Sunday, April 25, 2010

Issue XII - Biflation

Dear Readers,

As you probably know, in recent months there has been a heated debate among economists and politicians regarding inflation and deflation. The camps are divided over the direction of our economy with regard to both scenarios. As you may remember, I covered the arguments for and against both inflation and deflation before the New Year. While most investors are concerned with the prospects of either scenario ravaging their portfolios, many have failed to examine a little known theory on the subject that combines both inflation and deflation. What may be the situation at hand is a scenario where both parties are correct to a certain degree. With the current economic situation in the United States as well as the changing geography of the global economy, it could be that both camps are right, but neither argument can describe the situation entirely. Meet biflation, the stagflation of the 21st century.

Biflation is a relatively new economic concept¬¬¬ that was initially outlined by the economist F. Osborne Brown in 2003. Some commentators have been quick to view biflation as stagflation all over again. However, there are clearly defined differences. The ingredients of stagflation are simply a stagnating or recessionary economy against a backdrop of inflation across the board, with price increases in nearly all categories. Since biflation is an emerging concept, many economists are in disagreement with regard to its definition. In spite of that, several private economic research organizations have loosely defined biflation as an economy where inflation of commodity-based assets occurs alongside the deflation of debt-based assets.

First, let’s take a look at the inflationary aspect of biflation. Many economists and commentators, myself included, have argued that the money supply injected into the economy by central banks worldwide will lead to higher inflation in the future. If the economy goes through a biflationary stage, this is destined to be at least partially correct. The prices of commodity-based assets such as food, oil, and metals will increase. With the developing economies in Asia, demand for such assets, particularly food, will continue to grow. The price increases will be exacerbated further by the excess money supply pursuing the limited supply of goods. Such is the inflationary aspect of biflation.

One of the most prominent voices in predicting inflation has been financial guru Jim Rogers. After establishing the Quantum Fund with George Soros in 1970, Rogers went into semi-retirement in 1980. After stints as a professor, traveling extensively, and writing about his motorcycle trips around the world (Investment Biker and Adventure Capitalist, both great reads if you are interested), he moved to Singapore in 2007 to be in closer proximity to the growing Asian economies. He has emerged in the past few years as one of the strongest proponents of future inflation. When asked in a recent interview if he feels that the US will be hit by inflation due to Bernanke’s actions, he quickly cut the interviewer off, saying, “Not just the Federal Reserve. All central banks are part of the problem. We’re going to be paying more for just about everything down the road.” When asked if he foresees a 1970s-style period of stagflation ahead, Rogers replied with a smirk, “I hope it’s that good. It might be much, much worse.”

Every new set of data that points to inflation seems to be offset by an accompanying set of data that suggests otherwise, leading to mixed conclusions. We have seen oil continue its robust recovery from the violent, margin-induced selloff of late 2008 (refer to Chart 1). For the first time in nearly two years, the prospect of $100/barrel oil is once again a possibility with the spring and summer driving season approaching. The price of oil is now identical to that of October 2007, when the S&P 500 reached its all-time high. Gold, while still $75/oz. off its early December high, has also recovered 50% from the late 2008 interim lows. Across the world, government statistical agencies are reporting increasing levels of inflation. Last week, India’s annual inflation rate for March was reported at 9.9%, up from less than 2% last September. Consequently, on Tuesday the Reserve Bank of India (RBI) announced its intention to continue the trend of raising rates in the foreseeable future. The RBI’s governor described the situation as “worrisome.” This sudden increase is not limited to Asia. Inflation has now hit the UK, rising to 4% according to the most recent data. This exceeds the Bank of England’s internal 3% inflation target.

Chart 1 – Light Crude – Continuous Contract: April 2007-Present

Note that the 50-week moving average (Blue Line) is about to cross upward through the 200-week moving average, which despite the 2008 selloff, has remained steady due to oil’s recovery.

