Forget Fiscal Cliff! Can the Economy Grow in Five Years Without Government Stimulus?

I don't know about you, but the hysteria about the fiscal cliff is beginning to really rub me raw. It is not so much the politicians doing their dance. It is instead the distraction from the larger fundamental question of: "What is right for the long-term health of the economy?"

After a big step back, let's consider what deficit spending has meant to the economy.

% of GDP	2000	2012
Total Government Receipts	20.6%	15.8%
Total Government Outlays	18.2%	24.3%

The amount of taxes paid, as a percentage of GDP, has declined almost 5% of GDP to 15.8%. In other words, instead of paying money to the government, individuals have been purchasing goods and services, a stimulant for the economy. Secondly, government outlays have increased over 6% of GDP to 24.3%. A significant stimulant to the economy has been higher government spending, especially in the area of healthcare.

One can argue that these figures suggest more stimulus is needed in order to avoid an economic slowdown. Indeed, there are economists on the left-side of the spectrum advocating up to $2 trillion of additional stimulus spending in order to grow the "denominator," or GDP. The basis of the argument is that cutting the government deficit produces a 1-to-1 reduction in the private surplus, hurting the economy as witnessed in Europe under austerity measures. Yes, we are talking defined formulas for calculating GDP. Also, intuitively it makes sense that slowing government spending or raising taxes will be a drag on the economy, just as the opposite was true during the last decade.

Source: New Economic Perspectives

However, this raises the philosophical question of whether the government should be the main driver of economic growth for an extended period of time. The government can obviously drive growth, but when pursued for a decade how does this type of growth driver pervert private economic activity? President Obama has maintained budget deficits in excess of 7% of GDP during his term in office. While this has helped avoid a more catastrophic depression, I fear it is also increasing systemic risk as companies increasingly rely on both government spending and lower income and capital gains taxes, either directly or indirectly.

Where I respectively disagree is sustainability of these policies. Economists advocating stimulus spending generally argue that by growing GDP through deficits, the economy can reach a self-perpetuating growth rate, at which point the government can remove stimulus spending and on-going growth can then pay down the debt. Based on this theory, you would think after 4 years of historically high deficits the economy would have performed better. In fact, the only period in the last 10 years of fiscal stimulus that has approached "normal" economic activity was the result of an inflating housing bubble that proved short lived. I suppose an ever increasing deficit and increasingly aggressive monetary policy can keep the economy growing, but there may be a diminishing impact on GDP growth as inefficiencies in the economy are allowed to remain.

The budget deficit as a percentage of GDP has been 10.1%, 9.0%, 8.7% and 7.0% for 2009 through 2012, respectively.  To put this in perspective, the largest budget deficits since WWII were a little over 5%, which only happened twice. In 2013, the budget deficit is forecast between 5.5% to 6.0%.

Again, let's review some numbers:

• US Debt Held by Public - $11.5 trillion (~ 75% of GDP)
• US Debt Outstanding - $16.3 trillion (Greater than 100% of GDP)
• Estimated US Debt Outstanding 2016 - $22.8 trillion (~ 150% of GDP)
• Total Liabilities of US Government (Soc Sec, Medicare, Govt pensions) - $86.8 trillion (550% of GDP)

Here is a measure Debt/GDP from other countries:

• Spain - 85%
• Greece - 175%
• UK - 75%
• Italy - 126%
• France - 90%
• Japan - 235%

Why does the US benefit from ultra-low interest rates while other countries with a slightly higher debt-to-GDP have interest rates spike upwards? One of the main reason, in my opinion, is because of the Fed's bond buying. However, the size and strength of the US economy, a focus mostly on public debt, falling debt service payments, and the view of the dollar as a safe currency play important roles. But, the disparity in interest rates has caused some head-scratching. I believe my Sagflation theory helps to explain this issue through the combination of fundamental deflationary forces offset by expansionary monetary policies, both of which are pushing interest rates lower. 

So debt levels have been rising. At what level does the bond market pull back from US debt is very much debatable. I will leave it by stating the obvious, the higher the leverage ratio the less forgiving is the bond market if the economy slows. Stimulative policies that raise the leverage ratio increase the risk of interest rates spiking should the economy slow before the debt can be reduced.

Why I Continue to Remain Bearish

Returning to two points made previously, and adding one more. Since 2000, the following has happened in the economy:

1. Taxes paid, as a percentage of GDP, has declined almost 5% of GDP to 15.8%. 
2. Government outlays have increased over 6% of GDP to 24.3%.
3. Interest rates on 10-Year Treasuries from around 6% to about 1.5%.

The lower taxes have added a general stimulus to the economy, enabling individuals to purchase more products and services because of a higher after-tax income. Given the current battle in Congress it appears as though taxes paid may go up, either through higher rates or lower deductions. Either way, this stimulant is about to reverse and become a drag as after-tax income declines. Luxury sales are likely to soften as taxes on incomes over $1 million potentially go up.

The larger government outlays as a percentage of GDP have driven growth rates above what is naturally sustainable in segments like defense and construction; and has enabled a woefully inefficient healthcare industry rife with fraud and over-billing. The growth rates in these industries likely moderate, although healthcare may prove more resilient given the changes to the healthcare laws.

The falling interest rates have added significant stimulus to the economy, especially in industries requiring debt financing like housing and autos. Not surprisingly, both the housing market and auto industry has enjoyed a lift as the Fed aggressively purchases treasuries and mortgage-backed securities.

The critical question, in my mind, and the one everyone is fighting over is this:

Is the economy structurally efficient for the long-term?

Hard to answer this question, but I think the fundamental deflationary forces, shadowed by excessive bank reserves, hint at over-supply and poor returns in many industries. Structurally the tax code is inefficient and this constant whining from business leaders about "uncertainty" in Washington hints of businesses too closely tied to the government and its policies.  Finally, the rising amount of poorly written regulation as the government reacts to crises is likely having a cooling effect on the economy.

Mr. Bernanke can keep the growth engine bouncing along as the Fed's balance sheet now exceeds $3 trillion, and in many ways he is doing what is necessary to avoid a deflationary death spiral. But, until the government enables the economy to become more efficient I believe we are doomed to Stagflation.


So while the federal government pursues stimulative measures the markets likely respond favorably. These policies could continue throughout President Obama's term in office. However, the exit of these policies becomes riskier as the debt balance rises and the Federal Reserve's balance sheet inflates. For a fundamental analyst, it is tough to swallow any company-specific analysis when the foundation of the economy seems softer and riskier than ever before. 

The Nose in the Book Penalty

Last year, in the run-up to the debt ceiling, I wrote how the Democrats were advocating a pro-inflation policy of stimulus while Republicans were advocating a pro-deflation policy of austerity. The outcome was ultimately a stalemate that led to the status quo, enabling on-going stimulus deficit spending combined with monetary easing.

Roll the clock forward almost 18 months and the national debt has continued to climb, the economy enjoyed a short-term spurt, and the economic outlook is darkening. So much for the stimulus of another $1 trillion deficit in 2012. The Democrats now appear to be second-guessing the stimulus argument, instead encouraging more of a focus on reducing the deficit. At least the two sides are now focusing on the single largest controllable factor.

Now the argument has shifted from deficit spending versus austerity to what type of austerity: higher tax collections or lower spending. While good because DC is slowly spiraling in on confronting the core problem, it is scary because austerity means likely pain. Put differently, the debate is now over who feels the most chilled by austerity.

Not surprisingly, the argument has quickly devolved into a type of class warfare. The Republicans clearly defending the rich through lower taxes and the Democrats clearly defending the poor through protection of entitlements. In the cross hairs is the middle class, who could feel the pain of both higher taxes and reduced entitlements. Thus the debate over which plan protects the middle class.

