Macro Thoughts

Recession Is Here

2008-10-12T17:33:00.000-07:00

As I have written previously on this blog, it is becoming clear that the current market dislocation is not a tail event, but rather a serious systemic crisis that is likely a precursor to a 30's style depression. The stock market -- its almost 20% drop last week notwithstanding -- will retest 2002 lows during the ongoing secular bear before embarking on its next secular bull, which I believe will be no sooner than 2014. I realize this is a somewhat extraordinary claim, but I have very good motivation for suggesting it. In this article I want to look at one important statistic supporting that thesis, which I think the investing community does not fully appreciate. As always, please don't trade securities on my advice. I have made it no secret since I started writing this blog that I have been trading in and out of my short stock and long gold positions, but what I offer is an Austrian analysis of the financial markets, and not an investment advisory.

Manufacturing And Jobs

Disclaimer out of the way, let's dive in. The most telling statistic of the last couple of weeks has been the ISM manufacturing index, which came in at 43.5 for September. The ISM PMI is a diffusion index with a reading below 50 indicating contraction. Investopedia explains that

[the] PMI is a very important sentiment reading, not only for manufacturing, but also the economy as a whole. Although U.S. manufacturing is not the huge component of total gross domestic product (GDP) that it once was, this industry is still where recessions tend to begin and end. For this reason, the PMI is very closely watched, setting the tone for the upcoming month and other indicator releases.

There are two important points that investopedia makes. First, the one I more or less agree with, is that recessions begin with manufacturing. This is because when central banks expand the money supply and maintain interest rates below what Wicksell termed the neutral rate, they create false signals of time preference, thus encouraging more roundabout to more direct methods of production. This elongation of the production structure creates a diversion of real wealth towards malinvestments that are first realized as such higher in the production structure and are thus liquidated first when a tight money stance finally takes effect. In a free market economy, the interest rate equates consumer time preference with capital efficiency and is thus nothing more than the marginal efficiency of capital. When the central bank artificially lowers the interest rate, it fools entrepreneurs into expanding the production structure out of sync with consumer time preferences. Because this expansion occurs in the higher stages of production, the contraction must begin at the same place.

An easy way to visualize this process is to think in terms of Hayekian triangles. The central banks manipulation of the interest rate alters the characteristic of the triangle to both elongate the time dimension, as well as reduce savings and increase consumption, something that is completely impossible without an unnatural expansion of money or credit. By this means, the central bank creates distortions in the pricing mechanisms of the market, the most important one being the price of time. Sadly Keynes' grossly underhanded mischaracterization of Say's law -- perhaps his greatest contribution to the retardation of economic thought -- has influenced generations of economists to believe that consumption and not savings are at the root of economic growth. As I have argued elsewhere, this is false for the reason that growth occurs through capital accumulation and hard work. If there really was an easy way to grow the economy and create wealth, governments in all their meddling through the years should have accidentally stumbled upon it by now. Quite unsurprisingly, they have not. Unfortunately, it is this flawed logic in the Keynesian framework that brings us the fallacies of GDP, helicopter drops, wars and natural disasters being expansionary, and deficit spending.

Returning to investopedia, the point I disagree with is that manufacturing is less relevant than consumption because it is not a large part of GDP. That manufacturing is not a large component of GDP is true; that it is less relevant is false. The fact is that GDP measures economic output and not economic growth. Economic growth, as the classical economists and Austrians have written, occurs through the natural extension of the production structure through capital accumulation. This can happen only if consumers willingly forgo consumption today so as to build up their capital stock and create the potential for increased future production. A simple example would be Robinson Crusoe taking a day off from fishing and building a fishing net, thus going hungry for the day, but creating the ability for him to catch more fish with the same amount of labor in the future. Without giving up something today so as to build infrastructure, research and develop new processes and methods, or invent new technology, one cannot expect to increase real wealth in the future. I.e., one cannot expect to grow the economy.

It is at this point that I should interject my line of thought briefly to remind the reader that real wealth is tangible physical goods. Money is not wealth; it is a claim on wealth. Nobody trades dollars to satisfy an ultimate want. We trade dollars in the expectation of trading them again in the future for something we desire. Thus, when the money supply is expanded and entrepreneurs can get their hands on money more readily, they believe it is because there is an increase in real savings to support the availability of credit. But this is not true. However, it is not realized immediately because capital investment takes time. Entrepreneurs expand the production structure, which is narrowest at the point of consumption and expands as you move towards the higher stages of production. It is this phenomenon that ensures that recession always begin and end with manufacturing.

To sum up, manufacturing is by far the largest sector of the economy, and the most important in determining growth. If manufacturing is ailing then the economy is in a recession, regardless of how consumption is faring. Manufacturing has been in trouble for some time now, consistent with my thesis that the US has been in recession for most of the year. This may never get reflected in the official government statistics, which is not really a big concern since I don't trust those numbers anyway. The government can say the economy is growing all they want, but that does not make it reality.

In addition to the ISM index, we find that non farm payrolls declined 159,000 in September. The unemployment rate held steady at 6.1%. I think even these numbers may be painting a rosier picture than is actually reality as the surveys have flaws in their design that one must consider before drawing any conclusions. It is not my wish to exhume the dead horse only to beat it to death again, so I provide the link if the reader is interested.

I hope the reader has found my analysis useful. I realize I have raced through this somewhat quickly, but you will find many links on my blog explaining these concepts more carefully.

Scope And Severity

This discussion on the causes of the crisis notwithstanding, the important question to consider is the scope and severity of the recession. I believe that the central bank is out of bubbles to blow. Since 1971 the money supply has increased at a staggering rate, causing tremendous structural damage to the economy as a whole. The 2000-02 recession should have been the cathartic cleansing of the previous malinvestments, but in response to the markets hang over from the aforementioned money supply binge, the central bank blew an even bigger bubble in housing that has fatally damaged the production structure and shifted a lot of manufacturing overseas, creating a services based economy supported by debt and the illusion of wealth. Until Americans cut back on their expenditure, lifestyles, and most certainly debt accumulation, there cannot be a re-alignment of the production structure or the availability of savings necessary to effect that.

Since last summer when we saw the beginnings of the credit crisis, the talking heads have told us that this "subprime" event will be contained, that it will not spread, and that our benevelont masters in Washington are always vigilant to save us from unbridled free markets (as if such a thing has even existed in the last 100 years). I did not believe them then and I do not now. I predicted commercial real estate, auto loans, credit card debt, and unsecured loans of all forms, would be next. I predicted that the various liquidity measures, such as the TAF, TSLF, and PDCF would fail because the problem was solvency, not liquidity. I predicted that they would be forced to nationalize Fannie and Freddie. I predicted the stock market was heading lower and precious metals would rise. All of these predictions were predicated on one thing only, which is that, try as they may, the Fed and Congress cannot change economic laws. They are bound by them just as they are bound by the law of gravity.

Unfortunately, this means that we are still only at the beginning of what promises to be a deep and painful recession. If the Fed and congress continue to meddle, they will only prolong and worsen it. Consider that between 2002 and 2007 alone, the central bank expanded the money supply by more than in the entire history of the United States. This is madness! And now Bernanke, as a result of a conveniently under reported aspect of the TARP, has the ability to pay interest on deposits at the Fed. I cannot stress how important this is. The whole debate around $700bn in a bailout is a complete red herring. It was nothing more than jawboning to soothe an inflamed market. The real action, as always, happens when no one is looking. He correctly sees the immense deflationary potential in the fiat money system and intends to inflate his way out of it, but this will backfire or have undesirable consequences, just like every other attempt he has made. Should he succeed, the end result will be what is colorfully known as stagflation. Should he fail, it could be a complete loss of faith in fiat money system and all the attending ills that would bring. I truly hope he succeeds.

The Bailout Reader

2008-09-26T16:08:00.000-07:00

This is going to be a short post. With the markets blowing up everywhere I am working pretty long hours so I don't have much more time than to point out... the bailout reader, care of mises.org. The Austrians really did see this coming. Not just that, they predicted it would be the inevitable outcome of the Fed's actions, and clearly elucidated why. Something I have been talking about on my blog as well. If you have any interest in understanding the state of affairs today, I highly recommend starting with the articles linked above. In addition, if your interest is economics per se, the Mises Institute has plenty of resources on its website. If your interest is more towards the markets, as is mine, try this reading list.

It's really funny how the Austrian theory of the business cycle still gets almost no air time even though it is the most logical explanation of the events that have transpired, and really always has been. Did you know that Mises was one of the few people who predicted the great depression in response to the credit bubble of the 20's? The Austrians again predicted the housing and credit crisis we see today and the Pollyanna's conveniently ignore them. Well, as an Austrian, I respect their right to their (erroneous) opinions. However, dear reader, if you have any interest in successfully navigating what I expect to be a worsening financial landscape, I would highly recommend you familiarize yourself with Austrian theory and what it predicts going forward.

My Vindication?

2008-09-24T19:45:00.001-07:00

Since I started writing this blog I have made some fairly radical claims. Now that some time has passed, I thought it would be nice to reexamine them and see if I have been correct on any.

Stock market is headed lower; gold and precious metals are headed up; muni's, commercial real estate, credit card debt, auto loans, etc will be the next to blow up (here). I absolutely still stand by this.
Fannie Mae and Freddie Mac will be nationalized (here).
The TAF, TSLF, PDCF will fail because the issue is solvency, not liquidity (here).
Lehman is insolvent (here). I actually didn't mention on this blog, but I thought Morgan and Merril were in equally bad, if not worse, shape.
The US is in a recession that started Jan 2008 (here). I still stand by this.
The stimulus package is a red herring and will exacerbate the recession (here).
Housing has plenty more to go (need to find the article, will add link soon).
The US is in a secular bull market that will last until 2016 (here).
Investment demand for gold will take result in significant price appreciation (here).
The dollar will collapse.

That last one I have actually not written about here because I was yet unsure whether to expect a deflationary debt bubble collapse, or an inflationary endgame. There is too much structural damage to the economy to avoid one or the other; the only questions is which will play out. The Feds recent action leads me to believe they prefer the latter. Seems to me like they are seriously considering destroying the dollar in order to pave way for the amero. However, I do not want to comment further on that as I would like to avoid politics if possible. Going forward I expect Bernanke to devise novel and ingenious manners in which to inflate the money supply as the last thing he seems to want is a repeat of Japan. If that is the case, this may be a good time to pick up some gold.

India Is Not Immune

2008-07-20T19:47:00.000-07:00

I am currently on vacation in India (explaining the lack of activity on this blog) and I thought it might be interesting to talk about the Indian markets for a change. In the last few years the Indian market had a pretty phenomenal run, barring a few corrective spells, and was sitting pretty at 21,000 at the beginning of 2008. Since then it has shed over 40% and, as of this writing, is hovering around the 14,000 range with PE's in the 10-15 range. I suspect that the recent gain is a dead cat bounce and India has quite a bit more of downside potential as the global credit crisis continues to unfold. It may be a few months yet, but as foreign institutions continue to feel the pinch at home and attempt to shore up capital, India and other emerging markets will suffer from institutional withdrawals. Further, despite what appears to be stellar growth, I am not convinced the economy is on sound footing. This is largely due to the political system as well as the Keynesian ideology that seems to be firmly in charge at the central bank (The Reserve Bank of India).

The Blame Game

From my understanding of the Indian markets, the recent drop has been largely due to foreign institutional selling. Due to the credit crisis many foreign institutions have been withdrawing large amounts of capital to shore up their balance sheets at home. Insurance companies and retail investors in India seem to be unwilling (or unable) to pick up the slack. In short, if the credit crisis worsens towards the end of the year, as I suspect it will, then further institutional selling could mean further downside for the Indian markets, as well as other emerging markets.

Although foreign institutional investors (FII's) may have been the catalyst for the drop, I do not believe that they have caused a market dislocation. The Indian markets had become extremely overextended in recent years largely as a result of the Reserve Bank of India's (RBI) monetary policy. Valuations were extremely high at the peak and continue to be moderately expensive given current earnings estimates. Should estimates prove unrealistic, as I very well suspect they might, valuations are still looking quite on the high side.

Returning to the RBI and its monetary policy, the money supply in India has been growing at a staggering rate of 30% over the last few years. It has slowed to around 20% in the last year. Of course, official "inflation" figures are around 11% growth in the price index y-o-y. I remind the reader that inflation is NOT rising prices, but rather money supply growth. Therefore, true inflation in India is upward of 20%. That most people don't realize this is the only reason India cannot be considered to be in a hyperinflation, although the money supply growth certainly suggests so. Also, keep in mind that monetary policy always works with a lag, so India could actually see a drop in the official inflation rate as money supply growth has been slowing in the last couple of years.

ABCT Applied

Beyond this theoretical discussion of what inflation is and isn't, I have yet to argue why I believe the economy is not on sound footing. Inflation by itself can be harmless. Think back a few hundred years to when gold was money. Gold was continuously being dug out of the earth and added to the money supply (inflation by definition) but the effect was largely benign as the extraction and processing of gold required significant effort and created an economic good. Contrasting that with today where the central bank can type in a few 1's and 0's and create money, or banks can lend out deposits that do not belong to them (fractional reserve banking) and we have an entirely different kind of inflation altogether. This latter kind is undesirable because it creates distortions to the market process that result in malinvestments and bubbles. An example will illustrate:

Just like the US, the property market in India has been hit pretty hard. I am not sure of exact percentage rises and drops, but the residential market especially has taken a beating. When the RBI began pumping the money supply it facilitated the redirection of wealth. Investors and entrepreneurs used these redirected resources based on faulty price signals -- again created by the RBI -- to ramp up their investments. For a while it appears as though the economy is growing rapidly and the stock market begins to rise. Investors thus far on the sidelines are tempted to make an entrance, as are speculators who ussually avail themselves of further credit creation by the RBI and retail banks. Prices are bid up further.

