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Is Abenomics Going to Put Japan Back on the Map?
In a special Outside the Box today, Keith Fitz-Gerald, Chief Investment Strategist for Money Morning, dissects "Abenomics," the radical, not to say outlandish, fiscal moves that the newly installed government of Japan is making. And Keith has a ringside seat: he spends much of each year in Japan.

In an attempt to cut the Japanese a little slack, Keith comes up with four things that will have to happen for Abenomics to work – but when all is said and done, he says, Abenomics is a recipe for disaster. That does not mean, however, that there is not plenty of opportunity here for short-term profit, and Keith offers a play that is a potential money maker in this volatile Japanese environment.

For a limited time, Outside the Box readers can receive a 60% discount when they subscribe to Keith's Money Map Report. You can check it out here.

Our Strategic Investment Conference last week was over the top. It will take me several weeks to think through the presentations, and I will likely spend a few weeks writing about what I learned. But Japan was definitely a big topic, as was Europe. The focus on central banks is appropriate, if frustrating.

The consensus is that massive global QE will end in tears, but the final act may take quite some time to arrive in the US. Today, many central bankers are looking at the currency wars of the 1930s, and the lessons they are drawing from the Great Depression are clear. In a speech to the Economic Club of New York in early 2013, Fed Chairman Bernanke boasted, “In fact, the simultaneous use by several countries of accommodative policy can be mutually reinforcing to the benefit of all.” Bernanke argued that rather than call unconventional policies and devaluations “beggar-thy-neighbor” policies, they should be called “enrich-thy-neighbor” policies. That’s taking the lessons from the 1930s a step too far, but when it comes to unconventional policies and devaluations, Chairman Bernanke believes the more the merrier. And so do his fellow central bankers, apparently.

By the way, a theme is percolating in my mind, which I will develop at a later point. Briefly, the problems with “austerity” in Europe are not so much due to governments cutting back as they are to membership in the euro itself. In essence, the euro is a gold standard. In the '30s, when governments on a gold standard devalued they saw a boost to their economies. But since Eurozone members cannot devalue, they are left with deflation and depression. Then they blame others for not lending to them and forcing “austerity” upon them, when the primary culprit is their own inability to deal with their trade flows and labor costs. If the market cannot adjust currency values, the only choice left is a reduction in labor costs, which in the real world translates into higher unemployment.

But since the euro is a political and not an economic currency, you can’t address your national problem without leaving the euro, and that is not politically feasible. It is a conundrum.

I am really thinking about going to Cyprus in late June, and if any readers have suggestions for people to meet, I am interested.

I am learning more about marble and flooring than I ever thought I would know. We are getting closer to actually beginning construction, but I am ready to finish already, for a variety of reasons. Hotel internet is not always the best, and where I am here in Dallas it can really get slow. The weather here in Dallas is perfect, and I think I will walk to my next meeting. In a few short months, stepping outside will be like walking into an oven, but right now it couldn't be nicer out.

Have a great week.

Your up to my eyeballs in information analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

Is Abenomics Going to Put Japan Back on the Map?

By Keith Fitz-Gerald

On the surface, Abenomics – the radical unlimited stimulus plan put in place by newly elected Japanese PM Shinzo Abe – appears to be working.

The Nikkei is up 68% since July, 2012, the yen has weakened by 26% over the same time frame, and Japanese consumer confidence is up sharply to the highest levels in six years.

The theory behind Abenomics is that the rising stock market will create capital, and the falling yen will make Japan’s export-based economy more competitive in global markets, while newly profitable companies will hire more workers.

Don’t hold your breath.

As I noted during a recent interview on NHK, Japan’s national public broadcasting network, the beleaguered island nation faces significant challenges:
- Japanese debt is already nearly 500% of GDP when you add up public, private, and corporate obligations. That’s the highest on the planet and makes Europe’s spending look positively miserly. Mimicking Bernanke’s helicopter hijinks won’t help on anything more than a short-term basis.
- More money does not equal greater innovation. Many Japanese companies are struggling to remain competitive in industries they once dominated. Examples include Sony, Matsushita, and Fujitsu.
- Japanese utilities literally can’t produce enough power to fuel a Japanese recovery . Only three out of 54 nuclear reactors are running, and the national LNG import bill hit ¥621 billion in March. That’s more than double pre-quake limits, according to the Ministry of Finance. These costs will continue to rise as the yen weakens further. I doubt very seriously that any increase in export sales will be enough to offset rising energy costs, because margins are going to get pinched.
- Formerly deep trade surpluses are now deficits.
- Prices in Japan are rising faster than income at the same time that taxes are being raised. That’s a lethal combination that is serioiusly pinching consumers.
- Japanese corporations, once keen to return profits home, are now expanding overseas and keeping money outside Japan.
- Japan’s population is aging so fast that, effectively, there are no new workers, a problem that is compounded by the near complete lack of a workable immigration policy.
The bottom line?

Japan is making the same mistakes we’re making … or we’re making the same mistakes they’ve already made – it’s hard to tell.

Either way, the bottom line is pretty simple: You give me a trillion yen and I’ll give you a good time, too.

In order for Abenomics to work, four things have to happen:
1. Japanese banks cannot hoard money the way big banks have in the US. They have simply got to keep it moving right through to Japanese citizens and small local businesses.
2. Japanese bond market participants have to be willing to maintain bidding as the Bank of Japan conducts “market operations,” which is Fed-speak for interfering with normal pricing dynamics in an effort to maintain stability. If bidders walk away, the bond market will fail and the government will have to contend with offshore derivatives traders who are already lining up to play the same games they did in Italy, Spain, Greece, and the balance of the EU.
3. Japanese consumers have to engage. If wages fail to increase, living standards will decline and Abe will be up a creek without a paddle – and yes, I mean THAT creek.
4. The international banking community has to allow Japan to debase its currency without punitive repercussions. So far the G20 has acquiesced, but their tacit approval doesn’t really mean much. They have no choice but to go along with Japan's moves. Kuroda, who is Bernanke’s equivalent at the Bank of Japan and Abe’s sidekick, has made it clear he is fully committed to the program, no matter what the West thinks.
Longer-term, Abenomics is a recipe for disaster – have no illusions about that. Japan, as John Mauldin likes to say, is a bug in search of a windshield. No nation in the history of mankind has ever bailed itself out on anything more than a short-term basis by pursuing a course like Japan’s.

But short-term … that’s another matter entirely, and therein lies opportunity.

Historically, every 10% drop in the yen versus the dollar has translated to a 0.3% rise in Japanese GDP the following year, noted Kiichi Murashima, chief economist at Citi in an FT interview.

You cannot say the same thing about Japanese stocks.

Since the Japanese market’s initially collapse in 1991, the world has watched with bated breath as the Nikkei has risen … and plunged with alarming regularity.

If you’re going to buy and sell like a trader and you’re nimble, you can ride the Japanese equity bull – pun absolutely intended. Most investors aren’t so equipped, though, -and so the “buy and hope” approach they favor is far more likely to leave them disappointed than profitable.

Japanese bonds are probably of dubious value, too. So far they’ve been stable, because Japan has been able to issue mountains of debt to its own dutiful citizens. The cost of debt service has been negligible, because nearly all of it was held domestically.

Now, however, Japan has got a very different situation on its hands. Any rise in long-term rates, let alone a significant one like Kuroda is planning, is going to dramatically hike the cost of debt service to unsustainable levels. Factor in Japan’s rapidly aging population and dwindling workforce, and you’re looking at a far smaller pool of bond buyers.

My expectation is that Japan will be forced into international bond markets no later than 2015, which will effectively double their capital costs. Without meaningful social security reform and spending cuts, that’s going to really impact things.

That’s why I’d rather short the Japanese yen.

Stocks are fickle. Abe doesn’t care whether they go up or down. Bonds are a part of Kuroda’s repurchasing agenda, so those are covered, too. But the yen stands on its own.

In that sense, it’s the key to the proverbial castle.

In order to conduct any sort of serious financial reform, Abe is going to have to move the yen’s needle. Everything in corporate Japan depends on it.

Since I first brought this trade to everybody’s attention in Money Morning in February, 2012, the yen has dropped by 30%, and the investment vehicle I recommended, the ProShares UltraShort Yen Fund, is up more than 60% as it flirts with the psychologically important ¥100/$1USD level.

Now, having come close enough to that target for government work, I think the next stop is ¥125 to the dollar, which means that even if you missed the first part of this trade, it’s not too late to get on board.

And if you’re already holding Japanese equities?

Don’t look a gift horse in the mouth.

Hedge the snot out of them or sell into strength – equity markets are not as directly connected to central banking stimulus efforts. But they are absolutely linked to traders' expectations, which can and do change all too frequently on nothing more than a whim or an errant “tweet,” as we have recently seen.

You don’t want to be left holding the bag.

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About the Author: Keith Fitz-Gerald is a seasoned analyst, expert media contributor, and futurist with decades of experience in global markets. In his capacity as Chief Investment Strategist for Money Morning and Chairman of the Fitz-Gerald Group, he appears regularly on financial television programs around the world on the Fox Business Network, CNBC Asia, NHK, BNN, and more. He’s been called on for his extraordinary ability to see future trends in such publications as Wired UK and the Wall Street Journal. Forbes.com labeled him a “Business Visionary.” Even Mensa has called him to their stage. Mr. Fitz-Gerald splits his time between homes in Oregon and Japan, with his wife and two boys. He travels the world extensively in search of investment opportunities others don’t yet see or recognize.
Debt, Growth, and the Austerity Debate
Two weeks ago I wrote about the current debate over the 2010 paper by Ken Rogoff and Carmen Reinhart (hereinafter referred to as RR) on the correlation between debt and GDP growth. I said that the most important part of their work, which is the construction of an enormous database on debt and financial crises over the last few hundred years, was to be found in their book This Time Is Different and elsewhere. And their fundamental conclusion: debt is not a problem until it becomes one. And then it reaches a critical mass and you have what they called the Bang! moment.

They did make an unfortunate error in a few cells of a massive Excel spreadsheet, which subsequent analysis has shown to not be a huge deal, though some have made it out to be. And the more I read of the issue, the more I believe that the bulk of the negative response has political overtones. There are those who wish to find reasons to abandon any move toward balanced budgets and reasonable fiscal policies. They see austerity as a punishment, some type of masochistic conservative Calvinist plot foisted on poor unsuspecting citizens who should not be held responsible for the governments they elect.

As I wrote two weeks ago, austerity is a consequence, not a punishment.

Last Thursday RR published an op-ed in the New York Times. Some were uncharitably dismissive of it, but if you take a careful look at the detailed online version, which is this week’s Outside the Box, I think you'll find their counterarguments thorough and reasonable.

An essay on Bloomberg notes:

The biggest howler is the least consequential. By highlighting the wrong cells in an Excel spreadsheet, Reinhart and Rogoff actually took an average over 15 countries, rather than the full sample of 20. Embarrassing? Yes. Important? No. Of the five missing countries, only one – Belgium – had ever experienced very high debt. Adding it barely changed the findings because Belgium’s economic growth during its high-debt episode was roughly similar to that in other highly indebted nations.
[emphasis mine]

While the media loves to focus on the simple (and regrettable) coding error (which RR acknowledge), the main body of their analysis still points strongly in the same direction, and that direction has been noted by other, independent researchers:

Researchers at the Bank of International Settlements and the International Monetary Fund have weighed in with their own independent work. The World Economic Outlook published last October by the International Monetary Fund devoted an entire chapter to debt and growth. The most recent update to that outlook, released in April, states: "Much of the empirical work on debt overhangs seeks to identify the 'overhang threshold' beyond which the correlation between debt and growth becomes negative. The results are broadly similar: above a threshold of about 95 percent of G.D.P., a 10 percent increase in the ratio of debt to G.D.P. is identified with a decline in annual growth of about 0.15 to 0.20 percent per year.” (NYT)

In fact, when you examine the paper and underlying research of the University of Massachusetts trio who discovered and wrote about the error, you find that there is not all that much difference in outcomes if you use their assumptions. The best analysis I have read is in this piece by F. F. Wiley (even if he misspells my name in his links <g>). For those wanting even more detail on this issue, I suggest you read the Wiley piece after you read RR’s response below.

Economics, at least in its predictive and prescriptive forms, is not a physical science, notwithstanding the physics envy of many economists. To try and suggest that major policy differences should be formed on the basis of numbers to the right of the decimal point is folly. It is enough at times to get the direction right. North rather than south. With regard to the present debate, it is clear that a point can be reached at which too much debt is a problem. Is there a bright, unchanging line? This far and no farther? There is not.

Water transmutes from solid to liquid to gas. In physics and mathematics, limits, and indeed singularities, occur; and we can measure and even predict them. With debt-to-GDP ratios, all we know for now is that the Bang! moment exists, but the precise point for any one given country is not something we can calculate. But wherever that line happens to fall, once it is crossed, Bang! Everything changes. And dear gods, that is a fate to be avoided.

