Icebergs
John Riley, Chief Strategist
12/03/07
Did you hear
about the Fed Chairman that had his head in the oven and his feet
in the freezer? He told Congress, “On average, I’m comfortable.”
Dead, but comfortable.
This is the danger of using some averages, they don't tell the whole
story and it is the methodology that the Federal Reserve is following.
Three
Icebergs, Two Imported, One Domestic
What is going on in our economy is out of the Federal Reserve’s
control. There is nothing they can do about it. It is like an iceberg
bearing down on us and everybody can see it, but nobody can do anything
about it. (It’s actually 3 icebergs, more on them later.)
The US is importing
both Deflation and Inflation from overseas. On the surface, you
might look at that and say “Great, everything balances out!”
But like our friend with the appliance problem I spoke of earlier,
they don’t cancel each other out, they both kill you.
The Fed however
sees them cancelling out. It sees inflation numbers that are not
too hot and not too cold. And that is what they concentrate on.
Not the impact the two destructive forces are having on the economy.
Balance of Payments
We keep owing more and more overseas as our Trade Deficit gets worse.
Source: Fed Reserve
Trade Deficit
The Trade Deficit was supposed to get better as the Dollar weakened.
It hasn't.
Source: Fed Reserve
Deflation
– not a monetary phenomenon
First, let’s look at the importation of deflation. Unlike
most economists, we at Cornerstone do not view deflation from a
monetary standpoint. This, we believe, is the mistake both Wall
Street and the Fed are making. Instead, we look at it from a businessman’s
perspective.
A businessman’s
perspective on deflation is where he creates a product with the
expectation of selling it for a certain price. But along comes a
wave of foreign goods selling for much less. He is now forced to
lower his prices to compete. It has nothing to do with the money
supply. It has nothing to do with interest rates. It has nothing
to do with the velocity of money.
The businessman
doesn’t care about such things, nor does he take them into
account when he is creating his business plan. He sees a need, sees
an opportunity, creates a product for that need, and sells the product
for a profit. Foreign competition, even if it is only 5% of the
market, can dictate the price of the product. Consumers flock to
the lowest prices. Or should I say best value. Ask Detroit.
Domestic Auto Sales
Domestic Auto Sales have been declining for a decade.
Source: Fed Reserve
Imported Auto Sales
Meanwhile, Imports gain strength
Source: Fed Reserve
The Fed and
Wall Street have been telling us for years that the falling Dollar
would be good for US exports and slow foreign imports. As the Dollar
dropped, US goods would become more competitive and US consumers
would switch over to buying domestic again. The pitiful numbers
at Ford and GM prove this false.
As the Dollar
has weakened, the Trade Deficit has only gotten worse, as the US
consumer shows itself to be almost insatiable in its desire for
foreign products.
Is there anything
the Federal Reserve can do to slow the inflow of foreign goods?
The Fed can’t, but Congress can. They can slap tariffs on
foreign imports. Big tariffs. Enough to make domestic goods profitable
again. And we all know from history how successful tariffs can be.
(Look back at the 1930’s, tariffs are one of the major causes
of the Depression.)
Inflation
– out of our control
Inflation is our other chief import. How do we import inflation?
Through high commodity prices. Growing economies overseas are sucking
up virtually everything from oil to copper to corn at alarming rates.
And the increase in demand is not temporary. The citizens of India
are not going to have a taste of capitalism and all of the benefits
that come with it and decide, “no, not for us,” the
masses in China are not going to improve their diets and living
conditions dramatically and then decide “no, we liked not
having good food or medicines or warm homes.”
The demand side
of commodities is going to stay strong for years, maybe decades
thanks to global demographics and population shifts. And when the
growth cycle does end, it won’t end with a decline, it will
plateau, because better standards of living require higher consumption
of commodities.
The price of
many commodities is up because of foreign consumption. Is there
anything the Fed can do about this? Will raising rates slow down
the housing boom in Beijing? Of course not. The Fed is powerless
in this area.
The last time
the US was in a commodity driven inflation, it was in the 1970’s
and it was of our own making. Consumption in the US drove up commodity
prices. So when the Fed raised rates in an effort to slow the economy,
it worked, - because the Fed’s actions directly impacted the
cause of the inflation. This time the cause is overseas, outside
the reach of the Fed.
Mountain
of Debt and a Devalued Dollar– Greenspan’s Legacy
Greenspan's Legacy
The highest Debt to GDP ratio since the Depression. Make no mistake,
this ratio needs to come down significantly before there can be
any true
economic growth in the US.
Source: Fed Reserve; Format CIS
But there is
another inflation that the Fed can do something about and has chosen
not to. The Dollar’s decline tends to bring inflation with
it. But a collapse of the Dollar brings hyper-inflation. The Fed
has chosen to ignore the potential of a collapse and instead has
stoked the possibility by lowering interest rates.
