I wish that I had more time to respond to readers both in the comments and e-mail.  Unfortunately, I am having to spend more time working as I am in transition as far as my work goes.  I’ll try to catch up over the next week or so, but I am behind by about 50 messages, and I hate to compromise message quality just to clear things out.

That said, my inflation/deflation piece yesterday attracted two comments worthy of response.  The first was from James Dailey, who I would recommend that you read whenever he comments here.  We may not always agree, but what he writes is well thought out.  He thinks I attribute too much power to the Fed.  He has a point.  From past writings, I have suggested that the Fed is not all-powerful.  What I would point out here is that the Fed controls more than just the monetary base.  They control (in principle) the terms of lending that the banks employ.  With a little coordination with the other regulators, the Fed could restrict non-bank lenders by raising the capital requirements that banks (and other regulated institutions) must maintain in lending to non-bank lenders.  So, if credit is outpacing the growth in the monetary base, it is at least partially because the Fed chooses to allow it.  Volcker reined in the credit card companies in the early 80s, which was not a normal policy for the Fed; it had a drastic impact on the economy, but inflation slowed considerably.  (Causation?  I’m not sure.  Fed funds were really high then also.)

The other comment came from Bill Rempel.  He objected more to my terminology than my content, though he disliked my comment that “Inflation is predominantly a monetary phenomenon.”  I think we are largely on the same page, though.  I know the more common phraseology here, “Inflation is purely a monetary phenomenon,” and I agree with it, but with the following provisos:

  • If we are talking about goods, services, and assets as a group, or,
  • If the period of time is sufficiently long, like a century or so, or,
  • If we are talking about monetary inflation.  (Who disagrees with tautologies? 🙂 Not me.)

Part of my difficulty here, is that when we talk about money, we are talking about something that lies on the spectrum  between currency and credit.  By currency I am talking about whatever physical medium can be commonly deployed to effectuate transactions.  By credit, anything where the eventual exchange of currency is significantly delayed, and perhaps with some doubt of collection.  Because of the existence of credit, over shorter periods, the link between monetary inflation and good price inflation is more tenuous, which leads people to doubt the concept that “Inflation is purely a monetary phenomenon.”  My post, rather than weakening that concept, strengthens it, because it broadens the concept of inflation, so that the pernicious effects of monetary inflation can be more clearly seen.  I wrote what I wrote to distinguish between monetary, goods and asset inflation.  I think it is useful to make these distinctions, because most people when they hear the word “inflation” think only of goods price inflation, and not of monetary or asset inflation.

Now, onto today’s topic: how to protect ourselves from inflation and deflation.  With goods price deflation (should we ever see that under the Fed), the answers are simple: avoid debt, lend to stable debtors, and make sure you are economically necessary to the part of the economy that you serve.  You want to make sure that you have enough net cash flow when net cash flow is scarce.  You can use that cash flow to buy distressed assets on the cheap.  Economically necessary and low debt applies to the stocks you own as well.

On goods price inflation, take a step back and ask what is truly in short supply, and buy/supply some of that.  It could be commodities, agricultural products, or gold.   As a last resort you could buy some TIPS, or just stay in a money market fund.  You won’t get rich that way, but you might preserve purchasing power.  In stocks, look for those that can pass through price inflation to their customers.  In bonds, stay short, unless they are inflation-protected.

This is not obscure advice, but there is an art to applying it.  There comes a point in every theme where prices of the most desirable assets discount or even over-discount the scenario.  Safe assets get overbought in a deflation toward the end of that phase of the cycle.  Same thing for inflation-sensitive assets during an inflation.  As for me at present, you can see my portfolio over at Stockpickr; at present, I split the difference, though my results over the last five months have been less than stellar.  I have companies with relatively strong balance sheets, and companies with a decent amount of economic sensitivity, whether to price inflation or price inflation-adjusted economic activity.

I don’t see the global economy heading into recession; I do see price inflation ticking up globally, and also asset inflation in some countries (China being a leading example).   But we have a debt overhang in much of the developed world, so we have to be careful about balance sheets.

I may have it wrong at this point.  My equity performance over the last seven-plus years has been good, but the last five months have given me reason for pause.  Well, things were far worse for me 6/2002-9/2002; I saw that one through.  I should survive this one too, DV.

