Friday, November 28, 2008

Money for Nothing

Now that ain't workin' that's the way you do it
Lemme tell ya them guys ain't dumb
Maybe get a blister on your little finger
Maybe get a blister on your thumb
--Dire Straits

The simplest solution to the world's monetary problems is to use weight of precious metal (e.g., grams of gold) in monetary exchange rather than some state-sponsored construct such as dollars, euros, yuan, etc. No exchange rate issues, no figuring out how much metal backs each paper dollar...

If it's so simple, then why don't we do it? Because governments want to debase the currency. By disconnecting a country's currency from the underlying metal, bureaucrats could reduce the currency's value over time (e.g., 1 oz of gold = $20 --> 1 oz of gold = $35 --> 1 oz of gold = $800). To my knowledge, such a process has recurred in every large-scale society without exception in 5,000 yrs of civilized history.

One of the first to write about this phenomenon was Antoine Louis Claude Destutt de Tracy. Destutt de Tracy was a French philosopher and economist whose work substantially influenced Thomas Jefferson and other early U.S. liberal thinkers. Jefferson pushed for an English translation of Tracy's Traite de la volonte et de ses effets into what would become A treatise on political economy published in 1817.

Tracy (1817) claimed that the very act of naming currencies was used by the state to divorce the value of the currency from the underlying metallic value itself. This paved the road for government sponsored inflation and monetary debasement.

Smart cookie, that Tracy.

position in gold


de Tracy, C.D. (1817). A treatise on political economy. Georgetown: Joseph Milligan.

Wednesday, November 26, 2008

Time Passages

It was late in December, the sky turned to snow
All 'round the day was going down slow
Night like a river beginning to flow
I felt the beat of my mind go
Drifting into time passages
Years go falling in the fading light
Time passages
Buy me a ticket on the last train home tonight
--Al Stewart

Nice reference on current size and chronology of the bailout program.

$8.5 trillion and counting.

Speed Trap

State Trooper: Do you have any idea how fast you were going?
Del Griffith: Funny enough, I was just talking to my friend about that. Our speedometer has melted and as a result it's very hard to see with any degree of accuracy exactly how fast we were going.
--Planes, Trains & Automobiles

Ran across this passage in a speech given by Friedrich Hayek in 1977:

"I am afraid I am convinced that the hope of ever again placing on government this discipline [of restraint of money creation instilled by a gold standard] is gone. The public at large has learned to understand, and I am afraid a whole generation of economists have been teaching, that government has the power in the short run by increasing the quantity of money rapidly to relieve all kinds of economic evils, especially to reduce unemployment. Unfortunately this is true so far as the short run is concerned. The fact is, that such expansions of the quantity of money which seems to have a short run beneficial effect, become in the long run the cause of a much greater unemployment. But what politician can possibly care about long run effects if in the short run he buys support?"

You don't have to be a Nobel laureate like Hayek to to appreciate the relevance to current conditions.

Government is pulling out all stops in hopes that this is the short run and not the long run.

position in gold

Crude Attitude

"Six bucks and my right nut says we're not landing in Chicago."
Del Griffith (Planes, Trains & Automobiles)

Yesterday it cost me just over $20 to fill up my gas tank ($1.82/gal for premium). In mid summer, I was paying around $50.

Crude's spectacular decline over the past few months has erased about 75% of the price gains made over the previous few years.

In the near term, lower pump prices behave like a tax cut to consumers and should have a stimulative effect on the economy.

In the long run, however, the fundamentals behind oil are likely little impaired, and in fact may be improved. Why? Lower crude prices have driven many operators to curtail projects aimed at adding capacity. In fact, inefficient existing capacity is being retired.

Such 'supply destruction' should be bullish for oil prices over time.

position in crude

Tuesday, November 25, 2008

Beggar's Banquet

You can't always get what you want
But if you try sometimes you might find
You get what you need
--Rolling Stones

The $300+ billion Citigroup (C) bailout is sure to lengthen the monetary bread lines. Make sure you grasp the essence of this situation, as it boils down to the following:

We're seeking massive fiscal relief from a government that's $12 trillion in the hole.

Not sure you could mark much higher on the scale of folly.

I'm imagining my 8 yr old niece and (soon to be) 7 yr old nephew in school where their teachers are trying to explain this phenomenon to them. If such a 'teachable moment' is spun in a manner that attempts to justify our current actions, then we're surely lowering the financial literacy bar for our youngest generation.

Our kids deserve better.

no positions

Monday, November 24, 2008

Even It Up

A good man pays his debt
But you ain't paid yours yet


For years my buddy Don and I have been getting together for a weekly dine-and-discuss. A marquee topic since 2002ish: what plausible scenarios (e.g., hyperinflation, deflation, 'normal' inflation, etc) would result from the excesses that have been building in our economic and financial systems over many years? What would the scenarios look like in motion, and how should one be positioned to manage the risk/reward of each?