Now, many of the residential developers in India, who had thus far been privately held companies with sound investment strategies based on sound forecasting of demand, suddenly realize that there is a sucker born every minute and decide to IPO at the clearly inflated valuations. Of course, a conservative company with low leverage and realistic organic growth prospects will not command excess valuations so the developers begin to take on any and every project, regardless of economy viability, only so they could book the assets and show increased future earnings potential, thus justifying the excess valuations. As a result, there is a rapid increase in residential developments, most exemplified by the high-tech cities such as Bangalore and Hyderabad. Whether these new development will be well recieved by the market is not a priority; the only priority is to show future earnings potential in order to command high valuations. The net result is a residential bubble, resulting in oversupply that eventually must burst, and it has.

Conclusion

This little story -- true, mind you -- is typical of the results of "bad" inflation. The RBI, through its irresponsible monetary policy, set in motion a housing bubble that appeared sound initially, but was eventually realized to be illusory and based on faulty signals. I believe the same is true for India as a whole. The highly highly irresponsible monetary policy has created bubbles everywhere in the Indian economy. Apparently, India is not immune to Keynesian ideology, and it is to her own detriment. Even worse, however, is the political system. Bad monetary policy in of itself can only cause so much trouble. The real trouble is caused by the government. The comparison is often made between India and China -- both having gained independence around the same time -- that China is quite comfortably ahead in terms of economic growth and infrastructure development. This puzzles the Indian intellectual classes to no end, but is really no puzzle, just simple economics. I am hoping to elaborate in my next post.

Theodore Forstmann Interview

2008-07-07T18:27:00.000-07:00

There was a great interview with Theodore Forstmann in the WSJ a couple of days ago. He highlights some points I have made on this blog recently about the true causes of the credit crisis and what to expect going forward. The article begins:

Mr. Forstmann's argument about the present crisis starts with the money supply. After Sept. 11, 2001, the Federal Reserve pumped so much money into the financial system that it distorted the incentives and the decision making of everyone in finance.

100% agreed! See my earlier article on this. In fact, this observation is the crux of the Austrian theory of the business cycles. Interest rates are essentially the price of time. Like any other price, they contain information and work in concert with other market prices. An artificial lowering of the interest rate not only skews incentives it greatly hampers the decision making process by providing a false signal. It creates the illusion of false social time preference. The articles doesn't put it in these terms, but I think Forstmann would agree.

Distorting the market price mechanism always has unpredictable consequences that the economist must carefully consider. This was Herny Hazlitts excellent lesson. Take for example the ethanol boondoggle that is causing problems in functionally and geographically distinct areas of the economy due to faulty price information that renders rational economic calculation impossible. This is just the damage caused by ethanol subsidies. The price of ethanol is only one small element of the economic organism. Compare that to interest rates which are the single most important price in the economy. I ask you, dear reader, shouldn't we be scrutinizing the actions of the Fed more closely? Whether the intent was malicous or not, doesn't it make sense to understand the huge market distortions of the past decade so we can avoid making the same mistake in the future? Shostak has an excellent analysis here.

The article continues:

"They could not find enough appropriate uses for the money," Mr. Forstmann says. "That's why my little bank story for the kids is a fun way to put it. The money just kept coming and coming and coming and coming. What are you going to do with it? IBM only needs so much. The guy who can really pay his mortgage only needs so much." So you start thinking about new ways to lend the money, which inevitably means riskier ways.

Again, 100% agreed! I have said this earlier as well. The root cause of the credit crisis in not the financial innovations and the originate-to-distribute model, but rather the Fed which encouraged all these activities with its lose money policy. Certainly I don't mean to excuse reckless behavior, but let as also acknowledge the complicity and role of the Fed in the matter. This seems to be something most mainstream economists and commentators are unwilling to do.

Continuing, the piece of the puzzle everyone sees and blames is of course this:

Combine this with loan syndication and securitization, and the result is a nasty brew. Securitization and syndication allow the banks to take the loans off their books and replenish their capital. They then use this capital to make new loans, which they securitize or syndicate and sell to the hedge funds, which buy them with the money they borrowed from the banks. For a time, everyone makes money.

This is a great description of the skewed incentives in the originate-to-distribute model. Another commentator who has done a great job putting the pieces together is Steve Moyer. I particularly liked this article.

What To Expect

The problem, according to Mr. Forstmann, is that it's far from over. "I think we're in about the second inning of this." One reason is that the proliferation of new financial instruments has left the system more closely intertwined than ever.

I have discussed this earlier as well. There are also the lending channel effects, described here, and evidenced here, that one must consider. Not to mention the recession and the effect that will have.

At this point I am probably sounding like a broken record to anyone who has read my previous articles so I will stop. Suffice to say that I think we are yet to see the meat of the credit crisis, which is likely to happen towards the end of the year. It will mean pain for many banks, but will be a great opportunity for well positioned investors.

Links

Did the Fed cause the housing bubble? by Robert Murphy
Frank Shostak on Hymen Minsky's view on bubbles.

Trade Recommendations

2008-06-27T13:29:00.000-07:00

In a previous post on trade recommendations, I laid out my views on the markets long term. At the time, I did not recommend any particular trades because I was uncertain about the near term. Although I did catch the counter trend rally from the March lows to the May highs, and the subsequent decline since then, I certainly cannot take credit for calling either the bottom or the top. Most of the trades I made were based on the recommendation of others. The reason for my post today is because I have realized that what I can offer the reader is not market timing, but rather fundamental analysis of the macroeconomy. Although I do trade for my own account, I am reluctant to make trade recommendations on this blog. Sorry, but I believe me, you are better off getting your trading ideas from the sources I linked to above.

Market Fundamentals

So what do the fundamentals look like? Well, it is clear that the US is in a recession. I have been saying for a while that I believe January 2008 was the start. See here for my rationale. The more interesting question for me is whether the recession will be inflationary or deflationary. But first, let us clear up some confusions about what inflation is.

Inflation is nothing more or less than money supply growth. The classical economists knew this. However, in recent decades, inflation has come to mean a general rise in prices. I am not being overly pedantic when I take issue with this redefinition. That you start calling a chair a table, does not change the essence of the chair. People will continue to sit on it and use it for "chair" like activities. A rose by any other name does smell as sweet. The question we are faced with, then, is identifying the essence of "inflation". I have argued elsewhere that inflation is money supply growth and that "generally rising prices" is caused by inflation and other factors. Once we understand that inflation is not rising and falling prices, we can begin to understand what lies ahead for the US and world economies.

One important consequence of an accurate understanding of inflation is that we can separate inflation from economic growth. Rising money supply is inflation and a falling money supply is deflation. An expanding economy is growth, while a contracting economy is a recession. Thus, there is nothing inherently inflationary or deflationary about economic growth or recessions, and concepts such as stagflation are perfectly understandable. In fact, stagflation is a likely consequence of monetary policy that artificially lowers the interest rate below the so called neutral rate through the printing of money. Similarly, a deflationary recession is a likely consequence of monetary policy that artificially lowers the interest rate through the expansion of fiduciary media instead of printing cash. A very unlikely consequence of either is inflationary growth. The big question today, is which of the two recessionary scenarios will evolve. The arguments on both sides are certainly compelling. I need to do a little more research before I take a position myself.

It would appear odd that a recession can be inflationary or deflationary, but growth is always inflationary. The reason for this is because of the nature of the monetary system today. Under a fiat regime with 100% reserve ratios, all monetary pumping is inflationary because it occurs through actually printing more dollars. However, because of fractional reserve banking built on top of, not fiat, but debt based money, recessions today can be deflationary because money supply growth occurs more through expanding fiduciary media than the monetary base. That is, money in the broader sense grows while money in the narrow sense can remain unchanged or grow only slightly. That this has happened in the last few years is the prime reason for the immense deflationary potential in the economy today. Just to throw out a few numbers, fiduciary media stands at approximately $2.5 trillion, while bank reserves are a paltry $40 billion. In addition, sweeps ($765 billion) and retail money funds ($1078 billion) have no concept of reserves. Cash in circulation is around $800 billion.

Of course, the only healthy monetary system is a commodity standard (preferably gold or silver, but many other commodities have been used in history). Under a commodity standard with 100% reserve ratios growth is neither inflationary or deflationary, which is highly desirable since it is in accord with the social time preference and avoids the boom-bust cycle. I fully recognize how bizarre this claim sounds to anyone from the Keynesian tradition. I sincerely hope you give the article linked above an objective read.

[EDIT: Re-reading this section, I realize I haven't done a very good job explaining these concepts. I wrote it in some haste. I am hoping to do a much longer post shortly on which recessionary scenario I expect will unfold and why. I will describe the mechanisms at play carefully then.]

Conclusion

A US recession is fait accompli. Whether inflationary or deflationary is yet to be decided. Depending on the latter versus the former, the actions one should take to protect their wealth and/or profit will differ. An inflationary recession will be hugely bullish for precious metals and commodities. Bonds will suffer and equities will suffer in terms of valuations. A deflationary recession will sink all ships, except bonds. In both cases, I feel like relative value plays on asset classes (metals/stocks, metals/bonds) should preserve their relationships.

PS

I took profits today on my index shorts and precious metals holdings. It looks like the market is setting up for another counter trend rally. At the very least, I think we will be presented with better shorting opportunities going forward. Interestingly, gold seems to be shaping up for a giant short squeeze.

May Unemployment And Beyond

2008-06-24T18:29:00.001-07:00

When the May unemployment numbers came out a few weeks ago, I didn't have a chance to look at them very closely. Admittedly I still have not, but I wanted to put down a few thoughts consistent with the theme of this blog. I have been saying for a while now that I believe the US is in a recession. Ignoring the arguments about the unreliability of the data, I believe that even the official government data is clearly showing it.

Just as a start, consider the unemployment rate that jumped to 5.5% from 5.0%, the largest monthly rise since 1986. Although the change is alarming, in an absolute sense, the rate of 5.5% is still within the 4-6% safe range of Phillips curve adherents. Of course, this is only the headline number that ignores "discouraged workers", etc. Whether adding those back in results in a more accurate rate I refrain from commenting on, but only point out that that broader definition of unemployment is quite a bit higher.
Far more interesting in the report is that the economy is bleeding goods producing jobs, including construction and manufacturing. This should raise a red flag for anyone approaching the issue from the Austrian perspective. We know from the Austrian theory of the business cycle that job losses in the higher stages of production are indicative that malinvestments are being liquidated. This is because the credit driven boom that shifted resources towards more roundabout methods of production is finally being realized as illusory and based upon a false signal -- artificially low interest rates. The true time preference asserts itself by attempting to bring the production structure into sync. This entails a competition between various stages of production, with the lower stages (generally services) benefiting at the expense of the higher stages (generally manufacturing).

The official report shows this clearly. Construction and manufacturing lost 34,000 and 26,000 jobs respectively, while services gained 8,000. Even within services, those further removed from the consumer, professional and business services, lost 39,000, while those closer to the consumer gained. Government gained 17,000. Please keep in mind that manufacturing and construction are generally higher paying jobs while services are generally lower paying jobs.

Most interesting is that the loss in manufacturing happened depsite the weakness in the dollar that one would imagine should work to correct the manufacturing imbalances from previously. There is evidence that this process is underway with increased investment in the US on account of the dollar weakness. However, that investment is latent growth that will not contribute to the economy for a little while hence. In the meanwhile, the retrenchment will continue. The good news is that if investment genuinily picks up, the economy will recover from the recession sooner than I expected.

Birth/Death Model

In addition to the jobs numbers listed above, one should note that the birth/death model again played an interesting role. To remind the reader, the birth/death model is an ARIMA model of small business births and deaths. It is intended to correct for drawbacks in the payroll survey related to logistical issues with small businesses. As any time series analysis, it is backward looking and will project out trends into the future, missing important turning points. Even the BLS states this clearly:

The most significant potential drawback to this or any model-based approach is that time series modeling assumes a predictable continuation of historical patterns and relationships and therefore is likely to have some difficulty producing reliable estimates at economic turning points or during periods when there are sudden changes in trend. BLS will continue researching alternative model-based techniques for the net birth/death component; it is likely to remain as the most problematic part of the estimation process.

For the month of May, the birth/death model added 217,000 jobs, including 42,000 in construction and 9,000 in manufacturing. This seems at odds with other data that is showing construction and manufacturing declining. As I have said before, I believe this is because the model is projecting out previous trends and missing the turning point. Recall that in April, the model added 267,000 jobs. Recent revisions have removed 8,000 jobs from April and 9,000 from May. These revisions may not be enough; I expect more to come.

Further, one cannot simply subtract the 217,000 jobs of the birth/death model from the headline number of -49,000 because the latter is seasonally adjusted while the former is not. From the BLS:

Note that the net birth/death figures are not seasonally adjusted, and are applied to the not seasonally adjusted monthly employment estimates to derive the final CES employment estimates.

The only way to get accurate numbers is to wait for the final revisions, or start the analysis from raw data.

Looking Forward

Historically, the birth/death model has major revisions in the months of January and July. January is a much bigger month because most of the previous years excesses are wiped clean. However, July does have its fair share as well. The numbers for the coming July will be very important in understanding where in the economic cycle the model thinks we are. Of course, the impact on the headline number of a negative estimate is not clear due to seasonal adjustments.

In terms of unemployment, with many layoffs expected in the future, including Citigroup, Continental Airlines, and GM, we can expect unemployment to rise, perfectly consistent with the recession we are in. Most of the new jobs losses may not immediately show up in the headline numbers because of the methodological definitions, but that does not mean they are not impacting the economy.