This is far more than an academic tempest in a teapot. Understanding the relationship between debt and systemic financial problems is critical to how you construct your long-term portfolio positions. If there is not a relationship between debt and growth, then quantitative easing will have an entirely different effect on markets than if there is. It is really that simple. Can we point to exact figures and immutable relationships? Of course not. Nothing in life is that simple, and RR don’t even attempt to do so, although some of their critics (and to be fair, some of their supporters) try to see bright red lines around the 90% debt-to-GDP number.

I write this note from La Jolla, looking over the Pacific Ocean. I will have dinner with Jon Sundt and the partners at Altegris at George’s later this evening and then move on to Carlsbad, where I will meet tomorrow with my partners and team at Mauldin Economics. The bulk of the team will be in this week for a two-day planning fest before we celebrate our 10^th annual Strategic Investment Conference, starting Wednesday evening. I also have writing and reading and a brand-new speech to attend to. And I want to be there for all the speaking sessions. There will also be lots of late-night conversations with great friends on a very wide range of topics, from QE to biotech to geopolitics and all sorts of politically incorrect notions. Can it get any better?

It is about time to get to that next meeting. I hope your week is going well.

Your about as excited as I can get when I think about this week analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

Debt, Growth, and the Austerity Debate

By CARMEN M. REINHART and KENNETH S. ROGOFF
The New York Times, April 25, 2013

In May 2010, we published an academic paper, “Growth in a Time of Debt.” Its main finding, drawing on data from 44 countries over 200 years, was that in both rich and developing countries, high levels of government debt – specifically, gross public debt equaling 90 percent or more of the nation’s annual economic output – was associated with notably lower rates of growth.

Given debates occurring across the industrialized world, from Washington to London to Brussels to Tokyo, about the best way to recover from the Great Recession, that paper, along with other research we have published, has frequently been cited – and, often, exaggerated or misrepresented – by politicians, commentators and activists across the political spectrum.

Last week, three economists at the University of Massachusetts, Amherst, released a paper criticizing our findings. They correctly identified a spreadsheet coding error that led us to miscalculate the growth rates of highly indebted countries since World War II. But they also accused us of “serious errors” stemming from “selective exclusion” of relevant data and “unconventional weighting” of statistics – charges that we vehemently dispute. (In an online-only appendix accompanying this essay, we explain the methodological and technical issues that are in dispute.)

Our research, and even our credentials and integrity, have been furiously attacked in newspapers and on television. Each of us has received hate-filled, even threatening, e-mail messages, some of them blaming us for layoffs of public employees, cutbacks in government services and tax increases. As career academic economists (our only senior public service has been in the research department at the International Monetary Fund) we find these attacks a sad commentary on the politicization of social science research. But our feelings are not what’s important here.

The authors of the paper released last week – Thomas Herndon, Michael Ash and Robert Pollin – say our “findings have served as an intellectual bulwark in support of austerity politics” and urge policy makers to “reassess the austerity agenda itself in both Europe and the United States.”

A sober reassessment of austerity is the responsible course for policy makers, but not for the reasons these authors suggest. Their conclusions are less dramatic than they would have you believe. Our 2010 paper found that, over the long term, growth is about 1 percentage point lower when debt is 90 percent or more of gross domestic product. The University of Massachusetts researchers do not overturn this fundamental finding, which several researchers have elaborated upon.

The academic literature on debt and growth has for some time been focused on identifying causality. Does high debt merely reflect weaker tax revenues and slower growth? Or does high debt undermine growth?

Our view has always been that causality runs in both directions, and that there is no rule that applies across all times and places. In a paper published last year with Vincent R. Reinhart, we looked at virtually all episodes of sustained high debt in the advanced economies since 1800. Nowhere did we assert that 90 percent was a magic threshold that transforms outcomes, as conservative politicians have suggested.

We did find that episodes of high debt (90 percent or more) were rare, long and costly. There were just 26 cases where the ratio of debt to G.D.P. exceeded 90 percent for five years or more; the average high-debt spell was 23 years. In 23 of the 26 cases, average growth was slower during the high-debt period than in periods of lower debt levels. Indeed, economies grew at an average annual rate of roughly 3.5 percent, when the ratio was under 90 percent, but at only a 2.3 percent rate, on average, at higher relative debt levels.

(In 2012, the ratio of debt to gross domestic product was 106 percent in the United States, 82 percent in Germany and 90 percent in Britain – in Japan, the figure is 238 percent, but Japan is somewhat exceptional because its debt is held almost entirely by domestic residents and it is a creditor to the rest of the world.)

The fact that high-debt episodes last so long suggests that they are not, as some liberal economists contend, simply a matter of downturns in the business cycle.

In “This Time Is Different,” our 2009 history of financial crises over eight centuries, we found that when sovereign debt reached unsustainable levels, so did the cost of borrowing, if it was even possible at all. The current situation confronting Italy and Greece, whose debts date from the early 1990s, long before the 2007-8 global financial crisis, support this view.

The politically charged discussion, especially sharp in the past week or so, has falsely equated our finding of a negative association between debt and growth with an unambiguous call for austerity.

We agree that growth is an elusive goal at times of high debt. We know that cutting spending and raising taxes is tough in a slow-growth economy with persistent unemployment. Austerity seldom works without structural reforms – for example, changes in taxes, regulations and labor market policies – and if poorly designed, can disproportionately hit the poor and middle class. Our consistent advice has been to avoid withdrawing fiscal stimulus too quickly, a position identical to that of most mainstream economists.

In some cases, we have favored more radical proposals, including debt restructuring (a polite term for partial default) of public and private debts. Such restructurings helped deal with the debt buildup during World War I and the Depression. We have long favored write-downs of sovereign debt and senior bank debt in the European periphery (Greece, Portugal, Ireland, Spain) to unlock growth.

In the United States, we support reducing mortgage principal on homes that are underwater (where the mortgage is higher than the value of the home). We have also written about plausible solutions that involve moderately higher inflation and “financial repression” – pushing down inflation-adjusted interest rates, which effectively amounts to a tax on bondholders. This strategy contributed to the significant debt reductions that followed World War II.

In short: many countries around the world have extraordinarily high public debts by historical standards, especially when medical and old-age support programs are taken into account. Resolving these debt burdens usually involves a transfer, often painful, from savers to borrowers. This time is no different, and the latest academic kerfuffle should not divert our attention from that fact.

Carmen M. Reinhart is a professor of the international financial system, and Kenneth S. Rogoff is a professor of public policy and economics, both at Harvard.

In an appendix to this op-ed essay, the authors further defend their findings that high public debt is associated with lower economic growth.

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Hoisington Investment Management-Quarterly Review and Outlook, First Quarter 2013
Lacy Hunt and Van Hoisington launch into their first-quarter "Review and Outlook," this week's Outside the Box, with a statement that some may find eye-opening: "The Federal Reserve (Fed) is not, and has not been, 'printing money'…" But given the facts of life about how money is really created (and destroyed), they are of course right: it's all about the acceleration – or deceleration – in the M2 money supply.

But there are deeper currents here. For, as Van and Lacy say, "A review of post-war economic history would lead to a logical assumption that the money supply (M2) would respond upward to [the Fed's] massive infusion of reserves into the banking system. And yet, the Fed's 3.5x expansion of the monetary base over the past five years has only grown M2 by 35%, and year-over-year growth through March, 2013, was less than 7%. "In other words," say our authors, "there is no evidence that the massive security purchases by the Fed have resulted in a sustained acceleration in monetary growth; nor is there evidence that economic conditions have improved."

So what is wrong with this picture? Well, it turns out that not only can the Fed not control the money supply, it can't control the velocity of money either. And that means the Fed can't create rising aggregate demand. As in, Ben's shooting blanks.

To help us get our heads around this fundamental realization, Van and Lacy lead us deeper into the gooey cytoplasm of Federal Reserve genetics; but the bottom line, as Prof. Irving Fisher taught us, is that GDP = MV. That is, nominal GDP equals money times its turnover (velocity). And don't look now, but velocity is the lowest it's been in six decades.

The upshot (downshot?) is that the decade just past saw a growth rate worse than any in US history, except the 1930s. We already knew that, but it's good to have estimable gentlemen like Messrs. Hunt and Hoisington bring us the numbers and solid analysis to back up the surprising statements we find ourselves forced to make about this oh-so-Muddle Through Economy.

Hoisington Investment Management Company (www.Hoisingtonmgt.com) is a registered investment advisor specializing in fixed-income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $5 billion under management and is the sub-adviser of the Wasatch-Hoisington U.S. Treasury Fund (WHOSX).

I am back in Dallas for a week and getting ready for my conference next week, preparing a brand-new presentation, working on books, looking through architectural plans, spending time with family, dealing with endless minutiae, and all the while trying to stay caught up with my reading. Life seems so much busier than a decade or so ago when I had seven kids at home and a growing business, was deeply involved in politics, and was limited to old-fashioned publications on paper as the sources for my research. I am not complaining, mind you, as I am having a marvelous time; I just wonder how I would have done back then what I do now.,

I am really looking forward to my conference next week. This will be our (Altegris and my) 10^th conference. From the beginning I have always invited speakers I wanted to hear and who would challenge my thinking. This is about our best line-up ever, and I really would put it up against the roster of any conference anywhere. Most conferences have a few “headliners” and then other speakers, many of whom pay to sponsor and speak. We have nothing but headliners. My only regret is that we could not go for a couple more days and bring in a few more names.

I know some people look at our line-up of speakers and see mostly bears, but I think the attendees are in for a surprise. I am looking at PowerPoints and letters from the presenters, and the large majority of them are finding places to put capital to work. This dynamic is going to make for some lively debates at the conference. You can learn more at www.altegris.com/sic .

Two final thoughts. Given how much I travel it may be self-serving, but I find it inexcusable that the FAA would blame “sequestration” on the cutback in air-traffic controllers, etc. In a federal budget that large, they could find a few dollars to keep things rolling. That Congress would allow this without requiring prioritization funds is just one example – out of thousands – of the executive branch saying, “See, if you don’t give us money we will just inconvenience you,” all the while funding programs that we could well do without They might also take a look at cutting and rearranging budgets, as any normal business would do, to make sure that the important work for their customers gets done.

And finally, I have to apologize to my British friends. I am appalled that the current administration did not send a few officials to the funeral of Dame Margaret Thatcher. So much has been written about her that there is little I can add. I understand that some in the current administration might not agree with her policies, but an official acknowledgement of the “special relationship” that exists between Britain and the US would have seemed to require the presence of a representative from our government. That none were dispatched causes me to feel great shame for our country. Is this the way we treat our friends? It speaks volumes.

Have a great week. And are you paying attention to Italy? It seems that whom the gods would drive mad they first send to Italy to study politics.

Your needing to go back to Tuscany analyst,

John Mauldin, Editor
Outside the Box

subscribers@mauldineconomics.com

Hoisington Investment Management – Quarterly Review and Outlook, First Quarter 2013

Printing Money

“The Federal Reserve is printing money”. No statement could be less truthful. The Federal Reserve (Fed) is not, and has not been, “printing money” as defined as an acceleration in M2 or money supply. Just check the facts. For the first quarter of 2013 the Fed purchased $277.5 billion in securities (net) as their security portfolio expanded from $2.660 trillion to $2.937 trillion. A review of post-war economic history would lead to a logical assumption that the money supply (M2) would respond upward to this massive infusion of reserves into the banking system. The reality is just the opposite. The last week of December, 2012 showed M2 at $10.505 trillion, but at the end of March, 2013 it totaled only $10.450 trillion which was an unexpected decline of $55 billion. Printing money? No.

This broad misconception of the Fed’s ability to print money has been widely embraced since the Fed began its massive balance sheet expansion near the end of 2008. It was then that the Fed expanded the monetary base from $840 billion to $1.7 trillion in a matter of months. Further, from the initiation of this misguided program to the end of March 2013, the Fed has expanded the monetary base from $840 billion to $2.93 trillion. The money supply indeed went up (35%) but not in proportion to the increase in the monetary base (249%). Presently, the year- over- year expansion of M2 is only 6.8%, which is nearly identical to its year-over-year growth rate in March of 2008 before the Fed decided to “help out the economy” (Chart 1). In other words, there is no evidence that the massive security purchases by the Fed have resulted in a sustained acceleration in monetary growth; nor is there evidence that economic conditions have improved.

The Fed's Flaw

Not only does the Fed not control money, but it cannot determine velocity (V), the speed that money turns over, either. The great American economist, Irving Fisher, identified this connectivity between money and economic growth with a straightforward formula: Nominal GDP equals money (as defined by M2) times its turnover (GDP=MV). Two flaws exist in the belief that the Fed can create rising aggregate demand. First, they do not directly control M2. Second, velocity is almost entirely outside their control. In order to understand how these two variables prevent the Fed from increasing aggregate demand, it is necessary to become conversant with a few terms: monetary base, bank reserves, and money multiplier.

The monetary base, which is derived from a consolidated balance sheet of the Fed and Treasury, has an asset (source side), and a liability (use side). When the Fed purchases government securities, the asset side rises and the liability side, comprised of currency in circulation and bank reserves, increases commensurately. Bank reserves are funds that are held by banks on deposit at the Fed or in their own institution in the form of vault cash. These funds, or reserves, are available for lending. This process of lending reserves creates deposits and currency that constitute the definition of M2.

