Art Cashin: “Rumourmongers” and Why Traders Have Put Santa’s Picture On A Milk Carton

Wednesday, December 14th, 2011

With fundamentals, technicals, and now even headlines out of Europe largely irrelevant, it only leaves one market-moving thing: rumors. And yesterday was a terrific example of precisely this. Art Cashin does a “rumor by rumor” expose of the key “events”, however unfactual, that moved stocks yesterday. If history is any indication, and it is, today will likely see the rumor brigade unleashed all over again shortly.

From UBS:

Rumormongers Hold A Convention, Sending Market On A Roller Coaster Ride – Traders spent Tuesday’s session with one eye on Europe and one ear pressed to the rumor mill.

Early on, the commodity boys were pushing the idea that the 2:15 FOMC statement would come with a hint of a QE3 program. That rumor never quite gained full traction but its proponents kept pushing it.

The hope of the QE stimulus and some early strength out of Euro allowed U.S. stocks to open better.

Then around 10:00, two different rumors collided. One was that Merkel had given a thumbs down on European bonds to fund the rescue program. The second was that Iran was running military exercises around the Strait of Hormuz and, as part of the exercises, might shut down the Strait.

The Hormuz rumor sent oil up nearly $3 and scared off some bids in stocks. The Merkel rumored scared off even more stock market buyers. The trouble with the rumors was that they had both been around before. The Hormuz story was around Monday and the Merkel story was around on Friday. But, as we say on Wall Street, a rumor without a leg to stand on will find some other way to get around. So, for some inexplicable reason, the two semi-stale rumors caught hold on Tuesday morning.

The rumor related selling ended shortly after 11:00 and stocks churned sideways.

The rumormongers were not through, however. A story began to circulate that the CIA or maybe NATO was setting up military training camps in Jordan or Turkey or maybe both. The camps were said to be for training and arming Syrian dissidents to overthrow Assad. This rumor never seemed to get real traction.

The sideways churning continued into the FOMC statement at 2:15. The mongers kept pushing the QE3 hope all the way to the statement.

When the statement hit, there was virtually nothing new and certainly no hint of any QE in the visible future.

Stocks began to sell off. The selling accelerated as new rumors popped up. These rumors maintained that the S&P might downgrade one or more European sovereigns overnight. That put renewed pressure on the Euro and stocks.

The selling continued until about 3:40. Then, influenced by market on close orders that were heavily tilted to the buy side, the bulls circled the wagons and trimmed some of the losses.

Unfortunately, the action on the close swelled the volume enough to make Tuesday a “distribution day”. Traders wondered if they should consider putting  Santa’s picture on a milk carton.

Tags: Art Cashin, Commodity, Full Traction, Inexplicable Reason, Merkel, Military Exercises, Military Training, Milk Carton, Nato, Proponents, Qe, Roller Coaster Ride, Rumor Mill, Stimulus, Strait Of Hormuz, Technicals, Terrific Example, Training Camps, Tuesday Morning, Ubs
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Guest Post: Clean Energy – [Coal] Between The Lines?

Tuesday, February 8th, 2011

By Bill Willoughby, Feb. 1, 2011

In his State of the Union address on Tuesday, January 25, President Obama announced that by 2035, 80% of America’s electricity will come from clean energy sources.  Now, the first question that comes to mind - what are we counting as clean energy? The second question – what do we have to do to get there?

What Is Clean Energy?

The President went on to give us an indication, saying:

“Some folks want wind and solar. Others want nuclear, clean coal, and natural gas. To meet this goal, we will need them all.”

“Some folks” may have been a bit surprised and perhaps disappointed to see nuclear, clean coal and natural gas included that statement. Do an internet search for clean energy, and you’ll come up definitions that include the words–sustainable”, renewable, “green, environmentally-friendly, and non-polluting.

Usually included are references to wind, solar, biomass or biofuels, hydropower, and geothermal. Usually not included are nuclear and hydrocarbons, which, by nature, are extraction intensive, depleting, and generate waste in one form or another. Some definitions do include natural gas, however.

Proponents of nuclear, coal and natural gas were no doubt pleased by the President’s statement. Correction, clean coal, that is.

One might question whether the statement was really sincere, or whether the separation into two sentences with the words “Some” and “Others” was some sort of code: “Some” sources of energy we like, “Others” we don’t.

Nuclear, after all, has the decades-old waste disposal problem. The problem didn’t get any better last year when the government pulled the plug on the Yucca Mountain disposal site in Nevada.

The natural gas industry was no doubt happy to be mentioned, and usually gets props for being the cleanest of the hydrocarbons in terms of carbon dioxide. There is that little practice of hydrofracking, however, on some people’s minds.

