Article: Icebergs

Iceberg

Icebergs
John Riley, Chief Strategist
12/03/07

Did you hear about the Fed Chairman that had his head in the oven and his feet in the freezer? He told Congress, “On average, I’m comfortable.”

Dead, but comfortable. This is the danger of using some averages, they don’t tell the whole story and it is the methodology that the Federal Reserve is following.

Three Icebergs, Two Imported, One Domestic
What is going on in our economy is out of the Federal Reserve’s control. There is nothing they can do about it. It is like an iceberg bearing down on us and everybody can see it, but nobody can do anything about it. (It’s actually 3 icebergs, more on them later.)


The US is importing both Deflation and Inflation from overseas. On the surface, you might look at that and say “Great, everything balances out!” But like our friend with the appliance problem I spoke of earlier, they don’t cancel each other out, they both kill you.

The Fed however sees them cancelling out. It sees inflation numbers that are not too hot and not too cold. And that is what they concentrate on. Not the impact the two destructive forces are having on the economy.

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Balance of Payments
We keep owing more and more overseas as our Trade Deficit gets worse.
Source: Fed Reserve

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Trade Deficit
The Trade Deficit was supposed to get better as the Dollar weakened. It hasn’t.
Source: Fed Reserve

Deflation – not a monetary phenomenon
First, let’s look at the importation of deflation. Unlike most economists, we at Cornerstone do not view deflation from a monetary standpoint. This, we believe, is the mistake both Wall Street and the Fed are making. Instead, we look at it from a businessman’s perspective.

A businessman’s perspective on deflation is where he creates a product with the expectation of selling it for a certain price. But along comes a wave of foreign goods selling for much less. He is now forced to lower his prices to compete. It has nothing to do with the money supply. It has nothing to do with interest rates. It has nothing to do with the velocity of money.

The businessman doesn’t care about such things, nor does he take them into account when he is creating his business plan. He sees a need, sees an opportunity, creates a product for that need, and sells the product for a profit. Foreign competition, even if it is only 5% of the market, can dictate the price of the product. Consumers flock to the lowest prices. Or should I say best value. Ask Detroit.

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Domestic Auto Sales
Domestic Auto Sales have been declining for a decade.
Source: Fed Reserve

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Imported Auto Sales
Meanwhile, Imports gain strength
Source: Fed Reserve

The Fed and Wall Street have been telling us for years that the falling Dollar would be good for US exports and slow foreign imports. As the Dollar dropped, US goods would become more competitive and US consumers would switch over to buying domestic again. The pitiful numbers at Ford and GM prove this false.

As the Dollar has weakened, the Trade Deficit has only gotten worse, as the US consumer shows itself to be almost insatiable in its desire for foreign products.

Is there anything the Federal Reserve can do to slow the inflow of foreign goods? The Fed can’t, but Congress can. They can slap tariffs on foreign imports. Big tariffs. Enough to make domestic goods profitable again. And we all know from history how successful tariffs can be. (Look back at the 1930’s, tariffs are one of the major causes of the Depression.)

Inflation – out of our control
Inflation is our other chief import. How do we import inflation? Through high commodity prices. Growing economies overseas are sucking up virtually everything from oil to copper to corn at alarming rates. And the increase in demand is not temporary. The citizens of India are not going to have a taste of capitalism and all of the benefits that come with it and decide, “no, not for us,” the masses in China are not going to improve their diets and living conditions dramatically and then decide “no, we liked not having good food or medicines or warm homes.”

The demand side of commodities is going to stay strong for years, maybe decades thanks to global demographics and population shifts. And when the growth cycle does end, it won’t end with a decline, it will plateau, because better standards of living require higher consumption of commodities.

The price of many commodities is up because of foreign consumption. Is there anything the Fed can do about this? Will raising rates slow down the housing boom in Beijing? Of course not. The Fed is powerless in this area.

The last time the US was in a commodity driven inflation, it was in the 1970’s and it was of our own making. Consumption in the US drove up commodity prices. So when the Fed raised rates in an effort to slow the economy, it worked, – because the Fed’s actions directly impacted the cause of the inflation. This time the cause is overseas, outside the reach of the Fed.

Mountain of Debt and a Devalued Dollar- Greenspan’s Legacy

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Greenspan’s Legacy
The highest Debt to GDP ratio since the Depression. Make no mistake,
this ratio needs to come down significantly before there can be any true
economic growth in the US.
Source: Fed Reserve; Format CIS

But there is another inflation that the Fed can do something about and has chosen not to. The Dollar’s decline tends to bring inflation with it. But a collapse of the Dollar brings hyper-inflation. The Fed has chosen to ignore the potential of a collapse and instead has stoked the possibility by lowering interest rates.