The monetary base is often referred to as “high-powered money” since the reserve component has the potential to expand deposits and therefore money. The operative word is potential, which may or may not be realized. The massive reserve injection since 2008 is therefore the primary reason why there has been an elevated fear of inflation since these funds could be loaned. However, the empirical evidence is clear that high- powered money is not causing an increase in M2. Why? A bank’s conversion of reserves into money is called the money multiplier (Chart 2, left scale). At the end of 2007, the money multiplier was 9.0. That meant that the monetary base of $825 billion (Chart 2, right scale) was multiplied nine times to create the level of M2 that stood at $7.4 trillion. At the end of March, 2013 the monetary base had exploded to $2.9 trillion, but the money multiplier had collapsed to only 3.6, creating an M2 balance of $10.4 trillion. The Central Bank has very little control over the movement of the money multiplier; the actions of the banks and their customers primarily control this variable. This lack of control was evident in the first quarter of 2013 when the monetary base rose by $264 billion and M2 fell because the money multiplier declined from 3.9 to 3.6. Therefore, the Fed’s balance sheet expansion was thwarted.

Velocity

Referring back to Fisher’s equation GDP=MV, the other constraint on the Fed's ability to increase aggregate demand is velocity. If M2 actually expands, then velocity must remain stable in order for nominal GDP to be lifted in proportion to the rise of M2. While stable velocity was assumed in most of the post war academic work on monetary theory, clear empirical evidence is that velocity is woefully unstable (Chart 3). A host of factors influence velocity, but arguably the most important one is the type of borrowing and lending that occurs. For velocity to rise, any increase in debt needs to create a productive income stream. For the past several years, most of the borrowing and lending activities have related to daily consumptive needs, including borrowing by the federal government as well as much of the recent upturn in consumer lending. Borrowing to finance consumption does not generate a productive income stream nor does it create the resources to repay the borrowed funds. Consequently, velocity has collapsed and now stands at a six decade low.

No Inflation

Inflation cannot ignite in such an environment. Incomes will languish and growth in aggregate demand, as measured by nominal GDP, will slow except for brief, intermittent periods. Some inflationists point to the vast pool of reserves and conclude that if borrowing and lending begin to accelerate, money will surge and so will nominal GDP, but this argument is invalid. First, the money multiplier could continue to contract, just as the most recent figures confirm. Even if, contrary to the latest data, the money multiplier were to stabilize, an extended period would still transpire before any meaningful change in economic conditions. Second, no sign suggests that credit creation is turning more productive. Hence, velocity will continue to fall. Research further indicates that there is a considerable lag between monetary change and altered economic conditions.

In the current setting, those historically long lags should be even longer. The intersection of the aggregate demand curve (AD) with the aggregate supply curve (AS) determines the price level and real GDP. In today’s highly globalized markets, with services coming on-stream from all parts of the world, the AS curve could be in the process of continually shifting outward. Thus, the price level could fall even if there are small outward shifts in the aggregate demand curve. Additionally, the extreme level of indebtedness is a force entirely independent of the Fed, and it is restraining aggregate demand and serving to neutralize what minimal influence the Fed has on the economy. Moreover, this year’s tax hike will serve to shift the aggregate demand curve inward, reducing demand, providing a second powerful counter-force to the Fed’s feeble actions.

Perspective

Our present economic situation is nearly unparalleled in American history (Chart 4). An examination of the real economic growth rate of each decade in the United States from 1790 to 2012 reveals the unprecedented sluggishness of our present economic environment. The 1.8% average rise in the thirteen years of this century is less than half of the 3.8% growth rate since 1790. The only decade that witnessed worse economic conditions was, of course, the 1930s.

Debt Constrains Growth

Bad things happen when government debt exceeds 100% of GDP. Four studies published in just the past three years document this conclusion. These studies are highly relevant since OECD figures indicate that gross government debt exceeds 100% in the U.S., Europe, Japan as well as in other OECD member countries. Three of these studies were conducted by foreign scholars and published outside the United States thus avoiding attachment to the unfortunate domestic political debate. Here are the studies, starting with the one with the broadest implications:

(1) In Government Size and Growth: A Survey and Interpretation of the Evidence, Swedish economists Andreas Bergh and Magnus Henrekson find a “significant negative correlation” between size of government and economic growth.

Specifically, “an increase in government size by 10 percentage points is associated with a 0.5% to 1% lower annual growth rate.” (Journal of Economic Surveys, April, 2011)

(2) In The Impact of High and Growing Government Debt on Economic Growth, An Empirical Investigation for The Euro Area, Cristina Checherita and Philipp Rother find that a government debt to GDP ratio above the turning point of 90-100% has a “deleterious” impact on long-term growth. Additionally, the impact of debt on growth is non-linear. This means that as the government debt rises to higher and higher levels, the adverse growth consequences accelerate. (European Central Bank, Working Paper 1237, August 2010)

(3) In The Real Effects of Debt, Stephen G. Cecchetti, M.S. Mohanty and Fabrizio Zampolli determine “beyond a certain level, debt is bad for growth. For government debt, the number is about 85% of GDP.” (Bank for International Settlements (BIS) in Basel, Switzerland, September, 2011)

(4) In Debt Overhangs: Past and Present - Post 1800 Episodes Characterized by Public Debt to GDP Levels Exceeding 90% for At Least Five Years, Carmen M. Reinhart, Vincent R. Reinhart and Kenneth S. Rogoff confirm that public debt overhang episodes are associated with growth over one percent lower than during other periods, and such episodes lasted an average of 23 years. They write “the long duration also implies that cumulative shortfall in output from debt overhang is potentially massive”. (National Bureau of Economic Research, Working Paper 18015, August 2012)

When private debt to GDP rises above 160% to 175% of GDP, growth is also stunted. This argument is also operative since private debt to GDP in the U.S. was 260% of GDP as of the fourth quarter of 2012. The point on private debt is a serious matter since it strikes at one of the core purposes of central banking – to promote private credit growth. But this is only valid for normal considerations and not when private debt is excessively high. When private debt is excessive, efforts to promote more private debt are counterproductive, thus the Fed is destabilizing rather than facilitating economic growth. The two major studies on private debt, both completed in the past two years and published outside the United States, bear directly on this issue. The first is the 2011 United Nations Conference on Trade and Development (UNCTAD) study, Too Much Finance, authored by Jean Louis Arcand, Enrico Berkes and Ugo Panizza. They find a negative effect on output growth when credit to private sector reaches 104% to 110% of GDP. The strongest adverse effects are for credit over 160% of GDP. The second is the 2011 BIS study referenced above. It finds that these negative consequences, or what the BIS economic advisor Cecchetti refers to as the point at which debt levels turn “cancerous”, start at 175% just slightly more than the UNCTAD study.

Is Deflation a Continuing Risk?

In their pioneering work, This Time is Different, Carmen Reinhardt and Kenneth Rogoff (R&R) found that “In Depression-era defaults, deflation was the norm.” They, however, observed situations where extreme over indebtedness was followed by high inflation. For all its valuable contributions, R&R’s sample in this best selling 2009 book included both advanced and emerging economies. In later studies other researchers also separated advanced from emerging economies because the latter have options that the former do not. The emerging markets and very small economies in general can resort to currency devaluation when they become over-indebted which creates domestic inflation. Such adversarial action may succeed because the individual countries are too small and insignificant to harm others and thus would not evoke immediate retaliation. But inflation is optional for these smaller countries only. If advanced economies choose currency devaluation ("economic warfare") to deal with a debt overhang, this evokes retaliation and a “race to the bottom” that is globally deflationary (the 1927 to 1939 experience). As far as we know, all the debt studies of the past three years have confined statistical examination to the data on advanced economies, a procedure that is now widely supported.

Irrationality

Credible academic research indicates that economic growth deteriorates when debt to GDP reaches critical levels - a condition that has now been met in countries that represent 75% of global GDP. When this reality is coupled with the Fed’s inability to create money growth or inflation, the result will invariably be slow nominal GDP growth.

The financial and other markets do not seem to reflect this reality of subdued growth. Stock prices are high, or at least back to levels reached more than a decade ago, and bond yields contain a significant inflationary expectations premium. Stock and commodity prices have risen in concert with the announcement of QE1, QE2 and QE3. Theoretically, as well as from a long-term historical perspective, a mechanical link between an expansion of the Fed’s balance sheet and these markets is lacking. It is possible to conclude, therefore, that psychology typical of irrational market behavior is at play. This suggests that when expectations shift from inflation to deflation, irrational behavior might adjust risk asset prices significantly. Such signs that a shift is beginning can be viewed in the commodity markets. The CRB Commodity Index peaked about two years ago at 691, but now stands at 551, a 20% decline despite massive Fed balance sheet expansion. The ability of the Fed to arrest a downside irrational move in risk assets may be limited. Non-risk assets, such as long dated U.S. treasuries, should benefit from this shift in perception.

Van R. Hoisington
Lacy H. Hunt, Ph.D.
Are Earnings Expectations Realistic?
Outside the Box: Are Earnings Expectations Realistic?
In today’s Outside the Box, Sheraz Mian, Director of Research for Zacks Investment Research, gives us a thorough overview of corporate earnings trends for the past several quarters, along with consensus expectations for this year and next. Then he asks, “How realistic are these expectations?”

Not very, he says, and proceeds to tell us why. If we accept his analysis – and he admits right up front that it runs counter to the consensus – then we should be asking ourselves, how does a potential falloff in earnings vs. expectations matter, and why is it important at this particular juncture? I’ll let Sheraz answer those questions, too – he does so convincingly – but I’ll just add that his analysis is a significant piece in the puzzle we’re all putting together here in this tipping-point year of 2013.

Depending on what the politicians and bureaucrats do, or fail to do, in the US, Europe, and China (not to mention Japan), we could turn one of two corners this year: The left-hand turn – toward ever more QE, ballooning fiscal deficits, and an accelerating global currency war – would take us further up Inflation Hill, whose back side is a sheer cliff. The right-hand turn – toward deepening austerity and unemployment – spirals us down into the Morass of Negative Growth. It is only by forging straight ahead along the Main Street of innovative business and technological development, supported by balanced fiscal and financial policies and realistic market expectations (based on valid data and assumptions – something I have been driving at in my last couple Thoughts from the Frontline letters), that we will get through this challenging decade intact. But that is a difficult path to find between the siren calls of austerity and more printing.

Zacks Investment Research was founded in 1978 by Len Zacks, PhD. Many innovations have come from this firm over the years, including the creation of the Earnings Consensus that many investors now use to compare earnings estimates with actual earnings reports. Most notably, Len discovered the predictive power of earnings estimate revisions. He harnessed these benefits into the proprietary Zacks Rank stock rating system that has allowed Zacks Rank to compile an outstanding track record.

Zacks is offering OTB readers, at a very low rate, a one-month trial of all their products. You can learn more here.

As I write this, I find myself in Singapore, where it is early Wednesday morning, so I have lost a day – but I’ll get it back next Friday. I will meet Grant Williams in a few hours, and we will take a train to Malaysia for lunch and discuss the markets and business. Then it’s back to Singapore for a little work before enjoying the evening, when Simon Hunt and Steve Diggle will join us for dinner. The next day is meetings with event sponsors Saxo Bank and The Business Times, and then it is Writing Night – a day too early, but deadlines are deadlines, no matter which side of the international date line you are on.

Saturday night was rather amazing. I am used to more subdued fundraising events, but Dr. Mike Roizen is one of the senior guys in the Cleveland Clinic, and the Lou Ruvo Center for Brain Health in Vegas is part of the Cleveland Clinic system and is setting all sorts of records. If I or someone I knew had Alzheimer’s, I would check it out.

I guess if you are Michael Caine and Quincy Jones you can gather a lot of stars (it was their 80^th birthday). I was told they raised the second most ever for an event like this. The proceeds go toward research into Alzheimer’s and brain injuries/trauma. OK, so Bono walks out on stage unannounced and nails Frank Sinatra. Who knew Bono could do Sinatra? (The hook was, Q produced Sinatra). We were treated to Steve Wonder, Patti Austin, and Shaka Kahn – all of whom still have their chops and look great – Carlos Santana, and on and on. It was good to see people my age (ahem) still going strong on stage. You can watch the whole thing on various cable channels and donate a few dimes with your cell.

It really is time to hit the send button. Have a great week. And yes, I know gold went down. That just means I get more coins when I buy at the end of the month – if it will stay down.

Your needing to find a gym analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

Are Earnings Expectations Realistic?

By Sheraz Mian, Director of Research, Zacks Investment Research

We all know that markets don’t always reflect the health of the economy. It is not unusual to experience stellar market returns in an otherwise mediocre economic backdrop – something that investors are currently experiencing. But future success in this investing climate is a greater challenge and requires a good hard look at how realistic earnings expectations are.

On March 28, the S&P 500 hit a new all-time closing high and is now on the cusp of surpassing the intraday high set in March 2000. The Dow Jones Industrial Average and a number of market indices comprising small- and mid-cap stocks are already at record levels – all in the midst of a struggling economy.

