I've had a revelation that I thought I'd share with the thread. As most of you know, I spend a great deal of time thinking about the big picture. One of the things that has bothered me immensely is not understanding how it was possible for Greenspan to have doubled the money supply in the past six years with hardly any of the expected inflationary consequences. My lack of understanding here has prevented me from being comfortable buying long-term bonds or any other inflation-sensitive security, and pushed me wholly into short sales and short-term money instruments as an investment strategy. When I was out surfing yesterday, contemplating investment strategies for my father and grandmother, it finally occurred to me what was going on, and the major implications that accompanied the scenario.
For those who want the Cliff Notes version, let me summarize. What I realized was that the recipients of the money supply increase influence the kinds of inflation that appear. We've had massive inflation over the course of the bubble, but because of the unique economic conditions, the money supply increases weren't evenly distributed across the whole of society, and that caused the inflation to appear only in certain places. My thesis is that the doubling of the money supply in the past six years, the $4 trillion created, went almost exclusively to the wealthiest economic participants (this term includes people and corporations both). Why is that important? Because money creation, when focused on the wealthiest slice of the economy, doesn't result in a proportionate increase in consumption, and therefore doesn't drive commodity or wage inflation. Multiply Gates' fortune 10X, for instance, and he doesn't consume 10X as much in goods and services. However, it *does* impact the prices of the things the wealthy exchange among each other: stocks, real estate, and other assets.
I think this is a simple explanation for why we've been able to have massive money supply increases (a 2:1 split in the US dollar basically) with the result being a massive asset inflation but virtually zero commodity and wage inflation, and continued declining long-term interest rates. The excess capacity and inability to stimulate excess aggregate demand has meant that money creation has been limited to the richest entities, and not flowed into the whole of the economic system as it would if the aggregate supply and demand were in balance.
Going forward, it means there is no pent-up inflation risk. The inflation that is going to happen from the exploding money supply has already happened; it's just limited to asset inflation. Capacity and employment conditions will see to it that we see no commodity inflation, no wage inflation, and low interest rates for the forseeable future, potentially ten years or more. Future money supply increases *will* be increasingly limited to asset inflation, but with the value of the underlying corporations declining at rates comparable to the money supply increases, the absolute price level for equities may go either way. But here's the huge conclusion: when the money supply increases cease, there is another massive asset deflation looming. Keep an eye on that money supply; when the Fed runs out of pedal travel, the S&P will finally succumb to the gravity as we've all predicted.
For those who want my unabridged ramblings, they follow:
First, let me admit that I was early in noticing the bubble, and early in my exit. I realized the bubble existed in 1998 when looking at multi-decade channel breaks by all the stock indicies. I unfortunately started my hedging activities in late 1999 after the supposed monetary tightening by the Fed. I knew an historic economic event was underway, and I wanted to survive above all else, but I lost money fighting against the bubble months too early.
We are now at T+18 months and counting since the peak of the asset bubble. I, like most of the bears, hoped for and predicted a quick bear, and my patience has worn thin from time to time, as it is now. I keep returning to long-term histories of 1990s Japan and 1930s DJIA, reviewing the stunning short-covering rallies amid collapsing fundamentals. The longest was the 20+ week rally in the Nikkei after the first major leg of the bear. We are now in a similar bounce, and I am re-evaluating my strategies as well as those of my loved ones. My conclusions:
1. AGGREGATE ECONOMIC ACTIVITY WILL CONTRACT FOR SEVERAL YEARS
Regardless of how the government measures and reports the statistics, regardless of inflation or deflation, the true GDP will shrink for several years here. The GDP seen in 2000 was based upon debt; it required borrowing equal to 7% of the GDP by the private sector, which can't be repeated in a post-bubble peak environment. I know nobody likes to hear these words, and I don't mean that we are bound for a repeat of the 1930s, but the period we have entered will be the worst economic environment since the 1930s, and may be referred to as the first depression since those times. Webster's says that a depression is a period of sharply contracting economic activity characerized by falling prices and high unemployment, and we will have plenty of the above. This recession is unlike any that have preceded it in terms of excess capacity, asset deflation, commodity deflation, and global synchronization. I'm not here to defend this postulate though.
