Tuesday, May 15, 2007

Financial and Economic Cycles: A Short Story


A lighthearted note today... speculating on a hypothetical situation in a hypothetical world... where asset prices are going up-up and the perceived risks are going down down since its beginning. Let's call this hypothetical world: Omicron Ceti III (OC for short--star trek nerds will appreciate this), where a certain two groups of people interact in an imaginary economy, and establish economic exchange involving money. There were two clans in this world: The Klings and the Fergies.

The Klings were a nomadic hunter-warrior tribe before coming to OC. Honorable, proud, and sticklers for tradition, they are a hardworking people who have left their birthplace due to climatic changes and other acts of nature which forced them to find new sources of subsistence. The Klings were a very numerous people as women bore many children and men were prolific fathers. This eventually put strains on the environment when all their game were extinct. They had to move somewhere as many people were starving and had no food to eat.

The Fergies were in early stages of establishing agricultural surplus and an elementary economy before their coming to the OC. They have pride in their abilities to think beyond what's given in nature, and were superior to the Klings in education, intellect, and organization. They were also very resource minded and frugal, mainly because they were greedy. They established a very sophisticated system of social organization, and did not breed much and deliberately controlled breeding with complex systems of religion that promoted chasity. They wanted to conserve nutrients in their farmland and be frugal with what they know to be limited economic resources. They lived a rich life with a high standard of living per capita. Unfortunately, their military strengths were no match for a neighboring clan who has decided to invade them, and thus their trek to OC to find a new place where they can be left alone.

When the Klings and the Fergies met up in OC when both tried to settle in the land, the two chieftains who led the people at the time agreed to establish a democracy of equals, with the rule of law and property. The Klings were very impressed with Fergian knowledge of agriculture and political economy, and the Fergies needed badly the Kling dedication and experience with the "grunt work" and not to mention war-like activities to acquire and defend territory. Thus, generations have passed, and eventually both the Klings and the Fergies settled down and both called OC home. But of course, due to the Fergies previous intellect and experience with economic activities, and also due to their shrewdness and greed, they soon acquired significantly more wealth than the Klings. After a period of two generations, the Fergies were only 5% of the population, but controlled most of OC's vast amount of wealth and property. By then the economy has gotten relatively advanced. Not only were there a basic food and services industry that the people originally needed to survive, but tastes for consumer discretionary, finance, real estate, luxury goods, and the likes have also popped up on the backs of high population growth and a healthy labor market. Of course, it was mostly Fergies who had the bulk of the wealth to enjoy these amenities. Naturally, the Klings were unhappy with this, as their people were working very hard, but none could ever make as much as the Fergies. As the economy developed, up went the prices of assets such as land, shelter, and raw materials used to create the goods and services, and this meant it was very difficult for Klings to get in on the action with seemingly very meager wages. One day, a whole lot of Klings gathered and signed an official petition for a fairer distribution of wealth, and they protested and complained during a democratic council that the Fergies were guilty of manipulation and conspiracy to undermine the Kling people. This was the first time that the two groups of population had such problems since their founding.

Sensing danger of popular unrest, the democratic council tried very hard to figure out a solution. Around the same time, a secret committee of business and financial industry titans of the Fergie race convened in a secret meeting to try and figure out what to do to keep the Klings happy. The Fergies knew that the Klings were generally a proud and stubborn bunch who could in no way compare to the Fergie intellect and instinct for wealth accumulation, but they also did not think that this was a crime. These Fergies didn't look down upon the Klings, for they also needed the vast number of labor resources that the Klings provide for their civilization. They also realize that a Kling could kick a Fergie's butt any day in a physical match, which makes them dangerous if the Klings ever became politicized. The Fergie committee thought long and hard about what to do, and how to make the Klings feel richer without having to give up their own property and wealth that they've worked so long and hard to accumulate. But they just couldn’t figure it out, would they really have to give away their hard earned money and property in order to keep the social fabric from tearing apart?

Just then, a deus ex machina came and saved the day. A peaceful people known as the Chins sailed to OC from afar, with a caravan full of goods. They were very interested in opening up trade with OC, and the best part of it is that all they asked for in return for the ship full of goods were common shiny pebbles that were plenty to be found on a beach nearby. Apparently, where the Chins came from, these pebbles are very valuable.