The first-quarter 2013 reporting season about to get into high gear will be the second earnings cycle of the current market rally. The rally got underway last November, but the first two months this year overlapped with the fourth-quarter 2012 earnings season. With corporate earnings generally considered to be the mother’s milk of stock prices, the market’s positive year-to-date momentum could be safely interpreted as investor satisfaction, if not happiness, with the earnings picture.

Past performance matters to the market, but it is far more concerned with what will happen in the future. After all, stock prices reflect expectations about the future. You can think of these future expectations built into the current stock prices as the collective wisdom of all investors. “Consensus” estimates of all the key variables that investors care about – like earnings, revenues, the economy, the Fed, etc. – reflect this “collective wisdom.”

So, where do current market expectations stand?

Earnings growth has been essentially flat over the last three quarters, a trend that current consensus expectations project into the first half of 2013. But the market’s “collective wisdom,” as reflected by consensus estimates, expects growth to come roaring back in the second half of the year and continue into 2014.

My experience leads me to disagree with the consensus. I don’t see a return to booming growth panning out this way, and would like to share the basis of my skepticism with you.

I am by no means suggesting that an earnings train wreck is on the horizon. Nor am I making a call to exit the market altogether. What I am suggesting instead is that current earnings expectations are vulnerable to significant downward revisions. An acceleration in that negative revisions process will most likely result in the market giving back some, if not all, of its recent gains.

You don’t have to agree with my conclusions, wholly or partly. In fact, many of my colleagues and I don’t see eye to eye on this issue. But nevertheless, it would pay to be a little skeptical of current earnings expectations being touted in the media, and maybe take another look at your portfolio to perhaps reposition it for a period of potential market weakness.

The discussion is particularly timely with the 2013 Q1 earnings season about to get underway. Expectations remain low, as they were ahead of the 2012 Q4 earnings season. The Q4 earnings season turned out to be better relative to preseason expectations, and we will likely see a repeat performance in the Q1 earnings season. But that shouldn’t lead to overly optimistic expectations for the coming quarters.

My goal in this write-up is to give you an update on how the Q4 earnings season turned out, and what recent estimate revisions trends tell us about the future of earnings growth.

Evaluating the Q4 Earnings Season

By most conventional measures, the Q4 earnings season turned out to be average. Not particularly good, but not bad either.

Total earnings for companies in the S&P 500 were up +2% year over, and 65.6% of companies beat earnings expectations with a median surprise of +3%. Total revenues were up +2.6%, with 62% of companies beating top-line expectations and median revenue surprising by +0.6%. Excluding the Finance sector, earnings were barely in the positive category.

The table below provides a summary picture of the actual results for 2012 Q4 and consensus expectations for 2013 Q1. Please be mindful of two factors as you read the table below and other earnings data here.

First, we have divided the S&P 500 into 16 sectors, compared to the Standard & Poor’s official 10 sectors. This gives us a more granular view of sectors like retail, construction, autos, transportation, aerospace, and business services. Second, the earnings data here accounts for employee stock options as a legitimate expense, rather than excluding them, as is the practice on Wall Street. As a result, the earnings numbers and growth rates are relatively lower.

Source: Zacks Data. Finance-sector revenue in the fourth quarter got a one-off boost from gains at Prudential Financial (Ticker: PRU). Excluding the Prudential revenue, total Finance-sector and S&P 500 revenue growth would be +11.9% and +2.6%, respectively. The margins column represents the net margins (total net income/total sales).

Despite Q4's average results, the stock market’s strong year-to-date performance shows that investors are overall quite happy with them. But why would this be? Simply, the reason is the extremely low levels to which expectations had fallen as the reporting season was getting underway in early January.

As you can see in the chart above, consensus expectations in early January were significantly below where they stood in early October. This tells us that the market’s favorable response to the Q4 earnings performance was largely a function of how low expectations had fallen between October and January.

But how does the Q4 earnings performance compare to other quarters?
- The growth rates for earnings and revenues were better than in Q3, but significantly lower compared to the average for the preceding four quarters.
Note: The average is of the four quarters preceding 2012 Q4.
- The “beat ratio,” the percentage of total companies coming out with positive surprises, reflects the same trend, particularly on the earnings side. There is an unusually high proportion of beats on the revenue side, but that’s likely a “payback” for the very low beat ratio in the third quarter. Expectations had come down to an exaggeratedly low level following the Q3 underperformance, which set us up for the unusually high level of positive revenue surprises.
Evaluating Expectations for the Coming Quarters

Earnings estimates from analysts are heavily influenced by guidance from management teams, particularly on the earnings calls. And while the tone of guidance in Q4 was somewhat less negative relative to what we heard from management teams in Q3, it was nevertheless predominantly weak and tentative. This prompted analysts to cut their estimates for the coming quarters, and particularly Q1.

The first table below provides the expected earnings growth rates for the coming quarters, while the second table looks at this year and next.

Note: The growth rates are year over year

To provide a context for the consensus growth expectations for the coming quarters, the next two tables show the absolute dollar levels of total quarterly and annual earnings (as against the YoY growth rates shown above).

Note: The quarterly data is for actual total earnings in the last four quarters and the consensus earnings expectations for the coming four quarters. The annual data shows the actual earnings for the five years through 2012 and the next two years. For example, companies in the S&P 500 earned $238.2 billion in the last quarter of 2012 and $965 billion for the full year 2012. Consensus expectations are for total earnings to come in at $242.3 billion in 2013 Q1 and $1.03 trillion in full-year 2013.

What we see from looking at the last few quarters is that total quarterly earnings have yet to get back to the 2012 Q1 peak of $248 billion. Total earnings have basically been trending down over the last three quarters, but consensus expectations are looking for earnings to start trending back up from 2013 Q1 onwards, with the growth pace materially picking up from Q2 onwards.

Another way to look at this data is by comparing the consensus expectations for the first half of 2013 with the actual results for the same period in 2012. Expectations are for flat earnings growth in the first half of the year, but a ramp-up in the back half of the year to a growth pace of +9.5%. This growth momentum is expected to carry into 2014, giving us earnings growth of +11.7% that year, after the +6.8% gain in 2013 and the +3.8% growth in 2012.

In absolute dollar terms, consensus expectations are for companies in the S&P 500 to earn $1.03 trillion (yes that is a trillion) in 2013 and $1.15 trillion in 2014. In terms of earnings per share, this approximates to $109.88 per “share” of the S&P 500 index in 2013 and $122.72 in 2014.

How Realistic Are These Expectations?

In my professional opinion, they are not realistic. I don’t think these expectations will pan out, and here is why.

Earnings increase through two ways: revenue growth and/or margin expansion (margins are basically earnings as a percentage of sales). The outlook on both fronts is problematic.

Margins have peaked already and at best can be expected to stabilize around current levels. And you can’t have significant revenue growth in the current growth-constrained environment.

Another avenue for growth, particularly at the individual company level, is through mergers and acquisitions. While many M&A deals don’t end up creating value for the acquiring company’s shareholders and don’t generate growth at the aggregate level, they do produce growth at the company level. The historical track record of corporate deal making, in terms of aggregate growth and returns, is spotty at best. But management teams are ever ready for a deal, particularly when elevated equity markets provide them with an easy-to-use currency and the credit markets are willing to fund anything, as is the case at present.

The expected strong earnings growth in the second half of 2013 and next year reflect a combination of revenue growth and margin gains. Revenue growth has a very strong correlation with (nominal or non-inflation-adjusted) global GDP growth. But economic growth has been very anemic lately, with the rich world’s slow-motion deleveraging process casting a dark shadow over the faster-growing emerging world.

The US economy is actually in better shape relative to the recession in Europe and Japan’s nascent efforts to inflate away its problems. But that’s only in relative terms – the reality is that the US economy is at best on a sub-2% growth trajectory. Even that growth pace may be at risk from unfolding fiscal austerity efforts such as the budget sequester and Fiscal Cliff-related tax hikes.

But consensus expectations are looking for a second-half 2013 GDP growth ramp-up that pushes the growth pace close to +3%, and even higher next year. With the US economy barely producing any growth in 2012 Q4, it is hard to envision the growth outlook improving to that extent. But current revenue-growth expectations reflect these optimistic assumptions.

As the chart below shows, margin gains play a big part in projected earnings growth in the coming quarters.

©

Note: These are net income margins, meaning total net income for the S&P 500 as a percentage of total sales. The data for the last four quarters and last seven years represents what companies actually reported. Net margins for the next four quarters and two years represent current consensus expectations.

Margins have already travelled quite some distance from the 2009 bottom and are essentially in line with the prior cyclical peak. One could argue that margins should move past the prior peak like the stock market; but before we buy into that argument, let’s not forget what gave us the 2006/2007 peak in the first place. Without even getting into the details of how the housing bubble back then pumped up everything, one could say with a lot of confidence that those were unusual times and cannot be expected to repeat. Total earnings, on the other hand, are already above the 2007 peak.

Margins follow a cyclical pattern. They expand as the economy comes out of a recession and companies use existing resources in labor and capital to drive business. But eventually capacity constraints kick in, forcing companies to spend more for incremental business. At that stage, margins start to contract again. Given the extent of unemployment and under-employment in the US economy, one could reasonably say that we haven’t reached those levels. That said, it is hard to envisage companies doing more with less forever.

So What Gives?

Not only are margins already at record levels, but corporate earnings as a share of GDP are also at multi-decade highs. Just as trees don’t grow to the skies, margins and the ratio of earnings to GDP don’t expand forever, either.

What all of this boils down to is that current earnings estimates are too high and they need to come down – and come down quite a bit. One could reasonably draw a scenario where earnings growth turns negative this year. But the most likely path appears to be for earnings growth to flatten out – with the absolute level earnings this year and next not much different from what we got in 2012.

Granted, negative earnings revisions would not be a new phenomenon, as estimates have been coming down for more than a year now. But the market has essentially shrugged off this weakening picture in the hope of an improving earnings outlook for the coming quarters. Importantly, investors have been heartened by the improving outlook for China, a less worrisome European picture, and resolution of some of the domestic macro issues.

But the level of calm in the market is bordering on complacence. After all, Europe remains in a recession; and recent Chinese data about PMI, industrial production, retail sales, and inflation show that we can’t take a rebound in that country for granted. Importantly, recent talk of changes to the Fed’s QE program from within the FOMC are offsetting its effectiveness, Bernanke’s assurances notwithstanding.

With global tailwinds dissipating, the earnings outlook question becomes far more significant for the market. Unless the domestic and international growth backdrop materially improves from current levels, it is hard to imagine current earnings growth expectations holding up. And as investors wake up to the significantly weaker corporate earnings backdrop over the coming months, it will become harder to justify the market’s recent gains, potentially leading to a broad-based pullback.

Investing in a Low Earnings Growth Environment

The bottom line is that actual earnings growth will be substantially lower than what is currently built into stock prices. This view is contrary to current consensus expectations and could potentially serve as a major headwind for the market once investors begin to share it in coming months.

The way to invest in such an environment is to look for stocks that don’t reflect aggressive growth expectations and that enjoy company-specific growth drivers not tied to broader macro trends. Companies that generate plenty of cash flows beyond their immediate capital needs and have track records of sharing excess cash with shareholders through dividends and buybacks are particularly well suited for a period of sub-par earnings growth.

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Taking Distortion at Face Value

Last Friday I was in Sonoma, California, for Mike Shedlock’s investment conference. The weather was grey and gloomy, but the conversation was animated and bright. I was fully engaged the whole day and never more than when John Hussman was speaking, commenting, or asking tough questions. John and I have talked on the phone and corresponded for years but had never met. What a consummate gentleman and scholar. We felt like we had been old friends for years and committed to finding opportunities in the future to get together and compare notes in person.

John is no stranger to long-time readers of Outside the Box, as he has probably been the source of more OTBs than any other writer. John and I share a common foe that focuses our attention: a weekly deadline that we sometimes battle long into the night. This week John shares with us some of the insights he presented in Sonoma. One quick quote that I bet will spark your interest:

On the earnings front, my concern continues to be that investors don’t seem to recognize that profit margins are more than 70% above their historical norms, nor the extent to which this surplus is the direct result of a historic (and unsustainable) deficit in the sum of government and household savings. As a result, investors seem oblivious to the likelihood of earnings disappointments, not only in coming quarters but in the next several years. We continue to expect this disappointment to amount to a contraction in earnings over the next 4 years at a rate of roughly 12% annually.

Corporate profits are nothing if not mean-reverting. There are several explanations for this phenomenon; but whatever the cause, the current off-the-charts percentage of profits to GDP is highly unlikely to become an enduring feature of the New Normal. Especially not given the recent weakness across the rest of the data spectrum.

John manages the eponymous Hussman Funds, and you can learn more and read his additional work at www.hussmanfunds.com.