Tho other good indicator of unemployment is temporary employment. I must thank John Mauldin for this observation. He notes that if the workload is shrinking then one first lays off temporary workers or simply does not hire them. Temporary employment is down 5.7% y-o-y. It is also showing continued weakness month on month. Consistent with my predictions of the start of the recession, John Mauldin has also weighed in on the matter with essentially the same time frame: January 2008. It would appear that the unemployment data is confirming our predictions.

Update

2008-06-16T19:27:00.000-07:00

Finally done with my masters. I hope to be back to blogging regularly as soon as I take a few days to catch up with the markets.

Stimulus Package PS

2008-05-09T17:54:00.000-07:00

Just a brief postscript to my previous article.

A nice example of the demagoguery behind the first package is Nancy Pelosi who earlier in the week said she favors a second stimulus package as the economy is in worse shape than Bush admits. That Bush is in denial is obvious, but as I already argued, this will only exacerbate the retrenchment. Of course, Pelosi doesn't understand that. All she understands is that it makes her look good in front of the voters.

Stimulus Package Has No Clothes

2008-05-06T09:46:00.000-07:00

The $168bn economic stimulus package that was pushed through earlier this year on falling growth concerns is just about seeing the light of day now as many people will receive their rebate checks in the next few weeks. At the time the package was being debated, there were many naysayers who believed that the stimulus would come too late, or be insufficient to avoid a recession. Others believed that the stimulus would backfire with recipients spending their rebate checks on paying down debt or other such activities and not consumption. Still others questioned the prudence of attempting to prevent a recession today at the expense of pain at a future date, effectively robbing Peter to pay Paul, except Peter is yet unborn and cannot object.

I refrain from linking to any of these naysayers as it is not important who opined where on the spectrum. Sadly, they are all barking up the wrong tree. The stimulus package is all of the above, yet none at the same time. It is too little too late, many people will pay down debt instead of spend, and it will create debt that future generations must pay back. However, all of these are red herrings. Everyone who has weighed in on this issue, barring the Mises Institute, seems to have a political agenda. In this article I hope to lay bare the economics behind the stimulus package. In doing so, much like the little boy who said that the emperor has no clothes, I am stating a couple of simple, fundamental, yet widely ignored truths. They are:

Business spending and not consumer spending accounts for most of economic activity.
Savings and not consumption is the root of economic growth. Consumption, by its very nature, is the anti-thesis of growth.

The former implies that the stimulus package cannot prevent a recession if a recession is on the cards, while the latter implies that the stimulus package will actually exacerbate any slowdown. I fully recognize that both these statements sound absurd to anyone trained in the Keynesian tradition, which is why I hope the reader can look beyond the shock value of my claims and instead rationally evaluate them.

Consumer Spending in Perspective

Today, 70% of GDP is consumer spending, which leads many commentators to conclude that consumer spending is the health of the economy. Unfortunately, this is not true. During the 2000-20002 recession while the economy was clearly in a downward phase, consumer spending actually rose. This is a conveniently ignored fact that demonstrates a shortcoming in the existing paradigm. In reality, business spending accounts for the majority of economic activity, clocking in at around $25 trillion yearly, while consumption is a mere $7 trillion (even that is high by relative historic norms). The reason this is ignored by non-Austrians is for 2 reasons:

First, as George Reisman has argued, it gets hidden in the Keynesian formulation of GDP as GDP = C + I + G + NX. Reisman says:
In this article, I prove, to the contrary, that consumption is not the main form of spending in the economic system and that the source of most spending is, in fact, saving. I prove my claims by starting with the very formulations of the expenditure aggregates presented by the Keynesian doctrine itself.
Further,
The truth is that the great bulk of spending and income payments in the economic system is concealed under net investment! Net investment is analogous to an iceberg, nine-tenths of whose volume is concealed beneath the surface. Only in the case of net investment, what is concealed can easily be much more than nine-tenths.
Thus,
The belief that [consumption is the main source of spending] rests on a radically incomplete, highly superficial understanding of the formulas.
The second reason has to do with the Keynesian preoccupation with GDP. I have argued earlier that GDP is only indicative of economic output, and not economic growth. The common rebuttal to my argument is that one does not want to double count intermediate transactions in determining growth. However, by focusing on only consumer goods, Keynesian's actually ignore the vast majority of economic activity: the higher stages of production. The production structure is narrowest at the consumer end, and expands radically as one moves towards the higher stages of production. The more technology and roundabout methods entrepreneurs invest in, the more the production structure fans out. This is precisely why consumer spending can continue to expand while the economy as a whole experiences a retrenchment. This is also why thinking in terms of GDP to understand the direction of the economy can be misleading. One needs to look at, amongst other things, manufacturing, business spending, and the calculus of credit creation along different parts of the production structure.

The conclusion is that stimulating consumption, even if consumption was the source of economic growth, is not going to prevent an economy that is experiencing retrenchment in the higher stages of production from skirting a recession.

The True Nature of Economic Growth

As hinted at in point 2 above, the essence of economic growth rests in expanding the production structure. At the risk of over simplifying: assume you have 1 machine that can produce 10 widgets in a year. Assume further that the machine is made of 20 widgets. For the economy to "grow" there must be capacity for increased widget production. To this end, 20 widgets, 10 widgets for 2 years, must be saved to build a new machine. In those 2 years GDP drops to 0, but after 2 years the economy has actually grown 100%. On the other hand, if the first machine is consumed, you have a one time GDP increase of 100%, but have no capacity for future output. There appears to be a disconnect between GDP and economic growth.

This overly simplified example is intended to demonstrate that saving and investment (20 widgets to create the second machine) is economic growth even if GDP falls, while consumption (consuming your first machine) cannibalizes the production structure leaving you with diminished capacity for future output, even if it creates a boost to GDP. Shostak illustrates this idea more carefully using Crusoe economics in his article on the subsistence fund.

Conclusion

The implication for the "stimulus" package is that if the package actually does stimulate consumption then it will be at the expense of investment. The package will create a one time shot in the arm to GDP, but will actually cannibalize the production structure creating a diminished capacity for future output. Reisman makes the same argument towards the end of his article.

Since increasing the capacity for future output is the essence of growth, any real stimulus package should encourage investment consistent with consumers time preferences. Of course, that is an oxymoron because no government intervention can achieve that end. Only the free market left to its own devices can coordinate savings and investment for sustainable growth -- admittedly another bizarre sounding claim to anyone from the Keynesian tradition, but one that the Austrian school has clearly elucidated in the Austrian theory of the business cycle.

Reading Sources

2008-04-14T10:41:00.000-07:00

Sorry I have been MIA the last few days. My semester, and thus my degree, is winding up in the next few weeks and so I am busy tying up loose ends and looking for a job. Here's a quick list of some unconventional sources I read frequently. I hope you find them informative, and I hope to be back to blogging soon.

And, of course, mises.org.

Level 3 Assets and Insolvency

2008-04-04T11:57:00.000-07:00

Yesterday at dinner I had a very interesting conversation with a gentleman who is an economist at a macro hedge fund. One of the things we spoke about was the possibility of write downs on the level 3 assets. Given that I keep harping on these, I wanted to put down some thoughts that resulted from that conversation.

To remind the reader, FASB statement 157 is a statement regarding fair value measurements. It establishes a hierarchy for valuing assets based on the manner in which they are valued.

Level 1 assets are those valued based on observed market prices. They are marked-to-market.
Level 2 assets are those valued using a model for which the inputs are observable. They are market-to-model with inputs that are observed in the market.
Level 3 assets are those valued using a model where the inputs are unobserved. They are market-to-model with inputs that cannot be determined from market activity.

It has been my contention that many of the level 3 assets are booked at unreasonably high values. I went so far as to call "level 3" a euphemism for "coming write down." In this article I attempt to defend my statement. Unfortunately, it is not clear precisely what kinds of level 3 assets banks are holding and in what numbers, which makes it hard to determine the scope of the potential write downs. However, I am convinced that write downs have been underestimated because the scope of the housing crash and the ensuing ripples has been underestimated.

Another Bear Stearns?

I argued in an earlier article that it is very unlikely that another major investment bank will fail overnight. Any failure will be a slow drawn out death followed by acquisition before insolvency is reached. The Fed has demonstrated that it will provide as much liquidity as necessary with the TAF, TSLF, and PDCF. However, as I have argued earlier, the issue the financial industry is facing today is solvency, not liquidity. Liquidity is one catalyst that will bring solvency to the forefront. Another catalyst is mark-to-market on a distressed sale. The SEC has come out in defense of banks with a letter last week that urges banks not to consider prices from distressed sales as fair market value. One can argue the merits of such a directive at length, but my interest in that letter here is to point out that the regulatory powers are working to prevent a catalyst from bringing the financial system to a sudden halt.

Related to this, the gentleman I spoke with at dinner made an interesting observation: if level 3 assets become "fairly" valued because a market for them has returned that would imply that a large degree of normalcy has returned to the markets as a whole. In such a case, their value would likely increase. Thus, in a stressed environment, they will remain on the books as level 3 assets and when markets recover, they will recover in value as well. In the meanwhile, they may not weigh down significantly on balance sheets as the Fed has demonstrated an eagerness to provide liquidity to the market using the assets side of its balance sheet. All in all, level 3 assets may not be the ticking time bomb that some commentators have dubbed them.

In light of this observation, I would venture that level 3 assets will not be a catalyst for a financial meltdown either. In fact, I am finding it hard to think of any catalysts that the Fed, the SEC, Congress, or the PPT cannot effectively neutralize. It has never been my contention that a meltdown is imminent. However, that does not imply that the financial landscape is healthy as I foresee a slow steady decline. If level 3 assets are not a ticking time bomb, they are a slow acting poison.

Declining Level 3 Assets

Rather than a sudden write down, what I do foresee for these assets is a steady decline in value. Ultimately, all securities are nothing but rights to a series of cash flows. Level 3 assets are no different. In the case of CDO's, CLO's, and MBS's, their cash flows are tied to various borrowers (private or corporate) making payments on their mortgages or loans. As foreclosures, delinquencies, and defaults rise, checks that were expected in the mail will not arrive. Those checks (payments on mortgages or other loans) represent the cash flows the rights of which these derivatives confer upon their owners. If the checks do not arrive, the instrument experiences a loss. As these instruments experience losses, they must be written down. If a CDO is booked at X, but is a claim against only Y (less than X), that is hard to justify. By the nature of the process by which mortgages and loans go into delinquency and default, the cash flows will likely dry up slowly and not suddenly.

Extent of Mortgage Losses

Bloomberg is reporting that the IMF has come out with a report that mortgage losses may swell to $1 trillion. The IMF is not alone in its assessment. Some commentators over at seekingalpha have even predicted upward of $2 trillion. Of course, there are others who estimate lower. Here are my thoughts about why to expect mortgage losses to be higher rather than lower.

The Fed kept interest rates too low too long and fueled an unprecedented bubble in housing.
Financial innovations allowed the shifting of risk that allowed more and more origination in turn. This took the bubble even further.
A complete deterioration of credit standards seen in liar loans and NINJA loans was more fuel to the fire.
Points 1-3 above resulted in housing afford ability reaching a historic low. A mean reversion will likely be marked by an overshooting in the opposite direction.
There is a lot of overcapacity as many home builders did not scrap their projects in 2006 when it was clear housing had turned. Instead, they continued building, now flooding an already saturated market.
Many borrowers will walk away from underwater and negative amortization loans. We are already seeing a culture arising.

I have written more extensively on points 1-3 here. In addition to losses on residential mortgages, there are other sectors of the economy that will feel the pinch.

Commercial real estate will be the next shoe to drop. There is a lot of over capacity in this area too.
Unsecured loans such as credit card, auto, etc will soon follow.
Industrial and commercial loans will unlikely be spared.
Municipalities will see declining revenues and bonds will see increased defaults.
The monoline insurers are looking weak.
The US is in a recession.

This last point is perhaps premature to state as the data as yet does not show a recession. However, GDP is one of the most unreliable (read manipulated) economic reports out there. For a closer look at how CPI, GDP, and unemployment are misleading, see here. I believe the US is in a recession. I predicted in December that January will be official recognized as the start of the recession. Unfortunately, I will not be proven right or wrong until the data is revised next year. And even in that case, GDP may remain slightly positive, but should not be considered the final word. Besides that it is manipulated upward, GDP is not a good measure of economic growth. For one, it includes broken window costs. But, more importantly, it ignores all activity in the higher stages of production and the structural changes that are occurring to the economy. Economic growth occurs by expanding the production structure in line with consumers time preferences and thus increasing the capacity for output, and not through consumption that cannibalizing the production structure. GDP only measures economic output. Thus it is business spending, manufacturing, commodity margins and the calculus of credit creation to the higher stages of production, to name a few, that one must look at in determining a recession.

I urge the reader to take my philosophical differences with the Keynesian framework with a grain of salt and read the articles I have linked to. I personally think the arguments are compelling, but one is free to disagree. What is clear, however, is that economic reporting should be carefully examined, and it seems that even the governments own data is clearly showing a recession; it is just being papered over.

Credit Crisis Roundtable: Markus Brunnermeier

2008-04-02T11:39:00.000-07:00

The finance department at Princeton recently had a round table discussion on the financial crisis, causes and solutions. The panelists were Markus Brunnermeier, Hyun Shin, and Alan Blinder. All 3 panelists had some very insightful comments resulting in a very lively discussion. I wanted to share a few of the important points that I took away with some additional comments of my own. After I started writing this, I realized that there is plenty to say so I am going to split into 3 parts, one for each panelist.

