Welcome to 'Ermflation'

“Calm down, dear, it’s only a recession.”- A message on Michael Winner’s T-shirt, sported while in Barbados. (Hat tip to Money Week.)

In ‘Alice Through The Looking Glass’, the White Queen admits that she has sometimes believed as many as six impossible things before breakfast. She would be at home in today’s markets. Last week, pornographers Larry Flynt and Joe Francis lobbied Congress for a $5 billion bailout in line with that sought by the auto sector. “As long as the government is handing out money, we want to be there to take it,” said Francis. You can’t fault his logic. The appeal may have been brazen, opportunistic and self-serving – so perhaps he should really be working on Wall Street.

It turns out that Ronald Reagan had most of the best lines in anticipation of the current economic black comedy. “A recession is when your neighbour loses his job,” he said in 1976; “A depression is when you lose yours. And recovery is when Jimmy Carter loses his.” Refreshingly for a politician, he also suggested that “The ten most dangerous words in the English language are ‘Hi, I’m from the government, and I’m here to help’.” And on the same topic, he described government as “like a baby. An alimentary canal with a big appetite at one end and no responsibility at the other.”

Where we stand today, a problem caused primarily by the unconstrained greed of the private sector is now being addressed by the dubious intentions of the public sector. History suggests it will not be handled well. When money is spent, it can only be under one of three conditions. You can spend your money on yourself. You can spend your money on other people. Or you can spend other people’s money on other people. This last version is the very definition of government spending.

Answering just one question correctly should be sufficient to navigate the markets successfully during 2009 and for the foreseeable future: Inflation, deflation, or both ? And when ? Unfortunately the future is more than ordinarily unforeseeable (spot how many chief executives use the word ‘visibility’ over the coming months), because none of us has been here before.

On the deflationary side, take the largest credit expansion in world history – an expansion that of course has now become a contraction, and the largest debt deflation in world history. On the inflationary side, take the largest fiscal and monetary infusions in world history. Then pay your money and take your choice.

Of course, there is a middle way. Since western governments have effectively extinguished cash as a meaningful asset choice, ‘twin primacy’ in investment terms goes to blue chip equities and high quality bonds. Arguably the best way of dealing with ‘ermflation’ – the sheer inability to forecast which particular threat will be the most severe, and over what kind of timeline – is to maintain exposure to both types of asset. Blue chip stocks offer a hedge, of sorts, against eventual inflation, given that they represent a claim on the real economy. Blue chip bonds (and the value is now firmly in the corporate credit market as opposed to government debt, unless deflation kicks in with a vengeance) offer a realistic hedge against deflation. The caveat in both cases is that extreme selectivity will be required. The recession we are entering is going to be peculiarly savage. We already know that the High Street will be awash with blood, and vacant lots, before it is over.

So the onus on investors is to use a particularly robust screening process to identify the probable winners and losers in the Darwinian economic marathon ahead. Measures like the Altman Z Score work for selecting both equities and bonds. Indeed the trick in 2009 will be to treat equities like bonds, as primarily income-generating assets (and something has to replace those deposit accounts at dodgy banks, which is to say all of them).

So if the stocks in your portfolio are unlikely to maintain their dividend, or worse still don’t even pay a dividend, you would be well advised to eject them with extreme prejudice. We are long beyond the simple pursuit of capital growth: A deflationary (or ermflationary) depression is an environment that demands a commitment to capital preservation, inasmuch as anything so concrete is achievable in such freakish economic and market conditions.

Positive straws in the wind ? High yield seems to have turned something of a corner, but there have been enough false dawns on the way here to be a permasceptic. (And last Wednesday’s troubled German government bond auction sets an ominous precedent for megaborrowers like the UK.) But perhaps the most promising development is that we have entered the last days of the presidency of George W. Bush – a politician who reset the bar when it came to defining ignorance and ineffectuality. Which in turn begs the question of whether any populace deserves the government it gets. Overmuch contemplation on that score is just too horrible to bear.

