What’s that? You need more cowbell David Rosenberg? Here’s Rosie in his daily letter explaining how it’s not liquidity that’s driving the market:
You can always rest assured that a peak is at hand when you read and hear about how “liquidity” is driving the market. For one, nobody even has a clue as to how “liquidity” is even defined. It’s basically a catch-all term for “I don’t know”. But what we do know is that short covering remains an important source of buying power for equities as the bears bail out — short interest on the NYSE, for example, shrunk 2.4% in the second half of August, and was down 2.9% on the Nasdaq. Just in case you were wondering how it was that the S&P 500 managed to advance 20 points in the second half of the month.
The truth of the matter is that investment grade corporate bonds have outperformed the S&P 500 by 70 basis points so far this year — income at a reasonable price remains a primary theme. The problem with the equity market is that dividends no longer comprise a critical part of the total return pie as it used to. The reliance now is almost purely on capital appreciation, which can be secured when unit labour costs are falling at annual rate of at least 5%, as has been the case over the last two quarters. However, that rate of decline cannot possibly be sustained. But what can be sustained, and likely will be, is the deflationary backdrop in private sector demand, which influences the revenue line. Take note that 250 S&P 500 companies cut their dividends in 2Q, the highest number in over 50 years (and as per the WSJ, stock buybacks have declined now for six quarters in a row).
Take note that the Fed is now pumping reserves aggressively into the banking system again, with the monetary base accelerating at a 141% annual rate over the past four weeks. But the money multiplier is still contracting — over this time frame, M1 has contracted at a 28.7% annual rate; M2 has fallen at a 4.9% annual rate; and MZM has shrunk at a 6.2% annual rate. In other words, and with all deference to the excitement that a 50%+ bear market rally can engender in the media, the credit system is still … broken. When the investment community eventually figures out that the economy is not in, or even is it entering, a V-shaped recovery there will undoubtedly be a new round of deflated price discovery, followed by years of anemic economic growth, persistently high unemployment, ongoing consumer frugality, rising savings rates, and a prolonged period in which portfolios will move further towards strategies that provide income and preservations of capital rather than a focus on aggressive capital appreciation potential.
This is from an interview with Rosie in Barron’s:
The equity market is de facto priced for 4% real GDP growth. The corporate-bond market is priced for 2% real GDP growth. So in terms of asset mix, it’s pretty clear that you have more downside protection in corporate bonds right now than you have in equities. And if you can tolerate the risk, you can pick up a 12% coupon in the high-yield market. But if you are a more cautious investor, you have an array of solid investment-grade securities in the A-rated universe where you can pick up a 6% yield. With a negative 2% inflation backdrop, that equates to an 8% real yield — a very juicy rate of return. In the equity market, you have a 4% earnings yield plus a 2% dividend yield, and you are in a riskier part of the capital structure. Corporate bonds are priced for the sort of recovery I have in my forecast.
We are in a post-bubble credit-collapse environment, and what is critical is capital preservation and income. Asset mix is extremely important. We at Gluskin Sheff have a cautious view toward U.S. equities. We’re more positive on Canadian equities, given that the banks are stable and the commodity market is in a bull phase. We’ve been big fans of corporate bonds, though, admittedly, a good part of the low-hanging fruit is behind us. But they will be relative outperformers.
The rally in the U.S. equity market has been so pronounced that it is no longer just pricing in the end of the recession. It is pricing in two years of recovery. At this stage, there is a little too much risk. If the S&P 500 were to correct back to around 840 or 850, versus 1025 recently, I would be much more interested.
Read the full interview here
Ambrose Evans-Pritchard of the Telegraph writes that deflation is spreading from the core of the global system to the most unexpected regions of the world. It has even reached Latin America. Prices are sliding in Peru, Chile, Colombia, Paraguay, Bolivia, Ecuador, Guatemala, and El Salvador, to the consternation of everybody.
You can read the article below:
Enough of the world has already fallen so far into pre-deflation conditions that any misjudgment by the big central banks from now risks setting off a chain-reaction that may prove very hard to stop.
CPI inflation has dropped to –2.2pc in Japan (a modern record), -2.1pc in the US, -1.8pc in China, -1.4pc in Spain, -0.7pc in France, and -0.6pc in Germany.
This was not anticipated by the authorities anywhere, so we should be wary of their assurances now that we face nothing more than a brief dip in prices before rising energy costs bring inflation back into familiar and safe territory. No doubt prices will rebound as the “base effect” of oil prices kicks in. But by how much; for how long?
The sum of economists in the world (outside Japan) familiar with the cultural and psychological dynamics of deflation can fit into one London bus, and most are historians of the 1930s.
