This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Monday, November 30, 2009

The Deflation Debacle and Our Road to Recovery

The Deflation Debacle and Our Road to Recovery
Dock David Treece
11.25.09

As the endless stream of economic data continues to flow, let’s review our calendar of economic and monetary events.

Over recent weeks we have heard arguments back and forth by bankers, economists, et al, all weighing in on the inflation/deflation debate. Much of the disagreement in the inflation/deflation debate can be traced back to varying definitions and underlying assumptions. As a prime example, we have seen commentators bounce back and forth with regard to how they define inflation, as well as how they measure it.

After hearing references to everything from money supply growth and CPI to foreign exchange, we consider it of utmost importance that all commentators work from the same textbook. Without going into excessive detail, let us say that our definitions, which have remained consistent, are the following:

Inflation: a monetary event consisting of an increase in money supply in excess of growth in GDP over the same period.

Deflation: a decrease in the money supply circulating through the American economy that is not due to the destruction of wealth

Price inflation: measured by CPI, a symptom of monetary inflation that might also be due simply to supply and demand

Debt deflation: a loss of value on an asset that serves as collateral for a loan that leads to losses on the part both the bank and the creditor, who now has negative equity

In the near-term we still consider deflation to be a substantial threat to the global economy. We are particularly concerned with the prospects a second wave of debt deflation, spurred by another surge in real estate defaults, this time in commercial properties.

What’s more, with troubles in commercial real estate rapidly approaching, housing is still hardly out of the woods. With nearly 15% of Americans are behind on their mortgages (Mortgage Loans: Record number are late, CNNMoney.com), 23% are underwater on their homes (now having negative equity) (The Negative Equity Report, First American CoreLogic), and 7 months of inventory is sitting on the market (October 2009 Existing Homes Sales, Bloomberg), it seems hardly likely that housing will be returning to its glory days anytime soon.

As a brief side-note, after watching the activity of the Treasury and Federal Reserve for months and wondering why they continued to let banks hoard cash in excess reserves, be believe that we have finally found an answer in this theory.

We now believe that the Fed and the Treasury are both aware of the coming problems in commercial real estate, and they are allowing, nay encouraging banks to stockpile massive reserves – rather an extend credit to individuals and businesses – in order to cushion their books for a coming wave of write-downs in commercial real estate.

We find support for our hypothesis of coming debt deflation not only in bank losses/write-downs, money supply growth numbers, and a still-decreasing demand for consumer credit, both new and outstanding, but also in price indicators which typically measure the symptoms of inflation, namely CPI and PPI.

Consumer Prices as a whole are down from this time last year (CPI, St. Louis Fed), and since stopping their decline a major portion of increases in prices can be accounted for by increased energy costs that are more a function of a weaker dollar in foreign exchange – remember, oil is priced in dollars – than inflation.

In the longer-term we consider inflation to be a substantial threat to the global economy, particularly in the United States. Remember that an incredible amount of money was created out of thin air by massive government bailouts, and in all likelihood will continue as a result of quantitative easing.

That new money is presently creating a bubble in stocks and commodities that is being perceived by many economists as inflation. They’re wrong; the real inflation, an increase in money supply beyond growth in GDP, occurred with the expansion of money supply over the past decade, culminating with the government bailouts. “Inflation,” as defined by increasing prices and a currency declining in value, won’t occur until all this new money makes its way into the economy.

Inflation ultimately will become an issue. The government can’t double the monetary base without consequence (St. Louis Adjusted Monetary Base, St. Louis Fed). However, price inflation will not become a real factor until a true economic recovery begins.

This recovery will be characterized by the free flow and expansion of credit, otherwise known as an increase in velocity, which is thus far still contracting as the US savings rate climbs. Once velocity does pick up and the real recovery starts, inflation will be a major concern. However, it will be characterized not only by an increase in prices, but also in wages.

Remember: even Zimbabwe, with its recent run of hyperinflation that left its dollar worthless, experienced wage inflation along the way. Wage inflation is something that this country is, in our opinion, far from experiencing.

At this point unemployment is too high, too long, and still growing for there to be any kind of significant economic recovery. In our opinion, seldom are jobless recoveries are the real thing. This is evidenced by recent reports, durable goods among others.

It’s important to remember that the stimulus plans that were passed were never meant to foster an economic recovery, just to give the banks the keys to the Treasury. This administration, in the words of Hilary Clinton, does not want to waste a good crisis. The problem is that the crisis has gotten way out of hand, and the administration’s total lack of understanding of economics is becoming well-known.