The third part of the investment triumvirate for 2009, now that Bernie Madoff has effectively destroyed confidence in funds of hedge funds, and given that the unavailability of credit has performed the same function for private equity, is real assets. As we wrote last week, commodities performed well in the 1930s, and history is showing every sign of repeating itself – though whether as tragedy or farce is for the reader to decide.

Comments

[reveigel@ms...:]

Take exception. Cause was not the private sector greed, but government sector greed. Uncontrolled and reckless spending by Congress year after year. Result, deficit spending causing inflation and the devaluing of pay checks and savings. Private sector added to the mess, but the leader of the pack was GOVERNMENT. And unless and until someone has the guts to tell the American people the truth about government this will go on and on and on. Deficit spending is nothing more than legalized counterfeiting. It make take a bit longer to make the bill worthless, but in time it will be worth zero.

Jan 09 04:26 PM

[Chris B:]

"So if the stocks in your portfolio are unlikely to maintain their dividend, or worse still don’t even pay a dividend, you would be well advised to eject them with extreme prejudice. We are long beyond the simple pursuit of capital growth: "

You'd love Sovran Self Storage (SSS). It yields near 8%. Of course, it pays those dividends by having a critically low current ratio of 0.5, negative cash flow, and issuance of new shares! I suppose a lot of people who used to own GM for the dividend own it now - yield chasers.

GE is borrowing from Buffett at 10% interest plus options so that it can afford to pay its shareholders a 7.7% dividend! If that sounds like a successful strategy for building shareholder value, jump in!

So much for yield-chasing!

Jan 09 05:24 PM

[dw57:]

this was private sector greed and stupidity abetted by public incompetence and stupidity. while we might not like having the government spend money to get us out of the private sector's creation, we know they won't get us out of the mess they created and they will continue to claim they had nothing to do with it. so far in 200+ years when have they ever fixed a recession or depression that they caused. the last depression also had some of the same private sector stupidity, and it took 10 years to resolve. by government spending no less.

Jan 09 06:10 PM

[Brutto:]

Excellent summary of where we stand, and of the uncertainties ahead. If we are going to be heretics, we might as well mention that other asset class that saw previous generations through crises - Real Estate. Talking of failed German Bond Auctions: Real Estate was one asset that would have protected your wealth even if you had been on the bombed out losing side of WW2.

Real Estate may get even cheaper from here, but if you don't commit the mortal sin of leverage you can hold it 'till things improve. With luck, you might even get a yield higher than Treasuries! Just stay away from commercial High Street lots: be virtuous, go for Residential and provide a shelter for all those foreclosed homeowners...

Jan 09 06:24 PM

[Moon Kil Woong:]

It is right to be bearish but wrong to think that if a company doesn't pay dividends they are not worth owning. It is important that a company has enough cash flow to survive a year without requiring more infusions, however, companies have averted dividends in order to maximize value and avoid double taxation for their shareholders.

Of course, with no one getting capital gains that is less important these days. But there are plenty of profitable companies that don't pay a dividend and even more who's cash flow is positive.

I wish the US government was one of them but if you care about cash flow you'd be running scared of a balance sheet like Uncle Sam.

Jan 09 08:19 PM

[Steve in Gr...:]

"...But perhaps the most promising development is that we have entered the last days of the presidency of George W. Bush – a politician who reset the bar when it came to defining ignorance and ineffectuality..."

How is this promising? He is being replaced by someone even more clueless and socialist. Finding someone more clueless and socialist than Bush is hard, the Democratic party has found him in Bambi.

Jan 09 11:36 PM

[John Lounsbury:]

Brutto - - -

Regarding you comment on real estate, I would like to add two cautions. If you bought a home or a farm in the 1920's, in some parts of the country you were underwater until the end of WW II.

My first caution is: To be sure of recovery of investment principal be sure you can have a time horizon long enough to cover any possibility.

Another example would be real estate values in many parts of Detroit have gone down precipitously over the past 30 years.

My second caution is: Location, location, location.

Jan 10 12:27 AM

[Anthony Alfidi:]

Exactly. Dividends are great because they're paid from cash flow and not something imaginary (like EBITDA) or temporary (like surplus cash from selling debt). The cash flow is the key, and it's still valuable if it adds to the retained earnings of a growth stock or privately held corporation.


