Panic at the Disco!
My post title is both a reference to the band, quite popular in the summer of 2008, and to the mood gripping the nation as the Dow dipped below 12,000 this morning, perhaps temporarily, perhaps as part of a continued decline. The question is whether this is Summer 2008 redux, or Summer 2010 redux. Either way, the mo-mos are in panic mode, as many hot stocks collapse and 50-day moving averages and all that sh!t is breached. I for one am thrilled. Happily I sold all but one or two of my riskiest stocks towards the end of May.
However, it must be remembered, what we are seeing is not even yet an official "correction," though after this morning we are getting close toa 10% drop from the high. For that reason, I am keeping my powder dry, rightly or wrongly. One thing I learned in 2007 and 2008 and which I relearned this Spring, is that the market keeps going up even after the bad event has happened. In 2007 the market climbed even after the sub-prime crisis first exploded. In 2008 there was a significant rally even after the first major banks failed. This Spring, we had a rally (or a continued climb) even after the earthquake and tsunami in Japan, a rally that was totally unjustified.
I for one do not think we are going into a depression or anything. I think we have become accostomed to thinking with a broad brush, and everyone thinks the smartest move is to call the next collapse. There is going to be no immediate new collapse in my view, though that is largely an intuitive feeling. Yes, housing prices (including the price of my own house) may move significantly lower, yes we may see slower growth, and we may even see a recessionary quarter (which is not the technical definition of an actual recession, which requires two or more quarters of decline). But fundamentally, the banks are vastly better capitalized now, a vast amount of consumer de-leveraging has taken place already, and companies are sitting on oodles of cash.
People who think that the United States is going to "default" do not understand how a fiat monetary system works. The U.S. cannot default unless it chooses to do so. This is derived not from Modern Monetary Theory, though those are the folks who commonly say this. It is perfectly true under standard monetary theory as well. Bernanke knows this, and again the only risk is that the pitchfork-wielding economic flat-earthers will prevent the Fed from exercising its true independence and doing what needs to be done. Let me direct you to Bernanke's 2002 speech at the National Economics Club. Anyone who claims to be talking intelligently about what has gone on in this country in the last three years and who hasn't read this speech at least three times is a charletan.
Let me direct you in particular to this passage, which I'm going to quote in full:
"Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951. [footnote omitted] Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade. Moreover, it simultaneously established a ceiling on the twelve-month Treasury certificate of between 7/8 percent to 1-1/4 percent and, during the first half of that period, a rate of 3/8 percent on the 90-day Treasury bill. The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills. Interestingly, though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding. [footnote omitted] For example, the Fed held 7.0 percent of outstanding Treasury securities in 1945 and 9.2 percent in 1951 (the year of the Accord), almost entirely in the form of 90-day bills. For comparison, in 2001 the Fed held 9.7 percent of the stock of outstanding Treasury debt."
What people refer to as "Quantitative Easing" as if it is this entirely new thing, never before seen, as if we are in "uncharted waters" and as if the world is collapsing, they are morons at worst, and at best, they don't know what they are talking about. It has happened before. This time is not "different." The Fed could very easily reduce interests below even what they are today. The Fed could hold more of outstanding Treasury securities than it does today. When the Fed holds those Treasury securities that is not debt. Ninety-nine percent of the people who are freaking out about this stuff had never thought about the nature of fiat currency before the Fall of 2008. They had been blissfully unaware. But just because their conception of our fiat currency has changed, that does not mean that the nature of fiat currency has changed.
Our only real danger is inflation, which there is virtually none of. Why did gas prices and commodities prices drop before QEII ended? Because they are mechanically not related to QEII. Were you buying silver because of money you got from QEII? Of course not. Commodities were rising because of speculation, because of high margin allowances, and because of demand from Asia. (Gold is different, because it rises and falls as a function of fear about the soundness of fiat currency (see above).) Now that people are freakadoodling about inflation in China and Brazil and India, commodities have fallen. But not many agricultural goods, because additionally there have been a bunch of natural disasters, and man-made disasters, including the moronic policy of ethanol subsidization in this country, which utterly distorts the price of corn, for example.
And why is there inflation in China? Is it because of QEII? No. It's because the Chinese have pegged their currency to the dollar. That means the NOMINAL exchange rate changes not at all. But foreign exchange is like water; you cannot stop it. The REAL exchange rate between China and the United States mathematicall must change to adjust for China's greater productivity increases. That, in addition to a massive amount of "animal spirits" in Chinese markets, is why there is so much inflation in China. China has made the decision (vicious, morally bankrupt, cold-hearted and anti-democratic government that it is) to screw its workers and consumers in favor of benefiting its exporters. The economy is driven by export, and even more importantly, China's vision of itself as a future super-power, with world-leading companies, depends upon supporting those companies. So those who work in those factories pay more for bread, and meat, but the companies continue to do well. High end consumers still do fine, and buy Coach purses, and meanwhile the Chinese blame QEII for their inflation and idiots here buy that. And I imagine that it's Google and the U.S. that are engaged in a cyber-war, and not China, just as they say, right? Yes, we're engaged in a cyber-war when we complain that they have hacked our systems. It makes perfect sense.
