Systems and remoorings
By Daniel M. Ryan
Last week was a tough one for the American stock market. The question of what the renewed drop means for the American economy still overhangs. With the Big Three denied, and half of the TARP folded and packed away for another time, with the averages plummeting to new (and, to me, unforeseen) lows, with residential real estate not yet bottomed, it's no wonder that there's a lot of fear spreading. The word "leadership" was regularly used in CNBC's Friday night market wrapup.
So What's Gone Wrong?
As far as the performance of the stock market is concerned, the ostensible reason was plain last week, from the delay of $350 billion of TARP money to the appointment of Timothy Geithner as the new Treasury Secretary. Wall Street is watching Washington D.C., anxiously. This anxiety suggests that the late-October rally was kicked off by the Treasury Department stepping in.
There's another, deeper fear that's present too. It comes from taking the flipside of the killer assumption that got mortgage-based derivatives into the trouble that we've seen over the last year: unless there was an outright depression, there was no way that housing prices could generally decline. As best as can be ascertained, this assumption did hold up until the now-burst real-estate bubble. The only time these last eighty years that residential real estate as a whole fell down was during the Great Depression years.
Given this prior assumption, it's no wonder that there's been so much talk of another depression. Said assumption hasn't been shaken off; it's just been flipped backwards. (Logicians call this flip-around the "contrapositive.") Since residential real estate prices have in fact collapsed, so the inverse goes, there is a real likelihood of another depression unless the monetary authorities bend over every which way to rescue the monetary system.
Both lines of reasoning are widely believed, especially the latter. The prevalence of this belief explains a lot of the anxiety that's surfacing, even though there is little sign that the economy itself is on the precipice of a depression. The Fed balance sheet is expanding rapidly, the money supply is still shooting up, and the monetary base is shooting up even more on a percentage basis. There are only two trouble spots evident from the Federal Reserve statistics. The first one is captured by the Fed's measure of total credit outstanding held by commercial banks: it's dropped recently, although the drop has occurred after an unusually large run-up. (CNBC reporter Steve Leisman pointed out some time ago that October's spurt was largely caused by pre-emptive borrowing by firms that were afraid of having their credit lines cut. He seems to have been right on that call.) The second, for monetarists, is more serious: excess reserves have been increasing, with required reserves dropping, in the week ended Nov. 19th. The same explanation given just above could be proffered for the drop in required reserves, which were also up by an unusually large amount during the previous week. Nevertheless, the drop suggests that the big spurt in both money-supply definitions will show a halt in this week's new Fed report of the money supply.
The total amount of reserves that the banks have borrowed through Fed lending facilities kept growing as of Nov. 19th too. The combination of huge excess reserves and even huger net borrowing from the Fed by depository institutions paint a picture of a very sick banking system. No wonder why the FDIC has recently approved blanket guarantees of any interbank loan or deposit regardless of size. Although the Fed is evidently in string-pushing territory again, the monetary system came into this phase after a huge expansionary ramp-up in both reserves and the money supply itself. The same is true for the recent drop in total credit held by commercial banks. For now, it looks like the two-month monetary heat-up is being allowed to cool off. The same sense of panic in D.C. that arose in September is now gone – and the upcoming change in Congress and the Presidency don't explain why. Treasury Secretary Paulson is going to depart soon, but Fed Chair Bernanke isn't: he's around until 2010.
The Immediate Future…
I might as well admit to suffering on account of my previous call myself, although I don't trade any S & P-related ETFs or derivatives. As far as the U.S. markets are concerned, the system has currently slipped its moorings. There were a lot of metrics that implied the bear market would end as of Oct. 11th, but it hasn't. The combination of current metrics saying "bargain" – including one valuation criterion that hasn't been seen since 1958 – have coincided with further steep drops. Spreads on junk bonds have widened to record ranges. Even spreads on relatively solid corporate bonds have also widened. Although LIBOR rates have not shot upwards, they have risen slightly. The yield on the 3-month U.S. Treasury bill is almost exactly zero percent. (The last four data items come courtesy of CNBC, particularly from Larry Kudlow's hour last Friday.)
Reports on the general economy shows little reason for hope. Consumers are becoming frugal in a big way. Unemployment is still shooting up, as are jobless claims. The GDP release this week is expected to confirm what almost everyone expects: the U.S. economy is officially in recession. The only debate left is how long, and severe, it will be. The old forecasts of a mild recession are being replaced by ones that guess at a longer and more severe slump. All the news so far suggests quite plainly that the U.S. economy is in for a long, tough grind.
And The Future
Yet, the pile-up of bad news in the financial press may have another explanation: the huge drop in oil and gas prices give a clue as to what it is. An old saw holds that Americans are too inflexible to adjust gas consumption patterns when prices have ramped up. Recent consumption data indicate quite the opposite. The new frugality, generally bemoaned as a further sign of a long and hard recession, also shows a new adaptiveness to changing times. As price volatility in commodities has increased, so have coping strategies that meet this volatility. The next trend will be consumption strategies that seek to take advantage of this volatility.
Americans have discovered the virtue of the subcompact and other fuel-saving vehicles in a big way. Now that gas prices have plummeted, they may go back to the old SUV; ‘tis true. On the other hand, the memory of $4+ per gallon may incline suburbanites to use this flex-strategy: owning both a SUV and a subcompact. When gas prices are low, the SUV is the primary car; when gas prices are high, the subcompact is. When each have worn out their welcome, each is replaced with a new(er) one. There's no reason why hedging should be confined to the financial markets.
The next decade's answer to the now-infamous granite countertop may very well be a pantry room, like the linen closets of old. Paying double or more for a staple does drive the lesson home that it's better to buy in bulk when food prices are low, and eat from the supplies when food prices skyrocket. This stratagem won't work for perishables, unless some shrewd entrepreneur finds or pushes an economical device to preserve them, but it does work for imperishables like flour, rice and canned goods. Back in the inflationary ‘70s, it was fashionable to buy a separate freezer unit that had about as much volume as a fridge for bulk meat storage. This appliance may come back in fashion as part of the frugality trend. If this trend catches on, then added demand for consumer goods when cheap will help buffer the effects of a new recession by moving inventories of them faster.
As a final note, a two-car garage can be converted into a one-car garage with a 250 or 500-gallon gas tank, provided that it's fully vaulted by a non-flammable concrete container for it with a steel door….
Get weekly updates about new issues of ESR!