Has 'The Trampoline Effect' Come to an End?

After reading Peter Schiff's latest blog, I returned to a theme that I dwelled upon shortly before the crisis hit last October. It was easily evident to me that Greenspan and the Bush Administration in their infinite wisdom had not only deflated the tech bubble, but used that hot air to inflate not just one, but several bubbles in what I label a 'trampoline effect', ostensibly to raise morale at home during the 'war on terror'. Abnormally low interest rates had the effect of enabling leverage that, combined with Wall Street's hubric assessment of its risk-management capabilities, inflated the housing market -- when housing also began to deflate, the hot air transferred to commodities and emerging economies. One could argue that the reason the fall is so perilous this time around is because the consequences of the past bubbles have yet to be fully felt.

Jeremy Grantham has noted in several interviews that none of the recessions of the past 10 years approached his predictive models of where the S&P 500 would be to give him a clear buy signal. Grantham is important because he has called not only the point of decline with astonishing precision, he also was able to place the finger of blame on entities that, upon retrospect, the general public agreed were the parties responsible. It's quite possible he was slightly off on this aspect of his prediction because he underestimated the lengths to which the Fed would protect America from the negative effects of deflating the bubble.

To put the bubble into our trampoline-speak, every time the markets were headed down, it actually provided momentum for the next big jump upward, given that the cheap money sloshing around remained cheap, and some other sector of the economy remained exploitable. However, the exhilarating ride on this trampoline seemingly has come to an end, along with the severing of the leverage umbilical cord that America at all levels had come to depend upon...or has it?

There's so much commentary out there about 'deleveraging' and the Obama Administration's approach to handling this crisis, that I will only gloss over a play-by-play handling of this affair. However, it is poignant to note that the Keynsian solution favored by Obama has nothing to do with the deleveraging favored by many economists - indeed, the administration's solution is to incur more debt, encourage more spending, and hope that somewhere in this economy there is another type of investor out there [besides most hedge funds, Wall Street principle accounts, China, or taxpayers, all of which are now saddled with either mistrust or decimated assets] that can pick up the slack before the government runs out of ammunition. What this will do is essentially place responsibility of the economy NOT on the collective heads of all of the producers and consumers of our great country, but on the Federal Reserve, and to the lesser extent, the government in general. This has consequences in that the people of America, who so need a correcting of their profligate ways, will not correct, but will simply accost or give credit to the Fed as they see fit. This is dangerous.

I have come to the conclusion that the Fed, while sincere in its efforts and probably mostly correct in its analysis, is indeed the central problem in this scenario - the Fed IS the trampoline. Just think about what the Fed (and to a lesser extent Treasury) has done to combat this crisis along with the tech bust:

1) The Fed lowered interest rates to unprecedented levels in both 2002 and 2008, thereby bolstering inflated demand through easy money.

2) The Fed this time around was not done yet - it has also printed trillions of dollars in order to inject good money to commingle with the bad in zombie banks. These banks were not allowed to naturally fail because they need to be around to propel the next artificially propped up rally.

3) As if this was not enough, the Fed this time around has spent hundreds of billions of dollars to bring down the long end of the yield curve, thereby indirectly providing 'easy money' once again to homeowners that so desperately need to correct their spending habits - instead they are encouraged to continue to rely on the credit markets to sustain their unsustainable consumer binges.

4) Obama now is attacking credit card companies by, you guessed it, forcing them to provide 'easy UNSECURED money' in the form of low rate credit cards.

I hope my theme is clear. The Fed, and of course the political establishment that wrote its mandate, has become an animal of appeasement. Its original purpose was to encourage or discourage borrowing so that the economy could chug at a sustainable level, but something terribly wrong has happened...it has decided to go hog wild with Keynsian spend-and-inflate economics without really asking whether or not the economy could sustain such binges. This type of solution just happens to be very palatable to politicians, Wall Street, and Main Street (or at least the portions of Main Street that directly benefit), making the consequences of these actions seem less significant.