Now for the deflationary aspect. When the talking heads engage in this debate on CNBC's Squawk Box, Charlie Rose, or other programs, the general argument for deflation is that there is a large housing glut that will take years to wear off, in addition to excess capacity in manufacturing and many other areas of the global economy. The economy has been held down by increasing unemployment and decreasing purchasing power even as the recession has begun to abate. With individuals and families cutting back on spending, a greater amount of household income is directed toward buying essential items. Therefore, large purchases (read: debt-based assets such as McMansions, appliances, automobiles, etc.) increasingly fall into lower demand. Prices for these items remain stagnant, if not decreasing, and these sectors of the economy experience the deflationary aspect of biflation.

At the same time we have been receiving inflationary reports and data, other economists continue to ring the deflationary alerts. As I have mentioned in previous commentaries, the prospect of our economy falling into a destructive cycle of deflation is a scenario that our country’s fiscal leaders are willing to do nearly anything to prevent, up to and including debasing our currency. Despite that, some deflationary risks remain. The real estate market, after stabilizing in 2009, potentially could take another downturn via commercial real estate and a great overhang of housing supply that is not even on the market, often referred to as the “shadow housing inventory.” Many stories appearing in the financial media in the past several months have pointed out that despite foreclosures falling in number, the number of properties eligible for foreclosure has continued to climb through 2009. Fifty percent more US home mortgages are now seriously delinquent than during the heart of the financial crisis in late 2008. The rate is 9.67% now compared to about 6% then (refer to Chart 2). In fact, it is estimated that five to six million properties are eligible for foreclosure but have not been repossessed. I have seen a range of predictions, but the median estimate of economists is that it will take about three years for the housing market to digest the excess housing inventory.

Chart 2 – Seriously Delinquent US Home Mortgages 2005- Present

Deflationists are also supported by the lack of credit available to most small consumers and businesses, which continues to keep a lid on economic growth. In early February, the Core CPI figure fell by 0.1%, the first such occurrence since the early 1980s. This sparked fresh fears over a return to a deflationary environment, but moreover it reminded many that the recovery is modest at best, and therefore prices have good reason to remain contained. As with the inflation camp, there are some who feel it is a sign of things to come. Mizuho Securities Chief Economist Steven Ricchiuto said in February that even though core wholesale prices rose 0.3% in January 2010, they have only risen 1% in total since January 2009. Further, Gluskin-Sheff economist David Rosenberg, formerly of Bank of America, sees deflation as the “primary risk” to investments in the near future, noting that “it is truly difficult to believe inflation is going to be revived in the intermediate term.”

So what’s the verdict? I think it is reasonable to say that our economy is showing both ingredients of biflation, regardless of a universally-accepted definition. The prices of oil and food staples appear to be headed higher while home prices have begun to slide once again. According to home price tracker, house prices slid more than 6% in February and March. Obviously, the relative lack of credit is still a thorn in the economy’s side, and with the first-time homebuyer tax credit coming to an end, there is potentially another down leg coming up in real estate. If figures begin to tilt on the deflationary side, central banks may increase their intervention once again, propping up sectors of the economy that are experiencing deflation but having the inverse effect on the inflationary sectors. Along with rising worldwide demand for food and commodities, it could become a vicious cycle of biflation until home prices begin rising once again on a sustained basis, and rates are raised to the point that prices can be contained. Needless to say, raising rates with the situation the US is up against will be a heated topic of debate if inflation does take over. Unlike in 1980 when the US enjoyed the status of being the world’s largest creditor, such is not the situation today. Raising rates in earnest to crush inflation could be difficult with the debt our government will need to continue issuing. But this is a discussion for the future. Until then, biflation could be the situation for some time.

