THE GREAT DELEVERAGING / SEEKING ALPHA ( RECOMMENDED READING )

The Great Deleveraging

by: TJ Marta

August 21, 2009

Johan Rosenberg, President of DerivActiv, LLC and I recently spoke about the US economic and market outlook.

Additionally, the interview draws somewhat on my presentation, The Great Deleveraging, and I've included an open link (no Linked-In required) to that Powerpoint document:

The Great Deleveraging


Johan - How are things in 908 area code?

TJ - Hey, the recession's over, right? It's all good.

Johan - Yes. 90% of economists seem to think so. You would be in the minority here with this presentation [The Great Deleveraging]. But you know I was thinking about your presentation and economists generally speaking, and I was wondering if the majority of them aren't actually equity focused versus I think perhaps you are more fixed income focused? And fixed income people are a little bit more realistic than equity people.

TJ - I totally agree. I used to be an optimist and one guy that I really used to like was Brian Wesbury. And I can hardly read the guy now because he's just so "Pollyanna." He and Larry Kudlow are, "Everything's wonderful, Kumbaya, go US!" And one, I guess being in fixed income I'm a little bit more leery, and two, I also see the government policies as disruptive to a degree we've never seen before.

Johan - Yes, that's definitely the case and you've made a presentation here recently that speaks to a lot of these points and this one that you just made here, the one about measures that have never before been taken. You make a point here that we've had a heroic economic crash landing with respect to all the measures that have been taken. Maybe you can address that and elaborate a little bit on that. But then at the ending, the rest of the presentation that we're going to discuss today, it suggests that how can we call it a heroic crash landing because perhaps there's more woe to come. So is this sort of like a crash in the Andes here where it was a crash landing and we survived, but now we have 80 days of misery?

TJ - I think so. I think some of our responses are going to worsen. What the Fed did was truly heroic although they did precipitate it-one by causing the asset bubbles, two by not regulating the way the banks were securitizing, and three by not preventing the leverage that developed in the financial markets. But they did manage to prevent a complete implosion. The Fed, in my opinion, completely lost control of the new money supply. They did it by losing control of the leverage that was in the system and then they compounded the error by lack of regulation over the underwriting that was being employed by the banks. And in fact to the extent they were part of the system, the regulators chose not to hold the banks' feet to the fire over the poor underwriting because the banks were securitizing and off-loading this. The American regulators said, "Hey it's not our problem." Our banks and regulators were ignoring the fact that indeed the banks weren't free of the toxic debt, they were using off balance sheet vehicles to actually drink some of the toxic Kool-Aid they'd mixed. So there's a lot of culpability for the Fed. Having said that, they did massively inject liquidity into the system. They're attempting to at least recapitalize the banks. The banks still aren't lending but at least there's enough cash going into the banks that the banks can re-capitalize. The yield curve is being kept steep which allows banks' profitability. Accounting rules have been changed which prevents the banks from having to actually acknowledge the losses that are on their books. So that's keeping the system afloat.

Johan - Yeah, I've got one more for you TJ. The Fed has become another hedge fund. It's the lender of first, second, and last resort. And market maker, including everyone except for RVs and mobile homes. They're staffing-up. They're not staffing-up with research staff, but actually traders. They're accepting responsibility by mopping-up the assets, too.

TJ - And it's scary because you're right, to the extent that we think of money supply as including not just coins or deposits, but also leverage. We had a massive inflation due to money supply in the early 2000s. We had a massive deflationary impact where half of the shadow system collapsed or all of the shadow system and half of the overall financial system collapsed. And what the Fed now is doing is not only injecting cash into the system with its asset purchases, but it's also employing leverage. I totally agree with you that part of preventing a collapse, a deflationary collapse, is the leverage that the Fed is employing, which becomes incredibly dangerous in terms of potential unintended consequences.

Johan - So they're employing leverage but yet the rest of the market is still de-levering. Perhaps you could elaborate on that a little bit. Is it the banks are still hoarding cash and not lending? What are some key examples of the rest of the economy that's still delevering?

TJ - What the banks are doing, what a lot of people are saying is they're hoarding cash. I liken it more to they're recapitalizing. They're getting this cash. This cash is actually the transfusion blood for those banks that lost so much.

Johan - So they're supposed to be doing this?

TJ - I think it's healthy, what they're doing, because they need to get their balance sheets back in shape. The problem is somehow the impression was given that liquidity was going to go into the banks and immediately make it out to the real economy. I think most people didn't understand in just how bad of shape that the banks were. So people were confused, disappointed at the lack of lending. And so you've got that deleveraging at the bank level.