From here there are three defined paths, the Democrat path of higher tax rates with minimal entitlement cuts, the Republican path of significant cuts to entitlement spending and minimal tax increases, and the "kick the can down the road" solution our leaders love so much. Given that the President believes he received a voter mandate for higher taxes and the House Republicans believe they have a mandate to cut entitlements, the chances of compromise seem dim. The only real obstacle to the final path is the fiscal cliff, which seems to look more and more enticing to politicians as they struggle (or simply refuse) to compromise.

Ultimately I believe we need to "pay the piper," most likely through higher taxes AND meaningful entitlement cuts. Compromise must happen. But, since our politicians seem incapable of serious and intelligent compromises over a path out of our mess, we are likely to choose the least thoughtful and most disruptive path of the fiscal cliff. Yet should we go over the cliff we likely continue to have a deficit of over half a trillion dollars (assuming interest rates remain low) due to the sheer size of the problem. Maybe after going over the cliff our voter-elected partisan leaders will get down to actually figuring out some compromises.

If only there was a "nose in the book penalty" for our politicians who refuse to compromise...

We are a country of "AND's" voting for "OR's."

In a Coke Zero advertisement we watch a man emphatically dismiss "OR" and choose "AND..." to complete all his desires. The marketing behind this is pure genius, tapping into our sense of unfulfilled entitlement through a can of soda. The government has been governing in much the same manner, dismissing the need to choose and fulfilling our expectations of happiness through deficit spending AND... (wait for it...) money printing.

Everyone has been waiting for the election to solve our problems. We finally have a resolution! Obama remains President, the House remains Republican, and the Senate remains Democrat without a filibuster-proof majority. YEAH! ...Wait a second...o crap.

I love listening to the pundits spin it the morning after the election. The Democrats spin it as the Republicans now have to work with the President and the Republicans spin it as a messaging problem rather than a policy problem. Great, not much "hope" for the next four years.

But really, why should we expect our politicians to choose compromise when the voters choose partisan politicians? Moderates are a dying breed in the Senate, which is really a shame since Senators are the people who can usually broker some type of solution. (It is much more difficult to foster compromise in the House for multiple structural reasons.) If there was a message sent by the voters, it was party first, country second. We are a country of "AND's" voting for "OR's."

So do we go over the "fiscal cliff?" Looks pretty likely, in my view. Even after the lame duck session, the House likely remains opposed to tax increases. The fiscal cliff is simply a convenient maneuver to raise taxes without actually voting for it in the new session, while cutting some spending. The Senate can be filibustered from here to the next election. Maybe the President tries again to work with the House, but he will likely strike a harder line because of his re-election and his failure at brokering a debt ceiling deal last year.

Will Bernanke return the favor to the President now that his job seems more assured? Quite possibly, but at what expense? Good chance the US dollar slips more as money printing continues, pushing the country further along my Sagflation theme of fundamental deflationary forces offset by inflationary monetary policies. Sure, we can balance on the wire between these two forces for some time, but I fear the canyon is getting deeper and the winds stronger. We may see a very sudden spike in price volatility if the QE strategy begins to shake.

I remain largely in cash with a sizable position short the market. No need to change now since not much changed in the world yesterday, in my view.

Bubble Economics

we live in a bubble baby.
a bubble's not reality.
you gotta have a look outside.
nothing in a bubble, is the way it's supposed to be,
and when it blows you'll hit the ground.

 "Living In A Bubble" - EIFFEL 65

Sometimes pop culture captures the essence of the business environment. In this article I argue that we are living in an all-encompassing bubble created by the combination of a fundamentally deflationary U.S. economy and a decade of Federal Reserve overly aggressive policies focused on asset prices, instead of growth and inflation.

In the last article I highlighted data from McKinsey and Company that illustrated how ROIC bubbled up out of its historical range during 2004-2008. I ended the article with a series of possible reasons for this phenomenon, including tax rates, offshore labor, and monetary policy. In this article I put forth my theory that builds on my Sagflation thesis.

Sagflation Thesis
The Sagflation thesis argues that we are in a period of slow to negative real economic activity combined with more volatile prices caused by aggressive monetary policies. Capital allocation decisions have been perverted by interest rate manipulation for an extended period of time, resulting in the misallocation of capital in the economy. This manipulation has allowed economic activity to remain elevated and offset fundamental healthy deflationary forces in the economy, including offshore labor utilization, technology advancements, and lower tax rates. However, the artificially elevated economic activity has enabled poor capital allocation, increasing bad deflationary forces in the economy as low return projects founder. For a strong explanation of why investment spending is what really matters, please read Andy Kessler's editorial in the WSJ.

By repeatedly stimulating the economy through monetary policies, the bad capital decisions remain viable and likely even encourage additional poor capital allocation decisions. All this results in more volatile prices as fundamental deflationary forces are countered by increasingly inflationary monetary policies, something at which the Federal Reserve has become quite good.

Bubble Economics
By the end of 2013 the Federal Reserve could hold well over $3 trillion of government and mortgage-backed debt securities, assuming the government maintains its balance of treasury debt and continues to purchase about $40 billion of mortgage bonds each month. The Bank of England holds around $600 billion of government debt. The European Central Bank has announced a commitment to unlimited buying of bonds of troubled nations. The Bank of Japan recently expanded its asset-purchase program to over $1 trillion. Various other countries have implemented programs to manage interest and currency exchange rates.

The central banks are focused on driving GDP growth by expanding the money supply. However, actual nominal GDP growth remains weak. In formulaic economic terms, the velocity of the U.S. money supply continues to fall and the level of U.S. excess reserves continues to climb, largely offsetting the the efforts of the Federal Reserve and leaving nominal GDP below the desired level. These two variables suggest two possible trends: (1) individuals and businesses are holding money longer, which contributes to the decline in velocity, and (2) the demand for new loans is not strong enough to absorb the additional reserves supplied to the banks, which impacts velocity and excess reserves. As Professor John Harvey explains, "Supplying money is like supplying haircuts: you can’t do it unless a corresponding demand exists." Although I will add that changes in the credit approval standards of the banks, which may be loosening, has a significant impact on demand.

Both these trends suggest fundamental deflationary forces are present in the U.S. economy as income levels fall and consumers and businesses reduce leverage. As deflation expectations increase (such as for house values or wages) individuals are likely to hold their money more in cash for a longer period of time (driving actual deflation), just as the opposite is possible for inflation and hyperinflation. In essence, this may be one of the key reason for the Federal Reserve targeting mortgage-backed securities for the latest round of QE, to elevate house prices and attempt to change expectations towards inflation.

So if not economic growth, what has the monetary policy impacted? Benn Steil and Dinah Walker argue in the WSJ that the Federal Reserve changed its policy around 2000, from focusing on economic growth and inflation to a focus on asset prices. "Between 2000 and 2008...the Fed was behaving as if it were targeting "risk on, risk off," moving interest rates to push investors toward or away from risky assets." They argue that since 2009 the Federal Reserve has intended to mimic a negative interest rate environment.

Another way to consider this argument is that a deflationary environment should produce extremely low and even negative interest rates. From this perspective, the Federal Reserve recognizes, either on a conscious or unconscious level, the reality of the fundamentals and has created a mechanism to enable markets to function in their historical form with positive interest rates.

In either case, the question becomes: Is the monetary policy matched to the fundamental economic growth and inflation trends of the economy? Given my argument that we are in a deflationary environment, which implies negative economic growth, and the Federal Reserve targets a more historically normal growth rate, I believe the simple answer to be: no.