Then there’s coal, I mean clean coal: provider of over 40% of our electricity now, but the worst of the hydrocarbons in terms of carbon dioxide, and that’s without mentioning its other problems that from time to time crop up in the news (explosions, fly ash, dam failures, and mountaintop mines).

Clearly, when it comes to the idea of whether coal can be “clean”, there are those who don’t believe it and those who believe there will be a technological solution to the problem of carbon dioxide. Nevertheless, the country does have vast reserves, and the key to remember here is domestic jobs.

The Unmentioned

We are talking about clean energy for electricity, not transportation, but it’s worth mentioning the persona non grata of the evening–oil. This was made clear with the President saying:

“… I’m asking Congress to eliminate the billions in taxpayer dollars we currently give to oil companies. I don’t know if you’ve noticed, but they’re doing just fine on their own.”

“With more research and incentives, we can break our dependence on oil with biofuels, and become the first country to have a million electric vehicles on the road by 2015.”

Others in the unmentioned category are hydropower, geothermal, and fuel cells.

Hydropower is already a significant contributor to renewable energy in EIA electricity statistics. Don’t expect any growth in this sector, unless you’re thinking of tidal power — dropower is a still just a nice way to avoid saying the word dam.

Geothermal is looking like the Rodney Dangerfield of renewables; if it’s not third behind wind and solar, it’s left out entirely. Its omission on Tuesday appeared intentional.

Fuel cells were mentioned in another line about innovation, but, we’ve been hearing about them for years. Hybrids and EVs are winning in transportation, and so are wind and solar in serious power generation. Like geothermal, fuel cells went unmentioned for a reason.

How do we get there?

Clearly, if we take quick look at our current electrical energy balance, we see it makes a big difference whether nuclear, coal and natural gas are included in the clean energy mix.

EIA statistics show our current sources of electricity are currently 45% from coal, 23% from natural gas, and 20% from nuclear, for a total of 88% from the three.  Looking out to the year 2035, EIA projects US. electricity demand growing from 4 trillion KWH per year to 5 trillion KWH per year (See Chart). This is a growth rate that roughly mirrors the Census Bureau projections for US population, growing from 310 million people now to 389 million by 2035.

Source: U.S. EIA

Two areas that might cause EIA projections to be low are electric vehicles, which will increase home use for overnight charging, and a shift way from fossil fuels for home heating. Let’s assume, though, that the EIA projections are accurate.

By 2035, EIA projects the relative contributions from coal, natural gas and nuclear to be about the same: natural gas increasing to 25%, coal dropping to 43%, and nuclear dropping to 17%. Renewables, of which hydropower is currently dominant, are forecast to grow from 10% to 14%. That growth will come from wind and solar as hydropower will obviously remain flat.

With the counrty needing 5 trillion KWH per year, reaching the goal of 80% “clean” means we need 4 trillion KWH per year to come from the clean category. Obviously, counting natural gas and nuclear as clean makes the goal a lot easier.

Now, all we have to deal with is cleaning up the 43% portion from coal, meaning, get rid of the carbon dioxide emissions. To reach the 80% number, all we really have to do is to get half the coal, at least 1 trillion KWH per year, into the clean category.

Fans of wind and solar will be saying at this point: wait, we don’t need coal, just put more resources into wind and solar. Perhaps that could work, but there are those who say wind and solar will have their work cut out for them just getting renewables up to the 14% number.

Reading between the lines, then, we might expect to see more than a few clean coal ads cropping up in the future.

About The Author – Bill Willoughby is a Mining Engineer, and he blogs at Resource and Environment.

The views and opinions expressed herein are the author’s own and do not necessarily reflect those of EconForecast (Economic Forecasts & Opinions ).

Tags: Bill Willoughby, Biofuels, Biomass, Carbon Dioxide, Clean Coal, Clean Energy, energy, Energy Sources, Geothermal, Hydrocarbons, Hydropower, Internet Search, Natural Gas Industry, No Doubt, Obama, oil, Proponents, Sources Of Energy, State Of The Union, State Of The Union Address, Waste Disposal Problem, Yucca Mountain
Posted in Energy & Natural Resources, Markets, Oil and Gas | 1 Comment »

Is the Stock Market Cheap?

Thursday, July 1st, 2010

This article is a guest contribution from Doug Short, dshort.com.

Here’s the latest update of my preferred market valuation method using the most recent Standard & Poor’s “as reported” earnings and earnings estimates and the index monthly averages of daily closes for June 2010, which is 1083.36. The ratios in parentheses use the June monthly close of 1030.71. For the latest earnings, see the table below from Standard & Poor’s.