Respectfully Yours,

Matthew R. Green
April 22, 2010

Thursday, April 8, 2010

Issue XI - Boomers/Demographics

Dear Readers,

They called them the Baby Boomers, history’s most prosperous and powerful generation. With the first members of this vaunted generation now transitioning into their retirement years, there have been numerous documentaries produced recently (CBNC’s Boomers, PBS’s Frontline, etc.) reporting on the challenges that many Boomers will face going forward. In the course of American economic history, the heyday of the Boomers in the workforce ran alongside the greatest economic expansion ever. Indeed, Boomers contributed directly to its rise and fall, whether via the secular trend of buying stocks for retirement or conspicuous consumption, assisting to create the stereotypical mold of the American consumer. With these trends ending, catalyzed by the recession and subsequent need to save for retirement, the economy finds itself at a crossroads. Does the economy need the Boomers as much as they need it, and vice versa? Both statements may be correct.

The typical period that most people consider their “adult” life (roughly the time they exit college to retirement) is about 40 years in length. History is a collection of long and short term trends, and economic trends in particular are driven by a nation’s position within the world and demographics. When an individual’s lifestyle has been driven by these trends, it is reasonable to think that they, and indeed their entire generation, would come to recognize what had transpired to be normal. For the Boomers, I fear that many have yet to recognize that within the context of economic history, the past 40 years were anything but normal, driven by the rise and fall of their own, prosperous generation. Fiat money and expansion-friendly demographics resulted in four decades of successive booms and busts in many markets. Put together, it can be argued that they all fed into a larger, secular bubble that was demographically-fueled at its heart. We have found ourselves unprepared for the fallout from this bubble with no easy answers, especially for those in my generation.

Before the Boomers even got out of college, Lyndon Johnson was shaping their economic future without them knowing it. The budgetary strain of the Great Society programs and Vietnam were the final nails in the coffin for the Bretton Woods monetary system. This directly led to Nixon taking the US off the Gold Standard in August 1971. Even though the US was one of the last economic powers to do so, the system was widely regarded among economists as a relic that constrained economic growth. The significance of the move lay in the advantage that it gave to the Baby Boomers; it eventually would enable them, in middle age, to take on debt unlike any previous generation.

The shorter-term consequence of the brand-new era of fiat currency, when added to the oil embargoes of the 1970’s, was stagflation and the subsequent boom in commodities. Detroit kept producing gas guzzlers for Americans even as US oil production peaked early in the decade, and the Middle Eastern crises sent oil prices on an upward trajectory from an inflation-adjusted $15-17 a barrel to over $100 a barrel in 1981. In 1974, private ownership of gold was made legal for the first time since the Great Depression. Gold rose from its $35/oz fixed value to $850/oz (non inflation-adjusted) in 1980. This was the peak of an uptrend in commodities, with an accompanying secular low in the value of stocks. Things began to change when Paul Volcker replaced Arthur Burns as Chairman of the Federal Reserve.

Besides his well-known accomplishment of breaking the back of inflation, what is lesser known is that the Fed under Volcker also changed the definitions of inflation. Aiding the rise of inflation during the late 1970’s was the subsequent bidding up of wages by then-stronger unions and retirement systems alike. Many economists, including Yale economist Robert Shiller, have argued that the removal of the actual cost of home ownership within the CPI, replaced by the Owner’s Equivalent Rent, has created a distortion that has in turn contributed subdued inflation since then. Thus, once interest rates began to fall and the economy picked up in 1982, inflation did not follow due to the combination of new inflation definitions and a worldwide oil glut.

For the next decade, Boomers entered the heyday of their wage earning. Having retained the robust savings rate of their parents up until that time, Boomers began to invest those savings into the stock market and into other safe fixed-income investments. Simultaneously, the credit markets began to innovate and expand at an unprecedented pace. As the number of home-buying Boomers increased, Congress passed new regulations that enabled mortgage-backed securities to explode. Bonds, a backwater during the inflationary 1970’s, suddenly were the best department in which to work at the investment banks amongst the mortgage- and junk-bond booms. The trend of debt was not limited to Wall Street. US household debt began to rise above 20% around 1985, the first time this had occurred in the Boomer’s lifetimes. This initiated a secular increase in US household debt that would not be broken until 2008. At the time, it only served to further buttress economic growth.