Thus, the follow-on question becomes: What long-term outcomes should we expect from this policy? In my opinion, under my Sagflation thesis the long-term outcome includes an increasingly narrow for the Federal Reserve to maintain price stability, eventually resulting in either accelerating inflation or deflation.

Economic Fundamentals
Returning to the bubbling up of ROIC between 2004 and 2008. The best possible answer for this deviation from the historical range would be that businesses found extraordinary investment opportunities through R&D processes that opened massive untapped markets. This didn't happen. Instead, I believe this extraordinary period is largely explained by global economic trends and more rigid structural issues in the U.S. economy, exasperated by government actions. On the cost side, businesses enjoyed falling cost pressures as labor costs subsided through offshore arbitrage of costs, operational costs declined as technology advancements enabled more efficient processes, and tax code changes that both boosted spending and enabled lower corporate tax payments.

On the revenue side, businesses benefited from a falling interest rate environment, which spurred demand as consumers enjoyed lower debt service expenses. Amplifying this trend was the levering-up by the consumer. Additionally, businesses have developed more effective marketing strategies through improved customer data collection and targeting enabled by the internet. Specific businesses may also have benefited from rising barriers to entry through favorable patent decisions. All of these trends were the likely core drivers of an expanding ROIC for a short period of time.

From a financing perspective, the historically low interest rate environment encouraged business expansion as financing terms became more favorable, pushing up the velocity of money. Factor in a relatively lenient credit approval process and the result was likely growth above a sustainable level, as evidenced by the housing bubble. Since 2007 the credit approval process has been tighter, reducing the ability of the central banks to expand the money supply. This trend may be shifting, so long as banks remain confident that economic growth remains positive.

Eventually excessive economic profits tend to diminish due to competitive pressures, investment in lower return projects, and reversal of shorter term favorable trends. I believe we are witnessing reversal of a few key trends that were favorable. Arbitraging labor costs with less expensive foreign labor is becoming less feasible due to higher transportation costs, rising wages overseas, and hidden costs associated with operational complexity, skills management, and intellectual property. While technology continues to advance, the technology companies focused on consumer products have enjoyed the strongest growth, possibly implying businesses are experiencing diminishing returns on technology investments. However, a lasting impact has been the median income falling four straight years to 1995 levels, simply affirming the deflationary forces present in the economy.

A couple trends could continue to work against businesses, or possibly turn positive. Since the financial meltdown in 2007/2008 credit approval processes have been tightened, pushing consumer debt levels lower and hindering consumer spending. Whether credit approval remains tight or begins to loosen again is an open question. Finally, the tax code remains riddled with special interest loop holes that benefit certain businesses but make the overall expense of tax preparation more expensive. Next year may see the tax code cleaned up for businesses, albeit producing both winners and losers.

Of course the economy also has the issue of the fiscal cliff, in which taxes increase and spending decreases. If Congress does not act on this issue then a significant deflationary force may be introduced next year.

Internationally, Europe continues to battle the economic slowdown that is applying deflationary pressures in the economy. If the European Central Bank can navigate a tricky path to further stimulation then these force may be offset. Asia's labor markets appear fairly tight and combined with expansionary monetary policies may cause accelerating inflation. That said, an aging population in Japan and high inventory levels in China apply deflationary forces.

In short, price stability appears to be waning. 

Investment Implications
So where does this leave an investor? If deflationary forces take hold then treasuries and cash are attractive investments. If inflationary forces accelerate then precious metals and other commodities. If the prices remain in the relative sweet spot of 1-3% annual increases then equities likely remain attractive. However, I believe we may see price changes swing through the sweet spot between inflationary and deflationary more violently as fundamentals continue to wrestle with monetary policies.

For now I remain mostly in cash.

Was 2004-2010 The Best Business Environment EVER?

Main Point: During the period of 2003 to probably about 2010 businesses produced historically high returns while benefiting from historically low capital costs, resulting in significant excessive profit. Why does this mean going forward for the economy, markets and government policy?

Source: Koller, Tim; Goedhart, Marc; Wessels, David; McKinsey & Company Inc. (2010-07-16). Valuation: Measuring and Managing the Value of Companies (Wiley Finance) (Kindle Location 1707). John Wiley and Sons. Kindle Edition.

Every 5-10 years I like to re-read an updated version of my favorite book on valuation, Valuation: Measuring and Managing the Value of Companies by Tim Koller. I first read it in 1995, skimmed through it again around 2002, and have been reading the latest version. It always reminds of this important point:

"The guiding principle of value creation is that companies create value by investing capital they raise from investors to generate future cash flows at rates of return exceeding the cost of capital."

With this in mind, I have been considering the effect on business during a period of falling cost of capital. In 2009, Tim Koller estimated the cost of equity capital for most large companies fell in the range of 8-10% when the yield on the ten-year treasury was around 3% and they used a risk premium of 5.4%. In the second edition of the book, published in 1994 using examples from the early 1990's when the 10-year treasury yield was around 7%, the authors used a market risk premium of about 5-6%, which likely implied a cost of equity capital for most large companies between 12-14%. From the debt perspective, the interest rate for Triple-A corporate debt has declined from around 8% in the early 1990's to close to 3%.

My point is that the cost of capital for a business has likely decreased 4-5% over the past twenty years, and likely continues to decline as the Fed pushes long-term interest rates lower.

Basic economic theory argues that excess profit attracts competition until that profit goes away. This argument suggests that the rates of return on investment, or ROIC, have likely declined over the past 20-30 years as companies expanded and cut prices in an effort to capture the excess profit. However, I was surprised to see the statement in the book that,

"The median ROIC, [excluding goodwill,] between 1963 and 2008 was around 10 percent and remained relatively constant throughout the period." 

Somewhat more confusing is the additional findings that,

"However, there has been a recent shift toward more companies earning very high returns on capital, [excluding goodwill]. In the 1960s, only 1 percent of companies earned returns greater than 50 percent, whereas in the early 2000s, 14 percent of companies earned returns of that magnitude. In many cases, this improvement has occurred in industries with strong barriers to entry, such as patents or brands where gains that companies have made from decreased raw-materials prices and increased productivity have not been transferred to other stakeholders."

 If these findings are a fair indication of the fundamental trends in our economy, and not materially impacted by issues like survivor bias and other statistical problems, then it raises some significant questions. Among them:

(1) What impact has government policies had on ROIC versus fundamental economic trends?

Have patent laws enabled businesses to claim an unfair portion of the market? Are rounded corners on a cell phone and specific folding of cloth really "new" under law and deserving of patent protection. Has increased regulatory requirements in many industries simply raised the barriers to entry, thus enabling established businesses to charge higher prices? Was the Bush-era tax cuts the primary driver of higher ROIC, and what then do tax increases mean? Is corporate cronyism enabling certain businesses to capture excessive profit and diminishing competition?

On the other hand, did moving labor offshore provide a short-term (2-10 years) window of excess profit as costs declined while prices remained stable? Has social media improved business brand building and enabled established businesses to charge higher prices? Has technology advancements allowed a rapid decline in operating costs while allowing businesses to hold prices stable?

(2) Does ROIC return to a historically normal level, and how?

Do prices simply decline as competition intensives, suggesting deflation? Do businesses simply expand and then potentially falter as supply and demand shift to find a new equilibrium? Do government policies enable on-going elevated ROIC levels through regulation and patent law interpretation, or move to capture the excess profit through higher taxes?

(3) Was the period of 2004 to 2010 the best business environment ever?

If government policies and fundamental economic trends both favored business, and the cost of capital was historically low, could it have been any better for business? Did this excessive profit pump up the bubbles in the economy? Are these trends sustainable, or do they revert back to the historical norm? If they revert back, how long does it take and is it a headwind for the economy until equilibrium is again found?