If PIMCO guru Bill Gross and hedge fund manager Paul Tudor Jones are right in fearing that the US economy will tip back into a “W-shaped” recession as the sugar rush of fiscal stimulus fades, we may wake up to find that we have baked deep deflation into the pie for 2010 and 2011. The G20′s talk of “exit strategies” and rate rises will seem surreal.
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Joseph Salerno from Mises.org reports on a National Bureau of Economic Research working paper written by a prominent macroeconomist — and accepted for publication by the influential Journal of Economic Theory — which challenges the Friedman-Schwartz view and lends ample evidence to the Rothbardian position on the genesis of the Great Depression.
In America’s Great Depression, originally published in 1963, Murray Rothbard argued that the recession-adjustment that began in 1929 was greatly worsened and turned into a full-blown depression by the policies implemented by Herbert Hoover. Among the Hooverite policies that stifled the adjustment process, Rothbard identified public-works programs, increases in taxes, the imposition of the Smoot-Hawley tariff, but especially Hoover’s efforts to prevent the downward adjustment of nominal wages by exerting pressure on big industrialists not to cut (and even to raise) their employees’ wage rates.
Rothbard’s explanation of how the temporary and benign recession-adjustment process was impeded and diverted into the Great Depression ran counter to the view that Milton Friedman and Anna Schwartz put forth in their classic work A Monetary History of the United States, 1867–1960, also published in 1963. According to Friedman-Schwartz, it was the collapse of the money supply due to the negligence of the Fed that turned what should have been a “garden-variety recession” into the Great Depression. The Friedman-Schwartz view came to dominate mainstream macroeconomics after the collapse of the Keynesian consensus in the 1970s. Indeed, it is today the conventional explanation of the Great Depression, which Bernanke holds to and which governs the policy response of the Fed to the current financial crisis.
Thus, for decades Rothbard and a handful of Misesian economists were virtually alone in maintaining that Hoover’s interventionist policies, particularly as they impacted the industrial labor market, were mainly responsible for transforming what should have been a short and sharp recession into the economic catastrophe of epic proportions that we now know as the “Great Depression.” Now comes a National Bureau of Economic Research working paper written by a prominent macroeconomist with impeccable academic credentials — and accepted for publication by the influential Journal of Economic Theory — which challenges the Friedman-Schwartz view and lends ample evidence to the Rothbardian position on the genesis of the Great Depression. In writing his article, “Who — or What — Started the Great Depression,” UCLA economist Lee E. Ohanian spent four years poring over wage data and culling information from sources related to Hoover and his administration.
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Second Quarter 2009 Quarterly Review and Outlook by Van Hoisington and Dr. Lacy Hunt
DEBT ACTS AS A BRAKE ON THE MONETARY ENGINE
One of the more common beliefs about the operation of the U.S. economy is that a massive increase in the Fed’s balance sheet will automatically lead to a quick and substantial rise in inflation. An inflationary surge of this type must work either through the banking system or through non-bank institutions that act like banks which are often called “shadow banks”. The process toward inflation in both cases is a necessary increasing cycle of borrowing and lending. As of today, that private market mechanism has been acting as a brake on the normal functioning of the monetary engine.
For example, total commercial bank loans have declined over the past 1, 3, 6, and 9 month intervals. Also, recent readings on bank credit plus commercial paper have registered record rates of decline (Chart 1). The FDIC has closed a record 52 banks thus far this year, and numerous other banks are on life support. The “shadow banks” are in even worse shape. Over 300 mortgage entities have failed, and Fannie Mae and Freddie Mac are in federal receivership. Foreclosures and delinquencies on mortgages are continuing to rise, indicating that the banks and their non-bank competitors face additional pressures to re- trench, not expand. Thus far in this unusual business cycle, excessive debt and falling asset prices have conspired to render the best efforts of the Fed impotent. The 100% plus expansion in the Fed’s balance sheet (monetary base) has done nothing to rekindle borrowing and lending or revive even the smallest spark of inflation. What is clear is that as long as private market factors in the monetary/credit creation process are shrinking, as they are now, the risk for the economy is deflation, not inflation.
By Niels C. Jensen
“You can’t beat deflation in a credit-based system.”
Robert Prechter
As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won’t have to get more than a handful of key decisions correct – everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.
Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those ‘make or break’ decisions which will effectively determine returns over the next many years. The question is a very simple one:
Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?
Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or ‘quantitative easing’ as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?
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capital-markets, deflation, economy | Graham | 
Tuesday, September 15, 2009 6:22 pm | 
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