You've got consumers retrenching with the savings rates spiking. You've got corporations hoarding cash. So everyone is deleveraging. I've heard this term, the "paradox of saving," that goes on during a crisis where it makes sense for individual actors to increase their savings rate, that's responsible. However if everybody does it at the same time, well now you've got a problem. That's the situation in the US right now and it presents a significant hurdle for recovery.

One other aspect regarding monetary policy is this whole issue of whether or not the Fed is actually going to discontinue its asset purchase program. I must have read their recent statement 15 times now. And they did not actually say they were going to discontinue it. They expressed the hope that they could by suggesting that they've only got X amount, I think it's roughly $50 billion left to buy of US Treasuries. And in order to make that $50 billion last through September and October, they're going to slow their purchases. But then in the next sentence they said that they would continue to look at economic and financial market conditions to determine the timing and extent of asset purchases. So they left the door open in case the bond vigilantes come back and push up yields again. Because if Treasury yields get pushed up it's going to press up against mortgage rates. If mortgage rates go up, the housing market tanks again. And the policy makers in general have worked too hard to support the housing market to let it all go away.

Johan - So I think $50 billion is not very much money. So this suggests that they've got to get some more money to do some more buying otherwise what you just suggested is likely.

TJ - You know I think if you talk to most economists they're going to say that, "well the Fed doesn't really need it." Most economists are saying, "Well we're going to get at least 3% growth, recovery is here, everything's fantastic." I'm looking at rising foreclosures, house prices are down. And even if house prices level out here they're not rising, which means homeowners' balance sheets aren't improving. The other part of consumers' balance sheet is their 401Ks and their stock portfolios. I'm not particularly bullish on stocks because the earnings, the companies that beat earnings and the latest earnings season did it by cutting down expenses. Not a positive development.

Actually if you're a restaurant and you turn out all the lights and shut off the oven, you can cut your expenses to zero. The problem is that you're now out of business. So the fact that companies are meeting very, very low expectations from analysts by cutting expenses is not a positive development. That's why you're seeing the market trade sideways because the stock market has un-priced Armageddon but now it's back at levels that are recessionary but not indicative of strong growth. And I think if we get another rise in the stock market, based on strong economic data in Q3, I think that that's going to be a head fake because this surge in Q3 growth, liken it to when a submarine comes out of the water, the steep angle, it goes airborne actually for a second. And that Q3 pop is going to look like a submarine. But I think what economists are saying is, "Look, submarines can fly." That's really not the case. What we're going to see in Q4, we're going to see growth begin to settle back and then Q1 becomes problematic. And then what concerns me beyond Q1 is you've got tax hikes coming. At the very least the 2001 to 2003 tax cuts roll off. That becomes a de facto tax hike. Then you've got nobody in the White House administration will explicitly deny that there are going to be tax hikes next year because when they are questioned by people as to how the health care reform is going to be paid for, how is the cash for clunkers program going to be paid for, how are the states that are near bankruptcy going to get their budgets balanced without federal tax hikes? None of them will say, "Well tax hikes are off the table." So at the very least we get tax hikes from the removal of the 2001, 2003 tax cuts. On top of that we might get extra tax hikes. That is a recipe for disaster. Look at what caused the Great Depression - it was tightened monetary policy and tax hikes. With the Fed letting asset purchase programs expire, and tax rates heading upwards, that's exactly what we're looking at.

Johan - So you think the global data looks like the Depression if you look at a lot of different measures or do you think it's different this time?

TJ - Well always the same but different. The one conversation that I keep having with people and I don't often precipitate the conversation, but it goes that way, is we live in fancy houses, we drive nice cars, we go in outer space, but when you look at basic human behavior, it has not changed in 10,000 years. We're still driven by fear and greed, and as a result despite whether it's tulip speculation, or whether it's stock market speculation, or whether it's derivatives speculation, those are just new toys. But it's still the same human behavior. So this looks a little different than the Great Depression but I think when you step back you account for the differences that 1929 was the stock market and water dams. Now we've got not so much the stock market, but we've got housing derivatives and instead of water dams, we have green energy. So you know the issues are slightly different but also quite similar. Some economists have actually stepped back and they've looked at the global data because one other difference from the Great Depression is where the US is vis-à-vis the rest of the world. In the early '30s the US was the bread basket. We were the industrial power. At least the industrial power part has been given over somewhat to China. They're certainly not the bread basket of the world but we've moved from being more of an emerging market to being the world leader. So the way the Depression looks from our vantage point is necessarily going to be different. Some of the economists have actually gone out and looked at global data and they've looked at the collapse of global trade and industrial production, and from 2008 that trajectory looks exactly like it did in 1929 through 1931.

