"Hell there are no rules here - we're trying to accomplish something." - Thomas A. Edison
Today the euro zone came out with some good news. The plan is to shore up the financial conditions by increasing the euro zone bailout fund to $1.4 trillion, recapitalize the banks and increase Greece's haircut to 50 percent. While the details are far from being complete this is a great step towards curing the ills of Europe and the markets in Europe have responded with rallies of more than 4 percent.
In the United States third quarter gross domestic product (GDP) increased 2.5 percent. This is the largest increase since the third quarter of last year. All of this news has the stock market up more than 3 percent for the day. Further good news is that all sectors contributed to the GDP growth; personal consumption rose, residential construction was up and exports increased. All in all good news all around.
So is the end of the poor economy in sight? Certainly if things keep improving this fast then you would have to say we are at the beginning of the about turn. The issue is that there is still a long way to go before we can actually say with confidence that the trend is favorable. Housing is still a major drag on the global recovery, unemployment is still far too high and the euro zone still has a long way to go to vote these measures in to effect, but it is a step in the right direction.
A further caution is that if this bailout package appears to be too small (and there is more than a small chance that it is) then this relief rally will turn nasty in a hurry. If it turns out that sufficient funds have been allocated then the rally should continue but we will only know that in the months ahead. As such, if you are a gambler you can take a pick at a direction, but many a portfolio has been undone with an incorrect guess.
I suggest that you stick to your knitting and wait for there to be more concrete signs that things have stabilized before going all in as after all this patience, to jump the gun too early would undermine all of our work to date.
Thursday, October 27, 2011
Wednesday, October 19, 2011
Global Deflation - Is This Possible?
"Armaments, universal debt and planned obsolescence - those are the three pillars of western prosperity." - Aldous Huxley
I tend to agree with Aldous. In times of war government spending creates jobs and prosperity for those that are not in the trenches. For some that are in the trenches it is better than being at home unable to find a job and wondering why life has dealt you such a poor hand. A man needs to work for his soul more than anything. He needs a place to go, where he can feel wanted, needed and a part of something, whether it is fighting on the front line or working on Wall Street. A sense of purpose goes a long way to cultivating a positive attitude about the future. Those of you who follow this blog will know that I believe that a lot can be accomplished with positive consumer confidence.
Planned obsolesce is what technology thrives on. Think back just five years and try to remember what your cell phone could do. I am unsure if mine could even download emails let alone surf the web, play music, take pictures, give me directions, pay a bill, deposit a check, reserve an airline ticket and then be that ticket at check in, just to name a few. Technology creates obsolescence and this drives the consumer to upgrade and consume.
So with wars all over the globe and technology creating new products left and right plus a rapidly growing governmental debt burden we should be primed for inflation right? Not so fast. There are a number of people that think that deflation could be on its way and if they are correct then we are really looking at a long protracted problem.
In order to create inflation you need to have excessive demand over supply. Pumping money into an economy and lowering interest rates normally does the trick but the problem is that this works when other economies around the globe are growing and have a demand for your goods and services. The issue right now is that pumping money into the global pool is not working for two reasons; first there is no demand for the money no matter how cheap you make it, and second the bubbles that burst in the housing and the derivative markets were so large that the influx of cash is soaked up in a nano-second before reaching their intended targets.
With every government around the globe trying to resuscitate their economies at the same time the world is awash with cash. Furthermore the large companies of the globe are sitting on more than a trillion dollars. Pumping more money into the system is therefore having no effect. Those that can borrow do not need the money and those that desperately need the money are unable to get a loan. Consumers are trying to cut debt as fast as possible and are certainly not interested in adding more debt, so the Federal Reserve is pushing on a string.
Furthermore the recession is driving the prices of virtually everything down. Technology is one factor that is driving deflation but there are others. Amongst them is the continual depreciation in the price of housing and other assets. In addition, the lack of demand is forcing businesses to cut the price of thousands of items. Look no further than Walmart or all of the discount airfares and hotel prices that abound. The four stand-outs that are not getting cheaper are gas, food, health care and education. Of these I would expect that gas prices will start to drop as demand for oil drops. Food prices should continue to spiral higher as the world demand for food continues to outstrip supply and medical expenses will spiral higher as long as the government meddles. Education is similar to medical in that the government subsidies are creating a false market for these products and hence drive the prices higher, but these are the only three places where I can see sustained price growth.