At some point we as a country have to get beyond this crisis. If this administration doesn’t get us past it, rest assured that the next one will. What we desperately need is to find a sector that can provide the kind of jobs needed to pull us out. Unfortunately, we can safely say that the sector to lead this recovery will not be auto (which led in the 1980s), housing (as it did earlier this decade), tech (1990s), or green jobs, especially after everything that is now coming out about the Hadley Institute.

In our opinion, the only two sectors that might foster the kind of job growth that is required in an economic recovery could be energy (of all types, not just “green”), which also led a recovery in the 1980s, or possibly manufacturing (which led almost every economic recovery before 1980), if the recent trend continues of bringing back these kinds of jobs from overseas.

One major problem is manufacturing coming back to this country is that it is a long process. It took years for manufacturing to move abroad as outsourcing became popular. To bring it back requires massive investments in facilities, commercial processes, etc.

However, an even bigger obstacle standing in the way of creating both energy and manufacturing jobs is government. In order to encourage the kind of investment that is needed to create jobs, encouragement is required in the form of both deregulation and tax incentives. However, neither of those, much less job creation in any form, is on this administration’s agenda.

Monday, November 23, 2009

Economy May Prove a Grinch

Will Christmas 2009 turn out to be the season of scrooge?

As Black Friday approaches, around the world all eyes focus on retailers. While consumers prepare for some great deals on holiday shopping, investors and economists prepare for an influx of data that will provide significant insight into the health of the global economy.

Most readers know that Black Friday is the Friday after Thanksgiving. Fewer understand why: the majority retailers operate at a loss from January through November, and make their profit during the holiday season – or get “back in the black,” in accounting terms.

After Black Friday, bargains for this holiday season are likely to keep getting progressively better as the holidays draw nearer. However, physical inventory will likely fall as retailers make it their top priority to liquidate inventory.

Of course, holiday shopping this year is likely going to be weighed down by several economic factors. With the unemployment rate near 10% and the so-called “underemployment” rate, which includes workers whose hours have been reduced, over 17%, many Americans will be forced to cut back on their holiday spending.

Recently several big banks made headlines when they hiked up interest rates on credit cards to nearly 30%. This too will undoubtedly have a negative impact on retail sales this season as many shoppers will find it much more expensive to finance their holiday shopping.

Finally, with mortgage delinquencies and bankruptcies nearing all-time highs – with little sign of slowing – the retail sales numbers for this holiday season will provide valuable insight into Americans’ state-of-mind in these trying times.

The real question is whether Americans have the discipline to cut out unnecessary spending, or whether priorities in this country are so mixed up that holiday shopping actually takes precedence over a mortgage.

Despite these negative factors, retailers will surely see a spike in sales this holiday season, although numbers will likely be much less impressive when compared to seasonal sales of previous years.

However, no matter what the numbers are they will undoubtedly be spun in the most positive way possible to suggest that the worst is over and the economy is on the road to recovery.

For economists it is even more important this season to look past the numbers when drawing conclusions. For example, looking at same-store sales this year won’t give an accurate representation because too many competitors have gone out of business (case-in-point: Circuit City). Instead, it’s important to look at overall retail sales to weigh the success of this season’s shopping.

Monday, November 16, 2009

Headlines Reveal Investor Optimism

For eight weeks we have argued that the stock market is overbought, that we do not believe the economic fundamentals support this recent rally, and that a pullback should be occurring soon in order to realign the market with a realistic economic outlook.

However, week after week the market has continued higher, and as it has done so we have continually asked ourselves what we could have missed in our analysis. We have been forced to question our stance and ask ourselves whether what we are seeing truly is the economic recovery for which we have all be anxiously waiting.

In considering this possibility, we have looked at many arguments from differing perspectives. What we'd like to do is share some highlights with readers, which we believe support the idea that the recovery has truly begun:

National City Bank of New York anticipates an early recovery. Admits that so
far recovery hasn't been marked, but "business has been on the
down-grade for nearly a year and in the past 30 years depressions have rarely
lasted for a longer period". Says the danger now is excessive pessimism as
opposed to a year ago when it was optimism. Admits serious problems including
the worldwide business downturn and fall in commodity prices, but the country
has repeatedly demonstrated ability to recover in the past. For the last 30
years, with the possible exception of ..., when business has begun a depression
in one year it's always at least started the recovery before end of next year.
True that if we look back further there have been some more prolonged
depressions (panics of 1873, 1884, 1893). But U.S. business was much less
diversified then, and "lacked the recuperative power demonstrated in more recent
years". Also, money markets were uncertain then, as opposed to current easy
money conditions. With credit conditions this favorable and the past record of
recoveries, predicts a recovery starting slowly in the summer and apparent by
fall.