Markus Brunnermeier

The first panelist to present was Markus Brunnermeier who discussed the mechanism at work behind the crisis. His basic thesis is that the losses associated with the real assets that went sour is a drop in the ocean. By his back-of-the-envelope calculation on slide 11, he estimates that a bad case would see losses on the scale of $500 billion. Although a large number, this is quite small in the grander scheme of things as the stock market can lose or gain that much in a single day (less than 2%). He concludes that there needs to be some "amplifying mechanism" by which these relatively small losses create problems not commensurate with their size. I definitely agree with his assessment. Indeed, the mechanisms are precisely leverage that created the inverted pyramid we see currently and the real effect of credit tightening. He outlines these on slide 22.

Margin spiral. The losses, unlike in the case where the stock market loses 2%, are concentrated on certain sensitive players. These players tend to be highly leveraged. Even a small drop in assets causes large capital impairment, resulting in margin calls, distressed sales, and further capital impairment and margin calls. This is a theme I have discussed earlier so I will not beat it to death again.
Credit tightening. Prof. Brunnermeier refers to these as "lending channel effects." I mentioned these in the context of Lehman, but did not elaborate at the time. The basic idea is that the various financial institutions that were funding their long term assets with short term liabilities (commercial paper) cannot any longer pursue the activities they had previously been pursuing. First, their funding is drying up, as we have seen in the ABCP market; second, their capital is at significant risk of impairment resulting in precautionary hoarding; third, there is heightened counter party risk to worry about. The net effect is that banks and financial institutions must cut back on their activities and thus decrease their balance sheets.
Run on financial institutions. Just as banks can experience runs, various other financial institutions, such as hedge funds or SIVs, can as well. See slide 32.
Gridlock risk. I am actually not sure why this was discussed. It seems to me like if the situation ever arose there would be much larger problems at hand. It's kind of like if there's blood on your shirt, laundry is probably not your biggest problem. However, it is quite possible I am missing something so I refer the reader to slide 34.

The crux of these amplifying effects is the leveraged inverted pyramid structure that is built on top of housing as well as the real effects of money and credit. The latter is often hard to quantify as it involves unseen activities, but it is a very large and important cost. What I found most impressive about the discussion was that all the panelists, although they listed duration mismatch and risk shifting as central to the problem, were quick to point out that those are actually important fundamentally sound aspects of modern finance that should be taken in context. No point throwing the baby out with the bathwater. It was not discussed at much length, but I feel these are important points to be made:

Duration mismatch. This is an idea I have discussed earlier. Banks basically finance their acquisition of long term assets by issuing short term liabilities. Thus, they prefer an upward sloping yield curve. Much of modern finance is built around this theme. It is advantageous for all parties involved, including the average consumer. The crux of the modern economy is to eliminate the double coincidence of wants. I have discussed this problem in the context of money and interest rates on my other blog, but the idea extends to all aspects of economics. Well functioning capital markets serve a function that should not be underestimated. Unfortunately, the capital markets functioned in a skewed manner the last few years, but this has nothing to do with the duration mismatch and everything to do with the skewed incentives of various actors.
Risk shifting. The role of financial markets is to increase informational efficiency and allocate scarce resources in accord with consumer preferences. One such avenue is risk shifting. Prof. Brunnermeier mentions it on slide 7 as a "good" reason for structured products. In the case of structured products, various pension funds or other institutional investors who couldn't otherwise invest in the mortgage market were now able to because of the repackaging of risk. In addition, various actors (hedge funds) can assume precisely the risk they are looking for. The idea is fundamentally sound. In fact, the idea is no different from stocks, bonds, convertibles, or warrants, on the face of it. The problems arise due to agency issues. That the derivatives market has been so maligned is a reflection of the incentives within the market that resulted in deteriorating credit standards, and not derivatives themselves.

Although duration mismatch and structured products have taken a lot of flack recently, it would be wrong to accuse them of being the root causes of the credit crisis. The root cause was the structure of the regulatory environment that enabled the "originate to distribute" model and the highly misleading "ratings". As a result of the skewed incentives in the model, the house of cards built on the illusion of real wealth that is excess money flowing through the system, has finally been realized as paper wealth and not real wealth after all. Various mal-investments (level 3 assets) must now be liquidated (repriced) to borrow an analogy from the Austrian theory of the business cycle.

My Additions

Having discussed the topics Prof. Brunnermeier covered, I would now like to add some additional points that were not brought up, but that I feel are important.

Fed. The Fed kept interest rates too low too long and fueled one of the largest bubbles we have ever seen. Anyone who has played around with compounding can appreciate the difference a 1% versus 2% interest rate makes on the affordability of a mortgage. That interest rates were at historical lows for a large time enabled many buyers to bid up the price of houses considerably without increasing their monthly payments. But it doesn't stop there. The cash spigot created incentives for speculators and flippers to come in and further bid up prices. Banks in their eagerness to capture the liquidity the Fed was providing made it easier and easier for buyers to speculate on housing with deteriorating credit standards and financial "innovations". Just look at so called liar loans and NINJA loans. Further, the securitization and distribution of mortgages enabled capital to be freed up very quickly for originators to make more and more loans. Effectively, there was so much money in the system chasing all the various buyers that credit standards deteriorated and house prices were bid up furiously. When excess money is flowing through the system, it creates many skewed incentives along its path. I was surprised that Prof Brunnermeier failed to mention the role of the Fed in fueling the housing bubble.
Credit ratings. The major credit ratings agencies were the other players at the center of the problem. Their business model was built around originators paying them to rate the structured products that were being built. In order to get more business, they had to give more lenient ratings. In addition, institutional investors were pushing for higher yielding "AAA" rated securities that were within their mandates. With such incentives, is it a wonder that ratings were far higher than fundamentals would suggest. Although the structuring of the debt was a good idea, the ratings that were slapped onto it were unrealistic. Had more realistic ratings been provided, many of the investors who bought the repackaged debt would have been a little more wary. Unfortunately, as a result of the skewed incentive, structured products as a whole have received a bad rap.
Statistical models. One could argue that, even if there were skewed incentive to provide excessively high ratings, the ratings agencies still need to provide some objective justification for their ratings. Indeed this is true, but they did have those "objective" justifications in the form of statistical models. Statistical models are very useful, but need to be carefully understood and correctly employed. I have played around with the pricing methods for CDO's, CDS's, MBS's, and can attest first hand that the models are very sensitive to inputs. It is not very difficult to change a few inputs and create the desired effect. I discussed this elsewhere in the context of FASB 157. I am planning to write more detailed articles on the exact models soon.

Net I really enjoyed Prof Brunnermeier's presentation and the discussion that followed. I am sorry to race through such a vast topic. I wanted to put these thoughts down before I forget.

Lehman Upgraded By Citi

2008-03-28T09:59:00.000-07:00

Reuters is reporting that Lehman has been upgraded from "hold" to "buy" by Citigroup.

With $34 billion in liquidity at the parent company, the ability to get access to over $200 billion in liquidity from the Fed's primary dealer credit facility, and its ability to tap the term auction facility, access to liquidity is a non-issue

The target is $65 on the stock. Bloomberg adds:

Lehman said on March 18 that it had $30 billion of cash and $64 billion in assets that could easily be turned into cash. Lehman's stockpile of cash, money-market instruments, corporate bonds and equities available for sale is the largest among the five biggest brokers.

The Fed has already demonstrated with the TAF, TSLF, and PDCF (Lehman is a primary dealer) that it is happy to inject as much liquidity into the system as necessary. By expanding the collateral on the TSLF, as I predicted they would, they have also signaled their intent to prevent those assets from weighing down the books and further credit creation. Lehman appears quite liquid for now and with the Fed standing behind it liquidity should not be a problem. If anyone is hoping for a spectacular collapse a la Bear, I think they may be disappointed.

That having been said, appearances can be deceiving. Put options, especially deep out-of-the-money puts, on Lehman have recently seen an increase in activity. The article states:

An increase in trading of out-of-the-money put options on March 13 preceded the collapse of Bear Stearns Bear's stock plunged by almost half on March 14 amid concern it lacked sufficient access to capital.

Mish blogged about this on the 13th. He commented that put options were pricing in a bankruptcy for Bear. The situation with Lehman may reflect superior information. However, keep in mind that Lehman is a core wall street player. Bear was seen as somewhat of a maverick. I think it is unlikely that Lehman will collapse on liquidity concerns.

Solvency Not Liquidity

Although I agree with the Citigroup analyst that Lehman is unlikely to collapse overnight, I disagree about the price target and their prospects. He has convincingly argued that Lehman is currently liquid and will remain liquid, but he has prematurely concluded that they are well capitalized and undervalued. There are a few questions about their balance sheet and their latest earnings report. Bloomberg reports:

The firm's net income declined 57 percent in the quarter because of a $1.8 billion writedown on mortgage assets. Merger advisory fees jumped 34 percent, investment-management revenue surged 39 percent and equities rose 6 percent.

In the link above, I have argued that their balance sheet may be suspect. If there are further writedowns in the future, then earnings will suffer, as well as capital. The issue is solvency, not liquidity. The Fed is hoping that its various credit facilities will tide the banks over until the environment improves. Unfortunately, the macro environment does not look like it will recover anytime soon. That the US is in a recession is a foregone conclusion. The statistics do not show it yet, but they are highly suspect. Housing will unlikely bottom for another few years. There also appears to be a significant change of mood amongst consumers. In particular the weakest reading in consumer sentiment since 1973, which was the start of a bad recession. My assessment for Lehman is two-fold:

More writedowns. The Fed and banks can hide the true value of the securities they are holding. However, many of the level 3 securities are booked at unreasonable values and will sooner or later meet reality. It could be next month, it could be next year. However, they will experience significant losses as housing worsens and endanger Lehman's solvency.
Recession will hurt earnings. The secular bear the US is currently in is only half way done. Coupled with the recession, stock valuations are only going down. Unless Lehman is highly diversified, especially in Asia and emerging markets I cannot see how the slow down will not hurt their earnings and valuations further, especially given that Lehman is less well capitalized to grow their business.

The solution, of course, is for Lehman to raise capital. Given their current leverage, debt or convertibles would not be prudent. Their only choice is to issue equity. However, the dilution may be significant and existing shareholders will no doubt pose an obstacle.

[update 4/1/08: Lehman has raised $4bn from convertible preferred shares.]

I do not mean to bash Lehman. Many other wall street players are in similar situations. If I single out Lehman it is only because they have been the most active in the mortgage space and their stock has experienced some volatile trading on liquidity concerns.

Short Term Versus Long Term

Although my long term view on Lehman, financials, and stocks as a whole is bearish, it appears that we are long overdue for a short term bounce that may even take out nominal highs. The extreme pessimism as well as near everyones view that another major collapse is imminent has setup a nice contrarian environment.

Lehman Watch

2008-03-26T19:31:00.001-07:00

[EDIT - Great article by Whitney Tilson on Einhorn and his battle with Lehman. I have been following Einhorn for a while and I am glad to see others come out in support of him. Of course, as fundamental analysis goes, Einhorn is far more sophisticated than I and you should give him a read, but I hope you enjoy this article anyway.]

Bloomberg is reporting that "wall Street banks, brokerages and hedge funds may report $460 billion in credit losses from the collapse of the subprime mortgage market, or almost four times the amount already disclosed, according to Goldman Sachs." That is a staggering number. In light of this ominous statement, I thought a closer look at Lehman is warranted. Recall that on the day of Bear's troubles, Lehman's stock fell to $30, around 50% on concerns it would be the next shoe to drop. It has since returned to the $45 range after reassurances, acquiring lines of credit, and a better than expected earnings report. The problem, however, is that one needs to look beyond the myopic backward looking headline numbers on the income statement and focus on the future earnings potential by evaluating the balance sheet and the repeatability of the earnings. To do this, there are two important accounting rules to keep in mind.

FASB Statement 157. Issued last October to clarify how firms book assets and liabilities, the "Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement" and "establishes a fair value hierarchy" that is intended to describe the method by which assets and liabilities are booked. Level 1 of the hierarchy describes "financial instruments that trade in an active market," whereas level 3 describes assets valued "using significant unobservable inputs." Level 1 assets are high quality instruments such as treasuries or agencies that are still liquid in this environment and level 3 assets are the various structured products for whom liquidity has dried up (sub prime CDO's come to mind).

The nice thing about quoted prices is that they are very really fair value. Thus the value of level 1 assets, being marked-to-market, can generally be trusted. However, when it comes to level 3 assets, what raises immediate red flags are the "significant unobservable inputs" that are used, in essence, to mark-to-model. Having taken various financial engineering and computational finance classes here at Princeton, I can attest first hand to how sensitive prices can be to inputs. To illustrate, consider the Black-Scholes option pricing framework. Depending on what volatility is plugged into the formula, one can produce different prices; higher vol means higher price, and lower vol means lower price. In the case of Black-Scholes, the price may not change significantly, but when pricing more complex instruments using more advanced mathematical tools, prices become very sensitive to inputs. For example, the standard CDO pricing method is to use a Gaussian copula to capture correlation. I have played around with this a little and can tell you that changing the correlation affects the price quite radically, much more so than changing vols in the Black-Scholes model.

In short, the booked value of level 3 assets is dubious. There does not necessarily need to be an intention to mislead. In the case of Black-Scholes, there is a firm anchor in historical vols, implied vols, or some form of stochastic vol estimate. But with a CDO, how does one determine the appropriate correlation? We have seen correlations go haywire in this environment. Further, the very nature of the instruments, that they require significant assumptions (Gaussian copula, Gumbel copula, or something else entirely?) to make the models tractable, can result in imperfect prices. Even if one wishes to fairly mark-to-model, the model itself may be completely divorced from reality.