Since the Fed
started lowering rates this year, the Dollar has accelerated its
slide. Foreign holders of US Dollars and debt have been threatening
to start dumping if the Fed doesn’t shore up the Dollar. Dumping
would cause interest rates in the US to go up significantly. Forget
about a housing recovery. Forget about an economic recovery.
The Fed’s
complicity in the current economic conundrum in which we find ourselves
started way back in 1995, when the Greenspan Doctrine was first
introduced. Current Fed Chairman Bernanke is an enthusiastic student
of the Greenspan Doctrine.
What is the
Greenspan Doctrine? It is the experiment that Mr. Greenspan embarked
on where he threw money at whatever problem there was. (It is sort
of like going shopping when you have a fight with your spouse. Makes
you feel better for a while, but you eventually have to face the
music.) Asian currency crisis - lower rates; Russian Debt default
- lower rates; Y2K - lower rates; Mother-in-law coming over - hide
the good scotch and lower rates.
By the time
the new century rolled around, the world was awash in Dollars. Every
time the Fed lowered rates, they encouraged more debt to be piled
up by domestic consumers pushing millions of new Dollars into the
system and devalued the currency a little bit each time. So while
Wall Street applauds the Fed lowering interest rates to help their
own pocketbooks, remember, what the Fed has been doing is eroding
the value of those pieces of paper with presidents on them in your
pocket.
Total Consumer Credit
Thanks to the easy money policies of the Fed over the past 12 years,
consumers have piled up quite a mountain of debt.
Source: Fed Reserve
US Personal Savings Rate
Yet their ability to pay for all that debt has deteriorated to
the point that the Savings Rate is now negative.
Source: Fed Reserve
Bread
and Circus is not the basis for a strong economy
Much of the debt was used for consumption which added nothing long
term to the economy. Instead of debt used for investment into productive
economic purposes, (factories, not stocks) much of the debt raised
was used to finance lifestyles. To buy stuff. To have fun.
And like a husband
caught cheating on his wife, everything was going smoothly until
it hits the fan. And then there is no turning back. Everything you
thought was smart proves to be dumb. Everything you thought you
got away with comes back to haunt you. All that debt that was used
for consumption instead of production now has no asset behind it
and is just a weight around your economic neck.
What
it means to YOU
I talk to investors daily and they don’t get it. Few do. Just
like in Jesse Livermore’s* day, investors are consumed with
the right now, with which stock was going to make a move today,
instead of understanding the big picture, the macro economy.
*(Reminiscences
of a Stock Operator, by Edwin Lefevre, Published 1923 - “The
average man doesn’t wish to be told that it is a bull or a
bear market. What he desires is to be told specifically which particular
stock to buy or sell. He wants to get something for nothing. He
does not wish to work. He doesn’t even wish to have to think.”)
Investors tend
to have 2 reactions to this information. They either want to sell
everything and run and hide or they go into denial. Running and
hiding is understandable, but not prudent.
Denial is just
as bad and also comes in two flavors. The first type of denial is
from the true believer. Whether through ignorance or passivity,
they follow what Wall Street and the Fed say and believe “they”
won’t let anything happen to us. Larry Kudlow and Jim Cramer
are their heroes.
What these people
forget is that “they” didn’t do anything to protect
investors from the 2000 – 2002 bear market. “They”
didn’t give any warnings, had no strategy and still don’t.
The next type
of denial buys the story but not the scope of it. They are like
hospital patients that have just been told by their doctor that
they have a terminal disease and instead of dealing with it, they
ask the doctor about a hang nail that is bothering them.
Instead of trying
to understand what the size of the problem is, investors ask me
what stocks they should be looking to buy, next week, after everything
collapses. They don’t understand that the US economy can have
no significant recover, no sustainable growth until the debt problem
is solved and the Dollar strengthens. This may be years away. Decades
maybe. The Japanese market peaked in 1989 and here it is 18 years
later and their market is still down over 60% from that high.
Paradigm
Shift – Out with the old, in with the new
We have entered a time when the old way of investing is over. It
won’t work. It has ended.
Instead of buying
and holding your favorite US based company, the one your father
worked for all his life, investors need to expand their portfolios.
They need to realize that buy and hold is dead. They need to do
more work, have a flexible strategy, and look for investments in
areas they never thought of before.
The problems
that we outlined in this report are also the answers. Instead of
fighting the inevitable, the wise investor embraces it and takes
advantage of it.
Below are some
of the major, macro problems facing the US investor and how to invest
accordingly.
Overvalued
stock market – Hedge positions/Bear market funds
Rising interest rates – Shorten maturities/bond
market hedges
Declining Dollar – Foreign bonds/International
Equities/Gold
Inflation – Commodities/Gold/TIPs
None of these
are guaranteed to work every time with every short term move in
the market. These are long term trends we are talking about and
long term solutions. So don’t expect gold to go up every time
the Dollar drops.
The most exciting part of the economic situation is that investors
do have options. Much of what is listed above was not available
to the average investor the last time the US fell into a protracted
decline (the 1970’s).
At Cornerstone,
we would rather ride the icebergs than try to fight them.
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