The Fergies quickly capitalized on this opportunity and called in an emergency session with the democratic council on the island. The Fergies promised to fix the problem of income inequality by changing the money supply from the current rare gemstones to pebbles, and make available many assets in due time that Klings could purchase with these pebbles. The community built a 10 ft, heavily guarded wall outside of the beach, and established the first central bank in the OC. Of course, none of the Klings were smart enough to figure out what was going on, and the Fergies funneled enough pebbles into the pockets of Kling politicians to keep them happy enough to allow the Fergies to be the ones that controlled this seemingly endless beach full of pebble money. When the bank opened, all was welcomed to exchange their gemstones for these pebbles at a set rate of 50 pebbles per gemstone. The population quickly did so.

Trade with the Chins quickly heated up, and a vast surplus of goods and services were soon imported from the distant homelands of the Chins. A complex system of banking and finance sprang up as a result, where paper representing ownership of pebbles soon began circulating in the two-world economy. The Chins soon also incorporated bank-notes from the Fergies as a part of their currency back home, though they’ve always kept it tucked away as the Fergies didn’t export what they didn’t already have back home. The only thing that the Chins ever really wanted from the OC were the seemingly ubiquitous shiny pebbles and notes representing claims to these pebbles.

Soon, the food of goods from the Chins created a disinflationary effect on the economy of the OC, and the Klings, whereas before they could not afford the luxuries that the Fergies have enjoyed, quickly snatched up goods at cheap prices. The opening to foreign trade had allowed Fergie business owners to shift their production to low-cost foreign countries, outsourcing jobs once held by Klings. There were some complaints regarding job-loss, but in general, society in a very content state-of-being, everyone could purchase price-deflated consumer goods for cheap, and no one was hungry.

Of course, the Fergies who have outsourced labor overseas to the land of the Chins quickly found themselves able to earn very handsome margins on the products they shipped back home. Branded goods and services soon appeared, and an entire fashion and glamour industry sprang up on the backs of high selling prices. Voluptuous females, Kling and Fergie, paraded the catwalks and appeared in newly printed media advertising the new crowning consumerism, and urging the nouveau riche to splurge pebbles on luxury goods made widely available and affordable.

This worked pretty well for a while. The Klings were happy consumers, and could purchase more than they ever thought imaginable. And due to the flexibility of the Fergie dominated central bank, which has increasingly injected more and more pebbles and claims to pebbles into the money supply to pay for goods imported from the Chins, the Klings were able to enjoy very beneficial financing terms. They soon bought their own homes with very little down payment and mortgage debt with very little money down, low interest rates, and a terms of twenty-plus years. Despite the fact that more and more jobs were being shifted to the land of the Chins, in aggregate this was no problem because enough jobs were being created in the real estate, finance, and consumer retail industries in the OC to off-set job losses in hard-asset businesses. Nobody really worried about “real wages”, because inflation didn’t exist in this world of endless cheap Chin goods. Of course, all this prosperity have kick-started asset prices even more, and prices in the local stock exchange—once very illiquid and with only Fergie participation—has become very trendy among the new middle class Klings. Everyone was happy to see their home prices appreciate, and everyone was ecstatic when the value of their portfolios went up steadily day by day. This has created even more confidence in consumer spending, and the Klings were enjoying the seemingly unlimited wealth that the new banking/financial system created. Meanwhile, behind the scenes, the Fergie central bankers and central bank chairman Ulan Bluespan made sure that the system created enough pebbles and pebble denominated debt to sustain this asset inflation and the consumption binge.

And meanwhile, the Chins were increasingly worried that the pebbles and notes claiming pebbles would soon depreciate in value. After all, their economy is now flooded with pebbles, and they have been recently suffering a serious bout of deflation with more and more manufacturing capacity coming online with the easy pebbles available. However, the seemingly insatiable demand of the OCs were simply too profitable to ignore (at least in terms of what they thought was profit… more and more pebbles and pebbles denominated notes). Plus, the OCs were seen by the Chins as an economically and politically superior group of people. The Fergies, on the backs of a prosperous economy, had encouraged out-of-work young Klings to join in a new military expansion program—in the name of all that is good and just: freedom, liberty, and the pursuit of happyness. Over time, this military expansion program had lead to overseas expeditions known as freedom fights, and this showed off the OC economic and military might to the rest of the world, which significantly helped in the credit ratings of the OC central bank in the eyes of Chins and an increasing number of other societies.

All this has served to greatly increase the Klings satisfaction with the Fergie banking administration. Although the Fergies did not necessarily create real income equality, there was a standard-of-living equality that greatly satisfied the large Kling population, whom can now be largely considered “middle class”. At the same time, however, nominal income disparity widened further, as the original many Fergie asset owners, and a few Nouveau riche Klings accumulated an ever-increasing share of society’s wealth, so much that they had no idea what to do with it except to invest further into more assets and/or use them to flip stocks.