When noodling over the specter of deflation, we wondered how well gold would hold up in an environment of contracting credit and generally declining asset prices. Would gold plummet like other assets classes, or would it hold its value?

There's little question now that deflation is indeed what we've been experiencing over the past year or so. Debt and credit are contracting, and risky assets around the world have been declining in price in a correlated fashion.

Thus far, however, gold has been holding up well. In fact, since the beginning of the year, when other asset classes such as stocks, real estate, oil, etc are typically down 30-40%, gold is nearly even on the year.

Demand may be coming from buyers who view gold as a safe haven during uncertain times. Or perhaps investors are discounting a relatively brief deflationary period to be followed by massive monetary debasement (read: hyperinflation) as reflected by the $ trillions of stimulus being thrown around by bureaucrats. When the supply of fiat currency goes up, so generally does the price of gold.

Whatever the reason, gold has thus far passed the deflationary test in fine style.

position in gold

Sunday, November 23, 2008

Liquid Tide

When I'm drivin' in my car
And that man comes on the radio
And he's tellin' me more and more
About some useless information
Supposed to fire my imagination
--Rolling Stones

The amount of cash raised by hedge funds over the past few weeks is stunning. Due either to redemptions, margin calls, or lack of conviction, many large hedgies are sitting on 50% cash levels or higher.

The massive amount of risky assets that fund managers needed to sell to obtain these cash levels goes a long way towards explaining the depth (and correlated nature) of market declines we've seen.

An interesting situation now exists. Severely oversold markets. Extremely high hedgie cash. Five weeks till end of year.

If this market begins to lift and instills a 'lil end-of-year performance anxiety among fund managers, then we could see an explosive rally as hedgies perceive themselves under invested, turn their hats around, and scramble to start buyin' 'em.

The stuff of 1000+ point Dow days...

There are many sparks that could ignite such an upside explosion, such as the incoming administration's aggressive economic stimulus plans currently under construction.

There's an old axiom that markets tend to follow a path that frustrates most participants. As such, it's easy to visualize a scenario where investors, now that much of their risk has been shed, are whipsawed as prices sprint higher.

no positions

Saturday, November 22, 2008

Saved By Zero

Stretched by fewer
Thoughts that leave me

Chasing after

My dreams disown me

--The Fixx

The hallmark of deflationary periods is risk aversion. As deleveraging proceeds, prices of risky assets are pushed lower, and folks seek shelter in assets considered 'safe.'

The safest asset on the planet is currently perceived as short term US T-bills. Because of the US Dollar's reserve currency status (and the understanding that the US government will almost certainly print dollars to pay debt rather than default), short term US government obligations have garnered a supreme safety rating.

Over the past few months, investors around the world have poured into T-bills such that the yield on these instruments is effectively zero. This means that folks are willing to sacrifice any return on their money in exchange for return of their money.

While it's easy to marvel at the oddity of this phenomenon, it's quite consistent with the capital preservation mindset surrounding deflationary periods. Similar situations were observed in the US during the 1930s and in Japan during the 1990s.

Although risk averse behavior is a natural collective response to a previous period of extreme leveraging and risk taking, governments don't see it that way. In an over-leveraged world dependent on ever increasing consumer buying and consumption to keep the wheels on the wagon, deflation is a bureaucrat's worst nightmare.

At some point, the massive monetary stimulus being poured into the system by governments to combat deflation will likely gain traction. When precisely that will occur is anyone's guess. Some believe it will take years; others think that it will be soon.

Personally, I've been in the 'many years of deflation' camp. However, governments around the world are moving much quicker and more boldly than even I had anticipated. This is causing me to reassess just how quickly we may be facing a nightmare situation directly opposite our current predicament: global hyperinflation.

Three month T-bill yields should serve as a canary in the coal mine. When short rates reverse higher, then the inflationary game is likely on.

Meanwhile, I'm slowly adding to my commodity positions, particularly gold and silver, at these depressed deflationary prices as a means of protection against an inflationary future--whenever it may come.

positions in gold and silver

Friday, November 21, 2008

Reversal of Fortune

The sun goes out and night comes in
The time goes 'round and days grow dim

--Psychedelic Furs

The rally that some (including me) thought might surface yesterday never materialize. After a rally attempt, major indices flipped over and sold off to the tune of 6-7%. This puts closing prices at levels last seen more than 10 yrs ago.

On a monthly basis, it is possible that the technical damage can be 'reversed' if markets rally over the next week and close higher by month's end. That would leave a long 'whisker' at the bottom of the November candle. Long whiskers are often interpreted as significant bottoms--particularly if they are accompanied by significant volume (which is virtually assured this month). Note on the chart above that whiskers in late 2002/early 2003 months marked cyclical lows a few years back.