The 1980’s ended with a few localized real estate bubbles popping in California, Arizona, and a few other locales across the US. Michael Milken’s Drexel Burnham Lambert went bankrupt in February 1990, bringing the junk bond’s glory days to a close. However, the biggest bubble of them all during the 1980’s was across the Pacific in Japan. All Japanese assets, with real estate dwarfing everything else, soared to unprecedented heights. It was not uncommon to see Japanese companies trading at P/E ratios of over 100 in 1989. By late 1989, even respected fund managers such as Fidelity’s Peter Lynch bought into the idea, albeit temporarily, that this Japanese growth was permanent. “The total value of Japanese stocks actually surpassed that of US stocks in April 1987,” he noted in his 1989 book One Up on Wall Street. After peaking the week after Christmas in 1989, the bubble burst. Few lessons appeared to be learned, and it was a preview of what would transpire the next decade on this side of the Pacific.

Despite the US stock market’s crash on Black Monday (10/19/87), and the pesky, multi-year Savings and Loan Crisis, the Baby Boomers kept on earning. After a recession in 1990-91 (which, more than any other factor, cost George H.W. Bush the 1992 election), the market steadily increased through the first four years of the decade. With the help of a few interest rate cuts by Greenspan and relatively new forms of retirement planning (401(k)’s, etc.), the Boomers continued to invest their money in the stock market. After a fixed-income crisis in 1994 that claimed the investment bank Kidder Peabody, Greenspan once again began lowering interest rates. This contributed to a 28% increase in the Dow Jones Industrial Average in 1995, clearing the way for the final stage of the bubble. Then the final ingredient was introduced: the internet.

In 1996, Greenspan gave his famous “irrational exuberance” speech, warning of what he viewed as excesses in many areas of the economy. The next year, many internet companies began to go public. Simultaneously, the percentage of the public with access to the internet increased by more than 50% each year from 1995-1999. The recipe was perfect for the technology bubble that took the Dow, NASDAQ, and S&P 500 along for the ride. The Asian Financial Crisis in 1997 and the Russian Debt/LTCM crisis in 1998 did little to stir the tide, though it did produce a mini-crash on October 27, 1997, and again in August/September 1998. As Amazon, Yahoo, eBay, Qualcomm, and many other internet stocks began to see 400% increases, the NASDAQ soared 84% in 1999 to just over 5000 in March 2000. Not a peep was heard from Greenspan, who began to make speeches around this time embracing what was being referred to as the “new economy.”

Americans soon found out that for every Amazon, there were at least three examples of “dot-compost” such as Webvan,, and Kozmo. Like what had happened in Japan, Americans failed to realize that companies trading at P/E ratios of over 50 are more often than not overvalued. There were stories of a few select Baby Boomers investing sizable portions of their wealth into IPO’s of companies that were nowhere close to breaking even, losing everything in the process. In the broader picture, after spending the 1990’s watching their portfolios appreciate, many Baby Boomers saw dreams of early retirement put on hold. It wasn’t over yet. A key difference existed between the Japanese bubble and post-tech bubble America. Japan in the 1990’s saw two major bubbles deflate at once. For Americans, the other, more destructive half of the bubble would come later.

With the economy already struggling in the wake of the deflating tech bubble, the 9/11 terrorist attacks shocked the nation. Alan Greenspan said in a 2008 interview that 9/11 was the kind of event that “historically could result in the undoing of a nation.” Whether that statement was a stretch or not, he immediately began a series of sharp interest rate cuts (refer to Chart 1). The results came within a year. With the credit spigot wide open, Americans began to shop again and to buy and develop real estate. (I remember that when I went on college visits in July 2002, nearly every campus that I visited was initiating a major construction project. Not surprisingly, this was more pronounced at the well-endowed colleges in the Northeast.)