On Jan 09 08:19 PM constructe wrote:

> It is right to be bearish but wrong to think that if a company doesn't
> pay dividends they are not worth owning. It is important that a company
> has enough cash flow to survive a year without requiring more infusions,
> however, companies have averted dividends in order to maximize value
> and avoid double taxation for their shareholders.
>
> Of course, with no one getting capital gains that is less important
> these days. But there are plenty of profitable companies that don't
> pay a dividend and even more who's cash flow is positive.
>
> I wish the US government was one of them but if you care about cash
> flow you'd be running scared of a balance sheet like Uncle Sam.

Jan 10 02:53 AM

[Sigmund:]

Looking for culprits? Begin with the mirror. In great or small ways we all are all responsible. By action and inaction the body politic has managed to spend more than we can reasonably repay. So now we must do a bankruptcy and extinguish the excess quantity of loanable funds; i.e., outstanding loans. The quickest way to do so is by not providing solvency to insolvent institutions and enterprises. That means a very deep recession, quite probably a depression. Call it what suits you sensibility, a deep contraction is only the beginning of what needs to occur.

Jan 10 08:20 AM

[willynill:]

I agree with Steve in Greensboro. In ten years, I will buy lunch for this author if Bush's legacy doesn't outmatch Obama's.

Jan 10 08:46 AM

[WD:]

Steve in Greensboro is 100% right on. I think the American people are watching too many movies as in the last two elections they elected dumb and dumber.

Jan 10 09:51 AM

[secmaven:]

All dividends are not created equal. If the dividend is funded by depreciation cash flow the shareholder is just receiving a return of capital. And if the company borrows funds to make its capex and pays a dividend at the same time the dividend is actually being paid out of borrowed funds. When lenders realize their money is simply being passed on to the shareholders that is when the credit dries up. et tu Brutus.

Jan 10 10:31 AM

[ferguson:]

The whole story of the Bush administration is the story of Brownie at FEMA. Yes, they all did a great job, but the result is catastrophe. Obama brings a pragmatic outlook and intelligence to the job. If he doesn't do a better job than Bush, none of us will have enough money in eight years to buy lunch.

Jan 10 10:43 AM

[Mongoose:]

I have often wondered how NERO could sit idly by and fiddle while ROME burned. Now I know because I have seen with my own eyes over the past 8 years. If you live long enough all questions will be answered. Hopefully we will learn from our mistakes.

Jan 10 11:47 AM

[Steve in Gr...:]

Sell signal, big time.

Note the +2 -5 on my comment about Bambi being more socialist and clueless than our RINO-in-chief Bush. This shows that there are a lot of people who have ridden the market down during 2008, expecting that the Obamessiah will solve things. They are going to get hammered further in 2009 (along with any who is long U.S. equities) as Bambi and his fellow Democrat-rocket-scient... in the Congress implement their green technologies, union-card-check, socialized healthcare, etc.

Sell, sell, sell U.S. equities during 2009 and then U.S. dollar denominated assets generally in 2010 as inflation kicks in.

Jan 10 01:17 PM

[Obama is Bu...:]

"...But perhaps the most promising development is that we have entered the last days of the presidency of George W. Bush..."

This sounds like any January rally should be used to trim one's market exposure. No matter what Obama's strengths or weaknesses, no human being could possibly live up to the Obama hype.

Both Hilary Clinton and John McCain complained that Obama made "soaring speeches" in which he essentially said nothing. This might have been a great campaign strategy, but now Democratically leaning newspapers are running op-ed pieces saying (in so many words) "Obama, the election is over -- its time to get specific"

Very much like George Bush, Obama doesnt have any plan. Not a good plan, not a bad plan, not a medium plan -- just no plan. Speeches are great on the campaign trail, but once you sit in the Oval Office, you have to have a plan in order to lead.

Members of Congress from his own party (Barney Franks, Waxman, Pelosi, etc) are constantly on TV acting quasi-presidential in advocating new economic policies. Obama's first task will be to simply convince everyone that he is actually in charge -- and he has to put members of his own party "in their place" to do that.

