Wednesday, October 29, 2008

The Great Debate: Is the Fed Too Loose or Too Tight?

I have had a running debate with other blogsters regarding the current Fed policy of loose money. Being a student of history, especially the Great Depression, I know that one of the biggest factors contributing to the Depression was the fact a conservative (Hoover-led) government, Treasury and Federal Reserve kept money tight after the stock market broke down in October 1929. In fact, the Fed raised its Federal Funds rate in 1930 as it reacted to the perceived inflationary threat showing up in reports from data generated in 1928 and 1929 during the Roaring 20s Bubble.

I have contended that as assets aggressively contract, primarily real estate the past two years, some offset is needed to balance the national books. Otherwise, we have a deflation by definition (to little money chasing too many goods) and deflation is never a good thing as it causes people to save excessively (hoard) and not spend. This stops the economy and also feeds on itself. Some of my blog opponents feel that we should just let Free Markets work; that the market will do a better job of solving our problems than government. But history shows otherwise. A free market is a great thing during normal times, but it is too severe a master during times of stress.

To help me make my point, I am borrowing a column from "Barrons Online" posted yesterday. It says all that I have been trying to say, but more eloquently. Here it is:

TUESDAY, OCTOBER 28, 2008
UP AND DOWN WALL STREET DAILY

Pushing on a String or at the End of Their Rope?
By RANDALL W. FORSYTH

Sado-monetarists decry the doubling of the Fed's balance sheet, but is it enough?

THE FEDERAL OPEN MARKET COMMITTEE begins a two-day policy meeting Tuesday amid what now is conceded to be the worst financial crisis since 1930s. And, as in the Great Depression, the U.S. central bank is being criticized for being too easy and risking inflation amidst a severe debt deflation.

The Fed has doubled the size of its balance sheet in just seven weeks to attack the crisis. That has elicited squawks from what Barron's much-missed late friend and colleague, John Liscio, called the "sado-monetarists" who think that the central bank's efforts to cushion the pain of credit contraction invariably puts us on the road to perdition. As when he coined the phrase back in the early 1990s, the Fed is expanding its credit to offset the contraction in credit in the private sector.

Michael T. Darda, chief economist of MKM Partners, notes the Fed has expanded its balance sheet by $900 billion since early September, a seeming eternity ago when the Mets were cruising to the post-season and temperatures were sizzling. But that seemingly Zimbabwe-like 206% annual rate of increase in the Fed's assets in the latest 26 weeks hasn't ignited a monetary inflation. Quite the opposite, in fact.

A record percentage -- nearly 25% -- of the high-powered money the Fed has provided effectively sit idle as excess reserves, Darda points out. In other words, banks are sitting on a huge precautionary cushion. Banks are hoarding cash and are loath to lend to each other except for overnight periods.

That means banks are unlikely to unleash a new, inflationary wave of lending; quite the opposite. Yet the high levels of excess reserves in 1937 caused the sado-monetarists of the day to sound the inflation alarm back then and spur the Fed to tighten. That aborted the recovery and extended the depression, resulting in a resumption of the bear market. (Note: check out long term stock price charts and you will clearly see how the stock market cratered in 1937 due to this Fed tightening).

This time around, the deflationary symptoms are everywhere. Industrial commodity prices have been halved while the 30-year Treasury bond yield has sunk to its lowest level ever, under 4% last week. Gold has plunged to around $700 an ounce from $1,000 while the dollar has surged. And risky asset classes have melted down, he notes.

While the Fed is pumping more reserves into the banking system, less is being transformed into broad money and credit. And that money is turning over more slowly (velocity is falling, to use the economists' jargon.) The combination renders Fed policy "far less potent than it would otherwise be," Darda concludes.

That leaves the question, what's the FOMC to do at this point? The consensus of Fed watchers and the futures market is that the panel will cut its federal-funds rate target another 50 basis points (half percentage point) to 1% when it announces its decision Wednesday at 2:15 PM EDT. That would leave the Fed's main policy rate at its previous nadir touched in the past cycle and would, in effect, leave it relatively few basis points left to cut before the funds rate reached zero.