I have expressed my opinion earlier that "level 3" asset is just a euphemism for "coming write down" and I stand by it. Some more so than others, of course.
FASB Statement 159. This is a very interesting rule. It is described here:
How does that work? If the market decides a company is a bigger credit risk and starts demanding fatter risk premiums to buy its debt, the value of its existing debt falls. Under a rule being phased in throughout corporate America known as Financial Accounting Statement No. 159, that same logic applies to a company’s own debt. Companies that mark their liabilities to a market price, as Wall Street usually does, thus record as revenue a drop in the value of their own debt obligations.

In essence, they make money because they owe less.

Accounting experts said the exercise is perfectly legitimate, particularly if firms that mark liabilities to market do the same with their assets. At the same time, it highlights one of the ironies of so-called fair value accounting. “If you have a liability that declines in value because your credit worsens, you have a gain,” said Stephen Ryan, associate professor of accounting at New York University’s Stern School of Business.

Lehman's Balance Sheet

So how does this apply to Lehman? Well, here are the problems I see. Actually, all of this was noted by others, I am just collecting and distilling here.

Leverage. Lehman is highly levered, and that has only increased recently: "It’s quite simple: The more leverage Lehman has, the less room assets have to fall to wipe out its equity." They are currently at 32x. Not to belabor the point, but leverage has caused serious problems for others.
Definition of equity. Apparently Lehman counts long term subordinated borrowings as equity. Excluding this, leverage is in the 40x range.
FASB 159. Lehman "earned" $600 million this quarter from their debt trading lower. I would hardly consider those kosher earnings. Net income was only $489 million.
FASB 157. Bennet Sedacca notes that Lehman has four times as many level 3 assets as capital. Given the dubious nature of those valuations, that is a cause for concern.
Anecdotal evidence. I interned last summer at Lehman in fixed income research/trading. I was surprised at the time how much of their business was built around mortgages and structured products. More surprising was that every presentation I attended seemed to imply that mortgages and structured products would continue to remain high growth areas, even as the climate was changing. Of course, I wouldn't put too much weight in any impression I gained from presentations and prospectives, but I would use it as a guide to focus more detailed research. Previously their growth has been centered around structured products. We should look under the hood more carefully to see if there are any latent concerns, or if they have not successfully pursued other growth opportunities and moved away from mortgage backed debt.

What concerns me the most are points 1 and 4. That kind of leverage doesn't require much of a revaluation on the level 3 assets before solvency becomes a problem. Based on the Fed's credible signal, a revaluation is certainly on the cards.

Bear Stearns Bailout: A Credible Signal?

2008-03-24T22:19:00.000-07:00

One theme that I have been eager to introduce to this blog, but have been thus far unable to do on account of limited time is the issue of credible signals in this tumultuous environment. The lemon's problem, an important theme in finance, is an apt framework to understand the Fed's actions in the past few weeks. In a world characterized by asymmetric information, with the Fed being one of the largest sources of the asymmetry, any action taken by them should be carefully analyzed for the motive. They have taken two actions recently. First, the 75 bp cut in the fed funds rate, and second the engineered bailout of Bear Stearns. I believe both are credible signals. In this article I look at the latter.

To recap, Bear Stearns became insolvent two Friday's ago and was picked up by JP Morgan for $2 a share over the weekend before open on Monday. However, the stock continued to trade above $2, and it was yesterday announced that JP Morgan will up its offer price to $10. $236 million does seem a bit of a steal for the number one prime brokerage business on the street, not to mention that Bear's building alone, conveniently located where JP Morgan was looking for real estate, is alone worth over 5 times that amount. Read all about it here:

When J.P. Morgan and Bear Stearns announced the deal on Sunday, they had already obtained "all necessary approvals" from federal regulators. It was no surprise to have the blessing of the Federal Reserve, which had agreed to help finance the transaction. But these approvals included "all other federal agencies"—meaning that antitrust regulators signed off on the bailout before the ink on the deal was dry.

At the same time, the merger agreement gives J.P. Morgan an option to buy Bear Stearns' new headquarters in Manhattan at the discounted price of $1.1 billion if the deal does not go through. The option for the real estate, on its face, is worth more than the $236 million price to buy all of Bear Stearns at $2 a share.

"Everything about this deal is unprecedented," said a person with knowledge of the negotiations. And, in fact, many aspects of it are "on the edge of the applicable law."

What I found most unusual was the haste with which the Fed engineered the deal, the fire sale price, and the structure of the financing it provided JP Morgan. As per article 13-3 of the Federal Reserve Act, the Fed's "non-recourse" loan falls outside their legal abilities barring "exigent circumstances".

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

(emphasis mine)

Accepting "exigent circumstances", the phrases I bolded should raise a few questions. John Hussman points out that the loan was secured by the least credible mortgage debt on Bear's balance sheet. He has gone so far as to call this a "free put option" and a "tax-payer bailout":

The Fed did not act to save a bank, but to enrich one. Congress has the power to appropriate resources for such a deal by the representative will of the people – the Fed does not, even under Depression era banking laws. The “loan” falls outside of Section 13-3 of the Federal Reserve Act, because it is not in fact a loan to either Bear Stearns or J.P. Morgan. Bear Stearns is no longer a business entity under this agreement. And if the fiction that this is a “loan” to J.P. Morgan was true, J.P. Morgan would be obligated to pay it back, period. The only point at which the value of the “collateral” would become an issue would be in the event that J.P. Morgan itself was to fail. No, this is not a loan. It is a put option granted by the Fed to J.P. Morgan on a basket of toxic securities. And it is not legal.

The deal was made under duress, to the benefit of a private company, on the basis of financial assurances that the bureaucrats involved had no business making. The Federal Reserve is going to put up public assets and accept default risk so that Bear Stearns' own bondholders are effectively immunized?! That's not sound monetary policy – it's a picnic for insiders, bought and paid for through the abuse of public funds by government officials too unprincipled even to recognize the abuse. The only good thing about this deal is that it buys time while principled ways of busting and restructuring it can be settled.

That last sentence is particularly thought provoking. Why would the Fed need to buy time? It's almost as if they pushed through any deal they could to avoid Bear failing while markets were open. They knew the deal wouldn't mature on those terms, yet they showed desperation in their action. They invoked article 13-3, yet overlooked some if its key provisions. Why the haste? My guess is to prevent the chain of counter-party obligations from unraveling. Bear Stearns is holding $13.4 trillion (with a 't') worth of derivatives on its books. In addition their are the CDS contracts written on Bear itself. Had Bear failed, it would have caused two issues:

$13.4 trillion in derivatives cannot be honored with $80 billion in equity. Anyone exposed to Bear would have found themselves holding the short end of the stick. Besides the lawsuits, the write-downs would have been immense. The system simply cannot handle write downs on that magnitude. It would have seized up all markets and caused the contagion everyone fears.
The CDS contracts on Bear are worthless protection. Unfortunately I couldn't find numbers for Bear, but the notional on the CDS contracts of Bear, I am guessing, far exceeds its traded debt (look at the example of GM, with $1 trillion in CDS and $15 billion in traded debt). Anyone writing these contracts cannot possibly be hedged as the sizes of the two markets are completely out of sync. Anyone attempting to collect on Bear CDS's would find themselves facing an insolvent counter-party. Compound this with the fact that many of the CDS contracts themselves are not clearly defined. Even if the counter-party is solvent, one may not be able to collect due to technicalities in the contract itself. All in all, it appears to be the case that CDS contracts are written to be traded, but never collected on. One can profit from widening or tightening spreads, but not actual default. Had Bear gone under, the myth of CDS insurance would have been shattered.

These two scenarios are not either/or cases. Both would have likely transpired. Either one would have caused a systemic crisis that could have frozen all markets. This was successfully averted (postponed?) by the Fed.

Credible Signals and Nationalizing Insolvency

There are three credible signals that one can infer from the Fed's actions:

The markets cannot sustain a major failure. The unraveling of the counter-party claims should a major investment bank fail will create the systemic crisis that everyone fears. A cursory look at the CDS market itself with a notional of $45 trillion should raise some concerns. There is a clear possibility of severe contagion. But this observation is nothing new. Warren Buffet has gone on record dubbing credit derivatives "weapons of mass financial destruction". However, it is good that the Fed has finally come out and admitted it.
Bear is insolvent or near insolvent. What is not mentioned in the articles I linked to earlier is that JP Morgan itself is holding $77 trillion in derivatives contracts. Pooling Bear's derivatives with JP Morgans, paints the Fed's actions in an interesting new light. Recall that the $30 billion non-recourse loan was collateralized by the lowest tranche on Bear's mortgage debt. Bear claims that its book value is closer to $80 per share. Apparently, JP Morgan affirmed that in a conference call. However, actions speak louder than words. Even with the new offer, the Fed is still in for $29 billion in non-recourse loans. Bear is levered through the roof on assets that have more write-down to come. If even a small fraction of the "level 3" assets are sold, the losses could be staggering. The banks know this and are eager to prevent such a situation from arising. This deal is a clear indication that Bear is insolvent and that the "level 3" debt held on all books across the street is due for a significant revaluation.
They will nationalize to prevent insolvency. I refrain from speculating too much in the absence of any concrete moves to this effect, but, with the TSLF and PDCF, as well as the changes to Fannie Mae and Freddie Mac, both the Fed and Congress are signaling that they will take large steps to prevent a systemic crisis from firmly taking hold. They will nationalize if necessary, thereby socializing the fallout and bailing out the banks at the tax payers expense. As I predicted in a previous article, they have now expanded the acceptable collateral for the TSLF. Some commentators have questioned whether this is covert nationalization. Again, I don't wish to speculate, but I will say that barring nationalization of all the "toxic waste" in the system, I don't see how -- since the issue is solvency, not liquidity -- the market can navigate the storm that would result from a major investment bank failing.

It remains to be seen how this plays out...

(Some trivia: there's a rumor going around that Citadel was negotiating terms for a loan with Bear prior to the collapse, realized that Bear was in trouble, and shorted the stock for a nice 1 day gain.)

Credit Crisis: Causes

2008-03-19T20:01:00.000-07:00

Shostak has a great article on mises.org today about the Fed's new tricks. He succinctly describes the root cause of the credit crisis:

When new money is created out of thin air, its effect is not felt instantaneously across all the market sectors. The effect moves from one individual to another individual and thus from one market to another market. Monetary pumping then generates bubble activities across all markets as time goes by.

As with any other business, participants in financial markets like investment banks are trying to "make money." It is this that gives rise to the creation of various products like collateralized debt obligations (CDO) and mortgage-backed securities (MBS) in order to secure as big a slice as possible of the pool of newly created money. (Financial entrepreneurs are basically trying to exploit opportunities created by the Fed's loose monetary stance and get as much as possible out of the expanded pool of money.)

As long as the Fed kept pushing money into the system to support the low interest rate target, various activities that sprang up on the back of the loose stance appeared to be for real. When money is plentiful and interest rates are extremely low, investment in various relatively high-yielding assets like CDO's and MBS's that masquerade as top-notch grade investment becomes very attractive. The prompt payment of interest and a very low rate of defaults further reinforce the attractiveness of financially engineered investment products. However, once the central bank tightens its monetary stance — i.e., reduces monetary pumping — this undermines various bubble activities.

I will expand with my comments this weekend.

Mises.org blog post on investments

2008-03-16T01:27:00.001-07:00

FYI, here is what mises.org readers are currently invested in.

More Pain No Gain

2008-03-15T16:41:00.001-07:00

Since I wrote about hedge funds Peloton and Focus failing and Carlyle and others in margin call trouble, it appears that my gloomy talk has, unfortunately, played out. As an aspiring money manager, I personally am sad to see others in the business fail. However, we should treat this as a learning opportunity to understand the underlying problems and hopefully gain some insight into the future state of the markets. Most importantly, we should be honest with our assessment of their problems.

Here is a list from the last 4 weeks:

Citigroup funds: ASAT Finance (municipal bonds), MAT Finance (municipal bonds), Falcon Strategies (MBS), CSO Partners (corporate debt).
Blue River Asset Management (municipal bonds).
Carlyle Capital Corp (Bonds, CDO's).
Tequesta Mortgage Fund (Mortgages).
Focus Capital (swiss small cap).
Peloton Partners (ABS and multi strategy).
Sailfish Capital (fixed income).
Deephaven Event Fund (event driven).

Call A Spade A Spade

I have argued elsewhere that the problem facing funds today is very different from the LTCM crisis. LTCM's strategy was, fundamentally, selling tail risk. A tail event in the form of Russia's default which caused a flight to quality and wider spreads worked against their positions. Since they were highly levered, their capital base was unable to ride out the event and a bail out was necessary. There are three major differences today:

Macro environment is not a tail event. I believe that the current problems in financial markets are not a tail event that is causing unforeseen behavior. Many commentators that I have been reading for the past few years have predicted exactly what we are seeing. They have even carefully explained why. For anyone paying attention, the housing crash and the following subprime issues, and now Alt-A, jumbo, muni's, etc. were all perfectly predictable. Unfortunately, however, the macro environment is currently quite murky. That the US is in a recession is a foregone conclusion. Harvey Feldstein has finally admitted what has been obvious for many months. I predicted in December that January will be recognized officially as the start of the recession and I stick by that prediction. However, depending on where you get your data, the case can be made for earlier.

The real question is how severe the recession will be, and whether it will be deflationary or inflationary. My guess is extremely severe since there are simply too many variables that need to pan out perfectly in order for this to be a soft landing. For example, solvency issues at major banks, credit withdrawal, housing prices in the major speculative areas, people walking away from underwater mortgages, problems in muni's, problems in ARS, monoline concerns, global wage arbitrage, contracting service sector, and others.

