Inflation Or Deflation Or ?

Inflation Or Deflation Or ?

by

Stanley C. Clayton, Ph. D.

February 13, 2010

Economic Tea Leaves

    Decisions, decisions - investing is full of them.  So is governing especially in today's environment of many governments around the world trying desperately to cope with not enough money and too much debt coupled with struggling economies.  As we watch this play out, many of us are trying to anticipate whether there will be inflation or deflation or are we even asking the right question?  Science long ago developed The Scientific Method for answering questions of science.  Once in a while scientists come up with an answer of substantive value.  Wait!  Why are not all the answers of value?  Because most scientifically derived answers are to the wrong questions.  This is not unique to science as humans spend most of their time answering the wrong questions - that is just life.  Answers easily roll off the tongue while finding the right question is a tough slog.

    Today, we have clear deflation in home prices in many U.S. geographic areas - serious and continuing deflation.  Recently, commercial property has been added to the declining mix.  Meanwhile, if you do much grocery shopping, you can not miss the fact that food prices continue to relentlessly inflate.  We currently have both inflation and deflation at the same time.  There is nothing unusual about this as having some of each is the norm.  So, which will it be?  The answer that is always correct is: both.  That answer tells us there is something wrong with the question as its answer is of no value.

    A substantially better (but surly not the "right") question is to ask how important elements of inflation and deflation are working out for the dominant part of the economy - the consumer?  Usually at about 70% of sales, understanding their condition and outlook is instrumental for most investors.

    As we all know, a great many consumers are in tough shape, and the rest are worried they may follow suite.  Life on the float, as it has been known, no longer is the much sought after condition.  Many have been leaning the hard lesson that as your debts increase so do your risks.  Risk seemed like a foreign concept that had no place in the modern world.  House prices had risen for so long that it was obvious to most that their prices would rise forever.  Everything was coming up roses - until it did not.  House prices started to decline, and decline some more, and the decline continues through today and beyond.  That was the major risk few people factored in.

    In desperation, many started trying to sell assets such as an extra car, boats, RVs and anything else they thought they could get along without.  Then only to find out the market for these things suddenly was thin, and the occasional buyer was not willing to pay much (a little talked about sector of deflation).  The economy was tanking, and many became worried about their job, or finding themselves under employed or unemployed.  This level of deflation in such important parts of their lives weighted very heavy on them: most of their important financial assets were deflating.

    As if this were not enough of a burden, inflation is alive and well.  Many of the essentials the consumer must buy like food, electricity, fuel, clothes and such continue to rise in price.  This inflation is making it worse for the consumer.  What little wealth they have left from deflation of their assets is being eaten up faster and faster by the inflation of the essentials they have to buy.  They are being hammered by deflation and hammered by inflation all at the same time.

    While this was going on, the government continued to compute its usual figures on inflation.  Lo and behold, net net we have a stable economy - inflation and deflation cancel each other out.  As a statistician from a sociological perspective, I know full well how averages can sometimes be very misleading.  The above example of the consumer attests to this.  In this case, it hides the horrific plight of the consumer.  It makes things appear fine when they are not.

Stock Market Tea Leaves

    OK, but how does all this play out in investment markets?  First, we should recognize that many consumers are not homeowners, nor do they have to worry about selling that extra car, boat or RV they do not have.  While these people are an important part of our society and they are severely impacted by inflation of everyday essentials, in terms of dollars spent by consumers, they represent a smaller percentage.  However this is changing as their ranks are rapidly swelling from an influx of former homeowners, and from new entrants into the job market who are unable to find work or become under employed.  The spending of the wealthy does not total much as there are relatively few of them.  The conclusion seems obvious: the consumer is in a position of substantially reduced capacity to spend, especially on non-essentials.  They also seem to be gaining a better understanding of the risks of "life on the float".  The folly of buying consumer items on credit is a lesson being learned the hard way by many.  This further reduces their capacity to spend.

    This analysis adds to the argument that the investor may be looking down the wrong end of a double barrel shotgun: a double dip recession - or is recession the right word?

  

       

  

      

Tea Leaves 020710

U.S. Debt - Trouble Ahead For Markets ?

by

Stanley C. Clayton, Ph. D.