What this may mean is that bears such as Grantham may again look somewhat foolish, in that the Fed might successfully inflate not only bank balance sheets, but also confidence in the American economy - the market braces, and then unleashes all of its energy to 'jump' to new highs and leaves all doom-and-gloomers in the dust. The key would be to spot another bubble, and more importantly, to have the funds readily available to take advantage of it. Here the argument would seem to favor perma-bears, in that debt seems to be the cause of our current troubles, and because of our current debt loads, funds are more than likely not going to appear like magic from our local banks.

Whether or not this time around is THE time, the day of reckoning will come, and on that day, the people who lead our government need to be able to do the right thing, even if their survivability at their job is at risk. The recent track record is not good - I think Ken Lewis has provided the answer on what our leaders are choosing right now - he was not threatened with the dissolution of BofA shareholder interests when challenged by the government over Merrill - he was threatened with the dissolution of BofA (BAC) management! He took the selfish way out, and sold out the parties who put their trust in his management skills. We can only hope that the same is not true for Obama, Geithner, and Bernanke, but remember that Geithner and Bernanke, along with Hank Paulson, were intimately involved in the meltdown that occurred during Sept/Oct of last year. There's a decent chance that there's still something rotten lurking about in the administration.

So, after analyzing the prognosis, what is the treatment? That's a very tricky question. It's probably a combination of what the Fed is doing to stimulate borrowing, as well as a repairing of consumer balance sheets. However, the fact is, with choice comes consequence, and we have chosen as a whole profligacy, and unless the Fed is willing to inflate our debt to nothing (which is akin to one big bounce on the trampoline and never coming back down to earth), we will simply have to endure something similar to what Japan endured in their 'balance sheet recession'. (note - I've yet to read Richard Koo's book, but have listened to and read various essays and commentary on it)

When it comes to America, I'm sorry to say, but caveat emptor. That has been the M.O. for Japan for the last 20 years, we can only hope that our time in the pressure cooker will be more swift. Lastly, notice that Buffett has been a net seller of US common - he's bought a lot of exotic stuff (for him), but NOT EQUITIES.

Disclosure - long emerging markets and underpriced, high-quality balance-sheet stocks in the US.

Comments

[abetterplace:]

I prefer calling it a "safetynet". Being that it is not held as correctly as possible, it sure beats splatting the concrete if you're the one falling.

May 11 08:08 AM

[JMac:]

"the hot air transferred to commodities" was more likely a perceived price increase in the USA that was more an adjustment to a decliing dollar.

May 11 08:27 AM

[farmer448:]

The last time this crazyness went on Volker pulled the plug.

May 11 08:50 AM

[Insiderman:]

You can trace how spreading the failure of a few through the pockets of the many is PRECISELY the problem. Sure it hurts to hit pavement, but fools will learn in no other situation. Only when we all hit the pavement do we learn not to trust government with the solution to all our problems.

And we are certainly heading for the pavement on this one. But rather than have a few well-monied individuals lose their money, the government has doomed us all to years of economic atrophy and stagnation at best.


On May 11 08:08 AM abetterplace wrote:

> I prefer calling it a "safetynet". Being that it is not held as correctly
> as possible, it sure beats splatting the concrete if you're the one
> falling.

May 11 08:52 AM

[mrpitchfork:]

Why isn't there anyone trying to prosecute these dirtbags that caused this economic melt down? Why do we keep letting the Federal Reserve get away with their shenanigans?

May 11 08:56 AM

[axelrod608:]

>> "This is dangerous..." >> Best line of an overall good article.

When the Fed makes cheap money available, the folks with the most extravagant and least conservative business plans scoop it up and run with it. Chaep money is the problem, not the solution.

When money is dear and hard to get, investors use it cautiously and conservatively. When it flows like booze at an open bar, trouble is coming.

This entire mess is the result of Fed policy.