Markets around the world reversed higher last night and futes are strong this am. Let's see what happens.

no positions

Thursday, November 20, 2008

Ledge Hedge

Lunatic fringe
In the twilight's last gleaming
This is open season
But you won't get too far
--Red Ryder

A few interesting benchmarks for posterity's sake. Current prices off my streamer:

Citigroup (C) $4.90
General Electric (GE) $13.16
Morgan Stanley (MS) $9.28

Apparently Saudi Prince Alwaleed has upped his stake in C to 5% after nearly round tripping back to his 1991 buy price.

There are some green beans in the red sea out there, including Applied Materials (AMAT), Merck (MRK), and gold (GLD).

I did layer into additional commodity exposure this am, including ags (RJA) and silver (SLV).

positions in AMAT, GLD, MRK, RJA, SLV

Crunch Time

It's not in the way you've been treating my friends
It's not in the way that you stayed till the end

Feels like one of those defining times for the market. After yesterday's melt, we're within spitting distance of market lows of late 2002/early 2003. And we're opening in the hole with SPX down a coupla percent to 785 early (770ish is the 5 yr ago level that folks are watching).

Angst is palpable. Credit markets remain frozen. Talking heads are crestfallen.

The set up has that binary feel. Either we break thru these levels and melt way lower, or a powerful counter-trend rally is eminent.

no positions

Tuesday, November 18, 2008

Lost & Found

I believe in the kingdom come
Then all the colors will bleed into one
Bleed into one
Well yes I'm still running

Mr P checks in from Japan. He likens bureaucrats to guides who provide poor directions and get their followers lost. The solution? Ditch the guides and use your own reasoning skills for direction.

Well said, Mr P.

Also thought it interesting that he suggested paying down a home mortgage as a solid risk/reward project in this environ. I've concluded similar, and earlier this month began a campaign to pay off my house in 3 yrs or less.

Just started the program (35 months to go) although I'll look to throw additional income in this direction to hasten the pay down.

Sunday, November 16, 2008

Investment and Savings

"You're a part of something here, Bud. The money you make for people creates science and research jobs. Don't sell that out."
--Lou Mannheim to Bud Fox (Wall Street)

In a previous post we examined the relationship between income, consumption, and savings. Savings is the difference between income and consumption. Lower savings increases risk of a lower standard of living in the future. Dissavings, or borrowing so that consumption exceeds income, magnifies risk of lower future standard of living.

To improve future income prospects, individuals can allocate savings towards investment. Investment involves the utilization of resources as capital for generating income. Investments typically take the form of equity (full or partial ownership of a business to obtain a share of future profits) or debt (lending money to others to obtain a future interest payment).

Because it requires speculation about future returns, deploying resources as investment capital is by definition risky. Businesses may fail. Borrowers may default.

Many folks tend to equate investment with savings. It is true that investment capital comes from a pool of unconsumed resources. But investment capital may be lost as a result of poor investment decisions. True savings, on the other hand, carries little potential for loss.

The original mathematical expression of the relationship between income (N), consumption (C), and savings (S):

N = C + S

may be better written as:

N = C + (I + s)

where S becomes a blend of resources allocated towards investment (I) and true savings (s).

Individuals who consume much and save little might mitigate risk of lower future living standards by investing. If the investment decisions are good ones, then higher future incomes may be realized that compensate for the lack of savings.

However, investment itself carries risk. If investment choices are bad ones, not only are future incomes not improved, but capital is lost. In such cases, savings are reduced, and probability of lower future living standards increases rather than decreases.

Let's connect these concepts to a couple of practical applications. First, it is often proposed that individuals should 'save' 10-15% of their annual gross incomes in retirement accounts. To the extent that those funds are allocated towards stocks, mutual funds, corporate bonds, and other risky assets, these allocations constitute investment (I) rather than savings (s).

As many folks are realizing after opening recent quarterly 401(k) statements, these investments can result in losses. Lower future incomes, and lower future standards of living, have become more likely for those who have made poor investment decisions with their retirement 'savings.'

The second application streams from the following scenario. Suppose individuals consume more than their present income by borrowing resources from others. To mitigate risk of a lower future standard of living, the individuals borrow additional resources from others and invest in a manner that they hope will increase future income. Unfortunately, the investments are poor and most of the borrowed capital is lost. Prospects of a lower future standard of living have been magnified by borrowing money from others and by poor investment choices.

Now, government officials propose the following. Let's borrow even more resources and collectively invest in the same 'distressed' assets (mortgage backed securities, equity in companies such as American International Group (AIG, etc.) that individuals lost money on. If these assets become 'less stressed' in the future, then perhaps they can someday be sold at a profit.

Borrowing in an attempt to recover losses realized from poor investment of past borrowed money.

Such dysfunctional behavior is what made Kahneman & Tversky's (1979) prospect theory a Nobel winner.

no positionshneman, D. & Tversky, A. 1979. An analysis of decision under risk. Econometrica, 47: 263-292.