Abstract artists, once considered economically despicable in both the proud warrior-like Kling species and the practical Fergie race were soon making a good living tapping paint on a canvas and making random stories of feelings and heartbreaks. A canvas with three red dots were fetching on the market for as high as five hundred million pebbles. This mirrored the increases in securities markets and maybe even more.

However, the Fergies soon realized that this economic miracle would not be forever, and they soon started thinking about the downside to all this. The more they thought, the more they began to hedge themselves. The consumption binge and the seemingly endless asset inflation would grind to a halt if any trouble with the belief in the value of the pebble would come into question… but so long as the Chins and other nations impressed with the OC’s economic and military might were willing to take these pebbles and finance whatever account deficits and a growing national debt, and keep these in their foreign reserves and treat them as legal tender for possible future purchases, then the OC would be fine, and this binge would continue on and on. But all good things must end, and the fact remains that these pebbles were once just pebbles on a beach, and they hold no real value what-so-ever, and that sooner or later, there would be doubts to the real value of the OC pebble, and what goods and services that it might bring to the holder. The Fergies know this, and they are devising methods to try and shift the risk away from themselves.

Finally, the greediest among the Fergies would devise a method to enrich themselves one last time and still guarantee they would still come out alright. So, with a natural instinct for profit, and ever at a loss in finding ways to make money and keep money to themselves, the Fergies have devised very intricate financial innovations. The first of these innovations was asset securitization. The Fergies geniously devised a plan to extend even more credit to households that were not living the OC dream yet (they call this subprime pebble loans), and packaging these loans into fixed income securities called Mortgage Backed Securities. They also extended numerous loans to new start-up companies created by young, educated, and optimistic Kling entrepreneurs, and packaged the cash-flows to those and sold them off as Asset Backed Securities and Collateralized Debt Obligations. The Fergies loaned to whoever they could, and transferred the risk of default and asset depreciation to the investing public (whom by now are in a frenzy of asset purchases and speculation), and pocketed billions of pebbles worth of transaction fees and brokerage fees. Second, they began marketing various derivative instruments and packaged fixed income instruments to foreigners—in particular, the Chins, who were not as sophisticated as the Fergies in coming up with financial innovations, but were nevertheless eager to invest due to the strength of the OC pebble on the international currency exchanges. Third, the Fergies began to encourage leveraged products, as diminishing investment returns and low risk-return spreads plagued the rabidly greedy investors. This leverage allowed Fergies to pocket even more fees as they package ever increasing debt and sell them off to the public. As long as asset prices appreciated more than the interest on any of these loans that the Fergies made, then the investors were golden. Fourth, the Fergies began to create even more fervor among markets by organizing Private Equity funds, where they garner billions and billions of pebbles from investors, and take public assets private on the bank of billions of dollars in bank loans often at 20 – 30% premiums, and then IPOing these private equity funds back to the public at and even more mark-up.

Among all the frenzy in the markets, and everyone buying into the belief that the new financial innovations that the Fergies devised making investments permanently safer and more liquid, asset prices kept going up for a while. The Fergies have long gotten out of the game, while the Klings keep flipping and the Chins keep hoarding assets.

One day, out of the blue, the Chins decided that they now had enough pebbles and pebbles denominated debt to last them ad infinitum, so they started buying OC hard assets themselves (much like the Japanese did during their market bubble). The Klings also started selling these assets, and pretty soon, there was a rush of Klings wanting to sell and pocket their gains. Asset prices went down a bit, and margins on loans were called, and securitized products began losing some of their collateral. In other words, minor events and tremors in the system, and the subsequent asset price declines soon triggered several critical states in the economy. Those that had houses on subprime pebble loans began receiving rates that were beyond their payment capability, and they defaulted. Loans made on the backs of company products and equity securities were increasingly being called in. Klings and Foreigners across the board began losing money, and buying interest was taken out of the system by quite a bit.

And the Fergies central bank, in attempt to fix the problem, pondered two possible scenarios: lower borrowing costs, which will inject excess liquidity even more and support asset prices, but nevertheless will induce foreigners to sell pebbles, and will probably resulted in a run by the Chins on the existing pebble currency, where inflation hidden in years of disinflationary consumer products will finally kick in. Or, do nothing, which will create total illiquidity, where asset prices continue to tumble and across the board losses will occur with much of the value of pebble denominated assets wiped out—not to mention all the derivative products that were written to the public. Either way, however, the Fergies come out fine, due to their shrewd transfer of risk to the public, and their ability to buy back cheap assets when the markets tank.

Fergies 1, the rest 0. By now, the gems that were originally the money supply replaced by pebbles are now worth 600 pebbles per 1 gem. And the economy of OC is being plagued with an extended period of stagflation.

