Monday, September 10, 2007

HUMP 1, HUMP 2, HUMP 3, HIKE

The business cycle is composed of three humps. Hump one is a sine wave of the stock market. The stock market leads the second hum, the economy sine wave, typically by 6 months to a year. Therefore, stocks typically take off to the upside right in the middle of a period of economic weakness. While The economy lags the stock market it leads the third hump, which is the commodity sine wave.

Many stock market investors pay little attention to commodities as an indicator. They listen to the news about oil futures contracts without appreciating that futures contracts lead spot prices of commodities and often accept rumors of $1,000 gold or $100 oil as gospel.


KEEP YOUR EYE ON SHORT TERM INTEREST RATES!

Short term interest rates rise and fall in step with the commodity wave. Thus, the best way to get a good idea of where we are in the business cycle is to follow short term interest rate moves. Take a look at a chart of gold and you will see what I am talking about. Back in 2003, the price of gold was low. As I recall, in the low three hundred dollar range. By the time the FOMC had raised short interest rates 17 times, the price had risen to the $700 range. Please do not assume cause and effect; did the FOMC raise rates to try to hold down inflation? or did inflation cause the FOMC to raise rates?

Current futures contracts, this is where real money is being bet on the level of interest rates over then next many months, show that short rates are expected to decline several times between now and next March. The futures market expects short rates to be down to 4% by March.

STEPS 1 THOUGH 6!

Another way to look as the business cycle is the six stages presented by Martin Pring. I often disagree with the way Mr. Pring uses short term, intermediate term and two year indicators as a method of following a business cycle that is typically close to 9 years in length but his six stages are worth following closely. As you well know by now, I believe the typically business cycle is actually composed of two halves with the middle being divided by a mid-cycle rotation rather than a full blown recession. Harvard History Professor Alvin Hansen uses the term minor cycle and major cycle but lets not let terminology get in the way.

In Pring's six stages, the first stage is when bonds do well while stocks and commodities are doing poorly. Did you see happen to notice the huge rally in the bond market Friday, while the stock market fell out of bed? This is not a new event. Bonds bottom in July of 2006, tested the bottom a this summer and have rallied steadily since. Months ago, I wrote that the mid cycle turn is near because the last "event" of an old cycle is the sharp rally in the bond market.

With the BOOM, BOOM, BOOM in China, it was difficult to believe that the world economy would slow enough this cycle to allow for a massive rally in the bond market. In July of 2006, I wrote that I leveraged family accounts to purchase long term treasury bonds. I don't believe that I mentioned taking a nice profit, albeit too soon. In hind sight, I should have held the bonds at least until today.

Still, the bond market is giving strong evidence that we have entered Pring's stage one of the business cycle. Again, in stage one, the bond market soars while the broad stock market averages suffer and while short interest rates and commodities decline.

The current fly in the ointment is that the price of gold, oil and other commodities appear to be holding onto stage 5 for dear life. Here again, if you look at the broad commodity index (CRB), you can see that commodities are rolling over. The tricky part is that it is expensive to hold commodities when real interest rates are high. There is still a large group of traders who believe inflation is out of control and that real interest rates are still low. As is show by the spread between the 10 year bond and the 10 year tips bond, inflation rates have fallen, even while oil has tested the old highs. When the "inflation hawk" speculators finally capitulate, the price of oil will decline by at least $20 per barrel. As noted in other postings, there are numerous new supplies coming to market with the really big projects arriving in 2009 and beyond.

The bottom line is that real interest rates are high enough to drag down the price of commodities. Those that follow real interest rates closely, come to understand that real interest rates is where the "rubber meets the road". Real interest rates fluctuate wildly because when inflation rates are high, short rates must be raised by an even greater increase than the increase in inflation. When the economy slows down below trend growth (which it is likely to do over the next couple of quarters), short rates must be lowered to well below the inflation rate, in order to stimulate the economy. Thus, the series of 17 short rate increases that started in June of 2004, have worked their magic and the current 5.25% Fed Funds rate is MORE THAN 3% ABOVE THE INFLATION RATE! REAL RATES ARE VERY HIGH! THE COMING DECLINE IN REAL RATES WILL STIMULATE THE ECONOMY AND THE STOCK MARKET LEADS THE ECONOMY BY 6 TO 12 MONTHS!

HUT 1, HUT 2, HUT 3, HIKE

Big Ben is at the quarterback position and play is about to begin. We have already heard the count of hut 1, hut 2, hut 3, but Ben has not uttered the word hike. Ben is a smart fellow. He is also a highly educated fellow. His most recent use of the discount window to provide liquidity while continuing to squeeze out inflation was from a 150 year old play book found in England. Ben understands that making a move between meetings adds an emotional element to FOMC moves. Ben is playing a cool game. He is deflecting a lot of criticism. No matter what he does, many will blame him for all sorts of problems that are not within his control. The FOMC only controls monetary policy, it is the congress of the United States that consistently votes to handcuff the great US economic machine. The congress waste so much money that it is incredible for the economy to remain as strong as it does.

We should all be thankful for our "fractional banking system". Gold bugs are constantly on a rampage about our "fiat" currency. This means that they want a dollar in gold in the vault for each dollar printed by the US government. Americans live better lives because we are willing to "share the wealth". I am thankful for our wonderful free enterprise system and I am painfully aware of how much better we could all be if our government were not so wasteful. Our solace must come in knowing that "democracy is a very ugly form of government except when compared to all others".

