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Boo's Tears


While everyone is listening to television and CEOs and as a result borrowing no-cost money and speculating on stocks and houses, let's wipe the tear from Boo's eye and look at what is really going on.

The employment cost index is hitting multi-year lows, while a component, health insurance, is rising rapidly. Basically, wages are flat and benefits are being cut. The wage component is at a thirty year low.

The employment cost index is a large component in overall inflation. Inflation is nonexistent because personal income is stagnant, at least from an earnings point of view (although for now speculation in houses and stocks has added some to personal income). The other stuff that would cause inflation to rise, like higher commodity prices, is being offset by hedonics (a clever tool that only our government uses). Inflation in commodities and deflation in earnings is not a utopia by any stretch.

Consumers are getting squeezed, so they are replacing earnings with borrowings. As there are no countries not willing to print currency willy nilly, we have a situation where U.S. interest rates are not rising as trade and budget deficits balloon.

Thus we have a liquidity driven market where inflation (excess money) is still going into financial assets. But this is no 1982 when Mr. Volker tamed inflation and new value was released from bonds and stocks. The trailing P/E of the S&P 500 at the time was 7. Nearly everyone was bearish then while Bob Prechter was calling for a new bull market in financial assets. Everyone was calling him a fool.

Now, after decades of loose money and ever looser money we seem to instead be reaping the last of the harvest. The trailing P/E of the S&P 500 is 20. Nearly everyone is bullish while Bob Prechter is calling for a major bear market. Everyone is calling him a fool (although he is still waiting for redemption for this early call).

Thus if we look at money growth today, excluding lending, it is starting to wane significantly. This is because under the strain of ever increasing debt the velocity of money is slowing...people are still taking on new debt, but to lesser degrees and that new debt is not having the same effect on GDP growth that it once did. The rate of increase in that debt is highly dependent on financial asset prices as collateral, an irony that escapes most. That the rate has been sustained at all is due to a significant deterioration in lending standards.

And the yield curve flattens even more. The two-year/ten-year part of the curve is now down to a new low, 23 basis points, down from 180 basis points two years ago. Thank goodness the Fed has just told us that this does not mean anything about future growth, even though their own exhaustive work said it does. Most banking activities don't work with a flat yield curve.

As CEOs beat earnings estimates that they single handedly designed and the media croons to the beat, I emphasize extreme caution.

You can't short into a liquidity driven market and I would not advise it. But if you are buying, just know what you are buying into. When the music stops there will be a deafening silence.
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