"The question is what the Fed does next," write ISI's Washington policy analysts, Tom Gallagher, Andy Laperriere and Melissa Loesberg. "We think it might have one more conventional rate cut before resorting to unconventional measures. But the real answer is that the Fed will wait for fiscal policymakers to take their turn," they conclude. (Note: this will come in the form of another national "special rebate" of around $1000-1500 that will be passed by Congress during a special session in November and distributed in time to impact Christmas spending, so I predict).

Goldman Sachs' economists also look for a 50 basis point cut from the FOMC but think a 75-basis-point slash, halving the fed-funds rate to 0.75%, is a 33% possibility. An important factor in the FOMC's decision will be the results of the Fed's latest quarterly survey of bank loan officers, which Goldman notes the policy makers will have in hand. This survey, taken in September, will be made public next month. The previous survey released in August showed a sharp tightening in credit standards for consumer, mortgage and business loans.

In other words, the Fed has been pushing on a proverbial string.
More than pure quantitative measures, price indicators show persistent credit tightness. Spreads between market interest rates and risk-free or administered rates have come in from their peaks, but remain elevated.

In particular, the three-month London interbank rate has come down to around 3.50% as of Monday, from the peak of about 4.80% on Oct. 10, but this benchmark remains above the 2.80% that prevailed in September before the Lehman bankruptcy and the Fed's 50-basis-point cut, to 1.5%, on Oct. 8. (Note: Why is Libor still so high, when the Fed keeps pushing the Funds Rate lower? The answer is that banks don't want to lend to each other, or are afraid to, after so much bank carnage. This means that what interbank lending does occur, does so at a higher interest rate than in a freer, less risky market. This impacts us because Libor is the index for many consumer loans and mortgages, and is also a barometer of economic health).

Three-month Libor also remains elevated against OIS -- the overnight interbank swap rate, which reflects the market's view on the fed-funds effective rate. The Libor-OIS spread is down to 263 basis points from a peak of 366 basis points on Oct. 10. But before the crisis, when banks were willing to lend to each other, Libor-OIS was a relatively trivial handful of basis points.

Getting Libor down is a more important, though less visible aim of the FOMC. The Fed's program to purchase commercial paper, which commenced Monday, should take further pressure off the money market. The Fed initially set a rate of 1.88% for top-grade three-month paper Monday, far below Libor, which should help to continue pull the interbank rate lower, according to Banc of America Securities' head of credit research, Jeffrey Rosenberg.

The Fed's unprecedented push of liquidity may have nearly doubled its balance sheet but it still has not offset the private sector's need, according to Bridgewater Associates. The world has accumulated so many dollar debts, and the ability to refinance and expand these debts was so ingrained in the financial system that its breakdown requires an unprecedented response from the Fed. But with so much of the global financial system out of the reach of central banks, the risks to policy makers are numerous.

With debt deflation engulfing the credit markets and the economy here and abroad, the sado-monetarists should get over their Whip Inflation Now fetishes.

Monday, October 27, 2008

After the Bottom, Then What?

Some day soon, maybe today, maybe in a month, the stock market will find its bottom. Some technicians are predicting 7500, which is the same as the market lows in July 2002 and March 2003. Those form a natural line of resistance for the DJI. Others, like Art Cashin, the CNBC old-timer floor trader, thinks it might be 7000. It is very unlikely the market would crash down to 5000 or 4000. That would require the economic depression scenario, since it will require much lower aggregate corporate earnings to drive stock prices that low. Most think a depression is possible only if the global bankers do not respond with aggressive money creation. So far, the central bankers have responded.

What will be the investment class that does best coming out of the market slump? If you think that all the liquification to unfreeze the financial markets comes with the price of much higher inflation, as I do, then the best place to be will be asset classes that benefit from inflation: hard assets / commodities.

