Money,
Money Everywhere
and Not a Penny to Invest….
To listen to
the experts on Wall Street, you would believe that the investing
world is awash with deep pools of un-invested cash and being hit
with waves of new cash each month.
Not quite.
Let’s
first back up and define some of the terms we will be using and
what they mean to the economy and the markets.
Background
and definitions
Liquidity
Cash, or liquidity, is the fuel that keeps both the economy going
and sends the stock market higher. So having a lot of cash on hand
would be an important indicator of future economic growth and potential
stock market gains. And, in real terms, there is a big pile of cash
in both the mutual fund’s and the banks.
Debt
Debt is the load that holds back an economy and breaks the back
of companies and investors. It attracts people with its promises
of investment leverage, future growth and easy payments. Contrary
to popular belief, debt does eventually have to be paid off.
US
Dollar
The US Dollar is a store of value, the world’s reserve currency;
it is the safest means of exchange between countries. Or is it?
How much is
the Dollar in your pocket worth? Some will tell you 50 cents, others
may say 25 cents. To you and me, it is worth a buck. It buys things
labeled $1.00 at the store. So what is the big deal?
To foreigners,
with whom we have a mountainous Current Account Deficit, it is not
worth what it once was. They send us Toyotas, Nestles Chocolate
and French Wine, and we send them Dollars. The trouble is the value
of the Dollar has been declining, so when they go to exchange the
Dollars back into their own currency, it is likely they will get
less of their own currency in exchange. It is like selling a used
car to a friend for $1,000 and when you cash his check at the bank,
you only get $900. It will make for a bruised relationship and a
light wallet.
Monetary
World View
A Monetary Economic World View (or a Monetarist) is where you believe
that interest rates are the key to economic growth. Most of Wall
Street and the Federal Reserve have a Monetary World View. They
believe that lower interest rates spur an economy on and higher
interest rates slow an economy. This is made evident by the pivotal
position interest rates occupy in their “black box”
formulas and the importance placed on the direction of interest
rates as dictated by the Fed. And on the surface, they are correct.
The flaw in
the theory is apparent at the extremes. And that is where we are
today. Japan is the perfect example of the failure of the Monetarist
view. Japan slipped into deflation in the early 1990’s. By
the late 1990’s their interest rates were at 0% and even rates
that low couldn’t get them out of their economic hole. Today,
their rates are still some of the lowest in the world yet their
economy is still mired in a deflationary funk. Why? Because they
have failed to address their huge debt problem. Why is that important?
Debt,
the unseen killer
The variable that the monetarists ignore is debt. They believe that
as long as the cost of the debt (interest rate) is low, debt is
irrelevant. But what they ignore is the size of the debt and the
relationship of debt to the economy and markets. They ignore how
heavy a burden debt is for the economy. Japan’s example should
be a clear example to everyone what can happen when debt levels
get too heavy for an economy.
So, what does
all of this have to do with the title of the report?
Wall Street
talks about “excess liquidity” and a “liquidity
build-up” as sources for future economic growth and stock
market gains. But is there really a build-up of liquidity going
on?
Since liquidity
is the fuel for the economy, it makes sense to compare it to the
economy, to see how full the tank is. Since 2000, the Fed has been
feverishly pumping “excess liquidity” into the economy.
But the ratio of M1 (liquidity, cash in the economy) to GDP (the
economy) has been declining. Our research shows this is the lowest
level of liquidity relative to the economy in the past 45 years.
The economy is far from awash in cash.
But what is
worse is the debt load the economy has to endure. Relative to the
economy, the debt load has never been higher. The last time it was
even close to this level, the Depression in the 1930’s followed.
Source: Federal Reserve; Format: Cornerstone
Debt
as Leverage
Debt was once called leverage. This was because it helped you attain
more economic benefit than you would normally have. Let’s
assume you are running a small factory, producing $500,000 worth
of widgets a year. You borrow some money, increase the size of your
factory by 50% by building a new wing and invest in better equipment.