February 7, 2010

Economic Tea Leaves

    Our nation, businesses, families, and individuals face considerable economic headwinds.  Perhaps foremost among these is debt.  In Tea Leaves, I take a longer perspective than most looking primarily at where we are in the overall scheme of things especially as it applies to investing.  I have argued that we appear to be in the early phases of nation decline following more the pattern of England rather than the Roman Empire.  Today we look at the role of national debt in that decline, and then the implications for investing in such an environment.

    The actions of the Federal government in response to the “crisis” are perhaps best understood as a desperate and often frantic effort to recapture the glory days of our republic when we were the unquestioned powerhouse of the world.  One of the many measures of this decline is the shift from being the greatest creditor nation to the greatest debtor nation.  In the 1980's, we crossed the line into debt and have not looked back.  Now Congress has increased the debt limit to 14.3 trillion dollars.  A few trillion here or a few trillion there, does it really matter?  Many economists of the Keynesian school of thought would argue no.  After all, it is only about 85% of GDP (gross domestic product).  That is a correct calculation, but I find it is an erroneous interpretation.  I suggest we are in the process of learning the hard way and in real time that Keynesian economic theory has critical flaws.  Downplaying the importance of debt is one of them.

    Just to get a feel for just how much $14.3 trillion debt amounts to in terms we can grasp, look at this.  Interest per year on that amount of debt at 2.5% = $3.975 Billion.  Estimated (from U.S. census data) number of households in USA 2010 is 121.1 million.  Interest divided by number households equals on average about $3,000.00 per year interest only owed per household per year.

    $14.3 trillion means that each family in the U.S. is on the hook for about $160,000.  If we could all sell our homes and apply the proceeds to the debt, we might have it about paid off, but then we would all experience living on the streets.

    These are not precise numbers, but they are close enough for us to get the picture.  Debt matters and it matters big time.  Life on the float may be fun while it lasts, but it has its way of ending in tears.  As many individuals, families, and businesses large and small have discovered, as your dept goes up, so do your risks.  Pushed far enough, even the slightest setback results in insolvency (bankruptcy).  At the national level, it is often referred to as national default on its debts.  The challenge then becomes to avoid nation failure.

    Where are we now?  We have passed the tipping point or the point of incipient decline, and with every increase of the national debt, the downhill slope steepens.  It not only increases national risk, but it increases the headwinds for all of us.  National debt sucks money out of the economy that could be used, for example, by businesses.  It means increased taxes through either or both directly by increasing taxes, or indirectly through inflation.  With highly skilled stewardship, our nation can follow a somewhat graceful decline to several notches lower.  Without such stewardship, however, it could get ugly.

Ultimately, the voter will determine the outcome: be very careful who you elect to office at all levels of government.  Only the best will do.

    How long will all this take?  It is likely to follow an uneven geometric decline.  It has started with a rather steep decline, but it is likely to ease, voters willing, during this decade (2010's), then settle more slowly for decades to come.  Look to the ups and downs of England over the past 200 years for guidance on this issue.  Can the decline be avoided entirely?  I suggest that is the wrong question.  It may be more productive to ask what actions can we take as individuals and as a nation to limit our decent to a level that is still rather agreeable.

    Tea Leaves will devote a portion of these pages in the future to that question.  We will find there are constructive things we can do and actions we can avoid that provide a sound basis for cautious optimism about our chances. 

Stock Market Tea Leaves

    Past general market predictions remain unchanged.  The current market is one of the rough spots predicted.  While it could be the beginning of a major decline, remember the Fed is still in easy money mode.  This makes a stiff decline difficult.  As noted before, people are uneasy.  Sooner or later a major market turn down seems likely, and the high U.S. debt appears to me likely to play an important role.  Notice in this past week that Moody's stated that the U.S. Aaa investment status may soon be in jeopardy because of its debt.  Even more troubling is that Timothy Geithner (Treasury Secretary) publicly claimed that will never happen.  Such government denials often portend the denied event.  Why?  Because no high ranking government official will bother to deny something that obviously has no merit.  Such an event would have major implications throughout, the stock market included.  It is interesting that in such a case, easy money could quickly become seen as part of the economic problem and thereby become a negative rather than a positive for markets.  Tea Leaves has argued that easy money has been the major driver of the 2009 market rally.  If that becomes as much a negative, well... .

    Remember the focus of Tea Leaves  is long term market understanding.  Short term timing is not within its purview.