(4) Switching to the cost of capital side, is monetary policy a coiled spring or a limp string?

Does the cost of capital suddenly spike upwards as the large build-up in excess reserves indicate inflation could rise rapidly, like a spring coiled tightly? Or, is the build-up an indication of the government "pushing on a string" to stimulate demand? Structural inefficiencies are allowing excess profit to be captured and maintained by certain businesses as competitive pressures have been weakened.

These issues are all debated in various forms, but unfortunately are usually boiled down to ridiculously simple arguments about "uncertainty."

Life, Liberty, and the Avoidance of Pain

It would appear as though the markets have included the avoidance of pain as one of our inalienable rights, as outlined in the Declaration of Independence. The markets have rallied recently, apparently on the expectation of further action by the Federal Reserve. In fact, the equity markets rallied on a horrible jobs report that showed the number of job openings declined the fastest in over seven years. I know the markets are forward thinking, but this logic increasingly strikes me as strained and the equivalent of a driver excitedly accelerating the car because they see a tree ahead that will stop the car.

Maybe the Federal Reserve gives the markets all they want tomorrow. However, I struggle what would satisfy the markets. I suppose QE3 is what the market wants, but will it have an impact? If so, will the impact ultimately cause more harm than good? Sure, investment spending likely benefits from lower interest rates. But, do highly leveraged consumers need more debt? Can the people in need of low cost financing actually get it, despite the lower interest rates? I continue to believe that the Fed is losing its ability to stimulate demand, instead simply stimulating supply growth. This imbalance results in short-term boosts to the economy as businesses spend but eventually loses its steam as demand trends do not justify the increased investment spending. In short, Sagflation.

Potentially more ominous is my belief that the US economy has been built on a low interest rate foundation. What does this mean? It means that debt service has been low relative to the outstanding debt, enabling over-consumption on the demand-side and over-expansion on the supply-side. In essence, we have been painting ourselves into a corner with the only possible outcomes of depression, default or excessive inflation. Since all of these produce some form of pain, albeit in very different forms, our on-going avoidance of pain likely only leads to excessive pain in the future.

I was also amused by comments on CNBC about the housing market. The bullish bias continues as experts believe the industry should outperform the economy. Commentators take that as a bullish sign about the economy. In my view, the housing market likely outperforms only because mortgage rates keep declining, in essence enabling consumers to manage a larger debt balance and therefore pay a higher price for a house. Looking at it in reverse, when the rate on a 30-year fixed mortgage rises to the historically inexpensive 6% from the current level of around 4% the monthly interest payment for any prospective buyers increases 50%. So the Fed's actions can stimulate industries like housing for the short-term but also encourage excessive debt levels and inflates asset prices.

There is a lot of "hope" out there, but I fear this economy is living on borrowed time.

Expected ROIC Drives Stocks. This Likely Isn't Good for the Markets.

Spent some time during the recent market weakness listening to CNBC. Oh boy, the number of professionals simply hoping the market goes up is disturbing. Every possibly justification for higher stock prices was offered, including reversion to the mean, attractive dividend yields, low PEG, central bank intervention, and on and on. The other disturbing observation was the short sightedness of the views. Comments suggesting a Fed intervention is more likely simply avoids the fundamental issues, in my view.

Let me reiterate my very basic, but often misunderstood, argument: Expected Return On Invested Capital (ROIC) is the primary driver of stock prices, based on my experience covering stocks. PEG, dividend yield, and all other valuation measures are symptoms of the changes in ROIC, in my view.

The outlook is moving increasingly deflationary, as the PPI, CPI and PCE Index all moderate. In terms of company financials, this trend likely causes slowing revenue growth and compressing margins. For financial firms it may mean a death sentence to certain products (eg. annuities) or even firms as the yield curve flattens. Harder times for financial firms likely causes more restricted lending and liquidity, further hindering company performance and the economy.

All these trends mean falling ROIC for most companies. Falling ROIC means slowing earnings growth, cuts to dividends, worsening leverage ratios, and reduced investment spending.

I haven't even discussed debt in Europe, slowing growth in China, or the fiscal cliff at the end of this year. These topics are well covered by most financial news sources.

Sagflation - Slow to negative real economic activity combined with more volatile prices caused by aggressive monetary policies. As the "real" income of the average American slows, and even begins to decline due to excessive unemployment and mis-allocation of capital, I expect increasing deflationary pressure in the more middle-to-lower class discretionary segments of the economy as demand slows. This deflationary pressure may be offset for a time by increasingly aggressive monetary policy, but I believe more expansionary monetary policies likely disproportionately raises food and oil price, impacting debt levels of the middle to lower class. Ultimately, our monetary-policy-fueled economy becomes a snake eating its tail, in my view.

My IRA remains about 50% cash, 30% short position, and 20% long equities in specific companies expected to outperform the market.

Approaching the Main Event?

Performance in May was steady, increasing 1.0% for the month and 3.2% for the year-to-date. This performance is relative to the S&P 500 Index decline of 6.2% in May and a 4.2% increase for 2012. Over the past year my IRA has increased 13.2% compared to a decline of 2.6% in the S&P 500 Index.

Finally June!
My excitement may differ from other investors' excitement about turning the page on May. Right from the start of 2012 I believe I have had a clearer outlook about the second half of the year than the first half. By turning to June I believe my thesis for 2012 can begin to play out. First, a brief review of some of my comments:

On September 23, 2011, I wrote:
Looking at the news around March, 2009, when the stock markets bottomed, I was reminded that generally the economic indicators were negative. Investors, already hurt from a significant slide in the markets, were expecting the worst and in full-on survival mode. Both macro indicators and micro indicators from companies were negative. Personally, I don't think we are there yet. News out of companies remains generally okay and we have not actually tipped over in Europe or Asia. Investors remain hopeful it can be avoided. In my opinion, we may not get there until June 2012 as the full ramifications of bank failures in Europe and a slowdown in emerging markets take time to be understood.


Bottom line, I plan to exit my treasury position in the next few months. I am looking for one of the following occur: (1) 30-year treasury yields fall below 2.5% (a technical support level since it represents the low in 2008), (2) a major macroeconomic shock of the size of European sovereign debt defaults and bank failures, (3) a 30+% pullback in the equity markets, or (4) a Fed announcement about printing more money under QE3.

On February 27, 2012, I wrote:
The markets are increasingly worried about rising oil prices slowing economic growth. The rise in oil prices appears related to supply worries associated with Iran, rather than strong demand. However, the increase in the PPI for crude materials has slowed to less than 5% annually, after rising at a rate greater than 15% for the past two years. Aggressive actions by the ECB and Federal Reserve may continue to drive inflationary pressures, but I believe deflation may ultimately take over as the market driver later in 2012.

June 2012 and Beyond
Fast forward to the end of May and the yield on the ten-year treasury is near a record low and the yield on the thirty-year treasury is approaching 2.5%. Among the main driving forces behind the declining yields has been the nearing climax of the debt crisis in Europe with money exiting Europe and piling into US Treasuries. However, pricing dynamics in the US suggests inflation pressures are subsiding. Growth of PPI has continued to slow, even turning negative in April although on an annual basis the increase remained positive but slowed to 1.9%. Oil prices are falling and the CPI index is moderating. Without material actions taken by the Federal Reserve, I believe price increases likely continue to moderate and may even turn negative by the end of the year.

In summary, I believe the equity markets may soon follow the lead of the treasury market, implying the continued decline of valuations as deflationary forces increase debt burdens, slow personal income growth, and squeeze corporate margins.