Chart 1 – Federal Reserve Prime Rate 1954 - 2009

Although the stock market had been in a secular bull mode since 1982, the US housing market had (albeit in hindsight) experienced only a few localized bubbles. Occasionally, the corrections took down an overzealous investor or developer who leveraged themselves too much; Donald Trump’s difficulty during the early 1990’s is perhaps the most famous example. Regardless, nobody, not even the nation’s best economists, foresaw the magnitude to which Greenspan’s interest rate cuts would juice the housing market. Signs of a bubble were being pointed at by skeptics as early as 2002-03, but typical bubble behavior took over as annual refinancing by homeowners to tap into home equity became commonplace in 2003-06. Baby Boomers and Generation X’ers alike got into this habit. Such frequent refinancing was symptomatic of the expansion of all forms of credit, not just housing. Consequently, 2004-07 saw the biggest leveraged buyouts since the 1980’s and a subsequent second golden age for private equity. Real estate prices peaked in 2006, and by late 2007 were in serious decline. We all know what subsequently happened in 2008.

That brings us to today. For the past 40 years, the Baby Boomers’ earning power helped to fuel, and therefore ran concurrently with, a large secular bubble of US assets. Was it all an aberration, or was it the new normal? A March 9, 2010, article in the Wall Street Journal offered some insight as to whether stock valuations for the past generation have been normal. In short, they have not (refer to Chart 2). Those who called for a bottom in stocks in early 2009, saying it was a once in a lifetime low, have looked like geniuses in the interim. They are likely to be disappointed. The market may not fall back to those lows, but the inevitable devaluation of the dollar will have the same effect in terms of real money (refer to Chart 3).

Chart 2: This chart appeared in the Wall Street Journal on 3/9/10. Even after the 2008 crash, stocks are still historically overvalued as measured by multiples of company profits.

Chart 3: S&P 500 priced in Gold 1980-2009

As mentioned earlier, it has been almost 40 years since Nixon ended the dollar’s peg to gold. The era of fiat money, running parallel with the adult life of the Baby Boomers, brought with it a series of successive mini-bubbles, first in commodities, then real estate, and then stocks. Eventually, each mini-bubble repeated itself on a grander scale than before. All the bubbles were connected by the free flow of credit, directed by Maestro Greenspan, and subsequently came to an end in 2007-08. The US, and indeed the rest of the western world, finds itself trapped with debt from entitlements and cleaning up the mess of the past two years. A verdict on the fiat era is yet to be returned, but it is safe to say that many have doubts about the merits of this system that they would not have entertained the thought of 10 years ago.

With the population of the world continuing to increase, many investors are caught between anticipation and fear of a future bubble in commodities. As consumers, the fixed supply of our planet’s natural resources meeting an endless stream of paper money is a scenario about which we should not be excited. Alas, many questions and possibilities remain. At the least, a positive trend will be the resurgence of the debate with regard to what sound money is and is not. I am not saying we are going to have a return to the Gold Standard. After all, as mentioned earlier, by 1971 the Bretton Woods Gold Standard was looked upon as a relic that clamped down economic growth. However, the concept of free flowing credit within a fiat money system is clearly far from perfect as well. Facing an uncertain future, cooperation will be required in the next decade to work toward a new, sound financial system for the entire world. Asia will provide the Baby Boomers of the future. Even though they may not be as wealthy on a per capita basis, the numbers will result in the aggregate economic effect being just as big, or even bigger. Therefore, ideally a new monetary system that addresses the needs of American Baby Boomers, Generation X’ers, Millenials, and indeed the new, emerging middle classes in Asia can hopefully be devised. Whether that can actually be accomplished is yet another debate.

Respectfully Yours,

Matthew R. Green

April 8, 2010