The Logic of the Printing Press
11/30/08
Hedge fund assets worldwide shrank by 9 percent to $1.56 trillion last month, the lowest level in two years. The double whammy came from declining stock markets and cash withdrawals. Investors pulled $40 billion from hedge funds in October, according to Chicago-based Hedge Fund Research Inc., while market losses cut industry values by $115 billion. This historic financial crisis has taken a toll on every country, every market and every investor. The innocent have been punished alongside the guilty; erstwhile superstar investors got hurt just as much (percentage wise) as your average retirement saver. The tectonic shift in attitudes towards risk has found expressions in many strange ways. The word "asset", for example, has become a four letter word and sounds more like "liability" these days than anything else. A company gets in financial difficulties, because it has too many assets. Assets used to be a good thing, but what we understand today is that assets usually are not owned outright, as in the old days. Assets were purchased with debt and if their valuation drops beyond a certain point, then the only thing that is left is the liability. The word "Asset" is one side of the coin, the other side of that same coin is the financed portion of its purchase. An Asset has become the "Ying" to its concomitant "Yang", which is the liability that goes along with it. The modern techniques of optimizing one's balance sheet have brought us to this point - and beyond. Good techniques have gone bad due to excesses in "optimization" of balance sheets. Now everybody needs to shed bad assets in order to reduce liabilities. Deflation of asset prices is the result. Unsurprisingly, the consumer price index fell by a full percent in October. The last time the U.S. economy experienced a price collapse this big was in the 1930s. Falling energy prices may have contributed but as we discussed before, asset prices all over the world are falling. Home prices, shipping costs, toys, computers, hedge fund fees - you name it; everything gets cheaper. Everybody needs to sell, nobody can afford to buy.
The first chart above shows us the Anxious Index again. The Federal Reserve of Philadelphia is explaining it in detail on its website. Suffice it to say that it is based on a survey of professional forecasters who try to predict a recession in the following quarter. It is surprisingly accurate as you can see. It typically spikes right into the recession. I placed the last grey bar there because I believe that we have entered a recession. Do not blame the Philadelphia Fed. Blame me for taking this liberty. I am simply following Goldman Sachs, who expects GDP to fall by 5% this quarter. Ultimately the NBER will determine when a recession has started. The second chart above shows you the level of indebtedness in our society. The data were taken from the Flow of Funds report. The 100% mark represents roughly $14 trillion of this country's gross domestic product. Private households carry almost as much debt (mortgages are included) and the financial sector is carrying around $16.5 trillion in debt. Business has not accumulated as much debt as households and finance companies. The overall debt level has increased only slightly of the past 20 years. Nevertheless, all three sectors seem to have to de-lever in the coming years. The federal government is the only sector, that can (and should) lever up and is doing so just to avoid a catastrophe. In our last newsletter I made the argument that private households must de-lever by at least $700 billion dollars in order to achieve a savings rate of 5%. The financial sector also must de-lever but it is anybody's guess, by how much and how to achieve it. The Treasury Department and the Federal Reserve are trying desperately to inject sufficient capital into the sector in order to prevent a wholesale collapse. Following the Great Crash of 1929, one of every five banks in America failed. The Federal Reserve can not allow this to happen. Quantitative easing may be the only option left. Breanne has few options at his disposal. The economy is in a recession, the financial sector has to de-lever and the consumer has to de-lever, too. In his historic speech in 2002 "Deflation: Making Sure "It" Doesn't Happen Here" he had said: "To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system - for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation." He did follow through, didn't he? Look at the monetary base.
The adjusted monetary base barely increased over the past eight years and then exploded in a matter of two months. Everybody is fully aware that these are perilous times. On November 25th the Fed announced that it will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises (GSEs) - Fannie Mae, Freddie Mac, and the Federal Home Loan Banks - and mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae. The goal was to "reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally." It seems to have worked. Spreads have narrowed by a full percentage point since then. The last chart should give us a little hope at least. It is the Fed Model that was implicitly accepted by the former and now somewhat discredited Fed President Alan Greenspan. The model may have its drawbacks as an absolute tool for investors, but it does show us where stocks are trading in reference to the last 18 years. This model calculates the "Earnings-Yield" for the S&P 500 by dividing estimated earnings of all 500 companies ($68 is the current estimate) that make up the index for the year 2008, into the Price of the Index (Friday's close was 895). In this case: 68/895 = 7.6% as the S&P 500 "earnings yield". To determine whether this is a "fair" earnings yield, we must compare this to "Risk less" investments such as year Treasury Notes (T-Notes), which currently yield 3%. Since the earnings yield on stocks is about 4.6% higher than the yield on 10 year T-Notes, proponents of the Fed Model argue that the Stock Market (or at least the S&P 500) is dramatically undervalued. If Bernanke is right and the "logic of the printing press example must assert itself" then we may have the mother of all bear market rallies ahead of us.
Hermann Vohs
"We make a living by what we get, we make a life by what we give."
Winston Churchill
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