I am in the air, on my way to New York City at the moment, where I will enjoy a few dinners and two days of meetings and media before returning to Dallas. Tonight, Barry Ritholtz has called a dinner summit, and I notice that Maine fishing buddies Scott Frew and Jim Bianco are on the guest list. One of the topics, I am sure, will be the unintended consequences of central bank policy. I get what Japan, Europe, and the US want to try to achieve. But what uninvited and unwelcome guests will disrupt their efforts? We are in totally uncharted waters, with no historical precedent of QE on such a massive and global scale. And our political leaders, in Europe and elsewhere, pick this moment to screw around with the trust that depositors place in their banks? Is this really any way to run a railroad, barreling full speed down the track when there has been no slow-motion testing done? No stress tests on the bridges?

Do the politicians and central bankers actually think they can fully model the ramifications of their present actions? And if so, what model are they using? I get worried that they may be using a two- or three-level, variable-input model, when there may actually be a dozen or more major interconnecting nodes. Which is all the more reason to respect Hussman’s nervousness.

But tonight I will enjoy my dinner and friends. We have to take life’s pleasures as they come to us, and I am grateful that I get more than my share of such opportunities. I have to add, though, that looking over the latest analysis of the health insurance costs for my small company and family has certainly soured my stomach. Ouch. Good thing inflation is only 2%, right? If I couldn’t trust that government-derived number, I think healthcare cost increases might worry me.

But let’s all have a great week!

Your can’t afford to get sick analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

Taking Distortion at Face Value

By John P. Hussman, Ph.D.

March U.S. Non-Farm Payrolls +88,000 (payroll survey, median expectation was 175,000)

March U.S. Civilian Employment -206,000 (household survey)

March Canadian Employment -54,500 (worst print in 4 years)

March German Unemployment +13,000 (surprise increase)

Companies issuing negative earnings preannouncements for Q1 2013: 78% (h/t Josh Brown)

One of the striking features of the recent market advance has been the nearly triumphant confidence that there is zero risk of a U.S. economic recession. Back in January, I observed:

The economic data are wrestling between two likely possibilities and a third less likely one. The first of the likely ones remains that the U.S. already entered a recession in the third quarter of 2012. While I expect the full third-quarter GDP figure of 3.1% to remain positive post-revision, it’s not at all clear that fourth-quarter GDP (estimated to come in about 1.5%) will survive those eventual revisions – ditto for the marginal bounce in industrial production. The second likely possibility is that the enthusiasm about QEternity (combined with a positive jolt to personal income from special dividends to front-run the fiscal cliff) represented another successful round of “kick-the-can” to push a weak economy from the verge of recession for another few months. When we look at the broad evidence from a variety of good leading and coincident indicators, that’s actually the possibility that I am starting to lean toward. The unlikely possibility, in my view, is that the economy has started to walk on its own. (see Puppet Show)

With a few months of additional data in hand, the evidence further supports the "kick-the-can" interpretation. Specifically, enthusiasm about QEternity, coupled with a positive jolt to personal income from special dividends, can probably be credited for another successful round of “kick-the-can,” pushing a weak economy from the verge of recession for another few months, but not durably so.

My impression is that we have once again arrived back at that can. While there is no shortage of smug observers who believe that recession risk does not exist and never did, the fact is that the strongest leading indicators, as well as the most timely coincident data, have deteriorated and danced along the border between economic expansion and economic recession for more than two years. Meanwhile, repeated rounds of QE have produced little but short-lived bounces to defer a recession that historically would have followed such deterioration more quickly. The chart below offers a good picture of this process.

Notice the successively lower levels, as each round of quantitative easing has smaller and smaller effects on real economic activity (speculative activity in the financial markets aside). The question at present is whether the recent bounce will prove to be temporary as well. This expectation is certainly consistent with the series of rapid-fire misses from the Chicago Purchasing Managers Index (particularly the new orders component), the national PMI reports for both manufacturing and services, and the unexpected weakness on both payroll and household employment surveys.

For my part, I continue to expect the U.S. economy to join a global recession that is already in progress in much of the developed world (assuming a U.S. recession has not already started, which we can’t rule out, but would require knowledge of eventual data revisions to confirm). Suffice it to say that the realistic case for a sustained economic expansion here remains terribly thin.

While some observers will reflexively point to the housing market as a sign of economic recovery, it is important to recognize that the millions of homeowners with underwater mortgages (home values below the amount of mortgage debt still owed) have no ability to sell their homes even if they wish to do so, unless they can come up with the difference out of pocket. As a result, the natural flow of demand from new household formation must be satisfied from an inventory of homes for sale that is much smaller than the actual “shadow inventory” that would be available if losses did not have to be taken in order to sell those homes. So the demand for homes resulting from household formation is satisfied from limited inventory plus new home building, even though there is an ocean of distressed and unsold homes already in existence. From this perspective, it should be clear that the bounce we’ve seen in housing is not a sign of economic recovery, but is instead a sign of misallocation of capital due to what economists would generally call a “market failure.”

Taking Distortion at Face Value

On the earnings front, my concern continues to be that investors don’t seem to recognize that profit margins are more than 70% above their historical norms, nor the extent to which this surplus is the direct result of a historic (and unsustainable) deficit in the sum of government and household savings (see Two Myths and A Legend for an analysis, including more than a half-century of data on this). As a result, investors seem oblivious to the likelihood of earnings disappointments not only in coming quarters, but in the next several years. We continue to expect this disappointment to amount to a contraction in earnings over the next 4 years at a rate of roughly 12% annually.

Despite the enormous weight of both accounting identity, historical data, and simple arithmetic, we continue to encounter persistent hostility to the idea that profit margins are the mirror image of extraordinary and unsustainable deficits in the government and household sector. The actual relationship was first detailed by the economist Michal Kalecki in the mid-1900’s. James Montier of GMO gives a nice derivation. The full relationship is:

Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends

As I noted over a year ago, dividends exhibit very little volatility over time, and do not exert a material amount of volatility in the above relationship over the course of the economic cycle. It also happens that particularly in U.S. data, the difference between Investment and Foreign Savings (i.e. the inverse of the current account deficit) also fluctuates relatively little, because current account “improvement” is typically associated with deterioration in gross domestic investment, as shown below in data since the 1940's.

As a result, the Kalecki equation reduces, for all practical purposes, to a statement that corporate profits move opposite to the sum of household and government saving. Again, see Two Myths and A Legend. More than a half-century of data that demonstrates the tightness of this relationship.

The upshot is very simple, the U.S. stock market presently reflects two unstable features. One is that extraordinary monetary policy – specifically quantitative easing – has created an ocean of zero-interest money that someone has to hold at each point in time, and that provokes a speculative reach for yield. The other is that extraordinary fiscal policy, coupled with household savings near record lows, have joined to elevate profit margins more than 70% above their historical norm, as the deficit of one sector has to emerge as the surplus of another. The result is that investors quite erroneously accept the distorted “earnings yield” of stocks (and the associated “forward price/earnings multiple” of the S&P 500) at face value, without any adjustment for elevated profit margins or the historical tendency for such elevations to be eliminated over the course of the business cycle.

Put simply, stocks are not cheap, but are instead strenuously overvalued. The speculative reach for yield, encouraged by the Federal Reserve, has created another bubble – which is not recognized as a bubble only because distorted profit margins create the illusion that stocks are reasonably valued. We presently estimate a prospective 10-year nominal total return for the S&P 500 of less than 3.5% annually. The likelihood of even this return being achieved smoothly, without severe intervening volatility and steep market losses, is roughly zero. This does not imply or ensure immediate market losses, but it doesn’t need to. On any horizon of less than about 6-7 years, we expect that any intervening returns achieved by the S&P 500 will be wiped out, and then some. Speculate if you believe that your exit strategy will dominate that of millions of other speculators, despite market conditions that are already overvalued, overbought, overbullish. In my view, all of this will end badly.

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Cyprus Has Finally Killed Myth That EMU Is Benign
This piece from Ambrose Evans-Pritchard is about as hard-hitting an analysis of Cyprus as I have read and really makes an interesting introduction to this week’s Outside the Box. No messing around:

Capital controls have shattered the monetary unity of EMU. A Cypriot euro is no longer a core euro….

The complicity of EU authorities in the original plan to violate insured bank savings – halted only by the revolt of the Cypriot parliament – leaves the suspicion that they will steal anybody’s money if leaders of the creditor states think it is in their immediate interest to do so.

The IMF doesn’t get off easy here, either:

The IMF’s Christine Lagarde has given her blessing to the Troika deal, claiming that the package will restore Cyprus to full health, with public debt below 100pc of GDP by 2020.

Yet the Fund has already been through this charade in Greece, and her own staff discredited the doctrine behind EMU crisis measures. It has shown that the “fiscal multiplier” is three times higher than thought for the Club Med bloc. Austerity beyond the therapeutic dose is self-defeating.

I want to amplify Ambrose’s comments by excerpting from another piece, by my über-liberal friend Yves Smith over at Naked Capitalist (although she might characterize herself as mainstream reasonable). But we share a healthy skepticism of large banks.

As we say in Texas, it ain’t over till the fat lady sings. And that would be Italy, as Ambrose points out. (Which given the original intent of that quote and that Darrel Royal of the University of Texas (way back in the day) was referring to Opera Italiana, it is appropriate – in fact, we said it first!)

I have been spending a few moments here and there the last few days with my new granddaughter, Addison (and her parents). I’m now officially in a hotel room in Dallas for the duration until we can get the new place actually bought and construction done, which at best will be late summer; but I will be traveling a lot anyway the next three months, so it’s just another hotel room. I am using it as an opportunity to learn minimalist living.

But I am having to become acquainted with a new knowledge domain, that of architecture and design. If I was just looking at another fund or investment manager, I would feel pretty comfortable doing it on my own, but I clearly need help here and no shame in admitting it.

Many of you may be in a similar boat when it comes to investing. You can leave it to the professionals entirely, but then you get the results that they design and not maybe what you really want. It works a lot better if you spend some time getting familiar with the rules and communicating your objectives.

Most of you would not think (or your wives would not!) of building a home without a great deal of input. Someone has to learn that language if you want to have something that really works for your situation and budget.

The same is true of investing. It is a knowledge domain that is unfamiliar to many, but it is critical to your future happiness. You really do need to get the basics down. The more you learn the better off you will be. And using professionals is important – unless you are going to spend a whole lot of time learning the rules and the tricks. In fact, it takes more than a minor investment of time and effort just to develop adequate skill to be able to pick the right professionals. Not all investment “designers” are the same level of expertise or appropriate for what you want and need.

I did a lot of construction as a young man and can understand the basics even today. But I was never skilled enough to do finish work or design. We will see if I can learn enough to pick the right team in short order! Thankfully, most of you have more time to choose investment professionals.

Have a great Easter weekend. I see more family coming my way and maybe Mavericks and Stars games in our future.

Your can’t believe what everything costs analyst,

John Mauldin, Editor
Outside the Box

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Cyprus Has Finally Killed Myth That EMU Is Benign

By Ambrose Evans-Pritchard, London Telegraph

The punishment regime imposed on Cyprus is a trick against everybody involved in this squalid saga, against the Cypriot people and the German people, against savers and creditors. All are being deceived.

It is not a bail-out. There is no debt relief for the state of Cyprus. The Diktat will push the island’s debt ratio to 120pc in short order, with a high risk of an economic death spiral, a la Grecque.

Capital controls have shattered the monetary unity of EMU. A Cypriot euro is no longer a core euro. We wait to hear the first stories of shops across Europe refusing to accept euro notes issued by Cyprus, with a G in the serial number.

The curbs are draconian. There will be a forced rollover of debt. Cheques may not be cashed. Basic cross-border trade is severely curtailed. Credit card use abroad will be limited to €5,000 (£4,200) a month. “We wonder how such capital controls could eventually be lifted with no obvious cure of the underlying problem,” said Credit Suisse.

The complicity of EU authorities in the original plan to violate insured bank savings – halted only by the revolt of the Cypriot parliament – leaves the suspicion that they will steal anybody’s money if leaders of the creditor states think it is in their immediate interest to do so. Monetary union has become a danger to property.

One can only smile at the denunciations of Eurogroup chief Jeroen Dijsselbloem for letting slip that the Cypriot package is a template for future EMU rescues, with further haircuts for “uninsured deposit holders”.

That is not the script. Cyprus is supposed to be a special case. Yet the “Dijssel Bomb” merely confirms that the creditor powers – the people who run EMU at the moment – will impose just such a policy on the rest of Club Med if push ever comes to shove. At the same time, the German bloc is lying to its own people about the real costs of holding the euro together. The accord pretends to shield the taxpayers of EMU creditor states from future losses. By seizing €5.8bn from savings accounts, it has reduced the headline figure on the EU-IMF Troika rescue to €10bn.

This is legerdemain. They have simply switched the cost of the new credit line for Cyprus to the European Central Bank. The ECB will have to offset the slow-motion bank run in Cyprus with its Emergency Liquidity Assistance (ELA), and this is likely to be a big chunk of the remaining €68bn in deposits after what has happened over the past two weeks.

Much of this will show up on the balance sheet of the Bundesbank and its peers through the ECB’s Target2 payment nexus. The money will leak out of Cyprus unless the Troika tries to encircle the island with razor wire.