Wednesday, November 12, 2008

Against the Wind

And I guess I lost my way
There were oh so many roads

I was living to run and running to live

Never worried about paying or even how much I owed

--Bob Seger

The US dollar keeps ripping higher despite all fundamental and technical arguments that it shouldn't.

What's different this time? The massive amount of debt that's being unwound. In order to close projects funded on credit, individuals must buy dollars. Essentially, borrowing can be viewed as creating a synthetic short position in the dollar that must be 'covered' by buying back bucks when the project is closed.

I continue to watch the dollar as a key indicator of risk aversion. Right now, it's telling me there's still a low appetite for risk out there.

position in USD

Monday, November 10, 2008

Value Trap

Revvin' up your engine
Listen to her howlin' roar
Metal under tension
Beggin' you to touch and go
--Kenny Loggins

Astute investors such as John Hussman are offering cogent arguments as to why stocks offer long term value at these levels. My personal analysis also detects stock market value not seen in some time, although perhaps not as across-the-board as suggested by the work of others.

That said, a big risk to the 'stocks are good value at these levels' assessment is that investors (me included) may be overestimating future cash flows. As an example, consider a name that I'm involved with, Merck (MRK).

Currently, I'm estimating that MRK can generate $6 billion in annual free cash flow (FCF) over the long term (this is at the low end of MRK's annual FCF generation over the past few years). The value of that cash flow as a perpetuity discounted at 10% is $59.9 billion. A ratio of MRK's current market cap of $59.0 billion (stock price at Monday's close = $27.91) to this FCF perpetuity value = 59.0/59.9 or about .99. As such, MRK is selling for about a 1 percent discount using these assumptions and methodology. If we replace market value with enterprise value of about $52.9 billion, then this discount increases to about 12% (52.9/59.9 = .88).

The big 'if' here is our assumption of future free cash flow. What if MRK doesn't approach this FCF level? If, for instance, MRK's long term FCF generating power turns out to be only $3 billion annually, then MRK stock is currently overpriced, selling for about 2x fair value.

How might such a situation come about? Well, MRK could run into business or industry specific problems that drastically reduce the company's earning power. Depleted drug pipeline, increased bargaining power of buyers, legal actions, etc.

While such events are certainly within the spectrum of possibilities, I'm more concerned about changes to overall market structure that could permanently impair capital returns at firms across the board--not just at Merck. Specifically, I'm worried about the consequences of pervasive bureaucratic intervention in markets that we've experienced and may continue to experience moving forward. Persistent government meddling dramatically increases the probability of capital misallocation over time. Future returns on that capital and resulting free cash flows will almost certainly be reduced.

If returns on capital will indeed be chronically impaired, then those who are valuing stocks under the assumption that equities will ultimately revert towards historical cash generation patterns may produce over-optimistic forecasts.

The boilerplate warning that 'past performance may not be indicative of future returns' seems particularly appropriate when governments are assuming increased control over markets.

position in MRK

Sunday, November 9, 2008

Work Study

Well we're living here in Allentown
And they're closing all the factories down
Out in Bethlehem they're killing time
Filling out forms
Standing in line
--Billy Joel

While the big story this year has been the credit market bust, the focus in 2009 will likely turn towards the most visible economic consequence of the market meltdown: unemployment. Currently, the unemployment rate as measured by the government stands at 6.5%; we haven't seen rates this high since 1994. I wouldn't be at all surprised to see unemployment rates north of 10% next year.

Government will react in predictable ways. Programs will be initiated to 'create' jobs. Unemployment benefits will be increased. Policies will be enacted to 'protect' domestic jobs. Large firms such as General Motors (GM) or Chrysler may be nationalized.

After a huddle with his economic advisers on Friday, president-elect Obama indicated that he intends to pursue programs of this sort.

On top of the trillions of dollars already thrown at our economic problems, spending additional money that we don't have only sinks us deeper into squalor.

If bureaucrats truly wanted to improve the situation, then they would unwind regulations that have raised the unemployment rate. For example, a modest move in the correct direction would be eliminating minimum wage laws. Currently standing at $6.55/hr, minimum wage laws place a floor under labor prices, prohibiting buyers and sellers of labor from freely negotiating a mutually agreeable exchange. ECON 101 tells us that when price increases, demand decreases. Minimum wage laws increase unemployment by reducing demand for high priced labor.

Viewed from the worker's perspective, minimum wage regulations prevent those willing to work for less pay from finding employment.

A longer term consequence of minimum wage rules is that they reduce innovation. Higher cost of labor will deter some entrepreneurs from entering markets, thereby reducing potential for novel improvement and change. Longer run employment suffers as a result.

Other regulations inhibit employment as well, such as payroll taxes, licensing and certification requirements, and collective bargaining laws that reduce enterprise flexibility. Like most government intervention, labor regs tend to benefit special interest groups at the expense of everyone else.