�–� TTM P/E ratio = 17.0 (16.2)
�–� P/E10 ratio = 19.9 (18.9)

Background
A standard way to investigate market valuation is to study the historic Price-to-Earnings (P/E) ratio using reported earnings for the trailing twelve months (TTM). Proponents of this approach ignore forward estimates because they are often based on wishful thinking, erroneous assumptions, and analyst bias.

TTM P/E Ratio
The “price” part of the P/E calculation is available in real time on TV and the Internet. The “earnings” part, however, is more difficult to find. The authoritative source is the Standard & Poor’s website, where the latest numbers are posted on the earnings page. Free registration is now required to access the data. Once you’ve downloaded the spreadsheet, see the data in column D.

The table here shows the TTM earnings based on “as reported” earnings and a combination of “as reported” earnings and Standard & Poor’s estimates for “as reported” earnings for the next few quarters. The values for the months between are linear interpolations from the quarterly numbers.

The average P/E ratio since the 1870′s has been about 15. But the disconnect between price and TTM earnings during much of 2009 was so extreme that the P/E ratio was in triple digits — as high as the 120s — in the Spring of 2009. In 1999, a few months before the top of the Tech Bubble, the conventional P/E ratio hit 33. It peaked around 47 two years after the market topped out.

As these examples illustrate, in times of critical importance, the conventional P/E ratio often lags the index to the point of being useless as a value indicator. “Why the lag?” you may wonder. “How can the P/E be at a record high after the price has fallen so far?” The explanation is simple. Earnings fell faster than price. In fact, the negative earnings of 2008 Q4 (-$23.25) is something that has never happened before in the history of the S&P 500.

Let’s look at a chart to illustrate the irrelevance of the TTM P/E for a consistent indicator of market valuation.

Click for a larger image

The P/E10 Ratio
Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market’s value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by a multi-year average of earnings and suggested 5, 7 or 1-years. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the concept to a wider audience of investors and has selected 10 years as the earnings denominator. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic average is 16.35. Shiller refers to this ratio as the Cyclically Adjusted Price Earnings Ratio, abbreviated as CAPE, or the more precise P/E10, which is my preferred abbreviation.

Click here to see an overlay of the TTM P/E and the cyclical P/E10.

The Current P/E10
After dropping to 13.4 in March 2009, the P/E10 rebounded above 20. The chart below gives us a historical context for these numbers. The ratio in this chart is doubly smoothed (10-year average of earnings and monthly averages of daily closing prices). Thus the fluctuations during the month aren’t especially relevant (e.g., the difference between the monthly average and monthly close P/E10).

Click for a larger image

Of course, the historic P/E10 has never flat-lined on the average. On the contrary, over the long haul it swings dramatically between the over- and under-valued ranges. If we look at the major peaks and troughs in the P/E10, we see that the high during the Tech Bubble was the all-time high of 44 in December 1999. The 1929 high of 32 comes in at a distant second. The secular bottoms in 1921, 1932, 1942 and 1982 saw P/E10 ratios in the single digits.

Tags: Authoritative Source, Bias, Critical Importance, Earnings Estimates, Erroneous Assumptions, Forward Estimates, Interpolations, Market Valuation, Parentheses, Preferred Market, Proponents, Quarterly Numbers, Ratios, Spreadsheet, Stock Market, Trailing Twelve Months, Triple Digits, Ttm, Valuation Method
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Doug Short: Is the Stock Market Cheap?

Monday, May 3rd, 2010

This article is a guest contribution by Doug Short, dshort.com.

May 3, 2010 monthly update

Here’s the latest update of my preferred market valuation method using the most recent Standard & Poor’s “as reported” earnings and earnings estimates and the index monthly averages of daily closes through April 2010. The ratios in parentheses use the April 30 close of 1186.69.

�–� TTM P/E ratio = 19.4 (19.2)
�–� P/E10 ratio = 21.9 (21.7)

Background
A standard way to investigate market valuation is to study the historic Price-to-Earnings (P/E) ratio using reported earnings for the trailing twelve months (TTM). Proponents of this approach ignore forward estimates because they are often based on wishful thinking, erroneous assumptions, and analyst bias.

The “price” part of the P/E calculation is available in real time on TV and the Internet. The “earnings” part, however, is more difficult to find. The authoritative source is the Standard & Poor’s website, where the latest numbers are posted on the earnings page. Click on the Index Earnings link in the right hand column. Free registration is now required to access the data. Once you’ve downloaded the spreadsheet, see the data in column D.

