Thursday, November 13, 2008

YES the Healing Process is Working!

It seems that all is lost, but the healing process is having success after success. The economic patient is sick but recovering.

For weeks on end, US companies were not able to issue commercial paper; no one would buy it. The money that would have been used to buy commercial paper was dumped into short term treasuries, causing those to yield as little as .09%! Thus we have had a spike in investment grade bonds to almost 10% over the 90 day t-bill rate. This spread is higher than the one reached in 1982, when 30 year treasury bonds yielded 15%! As noted yesterday, when the spread spiked to 9% in August of 1982, before the month ended, the spread collapsed and stocks soared in value, virtually uninterrupted for the next 9 months. Many a stock jumped 100% or more in value.


For two weeks in a row, borrowing at the Fed Discount window has declined and for two weeks in a row the dollar amount of commercial paper being issued has climbed. Companies that can issue commercial paper at today's very low short term rates will save a bundle over other financing methods. The profit margins at these companies will increase due to the lower cost of funds. The markets are rapidly healing. Bond markets in the EU and in the US are forecasting a strong economic recovery. Remember, the cycle is lower commodity prices (including the cost of money) leads to higher bond yields and then to rising stock prices.

Yes, consumer sentiment is about as bad as it has ever been. People who own shares are being pounded day after day and people at many businesses are concerned about the health of their company and the safety of their jobs. As a result, consumers are saving all they can, indeed, they are saving too much! The more they save the less they spend and the less they spend the lower the sales of the next guy and the more compelled he is to save. In the short run, this is a positive feedback loop that seems to have no end; but it does.

Take a look at what is happening at Wal-Mart; the same thing that is happening at your local gasoline station. The wholesale price of gasoline is down to $1.25, implying that $1.85 is a fair price. The gasoline stations are enjoying, for as long as they can, an extra spread. Eventually the market will force the retail price down, but the gasoline stations that were hammered last year are witnessing the miraculous healing of their balance sheets. In like manner, Wal-Mart can hardly keep up with the falling price of its imports. The old saw is that when the US sneezes the rest of the developed world gets sick and a third world country goes into intensive care. Third world economies that rely on manufacturing are hurting for certain. There are too many --- you name it, in the world, too many cars, too many toys, too many houses. To make and sell a car or a toy or a house, you must be the lowest cost producer. The high cost producers must go out of business while the survivors battle to be competitive. Sooner or latter there is "Joy in Mudville". Consumers realize how many bargains are available to be scooped up and a year or two latter the successful competitors hire the laid off workers of the failed companies.

The banks, which have little incentive to lend, have cut available credit lines on everything from credit cards to home equity loans. However, in the long run, banks make their money by lending. In the short run, why would a bank make a prime plus 1 loan to a solid customer when the bank can buy an investment grade bond and lock in a 9% margin? In the short run, banks are not lending because they have capital requirements to meet and because there are more profitable alternatives. However, now that companies are once again able to issue commercial paper (back-stopped by the Fed and evidenced by solid growth the past two weeks), the rates on corporate bonds will soon fall dramatically. Money that is currently flowing out of stocks and into corporate bonds will soon start to flow the other way and stocks will do very well.

The opposing argument is that more companies will experience weak sales and corporate rates will even go higher, but this argument cannot possibly be a long term argument. The failure of the weakest of players will grant higher sales to the remaining competitors. The argument is being made by those who see a great depression on the horizon. Lest we forget, the foolish policies that caused and fed the great depression included, sharp restrictions on international trade, government restriction of money supply growth, higher taxes, and more higher taxes used to support many wasteful government programs. Even though Obama's platform included restrictions to imports, higher taxes and more higher taxes to support government programs, the fear may be greater than the reality.

So far, our government and the governments around the globe, have not certainly not made the mistake of tightening the money supply or raising taxes. Mitch McConnell has 43 votes in his pocket to stop the most silly of left wing proposals. To make the major reforms, such as the reform of health care, that Obama wants to make, he will need to meet McConnell more than half way between the left and the center. George Will is correct that democrats will be able to peal away a few republican votes now and then (of course these votes will include bipartisan shares of pork) but no one is in the mood to raise taxes out the roof during these tough times.

History shows that, with the exception of the great depression, sharp spikes in corporate bond rates have been short lived events. Stocks have historically moved up just when most people believed the worst. I have been wrong consistently wrong about the extremes of this cycle. For two years, I said that oil prices were on the verge of a major collapse. Once the prices started falling, I believed the worst of the real estate recession was over. I am just as confident in the coming economic boom as I was of the ultimate decline in oil prices. Most people were on the other side of the oil question and now most people are on the other side of the coming boom. One of the economic truths is that in economic matters the majority is always wrong. At some point, the auto pilot takes over. When people believe that their jobs are at risk, they work harder. When people believe in economic collapse they save more (short term dramatic increases in savings are bad but in the long run we must have savings).

The average Baa to T-Bill spread since 1970 has been 3.65%, the current spread of 10% is enough to make professional money managers, not sure of which stocks to own, to sell stocks to buy bonds. Other professional money managers are still convinced that high inflation is just around the corner. These managers have fallen lock stock and barrel for the belief that the world is over heated and running out of resources. Everyone seems to know we are in a deep real estate recession, but few are willing or able to buy real estate at these low prices. Most of those who know that small cap stocks, retailers, banks and consumers goods stocks will lead the way out of the recession are not willing to buy. The majority will pay down debt when they should be aggressive and they will resume their borrowing some years from now when they should be saving.

The healing process is underway but most people will not feel comfortable about the patients health until he is out running laps.