This is another in the irregular series on personal finance.  This article though, has implications beyond individuals.  I’m going to describe this in US-centric terms for simplicity sake.  For the 20-25% of my readers that are not US-based, these same principles will apply to your own country and currency as well.

Let’s start with inflation.  Inflation is predominantly a monetary phenomenon.  Whenever the Fed puts more currency into circulation on net, there is monetary inflation.  Some of the value of existing dollars gets eroded, even if the prices of assets or goods don’t change.  In a growing economy with a stable money supply, there would be no monetary inflation, but there would likely be goods price deflation.  Same number of dollars chasing more goods.

Let’s move on to price inflation.  There are two types of price inflation, one for assets, and the other for goods (and services, but both are current consumption, so I lump them together).  When monetary inflation takes place, each dollar can buy less goods or assets than in the absence of the inflation.  Prices would not rise, if productivity has risen as much or more than the amount of monetary inflation.

Now, the incremental dollars from monetary inflation can go to one of two places: goods or assets.  Assets can be thought of  as something that produces a bundle of goods in the future.  Asset inflation is an increase in the prices of assets (or a subgroup of assets) without equivalent improvement in the ability to create more goods in the future.  How newly printed incremental dollars get directed can make a huge difference in where inflation shows up. Let me run through a few examples:

  1.  In the 1970s in the US, the rate of household formation was relatively rapid, and there was a lot of demand for consumer products, but not savings.  Money supply growth was rapid.  The stock and bond markets languished, and goods prices roared ahead.  Commodities and housing also rose rapidly.
  2. In  the mid-1980s the G7 induced Japan to inflate its money supply.  With an older demographic, most of the excess money went into savings that were invested in stocks that roared higher, creating a bubble, but not creating any great amount of incremental new goods (productivity) for the future.
  3. In 1998-1999, the Fed goosed the money supply to compensate for LTCM and the related crises, and Y2K.  The excess money made its way to tech and internet stocks, creating a bubble.  On net, more money was invested than was created in terms of future goods and services.  Thus, after the inflation, there came a deflation, as the assets could not produce anything near what the speculators bid them up to.
  4. In 2001-2003 the Fed cut rates aggressively in a weakening economy.  The incremental dollars predominantly went to housing, producing a bubble.  More houses were built than were needed in an attempt to respond to the demand from speculators.  Now we are on the deflation side of the cycle, where prices adjust down, until enough people can afford the homes using normal financing.

I can give you more examples.  The main point is that inflation does not have to occur in goods in order to be damaging to the economy.  It can occur in assets when people and institutions become maniacal, and push the price of an asset class well beyond where its future stream of cash flow would warrant.

Now, it’s possible to have goods deflation and asset inflation at the same time; it is possible to save too much as a culture.  The boom/bust cycles in the late 1800s had some instances of that.  It’s also possible to have goods inflation and asset deflation at the same time; its definitely possible to not save enough as a culture, or to have resources diverted by the government to fight a war.

The problem is this, then.  It’s difficult to make hard-and-fast statements about the effect of an increasing money supply.  It will likely create inflation, but the question is where?  Many emerging economies have rapidly growing money supplies, and they are building up their productive capacity.  The question is, will there be a market for that capacity?  At what price level?  Many of them have booming stockmarkets.  Do the prices fairly reflect the future flow of goods and services?  Emerging markets presently trade at a P/E premium to the developed markets.  If capitalism sticks, the premium deriving from faster growth may be warranted.  But maybe not everywhere, China for example.

The challenge for the individual investor, and any institutional asset allocator is to look at the world and estimate where the assets generating future inflation-adjusted cash flows (or goods and services) are trading relatively cheaply.  That’s a tall order.  Jeremy Grantham of GMO has done well with that analysis in the past, and I’m not aware that he finds anything that cheap today.

We live in a world of relatively low interest rates; part of that comes from the Baby Boomers aging and pension plans investing for their retirement.  P/E multiples aren’t that high, but profit margins are also quite high.  We also face central banks that are loosening monetary policy to reduce bad debt problems.  That incremental money will aid institutions not badly impaired, and might eventually inflate the value of houses, if they get aggressive enough.  (Haven’t seen that yet.)  In any case, the question is how will the incremental dollars (and other currencies) get spent?  In the US, we have another demographic wave of household formations coming, so maybe goods inflation will tick up.