Under my Sagflation thesis, I argue that the Federal Reserve is reaching the limits of its capabilities to spur demand, instead providing short-term stimulant to supply. Consumer debt was $2.52 trillion at the end of March, just shy of the all-time high of $2.59 trillion at the end of 2008. Furthermore, consumer debt increased 10% y/y in March, suggesting debt outstanding likely hits a new all-time high in the near future. Given there are 5 million fewer people working now relative to 2008, the debt outstanding appears unsustainable. The bulls argue that rising debt levels are a strong indicator of a recovering economy, supported by the the highest consumer confidence in 4 years. Fueling the optimism, in my view, has been the ability to re-finance mortgages and a more healthy job market than in recent history. But, with refinancing activity waning and job creation coming in well below expectations for May, I believe this optimism shifts back to fear.

April was About Positioning, Nullifying Performance

My IRA was basically flat in April as I built up positions in Chesapeake Energy (Ticker CHK) as the stock declined. At the end of the month about 5.5% of my IRA was invested in CHK. Offsetting this decline was better performance by my ~30% position in the ETF Proshares Short S&P 500 (Ticker SH), which increased modestly as the index declined about 1.5% during the month.

I also exited all of my bond positions as the lack of liquidity became more concerning and I wanted to reduce my long positions as we approach June, a potential turn in the market in my view. My bearish view includes a worsening outlook for economic activity in Europe, a combination of potentially higher taxes and reduced government spending in the US starting in 2013, and on-going mis-allocation of resources in China producing a shock to the markets. As we enter the second half of 2012 I believe these issues begin to increasingly dominate market movements.

Besides the short positions and CHK, at the end of the month my exposure includes ~6% in commodities, ~10% equities, and ~49% cash.

On an annual basis, my IRA increased about 14.5%.

Which Comes First? Market Correction or Fed Stimulus with Abating Inflation Pressure

Is inflation or deflation the biggest threat to the economies of the world? In a word: both, in my view when the economy is in Sagflation.

Fundamentally, deflation is the driving force in many economies as poor capital allocations of the past need to be worked off, in my view, potentially pushing us into a depression. However, I believe expansionary fiscal and monetary policies have been offsetting these fundamental forces by pushing up commodity prices, enabling inefficient business activity, and inflating financial assets. These effects from monetary policies increase the risk of hyper-inflation if extended and amplified, in my view. In summary, I believe the combination of fundamental economic forces and activist policies push us further and further into a world of volatile prices and uneven economic activity.

In this entry I again borrow the framework developed by A. Gary Schilling on inflation to breakdown the trends and hopefully glean a bit more insight into the future. His framework breaks down inflationary/ deflationary pressures into seven areas, which are commodity, wage-price, financial assets, tangible assets, currency, fiat, and goods and services. Mr. Schilling has argued a deflationary period is ahead for the world, most recently in his book published in late 2010 titled, "The Age of Deleveraging."

My conclusion is that while inflationary fears are justified for basic necessities, like healthcare, food and fuel, the broader trend is deflationary as growth in wages, commodities, and asset values moderate and even decline. The Federal Reserve has been focused on broad measures of inflation, which include material weighting of asset values and wages, and thus I expect the Federal Reserve to launch another round of quantitative easing should these factors continue to weaken, possibly at the expense of higher prices for fuel and food, which may further erode real economic activity.

Summary Table

Segment	Trend
Commodity	Abating Inflation Pressure
Wage-Price	Abating Inflation Pressure
Financial Assets	Inflation
Tangible Assets	Deflation
Currency	LT Inflation, ST Deflation
Fiat	2012 Inflation, 2013 Possibly Deflation
Goods and Services	Abating Broad Inflation Pressure

Commodity
The pace of growth of commodity prices has been moderating, likely due to weakening demand in Europe as the debt overhang and austerity measures begin to bite. It remains unclear whether the slowdown in Europe spreads to China and resource-rich countries like Brazil should commodity prices continue to fall.

 
Wage-Price
The rate of growth of wages has been moderating to under 2%, putting pressure on spending despite some improvement in the number of people employed. The slowdown in wage growth in itself is deflationary, but its impact is likely uneven as higher prices for necessities like fuel, food and healthcare force both higher consumer debt, aided initially by low interest rates, and stronger deflationary pressures in more discretionary segments.

Financial Assets
Financial assets are modestly inflated, based on historical valuations of total market capitalization to GDP and the Shiller PE ratio. The current ratio of total market capitalization to GDP is above 95%, relative to a historically fair value of 75-90%. The current Shiller PE ratio is about 22x, compared to a historical mean of 16x. The market is relatively over-valued largely due to aggressive monetary policies, in my view, pumping up liquidity in the markets. Furthermore, should the economy slow in order to allow for what I consider to be an over due capital rationalization, the total market capitalization likely retreats 40-60% as both the GDP and earnings compress. While the equity markets may remain fairly-to-overvalued for some time, I believe there is an inflating air pocket under supporting these valuations as GDP is artificially increased through monetary actions.

Valuation	Ratio = Total Market Cap / GDP
Ratio < 50%	Significantly Undervalued
50% < Ratio < 75%	Modestly Undervalued
75% < Ratio < 90%	Fair Valued
90% < Ratio < 115%	Modestly Overvalued
115% < Ratio	Significantly Overvalued

Tangible Assets
Home prices continue to deflate in the country, despite historic low mortgage rates. While there are numerous investors trying to "call the bottom" on home prices, I believe it is difficult to argue for higher home values should monetary policies allow interest rates to rise. As people lose more equity in their homes it is difficult to see from where additional spending can be funded, in my view. Judging by the April Homebuilders' Index reading of 25, anything below 50 is considered negative, a recovery in the housing market is a long way off.

Currency
The longer-term trend is a weakening US dollar, likely driven by the expansionary monetary policy. This longer-term trend adds inflationary pressures to the economy. Shorter-term, however, the US dollar has strengthened as other regions have weakened and pursued more aggressive monetary tactics. This recent strengthening has added deflationary pressures to the economy as the prices of imported goods become relatively lower.

Fiat
The US economy continues to benefit from overwhelmingly inflationary fiscal and monetary policies. Deficit spending, fueled by both relatively low tax rates and stimulus, has enabled economic activity to remain elevated, in my view. Furthermore, expansionary monetary policies have enabled poorly performing businesses to remain in viable and has added to the money supply.

While fiscal and monetary policies have been inflationary, they potentially turn deflationary in 2013 when significant tax increases and spending cuts are expected to come into effect.

Goods and Services
As I discussed in March,  investors should look at the inflation of goods and services through two lenses. The first is the traditional inflationary measures impacting the consumer, which are the CPI and Personal Consumption Expenditures Price Index (PCEPI). These are the measures on which the Federal Reserve typically focuses when determining monetary policies. Both show a trend of abating inflationary pressure.

The second, and better measure of the impact of monetary policies in my view, is the AIER Everyday Price Index (EPI), which highlights increased volatility of prices and higher inflationary pressure on middle to lower class income levels. The EPI increased 8% in 2011, relative to a 3% increase in the CPI,  and increased 1.3% and 1.1% in January and February. The increases in the EPI are also moderating, although AIER expects them to continue to accelerate throughout this year and next. Based on the moderation of commodities, I expect the increase in EPI may moderate as well.

The last point on goods and services is a possible signal that demand is slowing. Industrial production declined 0.2% in March. This data may be a blip, but it is worth following as a sign of whether the economy is again cooling.