The table here shows the TTM earnings based on “as reported” earnings and a combination of “as reported” earnings and Standard & Poor’s estimates for “as reported” earnings for the next few quarters. The values for the months between are linear interpolations from the quarterly numbers.

The average P/E ratio since the 1870′s has been about 15. But the disconnect between price and TTM earnings during much of 2009 was so extreme that the P/E ratio was in triple digits — as high as 122 — in the Spring of 2009. At the top of the Tech Bubble in 2000, the conventional P/E ratio was a mere 30. It peaked north of 47 two years after the market topped out.

As these examples illustrate, in times of critical importance, the conventional P/E ratio often lags the index to the point of being useless as a value indicator. “Why the lag?” you may wonder. “How can the P/E be at a record high after the price has fallen so far?” The explanation is simple. Earnings fell faster than price. In fact, the negative earnings of 2008 Q4 (-$23.25) is something that has never happened before in the history of the S&P 500.

The P/E10 Ratio
Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market’s value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by the 10-year average of earnings, which we’ll call the P/E10. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the P/E10 to a wider audience of investors. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic P/E10 average is 16.3.

Click here to see an overlay of the TTM P/E and the cyclical P/E10.

The Current P/E10
After dropping to 13.4 in March 2009, the P/E10 rebounded above 20. The chart below gives us a historical context for these numbers. The ratio in this chart is doubly smoothed (10-year average of earnings and monthly averages of daily closing prices). Thus the fluctuations during the month aren’t especially relevant (e.g., the difference between the monthly average and monthly close P/E10).

Of course, the historic P/E10 has never flat-lined on the average. On the contrary, over the long haul it swings dramatically between the over- and under-valued ranges. If we look at the major peaks and troughs in the P/E10, we see that the high during the Tech Bubble was the all-time high of 44 in December 1999. The 1929 high of 32 comes in at a distant second. The secular bottoms in 1921, 1932, 1942 and 1982 saw P/E10 ratios in the single digits.

Where does the current valuation put us?
For a more precise view of how today’s P/E10 relates to the past, our chart includes horizontal bands to divide the monthly valuations into quintiles — five groups, each with 20% of the total. Ratios in the top 20% suggest a highly overvalued market, the bottom 20% a highly undervalued market. What can we learn from this analysis? Over the past several months, the decline from the all-time P/E10 high dramatically accelerated toward value territory, with the ratio dropping from the 1st to the upper 4th quintile in March 2009. The price rebound since the 2009 low has now pushed the ratio into the 1st quintile — quite expensive!

A more cautionary observation is that every time the P/E10 has fallen from the first to the fourth quintile, it has ultimately declined to the fifth quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 540. Of course, a happier alternative would be for corporate earnings to make a strong and prolonged surge. When might we see the P/E10 bottom? These secular declines have ranged in length from over 19 years to as few as three. The current decline is now in its tenth year.

Or was March 2009 the beginning of a secular bull market? Perhaps, but the history of market valuations doesn’t encourage optimism.

copyright (c) 2010 Doug Short

Tags: Authoritative Source, Bias, Critical Importance, Earnings Estimates, Erroneous Assumptions, Forward Estimates, Hand Column, Interpolations, Market Valuation, Parentheses, Preferred Market, Proponents, Quarterly Numbers, Ratios, Spreadsheet, Stock Market, Trailing Twelve Months, Triple Digits, Valuation Method
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Puru Saxena: Inflation is our future

Thursday, October 1st, 2009

This post is a guest contribution by Puru Saxena*, founder of Hong Kong-based Puru Saxena Wealth Management.

On one hand, the deflationists are claiming that given the extremely high debt levels in the West, further inflation is impossible. On the other side of the argument, many proponents of inflation are calling for Zimbabwe style hyperinflation. In this business, everyone is entitled to their opinion; however it is my contention that we will get neither deflation nor hyperinflation. If my assessment is correct, once business activity picks up, our world will have to deal with high inflation.

Although I have great sympathy for the deflation crowd, given the reckless attitude of the central bankers and their ability to create debt-based money, I do not believe deflation (contraction in the supply of money and total debt) is very likely.

For sure, in this post-bubble environment, American consumer debt continues to contract, but this is being more than offset by the expansion in federal debt. Over the past year alone, federal debt in America has surged from US$9.645 trillion to US$11.813 trillion. In other words, during the past twelve months, American federal debt has risen by a shocking 24.47% and it now stands at 83.52% of GDP! Now, given the ability of the American establishment to essentially create dollars out of thin air, I have no doubt in my mind that it be able to inflate the economy. However, this will come at a huge cost and the victim will be the American currency.