We’ll see.  More on this tomorrow; I’ll get more practical and less theoretical.

This post may be a little more disjointed than some of my posts.  Recently I have been working on calculating the fair value for mezzanine tranches of a series of real estate oriented CDOs.  Not pretty.  Anyway, here are few articles that got me thinking yesterday:

  1. Let’s  start with CD rates.  Bloomberg had a nifty table on its system which I can’t reproduce here, except to point you to the data source at the Fed.  Note how one-, three-, and six-month CD rates have been rising, somewhat in sync with LIBOR, but widening the gap with Treasury yields. (Hit your “end” button to see the most recent rates…)
  2. As a result, I have been debating whether the FOMC might not do a 50 basis point loosen next Tuesday.  CDs aren’t the bulk of how most banks fund themselves, but they can be a way to get a lot of cash fast.  Remember that after labor unemployment and inflation, the Fed’s hidden third mandate is protecting the depositary financial system, particularly the portion that belongs to the Federal Reserve System.
  3. Now, I’m not the only one wondering about what the FOMC will do.  There’s Greg Ip at The WSJ, who speculates on the size of the cut, and whether the discount rate might not be cut even more, with a loosening of terms and conditions as well.  Bloomberg echoes the same themes.  Even the normally placid Tony Crescenzi sounds worried if the FOMC doesn’t act aggressively here.
  4. The US isn’t the only place where this is a worry.  The Bank of Canada cut rates yesterday, as noted by Trader’s Narrative, partly because of credit pressures in Canada and the US.  The Financial Times notes that Euro-LIBOR [Euribor] is also rising vs. Government short-term yields, which may prompt the ECB to cut as well.  Or, they also could cut their version of the discount rate, or liberalize terms.
  5. It doesn’t make sense to me, but the Yen is weakening at present.  With forward interest rate differentials narrowing as more central banks tip toward easing, I would expect the carry trade to weaken; instead, it is growing.  For now.
  6. As noted by Marc Chandler, the Gulf States have largely decided to keep their US Dollar peg.  I found the article to be interesting and somewhat counterintuitive at points, but hey, I learned something.  Inflation is rising in Kuwait after they switched from the US Dollar to a basket of currencies, because residential real estate prices are rising.
  7. Credit problems continue to emerge on the short end of the yield curve.  Accrued Interest has a good summary of the problems in money market funds.  It almost seems like Florida is a “trouble magnet.”  If it’s not hurricanes, it’s bad money management.  Then there’s Orange County, which has a 20% slug of SIV-debt in its Extended Fund.  It’s all highly rated, so they say, but ratings don’t always equate to credit quality, particularly in unseasoned investment classes.  Then there’s the credit stress from borrowers drawing down on standby lines of credit, which further taxes the capital of the banks.
  8. As a final note, both here (point 6) and at RealMoney, I was very critical of S&P and Moody’s when they decided to rate CPDO [Constant Proportion Debt Obligation] paper AAA.  I’ll let the excellent blog Alea take the victory lap though.  We finally have CPDOs that are taking on serious losses (and here).
  9. In summary, we are increasingly in a situation where the major central banks of our world are reflating their currencies as a group in an effort to inflate away embedded credit problems.  Most of the credit problems are too deep for a lowering of the financing rate to solve, though it will help financial institutions with modest-to-moderate-sized credit problems (say, less than 25% of tangible net worth — does the rule of thumb for P&C reinsurers apply to banks?).  This can continue for some time, and credit spreads and yield curves should continue to widen, and inflation (when fairly measured) should increase.  Some of the inflation will move to assets that aren’t presently troubled, perhaps commodities, and higher quality equities, which are doing relatively well of late.
  10. Quite an environment.  The big question is when the “free lunch” period for the rate cuts end, and the hard policy choices need to be made.  My guess is that would be in mid-to-late 2008, just in time for the elections.  Now, wouldn’t that spice things up? 🙂

The ratings agencies have come under a lot of flak recently for rating instruments that are new, where their models might not be do good, and for the conflicts of interest that they face.  Both criticisms sound good initially, and I have written about the second of them at RealMoney, but in truth both don’t hold much water, because there is no other way to do it.  Let those who criticize put forth real alternatives that show systematic thinking.  So far, I haven’t seen one.