Initiatives that free labor markets move society towards complete employment and better standard of living.

no positions

Perpetual Motion

There's a room where the light won't find you
Holding hands while the walls come tumbling down
When they do I'll be right behind you
--Tears for Fears

The "Unintended Consequences" missive by Mr P illustrates the 'whack a mole' nature of government intervention in markets. Knock down a problem over here, a new problem pops up over there.

The article is also instructive in that it demonstrates complex market linkages that are difficult to grasp if you're an outsider looking in. Heck, while reading Mr P's narrative, I had to draw a little flow chart in order to understand the connection between Fed collateral acceptance policies and a collapsing convertible bond market.

Chances of bureaucrats not knowing what they are affecting when they meddle in complex social systems are extremely high. As Mr P asserts, they lack sufficient knowledge, plus they are driven by political motivation.

The unintended, adverse consequences of government intervention implies a couple of things. For investors, meddling reduces future returns on capital, which will impair investment and suppress stock prices.

For citizens in general, intervention today locks in a lower standard of living for tomorrow.

Saturday, November 8, 2008

Liberty Lost

We're not gonna take it
Never did and never will
We're not gonna take it
Gonna break it, gonna shake it
Let's forget it better still
--The Who

While giving lipservice to the notion of liberty, our country increasingly enacts policies to destroy it. One of the more cogent theses on the relationship between liberty and policy was elaborated by Frederic Bastiat in his 1849 pamphlet The Law. Bastiat, a French economist, wrote The Law to express the reason behind his concern over France's ongoing slide towards socialistic government.

Drawing from thought processes articulated centuries earlier by John Locke and others, Bastiat argued that individual freedom is the basis for productive life, and that this freedom is expressed through the preservation of property rights. Three dimensions reflect these rights. First, individuals have the right to their living and breathing selves. Their lives cannot be ended for the benefit of others. Second, individuals have the right to their wherewithal to produce. People cannot be forced into slavery for benefit of others. Third, individuals have the right to the fruits of their labor. Personal property cannot be forceably taken for the benefit of others.

To Bastiat, the role of policy, or the law, should be to help individuals defend their property rights. When individuals are unable to fend off threats on their own, then government should intervene, coercively if necessary, to ensure property rights are upheld.

If the scope of law is redefined to promote property appropriation and redistribution rather than individual property protection, then, Bastiat argued, governed society heads down a slippery slope that is difficult to reclimb. Bureaucrats are charged with determining who gets what. Special interest groups lobby for their piece of other people's wealth.

While proponents of redistributive law argue that such policy promotes stability, reason suggests the opposite. The redistributive environment is prone to corruption, sense of entitlement, and despotism. Incentive to produce and innovate falls. Standard of living under such conditions is certain to decline. Throughout history, such conditions have promoted instability and have led, perhaps without exception, to either internal revolution or external takeover.

Sadly, Bastiat died of tuberculosis soon after publication of The Law. Were he to visit the U.S. today, Bastiat would surely express concerns similar to those he conveyed to his homeland long ago.

Liberty, he would observe, is in decline.

Friday, November 7, 2008

Stepping Out

The mist across the window hides the lines
But nothing hides the color of the lights that shine
Electricity so fine
Look and dry your eyes
--Joe Jackson

This morning I heard a personal finance pundit advise listeners to max out contributions to their retirement accounts once they had 3-6 months living expenses covered. Employer matching funds amount to free money, he argued, plus the tax benefits...

Until last fall I was doing just that, diverting maximum gross pay towards my 401k. However, while my retirement balances marched higher, I lacked funds to deploy in the present. After monthly expenses, little was left for saving, investing, and lifestyle activities. As such, I was experiencing a liquidity problem not unlike many are experiencing now as part of the credit crisis. Although I had 'balance sheet' assets that suggested a decent long term financial position, I lacked resources maintain flexibility and to exploit opportunities in the near term.

So a year ago last August I decided to eliminate all voluntary retirement contributions. I currently pay in the required minimum to get the employer match but no more. The rest of my net pay comes to me. The net effect was like giving myself a significant pay raise. With the increased cash, I was able to pay off all non-mortgage debt, do some investing, and build a good year's worth of living expenses in cash. Now, I'm looking at paying down my mortgage within three years.

Sure, I'm paying taxes on the income. But after those taxes, it's mine. Moreover, given our current financial state, there is some question in my mind whether future retirement account distributions will be safe from government plunder.

While not as liquid as I'd like, shifting funds away from retirement and towards present life has improved capacity for controlling my finances.

Knife Even

Roger Murtaugh: "Pretty thin, huh?"
Martin Riggs: "Anorexic."
--Lethal Weapon

When economies slow, individuals typically cut back on consumption. We're seeing evidence of such behavior now. Rather than a temporary phenomenon, some postulate that we're entering a secular period of risk aversion which includes greater focus on frugal behavior.