Should we therefore be concerned that inflation is around the corner. For that to happen you require demand to exceed supply, therefore you need the consumer to buy more goods than are available. Think of what happens at Walmart and other stores on Black Thursday when prices are dropped to ridiculously low prices for one day just to drive traffic. It is madness and shows in real life what it is like to have demand exceed supply. In the real world however we have massive unused capacity at the factories around the world and there are million of unemployed workers looking for employment. Until these two data points start to dip it is hard to see how inflation can resurrect itself. You need consumers to buy goods but they are out of work and those that are working have seen their pay getting cut or are trying to whittle down their debt burden. Companies are not necessarily laying people off, but they are not hiring. In this environment I would expect to see increased productivity numbers as less workers produce more goods. So until there is a binge of hiring (which I do not see in the immediate future) we will be stuck in this quagmire.
In this environment consumers tend to save as buying assets is a losing proposition. Just look at Japan who has one of the highest savings rates in the world and who has been stuck in a deflationary environment for two decades. I would expect to see the US savings rate climb to a double digit number in the coming years and this will create a drag on economic growth for years to come. Furthermore, interest rates should remain low for years because until there is demand for the money being lent there is no reason for rates to increase. The incentive to borrow is that rates are low so take on debt, but when no-one wants to borrow rates can stay low for decades. Once again look at Japan which shows how this situation will be exacerbated by an increase in the savings rate.
Sluggish growth will not help the stock market and therefore I am firmly in the bear camp. That said there will always be rallies within a bear market so for you traders who can sniff out the next rally I wish you luck. For the rest of you I would continue to recommend that you sit in cash and start to get used to returns of three percent or less on your money.
I tend to agree with Aldous. In times of war government spending creates jobs and prosperity for those that are not in the trenches. For some that are in the trenches it is better than being at home unable to find a job and wondering why life has dealt you such a poor hand. A man needs to work for his soul more than anything. He needs a place to go, where he can feel wanted, needed and a part of something, whether it is fighting on the front line or working on Wall Street. A sense of purpose goes a long way to cultivating a positive attitude about the future. Those of you who follow this blog will know that I believe that a lot can be accomplished with positive consumer confidence.
Planned obsolesce is what technology thrives on. Think back just five years and try to remember what your cell phone could do. I am unsure if mine could even download emails let alone surf the web, play music, take pictures, give me directions, pay a bill, deposit a check, reserve an airline ticket and then be that ticket at check in, just to name a few. Technology creates obsolescence and this drives the consumer to upgrade and consume.
So with wars all over the globe and technology creating new products left and right plus a rapidly growing governmental debt burden we should be primed for inflation right? Not so fast. There are a number of people that think that deflation could be on its way and if they are correct then we are really looking at a long protracted problem.
In order to create inflation you need to have excessive demand over supply. Pumping money into an economy and lowering interest rates normally does the trick but the problem is that this works when other economies around the globe are growing and have a demand for your goods and services. The issue right now is that pumping money into the global pool is not working for two reasons; first there is no demand for the money no matter how cheap you make it, and second the bubbles that burst in the housing and the derivative markets were so large that the influx of cash is soaked up in a nano-second before reaching their intended targets.
With every government around the globe trying to resuscitate their economies at the same time the world is awash with cash. Furthermore the large companies of the globe are sitting on more than a trillion dollars. Pumping more money into the system is therefore having no effect. Those that can borrow do not need the money and those that desperately need the money are unable to get a loan. Consumers are trying to cut debt as fast as possible and are certainly not interested in adding more debt, so the Federal Reserve is pushing on a string.
Furthermore the recession is driving the prices of virtually everything down. Technology is one factor that is driving deflation but there are others. Amongst them is the continual depreciation in the price of housing and other assets. In addition, the lack of demand is forcing businesses to cut the price of thousands of items. Look no further than Walmart or all of the discount airfares and hotel prices that abound. The four stand-outs that are not getting cheaper are gas, food, health care and education. Of these I would expect that gas prices will start to drop as demand for oil drops. Food prices should continue to spiral higher as the world demand for food continues to outstrip supply and medical expenses will spiral higher as long as the government meddles. Education is similar to medical in that the government subsidies are creating a false market for these products and hence drive the prices higher, but these are the only three places where I can see sustained price growth.