In fact, the recent weakness in the US dollar is a sign that central- bank sponsored inflation has started to dominate the private-sector debt contraction in the West. Furthermore, over the past few weeks, various governments have issued US dollar-denominated debt and this suggests that the carry-trade is back in vogue. In a startling move, Germany recently announced that it plans to borrow money in US dollars!

Now, given the ongoing federal debt inflation, debasement of paper currencies, sky-high budget deficits and competitive currency devaluations, the macro-economic environment has never been better for precious metals. Yet, both gold and silver continue to frustrate the bulls by staying below the record-highs recorded in spring 2008.

So, what is going on here? Have we already seen the end of the precious metals bull-market or are we about to witness an explosive rally? Before I attempt to answer this question, I want to make it clear that even though gold failed to better its all-time high during last autumn’s panic, it was the only asset, (apart from US Treasuries) which stayed relatively firm. And looking at the various markets today, gold is the only asset that is flirting with its all-time high. So, whether you like it or not, gold deserves some credit for fulfilling its role as a safe haven.

Now, unlike some of the die-hard gold bugs, I don’t believe that gold is the ultimate asset to own at all times. Without a doubt, there have been times in history when gold has proven to be a lousy investment. For instance, between 1980 and 2001, the nominal price of the yellow metal fell by an astonishing 70%. This horrible price action spawned an entire generation who grew up hating gold and up until a few years ago, the vast majority considered gold a barbaric relic.

However, during other periods in history, when macro-economic uncertainty was high and inflationary expectations were running out of control, gold turned out to be a fantastic asset to own.

If my take on the macro-economic situation is valid, then we are in such a period now and gold must form a part of every investment portfolio.

You may remember that over the past year, central banks have injected trillions of dollars into the banking system and it is only a matter of time before inflationary expectations start spiraling out of control. Up until now, this ’stimulus’ money hasn’t permeated through the economy in the West but once money velocity picks up, prices will start rising and the investment community will become very concerned about inflation. When the deflation scare abates and people start protecting the purchasing power of their savings, capital will start to flow towards precious metals.

Long-term clients and subscribers will recall that about two years ago, I highlighted gold’s tendency to rocket higher every other year. Figure 1 captures this trend perfectly and you can see that since the outset, gold’s bull-market has been punctuated by lengthy consolidations and the yellow metal has surged to a new high every alternate year.

Figure 1: Is gold about to shine?

So, if gold remains in a bull-market and its trend consistency is intact, its price should surge over the following months. Conversely, if the price of gold fails to climb above its all-time high before year-end, it should start to ring alarm bells as this would open up the possibility that the bull-market may be over. Remember, certainty does not exist in the investment world and savvy investors should remain open to all outcomes.

Now, given the uncertainty in the world today and the ticking inflationary time-bomb, my view is that gold will soon embark on its north-bound journey. So, I suggest that investors hold on to gold and the related mining companies which will probably continue to perform well until next spring.

As far as silver is concerned, it has always been a high-beta play on the direction of gold. If the next up leg in gold’s bull-market materializes, the price of silver will also head towards the heavens. Accordingly, investors may also want to allocate a portion of their investment portfolio to silver bullion and silver producing companies.

Source: The Daily Reckoning, September 29, 2009.

* Puru Saxena is the founder of Puru Saxena Wealth Management. He is a registered investment advisor and money manager with the SFC of Hong Kong. Saxena conducts in-depth macro-economic research, formulates his firm’s investment strategy and manages discretionary investment portfolios. He is also the editor and publisher of Money Matters – a monthly economic report he has been writing since 2000.

Tags: American Currency, Business Activity, Carry Trade, Consumer Debt, Contention, Contraction, Debasement, Debt Levels, Deflation, Doubt In My Mind, Federal Debt, Gold, Gold Bullion, Hyperinflation, inflation, No Doubt, Paper C, Proponents, Thin Air, Twelve Months, Vogue, Wealth Management
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Roadmap to Inflation and Sources of Cheap Insurance

Thursday, March 26th, 2009

*This article is a guest contribution courtesy of John Mauldin, “Outside the Box.”

What happens when inflation once again returns. As this week’s Outside the Box writer, James Montier, writes, we may want to start thinking now about inflation insurance and he mentions a few ways to do so. But this letter is a must read for his bringing to light a speech by Fed chairman Ben Bernanke in 2000 given to the Japanese, where he suggest inflation targeting:

I think you will find this week’s OTB to be exceptionally thought provoking. Montier is one of my favorite economic thinkers (and a good friend). He works for Societe Generale in London in their Cross Asset Research group.