Here are the realities:

  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.  The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.  The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
  • New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
  • Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
  • Ratings can be short-term, or long-term, but not both.  The worst of all worlds is when the ratings agencies shift time horizons.

For my first point, the fixed-income community has learned that the ratings agencies offer an opinion, and they might pay for some additional analysis through subscriptions, but if they were forced to pay the fees that issuers pay, they would balk; they have in-house analysts already.  The ratings agencies aren’t perfect, and good buy-side shops use them, but don’t rely on them.

Second, the regulators need simple ways in a complex environment to account for credit risk, so that capital positions can be properly sized.  They either need rating agencies, or have to be one.  No way around it.

Third, financial institutions will buy new securities, and someone has to rate them so that proper capital levels can be held (hopefully).

Fourth, financial institutions and regulators have to be “big boys.” If you were stupid enough to rely on the rating without further analysis, well, that was your fault.  If the ratings agencies can be sued for their opinions (out of a misguided notion of fiduciary interest), then they need to be paid a lot more so that they can fund the jury awards.  Their opinions are just that, opinions.  Smart institutional investors often ignore the rating, and read the commentary.  The nuances of opinion come out there, and often tell smart investors to stay away, in spite of the rating.

Last, ratings agency opinions are long-term by nature, rating over a full credit cycle.  During panics people complain that they should be more short-term.   Hindsight is 20/20.  Given the multiple uses of credit ratings, having one time horizon is best, whether short- or long-term.  Given the whipsaw that I experienced in 2002 when the ratings agencies went from long- to short-term, I can tell you it did not add value, and that most bond manager that I knew wanted stability.

Now there are alternatives.  The regulators can ban asset classes until they are seasoned.  Could be smart, but there will be complaints.  I experienced in one state the unwillingness of the regulators to update their permitted asset list, which had not been touched since 1955.  In 2000, I wrote the bill that modernized the investment code for life companies; perhaps my grandson (not born yet), will write the next one.  Regulators are slow, and they genuinely don’t understand investments.

Another alternative would be to allow for more rating agencies.  I’m in favor of a free-ish market here, allowing the regulators to choose those raters that are adequate for setting capital levels, and those that are not.  For other purposes, though, the more raters, the better.

Let those who criticize the ratings agencies bring forth a new paradigm that the market can embrace, and live with in the long term.  Until then, the current system will persist, because there is no other realistic way to get business done.  There are conflicts of interest, but those are unavoidable in multiparty arrangements.  The intelligent investor has to be aware of them, and compensate for the inherent bias.

My main thesis here is that secondary and primary markets benefit investors in different ways, but that they are equally valuable to investors, and the public at large. Government policy should not discriminate in favor of one or the other.

I come at this topic from the point of view of someone who has been both a bond and stock investor professionally. When managing bonds, one boss of mine would say, “Primary market levels validate trading levels in the secondary market.” His point was that in the bond market, since a large proportion of the dollar value of transactions came from new issues, those deals in the primary markets were a good indication of where trades should go on in the secondary market for similar pieces of paper. He had a point; bigger markets should dominate smaller similar markets in discerning overall price/yield movements.

In the primary markets, deals have to come a little cheap on average in order to get deals done. That cheapness is necessary in order to get a lot of liquidity from investors at once. But that level of cheapness attracts flippers, i.e., people who buy the cheap new issue, and sell it away for a quick profit in the secondary markets. Bond underwriter syndicates do what they can to detect flippers, but some almost always get in. Even so, the flippers have some value. They reveal the level of discounting inherent in the offering process; when the discounting is high, there’s a lot of fear in the marketplace, and new deals stand a decent chance of performing well. Vice-versa when discounting is low, or even worse, when a new deal “backs up” and closes below the IPO price.