2. THE BUBBLE IMPACTED NOT JUST TECH STOCKS, BUT ALL ASSET PRICES INCLUDING EQUITIES AND REAL ESTATE.
It's important to understand that the scope of the bubble includes far more than the record-setting Nasdaq bubble. And while the Nasdaq bubble has for the most part burst, the actions of the Fed to fight the outgoing tide have kept the rest of the bubble afloat - for now. Before we are done here, the S&P bubble and the real estate bubble must be purged from the system. The bear will see to it.
3. THE NATURE OF THE MONEY SUPPLY CREATION HAS RESULTED IN ONLY ASSET INFLATION, NOT COMMODITY INFLATION
M3 has surged from $4 trillion to $8 trillion in the past six years. This is immense! It amounts to a hidden 2:1 dilution of anyone holding US dollars. Had it happened by decree, overnight, one would expect an immediate doubling in the prices of all assets, goods, and services. However, it did not impact those three elements equally. Pricing for goods and services hardly budged, as asset prices - stocks and real estate - soared. Understanding why that happened is key to any long-term projections of price movements.
4. THE VAST MONEY SUPPLY EXPANSION DID NOT END UP IN THE HANDS OF THE AVERAGE CONSUMER
My preferred explanation for this unexpected behavior is the unusual concentration of "wealth" that has occurred. Or, I should say, will occur. Money is not truly wealth; only assets are wealth. In the past six years, the Fed has created $4 trillion of new money, but the vast majority of this money did not end up in the hands of the average consumer. Rather, it was created at the expense of the balance sheet integrity of the average consumer. Think about money for a second - it is the OPPOSITE end of debt. When money is created, and equal and offseting debt is also created. We can infer by the statistics on the net debt load of consumers that they have not accumulated any of this increase in the money supply - meaning that the money created ended up in the hands of the richest few percent, as well as the corporations financing them.
The other evidence is the lack of wage inflation. Since wages have not kept pace with the money supply increase, the average wage earner has lost ground - not to commodity inflation, but to asset inflation. It now takes the average person several more years' salary to purchase a house outright, but the impact has been hidden from him through plummeting interest rates. Where debtors used to get inflated out of their debt loads, they are increasingly stuck with them.
5. THE ASSET INFLATION IS A LOGICAL RESULT OF MONETARY CREATION AMONG THE WEALTHIEST ENTITIES IN OUR ECONOMY
The wealthiest corporations and people in our economy are unlikely to actually *consume* with their winnings. Wealthy CEOs don't rush out and eat ten times as much food, eat out ten times more often, or buy ten times more electronic gadgets when their income goes up tenfold. The money created isn't going to those who are likely to consume with it; it is more likely used in the swapping of non-consumable assets. As a result, we observe equity and real estate inflation, but no commodity inflation. It may seem like I'm harping on this here, but it is extremely important to understand the nature of this monetary inflation.
6. THE MONEY SUPPLY INCREASE ENDED UP IN THE HANDS OF A SMALL MINORITY WHO WILL CONCENTRATE REAL WEALTH AS THE DOWNTURN PROCEEDS
Is there a price for handing the wealthy a $4 trillion gift? Of course; it's just a mortgage on the future.
As the downturn progresses, more and more average people will find themselves unemployed and overleveraged. What has basically occurred is that the wealthiest entities have given all the average consumers enough debt to hang themselves. Those who took enough rope and are unlucky enough to find themselves unemployed will end up forfeiting assets to their creditors as a result. Those creditors who were wise enough to back their loans with assets will accumulate real wealth through the increasing bankruptcy proceedings; those who lent unwisely (Providian et al) will find themselves also bankrupt. This is when the $4 trillion created since 1995 will resurface - to liquidate the country in a massive asset transfer from the cash-poor to the cash-rich.