John Mauldin, Editor
Outside the Box

**********************************************

As Albert [Edwards] and I regularly point out during meetings, we have never been more unsure on the inflation/deflation outlook. I have previously said I was torn between the deflationary impact of the bursting credit bubble, and the inflationary pressures of the policy response. When we read something by the deflationists we sit there nodding our heads in agreement, then we pick up something by the proponents of a return of inflation and we find ourselves agreeing with that as well. The respective sides seem deeply entrenched in their positions.

In contrast, we are trying to keep an open mind on the subject. Albert is biased towards a Japanese style outcome, and I am biased towards an inflationary outcome, but neither of us has any strong conviction.

Fisher and the debt-deflation theory of depressions

In the face of this uncertainty I decided to return to history and see what it has to say about the way out of a depression. My first point of call was Irving Fisher’s “The debt-deflation theory of Great Depressions” published in 1933¹. Fisher is probably most infamous to those in finance for his pronouncements of a new era of permanently high stock prices in 1929. But in the wake of his disastrous calls he turned to trying to understand the experience of the depression. Incidentally, he also invented the Rolodex.

In his debt-deflation theory, he posits “two dominant factors” in driving depressions “Namely over-indebtedness to start with and deflation following soon after… In short, the big bad actors are debt disturbances and price-level disturbances”. He continues “Deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debt cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed.” That is to say, debt-deflation spirals can easily become self-reinforcing.

The good news is that Fisher is also very clear on how to end a debt-deflation spiral: “It is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors… I would emphasize… that great depressions are curable and preventable through reflation and stabilization”. The irony of Fisher’s route out of deflation is that, probably only the Fed – after helping lead us into this mess² – can now get us out of it.

Romer’s lessons from the Great Depression

After reading Fisher’s analysis of the 1930s, I came across a recent speech given by Christina Romer, who is now the head of the Council of Economic Advisers, and who made her name in academic circles studying the events which ended the Great Depression. In the speech, Romer offers six lessons from the Great depression for the current juncture.

Lesson 1 – Small fiscal expansion has only small effects

Romer wrote a paper in 1992³ arguing that fiscal policy was not the key driver in the recovery from the Great Depression. Not because fiscal expansion is ineffectual per se, but rather because the fiscal stimulus that was conducted wasn’t large. As Romer notes “When Roosevelt took office in 1933, real GDP was more than 30% below its normal trend level… The deficit rose by about one and a half percent of GDP in 1934″.

Lesson 2 – Monetary expansion can help heal an economy even when interest rates are near zero

Romer notes that actually it was the Treasury rather than the Federal Reserve that drove the monetary expansion (a peculiarity of the system under the Gold Standard). In April 1933, Roosevelt suspended convertibility to gold on a temporary basis, and the dollar depreciated. When the US returned to gold at the new higher price, gold flowed into the US, allowing the Treasury to issue gold certificates which were interchangeable with Federal Reserve notes. As Romer notes “The result was that the money supply, defined narrowly as currency and reserves, grew by nearly 17% per year between 1933 and 1936″. Romer argues that this “Devaluation followed by rapid monetary expansion broke the deflationary spiral” – empirical evidence to support Fisher’s hypothesis outlined above.

Lesson 3 – Beware of cutting back on stimulus too soon

The monetary expansion seems to have produced remarkable results in terms of real growth: the US economy grew by 11% in 1934, 9% in 1935 and 13% in 1936 in real terms. This lulled the authorities into thinking that all was well with the system again. Hence, in 1937, the deficit was reduced by approximately two and half percent of GDP. Monetary policy was also tightened, as Romer notes “The Federal Reserve doubled the reserve requirement in three steps in 1936 and 1937″. She concludes “taking the wrong turn in 1937 effectively added two years to the Depression”.

Lesson 4 – Financial recovery and real recovery go hand in hand

Romer points out the inseparable nature of the real and financial recoveries. This meshes with our analysis that the banks aren’t really the problem in a debt-deflation environment, rather they are a symptom of the problem. The current policy in the US seems to be aimed at “fixing the financial system”, witness Bernanke’s recent comments “Recovery is not going to happen until the financial markets and the banks are stabilized”. This appears to be a misperception, as, Romer notes “Strengthening the real economy improved the health of the financial system. Bank profits moved from large and negative in 1933 to large and positive in 1935, and remained high through the end of the Depression”.