Should we therefore be concerned that inflation is around the corner. For that to happen you require demand to exceed supply, therefore you need the consumer to buy more goods than are available. Think of what happens at Walmart and other stores on Black Thursday when prices are dropped to ridiculously low prices for one day just to drive traffic. It is madness and shows in real life what it is like to have demand exceed supply. In the real world however we have massive unused capacity at the factories around the world and there are million of unemployed workers looking for employment. Until these two data points start to dip it is hard to see how inflation can resurrect itself. You need consumers to buy goods but they are out of work and those that are working have seen their pay getting cut or are trying to whittle down their debt burden. Companies are not necessarily laying people off, but they are not hiring. In this environment I would expect to see increased productivity numbers as less workers produce more goods. So until there is a binge of hiring (which I do not see in the immediate future) we will be stuck in this quagmire.
In this environment consumers tend to save as buying assets is a losing proposition. Just look at Japan who has one of the highest savings rates in the world and who has been stuck in a deflationary environment for two decades. I would expect to see the US savings rate climb to a double digit number in the coming years and this will create a drag on economic growth for years to come. Furthermore, interest rates should remain low for years because until there is demand for the money being lent there is no reason for rates to increase. The incentive to borrow is that rates are low so take on debt, but when no-one wants to borrow rates can stay low for decades. Once again look at Japan which shows how this situation will be exacerbated by an increase in the savings rate.
Sluggish growth will not help the stock market and therefore I am firmly in the bear camp. That said there will always be rallies within a bear market so for you traders who can sniff out the next rally I wish you luck. For the rest of you I would continue to recommend that you sit in cash and start to get used to returns of three percent or less on your money.
Friday, October 14, 2011
The Great Stock Recovery - Or Not?
"You can fool all the people all the time if the advertising is right and the budget is big enough." - Joseph E. Levine
Let me start this blog by saying that I am not a perma-bear (a person that is constantly negative on the stock market), I am just giving you the best advice I can based on my overall economic outlook. Let me also say that this blog or quote is not about Apple stock or its products both of which I believe are overly priced stocks and gadgets that have been hyped by an exceptionally brilliant salesman.
No, I am referring to the market which has just rallied more than 10 percent in less than two weeks. Many are talking about this as the beginning of the next bull market but I would caution you to remain on the sidelines. In dissecting the stock market movements that have occurred during the previous decades it is clear that the market has averaged returns north of 7 percent a year. This number is often touted by unseasoned professionals and financial planners as the reason to invest in a portfolio of stocks. The return is higher than those of the bond market or most other investments the argument goes, so it is imperative to hold stocks (and a large portion of them) in your portfolio. Not only should you buy them but no matter what the outlook you should remain in stocks as you can never time the market and the average return will even out over the long-term.
My beef with this argument is that the long-term is often longer than any of us have left in our lifetimes. This average return has been averaged over roughly 100 years! I am sure I do not have that long left on this planet and if I do then my son will have his hands full in supporting me! No, most of us have a horizon of 10 to 20 years at most, so I would argue that you need to look at returns over those periods of time. Taking these parameters the landscape changes in an instant. Stocks have not moved at all since 2000 and in fact are well below that peak and have provided a negative compound annual rate of return of (0.5) percent. Going back another 10 years (1990 to 2000) and suddenly you are rewarded for being in stocks with compound annual returns of over 13 percent for that decade. Taking the two decades together and your total return falls to just over 6 percent or below the general trend.
