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Joseph has been an analyst, investor, and student of economic theory; money and banking; and statistical methods for evaluating and implementing risk/reward trading algorithms since 1972. Joseph is also an occasional contributor to financial publications and his essays are frequently cited by... More
  • The Efficiency Dilemma  2 comments
    Dec 27, 2012 5:30 AM | about stocks: DIA, QQQ, SPY

    As we near the date certain where tax hikes and spending cuts -- approved by both parties and signed into law by the President in 2011 -- as a means of dealing with runaway debt and deficit I continue to wonder what would work to stimulate real growth. I have asserted on a number of occasions that no solution exists to turn the tide and put the economy on a real growth path.

    I am not in the camp that assumes political dysfunction - at least as it relates to the current dilemma - is the reason for inaction in Washington. The real reason politicians are at odds is that no viable solution exists that will avert recession. I will explain why I see it that way in a moment but assuming I am right, the political discord in Washington has more to do with political posturing than disagreement on how to resolve a problem that has no resolution.

    As I see it, all parties involved are doing what they can to position themselves in a way that allows them to blame the other side when the inevitable jump off the "cliff" and into recession occurs. The crux of the problem is that our economy has been on life support since the recession and the patient - our economy - remains in a coma with very little signs of being able to survive once the life support - fiscal stimulus - is taken away.

    I would advocate for such a continuation of fiscal stimulus if I saw any real signs of growth that would suggest the economy is showing signs of life but that is simply not the case despite the "rose colored glasses" view that almost all pundits take on the matter. To most, the resolution to the problem is simply for Congress to act responsibly and continue the policies of the last several years. That, in my mind, is every bit as irresponsible as the spending cuts and tax hikes that go into effect in January.

    First, consider that we have had a very modest growth in GDP since the recession and GDP is the fuel for growth and corporate profits. The result of that modest growth coupled with massive lay offs is that corporate profits have been remarkably strong in an environment where the unemployment situation is the worst it has been since the Great Depression. The consequence of that dynamic is that we are currently within a stones throw of all time highs on the major indexes.

    On October 9, 2007 the Dow Jones (NYSEARCA:DIA) peaked at 14,164. As I write this the Dow is trading at 13,142, just 7% below the 2007 high. The S&P 500 (NYSEARCA:SPY) peaked on the same day in 2007 at 1565 and is currently trading at 1423 and 9% below its all time high. The Nasdaq (NASDAQ:QQQ) composite peaked on September 21, 2012 and is currently trading at 2990 and 6% under its all time high.

    The "Efficiency dilemma"

    To explain my "Efficiency dilemma" thesis one must first take an objective look at where we are today and how we got here. The following chart sets up the discussion:

    (click to enlarge)

    What we see here is an economy that is growing - modestly for sure - but it is growing. Typically GDP growth comes from a very modest rate of inflation from a macro perspective. As wages go up and prices go up that translates into higher GDP. Population and labor participation also play a factor. As more are employed more have paychecks and as those paychecks are spent on goods and services it increases GDP.

    What the above chart shows us is that GDP growth has occurred but it has not been driven by high rates of employment. To the contrary, GDP has grown even as unemployment levels have shot higher. In fact, it hasn't been driven by inflation either as the Fed policy of quantitative easing has not produced inflation.

    It is the classic Keynesian liquidity trap. The Fed's attempt to induce inflation has not worked as banks aren't lending and consumers aren't borrowing and please don't tell me that your neighbor just closed on a new loan to buy a house. I am talking macro numbers here - not the insignificant example that one might use to disprove my thesis. The truth is excess bank reserves are at unprecedented high levels that literally work to dwarf all other periods in our history. M2 velocity is another metric that drives home the point that Fed policy is a bust. M2 velocity is at a 50 year low.

    So, how then have we been able to push GDP higher? The answer is obvious for anyone who is willing to examine the data. The only way we have managed to push GDP higher in spite of depression level unemployment is that those who aren't employed have remained in the consumer pool thanks to massive government stimulus programs. We have simply subsidized the unemployed through deficit spending that has ballooned to almost double the post recession levels in the last 4 years.