Investors seem to be rather excited about banks posting profits at the moment. Frankly, if a bank didn’t post a profit in this environment it should be shot out of kindness. The environment for profitability from banks has rarely been better, but that doesn’t make them solvent. If you were starting a business today, then setting up a bank would be a very attractive option. However, history – as represented by the balance sheet – cannot simply be ignored when it is inconvenient. As John Hussman noted “The excitement of investors last week about Citigroup posting an operating profit in the first two months of the year simply indicates that investors may not fully understand the term “operating profit.” Citigroup could burst into flames while Vikram Pandit sells lemonade in the parking lot, and Citi would still post an operating profit. Operating profits exclude what happens on the balance sheet.”

Lesson 5 – Worldwide expansionary policy shares the burdens

Given the worldwide nature of the current slump, Romer makes an interesting point on the effectiveness of competitive devaluations, “Going off the gold standard and increasing the domestic money supply was a key factor in generating recovery… across a wide range of countries in the 1930s… These actions worked to lower world [real] interest rates… rather than just to shift expansion from one country to another”.

This is something that Albert and I have been discussing of late. We have been pondering the possibility of competitive devaluation (obviously ultimately a zero sum game in terms of exchange rates) having enough of an impact on local monetary creation to increase inflationary expectations, thus helping countries reflate. It appears as if Romer has sympathy with this view.

Lesson 6 – The Great Depression did eventually end

The final lesson that Romer offers may be of use to investors at the current juncture. She makes the point that the Great Depression did finally end. As Romer puts it “Despite the devastating loss of wealth, chaos in our financial markets, and a loss of confidence so great that it nearly destroyed American’s fundamental faith in capitalism, the economy came back. Indeed, the growth between 1933 and 1937 was the highest we have ever experienced outside of wartime. Had the U.S. not had the terrible policy-induced setback in 1937, we, like most other countries… would probably have been fully recovered before the outbreak of World War II” This is a reminder that the current obsession with no scenario being too pessimistic is probably ill advised.

Bernanke and the policy options

The final source for signposts to watch comes from a speech given by Bernanke in 2000 to Japanese policy makers. As I wrote in Mind Matters 6 January 2009, in this speech Bernanke clearly acknowledged the greater threat that deflation poses in a highly leveraged economy, “Zero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era. The modern economy makes much heavier use of credit, especially longer-term credit, than the economies of the nineteenth century.”

Bernanke clearly believes that monetary policy is far from impotent at the zero interest rate bound. In essence his argument is an arbitrage based⁴ one as follows “Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero.”

In the speech, he laid out a menu of policy options that are available to the monetary authorities at the zero bound. First, aggressive currency depreciation, as per Romer’s analysis of the end of the Great Depression. Second on Bernanke’s list is the introduction of an inflation target to help mould the public’s expectations about the central bank’s desire for inflation. He mentions the range of 3-4%!

Third on the list was money financed transfers. Essentially tax cuts financed by printing money. Obviously this requires co-ordination between the monetary and fiscal authorities, but this should be less of an issue in the US than it was in Japan. Finally, Bernanke argues that non-standard monetary policy should be deployed. Effectively, quantitative and qualitative easing. Bernanke has repeatedly mentioned the possibility of outright purchases of government bonds – as the UK is now doing.

This menu should provide us with a roadmap of policy options to watch for. If (and when) the deflationary pressure builds, we should expect to see more and more of these options wheeled out. Note that we aren’t talking about trying to ‘fix the system’, to reflate the bubble (which would be the equivalent of giving crack cocaine to a heroin addict trying to deal with withdrawal). Rather, the suggestion from Fisher is that inflation erodes the real value of debt; it is the most painless way out of our current mess. Whether the authorities can create just a little inflation remains to be seen, as does their ability to actually create inflation in any way. Such imponderables are beyond my ken.

Investment implications – Cheap insurance

Howard Marks recently suggested that today’s investment decisions must focus on “value, survivability and staying power”. These factors lie at the heart of the three-pronged approach that I have been suggesting since the end of October last year.

The first prong is cash. This is a legacy from the lack of opportunities that characterised markets in the last few years. But it is also a hedge against outright deflation. The second prong is deep value opportunities in both debt and equity markets (as detailed for the equity markets most recently in Mind Matters, 4 March 2009). The third element is sources of cheap insurance. The idea behind this element of the portfolio is to prepare for a wide variety of outcomes by buying cheap insurance (which ideally, although not always, pays off in multiple states of the world). Of course, it should be noted that the purchase of cheap equities also contains an inflation hedge element.

Inflation/deflation insurance I – TIPS

The first and most obvious source of inflation/deflation protection when I first started thinking about this subject was US TIPS. These bonds have a deflation floor on the principal, so in the event of deflation I receive my cash back – representing a real rate of return equivalent to whatever the deflation rate is. In the event of inflation, I get whatever the yield is on the TIPS when I purchase them plus the inflation, of course (buying the new issue TIPS avoids the problem of accrued inflation).