Either way, I've personally been looking for ways to cut back. Some things I've done include:

  • Canceled premium TV channels (e.g., HBO)
  • Reduced eat out sit down dinners by at least 2/month
  • Work from home at least 2 days/wk
  • Grocery: more private label, more soup & crackers, less snacks
  • Cut all vending machine purchases at work
  • Reduced bottled water consumption; drink more tap water

These changes save about $1500 annually, or about $130/mo. It's easy to see on my monthly statements.

Other activities 'on the bubble' include canceling personal website hosting service, moving to bare bones DTV service, capping sit down eat outs to one/month. Doing this would save an additional $1500 per year.

Adds up to the equivalent of a double mortgage payment annually. Noice!

Thursday, November 6, 2008

Unsteady State

Should five per cent appear too small
Be thankful I don't take it all
--The Beatles

Each year, the Office of Management & Budget publishes government budget info. The 2009 historical budget tables provide a sense of how federal spending patterns have evolved since the country's founding.

Government inflows are known as 'receipts,' while outflows are 'outlays.' Subtracting annual outlays from annual receipts determines the extent of 'surplus' (receipts - outlays = positive difference) or 'deficit' (receipts - outlays = negative difference).

The federal budget has been in a prolonged state of deficit. Since 1970, we have realized an annual budget surplus only 4 times--during the years 1998 thru 2001. These so called 'balanced budget' years were driven by unusually high capital gains tax receipts collected during the Internet bubble era.

In 2007, $2.57 trillion in receipts - $2.73 trillion in outlays = $160 billion deficit. The record annual deficit currently stands at $413 billion set in 2004, although this year's value will likely blow the previous high away.

Since taxes are part of receipts and receipts don't cover outlays in deficit situations, deficits must be financed via additional means. Debt issuance in one way. Total US public debt now exceeds $10 trillion. Currency debasement (read: inflation) offers a more nefarious means towards the same end.

While many folks fixate on the budget and deficits, my eyes gravitate toward absolute levels of government outlays. Since the 1930s, federal spending has increased annually and is tracing a geometric-like progression.

In the 19th century, it was not unusual for government outlays to remain flat or decrease year over year.

A number of factors contributed to the structural shift towards persistent spending increases. The Sixteenth Amendment, ratified in 1913, gave Congress the power to collect income taxes. Prior to this grant, government receipts were collected primarily from customs duties, land sales, and excise taxes. The Federal Reserve Act was also passed in 1913, which established a national central bank with powers to influence money and credit supply.

Monetary discipline further eroded with the issuance of Executive Order 6102 in 1933, which effectively removed the USDs 'good as gold' backing so that government could ramp spending for New Deal programs. John Maynard Keynes' view that governments should spend money they don't have motivated bureaucrats further stoked the spending fire.

Laughably, many of these measures were implemented under the auspices of 'stabilizing' our economic and social systems. There is nothing stable about this situation.

An ever increasing diet of taxes, debt, and debased currency is necessary to feed the Leviathan.

position in USD

Wednesday, November 5, 2008

Saving, Debt, and Risk

So true
Funny how it seems
Always in time, but never in line for dreams
--Spandau Ballet

A basic problem facing any individual involves allocating inflows of scarce economic resources (also known as income). Two general possibilities exist: resources can be consumed in the present, or they can be saved for future consumption. Saving is the difference between income and consumption.

Individuals interested in elevating their current standard of living can consume more and save less. Increased consumption reduces resource stocks that can be applied towards future consumption. The lower the level of saved resources in the present period, the greater the dependence on future income in order to maintain today's standard of living.

Proposition 1: Lower levels of saved resources increase the risk of a lower future standard of living.

It is possible to further elevate current living standards if resources can be borrowed from others. Borrowed resources are consumed in exchange for a promise to pay back lenders' original quantity of lent resources (principal) plus usually some additional resources (interest) in the future. Borrowing depletes resource stocks that can be applied towards future consumption. In fact, saving is now negative because consumption exceeds income. Because of the obligation to pay back resources that have been consumed, borrowers are not only dependent on a future income, but on an increasing income in order to maintain the standard of living experienced today.

Proposition 2: Negative levels of saved resources (debt) magnify the risk of a lower future standard of living.

Over the past few decades in the U.S., saving has been declining. Debt at individual and aggregate levels have been increasing geometrically. While reduced saving and increased debt have increased current standard of living, risk of a lower future living standard has increased as well.

Accepting a lower standard of living means less consumption and more saving. Maintaining our standard of living means increasing future income at a rate that at least matches our negative savings.

Matching our negative savings with more income seems a tall order when debt is increasing geometrically.

Tuesday, November 4, 2008

Emotion in Motion

I would do anything
To hold on to you
Just about anything
That you want me to
--Ric Ocasek

Emotions are part and parcel of the human condition. Through a philosophical lens, emotions are often viewed as contributing 'spice' to life.