“In saving €5.8bn in bail-out money, the other euro area countries will likely be on the hook for four to five times more in contingent liabilities. But, of course, the former represents real money that gives politicians a headache; the latter is monopoly central bank money,” said Marchel Alexandrovich, from Jefferies.

Chancellor Angela Merkel will do anything before the elections in September to disguise the true cost of the EMU project. It has been clear since August 2012 that she is willing let the ECB carry out bail-outs by stealth, as the lesser of evils. Such action is invisible to the German public. It does not require a vote in the Bundestag. It circumvents democracy.

Mrs Merkel can get away with this, provided Cyprus does not leave EMU and default on the Bundesbank’s Target2 claims, yet that may well happen.

“I wouldn’t be surprised to see a 20pc fall in real GDP,” said Nobel economist Paul Krugman. “Cyprus should leave the euro. Staying in means an incredibly severe depression.”

“Nobody knows what is going to happen. The economy could go into a free fall,” said Dimitris Drakopoulos, from Nomura.

The country has just lost its core industry, a banking system with assets equal to eight times GDP, and has little to replace it with. Cyprus cannot hope to claw its way back to viability with a tourist boom because EMU membership has made it shockingly expensive. Turkey, Croatia or Egypt are all much cheaper. Manufacturing is just 7pc of GDP. The IMF says the labour cost index has risen even faster than in Greece, Spain or Italy since the late 1990s.

What saved Iceland from mass unemployment after its banks blew up – or saved Sweden and Finland in the early 1990s – was a currency devaluation that brought industries back from the dead. Iceland’s krona has fallen low enough to make it worthwhile growing tomatoes for sale in greenhouses near the Arctic Circle.

If Cyprus tries to claw back competitiveness with an “internal devaluation”, it will drive unemployment to Greek levels (27pc) and cause the economy to contract so fast that the debt ratio explodes.

The IMF’s Christine Lagarde has given her blessing to the Troika deal, claiming that the package will restore Cyprus to full health, with public debt below 100pc of GDP by 2020.

Yet the Fund has already been through this charade in Greece, and her own staff discredited the doctrine behind EMU crisis measures. It has shown that the “fiscal multiplier” is three times higher than thought for the Club Med bloc. Austerity beyond the therapeutic dose is self-defeating.

Some in Nicosia cling to the hope that Cyprus can carry on as a financial gateway for Russians and Kazakhs, as if nothing has happened. RBS says the Russians will pull what remains of their money out of Cyprus “as soon as the capital controls are lifted”.

The willingness of the Cypriot authorities last week to seize money from anybody in any bank in Cyprus – even healthy banks – was an act of state madness. We will find out over time whether this epic blunder has destroyed confidence in the country as a financial centre, or whether parts of the financial and legal services sector can rebound.

Yet surely there is no going back to the old model, even though the final package restricts the losses to the two banks that are actually in trouble. Savers above €100,000 at Laiki will lose 80pc of their money, if they get anything back. Those at the Bank of Cyprus will lose 40pc.

Thousands of small firms trying to hang on face seizure of their operating funds. One Cypriot told me that the €400,000 trading account of his father at Laiki had just been frozen, leaving him unable to pay an Egyptian firm for a consignment of shoes.

The Cyprus debacle has taught us yet again that EMU has gone off the rails, is a danger to stability, and should be dismantled before it destroys Europe’s post-War order.

Whether it marks a watershed moment in the crisis is another matter. Italy, Spain, France and Portugal have their own crises, moving to their own rhythm.

The denouement will arrive when the democracies of southern Europe conclude that recovery is a false promise and that the only way to end mass unemployment is to break free of EMU’s contractionary regime.

It will be decided by Italy, not Cyprus.

Will Cyprus Be Contained? (Updated)

By Yves Smith, Naked Capitalist

In March 2007, Fed chairman Ben Bernanke said that he thought the impact of losses on subprime mortgages was likely to be contained. It took five months for events to start proving him wrong.

August 2007 marked the onset of the first acute phase of the global financial crisis, when the asset-backed commercial paper market seized up.

Last week, in a press conference, Bernanke indicated that he thought the likelihood of the crisis in Cyprus having larger ramifications was limited, and avoided using the “c” word. But the message was similar to that of March 2007. So now that Cyprus has agreed to resolve its problem banks on its own, the island nation has secured a short-term sovereign cash fix. As MacroBusiness described it:

The restructure is enough for the IMF to agree to release a 10 billion euro bailout, which will do nothing whatsoever to address Cypriot public debt sustainability or the economy (other than hurt both).

And there also is a rather visible inconsistency between the Eurocrats’ insistence that Cyprus was too small to make any difference and the stock and currency market response to the news of a deal.

So are we likely to see the sort of delay between the assessment and the onset of trouble, as we did in 2007, or is Cyprus a nothingburger, as the Troika and many investors contend? I welcome reader input, but I’d say the odds of knock-on effects are greater than the cheery official assessments would lead you to believe.

As we’ve indicated before, the threat is that bank runs start in other periphery countries, based on a recognition that their bank is at risk plus a concern that they will be made to take losses, as large depositors were in Cyprus. We never thought the odds of a “hot” run, as in people lining up at banks to withdraw money, was all that high, and it’s been reduced even further by the fact that depositors under €100,000 were spared. However, we think the slow-motion departure of depositors from periphery banks is likely to resume….

First, confiscating bank deposits is now on the table in any future crisis. That’s toothpaste that’s not going back in the tube. Commerzbank chief economist Jörg Krämer has already suggested (Google translates) “a one-time property tax levy” for Italy and “a tax rate of 15 percent on financial assets.”

And adding fuel to the fire, the Leader of the UK Independence Party has urged expats in the periphery countries, in particular the 750,000 British in Spain to “Get your money out of there while you’ve still got a chance.”

Second, capital controls in Cyprus mean that there are now two Euros in effect: The Euro that you can use only in Cyprus, and the Euro you can use elsewhere in the so-called “monetary union.” So from the perspective of people in Cyprus, the results are in some ways worst that a breakup: rather than having depreciated dough, you have dough that has been impounded, particularly in terms of using it outside Cyprus.

In each case, why wouldn’t every business owner or wealthy Euro-holder in the periphery go into “First, they came for the Cypriots” mode, take economist Krämer at his word, and move their money to where they had some reason to believe it was safe?

Third, these concerns may be amplified by how rapidly and visibly the Cypriot economy craters. The “rapidly” is due to the fact, as discussed in greater detail in the post from Cyprus.com below, that the Cyprus economy will suffer a one-two punch: the loss of a big chunk of wealth, plus the disappearance of much of the financial services sector, which was 45% of GDP. The author estimates a 20% to 30% fall in output in two years; that could turn out to be conservative, given that the tender ministrations of the Troika will only make a bad situation worse. This is almost certain to be a more rapid and severe decay than in Latvia or Ireland.

But the “visibly” is just as important. The financial media has taken perilous little interest in the human suffering in Greece, Ireland, and Latvia (that should actually be no surprise given who their advertisers are). Oh, you’ll read the stories about how many medications aren’t being imported in Greece, sheets are being re-used in hospitals, suicides have skyrocketed, and trash collection is erratic at best, but these articles are few and far between. The dire conditions and the depopulation of Ireland and Latvia get even less press.

By contrast, the revolt by Cyprus’ parliament and the fraught negotiations have given this bailout negotiation far more profile than its predecessors. There is almost certain to be a fair amount of media coverage of the immediate impact of the bank restructurings and the capital controls. And we are also likely to get the BBC effect, which is ongoing coverage by the English press of conditions in Cyprus due to the number of expats living there (Richard Smith tells me that it was popular among RAF retirees, since their modest pensions and savings would not allow them to buy adequate housing in the pumped-up English market). That will probably produce some echo coverage in other English language press and possibly on the Continent. So the odd favor having ongoing media depictions of Cyprus’ distress, which in turn would increase anxiety levels in periphery countries.
Is The Government Lying To Us About Inflation? Yes!
In today’s Outside the Box, Gary D. Halbert (my old and very dear friend and former business partner of many years) reminds us about a few significant facts concerning the Consumer Price Index (CPI) that mainstream economists and the media tend to ignore. The central question is whether the CPI is really indicative of the actual inflation rate. Not likely, says Gary, since the US Bureau of Labor Statistics (BLS), which compiles the CPI, has engaged in methodological shenanigans over the past couple decades (as has been well documented by John Williams of ShadowStats, among others). The upshot of all their monkeying with the numbers is that the official rate of inflation may be two to four times lower than the actual rate (which is rather convenient if you’re a government bureaucrat trying to hold down interest costs and Social Security payments).

These changes are hotly debated in academic circles. There are many economists who agree with the changes and can show with their models that inflation is low. That is the currently accepted wisdom, or what passes for it. The problem is that inflation only shows up, as one person put it, in the things we actually buy. If your main costs are food, energy, education, and healthcare (ring any bells?), then inflation is a great deal higher than 2%. Other items are actually falling in price. It comes down to the mix of items in the calculations and whether you buy into the concepts of substitution (if beef gets too expensive we buy hamburger rather than steak) and “hedonics,” which says that prices of products drop over time as quality and manufacturing efficiency improve, so the calculation of inflation should take this into account.

Which means you can have official inflation at a low level (or even falling for certain items), while the amount you actually spend out of your very real pocket is rising! And thus the debate.

Having refreshed us on the basic techniques of CPI massage, Gary turns to food and energy, which the BLS includes in “headline CPI” but omits from “core CPI.” He points out that while headline CPI jumped an unexpected 0.7% in February, core CPI rose only 0.2%. That is, food and energy price increases accounted for more than 70% of the rise. “Not good for the economy,” he notes.

And of course, this is all bad news for unwary investors, since

Those who believe that inflation is only 2%, when it may be 5-8%, may be making investment decisions that are almost guaranteed to erode the purchasing power of their money over time. This is especially true with low-yielding investments such as CDs, Treasuries, etc.

Gary wraps up by taking a look at “chained CPI,” which he explains as follows:

hained CPI assumes that when prices rise, consumers will resort to entirely different products, rather than just seeking a cheaper brand. For example, if beef prices rise, chained CPI would assume that consumers might opt for chicken to save money.

The chained CPI debate is raging as we speak: I got an email from the AARP this morning, urging me to tell my Senators to say no to chained CPI being used to calculate Social Security cost-of-living adjustments (COLA) – sounds like they may vote today (Friday) on a bill to do just that. But as Gary points out, we either calculate benefits using chained CPI – which, yes, is tough on those living on a fixed income – or we eliminate the cap on salary subject to Social Security taxation (that is, we raise taxes). As Gary says, “Either way, somebody’s got to pay, and it might end up being a little [of] both.”

Finally, a quick note: I am doing a webinar on Tuesday for Mauldin Circle members. The current state of the equity markets brings back memories of 2007. As the market continues to reach new highs, stock selection on both the long and short sides requires considerable expertise. That is why I decided that now is a good time to introduce you to one of the leading long-and-short investment managers, Jacob Gottlieb, CIO of Visium Asset Management. During our conversation on Tuesday, March 26 at 12:00 p.m. EDT (9:00 a.m. PDT), we will find out what’s on Jacob’s mind – his investment themes and where’s he seeing equity opportunities on both the long and short sides.

If you are not aware of Visium, they are a premier long/short multi-strategy manager with over $3.7 billion in assets. It’s a firm I have been watching for some time. Bloomberg cited Visium as one of “The 100 Top Performing Large Hedge Funds.” Take a look at this recent write-up on Visium: “The Quiet Ambition of Jacob Gottlieb.”

You will need to register for this exclusive webinar through The Mauldin Circle. If you are a Mauldin Circle member and a qualified purchaser or an investment advisor, a webinar invitation has been sent directly to you by email. A replay will also be available to qualified registrants. If you are unable to listen in to the live discussion, be sure to register so you can receive the replay information. If you are not a member of The Mauldin Circle and are a qualified purchaser, please join today. Upon qualification by my partners at Altegris, you will receive an email invitation . I apologize for limiting this discussion to qualified purchasers and investment advisors, but we must follow the rules and regulations. I look forward to having you at this exclusive Mauldin Circle event. (In this regard, I am president and a registered representative of Millenium Wave Securities, LLC, member FINRA.)

Have a great week. I know mine will be eventful – daughter Amanda is due to give birth to granddaughter Addison on Monday!

Your thinking about the world Addison will discover analyst,

John Mauldin, Editor
Outside the Box

subscribers@mauldineconomics.com

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Is The Government Lying To Us About Inflation? Yes!

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
March 19, 2013

Consumer Price Index Jumped in February

On Friday, the Labor Department reported that the Consumer Price Index (CPI) jumped an unexpected 0.7% in February. This was above pre-report estimates and was the highest monthly reading since 2009. We should be very concerned, right? Let’s take a closer look.

Upon further examination, we find that if we subtract food and energy from the CPI, the cost index rose only 0.2% last month. It turns out that most of the big increase in the CPI last month was due to the sharp rise in gasoline prices. The experts tell us that due to the volatile nature of oil and gasoline prices, we shouldn’t include energy in the CPI. Ditto for food prices which can also be quite volatile.