What will the Fergies think up next?

Saturday, May 12, 2007

Complex Theory and Power Laws, With Philosophical/Economic Implications

An artist's depiction of fractals in complexity/chaos theory

These are concepts set out to replace linear causality. Instead of event A causing a response called event B, events A, B, C, D and so on act as either points, planes, or spatial objects, with or without mutual exclusivity, push and pull in tandem or in flux or with mutual influence but not to the full extent, either cause some other group of events to occur, cancel themselves out, or somewhere in between.

I suppose that's where things get complicated (thus, complex theory, what a cool name), but it is certainly a concept more befitting of economics than linear algebra--and not just economics either, but maybe existence itself too. Of course that's beyond what I'm trying to do in a blog entry. But what's amazing about complex theory is its scope of application, in back-testing of what's happend in the past, in understanding how we got to where we are now, and in setting a framework for any sort of art in predicting the future. After all, to make an example of a commonly known process: evolution, the beginnings of life were once considered humble and quite easy to understand. Now, to define life itself as an academic pursuit would take years of not decades of categorical work. As the theory goes, single celled organisms divided itself and combined with other organisms to form living beings planet earth is teemed with today. First with simple structures and organelles to sustain itself and reproduce--a cell wall to house cytoplasm, a nucleus to shelter chromosome, mitochondria to generate energy, and some endoplasmic reticulum to distribute resources. Then on to sexual reproduction and combination with the genetic codes of other cells to create intergenerational adaptation and evolution through the shared replication of superior genes. Then, as cells moved beyond being isolated phenomenons, vessels of massive size are created to house groups of cells who have found ways to co-exist under mutually beneficial arrangements--we can think of these as plants and animals at any given stage of evolutionary complexity. Some remain very simple as rudimentary genomes find no reason to evolve beyond what is necessary to survive in a simple, unchanging environment--phytoplankton, algae, and various other microorganisms. Some, in order to exploit changing circumstances and power over other organisms evolved into a complex entanglement of organs and biological fluids working together for the goal of common survival and reproduction. And some of these organisms even evolved an executive cell group created solely for the purpose of intellectual thought called the brain. And it didn't end there. Intellectual thought (at least only in humans on this planet) quickly became a means for what was once cellular organisms to go beyond biological fluids and structures, to create social interaction, common history, civilization as we know it recorded in the form of knowledge--the rise and fall of empires, the evolution of media and the press, religion, economics, politics, and most recently the creation of the most complex web of virtual ideas known as software. And who knows what the future holds. But what's clear to scientists and philosophers is that each stage of evolution and change can be traced and graphed as according to a secret order, and the magnitude and timing of each tipping point or critical state could be related back to a statistical power law. Changes of a certain magnitude will happen less likely the bigger these changes themselves are. The frequency of such revolutions in biology, science, knowledge, ways of thought will happen statistically less—as according to a power law, with some physicists and scientists pointing to a factor of four times as likely or not as likely. But these critical states of change happen in natural phenomena, and it gets quicker and more complicated with every branch of development expanding ever rapidly. It took longer for single-celled organisms to go from asexual reproduction to sexual reproduction, than for a moth to develop chameleon-like skin as according to their environment to avoid predators (a process that takes only a couple of generations, each lasting a couple of years). By the same token it took much longer for man to develop and pass on agriculture and basic technologies to the next generation, than for modern innovation to take a foothold in everyday life (remember the most daunting advancements in technology and social organization came about in the 19th and 20th century). This example of evolution, and the frequency of critical turning points in its progress (the second derivative), is just one of what modern intellectuals can attribute to complex theory and power laws--which, as the trend of our scientific times has determined, the origins of virtually everything on this planet, hardware and software, can be ascribed.