From a cognitive standpoint, emotions constitute a mechanism for constraining and directing attention (Matthews & Wells 1994). Because they offer capacity for 'framing,' or for winnowing the number of possible considerations to a manageable number for deliberation, emotions can be a useful component of rational thought.

However, we also know that emotions can impair reasoned thought process. For example, emotions can influence interpretation of past events (Kahneman 2000), recognition of temporal cause and effect relationships (Thaler & Johnson 1990), and assessment of risk and reward (Kahneman & Tversky 1979).

Under conditions of threat, emotional framing mechanisms may 'overshoot,' leading to an excessive narrowing of information processing that inhibits generation of well reasoned solutions for coping with the threat (Staw, Sandelands, & Dutton 1981). Individuals are often unaware of the role of emotions in shaping their decisions (Fingarette 1969).

A common expression of emotional influence on decision-making is confirmation bias. Confirmation bias involves the tendency of individuals to seek and side with information that supports their beliefs, while avoiding or dismissing information that refutes their beliefs (Lord, Ross, & Lepper 1979). Confirmation bias can impair critical thinking because it demotivates search for informed alternatives.

Confirmation bias is on my mind because of the current election context. And examples abound of confirmation bias among individuals engaged in political decision-making processes. Consider for example those folks who can readily recite a laundry list of defects regarding the opposition while staunchly dismissing all claims made against their preferred candidates. Processes and content of other political phenomena, such as rallies, satire, and political ads all seem consistent with exciting the reactive, emotional limbic system rather than other portions of the brain that support careful, reasoned thought.

In a democracy, one sided bias of political thought is sometimes viewed as acceptable because aggregating biased choices made during an election purportedly reflects a homogenously wise 'voice of the people' that magically corrects for individual bias (Surowiecki 2004).

Such a view seems misguided. Because individuals make choices, if voter thought processes are poorly reasoned, then election outcomes may not reflect collective wisdom. Instead, they seem more apt to reflect the aggregate ignorance of individuals.


Fingarette, H. 1969. Self-deception. London: Routledge & Kegan Paul.

Kahneman, D. 2000. "Evaluation by moments: Past and future." In D. Kahneman & A. Tversky (eds.), Choices, values, and frames, pp. 693-708. New York: Cambridge University Press and the Russell Sage Foundation.

Kahneman, D., & Tversky, A. 1979. Prospect theory: An analysis of decision under risk. Econometrica, 47: 263-291.

Lord, C. G., Ross, L., & Lepper, M. R. 1979. Biased assimilation and attitude polarization: The effects of prior theories on subsequently considered evidence. Journal of Personality and Social Psychology, 37: 2098-2109.

Matthews, G. & Wells, A. 1994. Attention and emotion: A clinical perspective. Hillsdale, NJ: Lawrence Erlbaum.

Staw, B.M., Sandelands, L.E. & Dutton, J.E. 1981. Threat-rigidity effects in organizational behavior: A multi-level analysis. Administrative Science Quarterly, 26: 501-524.

Surowiecki, J. 2004. The wisdom of crowds: Why the many are smarter than the few and how collective wisdom shapes business, economies, and nations. New York: Doubleday.

Thaler, R. H. & Johnson, E. 1990. "Gambling with the house's money and trying to break even: The effects of prior outcomes in risky choice." Management Science, 36: 643-660.

Monday, November 3, 2008

Rear Window

I keep looking for something I can't get
Broken hearts lie all around me
And I don't see an easy way out of this
--Cutting Crew

Here's the near term market scenario that I'm warming up to. Initially, optimism as credit markets find some traction, coupled with clarity over a presidential election verdict, sparks a multi-week or perhaps multi-month stock market rally. I wouldn't be surprised to see a 20% move or so--into SPX 1250ish.

The bloom comes off the rose in Q1-Q2 2009, as credit markets retighten and the economic consequences of the credit bust (e.g., unemployment moves towards 10%) become widely evident. A new round of bureaucratic interventions are enacted. Prices head lower, where we revisit and likely break below the recent October lows.

Such prognostications are nonsensical, I know. But it helps provide a working framework, sure to be revised, in the upcoming period.

no positions

First Impressions

You who are on the road
Must have a code that you can live by
And so become yourself
Because the past is just a good bye
--Crosby, Stills, Nash & Young

I've long held that during election cycles, and particularly during presidential campaigns, people revert back to child-like behaviors, such as attending 'rallies' to support their 'team', posting their particular affiliations on their sleeves (or in today's situation, in their yards, on their cars, etc), and the like.

But where do kids learn this behavior? In circular fashion, perhaps kids learn vicariously, by watching adults parade through their rituals during election time.

For example, by watching us, there's a good chance kids might learn the following:

-->Do what you can to discredit folks on the other side, including methods of parody and satire.
-->When making an argument, present and consider only your side of the story.
-->Communicate in a manner that intrudes on the privacy of others.

