The Macroeconomic Picture is Ugly (excerpt from an October 2008 newsletter)

AND A STOCK MARKET

You can unglazed your eyes now and refocus on the casino – that is to say the stock market. The truth is that few investors really want to spend the time rooting around in the financial statements of publically traded companies with a view toward discovering an undervalued business worth buying. It takes time and patience and more time. We ourselves have found it a profitable way of spending our time and we’re always fascinated by the inner workings of a business and the question of its true worth. But investing is boring compared to speculating – which over the last 20 years has more or less become the nation’s national pastime in our eyes.

Which brings us full circle in this, our first edition, to the derivatives bomb that has gone off in our faces and the resulting mess in which we currently find ourselves. We’ll give you a quick recap, since most of this is now fairly well known. We hope to save some space to sketch out a roadmap for the market in the coming years as well as for the economy that underlies it.
The root cause of our current pickle is easy money. The Federal Reserve dropped rates in response to the 1987 stock market crash and has been a one trick pony ever since (or at least until very recently). The consumer led recession of 1990-91? No problem, cut rates. Mexican Peso and Asian currency crises of 1994-95? No problem, cut rates. Long Term Capital Management implosion and Russian debt crisis of 1998? No problem, cut rates. Technology stock bubble implodes? No problem, cut rates and leave them at a historically low level for a very long time, ensuring that negative real rates will spike the velocity of money and force a veritable tsunami of liquidity into … housing markets around the world! Credit markets freeze as a mountain of bad mortgages and mortgage derived financial products lose their value once house prices start following? No problem, cut rates AND PROSTITUTE THE FEDERAL RESERVES BALANCE SHEET TO THE POINT THAT HYPERINFLATION IS A VERY REAL POSSIBILITY!

Ahem, we hope we now have your undivided attention because we’d like to throw out some thoughts on what the next 10 years or so holds for stocks, bonds, commodities, and our economy. The Federal Reserve appears to have reached the limits of what a one-trick pony can accomplish and so, under Ben Bernanke’s watch, the Fed has transformed itself into a multi-trick pony, all with the aim of preventing the mountain of debt that underpins our economy from crushing our major financial companies and, in a chain reaction, the companies and consumers that depend on them for credit.

In the process, the Federal Reserves balance sheet has ballooned from around $850 billion to some $1.7 trillion in just a matter of weeks, and is likely to reach $3 trillion by year-end. We will devote the rest of this edition to explaining just why that mammoth increase in the Federal Reserves balance sheet is likely to lead to inflation on a scale not seen since the 1970s (don’t worry, we’ll save a little space for telling you what’s likely to happen in the stock market in the next few months as well).

Ready? Okay, here it is…. inflation results when too much money chases too few goods and services. Double the amount of money in circulation but hold the amount of goods and services produced constant and inflation will result. The Federal Reserve has gone one better by doubling its balance sheet on the way to tripling it from what we’re hearing. What’s more, the dollars they are pushing into the system are now backed increasingly by collateral of dubious quality, to say the least. Boat loans, subprime credit card loans, and fancy triple A rated (and worthless) CDOs now represent a goodly portion of the assets backing the greenback. Not convinced that inflation is coming? How about the Federal Reserve buying debt directly from the Treasury? Here’s how that will work if Bernanke, as is currently rumored, elects to monetize the debt. The U.S. Treasury needs to raise the dough to buy up bad assets and make equity injections into insolvent banks, insurance companies and various other corporate miscreants. No one wants the debt because they already have too much of it so the Federal Reserve simple prints up a few hundred billion more of the good old greenback and uses the newly minted cash to buy the debt from the Treasury, which turns around and hands it over to the Titans of commerce in order to salvage our financial system. Sweet deal for sure, except for the fact that no one, and I mean no one will want to hold the dollar anymore if history is any guide. And all of that new paper will push prices higher and higher and higher. We hope the Federal Reserve doesn’t do it, but then we hoped they wouldn’t give J.P. Morgan $29 billion for a bunch of Bear Stearns assets that are almost certainly worth far less because, as taxpayers, we didn’t really want to take a loss on the overvalued paper…

As for the stock market? Our forecast for almost a year now has been for a substantial low in place sometime this fall with a retest sometime next spring. We see no reason to change it at this point. In fact, here’s what I wrote a buddy just a couple of days ago

Scott,

My forecast since last winter was for a significant low in the fall, a rally into winter and a retest by next spring. My fundamental reasons were that by this fall the horrifying extent of the credit market excesses would finally be laid bare for the masses to see, resulting in a selling climax sufficient to set a bottom that would hold for a few months. My retest was based on the thought that earnings estimates for the back half of 2008 and 2009 were way too high and the institutional weenies would start selling the misses and downward revisions by the winter pressuring the market into the spring. I also felt and still feel that the recession we're in (since about last fall) would be longer than normal, lasting up to a year and a half to two years - call it over by next fall/winter (fall of 2009/winter of 2010) at the latest. Figuring the market tends to lead us out by about six months also pointed to a springtime low/retest.

For the first time in 16 months, I’m excited about doing a little buying of some of the increasingly cheap stocks out there, recognizing that we were probably six to nine months early (but I don't want to get too cute with the spring of 2009 retest thing).

(The entire article can be accessed at http://theknowledgeableinvestor.blogspot.com)

Regards,

Chris