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Money Often Costs Too Much: Part I


Why is the quote, while short, so important?


"Money often costs too much"-Ralph Waldo Emerson

Let's get right to the point. What is Ralph Waldo Emerson referring to?

Usually, we start with a review of the quarter, but I found Mr. Emerson's quote so relevant to today's and future markets and economy that I thought I would mix things up in this quarter's commentary and would begin with why I used Mr. Emerson's short, but important quote in the first place. According to Bloomberg LP, Treasury securities suffered their worst first-half drubbing of the past seven years which makes us especially proud of our across-the-board gains in bonds during the quarter (in particular with less risk taken). In other words, yields spiked as the Fed continued their vigilant fight against inflation that they began in mid-2004.

Why is the quote, while short, so important? In a normal economy, the cost of money, set by the FOMC (or Federal Open Market Committee) in short-term rates, and other parts of the yield curve by market participants, determine what everyone pays for loans. And economies, since the beginning, have been based on leverage, but this is not a normal economy. We have been writing for nearly 10 years that it is an economy built on leverage and one that the cost of money may have a greater impact on than any other economy in history. Many people call our economy 'finance based'- I call it overleveraged. I will not bore you with the charts and graphs that I have been using over the years in my writings, but suffice to say, sports-fans, there IS a debt bubble in this country. When did it start? By my reckoning, it started in 1995 and continues still to increase in size. How can I tell? Simple. The money supply grew at a rate of 3.5% per year between 1985 and 1995 and from 1995 to 2005 at nearly 8% per year. Lately, it has experienced periods of growth well into double digits per year. Why you may ask? In my humble opinion, it is to support the bloated asset side of the balance sheet, an asset side that has gone from bubble to bubble to bubble-bubbles in stocks, real estate and now commodities. The larger the balance sheet, the more new money it takes to keep the economic ball rolling. This is what some would term a 'Fiat currency.'

My belief has always been that the bubbles were knowingly stoked by the Fed and that eventually, Mr. Greenspan's nickname would go from 'Maestro' as he was called during the stock mania to "villain." Personally, I think his term ended at just the right time and he was able to hand the reins off to Mr. 'Boom Boom' Bernanke. 'Boom Boom' is a Wall Street nickname given to Mr. Benanke by pros because as an academic, he has publicly stated that he would flood the system with cash if there were ever an economic problem. He is also nicknamed 'Helicopter Ben' as he once said in a speech during the deflation scare of 2002-2003 that he would drop money from helicopters to stop deflation. I happen to believe he wasn't kidding.

Where are we now in the economic cycle and what is the Fed doing?

The Fed finds themselves in a quandary, it seems. Bernanke really is at the reins of the Fed and other Fed Governors are mostly mouthpieces for him and everyone else listens and positions themselves (at least on a short-term basis) based on what he says. And what has he said since being in office? Well, to be honest, he has confused the heck out of me and I have been at this for a while. He has gone from hawkish (tough on inflation) to dovish (easy on inflation) at least 4 times since being sworn into office in February 2006. Each time he flip flopped the markets moved violently, which makes it a bit tough to anticipate the smaller moves. You may or may not have noticed the large rally on Wall Street in stocks right at the end of the quarter. While all money managers, including ourselves, appreciate the 'mark-up' in price, the FOMC release, which I have provided for your perusal below, was only part to blame. Here is the release:

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 5-1/4 percent.

Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices.

Readings on core inflation have been elevated in recent months. Ongoing productivity gains have held down the rise in unit labor costs, and inflation expectations remain contained. However, the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures.

Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives.

So, what did they say? They said that the economy was slowing (note the talk of cooling in housing) while also mentioning 'lagged effects' and the increase in the price of energy. In the old days, people would be uttering the ugly word - stagflation, when prices rise as the economy slows. But no! The market responded with a rousing 200+ point rally in the Dow the day of the release. Most people asked me if I thought if that made sense. My answer was that what happened was a market phenomenon, not an economic phenomenon. By that I mean that many short-term bets had been made against the market leading up to the release and those bets were simply reversed, resulting in a short squeeze. If the rally was 'for real,' it would have continued the following day, although I wouldn't be surprised by some further minor strength into mid to late July.

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Money Often Costs Too Much: Part II

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