Viewed through this lens, such a cycle is likely to perpetuate until adults change their behavior.

Sunday, November 2, 2008

Getting Real

Well, guess we're gonna have to take control
If it's up to us, we'll have to take it home
--Bobby Brown

From where I sit, there's considerable chance that a prolonged deflationary period is commencing. What financial strategies work best during deflation? Paying down debt, reducing risky assets, and raising cash (saving) help protect wealth during deflationary deleveraging and position individuals favorably for the cycle's end.

Over the past two years I've been acting accordingly. I've paid down nearly $100K in debt, including a $30K home equity loan, all credit card debt (another $30K+), and my car loan. I've sold many risky assets; my liquid asset allocation currently stands at nearly 45% cash and short term fixed income (CDs) across all accounts (including brokerage and retirement accounts). I've been raising cash (primarily via saving more of my paycheck) such that readily accessible cash account balances (checking, Vanguard money market account) currently stand at more than one year's worth of living expenses.

The big enchilada still out there is my home mortgage. About $124.7K in principal remains on my 15 year fixed mortgage originated in 2004 @ 5 1/8%. Using various payoff and amortization calculators, I modeled various scenarios. My conclusion: I can pay this off in 36 months.

Beginning this month of November, my plan is to add extra principal to my monthly payments at a rate that will pay off the home in 4 years. That will allow me to still build cash at a significant rate. Then, in October of 2011, if all goes well, I'll snuff out the 4th year principal in one lump sum payment.

It appears, then, that my big investment over the next couple years will be in real estate--to OWN my place of residence. Based on the interest savings, I estimate the annualized return on this project at about 5.4% pretax. The return improves if I'm fortunate enough to pay it off sooner.

In a low yielding deflationary environment, it may be difficult to achieve such a return on other projects.

God willing, total debt freedom is thirty six months away.

Saturday, November 1, 2008

Battle Royale

Everybody was kung fu fighting
Those cats were fast as lightning
In fact it was a little bit frightening
But they fought with expert timing
--Carl Douglas

A titanic square off is underway between hyperinflationary and deflationary proponents. Hyperinflationists believe that the massive world wide intervention, measured in the $trillions, to recent market crises will paper the globe in fiat confetti--and governments will do whatever it takes to stave off price declines.

Deflationists argue that the gigantic amount of global leverage built up over years (decades) is beginning to unwind and is unstoppable--regardless of bureaucratic meddling.

Often the answer to binary scenarios lies somewhere in between. In this case, however, I'm not so sure. An extreme amount of monetary and fiscal stimulus is being thrown at an extreme debt buildup. That these two extremes somehow average together to produce a 'normal' situation seems doubtful to me.

The problem for investors is that the appropriate responses to these binary scenarios diametrically oppose each other. Hyperinflation calls for staying away from cash, borrowing funds (since you pay back in currency that depreciates during inflationary price increases), and investing in risky assets that keep up with or exceed the price increases spawned by hyperinflation. In hyperinflationary periods, cash is trash because money is everywhere and there's too much supply.

Deflation calls for building cash, paying down debt (since you pay back in currency that gains in value during price deflationary price declines), and shedding risky assets that fall in value during deflationary deleveraging. In deflationary periods, cash is king since few people have it.

Rather than pick one scenario and bet all chips on it, I've found it more reasonable to design a portfolio around probabilitistic assessment of the future. For example, I currently estimate the following probabilities for general macroeconomic scenarios over the next few years:

hyperinflation - 30%
'normal' inflation - 20%
deflation - 50%

Correspondingly, I've been trying to blend my asset allocation to reflect these views. Here's a rough sketch of where I currently stand:

-->20% commodities (via ETFs such as GLD, JJE, RJA). Applies primarily to hyperinflationary scenario but should also 'work' under normal times.
-->45% cash and short term fixed income (money market funds, short term CDs). Applies to 'cash is king' deflationary scenario.
-->35% stocks (primarily high dividend paying pharma names Merck (MRK) and Pfizer (PFE)). Decent value and high yield applies across scenarios. Stock price appreciation for the hyper and normal scenarios. Dividend yield (MRK and PFE currently yield 5-7%) for the normal and deflationary scenarios.

These probabilities and allocations are, of course, not etched in stone; they're subject to change as things unfold. While favoring the deflationary argument, I've recently warmed more to the inflationary possibility given mamouth interventions still to follow from administrations that possess central planning mindsets. Thus, I've upticked my commodity exposure in kind.

Have you noticed the irony of this approach? Even though there's a good chance that these various scenarios don't average themselves together in reality, I'm blending my decisions as if they will.

There's plenty of risk to this approach, of course. For example, my assigned probabilities could be off, or my choice of investment vehicles may be wrong.

But my humble view is that such an approach may help navigate a period where preserving, let alone building, wealth promises to be extremely challenging.

positions in GLD, JJE, MRK, PFE, RJA