Monday, October 26, 2009

What you may have missed last week

At what point does the Keynesian response to the crisis become dangerous? By now it is clear to every man, woman, child and domestic animal in America that the policy prescription to get us out of this financial and economic quagmire is to throw stimulus dollars into the mix and print money. While this has plenty of gold bugs and fiscal conservatives understandably up in arms, the truth is that nobody knows for sure that the current actions of the government and Fed are going to produce severe inflation. There is no shortage of people calling for hyperinflation down the road at the same time that there are numerous pundits warning of imminent deflation. It is amazing how polarizing the inflation-deflation debate is. The only question that I think brings out more diverse opinions is whether the current rally in the stock market is the beginning of a lasting bull market or just a back-breaking bear market rally.

With all of the noise and the cacophony of opinions about the state of the US economy I try to take a step back and think of the US like I would an individual company. Now, I know there are differences. The government has the ability to tax and print money in a way that no company can. However, what I do know is that I would never invest in a company as levered as the US government is because I never want to own shares in a company that is subject to the kindness of strangers. In the case of the US those strangers are our foreign creditors who continue to complain about what is certainly an unsustainable fiscal path and may even be a clandestine attempt to inflate away our debts. In the end I just keep going back to the idea that there has to be a limit to how much money we can print and how large a deficit we can accumulate. Where is the tipping point? I have no idea. But as Doug Noland of the Prudent Bear pointed out last week, if I were a Keynesian I would even be questioning how much is too much:

By now, one would hope the inflationists would challenge their own views, doctrines and Mentalities. Instead, they trumpet the same old failed policy responses – only in much larger dimensions and with greater conviction. And that is precisely the flaw in inflationist doctrine: once it gets rolling it becomes extremely painful to rein in the forces pushing for only greater inflation. The more spectacular the inflationary boom and bust - the more strident the inflationists become.

History is strewn with enough collapses, worthless currencies and social upheaval that I find it ridiculous that the inflationists would today be taking shots at sound money and Credit. It is the inflationists Clinging to Misguided Monetary Mentalities. The principle of sound money and Credit has no reason to have to defend itself.

Inflationism doctrine is riddled with failings: Easy Credit distorts system pricing mechanisms; foments destabilizing speculation; spurs societal wealth transfer; distorts the underlying economic structure; fosters financial fragility; and debases the currency – to name just a few. History – including recent history – validates this analysis.

Yet there are two particular facets of today’s inflationism that make “Keynesian” policymaking extraordinarily dangerous. First, the global backdrop is one of unchecked Credit and the absence of any disciplining global monetary regime. Policy mistakes are free to run longer and with enormous global financial and economic consequences. Second, policymakers and pundits herald incredible post-Bubble policy responses, while failing to recognize that aggressive stimulus is, once again, fostering problematic Bubbles. For too long the inflationists have been negligent in their disregard for Bubble dynamics.

While confidence in the global reflationary backdrop may be rising, the dollar is in trouble. And many dollar apologists will claim the greenback has no immediate replacement and thus will retain its status as the world’s reserve currency. This line of reasoning misses the key point: the dollar reserve global monetary “regime” has broken down as a mechanism for supporting stable global Credit and economic performance. Unchecked global finance now rules, a consequence of the massive and ongoing devaluation of the world’s reserve currency…

The inflationists are keen to argue that, with “inflation” remaining so low, policymakers enjoy unusual latitude to stimulate. By this point, haven’t we learned that rising CPI is not a primary contemporary risk associated with ultra-loose monetary policy? The mispricing of risk, unchecked speculation, asset-Bubbles, financial fragility, and economic maladjustment have already proven themselves as deleterious effects of loose money.