May 11 08:59 AM

[Ricard:]

I used to agree with you. But, given the amount of stimulus the government has pumped through the safety net over the past several years, it now more resembles a trampoline, because with each landing and subsequent jump higher, the situation becomes more perilous.

On May 11 08:08 AM abetterplace wrote:

> I prefer calling it a "safetynet". Being that it is not held as correctly
> as possible, it sure beats splatting the concrete if you're the one
> falling.

May 11 09:08 AM

[James E Gam...:]

Bernanke/Obama rescue plan is working!
1. Loan Billions to worthless companies
2. Worthless companies give Millions to incompetent executivies
3. Incompetent executives buy Thousands of stock shares
4. Tax paying individuals agree to cover all costs
5. The New World Order is a success.

May 11 09:15 AM

[Roger Knights:]

"debt seems to be the cause of our current troubles, and... whether or not this time around is THE time, the day of reckoning will come ..."

We've shopped ...
... until we'll drop.

May 11 09:28 AM

[Investorazz...:]

"What this may mean is that bears such as Grantham may again look somewhat foolish, in that the Fed might successfully inflate not only bank balance sheets, but also confidence in the American economy - the market braces, and then unleashes all of its energy to 'jump' to new highs and leaves all doom-and-gloomers in the dust."

Not too foolish. Grantham acknowledges the possibility of a new bear-market rally in his latest quarterly newsletter...

May 11 09:48 AM

[Missing_Link:]

> I hope my theme is clear. The Fed, and of course the political
> establishment that wrote its mandate, has become an animal of
> appeasement. Its original purpose was to encourage or discourage
> borrowing so that the economy could chug at a sustainable level,
> but something terribly wrong has happened...it has decided to go
> hog wild with Keynsian spend-and-inflate economics without really
> asking whether or not the economy could sustain such binges.

Could it be any clearer at this point that the Fed is doing this intentionally, at the urging of the newly-elected government Democratic government that pushed so many of these policies onto the banks and the Fed in the first place?

The government had a "very good crisis," in the words of George Soros, when the subprime crisis, the credit crunch, and the 2008-09 stock market decline happened, and was able to use the crisis to push their agenda.

They're planning carefully to have a "very good crisis" when the other shoe drops as well.

May 11 12:04 PM

[sidestick:]

If I'm not mistaken it was our government under Republican (alleged "conservative") control that spent like a drunken sailor, prominently on an "off budget" war while cutting taxes. We had a Vice President who pronounced, "deficits don't matter!" and a President who encouraged us to support the war effort by going shopping! And please don't forget that TARP was initially asked for and (mis-)managed by the same Republican administration. The current Democratic administration was left with very few arrows in the quiver; some type of fix had to be pursued and they chose this one. Maybe it'll work, maybe it won't, but I imagine many of you would gripe no matter what program was chosen.

Did the Republicans really think consumers could keep spending forever? If they didn't why didn't they fix the problems with legislation while in power? If they did think consumers could spend forever then there's a serious disconnect in the Republican party between philosophy and reality.


On May 11 12:04 PM Missing_Link wrote:

> > I hope my theme is clear. The Fed, and of course the political

May 11 03:14 PM

[Alphameister:]

It seems to me the "permabears" (Schiff, Grantham, et al) have been forecasting economic Armageddon in connection with each of the busted bubbles of the past 35 years, only to see their gloom/doom undone by yet another bounce off that metaphorical Fed trampoline you've introduced into the discussion. Having seen the previews so often, some bears clearly have begun to worry that there might be one more bounce off that trampoline before things ultimately come undone.

I can't see a bounce to new highs. Instead, I see, at best, a series of bounces of diminishing amplitude such as would be seen at the end of a trampoline experience that does not end in disaster. I do not rule out the possibility of a disastrous end to this economic mess, but I'm more inclined to expect a frustrating period of sub-par economic performance analogous to the Japanese experience of the past generation but not as bad.