Whether the recession is inflationary or deflationary is a much harder question to answer. Thanks to the analysis of mish and the folk over at Minyanville, I am leaning towards the deflationary side. Surprisingly, the Fed seems to be on our side. They seem quite reluctant to inflate the money supply, hence the unorthodox approach to monetary policy. The interest rate decision in a few days, I think, will signal their intent more clearly as it has become clear since their last meeting that growth is negative and credit is being destroyed left and right.

The implications for hedge funds is that all those who were relying on rising house prices, the goldilocks economy, or permanent credit market liquidity will be faced with more losing positions and margin calls. I don't mean to imply that all those that failed in the last few weeks were naive. Some were simply highly levered and failed for reason 2 (below). Others did make investments that were unsound and are facing the consequences. Whether LTCM's strategy was sound or unsound I refrain from commenting on, but it ran into problems very different than what the markets are currently experiencing. Many funds, especially those long structured products such as CDO's, CLO's, MBS's, etc, even if not levered at all, will fail because their investments are fundamentally unsound.
Exposure to other hedge funds. Unlike 1998, the hedge fund industry today has tremendous exposure to others within the industry. Assets under management are close to $2 trillion, a number far far larger than 1998. We already saw the ramifications of this in August/November where positions that one might consider sound performed badly simply because other hedge funds were in the same positions and were experiencing problems elsewhere. If you have a pairs trade in Toyota and GM, but so do 20 other hedge funds, then for all intensive purposes you have bought a single security that is the spread between the two.

Given the deteriorating macro environment, if a certain fund finds itself in trouble because of illiquid credit instruments, it will be forced to liquidate its liquid positions in equities or precious metals to meet margin calls. Thus a fund with absolutely no CDO/CLO/MBS/etc exposure, by virtue of its investment in other markets and other funds' presence in those markets, can indirectly have exposure to all this so called "toxic waste." If you think you cannot be hit because you are not exposed to credit instruments, I urge you to look at the example of the funds that failed this month and reconsider the risk profiles of your positions. As mentioned, August/November already demonstrated how trouble in credit markets adversely affected more liquid markets simply because funds had to trim positions elsewhere to meet margin calls. If forced to trim a position, the natural choice is the liquid market.

To re-iterate, one should be careful about the risk assumptions they make on their positions. Deteriorating conditions in one market can have adverse effects on other more "sound" markets simply because a large number of hedge funds have exposure to many different markets. In a sense, hedge funds form a conduit through which trouble in one market can easily spread to other markets. Should this occur again, leverage will be the enemy, and may result in many more failures.
Badly understood positions/risks. In the case of LTCM, the positions they took (on-the-run/off-the-run treasuries) and the reason for the widening spreads was very well understood. Today, however, there are vast amounts of derivatives floating around the system that no one can fully describe the risk characteristics off. The models used to price these instruments are just that, models. They are simplified in order to be tractable, and sometimes the inputs are not clear. If one cannot understand the risks, or describe the instruments with a good model, then one cannot possibly be hedged. In short, there is much more uncertainty today about who is exposed to what risk.

Conclusion

There exist significant downside risks in all markets. The big question of whether the Fed can successfully inflate this time again should be answered quite soon. In the interim, I remain partially short the market, but mostly on the side lines as capital preservation, I think, is the most important concern going forward.

Term Securities Lending Facility

2008-03-11T18:55:00.000-07:00

The big news today that spurred the markets into action was that the Federal Reserve will be introducing a new Term Securities Lending Facility (TSLF) similar to the Term Auction Facility (TAF):

Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. As is the case with the current securities lending program, securities will be made available through an auction process. Auctions will be held on a weekly basis, beginning on March 27, 2008. The Federal Reserve will consult with primary dealers on technical design features of the TSLF.

What Are The Incentives?

Mish had a couple of great posts about this today: 1 2. He says:

The TAF, the PAF, lowering interest rates etc. are measures that can only work if the problem is lack of liquidity. The problem is not one of liquidity. The problem is solvency. Massive amounts of credit was created out of thin air because fractional reserve lending allows it. Speculation in assets went through the roof when the Fed held interest rates too low too long.

I would only add that the securitization of risk and its offloading from bank balance sheets to various buy side yield chasers that freed up capital for more loans created highly misaligned incentives. Understanding the incentives is key to understanding the situation we are in currently. Knowing that they could unload all the "toxic waste" onto naive yield chasers ("no warning can save a people determined to grow suddenly rich" -- Lord Overstone), banks and other lending institutions had the incentive to underwrite marginal loans, securitize, and sell them. Add the ratings agencies into the mix with their pay-to-rate model and you have some highly highly skewed incentives driving large amounts of capital and credit. The final piece of the jigsaw is the duration mismatched assumption that short term instruments (eg, ABCP) could be used to permanently fund the purchase of long term assets relying on perfect liquidity in credit markets. Playing with someone else's money creates the incentive for high variance bets, and the stage is set.

Mish continues:

Now with falling asset prices, margin calls are running rampant. Margin calls beget margin calls in an ever escalating chain reaction. Carlyle Capital, a once $32 billion fund, was Hit With Margin Calls And Default Notices. It may have to liquidate. If it does, most of that $32 billion will be wiped out because of the 32:1 leverage it was using.

With the TAF and now the TSLF, the Fed has been taking a very unorthodox approach to monetary policy. They appear to be both inflating and deflating at the same time! Please see the following articles.

Bernanke's Surprise.
Repurchase agreements and covert nationalization.
Monetary policy using the asset side of the Fed's balance sheet.
Bennie and the Monetary Jets.
Paul Krugman.

Solvency, Not Liquidity

The net effect they are trying to achieve, from my understanding, is that they are providing liquidity without increasing the money supply. I have argued elsewhere that money supply growth is inflation, not rising prices. The Fed knows this. However, it appears that many banks (especially Lehman and Bear) are holding large numbers of "level 3" assets -- those that cannot be reasonably priced. Today "level 3 asset" is a euphemism for "coming write down." The Fed knows this too. Their solution, eventually, is to provide liquidity via the level 3 assets. Let me say that again: the source of the illiquidity is that many of these assets cannot be reasonably priced, and hence traded. (Nor does anyone want that because it would result in further write downs.) However, if one could use them for repo's, they are no longer sitting idle on the balance sheets but working as capital to enable further credit creation. An essential for an economy experiencing withdrawal symptoms. The auction facilities currently do not accept level 3 assets, but that may well change.

However, this is just a band-aid. The problem is solvency, not liquidity. Well, that's not entirely true. Liquidity is the immediate problem that could precipitate a meltdown, but solvency is the fundamental problem that the Fed is hoping to hide. Unfortunately, I am at a loss to see how it could possibly be solved. The Fed appears powerless unless Congress jumps in and vastly expands the its bag of tricks allowing it to outright purchase these securities instead of merely monetize treasury debt or engage in repo's and reverse repo's. Congress has already somewhat credibly signaled its intent to do exactly that with the recent economic stimulus bill which conveniently had clauses related to Fannie Mae and Freddie Mac's caps. I'm not sure exactly what happened with that, but just the fact that they would try to sneak it in suggests they recognize the severity of the crisis and are willing to nationalize if need be to avert a disaster.

So perhaps this really is covert nationalization...

Trade Recommendations

2008-03-10T15:01:00.000-07:00

So I thought it might be interesting for readers if I update this blog with trade recommendations in addition to my thoughts on the markets. However, when it comes to trades, I am reluctant to make any recommendations that I am not sufficiently confident in, or that I cannot carefully elucidate the rationale behind. I will make a concerted effort in the next couple of weeks to put together some solid research, but this could take a while as I don't want to be sloppy or shallow. In the meanwhile, I will continue to post my thoughts on current events.

For the interim, here are my general long term thoughts on markets based on fundamentals.

Short the DOW, S&P, Nasdaq.

Although the US has experienced a cyclical bull in the last few years, it seems abundantly clear that it is still firmly in a secular bear that will end in 2016 or so. Further, as any Austrian will tell you, that the Fed kept interest rates at 1% for such a long time only served to lessen the cathartic effect the 2001 recession should have had. For this and other reasons (eg), I have maintained that the recent bull market was based on weak fundamentals and would likely turn after the housing market turned. Gerard Jackson is one of the few Austrians who believes that the US has a little while further to go as manufacturing has not been showing significant strains. I agree with Mr Jackson in theory. What is curious is that the US has been bleeding high paying manufacturing jobs (3.5 million this decade) and replacing them with lower paying service jobs. A weak dollar may serve to reverse that, but only if Congress refrains from meddling.

Ever since the housing bubble decisively burst and Mish issued a top call last summer, I have been aggressively short the market as a whole using ultra short ETF's SDS, MZM, QID, and DXD. Long term I expect the markets to continue to do badly, even if last summer was not the top. Unfortunately, since the Fed can inflate it's way out of price decreases, we should be careful to recognize a stagflationary environment early, exit one-directional bets, and replace them with relative value trades.

I have to admit that today I have simply no idea what will happen. The economy appears on a precipice, but the Fed may yet rescue it at the expense of the dollar. I have trailing stops on all my positions.
Long Gold, Silver.

For reasons described elsewhere, I am extremely bullish on precious metals. I have been long gold since I started investing in 2005. Long term I continue to be bullish on gold, but short term I feel it is overextended. In addition, since the macro environment is currently so murky (will we have deflation or stagflation?), I cannot recommend a one-directional bet just yet. I have taken profits in my gold and silver positions and remain on the sidelines for now.
Short Muni's, commercial real estate, credit card debt, auto-loans and various structured products.

Markets will worsen before they recover. I think we should be careful to understand that this is a credit crisis marked by changing attitudes and not a subprime issue. Subprime was the weakest sector and expectedly was the first to get hit. All those who said the crisis will be contained have been proven wrong, and will be proven wrong again in the future.
Long emerging markets.

While the US and Europe may be in secular bears, the various emerging markets should pose great buying opportunities once they de-couple. In the short term this means pain as I expect things to worsen. In the long term these will be once in a lifetime buying opportunities. It's going to depend on how the coming recession reorganizes the production structures in the various economies. I think India will be least hit as the economy is largely domestic driven. Russia too will not be badly hit, but China, on the other hand, will have many mal-investments to liquidate as its economy is so largely export driven. It could be in for some serious pain.

Capital Preservation

Because of the uncertainty in markets, I think playing macro trends currently can be very dangerous. If you are a long term investor, I would recommend staying on the sidelines for the next few weeks. The most important concern currently should be with capital preservation. Making a one-directional bet today has little upside and potentially large downside. Also, many opportunities will present themselves when the dust settles. As such, capital preservation is the name of the game.

That having been said, there are certain trades that I would feel comfortable putting on today to profit from the uncertainty in markets. For example, the VIX recently put in a triple top. Historically, any breakout above the triple top has been significant. Also, certain options strategies, such as strangles, or some sort of reverse butterfly can be highly profitable. These are the lines along which I am currently thinking and will post a more detailed analysis shortly.

Lies, Damned Lies, and Statistics

2008-03-07T13:52:00.000-08:00

Of the many economic data releases, perhaps the most widely followed are GDP, unemployment, and the CPI. Having worked at Lehman Brothers in Fixed Income Research and in my own time following research reports, I can attest to how important these series are in wall streets analysis of markets. Like any good data analyst, I have never taken the series at face value and have always questioned the methodology behind them. The reason, of course, is that the major weakness of the inherently positivist approach that is econometrics is that the usefulness of the analysis can never surpass the reliability of the data.

So how reliable is the data? Anecdotally, it seems to be quite out of sync with reality. The government reports that "inflation" is running at 3% whereas we see much larger rises in daily living expenses. The government reports that over a million jobs were added in 2007, yet we hear of many layoffs and general expansion pessimism in the media. What gives? Before we take a closer look at the data, let us first examine from a purely economic sense whether we expect the data to be reliable.

Disclaimer

First, a brief disclaimer is in order. As the reader may know, I have some philosophical differences with the Keynesian framework. As part of this article, in addition to discussing the methodology, I also present the Austrian critique of the Keynesian framework. Although I do hope the reader finds the Austrian critique insightful and well thought out, I just wish to point out that one does not need to accept Austrian economics in order to appreciate the rest of the discussion. I add the Austrian critique only for completeness.

What Are The Incentives?

The crux of micro-economics is incentives analysis. As such, what has always fascinated me about government economic reporting is the obvious conflict of interest. Take, for example, the CPI. The government has numerous liabilities indexed to the CPI (Social Security, TIPS, etc). In addition, actual inflation and inflation expectations are both very important in setting lending rates, for various business calculations, and in the consumers evaluation of the economic climate. They are one of the key factors that influence the macro economy. It is no wonder they are one of the key factors in any statistical analysis of macro trends. Yet, it is the government that defines the methodology, collects, and reports the data. I ask you, dear reader, what are the incentives in this situation? Are they not for government economists to understate inflation in the CPI as much as possible? Ex ante should we not expect exactly that? Not only are liabilities decreased, cheaper credit is enabled, and expectations are anchored.

A Closer Look At The Data

Having established our expectations in the matter, a closer look at the data is warranted. I borrow from John Williams of shadowstats who maintains alternate data for all the important series. A detailed analysis of each series is beyond the scope of this article. I will link to more detailed discussions.

CPI: is supposed to capture rising prices. It was doing a reasonable job pre-Carter, but thanks to numerous methodology changes, it now consistently understates rises in prices. See the Boskin commission for an introduction. The use of hedonics and substitution is perhaps the most misleading and manipulative practice. I have discussed these elsewhere.

