Wednesday, December 10, 2008

You Say Inflation I Say Deflation

Few things seem to be dividing economists more these days than the debate over whether inflation or deflation is in our future. I think in the near to medium term, i.e. two to three years at least, we are looking at deflation. The bottom has fallen out of consumer spending and lack of demand leads to falling prices. Job losses, cut backs in hours and people in fear of losing their jobs all lead to wage pressures, which also leads to deflation. Oil is down, commodities are down, international trade is down and the Fed has the interest rate at a point where it is effectively negative (so it has little rate change it can do to fight deflation). And demand is down and dropping on a world wide basis, which will lead to continuing declines. So I am with Nouriel Roubini on this; look for deflation to be around for a while.

http://www.creditwritedowns.com/2008/12/roubini-how-to-avoid-the-horrors-of-‘stag-deflation’.html

Those calling for inflation recognize over the very short term we may have deflation but they point out that as the economy rebounds, the unprecedented dollars the government has thrown at us will start to get spent and inflation will ensue. They also remind us that inflation sets in after every recession ends.

http://www.moneymorning.com/2008/12/03/bailout-programs/

http://www.moneymorning.com/2008/12/08/inflation-not-deflation/

So be it. The distinction here may in part be one of timing. The moneymorning folks see the recession ending and the economy rebounding next Spring. They base this in part on the average recession since 1900 lasting 14.4 months, and we are over 12 months into this one. (I take it that their 14.4 includes the great depression, which was over 40 months, so average without that is likely a good bit lower). My problem with their thinking is that this is by no means an average recession. I also agree with Roubini that we will be lucky to see it end by 2010. We may see a nice bear rally in the market before then, but that will be followed by new lows, I expect.

So if you think the recession will linger for some time, you should expect deflation to linger for some time, despite helicopter Ben trying to avoid it. If you expect the recession to end soon, then inflation expectations are more rational, but by no means guaranteed. As the following article points out, the Fed can throw all the money at this it wants, but it cannot make banks lend it or consumers spend it. If people use it to pay off debt and save, which they will, then that is deflationary. And if financial institutions hold on to what they are given and don't lend it, that is deflationary too. Right now, that is what is happening and we could continue on that course for years to come.

http://www.forbes.com/financialadvisernetwork/2008/12/09/deflation-lending-saving-fan-ii-in_ags_1209soapbox_inl.html

Q Tip

Take a tip from Tobin's Q ratio and run for the hills, but perhaps not just yet. James Tobin, a Nobel Prize-winning economist, developed the Q ratio in 1969. It compares company market values to the relative cost of replacing their constituent parts. It is at .7 right now, which is not bad, but according to Russell Napier, each of the four biggest bear markets the past 80 years ended with the ratio at .3 or lower, which he expects this time around. Now he does not expect it to happen until 2014, so you might have time to ponder his prediction, but he does expect it.

So what does a Q ratio of .3 mean to stock values? It means the S&P dropping to 400, that's what. That is around 55% off where it is presently. I personally don't think we will get there, but who knows. If we do, it could be an incredible investing opportunity when it happens - assuming by then we are not all living in boxes next to railroad tracks eating rat-on-a-stick.

http://www.nakedcapitalism.com/2008/12/tobins-q-ratio-says-equity-bottom-much.html

Question for those smarter than me or for those with access to say a professor smarter than me. If I am reading it right, the above article concludes noting that the dollar will eventually devalue and that bear markets end when the market prices in deflation. I may not be reading it right. I thought that devaluation of the dollar would lead to inflation as the price of imports, oil commodities and the like would go up in U.S. dollars. Domestic goods would remain reasonably priced but anything imported - and we import a lot - would escalate in price. Any hoot, maybe I am just reading it wrong. Or maybe I am wrong on the impact of devaluation of the dollar.

Survey Says!

I would try to summarize the following from Bloomberg but there is too much in it to summarize. You might as well read it yourself. Caution - not for the faint hearted.

http://www.bloomberg.com/apps/news?pid=20601087&sid=ado8P..GCtC4&refer=home

Let Them Fall

Here is a novel concept. In order to get housing stability, we need to let the prices fall. Gee, what a novel concept. Remember that old reverting to mean thingy. In the long run there are only two ways for housing to become affordable in a sustainable fashion. One, the prices drop to where they are affordable. Two, people on average see their wages go up to where they can afford the higher prices. Okay, I will let you pick which one is going to happen first. Go ahead . . . take your time . . . I can wait. If you picked number one, you have been paying attention.

Now the government does not like number one and it knows right now number two is pretty much impossible (though the infrastructure spending may help a bit), so it is looking for artificial - and thus not sustainable - ways to make housing more affordable. Freddie and Fannie are two ways, pushing for loan mods another, and throwing money at financial instutions yet a third. Well Freddie and Fannie are just becoming bigger messes (more on this below), financial institutions are not about to relax their lending standards any time soon, and the average Joe the plumber on the street knows not to buy until we hit bottom. So the sooner we let price declines work their magic, the better. Dean Baker is one of the economists that "gets it," as does his organization CEPR. Too bad the government is hell bent on making this problem last longer.

http://rismedia.com/wp/2008-12-03/house-prices-must-return-to-trend-levels-to-stabilize-market/

I promised more on Freddie and Fannie becoming more of a mess, well here it is. They are now considering doing refinancings without - I repeat without - requiring an appraisal. This can add a bunch of crap to their books (as in our books since we own them now). The only promising thing is that someone refinancing a house they believe is under water is attempting to keep it and make ends meet instead of walking away. It does not mean they will not go into foreclosure or later walk away, but the walk away inclined crowd is not likely to seek refinancing. Still adding to the garbage on the Freddie and Fanni books. Next step they are back to no doc liar loans with no credit check. I mean hey, these people already got their original loan so what is the problem in refinancing that loan without any underwriting whatsoever?

http://www.bloomberg.com/apps/news?pid=20601087&sid=amYW0UdC2LdY

In the interest of full disclosure, my sister works for Fannie Mae and my niece would be one of the first in line for the new no appraisal loan. She has a loan at over 14% and would love to refinance, but she is underwater on her mortgage. But Fannie would have to waive the credit checks too, as she has killed her credit rating trying to keep up with the mortgage payments, as in not keeping up with her mortgage payments.

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