One way to tell how hot the market is, is how rapidly deals close. Seven minutes? Days?  Mania and Lethargy are common attitudes for the market.  Normal behavior is, well, abnormal.  Abnormal behavior provides clues into what is likely to happen next, even if the timing is difficult.  Hot IPO markets eventually go cold, and vice-versa.

The secondary markets provide valuable clues for the primary market as to where deals should be priced, whether equity or debt.  Even if the primary market were dominated by buy-and-hold investors (more common in bonds, less common in stocks), the speculation inherent in much secondary trading provides real value to the IPO syndicates, and longer-term investors.

Longer-term investors who buy-and-hold, or sell-and-sit-on-cash provide clues to speculators as well. The longer-term investors are the ones who create “support” and “resistance” levels.  They care about valuation.

Secondary markets need primary (IPO) markets also.  Without the possibility of a company being bought out, share prices tend to suffer.  When few new companies go public, it is often a sign that the secondary markets are cheap.

My main point here is both markets are valuable, and they need each other.  Speculation is an inescapable part of the capital markets, and it should not be legally discouraged.  (Note: I am not about to become a speculator; I am a longer-term investor, and will stay that way.)

How does the system discourage speculation?  There are differential rates of taxation based on holding period, or investment class. My view is that all income, no matter how generated, should be taxed at the same rate.  All income generation is equally valuable, whether it comes quickly or slowly.

So, when I read drivel like this fellow Lawrence Mitchell is putting out, advocating high taxes on short-term investing, I sit back and say, “You’re not thinking systematically.  You’ve only thought through the first order effects; the remaining effects have eluded you.”  Imagine a system where we are all forced to become buy-and-hold investors through tax policy.  Where would the price signals for the primary markets come from?  Where would liquidity come from?  Would activist investing shrink, with the honesty that it helps to bring?  Who would be willing to step up to an IPO if he knew that tax policy favored him holding for ten years?  What would happen to venture capital if the secondary markets dried up because of tax policy?  Where would their exit door be?

A world composed of only long-term investors would not be as rich of world as we have now.  Though many short-term investors are only “noise traders,” the ability of short-term investors to take advantage of market dislocations helps stabilize the markets.  There should be no penalty to short-term investing versus long-term investing.

Now, if that’s not controversial enough, perhaps I will write a post where I say that tax policy should not favor savings over consumption.  Let people make their own decisions on buying and selling, and let the IRS take a consistent cut, but social policy through tax preferences is for the most part not a good idea.

After a lot of struggle (in my younger days I would have learned the coding, and reprogrammed the whole thing), my links are working again, though I have had to sacrifice the descriptive permalinks for now.  In the bargain, at least I upgraded to WP 2.3.1, which is a lot slicker than the old version.

For this evening, I want to offer you two unrelated thoughts on the markets.  The first is that the plan of the Treasury to freeze reset rates on subprime mortgages is a great big zero.  The real problem is too many homes chased by too few people able to afford them at current prices.  Subprime loans are a very modest portion of residential real estate finance.  Beyond that, the Treasury proposal does triage — separating borrowers into healthy, dead, and savable.  The savable are a small portion of a small component in the total residential financing scheme.  It will keep a few more people in their homes,  but that’s about it.  There will probably be court challenges from hedge funds that lose interest from the changes; they will probably win, because this is an illegal “taking” by the US Government.  That said, there is no way that I can see that they will be able to collect damages.

I said this was a zero, because paying the mortgage payment is not the problem here; it is the overhang of excess houses.  This does nothing to solve that problem.  My more radical solution of offering free US citizenship to anyone who buys a house in the US free and clear (for more than $250,000), is a non-starter for a wide variety of reasons, but it would kill two birds with one stone.  Clear up the excess houses, and solve the current account deficit problem.  A side benefit is giving wealthy foreigners a stake in the prosperity of the US.

Here’s my second thought.  Japan wants China to revalue its currency upward.  Perhaps that’s no big deal, but it reflects US dollar weakness.  China has been running a dirty crawling peg versus the US dollar, while letting other currency relationships languish.  As a result, the Euro and the Yen have gotten expensive versus the Yuan.  In this case, I think the Japanese are correct.  Let the US Dollar fall more, and let other nations buy our goods and services, rather than just swallowing our bonds (promises to pay later).