7. NO COMMODITY OR SERVICE INFLATION WILL RESULT FROM THE MONEY SUPPLY INCREASE DUE TO OVERRIDING DEFLATIONARY PRESSURES
The notable lack of commodity, service, and wage inflation results from the overcapacity that exists in our system, and it will take several years to abate. This overcapacity comprises capital equipment as well as labor, and will apply downward pressure to commodities, finished goods, and wages for perhaps the next decade. As the positive feedback from a highly leveraged economy pushes more corporations to cutbacks, unemployment will continue to rise, and the very parties that the Fed hopes will pull us out of this tailspin will continue to suffer deterioration in their position.
8. THE ASSET INFLATION THAT WILL RESULT FROM THE MONEY SUPPLY INCREASE IS LARGELY COMPLETE
The money created by the Fed impacts the system very quickly, particularly in the asset realm. One should expect asset prices in general to continue to track money supply growth, but that growth is likely nearing an end. With only a few more interest rate cuts at its disposal, the Fed will soon be out of the primary motivator for money supply creation, and the final prop underneath the stock and real estate bubbles will finally give way.
If you're wondering how I figure that stocks have continued tracking money supply growth, I figure that based upon measures of price to book, price to sales, and price to earnings. I see a market that, in general, is now *more* expensive than the absolute top in March 2000. So, the remaining money supply expansion may not result in absolute gains in equities, but this is due to the deterioration in the underlying asset value. As the value drops and the valuation increases, the net price movement will be less positive than money supply growth for this reason.
9. LONG-TERM INTEREST RATES ARE HEADED EVEN LOWER, AND FOR A LONG TIME
Long-term interest rates fell to below 4% for the bulk of the 1930s, 1940s, and 1950s, as the combination of excess capacity and weak aggregate demand limited inflation and capital demand. Even corporate bonds fell below 4% yield! As no commodity inflation should be able to occur here, we should see a similar extended period - potentially decades - of low interest rates and stable prices. Return on invested capital may actually be zero or negative for most, as the supply of capital exceeds the reduced demand.
10. FOR NOW, BONDS, UTILITIES, AND SHORT SALES ARE THE ONLY REASONABLE ALTERNATIVES TO CASH
As the brewing depression unfolds, there will be hardly any safe havens. Excess capacity nearly everywhere will compress corporate profitability for years, and if there is a credit risk somewhere in the system, this 100-year flood will expose it. Until the money supply growth stops and the asset deflation runs its course, you should stay in long-term fixed income securities and utilities, which have the benefit of operating in a regulated environment. If there are other regulated industries I'm not thinking of, please point them out to me. I see the health industry as one other potential safe sector. Other than that, the only other logical course is short sales, which are inappropriate for most investors.
11. WHEN THE MASS DEBT PURGE OCCURS, THOSE WITH CASH SHOULD STEP UP TO LIQUIFY THE SYSTEM
The asset deflation is going to be truly impressive, but in aggregate, it will not happen until the money supply stops increasing. Once it does stop expanding, we should await the usual signs that the bear is finally approaching an end, and step in to buy for another incredible period for equities. Watch for undervaluation by historical metrics: price to book, price to sales, price to earnings. Watch for excessive pessimism, not by 1990s bull standards, but all-time historic highs. Watch for massive insider buying. And, potentially even more important, watch for the money supply to resume growth after a period of lackluster growth. This resumption of growth will come not from Fed pressure on short-term rates, but due to the system finally deleveraging to a point where confidence is restored: confidence that debts will be paid, and confidence that a sustainable rate of growth can be supported.
When this deflationary period ends, buy-and-hold will once again yield stellar results. A new bull will be born, yielding double-digit percentage gains, even after inflation, for many years to come.
BC |