When I started looking at TIPS, the yield was over 3.5%. This has dropped since then, resulting in the 10 year TIPS delivering a 9% return since the end of October. The 10 year TIP is currently yielding 2.1%, against the 10 year nominal bond yield of 3%. This implies that the market expects US inflation to be a mere 1% p.a. over the next decade – this strikes me as an exceptionally low rate.

Inflation/deflation insurance II – Gold

The second inflation/deflation hedge I suggested in late October was gold. Now, gold concerns me for a variety of reasons, not least of which is that it has no intrinsic worth: I can’t really value gold – beyond extraction cost.

However, it has some attractive features from an insurance point of view. Most obviously, in a world of competitive devaluations, gold is the one currency that can’t be debased. Thus it provides a useful hedge against the return of this sort of beggar-thy-neighbour policy. In the event of significant prolonged deflation, what is left of our financial system is likely to collapse, thus holding a money substitute isn’t such a bad idea against this cataclysmic outcome.

Of course, recently everyone has been talking about gold (not hugely surprising given that it is up some 30% since late October) – something that makes me nervous. However, gold is institutionally massively under-owned, so whilst it may have been moving up the list of attractive assets of individual investors (if the EFTs are anything to go by) and sensible hedge funds (such as the likes of Greenlight, Paulson, Third Point, Eton Park and Hayman), the mainstream institutional appetite for it has remained depressed.

Inflation insurance I – Dividend swaps

As we noted in Mind Matters, 2 February 2009 the European and UK dividend swap markets are pricing in an outcome that implies greater dividend declines than witnessed in the US during the Great Depression. The pricing then implies that essentially the dividends won’t recover, pretty much forever. This strikes me as excessively pessimistic.

In addition, dividends have a relatively close relationship with inflation (as detailed in the aforementioned Mind Matters). Thus dividend swaps look like a deeply distressed asset fire sale, with the added advantage of offering inflation insurance if I buy the longer dated swaps (up around 7% from my original note in February). The most common rebuttal to my fondness for dividend swaps is counterparty risk. However, the European dividend swaps have an exchange listed future, which obviously doesn’t have any counterparty issues.

Inflation insurance II – Inflation swaps

The second of the pure inflation hedges comes via the inflation swap market. The charts below show the zero-coupon fixed rate necessary to build a swap against zero-coupon CPI appreciation over 10 years. When I first looked at the US version in January (see Mind Matters, 6 January 2009) the rate was a mere 1.5%. Today it has risen, although not dramatically, to 2.3%.

However, the cheapest inflation swaps in the world seem to be Japanese swaps. They are available for -2.5%! Both the US and Japanese inflation swaps strike me as cheap ways of buying inflation insurance at the moment. Although counterparty risk is obviously a significant factor in these long duration swap transactions.

Eurozone break-up insurance: Spanish and Portuguese CDS

The final element of the insurance policy concerns the risk of a euro break-up. In a world of competitive devaluation, it isn’t clear that the Eurozone will be able to stand the pressure. The one area of the world which has anything like the gold standard in place is the Eurozone. As Albert opines during our meetings with clients, this is less a function of economic realities and more a function of political expediency (I’ll leave a detailed exposition of this logic to Albert in a future note).

To protect against this risk (or even rising perceptions of this risk) the natural insurance is provided by the CDS market. If even one country was to publicly contemplate leaving the Eurozone then these CDS spreads would explode. I find it hard to believe that Portuguese and Spanish CDS are below those of the UK – where we have the ability (and have used it) to print our own money.

Footnotes:

¹ Available from http://www.fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf This is one of few articles published in Econometrica that I have ever read!

² See Bill Flecksenstein’s excellent book, Greenspan’s Bubbles or John Taylor’s insightful paper The Financial Crisis and the Policy Responses: An empirical analysis of what went wrong, available from http://www.stanford.edu?~johntayl/FCPR.pdf, or any of Albert Edwards’ myriad of rants on Greenspan.

³ Romer (1992) What ended the Great Depression?, The Journal of Economic History, Vol 52

⁴ As Stephen Ross once said, to turn a parrot into a learned financial economist it needs learn just one word: arbitrage. To my mind economists are far too happy to rely on arbitrage assumptions to rule out solutions. Indeed the second chapter of my first book, Behavioural Finance is spent detailing failures of arbitrage (both causes and consequences thereof, including the ketchup markets!).

Source: John Mauldin, Outside the Box

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