    I used the following chart in another article recently as a way of demonstrating the "catch-22" dilemma facing Congress today:

    (click to enlarge)

    To construct the chart I plotted the real GDP quarterly change in dollars and then reduced that number by the amount of the quarterly deficit. It is my attempt to show the impact of fiscal stimulus and the consequence of withdrawing that stimulus. The chart establishes that absent massive fiscal stimulus we would be in big trouble. I would suggest that we are still in big trouble and that Congress knows it and they know the outcome and therefore we see no action on the matter of the "fiscal cliff".

    We are in a unique situation with little in the way of historical precedence. The sheer magnitude of deficit spending is hard to comprehend. The only other time in our history that this has occurred was during World War II. The two situations aren't comparable though in that we needed workers to get back to the matter of producing goods and services for the consumer once the war ended. At the end of World War II we simply re-tooled the system for a peacetime economy. Unemployment from 1945 to 1960 ranged between 2% and 5.5%.

    So, to the point - we have become a very efficient producer of goods and services in that we have been able to produce at levels sufficient to supply 100% of the economies demand for goods and services but we have done so while employing only 85% of the workforce. Again, a situation that is unprecedented in our history.

    The truth is that only 85% of our workforce population is employed using the U6 number but to date close to 100% of our workforce population remain in the consumption pool thanks to massive government hand outs. Simply stated, we can meet the consumption demands of our society as if full employment were the reality but we don't need the 15% that are unemployed to do so. That is what I refer to as the "Efficiency Dilemma".

    Arguments that suggest companies will begin to add workers as signs of economic growth begin to appear in the data are strongly refuted by the large number of companies that have issued or are preparing to issue pink slips. The truth is demand must precede hiring. Absent demand that exceeds a company's capacity to meet that demand companies won't hire. It is significant that companies have discovered that they could move to a "lean and mean" business model and still manage to meet demand in the post "Great Recession" era.

    That leaves us in a real conundrum. If we elect to withdraw stimulus then demand will contract further resulting in more layoff's and a rapid recalibration in stock prices. That will only serve to exaggerate the business model currently being employed by companies that calls for rapid response to a drop in demand with additional cost cutting measures which means layoffs.

    The inconvenient truth is that absent massive debt and deficit spending we would have remained in recession. To date no significant metric suggests that we can continue to register positive GDP growth without that fiscal stimulus. The one thing that both sides in the debate agree on is that we must begin to tackle the problem of deficit spending in some manner. The only question is how much and where do we find the money to cut the deficit.

    Here is another problem as it relates to cutting the debt. If we do so - even on a limited basis - we won't really accomplish very much on the debt trajectory problem but it will have massive repercussions on the economy. Consider that even the full measure of the "fiscal cliff" reductions in deficit spending will only work to reduce the deficit by $600 billion. In August of 2011 Congress approved a $2.1 trillion debt ceiling hike. That money will be gone in January or February. That means we have spent $2.1 trillion in 18 months.

    That works out to $1.4 trillion a year on average in the last 18 months - not $1 trillion as most pundits and politicians want to suggest. A $600 billion reduction - that is the full magnitude of the "fiscal cliff" measures - leaves us with a national debt that is still growing at a rate of $800 billion a year. Using $16 trillion as the approximate level of GDP on an annual basis, $800 billion works out to be 5% of GDP.

    Since GDP growth has been no more than 2% in the better quarters (since the recession) and with no reason to think that number will improve, we are left with an annual 3% increase in debt to GDP even after the full measure of the impact of the "fiscal cliff" measures. Is it any wonder that Congress seems stuck in neutral?

    The implications and solutions are not obvious

    As I conclude my remarks I am watching the Dow rally back to the unchanged level after being down most of the day. We are now 3 business days away from the deadline on the "fiscal cliff" that everyone acknowledges will plunge us into recession. I am also taking note of the fact that we are still relatively close to all time highs in the major indices.

