Friday, February 22, 2008


When my wife and I operated our resort condo rental business, we bought a lot of furniture. The purchases were non events on our income statement. When we bought the furniture, we simply traded cash for furniture on our balance sheet. Following the federal law, we expensed the furniture over the seven years following the purchase. If our rental income stayed the same, the portion of the furniture expensed during the year showed up as a loss on our income statement.

Today, the pundits constantly focus on consumer spending to tell us if the economy is doing well or not. They like to tell how consumer spending is more than 70% of the annual GDP. The point is valid if kept in context but the big picture is much bigger indeed. When Duke Power builds a power plant, it does not show up as consumer spending. Power plants are like beach furniture. Power plants generate a lot of cost and a lot of revenue but it takes a lot of spending before there is a profit or loss to report.

National income is essentially equal to profits plus wages. But profits is a net number. It takes a lot of purchases of a lot of goods and a lot of sales of the final product to produce profits. Profits might be 5% of the amount of sales. When we typically see a figure for investment in the US accounts, we are usually looking at net investment which is an extremely small number relative to the investments made. Over long periods of time, net investment grows at about the same rate as profits are a percentage of sales. In the case of the furniture mentioned above, the furniture loses its value over time but the government allowed us to "get ahead" a little by allowing us to write off twice as much of the annualized value in the yearly years of ownership. Also, in the event the furniture lasted more than 7 years, we enjoyed the ownership of some used furniture without showing it as an asset with real value on our books. If we sold the fully depreciated furniture for any amount, the entire amount had to be reported as a taxable gain. In the USA there is a lot of value in fully depreciated plant and equipment. It often stays frozen in place in order to avoid capital gains taxes.

One point I am trying to make is that Americans have a net worth of 58 trillion dollars (much more in assets) but the pundits focus on the annual, double entry accounting, income of 14 trillion dollars. The fact that the 58 trillion is growing rapidly is dismissed as not newsworthy. Put another way, our condo rental business lost money year after year but the value of the condos went up year after year. The American people continue to enjoy a net increase in net worth even though they have been told that their house is falling in value.


People see the massive amounts of money flowing from pockets in the USA to the pockets of the oil producers and think the high price of oil means that there has been inflation. This flow of money is like the money my wife and I spent on furniture. We were not made less well off by our purchases. Buying the furniture allowed us to charge a good rental rate for a week at the beach. We profited or at least believed we would profit from the purchase of the furniture or we would not have bought it. Buying oil is the same. We only buy oil because we benefit more than it costs. If we did not, we would buy something else. If the price were really too high, we would buy a scooter, bicycle or shoe leather. The purchase of the oil did not create or destroy money. The oil seller traded one asset for another as did the purchaser. The seller is left with the choice of how to "spend" the money, but if all he does is trade it for another asset, then no inflation has occurred.

The current high price of oil is encouraging a lot of people to look at ways to produce more oil and it is encouraging a lot of other people to look at ways to use less. The real mind bending, counter intuitive and most important point is that it is not the spending that stimulates the economy but it is savings that does the trick!


The reason I went though the mess above about how the consumer is really a much smaller piece of the total economy than the consensus belief is because it is not consumer spending that stimulates the economy. Again, moving money from cash to oil is only an exchange of one asset for another. But, what happens when a hundred dollars are deposited into a five year certificate of deposit? The bank is allowed to lend about $92 of those dollars to another person. The person who deposited the $100 still has his $100 in the bank but the second person has $92 to invest.

The congress of the US just went through contortions of logic to explain why the "stimulus" package needed to go to the poor people who would spend it. The idea was to get the maximum "bang for the buck". When an individual, business or government borrows money to spend, they have increased the money supply and thus they have given the economy a short term boost and a long term financial obligation. They have also started a ripple effect whereby each dollar is re-deposited and re-lent an average of 5 times. Thus one dollar of new spending can become $5 of new spending. The fact that the government is likely to spend the first borrowed dollar unwisely, does not take away the stimulative effect of the remaining dollars.


The good news is that dollars are still flowing in and out of banks. Because the world wide growth momentum is so strong, the FOMC held their feet on the economic brakes for 19 months. Six months ago, excess liquidity finally dried up and the FOMC began to gradually let up on the brakes. Six weeks ago, liquidity finally started showing up again as evidenced by the drop in LIBOR rates.

Despite what is being said by financial news reporters, the credit markets are not "frozen up". Loans outstanding are rising. Asset values are down and yet there is plenty of money available. The potential for a big bull market is strong.

The short term problem is that commodities are still getting all the "juice" from speculators. Gary Shilling has this part of the story nailed. Investment managers must show investments in "hot areas" on their books or the public will take their money elsewhere. The thing is that there are several million people now trapped in a barn that is about to catch fire. Investors will not be able to get out of the barn fast enough to save themselves from financial loss.


Once the money starts to flow out of the commodities pocket, where will it go? I believe big cap stocks that have technology franchises will be among the beneficiaries. Companies such as IBM and MSFT will enjoy strong business growth for the next several years and they will enjoy high price multiples for those earnings. The combination of higher PE's and higher profits will lead to much higher stock prices.

The 58 Trillion Dollars of American net worth could easily swell by 10 trillion in just a few years. This will not show up as new money or inflation. After the big run, the public will once again be ready and willing buyers. I hope you buy all you can now so that you can be a willing seller.