Like magic, now you are producing $1,500,000 worth of widgets each
year. You tripled your revenues with only a 50% increase in space.
The profits from the increased widgets sales pay off the loan and
once paid off, you have more assets and more revenue. This is leverage
at work.
Leverage
in Reverse
It works that way in the macro economy as well. In the 1950’s,
every dollar of new debt produced over $4.00 of economic activity.
But by Year 2000 it had dropped to .20 cents of GDP growth and only
10 cents by 2005. Last month fell to only a nickel of economic growth
for every dollar of debt growth.
Source: Federal Reserve; Format: Cornerstone
The chart above
shows something more important than just our dismally poor use of
debt. It shows that the Fed’s easy money policy might be failing.
Yes, from the bottom in 2002, the use of debt became slightly more
efficient, as it rallied from just above 0 to 15 cents. But since
early 2004, less and less economic activity is being generated from
the increased debt load.
Diminishing
Returns
What this means is that as the Fed is increasing the money supply
and debt is increasing, it is having less and less of a positive
effect on the economy.
The details
of the increases in debt are scary. When the market last peaked
in 2000, it was said that debt growth was a major factor in the
decline. Luckily for the Fed, consumers bailed out the economy in
2002 (and beyond) by using their home equity like an ATM machine.
Source: Federal Reserve; Format: Cornerstone
In all of the
major economic categories listed above, the economy of 2007 is in
much worse shape than it was in year 2000. Debts are much worse,
our trade deficit has soared and the GDP has barely budged.
In a strange
twist of economics, the best way to reduce debt is through economic
activity. Think of our widget factory again. It was the profits
from the increased sales of widgets that paid off the debt. The
same is expected from an economy. But an economy that isn’t
growing faster than the rate of debt growth cannot be expected to
pay down the debt load. The debt load keeps getting heavier and
heavier until it breaks the economy.
And it is not
just the economy in general, it is individuals too that have no
real liquidity. The Government statistics show that the Savings
Rate has dropped below 0%. That means the average household in America
is spending more than they are bringing in.
Source: Federal Reserve; Format: Cornerstone
And the liquidity
that is supposedly sloshing around in mutual funds isn’t likely
to save the day either. Market bottoms are usually associated with
high cash positions in mutual funds. Market tops are associated
with low cash levels. The cash position in year 2000 was lower than
right before the Crash in ’87, and the same as the market
top of 1972, right before the market dropped 50% over a 2 year period.
Today’s cash position? Lower than both of those, the lowest
in history.
Source: Investment Co Inst.; Format Cornerstone
Conclusion
The Fed has painted themselves into a corner. We have just shown
that relative to the economy and the markets, liquidity levels are
at or near all-time lows. Debt levels on a relative basis and in
real terms are also at all-time highs. And the Dollar is declining
because the liquidity the Fed did create, was too much, diluting
the value of the Dollar. On top of that, the heavy debt load is
weighing the Dollar down further.
The Fed can’t
increase liquidity, because that would send the Dollar lower and
send interest rates in this country higher. The Fed can’t
reduce liquidity, because the economy is barely limping along on
the meager amount of liquidity it is getting now. A decline would
just send the US economy over the edge.
What this means
is clear – Since there is very little liquidity available
for future growth and market gains, paper assets (US Equities and
US Bonds) are likely to under-perform for a long time, until liquidity
and debt levels come back to normal levels. It also means that Hard
Assets (Natural resources, commodities…) should out-perform.
Along with this, non-dollar denominated paper assets should also
outperform.
This doesn’t
mean that markets around the world are all buys today or that all
commodities should be bought. What is does mean is that the fundamentals
are in place for future growth and that pullbacks and declines in
the US are warnings of worse things to come, while pullbacks in
overseas markets and hard assets could be viewed as buying opportunities.
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