Tuesday, March 11, 2008

Sane Economics

Jobs Data Suggest Already in Recession," says a headline in the Wall Street Journal.

Another headline from Bloomberg rounds out the picture: "Gasoline at record $3.20 a gallon."

We will put 2 and 2 together. Falling employment means families have less to spend. Rising prices mean they will need to spend more to stay in the same place. And here, Dear Reader, do you see what has happened? The immoveable force of deflation has run smack into the irresistible force of inflation right in Americans' own backyards. And we will tell you how the smash up will resolve itself: standards of living will fall.

And here comes the New York Times with even more bad news. "Seeing an end to the good times," begins its report. Then, it allows as how the good times weren't really so good after all. The median household earned $49,244 in '99. Now, it earns $48,201. It is a strange boom that doesn't boost family incomes. But heck, we've been saying that it was a freak and an imposter all along.

Inevitably, the feds have to react to the weakening U.S. economy. They can't allow people to realize that their living standards are going down - not in an election year! In theory, they can boost economic activity by lowering the cost of credit. In practice, things often turn out much differently.

We take a step back this morning to admire the intricate natural mechanisms of a market economy. Finely tuned, carefully balanced, exquisite gears, divine workmanship…the finest watchmakers of Geneva can't even come close. But nature's handiwork has more than wheels and levers - it has a quality that man cannot reproduce…nor even understand.

George Soros calls it 'reflexivity.' Mathematicians try to describe it with chaos theory and feedback loops. But what it means is that while prices look random, and professors of economics earned Nobel Prizes for proving that they were random, they really are not. Nor are they fixed…nor do they respond to simple, mechanical manipulation. You may push on Lever A…but you might get either Result B or Result Q…or something entirely unexpected.

As we say here at The Daily Reckoning, and you may quote us: prices are neither fixed, nor random, but subject to influence.

The Fed is desperately pulling on levers. Each day brings more evidence of a system-wide credit breakdown. The Fed intends to stop the meltdown in the only way it can - by pulling on the lever of inflation; that is, by introducing more 'liquidity' into the marketplace.

This might work, if the problem really were merely a lack of available cash and credit. But consider the problem in housing. A man's house goes down in price. He has a mortgage to pay. He notices that the mortgage is greater than the value of the house. In the past, he may have been too embarrassed or too proud to do it, but now he is likely to resort to what is being called 'jingle mail.' That is, he's likely to put the keys in the mailbox…and walk away.

What can the feds do about this? The problem is not liquidity. You could offer to lend the man more money on his house, but that doesn't really help his situation. And to whom would you lend more money, with the value of the collateral falling? As the value of the collateral falls, so do the value of the derivative assets and the institutions that hold them. All up and down the credit capital structure, losses whack into one another like balls on a billiard table. Hedge funds…banks…lenders…borrowers - as one takes a loss, the next one in line takes a hit…which causes the third to lose money too.

It is not a liquidity problem, in other words, but a solvency problem. Too much debt has led to too much lending to too many people who can't pay it back. And this lending was secured by too many assets that aren't worth what investors hoped they'd be worth. The losses are there. They are real. They won't go away - even if you offer more credit.

"Turmoil in the credit derivatives markets is having an increasingly brutal impact on the wider financial system," reports the Financial Times this morning, "as a vicious cycle of forced selling drives risk premiums on company debt to new highs."

Now, here's one of those curve balls that nature's markets like to throw. The Fed decreases rates - but actual borrowing costs go up! Mortgage rates are higher today than they were when the Fed began cutting last September. As asset prices slip…and the financial industry takes losses…lenders are afraid that they might not get repaid; they want higher yields to justify the risks. And since the real cost of borrowing is going up, real business activity is going down. The economy is sinking…along with the value of the collateral.

Meanwhile, the feds do the only thing they can - lower rates and come up with schemes to put more money in circulation. This produces the financial world we have come to know and love, with inflation on the one side (coming from the feds) and deflation on the other (coming from a natural market correction). Our hypothesis continues to be that the feds cannot reflate the real economy. The problem is debt - too much of it. Offering to lend more won't help. On the other hand, the feds' inflation will drive up commodity, gold, oil and consumer prices.

How long this trend will last, we don't know. But it is a dangerous time to buy stocks…or hold treasuries. Stick with gold and cash.

*** "What to do with $100,000" is the cover line from this month's issue of Smart Money magazine. What do the folks at Smart Money think you should do?

"Buy a second home…invest in comic book art?" It begins with questions. And then offers to help us make the right decisions. So far, so good.

But, uh oh…what's this? The magazine tells us that buying real estate can be 'fruitful' - "even now." Smart Money explains that if we put down 10% on a property…and then the price goes up 10%…we've made a 100% gain. Wow. Sounds pretty good. But what if the price goes down 10%? You'd be wiped out…but the magazine doesn't even mention it. Nor is there even a hint that property prices might be in a long-term, substantial decline. We don't know one way or another, but it is at least worth considering. If experts such as Robert Shiller are correct - an investor could put up 10% each year for the next three years - and be wiped out each time.

As for stock market advice, the smartest thing the magazine comes up with is buying shares in Warren Buffett's Berkshire Hathaway (NYSE:BRK.A). True, it is like a mutual fund run by the world's greatest investor - who doesn't even charge a fee. But it is also true that the fund is so huge that even its own manager is warning investors that past performance is extremely unlikely to be repeated. It is also a track record built during the greatest bull market the world has ever seen…probably never to be repeated…and one built in America during a period that was probably the apogee of the U.S. financial empire. Again, no one knows what the future will bring - but it might be worth mentioning that investments in Berkshire are no sure thing.

Smart Money suggests an unconventional approach too - use some of the money to retool yourself. It mentions a couple who decided that they wanted to give up their jobs and go into the wine business. How they were going to get into the wine business with $100,000, we can't imagine, but they wisely thought they should get some experience first. So get this, they spent THREE DAYS in a commercial winery doing "cellar work," moving barrels around, and so forth, and HOURS talking to the owner. What? How could they possibly learn anything useful in 3 days and a few hours? The wine business is one of the most competitive and complex in the world. Maybe they'll get lucky, but it if they get killed we'd rule it a suicide.

What else does Smart Money think you should do with $100,000? Well, you might want to "roll the dice" on some "emerging genres" in the art world, for example. Or you might want to fix up your house.

Yes, you might want to do these things…but don't confuse these things with using money to make money. When you put down new carpeting, you're not making an investment. Even if you think you're going to sell the place, the carpet is a gamble, not an investment. So is buying comic book art. Maybe it will go up…maybe it won't. Buying it is hardly a smart financial move for someone with $100,000. In fact, almost all Smart Money's advice seems dumb to us. Whether you fix up your house, launch yourself into a new career, or buy a house, chances are very good that you will have less money a year from now than you do today. Even buying Buffett's shares will probably be a losing proposition in the year ahead - since the entire stock market seems on a downward course.

What should you do instead? Gold and cash…cash and gold…that is all ye know in life…and all ye need to know. For now.

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