Meanwhile, people are also freaking the fluck out about the increase in bank reserves. Large reserves do not necessarily make banks lend, and when banks do not lend, there can be no inflation resulting from expansion of the M2 money supply. (See this chart for the source of the freakadoodle.) Not only are banks not inclined to lend, but the the interest the Fed pays on reserves is the tool the Fed has to control inflation, as many people have pointed out, for example here, and here (Bernanke himself). In short, if banks start lending a ton of money, and inflation picks up because the M1 and M2 money supplies pick up, the Fed can immediately increase the interest rate it pays on reserves. This will disincentivize lending, and be contractionary (both of the money supply and of the economy) because the banks will be able to get more money at less risk from the Fed than they will be able to get on a mortgage to grandma, so they will hold more as reserves (monetary base).
Where does this leave us. The best policy in 2008-2009 would have been an even bigger stimulus, double the size of the one that was enacted, combined with reform of social security and medicare/medicaid to allay long-term deficit fears. We got neither of those things. We got a stimulus that was insufficiently stimulative, opening the President to attacks that it had actually hurt the economy. These are wrong. When the government spends money, it stimulates the economy in the short term. Money the government did not spend was either: 1) retained by taxpayers, and not spent, because they were too scared to spend it; or 2) not borrowed, not spent, and stimulated nothing. Period. And we did not get the long-term deficit reduction that we needed, which would have allayed rational fears about our long-term fiscal sustainabiliyt, which would have provided further stimulus.
Why does that matter, given what I said about fiat currency? Because there is a tipping point, whereat a country realizes it can no longer pay its debts, and so it defaults, usually by allowing inflation. Here, the Fed will not allow significant inflation, contrary to what the wild-eyeds among us say, because it is in fact independent from Congress, it has a mandate not to allow huge inflation, and it is perfectly capable of adhering to that mandate. The risk is twofold: 1) it is possible that the economic flat-earthers gain control of Congress, eliminate the Fed's independence, and seek to monetize our debts with significant inflation in an unstable manner; 2) because the Fed will not allow significant inflation, debt will in fact consumer a larger and larger portion of our taxes, unless Congress fixes the f^cking long-term deficit problems.
So there you have it. That's my view. As an investor, where does this leave me? I am deeply concerned about the economy, but I am very grateful for the Fed. One thing it could do if it REALLY wanted to expand the money supply would be to charge banks for reserves. That would certainly get them to lend. But instead the Fed is trying to thread the needle. It is trying, if Congress, and the American public, will just f^cking let it, to ameliorate the pain long enough that: 1) massive consumer debt can deleverage without taking us all into a Depression; and 2) it can keep its finger in the dyke long enough for Congress and the President to get their acts together and fix the long term structural problems that are sapping confidence. Ultimately, I think Congress and the President do so, maybe this year, maybe the year after, maybe the year after that. But they will not do so until the crisis of confidence is so great that it overwhelmes their concern for their short-term political futures, which is to say, it is highly unlikely it will happen before January 2013.
Accordingly, I continue to stick with high-quality large cap companies that typically derive their earnings from a broad array of countries, and which are therefore not entirely dependent on the American or European economies. These companies also pay dividends that are higher than what I could get on any Treasury bill or in most cases on long term debt, and moreover pay dividends that may grow in time, unlike a bond coupon. Because I am buying stock in companies with near-bullet-proof balance sheets I am confident that they can survive any further crisis, and that they can continue to pay dividends to boot. In the meantime, while I am not outperforming on CAPS (where all my picks are real-life, and where later buys are indicated in the comments), I have essentially matched the market in the last year and half, while taking on vastly, vastly less risk than the average market participant. I view may strategy as better than simply holding and S&P index fund because the S&P has plenty of crappy companies in it, and as we have seen in the last month, while I should be able to match the S&P in a rising market, I will hugely outperform it in a falling market. Thus I am attempting to garner most of the benefits of any rise, while insulating myself from the worst of possible drops.
What I am not doing is freaking the f^ck out. I am above twenty-five percent cash, and if markets drop further, I may buy more. At this time, I remain most interested in MSFT, with lesser interest in INTC and CSCO, and also Apple, frankly. I may get confident enough that I'll forget the stock-purchases, pull out the elephant gun, and buy some January 2013 Leaps on all of these companies. The buy on Apple, note, would be both a bullish call, and also a hedge if in fact the iPad and the rise of pad/tablets/slates generally, does harm MSFT and INTC more than I believe it will.