GOLD, GOLD AND MORE GOLD

In the old days, the wealth took their gold to the "bank" and the banker earned a fee for keeping it safe. In other words, in the early days, banks were basically a collection of safety deposit boxes. If the citizens of a community had 1 million dollars of gold on deposit at a bank, that bank had one million dollars worth of gold in its vault. The history of the move to the "fractional" system of banking is a wonderful story of joy and horror and one you should take the time to explore.

The purpose here is to show where we are now and what that means for the immediate future.

The total output of our economy is composed of three components. We have government spending, consumer spending and investment. The formula is G + I + C = GNP. The TV pundits like to focus on C. They get in a tizzy about how much debt consumers have. There are three truths about the debts of Americans: 1) the total debts owed by Americans is a large number, one that is easily railed against 2) the total debt owed is a small amount relative to the total assets owned 3) our wonderful fractional banking system allows all of us who save and all of us who borrow to "share in the great wealth of America".

An important fact often over looked is that C is actually the most stable of all the components of GNP. Indeed, you can generally count on Americans to spend the money they get. Personal income in America is growing by leaps and bounds. During the past 12 months, personal income rose by 6.5%! We do not really have to worry about consumer spending. The employment numbers last week were a very late joke. They showed that government employment dropped by 29,000 jobs, ha, ha, ha. Employment numbers are lagging numbers and they are always revised time and time again. The "slowdown in jobs" relates to the slower economy of the first quarter of the year and not to the strong 4% growth of the second quarter. Jobs are plentiful and the reason we call this component consumers is because this word defines what Americans are know to be.

Government Spending is much more volatile than Consumer Spending and Investment Spending is the most volatile of the three. Ironically, the big problem comes when government waste becomes so pervasive that the votes are available to do something about it. In other words, when the government builds a bridge to no where, the economy grows! In our fractional system, we must remember that one dollar spent is "shared" or spent again by more than 5 other spenders. Like the economist Paul Samuelson did in my Econ 101 text, I will use a high fraction of 20% just to make the math simple. When the government builds a bridge to nowhere, each $1,000 spent is deposited by someone, somewhere. When one of the flagmen on the project deposits $1,000 to his bank, the bank must keep 20% (actually much less) but it can lend the other $800 to others. This $800 is ultimately deposited to other banks which also keep a total of less than 20% and they lend the other $640. The $1,000 deposit typically grows to more than $5,000 worth of deposits plus $4,000 worth of loans. The 500 million dollar bridge becomes a 2.5 Billion Dollar "surge" in the economy.

WE ARE SPENDING TO FIGHT A WAR!

Those who believe the economy is going deep into the tank might have forgotten that a recession is not likely during the middle of a war. After a war, governments must go to extremes to keep money circulating. They could give it back to citizens through tax cuts but, as we know, politicians generally like to control more not less. Chances are your government will find a way to spend all it has available plus another 3% that is borrowed. The good news is that the 3% borrowed never has to be paid back because the economy grows as fast as the debt. During a war, extra government spending stimulates the economy. The "big deficit" that is railed against is solid evidence that the government spending portion of GDP is strong. If you believe the war is Iraq is going to suddenly end if Hillary is elected, I have a bridge to no where I would like to offer for a very reasonable price.

THE BIG DOLLARS

The big dollars are the investment dollars. If all the needs of all the people were being met, there would not need to be any new investment. On the other hand, as the population grows, sooner or later another factory, hospital or fast food joint will need to be built. When you or I buy a stock, we only trade assets with other people. When a factory is built, an investment is made. When a factory is built, it is like a stone has been thrown into a pond, the ripples are felt all the way to the other side.

During the first half of an economic cycle, workers who were laid off in past recessions find new jobs and old machines are cranked up. During the typical four year rebound, some new "stuff" is added but gigantic new power plants are not needed to support the addition of a little bit of "new stuff". By the time the second half rolls around, the "big stuff" is running scarce. This weekend, Boeing announce the sale of still more big planes and Siemens signed a multi-billion dollar deal to build high speed trains throughout Russia. Only a few years ago, the Russian economy was on life support. Now, largely because the country is resource rich, they are spending billions to provide transportation.

SHORT RUN OR LONG RUN

In the short run, we have to get over the housing slump. In the short run, the announcement of one major capital project after another shows that a "big boom" is on the way. The big projects are all over. They range from Intel semiconductor factories to hundreds of refineries (both new and additions to old) to nuclear power plants, to WiMax installations. Some of these projects will be much more profitable than others but few will be as silly as bridges to nowhere. Even the dumb ones, will serve to stimulate yet other projects. In China, a very long list of projects have been delayed pending construction of electrical power generation facilities.

MID CYCLE TURN

The reason that we do not have to have a recession at the mid cycle turn is because there has not been "over investment", with the exception of residential housing, during the first half of the cycle. During the second half, when the big projects are going full steam ahead, we will eventually need a "serious cooling off time".

GO, GO, GO

Right now, we do not need a "serious cooling off". Big Ben can "afford" to lower interest rates because there are plenty of goods available which means prices are falling in many categories. China continues to export deflation. Japan cannot get up off the floor because its economy is a manufacturing economy in direct competition with China.

This six stage space rocket is ready to roar. Stage one is here. Aggressive investors will do well by going against the psychology of the masses and BUY, BUY, BUY!


This posting will be used in an investment class at the Winston-Salem Library. Your feedback is much appreciated. Are the ideas presented clearly? Where could improvements be made?

Please forward this to your friends and family. Should your 14 year old "catch the economic bug" he may become the next "Big Ben".

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