI numbers released on Friday showed the first drop in 27 years.  That tells me that companies are getting hit with higher costs but are not able to pass them on because the consumer is so strapped.  That keeps a lid on prices.  In fact, companies are dropping prices to get consumers to buy items.  That in itself is deflationary.

To be fair, the CPI minus energy and food costs decreased.  Yes we depend on energy and food which have been going up.  I think that net effect is clearly deflationary.     

In short, the reason that the printing of money is not causing inflation is simply because the printed money is not circulating.  It is absorbing losses of all kinds due to the effects of the debt crisis.  Until you get massive circulation which would show up in the above indicators, I think that we are stuck with deflation.  Plus you better hope that it doesn’t turn into inflation.  That would force the Federal Reserve Board to start aggressively raising rates which would easily throw us into a double dip recession if we aren’t already heading that way.

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The problems overseas aren’t settling with the markets very well and for good reason.  You have the developing problem in Europe with the first of many debt plagued countries on the brink of defaulting on their debt.  Greece is begging for a bail-out.  The EU tells Greece not so fast.  If you want help with your debt in the form of a guarantee by the EU, then some tough choices are going to need to be made.  Greece will actually be forced to cut spending and oh no…make wise financial decisions.  Oh the horror…

The day of the US style easy money bail-outs are over.  Now, bail-outs come with tough terms and conditions.  Shouldn’t it be that way?  Would the US be in a much better place if our creditors would have told us that the US can borrow money as long as changes were made?  The problem is that we are borrowing the majority of our money from ourselves.  So, that would mean we would be forced to actually be wise and make prudent fiscally responsible decisions on our own.  As long as there are politicians in Washington, that will not happen.

John Mauldin points out that there is no good solution for Greece.  The terms and conditions of a bail-out are going to be as tough as the cons of defaulting on debt.  The following is from his latest frontlinethoughts newsletter. This is one of the most excellent resources for investors and is free.  Everyone should be signed up for this newsletter. 

While German Chancellor Merkel has indicated a willingness to help, the German finance minister and other politicians are suggesting German cooperation will either not be forthcoming or only be there at a very high price; and the price is a severe round of “austerity measures,” otherwise known as budget cuts. Greece is being told that it must cut its budget to an 8.7% deficit this year and down to 3% within three years.

Now, here is where it actually gets worse. If Greece bites the bullet and makes the budget cuts, that means that nominal GDP will decline by (at least) 4-5% over the next 3 years. And tax revenues will also decline, even with tax increases, meaning that it will take even further cuts, over and above the ones contemplated to get to that magic 3% fiscal deficit to GDP that is required by the Maastricht Treaty. Anyone care to vote for depression?

And add into the equation that borrowing another E100 billion (at a minimum) over the next few years, while in the midst of that recession, will only add to the already huge debt and interest costs. It all amounts to what my friend Marshall Auerback calls a “national suicide pact.”

The problem is that this is just the problem with Greece.  There are many other countries that are going down the same path.  It is much like the domino problem that we had with the banks and financial institutions in 2008. 

Then there is Dubai.  Dubai created a shock across the markets when it was disclosed in December that they were on the verge of default on their debt.   Well, apparently Dubai has not done anything to solve this problem.  CNBC reported today that “Dubai World will offer creditors either 60 percent repayment over seven years and a government guarantee, or full repayment with a debt for equity swap for property assets of Nakheel and no guarantee.”

Those aren’t good solutions.  The issues that we still deal with in an ongoing financial problem in our own country are seemingly contained in the fact that everyone is getting use to the new normal.  However, the sovereign debt (debt from other countries) crisis is a whole other deal and new dynamic for the markets.  We could be seeing the start of financial crisis round 2.

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To listen to the politicians in Washington, the unemployment problem is well on its way to getting solved.  Just like that, the unemployment rate fell to 9.7% from 10% and we only lost 20,000 jobs.  As a rule of thumb you never want to fully trust the sound bite that leaves the mouth of a politician.  As another rule of thumb, you don’t want to fully believe the headline number that the government is reporting either.

Politicians don’t care how you get to the more positive numbers; they are just going to run with it and call it reality.  January’s unemployment numbers are far from reality.