So buy stocks now and be rewarded over the next 10 years? To answer that question we have to look at what drives stock returns. Returns to stocks are highly correlated to the increased earnings that companies enjoy as the economy expands. Looking back at the 1980s through to 2000 the US economy benefited from years of overspending by the US consumer whose savings rate dropped from 12 percent to 1 percent. Furthermore household debt increased from 65 percent of disposable after tax income to 135 percent. Added to this was low interest rates, easy money loans and many other exuberance's that were unsustainable. It was just a matter of time until the party was over and it is now over. These excesses are going to take a long time to unwind driving down economic growth and therefore company profits. I expect that the current economic environment will last at least another five years if not a decade therefore I conclude that the stock market will produce returns close to zero or even negative returns during that time frame. Assuming no return for the next decade takes the average return in the market for the 30 year period down to 3.85 percent. Certainly not something to crow over.
I would argue that rather than risk your money in a volatile stock market that is producing no returns but which has the propensity to nose dive at a given notice that you should exit stocks for an extended period and start to realize that a return of three to four percent on your money is the new "normal". At least for the next decade it is. If you then factor in the real probability that there may be global deflation coming your real rate of return on an investment yielding 3 percent could be as high as 6 percent. No-one would sniff at that now would they? (In my next blog I will look into the reasons that deflation is still an impending problem and how it will affect your investment outlook for years to come.)
In these poor economic times and until the global economy gives signs of stability I believe that you should exit stock positions and look to invest the proceeds in income bearing investments. If you must own stocks then look to large cap dividend plays as these companies will be able to sustain an extended downturn far more safely than smaller companies. Don't get me wrong, I believe that there will be plenty of companies that make a lot of money in this environment and innovators will succeed as always, but outside of these exceptions stocks are not a good place to be invested at present. Furthermore I would argue that finding a safe return of 3 percent will be looked upon as an excellent investment in the coming years.
Let me start this blog by saying that I am not a perma-bear (a person that is constantly negative on the stock market), I am just giving you the best advice I can based on my overall economic outlook. Let me also say that this blog or quote is not about Apple stock or its products both of which I believe are overly priced stocks and gadgets that have been hyped by an exceptionally brilliant salesman.
No, I am referring to the market which has just rallied more than 10 percent in less than two weeks. Many are talking about this as the beginning of the next bull market but I would caution you to remain on the sidelines. In dissecting the stock market movements that have occurred during the previous decades it is clear that the market has averaged returns north of 7 percent a year. This number is often touted by unseasoned professionals and financial planners as the reason to invest in a portfolio of stocks. The return is higher than those of the bond market or most other investments the argument goes, so it is imperative to hold stocks (and a large portion of them) in your portfolio. Not only should you buy them but no matter what the outlook you should remain in stocks as you can never time the market and the average return will even out over the long-term.
My beef with this argument is that the long-term is often longer than any of us have left in our lifetimes. This average return has been averaged over roughly 100 years! I am sure I do not have that long left on this planet and if I do then my son will have his hands full in supporting me! No, most of us have a horizon of 10 to 20 years at most, so I would argue that you need to look at returns over those periods of time. Taking these parameters the landscape changes in an instant. Stocks have not moved at all since 2000 and in fact are well below that peak and have provided a negative compound annual rate of return of (0.5) percent. Going back another 10 years (1990 to 2000) and suddenly you are rewarded for being in stocks with compound annual returns of over 13 percent for that decade. Taking the two decades together and your total return falls to just over 6 percent or below the general trend.
So buy stocks now and be rewarded over the next 10 years? To answer that question we have to look at what drives stock returns. Returns to stocks are highly correlated to the increased earnings that companies enjoy as the economy expands. Looking back at the 1980s through to 2000 the US economy benefited from years of overspending by the US consumer whose savings rate dropped from 12 percent to 1 percent. Furthermore household debt increased from 65 percent of disposable after tax income to 135 percent. Added to this was low interest rates, easy money loans and many other exuberance's that were unsustainable. It was just a matter of time until the party was over and it is now over. These excesses are going to take a long time to unwind driving down economic growth and therefore company profits. I expect that the current economic environment will last at least another five years if not a decade therefore I conclude that the stock market will produce returns close to zero or even negative returns during that time frame. Assuming no return for the next decade takes the average return in the market for the 30 year period down to 3.85 percent. Certainly not something to crow over.