- Wall Street Journal, Market Commentary, June 2

Harvard Economic Society predicts stocks will go up because of easy money
and favorable business prospects. "Though business activity continues to make
unfavorable comparison with that of a year ago, May transactions in the
aggregate, as measured by bank debits through the 21st, have shown more than the usual slight seasonal gain over April."

- Wall Street Journal, Market Commentary, June 3
Market students have been encouraged by the general gloom for the past two
weeks. This contrasts with the "new era" thinking of last summer when no end was seen to the rise in stock prices and margin debt was hitting a record every
week. History says the current gloom is just as mistaken as last summer's
unjustified optimism. Historically there has been no case in this country since
1900 when business failed to turn upward the year following a depression.


- Wall Street Journal, Market Commentary, June 16


As you will notice, all of these headlines are from June. However, if they don't look familiar, that's because they are all from June of 1930 (News from 1930, newsfrom1930.blogspot.com).

For a brief historical background, readers should recall that the stock market crashed suddenly in October of 1929, beginning on Black Monday (October 14, 1929) and finally bottoming in mid-November.

After bottoming in November, stocks (as measured by the Down Jones Industrial Average) recovered over several months, staging a 25% rally from the bottom and recovering nearly half of the losses incurred. That lasted through mid-April.

In mid-April the market started back down in what everyone believed was a short-term market fluctuation before stocks would continue higher. As the news stories above illustrate, no one thought much of this brief downturn, but thought that cheap money (sounds an awful lot like today) would certainly propel stocks higher.

However, few realized that April of 1930 had been a significant top in the market. Most thought they were still in the beginning of what would prove to be a major market rally. Unfortunately, history proved them terribly wrong.

After April, 1930, the stock market resumed its decline, albeit at a significantly slower pace. This decline stretched over months rather than days, yet it took the Dow from a high around 280 points down to a low under 50 points in the summer of 1932.

All the optimism in the market, revealed in the news stories quoted above, existed even AFTER stocks at seen their top. Despite that optimism, stock prices fell by over 80% over the next 2 years.

Even worse is that all those investors, with all their optimism that the worst was behind them in June of 1930, would not see prices back at their April highs for over 20 YEARS. After the end of the bear market rally that lasted from November of 1929 until April of 1930, stock prices began falling then traded within a range for more than a decade. It wasn't until the late 1940s that a rally began which would take stock prices over their highs set in April of 1930.

The question that investors need to be asking themselves right now is where we are in the current cycle. Our argument has long-been - and will likely continue to be - that the stock market is nearer to a top than a bottom.

Let me be clear: We are NOT currently predicting another crash or a replay of the Great Depression. We are simply arguing that, despite all the market prognosticators who say the recovery is under way, we simply don't buy into all the hype. The economic numbers being released do not support the idea of a jobless recovery, or even a recovery at all.

Investors would do well to think twice about whether the worst is really over just because the market is doing well as of late. We urge investors to be very cautious when testing the waters with this market; a bit of skepticism may prove immensely valuable.

Monday, November 9, 2009

A Truism for Turbulent Times

Even since the market bottom, we’ve been hearing quite a bit from friends and concerned clients. Mostly they’re worried about what they see happening in this country, both politically and economically.

This simple observation reveals a truth that we have noticed over the years in just about any issue people face, and that is: People have a natural tendency to extend current conditions into the future indefinitely.

For example, in 1999 stocks had been delivering outstanding returns for several years, particularly from innovative technology/dot-com companies. No one saw that fad coming to an end; they thought it was the new norm. Anyone could make a fortune inventing new technologies, or trading companies that did.

Likewise, in 2005 it was accepted as fact that real estate gained about 15% in value every year. So long as you made enough income to service your mortgages, at least until you felt like flipping, you could and should buy as many properties as possible.

The problem with this tendency is that simply is not the way the world works. Everything cycles; be it stocks, real estate, interest rates, or political tendencies, even temperatures around the world.