Lots of people like to blame Bush for his handling of hurricane Katrina... In the run up to the Gulf War, it took the US military about 5 months to move 500,000 troops into the Iraq theatre. Military personnel are trained and equipped to be very mobile, they are in better physical condition than the general populace, and the military transport system is geared around moving troops to/from the battlefield. The military has a very clear chain of command.

New Orleans (never mind Alabama and the rest of Louisiana) had a population of 2.5 million people (five times the number of military personnel moved above) -- including elderly, sick, babies and others who cannot move themselves. I imagine the people of New Orleans are as healthy as the rest of the country -- but as a general statement not in as good physical condition as military members. The military spent five months moving to Iraq; New Orleans had about 8-10 days notice of Katrina. And lastly, there were (and still are) disputes over what resources are controlled by FEMA and which are controlled by city and state officials. Everyone wants to pass the buck on Katrina -- and they are able to do so because there was no clear chain of command.

New Orleans was built below sea level, with highways that could barely handle daily commutes never mind full evacuations. The city's desire to collect more property taxes made them develop the wetlands on the outskirts of the city -- reducing protection from the sea and limiting areas where water could drain without effecting residents.

I am not trying to exonerate FEMA/Brown's behavior -- I am just saying that there is no precedent for evacuating an entire city full of people (2.5 million people, including elderly, etc), on 10 days notice, to an undefined place, with no clear chain of command. It took the military 5 months to move 1/5th as many well trained, well equipped troops that were in condition to move themselves. Even if Brown had done an effective job, the infrastructure of New Orleans was almost designed to be a major problem.

Obama faces a similar issue with the US economy. We have too much debt already. We really on credit to over-consume / live beyond our means. Clearly, any real solution involves more savings and less consumption -- but that solution will exacerbate the recession in the short run. Our lack of savings makes us completely at the mercy of foreign creditors.

Even if Obama does a "perfect job" (assuming we could agree what that is), the "infrastructure" of our economy will not allow a pain free outcome.

Even if Obama rises to the challenges of the Oval Office, expectations are far above what any man (or woman) is able to do.

Jan 10 02:42 PM

[digitaldorobo:]

What's wrong with socialized healthcare? Here in Canada we have universal healthcare (and I don't know any Communist Party members, lol).

Is it better for an economy if people go bankrupt by not being able to pay their medical bills?



On Jan 10 01:17 PM Steve in Greensboro wrote:

> Sell signal, big time.
>
> Note the +2 -5 on my comment about Bambi being more socialist and
> clueless than our RINO-in-chief Bush. This shows that there are a
> lot of people who have ridden the market down during 2008, expecting
> that the Obamessiah will solve things. They are going to get hammered
> further in 2009 (along with any who is long U.S. equities) as Bambi
> and his fellow Democrat-rocket-scient... in the Congress implement
> their green technologies, union-card-check, socialized healthcare,
> etc.
>
> Sell, sell, sell U.S. equities during 2009 and then U.S. dollar denominated
> assets generally in 2010 as inflation kicks in.

Jan 10 08:50 PM

[Jim in Ohio:]

Obama will have to capture the hearts and minds of the American people. He will also have to convince the economies around the world that everything will be ok. Essentially, having faith in what he says. Kennedy did this in the 60's but an opposing side with the power and might to stop in dead in its tracks. Pray with all your might that he will make it to the Presidency. We need a leader to give us hope and guide us into the next 4 years and beyond.

Jan 10 11:28 PM

[Obama is Bu...:]

digitalrobo - Your comment is a half truth...

Canada's healthcare system is heavily subsidized by Canada's oil and natural gas exports. Canada also has a much smaller population. The U.S. population is much larger (requiring more resources) and we import 40% of our energy needs --- indeed Canada is our #1 supplier.

Canada relies on "free" pharmaceutical research... or to be more blunt, the U.S. pays for you. Try paying for your own research before telling us how great you think you are.

Lastly, Canada has **TWO** healthcare systems. One for the rich (who travel to the United States or Asia for anything other than emergency care) and the government one for the poor. That is hardly a healthcare system anyone should brag about

Jan 11 10:25 PM