The Drop in the Unemployment Rate

How can you get to a lower unemployment rate with so many people unemployed?  It is pretty easy.  You just don’t count them.  Hundreds of thousands of people have fallen out of the system since they have been unemployed for so long.  Then there are the ones who have given up.  They are just not being counted.  As a result, you get a lower rate.

Seasonality also plays a part.  There are a lot of part-time employed workers that are hired depending on the time of the year.  For this report, seasonality gave the report a positive bias. 

The lower drop in jobs

As we have discussed throughout the year, the government estimates how many jobs were created through the “birth/death” formula.  Typically, this adds hundreds of thousands of jobs throughout the year.  These aren’t verifiable jobs.  These are jobs that the government “assumes” are created from small business.   In January they typically revise that number and subtract jobs from the system.  These are pretty large revisions.  This revision was a job loss of 427,000 jobs for the month.  Yet, we only lost 20,000 jobs?  Really??

That is the magic of revision.  They wait until time has passed and then subtract jobs from past months and even years well after the fact.  They will get that figure in there some way.  Getting it into the system can happen well after the fact when it will not affect the market.  Can you imagine the carnage on Wall Street had they really reported the truth?  They will report it when it matters the least.

I am currently reading a very detailed account of all of the financial crises that this country and other countries have faced through the decades.  The premise of the book is that it is not different this time and this is not unprecedented.  As I get through the book, I will write about it.  The authors write that a common thread exists amongst all financial crises.  It is the crisis of confidence.  Confidence can quickly escalate to crisis levels. 

My greatest concern is that this Government continues to sell the American people on a story that does not jive with reality.  Confidence could be severely damaged when reality come into full view. 

For a good example of this in real time, just watch the implosion of Toyota.  You are looking at a car company that has been hiding problems for years.  Now that the truth is coming out, there might not be enough confidence left for consumers to want to buy a car that has had a bad sudden acceleration problem.  It looks like they really don’t have an answer for it and they are buying time. Well, more on that story at a later date!

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There are hundreds of signs and indicators that can be predictive.  I wanted to run a few by you this week as food for thought.

(1)               The January Indicator

The old saying goes “so goes January so goes the rest of the year.”  During the last 59 years, January has had a negative return 23 times.  This was the result of those negative first months of the years:

13 of those years ended negative

4 years had a greater return than 4.5%

6 years finished the year with a return of less than 3%

On the percentages, it has been a pretty accurate predictor of things to come (Stock Market Almanac).

(2)    The December Low Indicator

Lucien Hooper, a Forbes columnist and analyst, coined a stock market warning sign called the December Low Indicator.  If the stock market anytime during the first quarter goes below the lowest price level of the preceding December, a warning sign appears.  This occurred on January 22nd.  The Stock Market Almanac further researched this sign and found that this has occurred 30 times since 1952.  When you combine a negative January and the December low indicator, the stock market ended those year negative 75% of the time. 

(3)  The Decennial Pattern

There are many studies that look at the significance of cycles.  For instance, there are studies that determine which year of the 4 year term of a President is likely to be either positive or negative.  There is a look at the 7th year of every decade.  The number 7 stands for panic.  You can literally go back and look at every 7th year dating back to 1887 and see some type of panic.  The two more famous panics would be the stock market crash in 1987 and then the start of the financial crisis in 2007.

There is also a look at the tenth year of every decade.  Out of any year of a decade, the 10th year is by far the worst year on average.   Tenth years have the worst record within the Decennial Cycle and 2010 is a midterm election year, which has the second worst record of the 4 year presidential election cycle.  Of the last 12 occurrences dating back to 1890, the stock market lost money 8 out of the 12 times during the 10th year.  The average loss has been -7.2%.   

 Year                 % gain or loss

 1890                -14.1

1900               + 7

1910                -17.09

1920                -32.9

1930                -33.8

1940                -12.7

1950                +17.6

1960                -9.3

1970                4.8

1980                14.9

1990                -4.3

2000                -6.2

2010                ???

 These warning signs might end up amounting to nothing.  At the same time, it also might be prudent to pay attention to what the signs are saying and making sure that you have a Plan B.

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