The Aleph Blog » Blog Archive » Depression, Stagflation, and Confusion

Depression, Stagflation, and Confusion

I’m not sure what to title this piece as I begin writing, because my views are a little fuzzy, and by writing about them, I hope to sharpen them.  That’s not true of me most of the time, but it is true of me now.

Let’s start with a good article from Dr. Jeff.  It’s a good article because it is well-thought out, and pokes at an insipid phrase “behind the curve.”  In one sense, I don’t have an opinion on whether the FOMC is behind the curve or not.  My opinions have been:

  • The Fed should not try to reflate dud assets, and the loans behind them, because it won’t work.
  • The Fed will lower Fed funds rates by more than they want to because they are committed to reflating dud assets, and the loans behind them.
  • The Fed is letting the banks do the heavy lifting on the extension of credit, because they view their credit extension actions as temporary, and thus they don’t do any permanent injections of liquidity.  (There are some hints that the banks may be beginning to pull back, but the recent reduction in the TED spread augurs against that.)
  • Instead, they try novel solutions such as the TAF.  They will provide an amount of temporary liquidity indefinitely for a larger array of collateral types, such as would be acceptable at the discount window.
  • We will get additional consumer price inflation from this.
  • We will continue to see additional asset deflation because of the overhang of vacant homes; the market has not cleared yet.  Commercial real estate is next.  Consider this fine post from the excellent blog Calculated Risk.
  • The Fed will eventually have to choose whether it is going to reflate assets, or control price inflation.  Given Dr. Bernanke’s previous statements on the matter, wrongly ascribing to him the name “Helicopter Ben,” he is determined not to have another Depression occur on his watch.  I think that is his most strongly held belief, and if he feels there is a modest risk of a Depression, he will keep policy loose.
  • None of this means that you should exit the equity markets; stick to a normal asset allocation policy.  Go light on financials, and keep your bonds short.  Underweight the US dollar.
  • I have not argued for a recession yet, at least if one accepts the measurement of inflation that the government uses.

Now, there continue to be bad portents in many short-term lending markets.  Take for example, this article on the BlackRock Cash Strategies Fund.  In a situation where some money market funds and short-term income funds are under stress, the FOMC is unlikely to stop loosening over the intermediate term.

Clearly there are bad debts to be worked through, and the only way that they get worked out is through equity injections.  Think of the bailing out of money market funds and SIVs (not the Super-SIV, which I said was unlikely to work), or the Sovereign Wealth Fund investments in some of the investment banks.

Now, one of my readers asked me to opine on this article by Peter Schiff, and this response from Michael Shedlock.  Look, I’m not calling for a depression, or stagflation, at least not yet.  At RealMoney, my favored term was “stagflation-lite.”  Some modest rise in inflation while the economy grows slowly in real terms (as the government measures it).   A few comments on the two articles:

  •  First, international capital flows from recycling the current account deficit provide more stimulus to the US economy than the FOMC at present.  Will they stop one day?  Only when the US dollar is considerably lower than now, and they buy more US goods and services than we buy from them.
  • Second, the Federal Reserve can gain more powers than it currently has.  If this situation gets worse, I would expect Congress to modify their charter to allow them to buy assets that it previously could not buy, to end the asset deflation directly, at a cost of more price inflation, and spreading the lending losses to all who hold longer-term dollar-denominated assets.  If not Congress, there are executive orders in the Federal Register already for these actions.
  • Third, in a crisis, the FOMC would happily run with a wide yield curve — they will put depositary institution solvency ahead of purchasing power.
  • Fourth, the Fed can force credit into the economy, but not at prices they would like, or on terms that are attractive.  In a crisis, though, anything could happen.
  • Fifth, I don’t see a crisis happening.  It is in the interests of foreign creditors to stabilize the US, until they come to view the US as a “lost cause.”  Not impossible, but unlikely.  The flexible nature of the US economy, with its relatively high levels of freedom, make the US a destination for capital and trade.  The world needs the flexible US, less than it used to, but it still needs the US.

One final note off of the excellent blog Naked Capitalism.  They note, as I have, that the FOMC hasn’t been increasing the monetary base.  From RealMoney:


David Merkel
The Fed Has Shifted the Way it Conducts Monetary Policy
12/21/2007 11:56 AM EST

Good post over at Barry’s blog on monetary policy. Understanding monetary policy isn’t hard, but you have to look at the full picture, including the presently missing M3. I have a proxy for M3 — it’s total bank liabilities from the H8 report –> ALNLTLLB Index for those with a BB terminal. It’s a very good proxy, though not perfect. Over the last years, it has run at an annualized 9.4%. MZM has grown around 12.8%. The monetary base has grown around 3%, and oddly, has not been spiking up the way it usually does in December to facilitate year-end retail.