I have always argued to the contrary, that food and energy prices do indeed need to be considered in the CPI. Think pocketbook: if gas prices rise $1.00 per gallon, and you have to fill up once a week, and it takes 20 gallons to fill up your car, then you have $20 less to spend on something else that week, or $80 less per month. Not good for the economy.

Some others disagree with me, arguing that you spend the same amount each month, and that if you spend more on gas, then you spend less on other things, but the overall economy gets the same amount of money from you one way or the other. Both points are valid.

But if you are trying to measure the true inflation rate, I maintain that food and energy should be included. Apparently the government agrees with me since they continue to report the headline Index including food and energy, and secondarily report what the Index was without food and energy.

The real question is whether or not the Consumer Price Index is really indicative of the actual inflation rate. I will argue that it is not a very good indicator with, or without, food and energy. At the very least, the CPI is controversial.

Why the CPI is So Controversial

The Consumer Price Index (CPI) is produced by the US Department of Labor’s Bureau of Labor Statistics (BLS). It is the most widely watched and used measure of the US inflation rate. For years, there has been controversy about whether the CPI overstates or understates inflation, how it is measured and whether it is an appropriate proxy for inflation.

Originally, the CPI was determined by comparing price changes in a fixed basket of goods and services. Determined as such, the CPI was a cost of goods index (COGI). Over time, however, the US Congress embraced the view that the CPI should reflect changes in the cost to maintain a constant standard of living. Consequently, the CPI has been moving toward a cost of living index (COLI).

Over the years, the methodology used to calculate the CPI has also undergone numerous revisions. According to the BLS, the changes removed “biases” that caused the CPI to overstate the inflation rate. The new methodology takes into account changes in the quality of goods and “substitution.” Substitution is the change in purchases by consumers in response to price changes, and this alters the relative weighting of the goods in the basket. The overall result tends to be a lower CPI.

Critics view the methodological changes and the switch from a COGI to a COLI focus as a purposeful manipulation that allows the government to report a lower CPI. Most critics prefer that the CPI be calculated using the original methodology based on a basket of goods with fixed quantities and qualities. Doing so can result in a significantly higher inflation reading.

On Friday, the BLS reported that the CPI rose only 2.0% over the last 12 months. Economists using different methodologies (including the original methodologies) estimate that the real US inflation rate over that same period was anywhere between 5% and 8%. That’s a huge difference!

If Inflation is 2%, Why Are Prices Up So Much?

I read a good article last week from TIME Business & Money columnist Michael Sivy. He pointed out that his printer ran out of ink recently, and he was “shocked” to find that the same printer cartridge had gone up in price by 25% in less than a year.

While the government’s CPI has averaged only 2% since the end of the Great Recession in early 2009, many basic commodities have soared since then. Gold was $930 an ounce when the recession ended, and today it’s just over $1,600. That’s an increase of 70% in four years, or an annualized rate of over 14%.

Of course, that’s just one commodity. How about a broader measure? The Reuters CRB Commodity Index, which tracks the prices of energy, coffee, cocoa, copper, cotton, etc. is up 38% over four years, or 8.6% at a compound annual rate.

The price of gasoline has gone up from $2.60 a gallon when the recession ended to around $3.70 today nationally. That’s a 41% increase in four years, or an annualized rate of 9%. Taxes have gone up almost as much. Federal, state and local income taxes have risen 35% over four years, an annualized rate of 7.8%.

Then there’s the so-called “Big Mac Index” that was popularized by The Economist some years ago. McDonald’s hamburgers are available in many countries and their prices reflect the cost of food, fuel and basic labor. The price of a Big Mac, therefore, can be yet another indicator of inflation in a particular country. Since the recession ended, the cost of a Big Mac in the US has risen from an average of $3.57 to $4.37, or 5.2% a year.

As the main grocery shopper (and cook) in our family, I am reminded several times a week how food prices continue to go higher. Take a look at this chart from the St Louis Fed.

And while we’re on the subject of food, have you noticed how many manufacturers reduce the size of the containers and/or packages so as to reduce the enclosed amount – but still charge the same price as before? I know I’m not the only one!

Severe Drought Led to Higher Food Prices

Forecasters lay much of the blame for higher food prices on the drought that swept through much of the US last year, and is continuing this year. Last year’s severe weather put nearly 80% of the continental United States in drought conditions – the worst in 50 years. Particularly hard hit areas include the Midwest states of Illinois, Iowa, Minnesota, Nebraska, Kansas, as well as Oklahoma, Texas, Arkansas and many parts of Colorado and California.

The drought damaged key crops like corn, wheat and soybeans while driving up commodity prices and forcing farmers to scramble to find feed for livestock. Farmers and ranchers have had to cut back on the number of livestock and poultry in order to limit their own costs, which created a shortage of beef, chicken and pork.

Although conditions have improved in some areas, roughly 61% of the country still suffers from drought, which is remains at its worst levels in more than a decade, according to the US Drought Monitor.

On a personal note, we are fortunate to live on beautiful Lake Travis, just outside Austin. Lake Travis is a Corps of Engineers man-made lake, and it supplies water for hundreds of thousands of area residents and countless businesses in Central Texas. As such, the lake level varies significantly, depending on the amount of rainfall we receive each year.

The drought in Central Texas is in its third year. Lake Travis, which is 65 miles long and over 200 feet deep in places, is now only 40% full (or 60% empty). As the water level falls, we have to push our dock out further and further to keep it in the water. A trip down to the dock is over 125 steps (one way)!

So How Is the CPI at Only 2%? It’s Not.

As we’ve seen above, the prices of many things that consumers buy on a regular basis have risen much faster than the CPI. So how can the CPI be at only 2%? And how could it have averaged just 2% since the end of the Great Recession four years ago?

Some argue that it’s because wages are down, and with the economy so weak, workers can’t demand higher pay to make up for their increased cost of living. Indeed, that’s one of the factors causing the decline in real after-tax household income.

Real median annual household income in January of this year was $51,584 – or 92.7% of the level in January 2000. Incomes inched up early in 2012 but have been treading water since May, according to the Household Income Index. While household income ticked up slightly in the past year, it remains well below the $54,008 level seen at the start of the recovery roughly four years ago.

These are all factors influencing the economic recovery (or lack thereof) and thus the inflation rate. But they don’t explain why the headline Consumer Price Index has hovered around 2% for the last four years, or why other inflation measurements are in the 5%-8% range. How can this be?

Quite simply because it’s a government report that’s been frequently manipulated over the last 35 years. Whether by design (my bet) or coincidence, these revisions have served to reduce the official inflation rate.

Also, keep in mind that our government has a record $16.7 trillion in debt it is paying interest on. If interest rates rise, it costs Uncle Sam more money. If inflation rises, interest rates follow. Obviously, the government has incentives to manipulate the official inflation rate lower than it really is.

The bottom line is that there is no absolute and objective gauge of inflation. Any particular measure is simply one way of making the calculation, based on a host of assumptions. We do know with certainty that a number of the costs that American households face are going up considerably faster than the CPI.

Finally, the fact that real world inflation is higher than the CPI poses challenges for investors. Investors should calculate their total required return net of the effect of inflation. As the inflation rate increases, higher returns must be earned in order to obtain a desired real rate of return.

Those who believe that inflation is only 2%, when it may be 5-8%, may be making investment decisions that are almost guaranteed to erode the purchasing power of their money over time. This is especially true with low-yielding investments such as CDs, Treasuries, etc.

Obama’s Olive Branch – “Chained CPI”?

Before we leave the subject of CPI, I think it’s important to discuss something going on right now in the budget negotiations in Washington. Over the shrill opposition of liberal Democrats, Obama has verbally offered to change the way cost of living increases are calculated for Social Security and other entitlements. Instead of the CPI now used, he said he might consider using something called the “chained CPI.”

In a nutshell, chained CPI is a measure of inflation that seeks to account for substitution by consumers when prices rise. While the current CPI measure uses substitution to a small extent, chained CPI assumes that when prices rise, consumers will resort to entirely different products, rather than just seeking a cheaper brand. For example, if beef prices rise, chained CPI would assume that consumers might opt for chicken to save money.

The end result is that chained CPI is generally lower than the current CPI used for measuring inflation. As I noted above, the

CPI for the past 12 months was measured at 2.0%. The chained CPI for the same period was 1.8%.

If we switch to chained CPI for entitlement cost of living increases, which remains to be seen, it would mean that benefits would rise at a slower rate. Alan Greenspan recommended moving to chained CPI for Social Security back in his day at the Fed, but it went nowhere.

Liberal Democrats oppose the switch to chained CPI and demagogue it as a “war on seniors,” while Republicans feel it’s a way to save Social Security as we know it. Democrats prefer eliminating the cap on salary subject to Social Security taxation (read: increase taxes) to using chained CPI, which they view as a cut in benefits. It seems that only in a politician’s mind can a slower rate of increasing benefits be called a “cut.”

It’s still too early to tell how the current chained CPI debate will play out. This is one of those issues that hits both old and young. If chained CPI is used, then entitlement benefit increases will be lower. If it is not, then future Social Security taxes may well have to be higher. Either way, somebody’s got to pay, and it might end up being a little from both.

Hoping you stay ahead of inflation,

Gary D. Halbert
Would the Real Peter and Paul Please Stand Up?
As I sit here in Cafayate, surrounded by sumptuous beauty and enjoying a slower pace, I find myself reflecting on the magnitude of the human economic endeavor and our search for a path to sustainable investing in a world where central bankers seem hell-bent on changing the very nature of the medium of exchange. All in the name of helping us, to be sure, with the most positive of intentions; but if you are a retired person living on your lifetime of accumulated savings, you might be wishing for a little less of what they call help and a little boost to interest rates, to help you afford a safe and pleasant retirement.

In this contemplative mode, I received a brief essay from one of my favorite thinkers, Dylan Grice, who has left the labyrinthine halls of Societe Generale to work with Edelweiss Holdings. This is a move I applaud, as I expect it will enrich us all by making his writings more accessible. He is a thinker of the very highest order and someone I go out of my way to spend time with. I am being somewhat presumptive in sending to you a portion of his inaugural appearance in Edelweiss Journal, but I don’t think he will mind. (I am under a deadline, and he is appropriately focused elsewhere at the moment.)

Let me preview his work with this one paragraph, where he talks about that most precious of commodities, trust, and its relationship to central banks:

Of the many elemental flaws in macroeconomic practice is the true observation that the economic variables in which we might be most interested happen to be those which lend themselves least to measurement. Th us, the statistics which we take for granted and band around freely with each other measuring such ostensibly simple concepts as inflation, wealth, capital and debt, in fact involve all sorts of hidden assumptions, short-cuts and qualifications. So many, indeed, as to render reliance on them without respect for their limitations a very dangerous thing to do. As an example, consider the damage caused by banks to themselves and others by mistaking price volatility (measurable) with risk (unmeasurable). Yet faith in false precision seems to us to be one of the many imperfections our species is cursed with.

For those who are interested, his website is http://www.edelweissjournal.com/.

I have been seriously off the grid for a few days, up in the Andes at Bill Bonner’s hacienda, which is in as remote a place as I have ever visited. Using the term road in conjunction with getting there does not quite convey the reality. Animal paths, dry riverbeds (where we got stuck in the sand), rock-strewn trails, overhangs, gorges, and river crossings (where we once again had to be towed when we did not make it all the way across), flat tires, wrong turns on unmarked tracks leading to canyons of immense beauty but not exactly on our map. During the rainy season his place is completely inaccessible; but oh dear gods, when we arrived it was to a beauty and serenity seemingly out of place and time.

Then it was all about wood stoves, cold showers, and power for just a few hours a day, but also much laughter and thought-fueled conversation with Bill, Doug Casey, David Galland, and a few others. It is a working cattle ranch (Doug Casey calls them sand-fed beef, but there did seem to be pastures here and there), with high-altitude vineyards producing wines that Parker has rated at 93. I rode a horse and managed to not fall off, although there were a few moments when I wasn’t sure who was more scared, me or the horse.

Bill lives there a few months a year, and until I got there I did not understand the attraction. If he allows me, I will return next year, but with a more appropriate vehicle for the “roads.”

As I sat beneath the most star-filled sky I have ever gazed upon (and I have taken in a few remote and lightless vistas), I took time to reflect on what a remarkable life I have been blessed to lead these last few years. Never in my dreams did I foresee this path. It is not just the places I go, it’s the people I meet everywhere, who invest in my own limited understanding and meager insights. What a fascinating world and time in which we find ourselves. I wake up every day hoping to continue the journey a little longer, thinking about our collective economic path and writing to you of what I learn.

Now, let’s enjoy thinking with Dylan. (And I am off to the gym and then back to my book writing!) If you have not registered to come to my Strategic Investment Conference, May 1-3, you need to do so now. I hope we will create a time and place where you can gather your own insights and have some learning moments. This will be the best conference we have ever done.

Your thinking about the future of work analyst,

John Mauldin, Editor
Outside the Box

subscribers@mauldineconomics.com

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Would the Real Peter and Paul Please Stand Up?