Expanded Long Position in Natural Gas Segment

This morning, after the DOE announced that the inventory for natural gas was well below market expectations, I expanded my position in EnCana Corporation (Ticker ECA) and established a position in Chesapeake Energy Corporation (Ticker CHK). At the end of the day I have a combined ~5% position in these natural gas-related companies. I expect these positions to remain in my IRA for at least one year, unless natural gas prices continue to fall or the stock prices appreciate back to near 52-week highs. I may establish additional positions related to natural gas that could increase my exposure to 10-20% of my IRA.

This morning the US Energy Department announced that natural gas inventory increased by 8 billion cubic feet, lower than the anticipated 19-25 Bcf. While inventory remains well above historical averages, my take on the data is that the recent declines in rig count is (1) slowing the growth of inventory, and (2) the market estimates likely are too high for future inventory increases. At this time of year the inventory of natural gas typically increases due to milder weather, but with the glut of inventory many producers have been shutting down rigs, as highlighted in my previous article.

Natural gas prices remained weak during the day. However, I believe the lower than expected inventory build combined with rig closures likely signals more balance between supply and demand and could even lead to a higher rate of draw down of inventory during the summer if the weather is unseasonably hot. All that said, natural gas prices may not appreciate materially until next year, as highlighted by Goldman Sachs today.

Under my Sagflation theme I expect more volatility in prices, thus I would not be surprised if natural gas prices do not remain around $2 for long.

Natural Gas Market Dynamics Suggest Price Rebound

The price of natural gas continues to slide downwards as production remains high and consumers benefit from mild weather, reducing their need for the fuel. This continuing trend would appear unfavorable for many of the natural gas companies, including Chesapeake Energy Corporation (Ticker CHK) and EnCana Corporation (Ticker ECA). Indeed, the stock prices of these companies have continued to slide over the past month as investors worry about the financial impact.

Furthermore, a recent article in the Wall Street Journal highlights that storage for natural gas is expected to reach capacity before the end of the year if production does not slow down and the weather remains mild. This highlights that the price of natural gas in the US is determined more on short-term supply-demand trends due to an inability to store large amounts of the gas. It also highlights that something has to give because companies likely won't simply blow the excess into the atmosphere, accept negative prices, or some other crazy market scenario. Under my Sagflation theme, I expect more volatile prices, especially for commodities, and thus a strong rebound in natural gas prices would not be surprising, in my view.

Investing in a company that produces natural gas would seem foolhardy with the price of natural gas around $2, the lowest in about 10 years, and supply apparently continuing to outpace demand. But, there are signs that drilling is slowing and demand may pick-up. With limited storage capacity, making prices more volatile, this shift in supply-demand potentially precedes a turn-around in natural gas prices later in 2012 and 2013. For these reasons I have begun to build long positions in natural gas companies, initially a small position in EnCana Corp. with a 4% dividend yield.

Let's go through some market dynamics of natural gas:

(1) Demand likely increasing
There are four basic domestic users of natural gas, which are (1) Homes for heating, hot water, appliances, (2) Businesses for heating, hot water, appliances, (3) Commercial for manufacturing, and (4) Electricity production. The only one of these four segments that has grown over the past decade is electricity production. The first two segments have remained relatively flat due to improved efficiency through better furnaces and insulation. Industrial demand has slid, most likely due to the shift of manufacturing overseas.

An increasing number of electric power plants may shift to natural gas as an alternative to coal as the price for natural gas falls. Energy analysts at Sanford Bernstein estimate that electric utilities may increase consumption of natural gas by 13.5% in 2012 as they switch from coal. This is likely driven by the falling price of natural gas. As discussed on the Wall Street Journal, the market is already pushing electricity producers towards building additional gas-fired plants. But, referring back to the fact that natural gas prices are set more based on short-term market dynamics than long-term, there is greater risk relying solely on gas-fired plants because prices may increase dramatically in the future.

Furthermore, if a recent ruling by the EPA stands-up, then more utilities may be forced to shift to natural gas as a greater amount of the externality costs associated with the use of coal, and its larger release of carbon dioxide, are captured in the price of electricity. However, I believe this ruling is unlikely to stand-up to scrutiny by Congress given the outrage from the coal producers.

Another potentially major driver of demand in the near-term is increased exporting of the fuel as more ports come on-line with the ability to export the fuel. To export natural gas is to invite political scrutiny, and some debate about the advantages and disadvantages of creating a world market for natural gas. However, producers likely push hard to open up new markets that are willing to pay three to four times the price in the US. Simple market dynamics suggests that if the US does begin exporting natural gas, and thus creating more of a world market, the relatively low prices in the US likely rise and the relatively higher prices in Asia likely decline.

Longer-term an increasing number of industries may begin relying more heavily on natural gas, should manufacturing in the US continue to pick-up. Additionally, a device that allows fueling of cars with natural gas from the home may eventually prove a major driver of natural gas demand. A stimulant to home refueling could be a tax incentive towards purchasing the home device.

(2) Drilling for dry natural gas slows
There are signs that drilling for natural gas has slowed. Baker Hughes recently announced the company expects lower operating profit in the first quarter due to rapid transition in drilling away from natural gas towards oil. Indeed, the rig count for natural gas has fallen to a ten-year low of 647, relative to the 2011 high of 936 and all-time high of 1,606 in 2008. With production down around 60% from the all-time high, and continuing to decline, I believe natural gas prices should turn around.

Chesapeake Energy Corp, the second largest producer of natural gas behind Exxon Mobil Corp, has allocated approximately 85% of capital expenditures in 2012 toward crude oil and liquid natural gas resources, up from 10% in 2009. Comstock Resources (Ticker CRK), with 85% of its reserves in natural gas, has shifted to oil production with 77% of its 2012 drilling budget devoted to oil production. Devon Energy Corporation (Ticker DVN), with about 60% of its reserves in dry natural gas, has cleared much of its rigs out of natural gas production sites and has said the company is not "investing in new wells in a $2 market."
 
While a significant amount of natural gas continues to be produced as a by-product of oil drilling, this highlights that the trend is downward in natural gas production. It also potentially creates excess supply in the NGL market and may ultimately result in a strong rebound in natural gas prices when demand picks up.

Real Economic Growth Elusive

The NFIB Small-Business Optimism Index fell during the month of March, largely due to lower readings on expected sales and hiring plans. This decline in March followed six successive months of increases in the index. The lower than expected reading was another recent indication that hiring, and therefore the economy, are not as robust as expected. In my mind, the lower than expected sales and hiring amongst small businesses reinforces my earlier comments about a supply-driven economy. The Fed can stimulate the economy by encouraging businesses to invest capital, but the demand-side likely remains weak due to excessive consumer debt. The result is declining productivity and modest-to-negative real economic growth.

I believe the economy may produce increasingly bearish signs, albeit mixed over the next few months. Treasuries may not be the best opportunity, in my mind, since yields have already fallen. Instead, I may focus on the equity market and the potential pullback in valuations.

NFIB’s Small Business Economic Trends is a monthly survey of small-business owners’ plans and opinions. For March, the survey is based on 757 responses from NFIB members. 

Is the Market at a Pivot Point?

A bullish investor would likely argue that the US economy is improving and should continue to improve without additional stimulus. A bearish investor, like myself, argues that the recent improvements in the market are more a result of monetary stimulus than real economic improvement. This week the markets faltered somewhat on the perception that the Federal Reserve may not provide additional stimulus. Was this weakness a momentary blip or a pivot point?

Clearly I have been wrong to date on the markets. While my strategy of maintaining a relatively neutral balance between long and short has avoided any catastrophic losses, my edging towards more weighting of short positions by the end of the quarter clearly hurt the performance of my IRA. For the month of March my IRA declined 1.2%. For the quarter I managed to squeak out a small gain of 1.9%, largely due to healthy performance by my high yield bond positions. This performance has under-performed the markets by a fairly wide margin. On an annual basis, my IRA increased 15.2%, aided immensely by my weak performance during the first quarter of 2011. I guess I am just a slow starter.