As any model goes, it serves very well as a framework for organizing and back-testing data collected on historical data and developments. Simple and seemingly linear progressions would start very easy, but accelerate into multifaceted networks of causality weighing on one another and create systems of stable equilibrium that expand infinitely. This is mathematically beautiful (I personally think so). You could look at the development of anything with a new perspective, from evolution as we've just mentioned, to the development of our current government (from townhouse meetings to national democracy to national committees and agencies to bureaucratic glut), the great monotheistic religions (from simple beginnings of monotheism to Judaism to the crucifixion of Christ and the spread of 'the word' by Paul to the arrival of Mohamed and the thereafter split between Sunni and Shia to the splits in Christendom of Eastern Orthodoxy, Catholicism, Coptic Christianity, Protestants, Evangelicals, and the arrival of Islamic fundamentalism), to why one should do well early on in school (from As in math, science, and english, to an A in subjects derived from these subjects, history and economics for example, and then knowledge of each subject in detail, which is virtually every subject from the beginning ones, and the detrimental effects of having to catch up if full understanding of simple origins of such knowledge is not achieved) to categories in science, politics, economics, philosophy, you name it. And all knowledge and existence could be related to a tree, with which metaphorical branches spawn even more branches, and it doesn’t stop. Sometimes branches get old and die, in existence and in knowledge, and when branches wither and fall from the tree the other branches fall with it—like an act of god or maybe the inability for the environment to support certain phenomena or without the environment going head-to-head against its very existence. And thus a web is disturbed. The example would be like a tiny moth going extinct due to an external factor such as human intervention to control their population, leading to certain smaller birds of prey unable to feed their young, leading to tree-dwelling mammals unable to find birds eggs as a source of food, and larger predators unable to secure a steady supply of these mammals as prey, and extinction occurs at the top of the food chain more often than the bottom, ect. Sometimes branches continue their upward and outward growth, far outpacing what its original host had intended, due to its prolific potential as a basis to develop offspring—knowledge, for one, has several of these: monotheism, mathematics, literature and philosophy, or even the more modern ones such as the Einstein’s theory of relativity, Darwin’s theory, game theory, critical state ubiquity (the most recent). Sometime knowledge could be destroyed or rarified in human knowledge, and rendered antiquated and useless—such as geocentric theory, medieval treatment of lunacy through exorcism, Zoroastrianism, countless languages from extinct tribes of people, and the list goes on.

To put it in a nut-shell, "complex theory" serves to describe an underlying order to what seems to be the complete chaos of modern day life, by first ascribing the origins of any categorical phenomenon under consideration and then, with a model--either scientific or philosophical, slowly branching out these origins and fitting more modern manifestations under these models, and be able to explain their evolution or destruction and the prospects of the “branch” going forward. The "power law" describes the speed and the frequency at which the branching out occurs—for example, outlining the occurrence of earthquakes and its statistical frequencies according to their magnitude—the famous Gutenberg-Richter theorem, or the accumulation of wealth being defined as being a certain power of more or less frequency as the amount of wealth increases or decreases by a certain factor in the individuals of a population, or just the normal curve under any statistical study delineating the expected normal occurrences spread across standard deviations—with events getting rarer as sigma grows.

Anyway, that was quite a bit of description, but hopefully one can see the implications that these theories can have on economic development, whether macro or micro, and the relevant policy or investment decisions might be derived from understanding such models. But, as any model, it's very good for hindsight. We should keep in mind the adage "Models do not provide answers, they only serve to detail questions". So what would this theory tell us in the world of finance and economics? Could we use something like this to learn more about how the world of practical matters such as money, employment, social security, empire building, etc.

Let’s leave that for another time.

Just another suggestion, pick up these books, they are insane and make you go "holy shit this kicks ass" with every page:

Ubiquity - Mark Buchanan, Deep Simplicity - John Gribbins, The Selfish Gene - Richard Dawkins

They may mention finance/economics only seldomly, but the concepts and simple truths delineated in the pages is something that everyone in perhaps every profession would benefit to know.

Wednesday, May 09, 2007

Fortune Favors the Bold?

These spreads are pitiful (yields of riskier credit securities compared to treasuries)...

In a nutshell, this chart shows how much investors of debt securities demand back in terms of yield. This chart relates a nice picture back to us regarding the general sentiments regarding risk, and how much return should compensate for that risk. The relationship of credit-spreads between what is considered "risky" and "riskless" shows very well the risk-reward expectations of the investing public. Basically the yellow and the red line compare how much "extra" return is expected when investing in securities other than the completely riskless U.S. treasuries market (the bonds issued by the U.S. government). Why does this picture scare me?

1.) People are no longer afraid of credit risk, expecting a measly 1% spread for barely investment grade securities and a little under 2% for emerging market sovereigns (usually considered pretty risky, but given the fact that "emerging market" has become a buzzword for growth and riches now-a-days, nobody really thinks about default or non-payment). With the easy availability of credit default swaps (derivative instruments that allow an investor to completely diversify out of default risk--provided the counter-party does not double-default... but who knows?) brunting the bulk of the uncertainties with investing in instruments of dubious integrity.

2.) To get the return required for yield hungry U.S. investors, institutions and money managers (alright alright, mostly hedge funds...dammit) have been using substantially higher leverage to capture ever decreasing returns. If you think credit spreads are bad, you should see how much people are willing to pay for equities these days (15-20x earnings on normalized businesses not unusual!) But yeah, here's a picture of how much hedge funds are levered. Prime brokers (firms who execute trades, lend money, and provide various other financial and administrative services to investment funds) have been literally giving money away since late 2003. Who can blame them? Money grew on trees as we were coming out of the tech bubble, all that extra cash needed to go somewhere, the new wonder-kids of finance at hedge funds are 'good' at making money all of a sudden because everything is going up, and the fees on these borrowings are not half bad.