I would argue that rather than risk your money in a volatile stock market that is producing no returns but which has the propensity to nose dive at a given notice that you should exit stocks for an extended period and start to realize that a return of three to four percent on your money is the new "normal". At least for the next decade it is. If you then factor in the real probability that there may be global deflation coming your real rate of return on an investment yielding 3 percent could be as high as 6 percent. No-one would sniff at that now would they? (In my next blog I will look into the reasons that deflation is still an impending problem and how it will affect your investment outlook for years to come.)
In these poor economic times and until the global economy gives signs of stability I believe that you should exit stock positions and look to invest the proceeds in income bearing investments. If you must own stocks then look to large cap dividend plays as these companies will be able to sustain an extended downturn far more safely than smaller companies. Don't get me wrong, I believe that there will be plenty of companies that make a lot of money in this environment and innovators will succeed as always, but outside of these exceptions stocks are not a good place to be invested at present. Furthermore I would argue that finding a safe return of 3 percent will be looked upon as an excellent investment in the coming years.
Thursday, October 6, 2011
A Liquidity Trap?
"Putting somebody who is suffering from anorexia on a diet doesn't make a lot of sense to me." - Paul McCulley
A liquidity trap is loosely defined as a period in which the private sector delevers their balance sheet of debt or increases their savings rate at which time reducing interest rates has no effect on aggregate demand as there is no desire to accept more debt regardless of how cheap. During these periods the Keynesian economists believe that the only way out of this trap is to have the government shoulder more debt until such time as the private sector has cleaned itself up and is ready to start to grow again. In this argument, cutting government spending and stimulus during this period is suicide as this will lead to further contraction and exacerbate the problem.
The main example of how this worked in real life was back during the great depression era. The great depression ended in large part to WWII. The massive influx of spending from the government produced the stimulus needed to pull the economy out of its malaise. Furthermore the GI Bill helped millions of Americans returning from the war purchase a house and get retrained. In those times it was considered a privilege rather than a handout (as it would be today). Having been in combat myself I can assure you that it is a privilege that is deserved whereas right now it is definitely a handout.
At present there is a global call for governments around the world to delever their balance sheets and this could push the entire global economy over the edge. I must admit that to some extent I agree with this argument. Cutting government spending would mean cutting jobs and this would lead to an increased unemployment level reducing demand for goods and services even further. On the other hand having the government spend more money sends a chill down my spine. So why is that and what are the differences between then and now?
The difference between the government spending money on a war and spending money during peace time are significant. During a war you send away (or employ) thousands of people to fight, many of whom never come back. This contracts the workforce significantly. During WWII it resulted in there being a lack of employable men to run the factories so the women stepped into that roll. Furthermore the government spent money on factories and innovation, a direct stimulant to the economy that required immediate employment. The result was that after the war the boom continued and lasted for decades as the private sector stepped in to monetize the opportunities.
Today we see a government that is bent on spending but the use of the money is what is exasperating. To date we have spent more than $3 trillion to fix nothing. Had the government used that money to hire people to work factories and innovate rather than sink it into the hands of a few large failing banks and businesses we would have a different outlook. People would be back to work rather than collecting unemployment checks for 99 weeks. This would have the effect of turning our current pessimistic outlook into a positive outlook and we have all seen what happens when everyone believes in the future - the future is bright.
The current pessimism around the world is a factor of a poor economy AND a lack of leadership. If it were just a poor economy people would be of the mindset that the vacation this year may have to be cancelled. Adding in weak leadership and people start to think that not only will we not go on holiday this year but we will never go on holiday again. Furthermore they begin to question the government spending programs and start to call for austerity right at the time when we need the government to step up spending.
Do we still have time to fix this? I believe that we do, however I do not think it will happen until we have a leader that takes the helm and drives the ship away from the rocks towards which we are headed. At present we have the capacity to take on more debt. Due to the weakness around the globe every country is trying to weaken their currency. With everyone trying to weaken stimulating more should not create a capitulation in the dollar. The problem therefore is not that we are unable to print more money (like Greece) but that if we do we will not spend it in the correct manner.