By Dylan Grice

In a previous life as a London-based ‘global strategist’ (I was never sure what that was) I was known as someone who was worried by QE and more generally, about the willingness of our central bankers to play games with something which I didn’t think they fully understand: money. This may be a strange, even presumptuous thing to say. Surely of all people, one thing central bankers understand is money?

They certainly should understand money. They print it, lend it, borrow it, conjure it. They control the price of it... But so what? What should be true is not necessarily what is true, and in the topsy-turvy world of finance and economics, it rarely is. So file the following under “strange but true”: our best and brightest economists have very little understanding of economics. Take the current malaise as prima facie evidence.

Let me illustrate. Of the many elemental flaws in macroeconomic practice is the true observation that the economic variables in which we might be most interested happen to be those which lend themselves least to measurement. Thus, the statistics which we take for granted and band around freely with each other measuring such ostensibly simple concepts as inflation, wealth, capital and debt, in fact involve all sorts of hidden assumptions, short-cuts and qualifications. So many, indeed, as to render reliance on them without respect for their limitations a very dangerous thing to do. As an example, consider the damage caused by banks to themselves and others by mistaking price volatility (measurable) with risk (unmeasurable). Yet faith in false precision seems to us to be one of the many imperfections our species is cursed with.

One such ‘unmeasurable’ increasingly occupying us here at Edelweiss is that upon which all economic activity is based: trust. Trust between individuals, between strangers, between organizations... trust in what people read, and even people’s trust in themselves. Let’s spend a few moments elaborating on this.

First, we must understand the profound importance of exchange. To do this, simply look around you. You might see a computer monitor, a coffee mug, a telephone, a radio, an iPad, a magazine, whatever it is. Now ask yourself how much of that stuff you’d be able to make for yourself. The answer is almost certainly none. So where did it all come from? Strangers, basically. You don’t know them and they don’t know you. In fact virtually none of us know each other. Nevertheless, strangers somehow pooled their skills, their experience and their expertise so as to conceive, design, manufacture and distribute whatever you are looking at right now so that it could be right there right now. And what makes it possible for you to have it? Exchange. To be able to consume the skills of these strangers, you must sell yours. Everyone enters into the same bargain on some level and in fact, the whole economy is nothing more than an anonymous labor exchange. Beholding t he rich tapestry this exchange weaves and its bounty of accumulated capital, prosperity and civilization is a marvelous thing.

But we must also understand that exchange is only possible to the extent that people trust each other: when eating in a restaurant we trust the chef not to put things in our food; when hiring a builder we trust him to build a wall which won’t fall down; when we book a flight we entrust our lives and the lives of our families to complete strangers. Trust is social bonding and societies without it are stalked by social unrest, upheaval or even war. Distrust is a brake on prosperity, because distrust is a brake on exchange.

But now let’s get back to thinking about money, and let’s note also that distrust isn’t the only possible brake on exchange. Money is required for exchange too. Without money we’d be restricted to barter one way or another. So money and trust are intimately connected. Indeed, the English word credit derives from the Latin word credere, which means to trust. Since money facilitates exchange, it facilitates trust and cooperation. So when central banks play the games with money of which they are so fond, we wonder if they realize that they are also playing games with social bonding. Do they realize that by devaluing money they are devaluing society?

To see the how, first understand how monetary policy works. Think about what happens in the very simple example of a central bank’s expanding the monetary base by printing money to buy government bonds.

That by this transaction the government has raised revenue for the government is obvious. The government now has a greater command over the nation’s resources. But it is equally obvious that no one can raise revenue without someone else bearing the cost. To deny it would imply revenues could be raised for free, which would imply that wealth could be created by printing more money. True, some economists, it seems, would have the world believe there to be some validity to such thinking. But for those of us more concerned with correct logical practice, it begs a serious question. Who pays? We know that this monetary policy has redistributed money into the government’s coffers. But from whom has the redistribution been?

The simple answer is that we don’t and can’t know, at least not on an amount per person basis. This is unfortunate and unsatisfactory, but it also happens to be true. Had the extra money come from taxation, everyone would at least know where the burden had fallen and who had decreed it to fall there. True, the upper-rate tax payers might not like having a portion of their wealth redirected towards poorer members of society and they might not agree with it. Some might even feel robbed. But at least they know who the robber is.

When the government raises revenue by selling bonds to the central bank, which has financed its purchases with printed money, no one knows who ultimately pays. In the abstract, we know that current holders of money pay since their cash holdings have been diluted. But the effects are more subtle. To see just how subtle, consider Cantillon’s 18th century analysis of the effects of a sudden increase in gold production:

If the increase of actual money comes from mines of gold or silver... the owner of these mines, the adventurers, the smelters, refiners, and all the other workers will increase their expenditures in proportion to their gains. ... All this increase of expenditures in meat, wine, wool, etc. diminishes of necessity the share of the other inhabitants of the state who do not participate at first in the wealth of the mines in question. The altercations of the market, or the demand for meat, wine, wool, etc. being more intense than usual, will not fail to raise their prices. ... Those then who will suffer from this dearness... will be first of all the landowners, during the term of their leases, then their domestic servants and all the workmen or fixed wage-earners ... All these must diminish their expenditure in proportion to the new consumption.

In Cantillon’s example, the gold mine owners, mine employees, manufacturers of the stuff miners buy and the merchants who trade in it all benefit handsomely. They are closest to the new money and they get to see their real purchasing powers rise.

But as they go out and spend, they bid up the prices of the stuff they purchase to a level which is higher than it would otherwise have been, making that stuff more expensive. For anyone not connected to the mining business (and especially those on fixed incomes: “the landowners, during the term of their leases”), real incomes haven’t risen to keep up with the higher prices. So the increase in the gold supply redistributes money towards those closest to the new money, and away from those furthest away.

Another way to think about this might be to think about Milton Friedman’s idea of dropping new money from a helicopter. He used this example to demonstrate how easy it would theoretically be for a government to create inflation. What he didn’t say was that such a drop would redistribute income in the same way more gold from Cantillon’s mines did, towards those standing underneath the helicopter and away from everyone else.

So now we know we have a slightly better understanding of who pays: whoever is furthest away from the newly created money. And we have a better understanding of how they pay: through a reduction in their own spending power. The problem is that while they will be acutely aware of the reduction in their own spending power, they will be less aware of why their spending power has declined. So if they find groceries becoming more expensive they blame the retailers for raising prices; if they find petrol unaffordable, they blame the oil companies; if they find rents too expensive they blame landlords, and so on. So now we see the mechanism by which debasing money debases trust. The unaware victims of this accidental redistribution don’t know who the enemy is, so they create an enemy.

Keynes was well aware of this insidious dynamic and articulated it beautifully in a 1919 essay:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.... Those to whom the system brings windfalls... become “profiteers” who are the object of the hatred.... the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

Deliberately impoverishing one group in society is a bad thing to do. But impoverishing a group in such an opaque, clandestine and underhanded way is worse. It is not only unjust but dangerous and potentially destructive. A clear and transparent fiscal policy which openly redistributes from the rich to the poor can at least be argued on some level to be consistent with ‘social justice.’ Governments can at least claim to be playing Robin Hood. There is no such defense for a monetary driven redistribution towards recipients of the new money and away from everyone else because if the well-off are closest to the money, well, it will have the perverse effect of benefitting them at the expense of the poor.

Take the past few decades. Prior to the 2008 crash, central banks set interest rates according to what their crystal ball told them the future would be like. They were supposed to raise them when they thought the economy was growing too fast and cut them when they thought it was growing too slow. They were supposed to be clever enough to banish the boom-bust cycle, and this was a nice idea. The problem was that it didn’t work. One reason was because central bankers weren’t as clever as they thought. Another was because they had a bias to lower rates during the bad times but not raise them adequately during the good times. On average therefore, credit tended to be too cheap and so the demand for debt was artificially high. Since that new debt was used to buy assets, the prices of assets rose in a series of asset bubbles around the world. And this unprecedented, secular and largely global credit inflation created an illusion of prosperity which was fun for most people while it lasted.

But beneath the surface, the redistributive mechanism upon which monetary policy relies was at work. Like Cantillon’s gold miners, those closest to the new credit (financial institutions and anyone working in finance industry) were the prime beneficiaries. In 2012 the top 50 names on the Forbes list of richest Americans included the fortunes of eleven investors, financiers or hedge fund managers. In 1982 the list had none.

Besides this redistribution of wealth towards the financial sector was a redistribution to those who were already asset-rich. Asset prices were inflated by cheap credit and the assets themselves could be used as collateral for it. The following chart suggests the size of this transfer from poor to rich might have been quite meaningful, with the top 1% of earners taking the biggest a share of the pie since the last great credit inflation, that of the 1920s.

Who paid? Those with no access to credit, those with no assets, or those who bought assets late in the asset inflations and which now nurse the problem balance sheets. They all paid. Worse still, future generations were victims too, since one way or another they’re on the hook for it. So with their crackpot monetary ideas, central banks have been robbing Peter to pay Paul without knowing which one was which. And a problem here is this thing behavioral psychologists call self-attribution bias. It describes how when good things happen to people they think it’s because of something they did, but when bad things happen to them they think it’s because of something someone else did. So although Peter doesn’t know why he’s suddenly poor, he knows it must be someone else’s fault. He also sees that Paul seems to be doing OK. So being human, he makes the obvious connection: it’s all Paul and people like Paul’s fault.

But Paul has a different way of looking at it. Also being human, he assumes he’s doing OK because he’s doing something right. He doesn’t know what the problem is other than Peter’s bad attitude. Needless to say, he resents Peter for his bad attitude. So now Peter and Paul don’t trust each other. And this what happens when you play games with society’s bonding.

When we look around we can’t help feeling something similar is happening. The ïï% blame the 1%; the 1% blame the 47%. In the aftermath of the Eurozone’s own credit bubbles, the Germans blame the Greeks. The Greeks round on the foreigners. The Catalans blame the Castilians. And as 25% of the Italian electorate vote for a professional comedian whose party slogan “vaffa” means roughly “f**k off” (to everything it seems, including the common currency), the Germans are repatriating their gold from New York and Paris. Meanwhile in China, that centrally planned mother of all credit inflations, popular anger is being directed at Japan, and this is before its own credit bubble chapter has fully played out. (The rising risk of war is something we are increasingly worried about...) Of course, everyone blames the bankers (“those to whom the system brings windfalls... become ‘profiteers’ who are the object o f the hatred”).

But what does it mean for the owner of capital? If our thinking is correct, the solution would be less monetary experimentation. Yet we are likely to see more. Bernanke has monetized about a half of the federally guaranteed debt issued since 2009 (see chart below). The incoming Bank of England governor thinks the UK’s problem hasn’t been too much monetary experimentation but too little, and likes the idea of actively targeting nominal GDP. The PM in Tokyo thinks his country’s every ill is a lack of inflation, and his new guy at the Bank of Japan is revving up its printing presses to buy government bonds, corporate bonds and ETFs. China’s shadow banking credit bubble meanwhile continues to inflate…

For all we know there might be another round of illusory prosperity before our worst fears are realized. With any luck, our worst fears never will be. But if the overdose of monetary medicine made us ill, we don’t understand how more of the same medicine will make us better.

We do know that the financial market analogue to trust is yield. The less trustful lenders are of borrowers, the higher the yield they demand to compensate. But interest rates, or what’s left of them, are at historic lows. In other words, there is a glaring disconnect between the distrust central banks are fostering in the real world and the unprecedented trust lenders are signaling to borrowers in the financial world.

Of course, there is no such thing as “risk-free” in the real world. Holders of UK cash have seen a cumulative real loss of around 10% since the crash of 2008. Holders of US cash haven’t done much better. If we were to hope to find safety by lending to what many consider to be an excellent credit, Microsoft, by buying its bonds, we’d have to lend to them until 2021 to earn a gross return roughly the same as the current rate of US inflation. But then we’d have to pay taxes on the coupons. And we’d have to worry about whether or not the rate of inflation was going to rise meaningfully from here, because the 2021 maturity date is eight years away and eight years is a long time. And then we’d have to worry about where our bonds were held, and whether or not they were being lent out by our custodian. And of course, this would all be before we’d worried about whether Microsoft’s business was likely to remain safe over an eight year horizon.

We are happy to watch others play that game. There are some outstanding businesses and individuals with whom we are happy to invest. In an ideal world we would have neither Peters nor Pauls. In the imperfect one in which we live, we have to settle for trying hard to avoid the Pauls, who we fear mistake entrepreneurial competence for proximity to the money well. But when we find the real thing, the timeless ingenuity of the honest entrepreneurs, the modest craftsmen and craftswomen who humbly seek to improve the lot of their customers through their own enterprise, we find inspiration too, for as investors we try to model our own practice on theirs. It is no secret that our quest is to find scarcity. But the scarce substance we prize above all else is trustworthiness. Aware that we worry too much in a world growing more wary and distrustful, it is here we place an increasing premium, here that we seek refuge from financial folly and here that we expect the next bull market.

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