So, pivot point or bump in the road?

The job data released on Friday of 120,000 net new jobs created in March was another conflicted data point. It was well below the expected number of over 200,000 and potentially portends declining job growth, and thus weakening economic growth. But, does the number increase the likelihood of additional monetary easing, floating the market higher? So, the question in my bearish mind is: Over the next few months, is the market driven by weak real economic activity or excessive liquidity? Longer-term, I believe the market must ultimately succumb to fundamentals, it is just a matter of how long the Fed allows us to keep digging a deeper hole.

The question, in my mind, is somewhat misleading. To me, the trends of Sagflation continue to act on the economy and markets. Weak real economic growth and more volatile prices is not a friendly investing environment. Debt levels in Europe and weakening economic activity (and political stability) in China may continue to weigh on the markets. The Federal Reserve can inflate the economy for a while, but we are in trouble when the markets begin to question the "realness" of the economic strength. Does this play out as accelerating inflation, falling employment, or both? For now I plan to pursue three steps:

Step 1 - Continue to move the net balance of my portfolio towards short positions.
Step 2 - Opportunistically invest in treasuries, non-cyclical commodities, and consumer staple stocks.
Step 3 - Look for attractive themes, like the aging car fleet in the US and potential rising demand for US natural gas.

The first quarter was surprisingly tame, I doubt the next three quarters can offer the same tranquility.

Preview of What's to Come? Increased Short Position.

The economy of Spain may be edging towards something pretty ugly. A 23+% unemployment rate, negative GDP growth, and upwards of Debt/GDP of 133% (about 70% if excluding European liabilities) is a recipe for an implosion, in my view. The cherry on the top may come tomorrow when the government is expected to announce deeper cuts in government spending. For an economy heavily reliant on government spending, which accounts for approximately 40% of GDP, and the 12th largest economy in the world, this is something to take seriously. While Greece was significant, Spain could actually pull down some other economies should it implode.

My suspicion is that the markets may downplay the risks for a few months until investors can no longer ignore the potential damage. The level of bullish commentary in the media has been quite high lately and it may take some time to remove the froth. That said, this week I increased my short exposure and trimmed some of my corporate bonds. Currently my portfolio is as follows:

Short S&P 500 (ETF ticker SH) ~ 30%
Corporate Bonds ~ 28%
Commodities (Gold and Agriculture) ~ 8%
Equity ~ 7%
Cash ~ 27%

Mr. Bernanke Likely Stinks at Angry Birds

Trying to teach my three year old to play Angry Birds was initially rather frustrating. She was more enamored with the slingshot rather than actually trying to knock anything down. Not surprising since she is three years old, after all. But, this meant she typically pulled back the sling shot in random directions, often repeatedly driving the bird directly into the ground. While frustrating to watch, it seemed to please her and she eventually became more focused on knocking down structures. Now it is frustrating that my still three old daughter is better at Angry Birds than me.

I was reminded of my daughter while reading about Mr. Bernanke's recent comments on monetary policy. Monetary policy is somewhat like a sling shot. The Fed stimulates the economy by pulling back and releasing on the rubber band by cutting interest rates and letting the economy fly forward. While the economy arcs through the air the Fed can re-load the energy in the slingshot by raising interest rates for when the economy next slows. I recognize this is not a perfect analogy because the Fed is not trying to hit a specific target in the distance but instead trying to reach a certain height, or inflation/ unemployment level, while maximizing the distance of the arc, or period of time.

The reason for offering the Angry Birds analogy is that I believe the Fed's slingshot is stretched out and the bird/ economy is getting heavier. By repeatedly trying to snap the economy higher the Fed has stretched out its slingshot, in my view. Furthermore, by allowing on-going inefficient capital allocations in the economy through repeated stimulation at the initial signs of slower economic growth, the dead-weight in the economy has increased. I believe these combined issues have deteriorated the Fed's slingshot to where it must "aim higher" in order to reach the desired economic lift, at the expense of the distance in the arc. My fear is that soon the Fed may need to pull straight down in an attempt to push the economy to the desired height, resulting in a brief and ultimately unsuccessful boost. In other words, the much desired "escape velocity" for the economy is becoming more and more remote.

But my concerns expanded recently after recent speeches by Mr. Ben Bernanke. On March 22 Federal Chairman Mr. Ben Bernanke gave a speech at George Washington University in which he claimed "monetary policy did not play an important role in raising house prices during the upswing."

This comment is somewhat confusing and increases my feeling of unease. My initial interpretation is that Mr. Bernanke is becoming more concerned with how people perceive him than actually ignoring the political pressures, learning from history, and applying a critical analysis to improving actions in the future.

The fundamental role of the Federal Reserve, as I see it, is to impact the expansion or contraction of credit in the economy to provide price stability and full employment. For the Chairman to claim monetary policies do not have an impact on credit availability in certain segments of the economy, and thus economic expansion, implies either he believes monetary policy is irrelevant or extremely specific in its application. Both implications strain credibility, in my mind.

That said, I believe Mr. Bernanke was offering a Goldilocks explanation, in which monetary policy was just right to stimulate demand but structural problems resulted in housing over-heating. While convenient for his legacy, I believe this explanation actively ignores the Fed's role in the economy. By side-stepping deeper recessions over the past few decades the Federal Reserve has encouraged inefficient or out-dated economic structures to remain in the economy. Furthermore, if Mr. Bernanke believes the problem is structural, then to continue pursuing aggressive monetary policies when one knows there are problems is like a builder adding another level to a house when they know the foundation is weak. The risk increases of it all coming crashing down.

I raise this comment to make the following points:
(1) The Federal Reserve policies remain a hammer looking for a nail.
(2) Significant structural inefficiencies have likely continued to build up in the economy.
(3) The root cause of Sagflation likely remains in place, which is overly aggressive monetary policies enabling the inefficient allocation of capital. This likely produces heightened price volatility with stronger swings between inflation and deflation.

To return to my Angry Bird analogy, my expanded fear is that the Federal Reserve is becoming less concerned about its "aim," and more enamored with how to stretch the slingshot further in order to try and recover the power of its snap. Much like my daughter who found she could pull the slingshot back further if she pulled it straight-up, I now fear that the Federal Reserve may begin to start aiming at the ground in order to stretch the band further. Whether this leads to deflation or excessive inflation is yet to be determined, but real economic growth likely suffers.

One last point I'd like to make clear. In my view, Congress clearly is a major part of the problem due to its difficulty in passing legislation, the influence of special interest money, and inflexible bipartisan positions. In many ways, Congress represents the crumbling foundation. That said, the Federal Reserve is enabling the problems to fester and deepen, possibly creating a larger issue in the future, in my view.

Bought More Gold During a Period of Calm

Given the recent pullback in gold, yesterday I increased my position in iShares Gold Trust (Ticker: IAU) to ~5% of my IRA. The reasons for my increasingly bullish position are the following:

(1) Gold has pulled back almost 10% since its end of February peak.
(2) I do not believe aggressive US monetary policies have ended, and in fact the current policies remain quite expansionary.
(3) I do not expect the US economy to accelerate from here. If anything, I expect at least a few more bumps in the road later in the year. As I detailed in the post about Okun's Law, I believe the current health of the economy is much more about monetary policy driving supply growth, instead of fundamental consumer demand growth.