The Fed is getting weird. At least, weird compared to the Greenspan era. They seem to be using regulatory policy to allow the banks to extend more credit, while leaving the monetary base almost unchanged. This is not a stable policy idea, particularly in an environment where banks are getting more skittish about lending to each other, and to consumers/homebuyers.

This has the odor of trying to be too clever, by not making permanent changes, trying to manage the credit troubles through temporary moves, and not permanently shifting policy through adding to the monetary base, which would encourage more price inflation. But more credit through the banks will encourage price inflation as well, and looking at the TED spread, it seems the markets have given only modest credit to the Fed’s temporary credit injections.

I am dubious that this will work, but I give the Fed credit for original thinking. Greenspan would have flooded us with liquidity by now. We haven’t had a permanent injection of liquidity in seven months, and that is a long time in historical terms. Even in tightening cycles we tend to get permanent injections more frequently than that.

Anyway, this is just another facet of how I view the Fed. Watch what they do, not what they say.

Position: noneThe Naked Capitalism piece extensively quotes John Hussman.  I think John’s observations are correct here, but I would not be so bearish on the stock market.

After all of this disjointed writing, where does that leave me? Puzzled, and mostly neutral on my equity allocations.  My observations could be wrong here.  I’m skeptical of the efficacy of Fed actions, and of the willingness of foreigners to extend credit indefinitely, but they are trying hard  to reflate dud assets (and the loans behind them) now.  That excess liquidity will find its way to healthy assets, and I think I own some of those.






bloggerbuzzdeliciousdiggfacebookgooglelinkedinmyspacenetvibesnewsvineredditslashdotstumbleupontechnoratitwitteryahoo
Bonds, Currencies, Fed Policy, Macroeconomics, Portfolio Management, Real Estate and Mortgages, Speculation, Stocks, Structured Products and Derivatives | RSS 2.0 |

2 Responses to Depression, Stagflation, and Confusion

  1. James Dailey says:

    Hello David,

    I agree with most of your post with one caveat – valuation. I’ve posted before and not yet seen a response from you regarding the great valuation debate! Valuations mean little in the short to intermediate term, but it is what drives long term returns. I know you have argued that profit margins could sustain higher levels for longer than most think, but don’t the macro numbers from Q3 and likely now Q4 suggest your assessment was wrong? Margins are clearly contracting and with the implosion continuing in the credit markets, it is hard to see how financial sector profits will reverse quickly. In fact, I have posted and argued that profits from the past few years will be written down like the profits of the late 1990′s (for different reasons obviously) and that the record profit margins will end up having been a fantasy.

    So with price to book and most importantly to me, price to sales WAY above long term median/average levels, how can one argue that stocks in general are fairly valued or cheap? Margins would have to stay high for a long time, but that defies a basic tenet for me of a margin of error. I see a lot of lazy (and I am NOT including you in that group) of analysis regarding valuation using purely a P/E or Fed model analysis but have yet to find someone willing/able to posit an argument against my view other than “higher margins”. I would really value any response from anyone reading the blog because I constantly try to prevent myself from becoming dogmatic.

  2. AllanF says:

    Hello David,

    Thanks for the thoughtful and thorough response. I hope I’m not becoming a bore on this topic… I keep bringing it up, you keep graciously responding ‘stag-lite’. :-)

    Presuming consumer goods inflation in tandem with asset deflation seems a pretty safe investment theme to have. I’ve mentioned I-bonds previously, and it occurs to me they should do OK in that type of environment.

    As for equities generally, I am being very cautious. James’ position resonates with me. And it doesn’t depend on a full-blown 70′s stagflation to cause a note-worthy correction.

    Again thanks David. And thanks James.

    (BTW, I’m in the East-coast time zone this week and next.)

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

 Subscribe in a reader

 Subscribe in a reader (comments)

Subscribe to RSS Feed

Enter your Email


Preview | Powered by FeedBlitz

Seeking Alpha Certified

Top markets blogs award

The Aleph Blog

Top markets blogs

InstantBull.com: Bull, Boards & Blogs

Blog Directory - Blogged

IStockAnalyst

Benzinga.com supporter

All Economists Contributor

Business Finance Blogs
OnToplist is optimized by SEO
Add blog to our blog directory.

Page optimized by WP Minify WordPress Plugin