Since the Fed started lowering rates this year, the Dollar has accelerated its slide. Foreign holders of US Dollars and debt have been threatening to start dumping if the Fed doesn’t shore up the Dollar. Dumping would cause interest rates in the US to go up significantly. Forget about a housing recovery. Forget about an economic recovery.

The Fed’s complicity in the current economic conundrum in which we find ourselves started way back in 1995, when the Greenspan Doctrine was first introduced. Current Fed Chairman Bernanke is an enthusiastic student of the Greenspan Doctrine.

What is the Greenspan Doctrine? It is the experiment that Mr. Greenspan embarked on where he threw money at whatever problem there was. (It is sort of like going shopping when you have a fight with your spouse. Makes you feel better for a while, but you eventually have to face the music.) Asian currency crisis – lower rates; Russian Debt default – lower rates; Y2K – lower rates; Mother-in-law coming over – hide the good scotch and lower rates.

By the time the new century rolled around, the world was awash in Dollars. Every time the Fed lowered rates, they encouraged more debt to be piled up by domestic consumers pushing millions of new Dollars into the system and devalued the currency a little bit each time. So while Wall Street applauds the Fed lowering interest rates to help their own pocketbooks, remember, what the Fed has been doing is eroding the value of those pieces of paper with presidents on them in your pocket.

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Total Consumer Credit
Thanks to the easy money policies of the Fed over the past 12 years,
consumers have piled up quite a mountain of debt.
Source: Fed Reserve

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US Personal Savings Rate
Yet their ability to pay for all that debt has deteriorated to
the point that the Savings Rate is now negative.
Source: Fed Reserve

Bread and Circus is not the basis for a strong economy
Much of the debt was used for consumption which added nothing long term to the economy. Instead of debt used for investment into productive economic purposes, (factories, not stocks) much of the debt raised was used to finance lifestyles. To buy stuff. To have fun.

And like a husband caught cheating on his wife, everything was going smoothly until it hits the fan. And then there is no turning back. Everything you thought was smart proves to be dumb. Everything you thought you got away with comes back to haunt you. All that debt that was used for consumption instead of production now has no asset behind it and is just a weight around your economic neck.

What it means to YOU
I talk to investors daily and they don’t get it. Few do. Just like in Jesse Livermore’s* day, investors are consumed with the right now, with which stock was going to make a move today, instead of understanding the big picture, the macro economy.

*(Reminiscences of a Stock Operator, by Edwin Lefevre, Published 1923 – “The average man doesn’t wish to be told that it is a bull or a bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He doesn’t even wish to have to think.”)

Investors tend to have 2 reactions to this information. They either want to sell everything and run and hide or they go into denial. Running and hiding is understandable, but not prudent.

Denial is just as bad and also comes in two flavors. The first type of denial is from the true believer. Whether through ignorance or passivity, they follow what Wall Street and the Fed say and believe “they” won’t let anything happen to us. Larry Kudlow and Jim Cramer are their heroes.

What these people forget is that “they” didn’t do anything to protect investors from the 2000 – 2002 bear market. “They” didn’t give any warnings, had no strategy and still don’t.

The next type of denial buys the story but not the scope of it. They are like hospital patients that have just been told by their doctor that they have a terminal disease and instead of dealing with it, they ask the doctor about a hang nail that is bothering them.

Instead of trying to understand what the size of the problem is, investors ask me what stocks they should be looking to buy, next week, after everything collapses. They don’t understand that the US economy can have no significant recover, no sustainable growth until the debt problem is solved and the Dollar strengthens. This may be years away. Decades maybe. The Japanese market peaked in 1989 and here it is 18 years later and their market is still down over 60% from that high.

Paradigm Shift – Out with the old, in with the new
We have entered a time when the old way of investing is over. It won’t work. It has ended.

Instead of buying and holding your favorite US based company, the one your father worked for all his life, investors need to expand their portfolios. They need to realize that buy and hold is dead. They need to do more work, have a flexible strategy, and look for investments in areas they never thought of before.

The problems that we outlined in this report are also the answers. Instead of fighting the inevitable, the wise investor embraces it and takes advantage of it.

Below are some of the major, macro problems facing the US investor and how to invest accordingly.

Overvalued stock market – Hedge positions/Bear market funds
Rising interest rates – Shorten maturities/bond market hedges
Declining Dollar – Foreign bonds/International Equities/Gold
Inflation – Commodities/Gold/TIPs

None of these are guaranteed to work every time with every short term move in the market. These are long term trends we are talking about and long term solutions. So don’t expect gold to go up every time the Dollar drops.
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The most exciting part of the economic situation is that investors do have options. Much of what is listed above was not available to the average investor the last time the US fell into a protracted decline (the 1970’s).

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