Money, Money Everywhere
and Not a Penny to Invest….
To listen to the experts on Wall Street, you would believe that the investing world is awash with deep pools of un-invested cash and being hit with waves of new cash each month.
Not quite.
Let’s first back up and define some of the terms we will be using and what they mean to the economy and the markets.
Background and definitions
Liquidity
Cash, or liquidity, is the fuel that keeps both the economy going and sends the stock market higher. So having a lot of cash on hand would be an important indicator of future economic growth and potential stock market gains. And, in real terms, there is a big pile of cash in both the mutual fund’s and the banks.
Debt
Debt is the load that holds back an economy and breaks the back of companies and investors. It attracts people with its promises of investment leverage, future growth and easy payments. Contrary to popular belief, debt does eventually have to be paid off.
US Dollar
The US Dollar is a store of value, the world’s reserve currency; it is the safest means of exchange between countries. Or is it?
How much is the Dollar in your pocket worth? Some will tell you 50 cents, others may say 25 cents. To you and me, it is worth a buck. It buys things labeled $1.00 at the store. So what is the big deal?
To foreigners, with whom we have a mountainous Current Account Deficit, it is not worth what it once was. They send us Toyotas, Nestles Chocolate and French Wine, and we send them Dollars. The trouble is the value of the Dollar has been declining, so when they go to exchange the Dollars back into their own currency, it is likely they will get less of their own currency in exchange. It is like selling a used car to a friend for $1,000 and when you cash his check at the bank, you only get $900. It will make for a bruised relationship and a light wallet.
Monetary World View
A Monetary Economic World View (or a Monetarist) is where you believe that interest rates are the key to economic growth. Most of Wall Street and the Federal Reserve have a Monetary World View. They believe that lower interest rates spur an economy on and higher interest rates slow an economy. This is made evident by the pivotal position interest rates occupy in their “black box” formulas and the importance placed on the direction of interest rates as dictated by the Fed. And on the surface, they are correct.
The flaw in the theory is apparent at the extremes. And that is where we are today. Japan is the perfect example of the failure of the Monetarist view. Japan slipped into deflation in the early 1990’s. By the late 1990’s their interest rates were at 0% and even rates that low couldn’t get them out of their economic hole. Today, their rates are still some of the lowest in the world yet their economy is still mired in a deflationary funk. Why? Because they have failed to address their huge debt problem. Why is that important?
Debt, the unseen killer
The variable that the monetarists ignore is debt. They believe that as long as the cost of the debt (interest rate) is low, debt is irrelevant. But what they ignore is the size of the debt and the relationship of debt to the economy and markets. They ignore how heavy a burden debt is for the economy. Japan’s example should be a clear example to everyone what can happen when debt levels get too heavy for an economy.
So, what does all of this have to do with the title of the report?
Wall Street talks about “excess liquidity” and a “liquidity build-up” as sources for future economic growth and stock market gains. But is there really a build-up of liquidity going on?
Since liquidity is the fuel for the economy, it makes sense to compare it to the economy, to see how full the tank is. Since 2000, the Fed has been feverishly pumping “excess liquidity” into the economy. But the ratio of M1 (liquidity, cash in the economy) to GDP (the economy) has been declining. Our research shows this is the lowest level of liquidity relative to the economy in the past 45 years. The economy is far from awash in cash.
But what is worse is the debt load the economy has to endure. Relative to the economy, the debt load has never been higher. The last time it was even close to this level, the Depression in the 1930’s followed.
Source: Federal Reserve; Format: Cornerstone
Debt as Leverage
Debt was once called leverage. This was because it helped you attain more economic benefit than you would normally have. Let’s assume you are running a small factory, producing $500,000 worth of widgets a year. You borrow some money, increase the size of your factory by 50% by building a new wing and invest in better equipment. Like magic, now you are producing $1,500,000 worth of widgets each year. You tripled your revenues with only a 50% increase in space. The profits from the increased widgets sales pay off the loan and once paid off, you have more assets and more revenue. This is leverage at work.
Leverage in Reverse
It works that way in the macro economy as well. In the 1950’s, every dollar of new debt produced over $4.00 of economic activity. But by Year 2000 it had dropped to .20 cents of GDP growth and only 10 cents by 2005. Last month fell to only a nickel of economic growth for every dollar of debt growth.
Source: Federal Reserve; Format: Cornerstone
The chart above shows something more important than just our dismally poor use of debt. It shows that the Fed’s easy money policy might be failing. Yes, from the bottom in 2002, the use of debt became slightly more efficient, as it rallied from just above 0 to 15 cents. But since early 2004, less and less economic activity is being generated from the increased debt load.
Diminishing Returns
What this means is that as the Fed is increasing the money supply and debt is increasing, it is having less and less of a positive effect on the economy.
The details of the increases in debt are scary. When the market last peaked in 2000, it was said that debt growth was a major factor in the decline. Luckily for the Fed, consumers bailed out the economy in 2002 (and beyond) by using their home equity like an ATM machine.
Source: Federal Reserve; Format: Cornerstone
In all of the major economic categories listed above, the economy of 2007 is in much worse shape than it was in year 2000. Debts are much worse, our trade deficit has soared and the GDP has barely budged.
In a strange twist of economics, the best way to reduce debt is through economic activity. Think of our widget factory again. It was the profits from the increased sales of widgets that paid off the debt. The same is expected from an economy. But an economy that isn’t growing faster than the rate of debt growth cannot be expected to pay down the debt load. The debt load keeps getting heavier and heavier until it breaks the economy.
And it is not just the economy in general, it is individuals too that have no real liquidity. The Government statistics show that the Savings Rate has dropped below 0%. That means the average household in America is spending more than they are bringing in.
Source: Federal Reserve; Format: Cornerstone
And the liquidity that is supposedly sloshing around in mutual funds isn’t likely to save the day either. Market bottoms are usually associated with high cash positions in mutual funds. Market tops are associated with low cash levels. The cash position in year 2000 was lower than right before the Crash in ’87, and the same as the market top of 1972, right before the market dropped 50% over a 2 year period. Today’s cash position? Lower than both of those, the lowest in history.
Source: Investment Co Inst.; Format Cornerstone
Conclusion
The Fed has painted themselves into a corner. We have just shown that relative to the economy and the markets, liquidity levels are at or near all-time lows. Debt levels on a relative basis and in real terms are also at all-time highs. And the Dollar is declining because the liquidity the Fed did create, was too much, diluting the value of the Dollar. On top of that, the heavy debt load is weighing the Dollar down further.
The Fed can’t increase liquidity, because that would send the Dollar lower and send interest rates in this country higher. The Fed can’t reduce liquidity, because the economy is barely limping along on the meager amount of liquidity it is getting now. A decline would just send the US economy over the edge.
What this means is clear – Since there is very little liquidity available for future growth and market gains, paper assets (US Equities and US Bonds) are likely to under-perform for a long time, until liquidity and debt levels come back to normal levels. It also means that Hard Assets (Natural resources, commodities…) should out-perform. Along with this, non-dollar denominated paper assets should also outperform.
This doesn’t mean that markets around the world are all buys today or that all commodities should be bought. What is does mean is that the fundamentals are in place for future growth and that pullbacks and declines in the US are warnings of worse things to come, while pullbacks in overseas markets and hard assets could be viewed as buying opportunities.