3.) The justification for this complete negligence of investment sense is the circular argument that derivatives and credit default swaps has permanently made financial markets safer and more liquid, when the wide availability of these derivatives were a product of a secular bull-market driven by the wide availability of money supply in the first place. A paradox of the chicken and the egg is here. When I think about it, it makes my head hurt, because... first of all... would derivatives and credit default swaps be so easy to finance if it weren't for the fact that volatility was low and asset prices were perceived as sound? Second of all... would asset prices be sound and leverage/money be so easily dished out if it weren't for the fact that derivatives and credit default swaps has created "permanently" less risk and much more trading and liquidity? So, look at the two charts below... is it the chicken or the egg?

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The image “http://www.oftwominds.com/blog-photos/volatility.gif” cannot be displayed, because it contains errors.

If I'm brilliant enough to call what's supposed to happen next as a result of this non-sense, I would be making millions of dollars right about now (if not billions)... I don't claim I know what's going on, but I do know that somebody has to be getting the short end of the deal. When there's a winner that has diversified away all his/her default risk and volatility risk, somebody else is taking it on--even if that somebody else has diversified that risk away themselves, then that somebody else's somebody else will be the one brunting the blow. Even if it comes full circle, somebody will probably have to default if things get bad enough.

I just wanna see what happens in a bear market, when liquidity suddenly dries up and trading grinds to a slow. When everyone wants to sell, you can bet this scenario of permanently lower volatility/risk/returns, higher leverage, and the happy-go-lucky world of record-high dow closings and never-ending LBO/M&As will be less enthusiastic.

Fortune doesn't favor the bold these days, it favors everybody. Virgil wouldn't be quite as poignant on courage if he saw what's happening today. Bankers winning on fees and investment funds winning on returns forever and ever seems like a utopia, but utopias are never quite so economically viable--for an extended period of time anyway.

Friday, May 04, 2007

How Loose Monetary Conditions (not economic) Affect Stock Market Returns, and Why I'm Still A Bear

Before I begin a long-winded thought jot-down that was long before due regarding my views on the economic and investment outlook that I personally hold regarding the future, I'd like to say right now that I am not assigning any time-line to when I think my views would come to pass. Any economic view on the market, despite the potential inevitability that views suggest, are by no means ever imminent--as the market is still after-all a voting machine that is run by human psychology rather than the fundamental truths that might be of consequence. I've been bearish on the state of the U.S. economy and stock market for a while now, but that doesn't necessarily mean I want the stock market to fall, and for people to lose their jobs, or for America to lose its economic supremacy in time. What I am is worried, and I worry because I need to know where money can be made in the finance world if making money was the cause of a lot of fundamental disequilibriums in the first place. The problem of excess liquidity (I'm probably one of very few on the street that think excess liquidity is a problem rather than a solution)  have weighed heavily on real returns, and the illusion of capital gains are paid on the backs of an unending quest to build capacity in Asia and the ebullient view of a neverending consumer binge that drives what it means to be American today. Nevermind the fact that the performance of the S&P has been caused mainly by the rise of financial stocks and consumer stocks, and nevermind the reason that much of the core growth in corporate earnings actually came from abroad in the form of a weakened dollar. The question that must be addressed is how America's chronic deficit spending, and the economic liberalization of the previous Greenspan regime effected our futures as investors and every day citizens going forward. And why we should be worried about a potential pitfall in investing in America if things go unaddressed. Difficulties in curbing inflation (i.e. things getting more expensive and our retirements getting more difficult) will be the challenge of the Fed and central bankers around the world as they try and figure out how this financial frenzy of today will affect money supply and velocity, where people give three cheers for M&A activity that make little to no sense simply because it drives stock returns, and where the wealthy simply give money away to anybody with a business plan for a (fill in the blank) fund. One can cite countless deals that have happend over the last few years done by private equity or investor consortiums that have investment yields thinner than Victoria's Secret models, and how if wealthy people really wanted to throw away money they might as well throw away money at kids starving around the world rather than down a black hole of greed and expectations comforted only by the scant hope that maybe someone else will buy the investment at a higher price (because, there's enough liquidity, duh).