One of the most common phrases I hear from traders is that “the trend is your friend.” The problem is that nearly all of those who use it leave out the last, most significant part: “…until it bends.” We saw this with dot-com’s, we saw it with real estate, and now we’re seeing it in the case of gold and a declining dollar.

Currently there is a growing concern among Americans regarding the tendencies of the current administration. Yesterday’s elections have shown that the majority, long-silent, is awake, and it’s angry. In a single night a very clear message has been sent to Washington that politicians who continue to pursue recent fads will likely find themselves unemployed in short order.

The fears of some focus on the US dollar and the idea that it’s going to be worthless. Consider this: If you told someone fifty years ago that the dollar they were holding would lose 85% or more of its purchasing power by today, do you think they would have been concerned?

And yet, according to CPI – which is a conservative estimate of declining purchasing power – the US dollar has done just that. Yet we seem to be getting along just fine. Face it, folks. We’re already living this fear. The dollar is worthless. The sun still came up this morning.

When it comes to inflation, the bottom line is that ever since governments discovered how to dilute money, they’ve been doing it. Historians can trace it all the way back to the Roman Empire when emperors started shaving coins so they didn’t contain as much metal as they were supposed to.

My point is that, since politicians have figured out how to run the printing presses, they’re never going to stop. Pandora’s Box has been opening, and you can’t un-invent the wheel. However, those numskulls in Washington aren’t going to bring the world to an end either.

Plenty of economists point to the hyperinflation that occurred during the fall of Weimar Republic in Germany or the current situation in Zimbabwe. They raise some valid points, but there are many more differences than similarities.

These countries, like all others, did and will continue to cycle. Life didn’t end in Weimar Germany, nor has it ended in Zimbabwe. Adjustments have and will be made, and the world goes on. Cycles like these may be so [unbearably] slow that they’re sometimes hard to see. But then, just because I can’t see my grass growing doesn’t mean I get to forget about cutting it.

Fortunately, we think this is just what’s happened in Washington. Americans got lazy about scrutinizing their elected officials. Now we’ve woken up to find the grass somehow much longer than we like, and with plenty of weeds that need pulling.

Friday, November 6, 2009

The Joys of [Careful] Giving

“Giving back to the community” means different things to different people. To some it means giving extensively of themselves, their time, and their skills for a vast number of causes. To others it might simply mean cutting a yearly check to Green Peace.

Philanthropy is not something to which all of us feel obliged. Some of us have trouble finding a cause whole-heartedly support; others simply lack the resources, be it time or money. We could all, most assuredly, do more. But then again, we could all just as easily do much, much less.

It’s no simple task to balance our obligations to our community with those to our family. We all work hard to provide a better life to those closest to us, at the same time trying to leave our community in better shape than as we found it.

We all have reasons to give. Many have organizations or causes of personal significance, or that have had particular impact on their lives. Others have the desire to build a longstanding legacy with the hopes of being remembered by the community they love.

When it comes to giving back, not everything can be monetary. Those who have particular skills have a responsibility to put those skills to work for the benefit of their community, not always for personal gain.

For some, especially those with heavy business obligations, time constraints, et cetera; money is a much more preferable way of giving back. Such gifts are certainly worth no less than gifts of time or skills, and they certainly come with their own benefits, namely tax deductions. However, they come with their own drawbacks as well.

Even those who lack the capability to give of themselves, preferring instead to share the spoils of their own labor – money – have an obligation to serve as a steward for those gifts, to follow that gift through to ensure that the gifts they grant or used in accordance with their wishes.

Now, friends, therein lies the rub.

For years stories have come out about different charities that donors have found not to be using gifted funds appropriately. Some have developed extremely high overhead costs, while others have been documented paying administrators ludicrous salaries.

In other instances the misgivings are much more subtle.

Most local organizations rely on the local community for support, both moral and, more importantly, financial. However, for years, in this region particularly, those same organizations that rely on the local community have failed to return the favor by using local businesses for goods and services.

Many think of themselves as major institutions and feel privileged as such, often using big-city firms out of New York, Chicago, or Los Angeles for services like accounting and asset management, and even construction work. They seem to have lost their own sense of obligation as organizations built by the local community for the benefit of the local community.

Now we have an array of local causes that are begging for funding but getting nothing, not that it should be any surprise. For years the local community supported these causes from the Museum to the Zoo, not to mention COSI.

Yet when the time came for these same causes to procure services, do you think they utilized those same local patrons that were footing the bill? Absolutely not. Instead these organizations have looked outside the region for the services they require, with absolutely no understanding that with every dollar that they pay to an outside vendor, that’s one less dollar that they will ever see back in a donation from a local supporter.

