Tuesday, May 10, 2005

Bill Cara: Capital Markets & Social Equity

Bill Cara produces one of the best market blogs. I enjoy reading it daily. Many days I disagree with his point but he does a great job of making the point. Sometimes I agree with his point but disagree with the points he argues to reach the conclusion. I think in many cases, Bill has the sixth sense required to recognize a good trade without being fully sure of the reasons the trade is good.

I wrote earlier today that we are nowhere near inflation. I wrote the the nominal GNP is growing at about 6.2% and real GNP is growing at about 3.4%. A real GNP of 3.4% is certainly not stagflation. Furthermore, I wrote that the flat yield curve is forecasting a slow down in the economy and or a slow down in the inflation rate. Bill writes, "...and economic growth is slower than the inflation rate, which is classic 'stagflation".

The truth is that no one knows which is going to slow more, the inflation rate or the economic growth rate. At the same time, we have corporate revenues and profits growing far more rapidly than the naysayers projected. Finally the growth in the job market and the growth in revenues is forecasting a pick up in GNP. My guess is that it is inflation that is getting ready to slow down.

Productivity, four years into the recovery, is still extremely strong. We simply cannot have strong GNP growth, strong productivity growth, high inflation and low long-term interest rates at the same time. The case can be made and has been made for the past two years that long rates can't stay down. The worriers lost that battle so now they worry over stagflation. Of course long-rates will eventually go up but after the majority has stopped expecting them to do so.

Bill suggest that consumers are about to hit a credit wall. On the one hand, I am tempted to agree simply because the second half of an economic recovery is traditionally a time when consumer credit is crowded by the strong demand for corporate borrowing. Indeed the demand for commercial paper has skyrocketed in recent months as capital spending has grown rapidly.

On the other hand, consumers are no where close to maxing out real estate credit lines. The value of real estate in this country went up almost a trillion dollars in the past 12 months. No, the "t" was not a typographical mistake. The "t" was a bit of an exaggeration but not a typo. Baby boomers are still buying second homes and echo boomers are still buying first homes. Until this real estate boom is over, you can count on consumers feeling wealthy. Those who bought homes in hot markets last year can refinance this year and withdraw enough to buy a couple of Mercedes if that is what they want. The total payment will be far less than if they financed the Mercedes directly. Yes, there is a train wreck built-in if enough folks go wild but the ability to tap these funds is there now.

The reality is that consumers are spending at a relatively low rate versus their disposable income. Consumers have not increased the percentage they owe against credit cards for quite some time.

During the 1990's, the auto companies turned the increase in interest rates upside down. Prior to the '90's, business borrowing in the expansion phase caused rates to rise and crowed-out consumers. In the 1990's the car companies offered zero rate loans. The high interest rates caused consumers to think they were getting an extra special deal on a car. Of course the car companies bought down the financing.

I agree with Bill in that I am not looking to invest in consumer lenders at the current time. However, this has nothing to do with stagflation. I believe we are in a period of strong economic growth with continued high productivity. A period when long-term stock investors will do very well.

James O'Shaughnessy has written in wonderful books and articles that investors should practice the keep it simple strategy. He is very right. The simple things to know now are that stocks are cheap relative to bonds and real estate and that out of favor stocks tend to do better than hot stocks.