Based on this it certainly appears that the economy will stagnate for a longer period than anyone is prepared to accept. My view is that at present we are locked into this malaise until the property market clears and that is looking like at least another five years if not longer. Low interest rates are here for the foreseeable future as well as there is no demand to borrow from the private sector. Furthermore inflation seems to be contained as there is such an output gap that further stimulus from the government should keep a lid on this for the foreseeable future. In addition the price of raw materials is falling as weak demand is starting to seep into those prices. For example oil is down more than 25% from its recent highs.
In this environment stocks will not perform well and there will be limited opportunities to make money on your investments in the traditional ways. Look to alternative investments and once you have found an opportunity make sure that you scrub it down thoroughly as often times the risks associated with the investment will far outweigh the potential rewards.
A liquidity trap is loosely defined as a period in which the private sector delevers their balance sheet of debt or increases their savings rate at which time reducing interest rates has no effect on aggregate demand as there is no desire to accept more debt regardless of how cheap. During these periods the Keynesian economists believe that the only way out of this trap is to have the government shoulder more debt until such time as the private sector has cleaned itself up and is ready to start to grow again. In this argument, cutting government spending and stimulus during this period is suicide as this will lead to further contraction and exacerbate the problem.
The main example of how this worked in real life was back during the great depression era. The great depression ended in large part to WWII. The massive influx of spending from the government produced the stimulus needed to pull the economy out of its malaise. Furthermore the GI Bill helped millions of Americans returning from the war purchase a house and get retrained. In those times it was considered a privilege rather than a handout (as it would be today). Having been in combat myself I can assure you that it is a privilege that is deserved whereas right now it is definitely a handout.
At present there is a global call for governments around the world to delever their balance sheets and this could push the entire global economy over the edge. I must admit that to some extent I agree with this argument. Cutting government spending would mean cutting jobs and this would lead to an increased unemployment level reducing demand for goods and services even further. On the other hand having the government spend more money sends a chill down my spine. So why is that and what are the differences between then and now?
The difference between the government spending money on a war and spending money during peace time are significant. During a war you send away (or employ) thousands of people to fight, many of whom never come back. This contracts the workforce significantly. During WWII it resulted in there being a lack of employable men to run the factories so the women stepped into that roll. Furthermore the government spent money on factories and innovation, a direct stimulant to the economy that required immediate employment. The result was that after the war the boom continued and lasted for decades as the private sector stepped in to monetize the opportunities.
Today we see a government that is bent on spending but the use of the money is what is exasperating. To date we have spent more than $3 trillion to fix nothing. Had the government used that money to hire people to work factories and innovate rather than sink it into the hands of a few large failing banks and businesses we would have a different outlook. People would be back to work rather than collecting unemployment checks for 99 weeks. This would have the effect of turning our current pessimistic outlook into a positive outlook and we have all seen what happens when everyone believes in the future - the future is bright.
The current pessimism around the world is a factor of a poor economy AND a lack of leadership. If it were just a poor economy people would be of the mindset that the vacation this year may have to be cancelled. Adding in weak leadership and people start to think that not only will we not go on holiday this year but we will never go on holiday again. Furthermore they begin to question the government spending programs and start to call for austerity right at the time when we need the government to step up spending.
Do we still have time to fix this? I believe that we do, however I do not think it will happen until we have a leader that takes the helm and drives the ship away from the rocks towards which we are headed. At present we have the capacity to take on more debt. Due to the weakness around the globe every country is trying to weaken their currency. With everyone trying to weaken stimulating more should not create a capitulation in the dollar. The problem therefore is not that we are unable to print more money (like Greece) but that if we do we will not spend it in the correct manner.
Based on this it certainly appears that the economy will stagnate for a longer period than anyone is prepared to accept. My view is that at present we are locked into this malaise until the property market clears and that is looking like at least another five years if not longer. Low interest rates are here for the foreseeable future as well as there is no demand to borrow from the private sector. Furthermore inflation seems to be contained as there is such an output gap that further stimulus from the government should keep a lid on this for the foreseeable future. In addition the price of raw materials is falling as weak demand is starting to seep into those prices. For example oil is down more than 25% from its recent highs.
In this environment stocks will not perform well and there will be limited opportunities to make money on your investments in the traditional ways. Look to alternative investments and once you have found an opportunity make sure that you scrub it down thoroughly as often times the risks associated with the investment will far outweigh the potential rewards.
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