When the Fed pumps massive amounts of money into the economy, prices usually rise somewhere. I've been delighted to be a beneficiary of inflation in the stock market thanks to Fed largesse. I believe a cyclical bull market has begun that has virtuallly no chance of surpassing prior peaks before yielding to a cyclical bear within a secular bear market.

Despite the awesome future challenges posed by quantitative easing, I do not expect hyper-inflation. I do believe there will be a contentious political debate as to the degree of inflation deemed tolerable, possibly posing a threat to the independence of the Fed. Some will want a higher inflation rate simply to reduce the effective debt burden. But none of the powers that be will countenance hyper-inflation, and the Fed has the tools to prevent it.

It could not be more clear to me that Obama poses a huge threat to corporate profits and economic prosperity over virtually all time frames. He will need tremendous tax increases in engineering his socialist programs, and there just aren't enough rich folk in this country. He can't tax the lower and middle classes directly, but he will tax them indirectly through the inflationary burdens his "team" will impose on employers.

So, notwithstanding my belief that the current market advance has further to run (after a pause that refreshes), I'm placing most of my equity bets in emerging markets that seem to be moving toward capitalism and away from socialism about as fast as the US is moving in the opposite direction.

May 11 05:43 PM

[Ricard:]

A very well-reasoned approach. Your viewpoint almost mirrors my own, all the way down to the application (buying emerging markets). Good luck with your investments.

On May 11 05:43 PM Alphameister wrote:

May 11 07:01 PM

[Ricard:]

investorazzi:

Good point. I've noticed that Grantham is very good at hedging his predictions - either an S&P of 600 (33% chance) or an S&P of 900 (66%) - he's right either way, I suppose. He also seems a lot more methodical on the surface than, say, Buffett, whose Coke-binging apparently led him to his most famous investment. I still remember Grantham joking about his models, how they may be wrong, but they certainly are precise. Contrast that with Buffett, who would rather be approximately right than precisely wrong.

Sidestick & Missing_link:

Not sure about the political angle - I just noticed that my article seemed to lay all of the sh*t on the doorstep of the current administration. I'll just simply say that Paulson (a Republican) was the instigator, with his rather bold request for nearly $1 trillion back when such numbers really numbed people.

May 11 07:08 PM

[Old Trader:]

I tend to agree with Alphameister. It certainly appears that we might be at the start of a second decade of "going nowhere".

May 11 08:55 PM

[Ricard:]

Your point is one of several causes. Disruption in oil supplies, coupled with (IMHO) over-inflated, irrational fears that China would quickly out-pace the US in oil demand, and misbegotten energy policy decisions like food-based ethanol are other causes that led to a boom in commodities.

On May 11 08:27 AM JMac wrote:

> "the hot air transferred to commodities" was more likely a perceived
> price increase in the USA that was more an adjustment to a decliing
> dollar.

May 12 02:14 AM

[Ricard:]

This is slightly nuanced, but my main point was to advocate a gradual weaning off of the Fed's influence. People need to learn to take responsibility for themselves, and over the past six months, I've seen far too many instances of people blaming the government, and specifically the Fed. Hell, even Paulson did it.

I think the Fed's doing what they ought to be doing. However, the Fed can do circus tricks as long as they want to, and still not be able to fix the economy. That, lies with you and me.

Japan has been doing it for nearly 20 years now. The most interesting fact I got out of Richard Koo's work is that apparently the living standard of the Japanese barely changed, even though the asset bubble gradually deflated to a small fraction of its size at the height of their boom.


On May 11 08:59 AM axelrod608 wrote:

> >> "This is dangerous..." >> Best line of an overall good article.
>
>
> When the Fed makes cheap money available, the folks with the most
> extravagant and least conservative business plans scoop it up and
> run with it. Chaep money is the problem, not the solution.
>
> When money is dear and hard to get, investors use it cautiously and
> conservatively. When it flows like booze at an open bar, trouble
> is coming.
>
> This entire mess is the result of Fed policy.

May 14 11:21 PM