Johan - You brought up a book which I've actually never heard of before. And it's called The Fourth Turning, it suggests that there are these generational cycles in history with respect to the economy. These are distinct sort of personalities that have an ebb and tide type cycle or a rise and a fall cycle. Maybe you can elaborate on that a little bit.

TJ - Along with the concept that human nature hasn't changed in 10,000 years, a similar thought is a paradigm introduced in the book called, The Fourth Turning. This book focuses on the cyclical nature of human experience even as we evolve and advance with time. Think of Christmas wreaths that people place on their doors, which are actually based on Paganism. The circular form expresses the idea that life doesn't move forward - life merely goes through phases. You're born, you grow up, you become adults, you age, and then you die. You look at it and see it in the seasons, the phases of the moon, the cycling of the sun. That falls on deaf ears with modern Americans. Modern Americans solely focus on moving forward. Whether it's our military where they believe in just driving through ambushes or American business, which says, "show me the last quarter, show me the next quarter, and I don't care about anything else, let's just move forward." That's at odds with the way ancient people and cultures thought.

What this book, The Fourth Turning says, is there's room for both paradigms throughout history. How I describe the marrying of paradigms is to think of either a slinky or a corkscrew. You are evolving through cycles that revolve at the same time that you are moving forward and progressing through time. The forward movement is all the new toys that you have to play with as you advance through cycles.

And so what this book did was tie this paradigm to American history and suggested that about every 80 years we run the cycle between awakenings and crises, or booms and busts. For example, start out with 1794, just after the American Revolution and you go forward about 80 years you get 1865, go forward about 80 years you get 1945, go forward 80 years and you get about 2025. So all those years we just mentioned are around the end of crisis periods. Now within the concept of the circle each segment, the four stages of these cycles is about 20 years. So what the authors of The Fourth Turning did was suggest that - and note that this book was written in 1997 - that in the mid-2000s we were going to enter the fourth cycle, or a crisis period. I posit that perhaps we entered that cycle a little bit early, maybe 2001, which was the internet bubble and 9/11. And one thing about crisis periods is that they often result in severe economic dislocations. The books also talks about how the economic equilibrium can become so dislocated that it is often accompanied by civil strife and perhaps even war.

Johan - I popped it up on Wikipedia, actually it has some interesting concepts in it and probably a worthwhile read to get a different and new perspective on economic cycles.

TJ - It also has ramifications for stock market cycles. A lot of people who think about these cycles will say or note that if you look at the S&P, it generally follows 17-year cycles of flat and then bull markets, and the last bull market ended in roughly 1999 or 2000. My belief is that we are in a flat market. Supporting that notion is that the last two flat markets coincided with FDR's New Deal and LBJ's Great Society. Large government interventions certainly appear to accompany slowdowns in growth, slowdowns in private economic activity that prevent stock market appreciation. Right now what we're seeing is another large government intervention. The Time Magazine drawings of Obama dressed as FDR are accurate. In some ways, Obama is the second coming of FDR. We are going to have on a layering of government spending. Between the healthcare and energy cap and trade, we are layering on new government. What is particularly troubling to me, is we haven't figured out how to pay for the legacy of the prior two government interventions. Particularly, we haven't figured out how to pay for the New Deal which left us with Social Security, and we haven't figured out how to pay for the Great Society, which left us with Medicare and Medicaid. So not only are we layering on new programs, we're coming to a point where we're either going to have go bankrupt or we're going to have to come up with some dramatic way to pay for those past two legacy programs. That feeds into the whole notion of a crisis. And the crisis could easily take on a global aspect as the US increasingly loses its moral authority as the keeper and engine of western liberal capitalism.

Johan - You mentioned that some of the ramifications of what we're currently experiencing is price uncertainty and this price uncertainty both in real prices but also in currency fluctuations equals geopolitical uncertainty. What will keep the lid on uncertainty there? Military, economic relationships, what do you have to say about that?

TJ - We are watching and experiencing the loss of American supremacy that derived from the victory in World War II. The last global power to lose its global supremacy was Great Britain and two world wars resulted. Because the US emerged as the one major power that was largely unscathed by World War II, the world has enjoyed the dominance of one benign superpower.

Unfortunately, this superpower is going down. It's being de-legitimized by forces as varied as fascist Muslims and the Chinese export machine. The US dollar is increasingly not viewed as a legitimate the global reserve currency, at least that it was seen over the last 30 years.
So that de-legitimacy leads to power grabbing as certain powers see the opportunity to increase prestige. Moreover, enemies of the US see opportunities to attack us. This all manifests itself in friction that can be quite hostile.