Have you noticed how the global deflationary environment rewards currencies that are doing the most to reinflate their economies, like Japan and the USA? The dollar has soared the past two months from $1.60USD per 1 Euro, to $1.20USD to 1 Euro, a 25% move. The turnaround in Japan is even more dramatic. The yen is now trading at 92Y per $1USD while it was at 120Y per $1USD just a few months ago. The Euro has weakened against the Dollar and the Dollar against the Yen. The Euro has weakend by 40% to the Yen in just a few months. Amazing! And disruptive! How can Japanese export goods compete in Europe after such a currency move? The answer is, they can't. This is why the Japanese Nikkei stock index dropped to a 26 year low today.

This is all about the unwinding of the "Yen Carry Trade" where global investors borrowed the very cheap yen, with interest rates in Japan at only 0.5%, and loaned the same money in other countries at much higher rates, or used the funds to finance commodities futures transactions, which helped drive up commodity prices. With the trade now in full-speed reverse, all that borrowed money is flowing back to the Yen as traders and hedge funds sell their positions and repay their Yen borrowings. As they do so, they convert some / most of their Yen back to US dollars, which strengthens the dollar. Because they are preparing for fund redemptions, they put the funds in very short term, super safe US Treasury bills. This causes competition for Treasury bills causing the interest rates on those instruments to drop to ridiculous low levels of less than 0.25%.

Even the Canadian dollar has gotten into the game, and has gone from parity at $1C per $1USD to $0.78C to $1USD in just a couple months.

On this last point, it has made the performance of the Canroys and other Canadian stocks more dismal when converted to $USD. My Canroy stocks, like Pennwest, Pengrowth, Provident, Canadian National Resources and Daylight Energy, are all down 50% or more the past two months. So is DHG, the closed end high dividend fund that is heavily invested in Canroys. About 1/3 of this decline, though, is the exchange rate. The other 2/3 of the decline can be attributed to the decline in the price of oil, which itself is because of the unwinding of hedge and mutual fund positions. That is a temporary phenomena, so long as I don't have to sell. Since mine are (now) completely unlevered retirement funds, I can hang on till the environment changes. Most of the Emerging Market stocks (Brazil, Mexico, Russia, etc) share with Canada their reliance on commodities for their economy and currency strength. So, emerging markets will also benefit from a global change in sentiment.

What will cause this change? Reflation. Once the markets, and then the economy, bottom, and economic growth reappears here in the USA, but even more dramatically in the emerging markets, global demand will once again increase for all things commodity: energy, grain, metals, chemicals and gold. I do not believe that the global banking system is nimble enough to take all the liquidity back out of the market that has been put in to save the financial system, as fast as will be necessary to avoid inflation. I think inflation, maybe relatively high inflation of over 5%, is a certainty within 24 months. The pain to avoid inflation will politically be just too great, as it will require buying back the financial instruments issued to flood the economy with money. When central banks buy back financial instruments, they raise interest rates in the process and make capital more scarce. It will be hard to take actions that will hurt the economy almost as soon as it starts to get repaired.

So, if you can stomach the volatility, and if you are still invested today, then I guess you have proven you can, hang on to your energy and commodity stocks. If possible, buy more, or at least reinvest dividends to capture more stock at the current low prices. The next couple years will not be much fund. But eventually the sun will shine. And if the 1970s are any precedent, it will shine most brightly on asset classes that benefit from too many dollars chasing too few goods.

Bill Gross, the oft quoted chairman of PIMCO Advisors and global bond guru, agrees with this perspective. Today on CNBC he made took a similar position (I was just happy to be aligned with his perspective, certainly not the other way around). I have posted his appearance for your viewing pleasure (see right hand bar).

www.cnbc.com/id/15840232?video=906626482

Saturday, October 25, 2008

What is Next for our Economy and Currency?