Before anything, here's a very interesting piece courtesy of Marc Faber of the GBD Report and John Paul Koning of Pollitt & Co in Toronto:

The Zimbabwe Stock Exchange is growing some three times faster than consumer prices. This relative outperformance versus general prices is a result of stocks being a chief entry point for the flood of newly created money. Keep Zimbabwean dollars in your pocket, and they've already lost a chunk of their value by the next day. Putting money in the bank, where rates are pithy, is not much better. Investing in government bonds is the equivalent of financial suicice. Converting wealth into foreign currency is difficult; hard currency is scarce, and strict rules limit exchangeability.

As for capital improvements, there is little incentive on the part of companies to invest their already-losing enterprises since economic prospects look so bleak. Very few havens exist for people to hide their wealth from the evils created by Mugabe's policies. Like compressed air looking for an exit, money is pouring into shares of ZSE-listed firms like banker Old Mutual, hotel group Meikles Africa, and mobile phone firm Econet Wireless. It is the only place to go. Thus the 12,000% year over year increase in the Zimbabwe Industrials.

Our Zimbabwe example, though extreme, demonstrates how changes in stock prices can be driven by monetary conditions and not changes in GDP. New money gets spent or invested. In Zimbabwe's case, because there are no alternatives, it is stocks that are benefiting.

This sort of thinking can be applied to the stock markets in the Western world too. Though western central banks have not been printing nearly as fast as their Zimbabwe counterpart, they do have a long history of increasing the money supply. It forces one to ask how much of the growth in Western stock marekts over the preceding twenty-five yeras has been created by a vastly increasing money supply, and how much is due to actual wealth creation. Perhaps stock prices have increased faster than goods prices for the last twenty-five years because, as in Zimbabwe, Western stock markets have become one of the principal entry points for newly printed currency.

This example really hit me, it describes a whole lot of what's going on around the markets in a more extreme manner. The emphasis in bold is mine, and what it's suggesting hints at how any investment return--viewed in absense of a perspective on the general monetary conditions of an economy--is at best illusory and at worst stupid. One might view the 12,000% returns in Zimbabwe industrials as very attractive, but in light of the horrible inflation and the lack of general investment options to preserve capital enough for a meal the next day is scary. Of course, the current inflation in the United States might be viewed as benign in comparison to much of the developing world (some 2.0%+ annualized), and compared to the 20%+ returns in the S&P500 over the last year or so this is a very good deal for anyone that has gotten into the markets, for their wealth in real dollar terms have increased by quite a bit.

But what does it really mean to hold wealth? What is money? To the average joe, the more money the better, and the more things money can buy, the merrier, if only everybody in the world could have money then every problem we have would go away. This is a fantasy not far off from what perhaps 95% of the population would agree with. However, for economists and interested investors, this is far from true. Economics 101 would tell you that if everyone in the world could make fast money, and build wealth in nominal dollars, and have a fatter bank account that grows day by day for some reason or another--with the awesome money their mutual fund managers and their mutual fund manager's fund managers makes--then there would be a case of increasing prices so that everybody loses purchasing value year after year and no "real" wealth is built at all. Certeris Paribus, $100 dollars that used to buy a coffee machine will now only buy a pack of coffee machine filters. Of course, the real world isn't ceteris paribus, but enough empirical evidence has already given us signs of danger that the next recessionary pressure we feel will surely be stagflationary, in consequence to lagging consumer spending, job loss, much higher commodity and raw material prices, and a weakening dollar. So we must ask ourselves is inflation truly under control? Prices in the United States have stayed stable, but any traveler can tell you that staying in other places around the world (developing economies excluded) have become much more expensive. Americans, as usual, are pretty complacent spending their evenings at home and not thinking outside of their own continents--but people really should be more concerned about the falling value of the U.S. dollar, and what implications on inflation it actually has at home.

While stock prices and house prices (until recently) have continued their upward climb slowly but confidently, driven primarily by the reflexive success of financial and consumer markets on the back of increasing asset prices that becomes its own grandpa, the rest of the world seems to have begun a bleek view on the fate of American status and the strength of the American Dollar (once pinnacled as the currency of dicipline and value preservation). A comparative glance at several currencies considered relatively "hard" against the dollar--meaning more fiscal dicipline and less monetary expansion--can tell you something about "true" inflation, in terms of how much it actually costs an American to live in the world (as opposed to his couch in surburbia).