I have also argued that rising prices are not inflation; they are the effect of inflation.
GDP: is supposed to be indicative of economic growth. Unfortunately, it is not the whole picture. GDP is really only indicative of economic output. Economic growth arises from changes to the production structure that cannot be capture by GDP. I have discussed this elsewhere.

Despite being an inaccurate measure of growth, GDP is perhaps the most important economic series. It has many subtleties that John Williams highlights. Pay close attention to "imputations" where the government pretty much makes up new sources of income.
Unemployment: is really two separate series. One is the unemployment rate, and the other is non farm payroll. They are based of two separate surveys. The unemployment rate is based off the household survey and jobs growth is based off the payroll survey. See John Williams analysis here.

The payroll survey has an additional component known as the birth/death model. It is an ARIMA model of small business "births" and "deaths" and their associated job changes as the payroll survey does not include those. Like with any time series analysis, it is always backward looking. The tendency is to project current trends into the future. Thus, at key economic turning points, it will project the previous trend and not predict the change. The BLS freely admits this. What they are not so free about is the model itself. It is a closely guarded secret. Today, with the economy at a clear turning point, the birth/death model has been responsible for some bizarre predictions and overestimations.

The housing survey too is not short of its problems. Most notably the way unemployment is defined is very misleading. For example, "discouraged workers," people willing to work but who have given up looking for a job as they do not expect to find one, are not considered unemployed. This number has been rising recently indicating that the economy may be worse than we suspect, but the unemployment figure dropped 0.1% this month.

Conclusion

The various government reports, although unreliable, should not be confused as inaccurate. The institutions that collect government data, as far as I know, collect accurate numbers. The problem is in how they are presented. Methodological changes result in understatements when desirable (CPI, unemployment) and overstatements when desirable (GDP, jobs). As the famous quote goes "there are three kinds of lies: lies, damned lies, and statistics." The statement "succinctly describes how even accurate statistics can be used to bolster inaccurate arguments." In order for any analysis to be useful, it must account for the quirks in the data.

I remind the reader of the alternate data.

Market De-leveraging?

2008-03-06T13:45:00.000-08:00

The Woes Continue

Since my previous post on Peloton, it appears as though another EuroHedge award winner, Focus Capital, has been forced to close shop. According to reports (2), Focus lost 80% of its $1bn investing in Swiss midcap stocks. Again, the culprit was leverage:

In a letter to investors, the founders of Focus, Tim O'Brien and Philippe Bubb, said it had been hit by "violent short-selling by other market participants", which accelerated when rumours that it was in trouble circulated.

Focus returned 112% in 2006 and 33% in 2007.

Recall that with Peloton, the culprit also was leverage:

With the credit crunch draining away cash, the company was unable to finance the exposure and was forced to find buyers at any price. With no buyers, it was forced into what appears to have been a fire sale.

Both Peloton and Focus appear to have been quite highly levered. When trades moved against them, their capital base was quickly eroded and margin calls forced them to engage in fire sales. In both cases, the founders have blamed others (market participants and lenders) for the forced liquidation. This may be true, but one should consider whether without the high leverage they would have found themselves at the mercy of others unable to ride out their setbacks (if that was even possible)? And on the flip side, would they have made the phenomenal returns in 2006/7 that earned them their EuroHedge awards?

Given that not one, but two EuroHedge award winners have now found themselves succumbing to excessive leverage in illiquid markets, it begs the question whether other funds are in trouble as well. Sure enough the WSJ is reporting that Carlyle Capital Corp., an investment subsidiary of the Carlyle Group has been faced with margin calls on a book levered 32 times. Their $21.7bn portfolio is supported by only $670m in equity. That's a mere 3%. Carlyle Capital Corp. finances purchases of their Fannie and Freddie securities through short term repo's. Essentially, they are borrowing short and lending long. Given the duration mismatch and the complete seizing up of credit markets, this does not bode well.

Mish has more to say on this topic. And care of Mish, we also find that the Bank of Montreal recently missed margin calls and Thornburg Mortgage received a few of their own.

This is in addition to Falcon Strategies, an MBS fund at Citigroup that was bailed out by their parent after losing 52% in the fourth quarter of 2007.

De-leveraging?

As far as I know, these are the major outfits of the past 2 weeks that have wound down or are in serious trouble. What's most curious is the wide spectrum of asset classes involved. Granted, both Peloton and Focus would not have been liquidated had they not been so highly levered, that still does not mean they would have recovered completely. It's hard to say. What seems easy to say, however, is that given the recent events, many other highly levered funds will be wondering if they are safe in their leverage. Market conditions have not materially improved since the beginning of the year, and even look to be worsening. It would be unwise to assume that any asset class is safe from large volatility. Even precious metals that I am very bullish on have shown tremendous volatility this week; down a few points, up a few points, and down again a few points, all in the span of 3 days. If that kind of volatility isn't enough to knock one out of a highly leveraged position, I don't know what is.

The short of it is that I would not be surprised to see many funds taking precautionary steps to avoid following in Peloton and Focus' footsteps. I cannot say what impact this de-leveraging will have as I have no data indicating what scale to expect. The next few weeks will be very interesting. I am highly inclined to say that the market will decide its path soon. It will either put in a nice bottom before breaking above 13,000 again, or if 12,000 is decisively breached, I expect 10,000 to follow. I suspect the latter, unless the Fed can successfully inflate, something it seems oddly reluctant to do as 3 month T-bill rates are still quite a bit below the Fed Funds rate. Given that, I would not be surprised to see a 75bp cut at the March meeting.

I also argued in my previous article that what we are witnessing is not an LTCM style tail event, but a systemic crisis.

Peloton Wound Down

2008-03-02T16:39:00.000-08:00

At the 2007 EuroHedge awards Ron Bellar and Geoff Grant, co-founders in 2005 of Peloton Partners, received the awards for best new fund of the year and best credit fund. Fast forward one month to last Thursday and Peloton warned investors that its recent bet on AAA securities went sour. On Friday Reuters reports that assets in Peloton's $2 billion ABS master fund have been seized by lenders and are being liquidated:

Several U.S. lenders have taken control of failing hedge fund Peloton Partners' assets, one day after the fund said it was liquidating a portfolio, a person familiar with the situation said on Friday.
Some banks are taking matters into their own hands, while others are being more patient and are cooperating with an orderly liquidation, said the person who was briefed on the matter but who is not authorized to publicly speak about it.

Peloton has also frozen redemption on its smaller multi strategy fund:

Peloton has a second fund, the Multi-Strategy Fund, whose fate remained unknown after redemptions were suspended this week.

Peloton gained 87% in 2007.

The Financial Times reports that Bellar and Hunt were both heavily invested in the fund and stand to lose a substantial amount of their personal fortunes. As expected, the culprits were leverage and margin calls:

The $2 billion or so of equity in the fund was constantly leveraged four or five times over, giving the fund a portfolio of assets worth some $9 billion. The high-quality mortgages in Peloton’s portfolio were used as collateral to back the leveraged positions.

I would venture that both leverage and margin calls are not the root problem, but rather the catalysts. Peloton was holding "AAA" rated securities which were rapidly losing value. Since highly leveraged, this was eating into their capital base at an alarming rate, thus precipitating a blow up.

Citadel to The Rescue?

In an interesting turn of events, Chicago based hedge fund Citadel has declined to bid on Pelotons distressed book:

When it became clear that hedge fund Citadel Investments Group, which rescued ailing portfolios from Sowood Capital and Amaranth in the past, had no interest in Peloton, some lenders got even more nervous and took the assets back, a person said.

This could indicate that the book is not as solid as Peloton thought, or that Citadel itself is capital constrained. The current market turmoil as well as any further deterioration (which I expect) is going to present excellent opportunities for well capitalized and savvy investors. Citadel, for one, has been building quite a reputation so I am very curious why they declined to bid. It is possible they are being cautious as they expect further deterioration or are, at least, uncertain of the fundamental value of the book. The most important variable for distressed debt in the coming years is going to be solid fundamental analysis guided by a good grasp of the macro environment. The macro environment currently is very uncertain.

No LTCM

Doug Noland over at prudent bear discusses this story in his latest credit bubble bulletin. He argues that Peloton's experience, although similarly driven by a highly leveraged book, is vastly different from the LTCM crisis:

This is No LTCM. The current financial and economic backdrop is altogether different. Speculators that would typically seek to capitalize on depressed securities prices now confront enormous uncertainties. How bad will things get in California, Florida, and elsewhere? How many will walk away from underwater mortgages – for starter homes and million dollar-plus California bungalows? How badly will the U.S. “services” economy be hit by housing and financial woes? How bad are the unfolding Credit problems in state and local finance? Will pinched consumers also turn their backs on Credit card, auto and student loans? How long will the seizing up of the securitization markets last? How will corporate Credits hold up in the event of prolonged Credit restraint and economic tumult? What are the ramifications if the “monolines,” GSEs, private-label MBS/ABS, the Credit derivatives marketplace, and Wall Street “structured finance” (more generally) don’t recover? None of these pertinent questions were even remotely contemplated or relevant in 1998.

I agree with Mr. Noland 100%. There are simply too many variables for a fundamental analysis to establish any reasonable margin of safety. One needs to have a firm grasp on the macro environment, which is currently too murky.

Systemic Crisis Not Tail Risk

The problem today is that the Fed fueled a speculative real estate bubble that was supported by bad incentives in the credit markets. Not only did this cause dislocations in the production structure, it resulted in risks being shifted to yield chasers who perhaps did not fully understand their exposure. As I understand it, the problem in 1998 was different in that LTCM sold a bunch of tail risk and was hit by a "100-year flood". Due to immense leverage LTCM's equity base eroded quickly and they could not ride it out. Peloton too was leveraged, but they did not sell tail risk. Neither has the recent trouble in quantland been tail risk. Of all the funds that have recently blown up, it seems like most were playing with risks they didn't understand; not merely selling tail risk. It would thus appear that the current crisis is a systemic issue. Subprime, being the weakest sector, was the first crack. The cracks have since spread to structured products at large. Muni's are currently showing strain. Jan 25th seems to have marked the turning point for them.

I believe this is a systemic crisis that cannot and will not be contained. Since capital markets are an integral part of the allocation of resources towards productive enterprise, any tightening of credit will have a very real effect on the economy. If the US is not already in a recession, I expect one in the near future.

Krugman vs Bastiat

2008-02-29T13:23:00.001-08:00

Bastiat's Broken Window Fallacy

As Jeffrey Tucker notes, an absolute howler from Krugman:

The fact is that war is, in general, expansionary for the economy, at least in the short run. World War II, remember, ended the Great Depression. The $10 billion or so we’re spending each month in Iraq mainly goes to US-produced goods and services, which means that the war is actually supporting demand. Yes, there would be infinitely better ways to spend the money. But at a time when a shortfall of demand is the problem, the Iraq war nonetheless acts as a sort of WPA, supporting employment directly and indirectly.

This is a text book example of a broken window fallacy. In the words of Bastiat:

Have you ever witnessed the anger of the good shopkeeper, James Goodfellow, when his careless son happened to break a square of glass? If you have been present at such a scene, you will most assuredly bear witness to the fact, that every one of the spectators, were there even thirty of them, by common consent apparently, offered the unfortunate owner this invariable consolation—"It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?"

Now, this form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions.

Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier's trade—that it encourages that trade to the amount of six francs—I grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.

But if, on the other hand, you come to the conclusion, as is too often the case, that it is a good thing to break windows, that it causes money to circulate, and that the encouragement of industry in general will be the result of it, you will oblige me to call out, "Stop there! Your theory is confined to that which is seen; it takes no account of that which is not seen."

It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way, which this accident has prevented.
(emphasis mine.)

Hazlitt, too, uses the same example, but elaborates the material destruction a little further:

Let us begin with the simplest illustration possible: let us, emulating Bastiat, choose a broken pane of glass.

A young hoodlum, say, heaves a brick through the window of a baker's shop. The shopkeeper runs out furious, but the boy is gone. A crowd gathers, and begins to stare with quiet satisfaction at the gaping hole in the window and the shattered glass over the bread and pies. After a while the crowd feels the need for philosophic reflection. And several of its members are almost certain to remind each other or the baker that, after all, the misfortune has its bright side. It will make business for some glazier. As they begin to think of this they elaborate upon it. How much does a new plate glass window cost? Fifty dollars? That will be quite a sum. After all, if windows were never broken, what would happen to the glass business? Then, of course, the thing is endless. The glazier will have $50 more to spend with other merchants, and these in turn will have $50 more to spend with still other merchants, and so ad infinitum. The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be, if the crowd drew it, that the little hoodlum who threw the brick, far from being a public menace, was a public benefactor.

Now let us take another look. The crowd is at least right in its first conclusion. This little act of vandalism will in the first instance mean more business for some glazier. The glazier will be no more unhappy to learn of the incident than an undertaker to learn of a death. But the shopkeeper will be out $50 that he was planning to spend for a new suit. Because he has had to replace a window, he will have to go without the suit (or some equivalent need or luxury). Instead of having a window and $50 he now has merely a window. Or, as he was planning to buy the suit that very afternoon, instead of having both a window and a suit he must be content with the window and no suit. If we think of him as a part of the community, the community has lost a new suit that might otherwise have come into being, and is just that much poorer.

The glazier's gain of business, in short, is merely the tailor's loss of business. No new "employment" has been added. The people in the crowd were thinking only of two parties to the transaction, the baker and the glazier. They had forgotten the potential third party involved, the tailor. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye.

(emphasis mine.)

Krugman himself admits the fallacy:

Yes, there would be infinitely better ways to spend the money.

but then attempts this completely absurd rationalization:

But at a time when a shortfall of demand is the problem, the Iraq war nonetheless acts as a sort of WPA, supporting employment directly and indirectly.

