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.