How much Euros to buy one dollar

How much British Pounds to buy one dollar

How much Swiss Francs to buy one dollar

How much Austrailian Dollars to buy One Dollar

How much Korean Wons to buy One Dollar

For any of these foreigners to have invested in American assets in the last five years would have been difficult due to the falling to flattish real returns they would have earned on average (say in the S&P or treasury markets). The story of real inflation for Americans haven't hit home quite yet due to the still relatively cheap goods and cheap capital that is available in China and Japan, respectively. In China, manufacturing capacity and saturation have literally reached its limits, and the endless supply of labor have since cooled the price of consumed goods in America while under normal circumstances Americans would have certainly felt heat. But the China problem (the one that US politicians and economists keep talking about) might have found a solution yet--a gradual appreciation of its currency to reflect global norms and correct trade deficits.

The biggest draw back in the case of China is that, although "lowering our deficits to China" and "help save our jobs" sounds good to Americans now, the actual consequences will be dire in the form of much higher prices. China has acted as a cooling engine in world inflationary pressures in consumer goods (a cost that has arguably been passed on to increases in raw materials, energy, food and commodity prices that they are continuing to drive up), and this has enabled many societies around the world to live with relative comfort and still be frugal. Now I say Americans will feel heat, because while China has enabled a much cheaper manufacturing environment and thus cheaper goods to be enjoyed by everyone, Americans have been overspending even in light of this. A quick glance at the household savings rate and the household debt level (manifested primarily in credit cards, auto-payments, and mortgages) in Amerca will tell you the story:

Chart of household financial obligations ratio, 1992 to 2006.

Chart of personal saving rate, 1983 to 2006.

But in light of these increasing pressures in actual finances of the consumer, it's still "okay" to buy the new playstation and the wii because the stock market or the value of the house is going to pay for it. The stock market, specifically, has continued its run over the last two years, and is coming closer to the levels reached in the Tech Bubble--only this time around, it's the consumer-spending-on-frothy-assets-and-financial-stocks-on-M&A Bubble as a result of easy credit expansion and the exponential growth in derivatives that "hedge-out" risk (provided that nobody defaults). A self-reinforcing phenomenon occurs here with two factors: (1) consumer spending and financial returns based on rising asset values (2) rising asset values based on increased consumer spending and financial returns.

Nominal S&P returns in the last 5 years

Nominal S&P returns in the last decade (tech bubble included in 2000)

Again, I repeat, foreigners (who fundamentally would view the dollar as an important consideration in investment decision making, and those more keen to inflationary pressure and American froth than we Americans) have seen little appreciation in the value of their investments if one were to adjust market returns in terms of their currency (look at the charts of dollar value of other currencies above). This tells a true story about the "real" wealth actually being built in the United States.

And the bit going around the market talking about how a "weak" dollar will help the American economy is declaring ignorance of the painful short-term effect of a continuing weak dollar. Namely, a slow-down in consumer spending, and a flatting and falling asset market that Americans pride itself on. Longer-term, the macroeconomy will adjust, and maybe we can see the United States actually making something "tangible" again in the future instead of just shuffling money and intellectual property, but nobody can predict when this long-run is. The case in point is that inflation in Ameica will hit sooner or later, and the factors have already been set in motion: (1) calls for a weaker Chinese Yuan that will increase consumer prices across the board (2) falling real estate prices and defaulting mortgages hurting consumer spending and financial returns over the next year or two (3) drying liquidity as capital loses value in the form of less trading, less M&A, and unwinding of the Yen carry-trade (4) yields too low to chase--which eventually but surely must happen unless the entire investment community collectively lose their minds.

All the money that's been spent in the Iraq War and the war against terrorism, and all of the money funneled into foreign central banks (such as China's and Japan's) will also play a role in increasing the money supply in the US. Although the velocity of these "eurodollars" are not enough to create rampant inflation in their current idle state, it would be interesting to see if any of them would make their way back into the states eventually as the dollar continues to weaken and money floods back to buy American goods. We would all be much poorer when that happens if we don't invest appropriately...

Whatever lessons this situation could tell us paints a picture of much uncertainty in the future. Stock prices will not increase forever, and macroeconomic conditions, although benign currently, are starting to slow. Making "real" money is difficult, but money in large doses as according to hedge funds and private equity funds still is performance since inflation doesn't hit that hard in its current manifestation. The investment outlook of any prudent investor should be one of caution as we move forward. Nobody can predict the timing of the unwinding of this seemingly stable disequilibrium (if it even unwinds in our career), but an investor can always protect against these events by going into foreign markets, and investing in sound businesses uncorrelated with the market at large that are cheap (something that calls for much more qualitative research in the microeconomic perspective). Just don't buy into the easy solution of investing in whatever grows that will most likely continue to grow so long as the economy is doing well and excess liquidity never stops.

w00t, that sure was long-winded. Probably would have tons of grammatical mistakes and concept left out if i were to go back to read it too... but that's my two cents, for whatever its worth (which will probably turn into one cent sooner than we think)