Remember in May of 2001, we had the spy plane incident where one of our spy planes was arguably inside Chinese airspace and the Chinese fighter tried to bump wings, which did not turn out very well for either plane. But more recently this past year what we've seen is Chinese ships approaching US spy ships on the water. We had two incidents - one where the US ship actually - because it was a spy ship it wasn't armed - had to use water hoses on the Chinese ships to keep them away. In the second incident, a Chinese submarine actually tore off a sonar that one of our ships was dragging. So we're seeing an on-going percolation of "chest bumping," as it were, between China and the US.

Other examples of heightened frictions abound. Regarding those between traditionally Muslim and Christian civilizations, we have not only terrorism but the rising acceptance of aspects of Sharia law in the UK. The heightened state of tension between Iran and Israel represents an apocalyptic risk. And of course, one cannot forget the international pariah that is North Korea.

Unfortunately, nothing is settled or legitimate at this point. Everything's up for grabs. Everything is arguable, whether it's control of the high seas, nuclear arms proliferation, or centuries' old common law. With that much uncertainty you're going to have a lot of friction and rising potential for catastrophic misunderstandings.

Johan - So coming back from the geopolitical uncertainty, what is your long-term outlook for the equities market and what is your outlook for the municipal bond market and what is your outlook for the corporate bond market?

TJ - I believe the equity market will fail to make new highs for at least eight to 20 years. That's predicated on the government involvement and uncertainty that's involved for business given all the geopolitical friction. I had a conversation yesterday with someone who's been doing private wealth investment for 30 years, and his take was that money managers who prove unable to navigate both bull and bear markets probably won't be in the business in another five years because of the cumulative effects of the internet bubble, the crash from 2007 to 2009, and the declines that are likely to come.

Anyone who can play only the long side of the market is gradually going to have their money - and money that they have been managing - taken away from them.

Johan - Just because there will be real declines and no gains for a very long time and investors just won't put up with it so they'll put it into something else.

TJ - I think what happens is is the investors will get aggravated. They were loyal through the internet bubble. They're upset to hysterical after this last crash. You get another crash and people are going to take their money out at the worst times for money managers and give it to managers who are enduring and actually profiting in flat markets.

Johan - So who is going to get the money? Corporate bond investors? We will have some yield they're at what, 300 over Treasuries right now for "Baa" corporate bond yields. Is that where the money's going to float to?

TJ - Well talking to the corporate bond traders, what they say is if you were going to buy you should have been buying, you know 20/20 hindsight being what it is, in December '08 and February '09. That's when you should have been loading the boat or backing the truck in to take on risk. Unfortunately corporate bonds are more legitimately priced at this point. There is a lot of uncertainty in bankruptcy law at this point. But certainly to the extent that there are going to be more bankruptcies and corporate bonds provide greater protection, the bond market is a better place to be than equities. So unfortunately, corporate bonds are not a raving buy at this point, but they represent better value than the stock market.

Johan - Yeah, they were a raving by when it was 600 over, just a few months ago. Now they're about 300. 300 is not a raving buy but it's probably going to produce a better return than equities itself. So what's your view on the municipal bond market? You've got a lot of state governments that are near insolvency. They have to balance their budgets. You really have some issues there. They're probably going to raise taxes. Is that a place to park money right now from your perspective?

TJ - Higher taxes make municipal bonds more attractive. Unfortunately, at the same time, municipalities and state governments face extreme and worsening financial issues, and solvency is a very real consideration. I think that certain areas would provide better value but any investment in municipal bonds should be underwritten on a case-by-case, fundamental analysis type basis. There are extraordinary pressures in the state government and also the municipalities and they're having to raise tax rates at the same time people are losing their jobs and people are being foreclosed upon. And I tend to be a believer in the Laffer Curve in terms of: increasing tax rates does not always increase tax revenue. It depends very much on where that tax rate is. So increasing tax rates in this fragile economy might at best help cushion the decline in tax revenues. But the budget situation is going to be problematic at least through 2010, probably well into 2011. Now hopefully the federal government will step in and cushion the blow for the states. The problem with that is that there's only so much the federal government can do.

Johan - Well let's wrap up here. Are there any concerns that we haven't covered yet? Housing, employment, consumers, anything else that you want to highlight as an issue that might keep you up at night?

TJ - To me the main issue to caution investors about is to the extent there's a euphoric wave that runs through the markets here in the next couple months, ride it, but don't expect that this is anything like a return to normal. Ride that wave higher. But be ready to get out because there is going to be downside from that wave. It would be a shame to ride the market up only to lose it late in the year or early next year.