Reading Barrons today, I came across a good piece by editor Thomas Dolan. It reflects on where we are as a nation and world in respect to our economic system(s). It questions what will be the new-world order for exchange. I will paraphrase and add my own comments:

""The worst financial crisis since the Great Depression is claiming another casualty: American-style capitalism." The French president, Nicolas Sarkozy, has announced, with neither a trace of an accent nor a trace of sarcasm, that "Laissez-faire is finished."" And that is good, isn't it? Laissez-faire as a recipy for economic disaster. Humans are driven by greed and fear. Left alone in a capitalist economic system, people will try to maximize their own personal gain at the expense of their fellow man, the definition of greed. SOME regulation is required to keep man from hurting himself in his primative drive for economic gain.

As Dolan quotes and interprets, correctly in my opinion: "In one of the more lucid passages of Das Kapital, Karl Marx said, "In every stockjobbing swindle everyone knows that some time or other the crash must come, but every one hopes that it may fall on the head of his neighbor, after he himself has caught the shower of gold and placed it in safety. 'Après moi le déluge!' is the watchword of every capitalist and of every capitalist nation.""

America is painted by some as the land of greed, and in fact, many in this land act greedily and without regard for their fellow man, as will most people given the opportunity and means, and with NO limits or regulation. It did not help that after World War 2, America's was the only significant economy left standing in the world. Because America had the only functioning industrial complex, by lieu of geographic isolation and friendly status with the border nations of Mexico and Canada, when world finance leaders met in New Hampshire in 1944 to repair the world financial system, the decision was made to index all other currencies to the US Dollar, and the dollar to gold in what was called "Bretton Woods".

http://en.wikipedia.org/wiki/Bretton_Woods_system

As Thomas Dolan continues: "(The agreements reached at "Bretton Woods" were) dictated by the United States. It reflected the astounding dominance of America in the world economy (near the end of) World War II. The U.S. accounted for 40% of global economic output and had at least 80% of the gold reserves. Only the dollar was credible enough to be pegged to gold; other currencies could be pegged to the dollar. Thus, the U.S. became the world's creator and judge of money."

"The U.S. eventually abused its power to create the world's money, flooding the globe with unwanted dollars in such profusion (during the Johnson Presidency years of "guns and butter" during Vietnam and civil unrest), that it couldn't redeem them for gold (when foreign Central Banks so tried in 1971). In 1971 (the US governmnet) admitted that, went off the gold standard and left the world and itself with no restraints on the creation of money and credit."

I don't think it is possible to go back on the gold standard, nor is it wise. Gold and other forms of hard asset economic regulation do not reflect the ability of mankind to grow its economic value. Humans are creative and productive. We can make more with less as we apply intellect to practical problems of life. A currency fixed to a finite amount of gold does not reflect this fundamental truth. This is why gold as financial proxy does not now and never has worked.

What is needed is a GLOBAL method to measure in real time, human productivity and growth, and index the sum of tradable financial instruments to the sum of all productive capacity. This will allow economic growth without artificial restraint, but will also allow expansion without risk of inflation and currency devaluation. Accompanying this new form of financial index should be investing and banking regulations that are tight enough to ensure transparency of all financial structures and transactions, along with limits to leverage; but still loose enough so as to not choke off risk taking that leads to economic expansion and opportunities for everyone.

How can this be done across all economies around the planet? Greater minds than mine will need to figure this out. But it is worthy for global leaders to try to find a way. Do we need a Bretton Woods 3?

Saturday, October 18, 2008

Buffett Believes in America, Shouldn't We?

This editorial from the NY Times has already received a lot of public attention. But in case you did not have a chance to read it in full, I thought I would make it available to you. I have my arguments with Buffett on his politics, but regarding his investing acumen, there is no doubt.

If American stocks are good enough for him now, they are certainly good enough for me. So I am 100% invested in the stock market as of today, mostly large cap, secure and high dividend producing stocks and mostly in the energy / commodities space, since I am fairly certain we will have price inflation in commodities when the economy rebounds.

"Buy American. I Am. "
http://www.nytimes.com/2008/10/17/opinion/17buffett.html

By WARREN E. BUFFETT
Published: October 16, 2008

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities.

Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.