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Minyan Mailbag: Heed the Warning


Because nothing bad has happened yet should not lead investors to conclude that nothing ever will...

Prof. Succo-

Thank you…warning indeed. Folks incredibly have already forgotten May and June. We should see Volatility increasing along with junk spreads real real soon. They are already pricing in a rate cut end of the year/early 2007. Do you think that fact is something that "should" also give warning? As Toddo said, the risks are increasing and it really feels like, despite the "joy" in fictional characters like Goldilocks, something really ominous is "setting up" and approaching quickly?

Minyan Steve


Companies have benefited dramatically from globalization. It has given them leverage to lay workers off here and pay them less in incentives. As we have stated, cost cutting (productivity?) has been a big driver of past earnings. Consumption has kept up as consumers have borrowed more and more from the equity they have in their houses to continue to purchase. Rising housing prices have made their balance sheets seem better than they really are and they have borrowed much more than they should have been able to. Instead of going bankrupt, they have been rolling up some of their credit card debt into "home loans." So the way I look at it, the consumer has been compressed into a position of high leverage.

As housing prices are no longer rising and are beginning to fall, this source of liquidity dries up. Companies squeezing their employees will soon realize they are selling their wares to them. They will realize this when consumption begins to fall. We are starting to see that now.

And then the process reverses itself into deflation. Consumers try to pay back debt they realize they cannot support, which crimps consumption even more. With the level of debt, we risk a recession turning into something much worse. Companies sense this already as we see in their reluctance to increase capital spending. They instead buy back stock to make earnings look better, but as deflationary forces kick in, this factor becomes a drop in the bucket.

And then we have the Fed coming to the rescue by lowering rates and injecting liquidity. Prof Scott Reamer has spent many pages describing how difficult this will be when the market does not want to increase risk, but reduce it. It will take some truly unprecedented moves by the Fed to force liquidity into the system. Ben can only "drop dollars from helicopters" by monetizing risky assets: printing dollars and buying stocks and houses and just about everything. Imagine that world.

And even if they do, that presents all types of unprecedented problems like high inflation in the U.S. and higher interest rates as foreign lenders balk at providing any more exposure to a dollar the Fed is trying to make worthless.

It will be a choice of bad choices. Because nothing bad has happened yet (except anemic job growth if not worse and anemic income growth and the squeezing of the middle class) should not lead investors to conclude that nothing ever will (inductive reasoning). The pressures are cumulative as debt continues to grow and is becoming harder and harder to support. The deductive conclusion is that it will be just worse when investors try to reduce risk.
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