What is the Wall Street business model again? After Goldman Sachs’ most recent astonishing quarterly report that included some ungodly amount of profits from trading, isn’t it time for society as a whole to ask the simple question, what value are the Wall Street banks really providing to the world? I know a lot of people who work for these banks and by in large they are some of the brightest, most genuine people you could ever meet. They work very long hours, don’t do anything illegal or unethical, and certainly don’t deserve populist ire. Accordingly, my concern about the relative costs and benefits of the current Wall Street model is not an indictment of them. In other words, this is not a criticism of these firms from a bottom’s up perspective but more so from a top down, strategic point of view. I guess I just think proprietary trading, high frequency trading and anything having to do with the creation of new derivatives are highly risky, inherently opaque and have no place within company that is implicitly (as in too big to fail) or explicitly (as in the case of insured deposits) backstopped by the taxpayer. Call me old fashioned like Paul Volcker, but I agree with Martin Hutchinson (see his piece from which the below excerpt is taken from here) that most families still put food on the table even before we had $1B block trades and $500 trillion dollars in notional derivatives. I’m not saying we need to go back to the Stone Age, but at what point has the financial system gotten too large and too focused on rent seeking to be actually beneficial to society?

Investment banking has changed radically over the last 30 years, and it's not clear that either regulators or the market fully understand the modern sources of its income. Trading, a fairly peripheral activity 30 years ago, has come to dominate the investment banking income statement, with income arising for investment banks both through acting as intermediary and through "proprietary trading" for their own account.

The immense and unstoppable proliferation of derivatives is the principal factor that has brought this about. After all, total outstanding derivatives contracts at the end of 2008 had a nominal principal amount of $514 trillion, more than 10 times Gross World Product. You don't need to skim very much off the top of a pot of cream that size to make your practitioners very rich indeed. A decade ago, defenders of the derivatives revolution could reasonably claim that the economic value and risk of those contracts was a tiny fraction of the total outstanding. Today, when we have seen multiple examples of credit default swaps paying close to 100% on billions of dollars of obligations, that claim has become laughable; the fraction of risk involved in that $514 trillion isn't as tiny as all that.

The intellectually curious must wonder what purpose all this activity serves. Defenders of derivatives and trading in general mutter the magic words "hedging" and "liquidity" and expect their questioners to fall back abashed. However, there aren't $514 trillion of exposures to hedge; indeed in a $50 trillion world economy, there aren't even $50 trillion of exposures to hedge. Hence – and this is a very conservative estimate – 90% of all derivatives activity serves nobody beyond the dealer community.

The same applies to liquidity; the immense trading volumes daily in the foreign exchange or futures markets do indeed provide liquidity, indeed more liquidity than can possibly be necessary to run the system. Proponents of trading will again say that it is necessary for a large financial institution to make a $1 billion block trade, but why? Surely in a well-run economy, institutions should invest on a long-term basis, not engaging in random short-term speculation…

If the economic value of hedging and liquidity are modest compared to the galactic amounts of contracts outstanding, or even to the enormous sums earned by trading, then it follows that some pretty large percentage of trading revenues represents nothing more nor less than rent seeking, the extraction of value from the economy without providing any economically valuable service in return. The explosion in derivatives and trading volume can then be seen as a gigantic smokescreen, which has enabled Wall Street to extract larger and larger rents from the remainder of the economy.

William Hester of the Hussman Funds says be careful how much emphasis you put on international sales: While the science is bit inexact as a result of the need to use forecasts, Hester estimates that only about $7.80 in earnings out the $75 the S&P 500 companies are projected to produce next year will come from countries that are growing faster than the US. (Remember that many companies generate a lot of revenue from Europe, which has its own set of interesting issues to deal with.) We hear almost daily from the bulls that a cheap dollar combined with significant emerging and developing market exposure will lead to a windfall for US-based multinationals. I certainly don’t disagree that investors should be looking to diversify out of the US as much as possible, especially when it comes to companies that sell consumer goods. But let’s not overstate the magnitude of the potential boost to earnings these foreign operations are going to produce. If Hester is anywhere near right and earnings from higher growth countries are only going to make up about 10% of the total for the S&P next year, investors need to be careful not to pay too much for what may not be as much diversification as advertised:

For S&P 500 companies taken together, about 28 percent of sales come from outside the US. That's up from about 24 percent three years ago (the 50 percent figure often quoted in the press is from S&P's smaller sample of companies that specifically represents large global companies, and therefore likely skews the number higher). It's important to keep in mind that the bulk of these international sales originate from developed markets. Only about 5 percent of total revenues come from developing markets, including most of Asia, Brazil, India, and from those areas that are reported broadly as ‘Emerging' or ‘Developing'.

This number likely doesn't capture the entire sensitivity to areas that are likely to grow faster than the US. There are sales that are not included in this number because of insufficient disclosure. Also, there are second-order effects – US companies may sell products to companies in other developed economies, which are used in the production of final goods that are sold to developing markets. A generous estimate might double the portion of sales that are sensitive to fast-growing countries, to 10 percent. This may be an overestimate, but it picks up the trend of S&P 500 earnings becoming more global and sensitive to developing economies.

Next year the S&P 500 revenue per share is expected to be $975 a share, with earnings of $75 a share. We'll apply an above-average profit margin of 8 percent the developing-market sales, because the technology group is somewhat over represented among these companies. This gives us $7.80 a share in earnings that are sensitive to developing economies ($975 * 10% * 8%) and would be subject to the benefits of potentially higher growth in those regions.

Now, $7.80 out of a total $75 of earnings is not immaterial, and it's a percentage that is likely to grow when the global economy eventually heals. But it turns out that the estimate of profit margins may end up playing a much more material role in whether S&P earnings meet or surpass expectations. Analysts are forecasting 7.6 percent profit margins next year, compared with a long-term average of less than 6 percent. If profit margins turn out to be a point lower, just 6.6 percent instead of 7.6 percent, then estimated earnings are almost $11 a share too high – $3 more than our estimate of the entire contribution of developing markets earnings. If profit margins come in at the long-term average, then forecasted operating earnings will be $16 a share too high, at least twice the entire contribution of developing markets to earnings. If we observe a tepid recovery of developed markets over the next couple of years, trends in profit margins will likely have the greatest influence in whether earnings reality meets expectations.

In case you had forgotten; recovery is still all about jobs: Hat tip to Yaser Anwar for bringing this piece by none other than John Hatzius of Goldman Sachs to my attention. You know the BLS data has to be pretty shaky if even a Goldman guy is pointing out the numerous flaws in the calculation of the number of jobless in the US. If you read The Market Ticker or Zero Hedge you are probably well aware of the optimism inherent in the monthly jobs reports. The main skewing factor is the birth/death model of small businesses that inexplicably and consistently estimates that thousands of new jobs are being created when entrepreneurs start up new businesses. Really, with what credit I ask?

So, yes, there are probably more people unemployed or underemployed than the government statistics show and this of course makes a V-shaped recovery less likely. This probably isn’t earth shattering news to anyone who follows the data or talks to real people outside of Wall Street and Washington. However, what is intriguing is what this fact leads Hatzius to conclude. His claim is that since the equity markets are by definition dominated by large firms, even if small firms are struggling it doesn’t mean that big firms can’t continue to do well. I would be remiss not to point out that big firms sell stuff to little firms and the people who work for (or used to work for) small firms so my guess is that eventually small business weakness will hurt the S&P 500 titans. Hatzius acknowledges this fact but you get the feeling that he might be stretching a bit to justify the meteoric rise we have seen in stocks:

Nonfarm payrolls: At least up to early 2009, we already know that weakness among small firms led to an overstatement of nonfarm payrolls, judging from the upcoming sharp downward revision to the level of nonfarm payrolls in March 2009 announced by the Bureau of Labor Statistics on October 2. Moreover, history alone suggests a reasonable probability that the overstatement of nonfarm payrolls has continued beyond the March 2009 benchmark date, as a downward revision in one year has more often than not been followed by predict another downward revision the following year. This is not surprising because the statisticians cannot react to the “signal” sent by the revision—namely that the assumptions underlying the preliminary data were too optimistic—until they know the results of the benchmark. Indeed, the birth/death model has made even bigger positive contributions to estimated nonfarm payroll growth from March to September 2009 than in the year-earlier period. We suspect that these estimates will once again prove overly optimistic when the next benchmark revision rolls around…

The behavior of the household survey of employment also suggests that the preliminary payroll data may still be too optimistic. Unlike the establishment survey, the household survey is not subject to small business bias because employment is measured at the level of the individual worker rather than the level of the establishment. It is therefore noteworthy that the household survey—adjusted to conform to the definitions of the establishment survey—shows an average loss of 479,000 jobs per month since the March 2009 benchmark date, about 140,000 more than the nonfarm payroll data. This is consistent with the idea that the birth/death model continues to result in overly optimistic nonfarm payroll data.

So what are the implications of the small firm story? First, it suggests that economic activity probably remains weaker than suggested by some standard economic indicators. Although both the economy and the financial markets are in much better shape than they were earlier this year, we are far away from a V-shaped recovery.

Second, however, the financial market implications of our story are more benign than one might think at first glance. Even if the small business sector remains mired in weakness, the equity market—which almost by definition is dominated by larger firms—could continue to do significantly better than the overall economy. This is not to deny the risk of adverse “spillovers” from small firms to larger firms, e.g. via continued weakness in household income and thus lackluster consumer demand. But at least in the short run, underlying weakness in the overall economy and decent profit news for publicly traded firms need not be as contradictory as they sound.

What would happen to the price of oil if the economy really started to recover? Hat tip to The Pragmatic Capitalist for posting the link to this piece in Business Week. The article points out the irony in the fact that the US has printed all this money and provided all these stimuli, but one unintended consequence has been the dramatic rise in the price of oil. I think this goes to show there is no free lunch. You can load up the helicopter with $100 bills and toss them out like Santa Claus but even in a liquidity trap there are unintended consequences in the asset markets. We know that people are very sensitive to how much they are shelling out at the pump. I would really hate to see what $4 gas would do to consumer spending and sentiment given the dire unemployment situation. It’s scary to think how much oil has risen (even if speculation is playing a role) given the lack of anything I would call a sustainable recovery. The question is, if the economy really does start to recover, what’s to stop oil from going back over $100? Combine that with the Fed raising interest rates and you could almost bank on a double dip recession. The point is to keep your eyes on the non-equity asset markets to make sure that (a) you aren’t investing a liquidity induced bubble (b) asset inflation is not becoming a substitute for CPI inflation and (c) prices have not completely decoupled from economic reality.

Another excuse given is that oil is following the equity market, but that's not how it's supposed to work. The futures market for oil is supposed to be governed by supply and demand, not react sympathetically to speculative moves in equities. In any case, it's been reported widely this year, starting with Der Spiegel's article on July 28, that the excess liquidity put into the system by central banks worldwide, money that was supposed to be put into consumer and business loans, has once again been used for speculation and quick paper profits in stocks and commodities, including oil.

As Washington irony goes, this is a new high-water mark: They've printed money to save our financial institutions, claiming it's there to stimulate a recovery. Yet much of that newly minted money is being used against consumers and small business owners. The money that's supposed to save them in new loans is instead increasing their energy costs through speculation, to the point of devaluing corporate earnings and personal incomes and prohibiting other purchases.

The sad truth is that if oil costs have more than doubled during a period when so little economic growth was taking place, you have to wonder how high the oil market will rise next year, when a real recovery has the chance of taking hold. In that statement lies the fact that this recovery will be stopped again.

(Picture of Keynes courtesy of