Per Krugman's logic, and as Keynes famously stated, the government should pay people to dig ditches and others to fill them up, thus creating employment and boosting GDP in a time of failing aggregate demand. As absurd as this notion is, the claim that war is expansionary far dwarfs it. Not only does the government encourage completely unproductive work, it encourages completely destructive work. Wikipedia explains:

However, immense resources are spent merely to restore things to the condition they already were before the war began. After the war, the nation has a rebuilt city; before the war, it had a city and time in which its labour could have been used for more fruitful purposes. Further, the fixed amount of natural resources could have been used to build a second city rather than to rebuild a destroyed city, hence highlighting the occurrence of waste.

War is always a destructive enterprise. Real wealth is destroyed, the replacement of which is hailed as economic growth. At best it is replacement. In reality, it is tremendous lost opportunity.

The Fallacy of GDP

It is true, however, that war and natural disasters boost GDP. So how are we to reconcile this? The fact is that GDP is not indicative of economic growth, it is only indicative of economic output. What Krugman and other Keynesians fail to grasp is that savings and capital investment are the engines of growth, not consumption. By investing in more roundabout methods of productions - presumably for efficiency reasons - entrepreneurs expand the production structure, which is narrowest at the consumer end and expands as you move towards higher order goods. Thus, savings and capital investment expand the production structure creating the capacity for increased future output, while consumption cannibalizes the production structure and decreases the capacity for future output. George Reisman makes this argument quite cogently here.

Unfortunately, we are repeatedly told by economists and economic commentators alike that GDP is the be all and end all of a prosperous society. As we have already seen, various unproductive and destructive things can create one time boosts to GDP because GDP doesn't deduct "broken window costs". Nor can it hope to in any objective manner. Besides that GDP is incomplete as Reisman argues, Shostak argues that it is fundamentally flawed.

Market Implications

For this reason I believe the recent economic stimulus package is a smoke screen that will boost GDP but not actually create a material improvements in the economy. In fact, I think it will create material destruction that will not be realized until later. I will write more on this shortly.

[EDIT: an example from a later article.]

At the risk of over simplifying: assume you have 1 machine that can produce 10 widgets in a year. Assume further that the machine is made of 20 widgets. For the economy to "grow" there must be capacity for increased widget production. To this end, 20 widgets, 10 widgets for 2 years, must be saved to build a new machine. In those 2 years GDP drops to 0, but after 2 years the economy has actually grown 100%. On the other hand, if the first machine is consumed, you have a one time GDP increase of 100%, but have no capacity for future output. There appears to be a disconnect between GDP and economic growth.

This overly simplified example is intended to demonstrate that saving and investment (20 widgets to create the second machine) is economic growth even if GDP falls, while consumption (consuming your first machine) cannibalizes the production structure leaving you with diminished capacity for future output, even if it creates a boost to GDP. Shostak illustrates this idea more carefully using Crusoe economics in his article on the subsistence fund.

What drives gold prices?

2008-02-29T09:40:00.000-08:00

Types of Demand

Although gold is often clumped together with other commodities (oil, copper, aluminium, wheat) and is said to have been participating in the global commodity bull, it is important to understand that what drives the price of gold is very different from what drives the prices of the other commodities. Briefly I wish to distinguish various forms of demand that can affect commodity prices in order to illustrate how vastly different the supply demand dynamics in the gold market are from other commodities. This analysis is important because the changing macro environment suggests that gold may decouple from other commodities and benefit from both inflation and deflation, while commodities at large will suffer in a deflationary environment. My analysis draws heavily from Antal Fekete, Jullian Phillips, and others.

Since all prices today are expressed in an inherently inflationary unit (paper currencies such as dollars, euro's, or yen), this makes the analysis a little harder as we must distinguish a real rise in prices from a cosmetic rise in prices on account of increased money supply. What compounds the issue further is that money is not neutral and an increased money supply actually has a real effect on commodity prices.

Like any other good or services, commodity prices are determined by supply and demand. I distinguish 3 types of demand:

Industrial demand is that demand for industrial use, productive enterprise, or consumption. The good is destroyed or transformed so as to make recovery hard.
Monetary demand is that demand as a result of a commodities status as money - it is widely transacted as a medium of exchange. If my meaning is unclear, please see my article on money. Currently, no commodity meets this criteria.
Investment demand is any demand that is not industrial demand or monetary demand. It is easier to state what isn't investment demand than what is because many different things qualify. I use it as a catch all phrase for speculation, hedging, and even outright investment.

My thesis is that industrial metals, energy, grains, everything you would traditionally consider commodities are driven by industrial demand and to a small extent investment demand. The global economy, especially the BRIC countries, has been powering ahead in the last few years and have been one of the major factors affecting the prices of these traditional commodities. A rapidly expanding money supply has also been responsible, but I venture that the monetary cause has been cosmetic and not real. That is, if money supply doubles, the price of copper will around double. Thus, if copper has risen 8 fold and money supply only doubled, my interpretation is that the industrial demand for copper has risen around 4 fold.

In contrast, the price of gold is determined solely by investment demand. Something like 90% of above ground gold is still in circulation. Thus, money supply growth has a real effect on the price of gold. If money supply doubles, the price of gold will more than double. This is because one purpose gold serves is as a hedge against inflation (money supply growth). It's more important investment purpose, however, is a hedge against bad times. The price of gold last spiked in 1980 and steadily declined until 2000 during probably the greatest secular bull in history. This was despite the money supply in all countries expanding quite rapidly during the same era. Since 2000, the price of gold has taken off for 2 reasons: money supply is still increasing, but more importantly, the US and western Europe have now been in secular bear markets. If economic prospects worsen, expect the price of gold to take off further.

The reader must be wondering why I distinguished monetary demand from industrial and investment demand if no commodity currently qualifies. The reason is because there is a very real dollar crisis. I suspect it will not actually pan out into a crisis because the Fed will be forced to choose deflation rather than destroy the currency, but if a crisis does ensue and the public loses faith in fiat currencies, then the world may return to a de facto gold standard. Should such a scenario come to pass, I cannot begin to describe the explosive effect it will have on the value of gold. I would not be surprised to see gold increase 5 to 10 fold in value virtually overnight.

Many other commentators will maintain that gold is money. Technically, it is not because it is not the preferred medium of exchange. However, neither has it been completely de-monetized, which is why it is driven by investment demand and not industrial demand. As someone who has been long gold for a while, I can only hope that we enter a de facto gold standard. Anyone holding bullion (and not paper claims to it!) will profit tremendously.

Macro Outlook

It is my opinion that the Fed is currently faced with the choice between deflationary Scylla or hyper-inflationary Charybdis. Should the Fed navigate the economic ship towards the gaping mouth of Charybdis, all commodities will experience nominal price increases, but only gold and other precious metals will experience additional real increases. On the contrary, should a deflationary environment ensue I suspect all commodities (with the possible exception of oil and certain key grains) will experience falling dollar prices, but gold will continue to gain in value as it remains a hedge against declining prospects. Keep in mind, however, that if the environment is sufficiently deflationary, dollars may gain value faster than gold and the price of gold will actually fall, which makes trading for such an environment hard unless one is properly hedged. A relative value play is called for.

When the global economy decouples from the US slowdown, I suspect commodities at large will continue their bull market. However, in the short term, I would not be surprised to see them take a sizable knock as the true extent of the recent excesses becomes clearer.

It seems odd that I am universally bullish on gold. Surely there no such thing as a free lunch. Indeed, if it turns out that the Fed is able to navigate the stormy waters with success then the stored potential in gold will quickly dissipate. There is also the additional concern that a sufficiently deflationary environment can have a negative real effect on the price of gold. If one is long gold, one should have carefully thought-out stops in place.

For a more detailed analysis of gold's prospects in various macro environments, see: gold - how high will it go.

Even Better Than Gold: Silver

In light of our discussion, silver is a very curious case because it is both an industrial metal as well as a precious metal. Silver has many industrial uses, but has also been a monetary metal in the past. Most notably in China where I suspect the sentiment still remains. Silver should benefit from the same factors as gold, but in addition will also be in high demand when the global economy decouples from the US and the commodity bull continues. For this reason, I would venture that silver is a better, albeit more volatile, long term investment than gold. It certainly has been since the commodity boom began earlier in the decade.

Bulls and Bears

2008-02-27T12:31:00.000-08:00

Defining Bulls and Bears

Alternating bull and bear markets seem to be a fairy regular phenomenon in the markets for the last few decades. But what precisely is a bull or bear market? Investopedia defines a bull market as "A financial market of a group of securities in which prices are rising or are expected to rise." And similarly, a bear market is "A market condition in which the prices of securities are falling or are expected to fall." If you have been following my other blog on Austrian economics, especially the discussion on inflation, a definition involving rising and falling prices should sound suspicious. The most fundamental law in economics is that prices are set by supply and demand. In the case of financial securities, such as stocks, supply is generally fixed (unless there are equity offerings), so what causes price rises is increased demand. There are two factors that can drive demand. First, is improving fundamentals, and second, is an increased flow of money towards the financial markets. The former is a real change in the value of the security, while the latter is a cosmetic change. Strictly speaking, it is not purely cosmetic, because money is not neutral, but let us ignore that for now as we will reconcile it later.

One consequence of the fiat money system we currently have is that the Fed can print money causing inflation, and by extension price increases. (Technically, the Fed cannot print money, it can only monetize debt.) Money supply in the last 2 decades alone has more than quadrupled. See also M3, now discontinued. By any measure of money supply, we can see that the availability of money and credit is rising rapidly. And therein lies the problem. Imagine the fundamentals of the economy have worsened 50%, but there is 4 times as much money available. The net effect is that prices double and create the illusion of a bull market.

Unfortunately, because we do live in a world of an unstable, and rapidly rising, money supply, we must establish some way to distinguish the cosmetic rise in prices as a result of increased money and credit from the real rise in prices as a result of improved fundamentals, and incorporate that into our definition of bull/bear markets. In order to do this, we need some mechanism to correct for increased flow of money and credit towards financial markets. So what are our options? One common approach is to correct for nominal prices using the CPI. This is supposed to yield real prices as it purports to correct for inflation. Please read my articles on inflation linked to earlier to see why this is a bad approach. An alternate approach is to correct using the price of gold. Unfortunately, this too is flawed. We wish to separate out the cosmetic effect of increased money supply. The price of gold is itself controlled by supply demand dynamics that may have no bearing on this. For similar reasons, Euro's or any other currency are a bad choice. We do not want to introduce additional dynamics into the equation.

Looking At Valuations

Given all these issues with prices and correcting for them, perhaps we would be best to simply avoid prices and look at other aspects of the market. For example, consider valuations such as P/E ratios. Imagine if the growth prospects of a stock are captured perfectly by its P/E ratio. If earnings rise 50% across the board due to increased money supply and unchanged fundamentals, then we expect a 50% rise in price with the P/E ratio remaining unchanged. By looking at valuations we have quite effectively removed any money supply issues. However, there are two things to keep in mind:

We are not building fair value models. Looking at P/E, capital investment, dividend payout, return on equity, etc is intended to distinguish changes in the market as a result of changing fundamentals versus changing money supply. At no point are we claiming that stocks are fairly or unfairly valued, or that prices will rise/fall. We only attempt to understand the trend in valuations to correct for cosmetic changes in prices.
Money is not neutral. To assume so is quite dangerous. Any excess money flowing into the financial markets will not flow towards each security equally. We have humans in the loop. Humans make subjective evaluations. Money will flow as per the subjective evaluations of the market participants. However, if we look at the market as a whole, the positive and negative flows should more or less counterbalance each other. Therefore, while it may be misleading to look at individual valuations, market valuations can be informative.

Secular Market Trends And Treasury Yields

We have argued that bull/bear markets are not marked by rising/falling prices, but rather by rising/falling valuations. This distinction is necessary to distinguish the real effect of changing fundamentals from the cosmetic effect of changing prices. Because bull markets experience rising valuations, they also experience rising prices. However, bear markets may not experience falling prices even though they experience falling valuations, as there is an interplay of declining fundamental value and rising cosmetic value. Nominal prices can actually be quite stable, or even rise.

We should also distinguish secular and cyclical bull/bear markets. A secular trend is a long term trend, usually lasting around 17 years. Within a secular trend, there can be many cyclical trends lasting a few years. John Hussman of Hussman funds has recently written on the topic of secular bear markets. His claim is that a "secular bear is self-evident." To make the argument he uses valuations instead of prices, recognizing that secular bear markets can actually have multiple cyclical trends within them.

His other approach is to compare stock market returns to treasury yields. He poses the simple question whether one should expect the stock market to outperform t-bills over the next decade. Indeed, this is a very pertinent question. Secular bear markets, despite cyclical bulls that bring volatility to prices, should not be expected to outperform t-bills over the course of trend. The relevance to any buy and hold investment strategy should be apparent. I refer the reader to Dr. Hussmans article for further details.

The Market Today

I agree with Mr Hussman that the US is currently in a secular bear market that commenced in 2000, but has experienced a cyclical bull for the last 5 years. It appears as though the cyclical bull has topped and has given way to a cyclical bear. For a detailed analysis of secular and cyclical trends in the US markets for the last century, complete with colorful graphs, I refer the reader to Adam Hamilton's work on long valuation waves.

Historically, the US has tended to observe secular bull and bear markets lasting 17 years on average. During a secular bull, valuations go from 7 times earnings to in excess of 24 times earnings, with around 14 times earnings being the long run mean. A secular bear then proceeds to knock valuations down to the 7x range before a new secular bull can commence. Currently, the markets appear to be around halfway through the secular bear in both time (start: 2000, end: 2017) and valuation (2000: 44x, 2008: 24x).