If there’s anything that can be said about the Northwest Ohio region, it’s that money follows the same trends as people: Once they leave, they don’t come back.

So, fortunately, it seems we all have something to learn when it comes to philanthropy. We in the general public need to give more freely of ourselves, including our time and our skills rather than just our wallets.

Likewise local charities, foundations, unions, et al need to understand that this giving is a two-way street. If they expect to be supported by the local community, they need to return the favor when they require goods or services by using local talent.

Monday, November 2, 2009

Experts Agree Correction Coming

Looking back over my past articles this morning, I have been calling for a pullback in the markets now for the last six weeks. Now, six weeks later, after some ups and downs, the stock market is essentially right where it started (the Dow is up less than 0.5%, while the S&P 500 is down about 1.5%).

After six weeks and little or no movement, investors in the broader stock market haven’t made a dime. And still, after six weeks, the markets still have us awaiting a correction.

But, oh how vindication can be sweet. After six weeks of telling investors that the economy hasn’t turned, and that this rally is built on nothing but air, finally we’re seeing more and more market technicians and other professionals on the markets follow our lead.

What’s more, they’ve been turning bearish for precisely the same reasons we’ve been harping on for more than a month. They say, as we have been, that the credit markets haven’t loosened. In aggregate, more debt is being paid off than taken on.

Credit cards are a prime example. In an industry built entirely on financing purchases – helping people pay for something today with money they’ll [hopefully] earn tomorrow – credit card companies, who have access to vast sums of credit through the Federal Reserve, have been raising rates to astronomically high levels (Citi Jacks Credit Card Rates…, Vince Veneziani).

What other experts are realizing is that with credit continuing to tighten, the flow of money through the global economy (velocity) has slowed incredibly. We would liken it to blood circulating through constricted veins. All this means that, in the short-term, deflation is still a very real threat in the United States.

Perhaps more importantly to investors, this means that the recent market rally is not based on economy, just added liquidity. Prices have been driven higher by money flowing into the market from the sidelines. Some of that money is from banks that were given bailout funds in the stimulus packages.

When they were given these stimulus funds, banks needed to do something with that money, but considered it too risky to loan it out. Instead, the vast majority of those funds were left in the Federal Reserve System, where the Fed pays interest on excess reserves. Some funds eventually made their way into global markets, and have contributed to supporting share prices.

While deflation is a serious threat in the immediate term, inflation is still a larger, more long-term worry. We believe, as we have for some time, that the United States may very well be on the road to more 1970’s-style inflation. In fact, we begin we are already beginning to see this on the horizon. Now, as in the ‘70’s, unions refused to make wage concessions (Opposition Builds to Ford Union Concessions, Jeff Bennett), and this later contributed to massive wage inflation, despite high unemployment.

In the meantime, we continue to wait for the approaching market correction. The big question investors now need to be asking themselves [or their advisors] is where to weather the coming storm. Unfortunately, this correction is likely going to be very similar to the one that occurred last year; perhaps not in depth, but certainly in depth. In the coming correction, like last year, diversified portfolios are going to take a serious beating.

The market is overpriced across nearly all sectors, with few exceptions. However, more bank failures are almost a certainty. In addition, interest rates are so low right now that they simply can’t get much lower, meaning that bond positions are not likely to perform well.

However, looking past the storm, with election season coming up for many Congressman in just over a year, we can say beyond a doubt that the Fed is going to be getting quite a bit of political pressure to do something in order to get this economy going before voters go to the polls next year. We also know that changes in monetary policy by the Fed usually take at least six months to take effect.

With all this in mind we can construct a rough timeline of the way things will likely play out over the next six months, year, and two years, which are pretty good time horizons when considering investments.

First, with each passing day a major market correction draws nearer. Hopefully investors have been getting prepared to buckle down. If they haven’t, they certainly need to.

Second, once the market corrects the Fed is likely to work with the Treasury to make major shift in monetary policy in order to appease pressuring politicians. Knowing what we do about monetary policy, major changes will need to be made by the time it’s getting warm in spring, at the very latest.

Lastly, once the economy and the markets begin a sustainable recovery, inflation is likely to reach levels not seen in the US since the ‘70s. While this may alarm some investors, and inflation on the scale we see coming is certainly never fun, it’s nearly always better than the alternative.