I am also keeping my eyes on treasuries and may establish a long position if yields on the 30-year rise above 3.5%. If my Sagflation theme plays out then I expect increasing deflationary pressure over the next couple years, unless the Federal Reserve begins aggressively adding to the monetary base through treasury purchases. In either case, I believe yields on the 30-year treasury have at least one more trip well below 3.0%.

Another segment is natural gas. I continue to consider possible plays on the low prices of natural gas, and the likely rebound in prices, in my view. Playing gas prices through an ETF proved quite inefficient and thus I am considering equity positions in natural gas companies. However, I feel a need for patience until the natural gas market firms up a bit more and stocks like Chesapeake (Ticker CHK) and Encana (Ticker ECA) to fall further. At this point I believe these stocks are lifted more by broad market trends than actual fundamentals.

Broken Okun's Law May be Sign of Unsustainable Supply Driven Economy

On Monday March 12, The Wall Street Journal puzzled over the apparent break down of a long-running relationship between economic growth and jobs. The relationship is called Okun's Law, after Yale University economist Arthur Okun. The basic relationship is that when economic growth exceeds its long-term trend the unemployment rate tends to fall at a rate of about half of the excess economic growth rate. This relationship has broken down recently as the employment rate has fallen despite weak economic growth.

I believe my Sagflation theme explains this breakdown, and offers an opportunity to look at Sagflation from a slightly different perspective. In summary, I believe the apparent breakdown in Okun's Law is an unsustainable situation in which supply is growing due to inexpensive credit (encouraging hiring) but demand is relatively stagnant due to historically high consumer debt levels (slow growth), resulting in falling productivity.

To get into the details let's review a couple key facts:

(1) Consumer debt ratio is relatively high: Consumer debt to after-tax income is 113% compared to an average of 85% during the 1990's. Debt service payments to income shows a healthier picture but if consumers are expecting interest rates to rise then they may focus more on the absolute level of debt rather than the debt service. That said, if the consumer believes interest rates may remain low for an extended period, which is the strategy of the Federal Reserve, then demand may increase for a period until either rates increase or expectations of rate increases begin. While debt-driven spending may drive markets for a period of time, this possible belief of low and stable interest rates is misplaced and temporary, in my opinion, and likely results in larger issues later on after debt levels have increased. Therefore, over the long-term I believe the historically high level of debt hinders economic growth.

Source: Federal Reserve         

(2) Corporate balance sheets are relatively healthy: Whether it is the record $1.2 trillion in cash on company balance sheets, or the record low yields on corporate debt, corporations are swimming in a deep pool of liquidity. This abundance of inexpensive capital enables companies to invest aggressively in their business, both offensively to take market share or defensively to avoid market share loss. Furthermore, I believe companies are encouraged to pursue riskier projects in search of returns, similar to how investors seem to be moving into higher risk asset classes. Indeed, capital expenditures have risen to levels near the peak prior to the start of the 2007 recession.

(3) Labor productivity moderation: At 0.4%, output per hour of labor grew at the smallest rate in 2011 of any year during the past decade. By BLS estimates, productivity actually turned negative in the first half of 2011. The slowing productivity improvements are one of the primary reasons many propose as the reason for the breakdown in Okun's Law. However, I believe it is merely a symptom of Sagflation rather than cause.

Source: Bureau of Labor Statistics         

To review my Sagflation thesis,

Sagflation, as I define it, is moderate to negative real economic growth combined with more volatile prices. The reasons for the relatively slow growth is a combination of a build-up in poorly allocated capital, creating excess supply, and subdued demand associated with a build-up of excessive debt. The price volatility is primarily a result of an overly aggressive monetary policy that repeatedly attempts to expand credit despite excesses in the economy.

The simple answer to the apparent breakdown between unemployment and economic growth is that the long-term sustainable growth rate of the economy may have declined. Thus when economic activity picks up even a bit the unemployment rate eases. This simple answer allows for the long history of Okun's Law to remain intact.

Of course the question then becomes, why has the long-term sustainable growth rate of the economy declined. In my mind, the answer is the causes of Sagflation, which are (a) high consumer debt levels, plus a (b) build-up of excessive supply, which both were encouraged by an (c) overly aggressive monetary policy.

The Federal Reserve has been encouraging investment spending by lowering interest rates. However, consumers hurt by the housing bust may be less willing to ramp-up purchases just because they have available credit. Instead, consumers may be more focused on their debt balance and the potential for interest rats to rise in the future. Therefore, demand stimulation has exhibited diminishing returns from monetary policies.

Businesses, however, generally have healthy balance sheets and access to inexpensive financing. Competition is driving investment spending as market share remains a primary concern. Given a relatively low cost of capital, businesses can continue to invest capital despite possibly slowing sales growth and shrinking margins. Thus excess capital continues to build-up in areas of the economy, along with employees to provide service, despite relatively weak economic fundamentals. Productivity declines as each additional man hour brings in fewer sales because demand has not been stimulated.

While not sustainable, if supply continues to grow and demand remains stagnant, you might expect to see weak economic growth, falling unemployment, and falling productivity.

Everyday Price Index (EPI) Helps Illustrate Sagflation

An interesting gauge of inflation is the Everyday Price Index, or EPI. This measurement has recently received more interest lately because it shows an increase of 8% in prices last year, thus raising fears of hyper-inflation.

The EPI is calculated by the American Institute of Economic Research to address a concern that the CPI does not fairly reflect the price fluctuations impacting day-to-day consumers. The EPI tracks common household items purchased frequently, such as food, fuel and toothpaste.

To start, any measure of inflation has its flaws, so one must tread lightly when highlighting these measurements. For example, the EPI is biased towards more inelastic prices, or products less impacted by economic cycles, because it focuses more on non-discretionary items. Secondly, the EPI is weighted heavily to food and beverages (38-47% of the EPI), and motor fuel and transportation (14-20%). Thus the index is much more sensitive to changes in the relatively volatile commodity prices. It also minimizes the effect of many sectors experiencing deflationary forces, such as technology and manufacturing. All that said, it does offer some insight into interesting trends.

The EPI highlights a couple trends I have been arguing under my Sagflation theme of slow to negative real economic activity combined with more volatile prices caused by aggressive monetary policies. As the "real" income of the average American slows, and even begins to decline, I expect increasing deflationary pressure in the more middle-to-lower class discretionary segments of the economy as demand slows. This deflationary pressure may be offset for a time by increasingly aggressive monetary policy, but I believe more expansionary monetary policies likely raises food and oil price. Ultimately, our monetary-policy-fueled economy becomes a snake eating its tail, in my view.

The two points I take away from the EPI data are:

(1) Increasingly volatile prices due to aggressive monetary policies. Prices for everyday products have become progressively more volatile over the past couple decades as the activist monetary policies have attempted to offset the fundamental deflationary forces in the economy, in my view. Recently, the EPI swung from a 15% increase to a 10% decline between 2008 and 2010. This increased volatility makes budgeting more difficult for the average American. Assuming monetary policies continue their aggressive policies, I expect the EPI to become even more volatile.

                                                                                            Source: AIER

(2) Moderating real income growth for the average American. For this analysis I took the Personal Income (actual) data provided by the government and adjusted it to 2011 prices based on EPI data. This measure of real income should provide a good reflection of the trends impacting middle and lower class citizens, for which non-discretionary items like food and fuel account for a larger percentage of consumption.

This measure highlights, in my view, the increasing pressure on the average American as their real income growth slows, and even turns negative. It also reinforces many of the frustrations expressed by grass roots movements like the Tea Party and Occupy. So far the moderating real income growth has been partially offset by falling prices for things like consumer electronics and by competition within a overly-saturated retailing segment. Furthermore, the falling interest rates have enabled the average American take on more debt to fund on-going consumption.