    The ability to rationalize the horrendous dilemma we are in continues to amaze me. As a 40 year veteran of the markets I have been astonished at the irrational nature of stock traders over the years but never have I seen a market so resistant to pricing in reality.

    I am certain that the points I have made here haven't been missed by Ben Bernanke, Tim Geithner or many of the others in Congress. It is my opinion that the only way we end up correcting this situation is through the process of completely revamping the global financial markets. The United States is in the unique position of being a reserve currency nation and that presents a particularly troubling dilemma.

    The dilemma is referred to as The "Triffin dilemma" and argues against the use of any sovereign nation's currency as a reserve currency. The "Triffin dilemma" recognizes the inherent problems of correcting domestic issues with a monetary policy that may not be good for the global economy. The subject deserves considerable attention and limited space prohibits a full discussion of the dilemma.

    The gist of the problem though is that domestic policy in difficult times would suggest an easing of monetary policy - in other words an expansion in the supply of dollars. An action to expand dollars works to devalue the dollar and theoretically stimulates exports. The problem is that a weak dollar can produce detrimental effects to those nations who hold dollars as a reserve currency. The United Nations has weighed in on this subject at some length and advocates the use of "Special Drawing Rights" issued by the IMF as an alternative to the US dollar.

    The UN has made a number of very astute observations in its Trade and Development Report, 2009 and is worth reading. The following observation -- made 3 years ago -- tends to support my thesis on the "Efficiency dilemma":

    "The likelihood of a recovery in the major developed countries that would be strong enough to bring the world economy back to its pre-crisis growth path in the coming years is quite low. This is because neither consumption nor investment growth can be expected to revive significantly due to very low capacity utilization and rising unemployment." (emphasis added)

    The report also supports my position that the stock market has become irrational. The following excerpt expresses my own sentiments:

    "Financial market participants act on the basis of centralized information that is quite different from the disparate sources of information on normal goods markets. The large majority react to the same set of "information" or "news" with very similar patterns of taking on or unwinding of their exposure to risk.

    Speculation of this kind leads to upward and downward overshooting of prices, or even to price movement in a direction that is not justified by fundamentals. This causes lasting damage to the real economy and to the international trading system." (emphasis added)

    The United Nations presents a very well articulated agenda and a view of the global macro picture that is decidedly different from what one hears or reads from the pundits and the politicians. Their assessments on the problems we are faced with on a global scale aren't based on a "rose colored glasses" perspective.

    I am not sure I am in agreement with that agenda but I do suspect it is being implemented behind closed doors. Crucial to the implementation of the agenda is a systemic shock to the global economy that will lead those opposed to the agenda to finally relent and accept change.

    I don't suggest that the current dilemma - the "fiscal cliff" - is a manufactured event that was intended to lead to the systemic crisis that results in a new "Bretton Woods" type agreement. That said, I do think our policy leaders are finally coming to the conclusion that a global central bank and a new reserve currency - probably the IMF "Special Drawing Rights" units - are going to be needed to deal with the one world economy that has become reality in recent years.

    I admit that I could be wrong but one must ask if the reward justifies the risk in this case. If in fact, our policy makers have made a decision and simply failed to inform us based on the political ramifications of doing so, I suggest the risk to long side stockholders is huge if we do in fact enter a phase of self imposed austerity. If I am wrong and they intend to continue with the same failed policies I still think the risk is huge as the policies of recent years have failed and a continuation of these same policies offers little support for higher stock prices.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Additional disclosure: I am short a group of tech stocks, financial stocks and curde oil. I am long VIX.

    Stocks: DIA, QQQ, SPY
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Comments (2)
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  • Petelovesamy
    , contributor
    Comments (178) | Send Message
    I am long VIX
    2012, slowest year in the last 12 ! .......The Fed is the enemy of both, "bull" & " bearer" !
    29 Dec 2012, 02:41 PM Reply Like
  • Vermontistan
    , contributor
    Comments (29) | Send Message
    "The real reason politicians are at odds is that no viable solution exists that will avert recession."


    22 Feb 2013, 05:04 PM Reply Like
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