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First Principles


"It is therefore of immense importance to men to have fixed ideas about God, their souls, and their duties toward their creator and their fellows, for doubt about these first principles would leave all their actions to chance and condemn them, more or less, to anarchy and impotence"

- Alexis de Toqueville

Almost certainly each of us has our own first principles; ones that relate to God, family, country, friends, profession, etc. Sometimes they are conscious, as in attending church or temple; sometimes they are unconscious, as in reflexively offering aid to a friend or loved one in need. Either way, they are bedrock beliefs that constitute the foundation of our souls. No event since WWII has served to reinforce the importance of those first principles in our everyday lives more than 9/11. And with one day to the 9/11 anniversary, it is another good time for all of us to reflect on, and reinforce our dedication to, our own first principles.

First principles can also be intellectual as well, immutable ones like the gas laws in chemistry or the theory of relativity in physics or softer ones like those that attend various schools of economic thought (e.g. the Austrian School and the Keynesian). And since we are contemplating first principles and because stock prices are so close to what I believe will be an important high, I thought it would be helpful to lay out the broad strokes of what concerns me about this economy and this stock market.

One of my own economic first principles is that the credit-driven excesses of the 1990s, from the repeal of the Fed's excess reserves requirement on banks, to the LTCM bailout, all the way to the Y2K liquidity injection, were the primary cause of the asset bubble that we witnessed that ended in 2000. The malinvestment - in dot coms, in telecom lines, in hotel rooms, in retail stores - that resulted from the cumulative easy credit policies of the Fed was the secondary cause of the bubble. The primary cause was the easy credit itself. [This is not to say, of course, that sentiment and psychology didn't have a very important role to play for they surely did.]

In my opinion, all analyses of the economy and the stock market must start with this observation, with this first principle.

The current reflation effort - from the Fed (via discount and Fed funds rates as well as excess reserves growth) and from the administration in the form of nominal tax rebates - serves to do three potential things: (1) delay the necessary liquidation of excess capacity or, (2) make the final liquidation reckoning worse or (3) both. I have noted in previous articles how the process of liquidation has hardly been completed. I have also noted, as has John Succo, that the increasingly aggressive reflation efforts by the Fed further incent malinvestment and create a greater pool of goods and services that must inevitably be liquidated. Like night follows day, booms lead to busts. And any effort, but particularly egregious efforts, to stave off the bust part of the equation, make the eventual bust more painful for all. Sure, a few will benefit from the stimulus in the short run, but all of us pay in the long run.

Not convinced of that last assertion? Thanks to the media, everyone knows the "winners" in this reflation effort: stock market participants, automobile and home buyers, mortgage refinancers, etc. Few economic observers note the other side of that coin: that there are real people that lose under a reflationary scheme. How about the pool of savers, retirees most obviously, who live off of interest income? How about the unemployed who would welcome a fall in prices ("deflation") for goods such as healthcare, food, fuel, lodging, and other necessities? How about the increase in the cost of labor relative to (again cheap) capital; this makes firms more likely to purchase productivity tools rather than hire new employees.

We have mentioned the idea of decreasing returns before; that is, the growth impact one would normally expect from such reflation is being met with less and less actual growth in the economy. That the reflation efforts have been met with decreasing returns should not surprise if the logic holds that the easy credit was the cause of the malinvestment and subsequent asset bubble.

Of course, part of the culprit too is the idea that consumer spending - the largest source for that elusive "aggregate demand" the Fed is trying to stimulate - can power us higher. I have already written about the fact that personal consumption expenditures did not, in fact, turn down into negative territory in the latest recession, so there is no need to repeat the idea that consumers have pretty much spent all they can.

But the following is a point I think is worth making. It goes without saying that the largest "beneficiary" of the easy money of the 1990s was clearly the technology sector, which had the highest valuations, the most capacity built, and the most subsequent malinvestment. Of course, that sector, typified by the NDX, got hit the hardest when the easy credit reached the point of maximum benefit and turned down.

Fast forward to 2003. I contend that the Fed has done at least as much to stimulate the US consumer as they did to stimulate corporate spending (most notably on technology) in 1998-2000. We know how the easy credit-led tech boom ended with such a malinvestment genesis.

I purport to you that we are seeing almost the same dynamics on the part of the Fed, on the part of consumers, and on the part of the stock market in the consumer cyclical sector in 2003 as we saw in the technology sector in 1999 and 2000.

I know the enormity of that statement, but I make it nonetheless. In my opinion, the single best area for shorting is the consumer cyclicals, most notably within it the retailers. The easy credit has caused retailers to vastly overstore the nation, low rates and tax rebates have caused consumers to spend that which they do not really have (having turned their house into an ATM machine with equity extractions), and both of those have caused stock market participants to value these retailers on a near historic basis.

To pick one at random, the S&P 500 retailing index (S5RETL) is even today at 348. This index hit its all-time high on 12/99 and 4/00 at 390 or so, a mere 10% above current levels. It peaked again at 365 or so in the spring of 2002 and just peaked last week at 371. It has a triple bottom at roughly 250, about one third lower than current levels.

Needless to say, much of my time these days is being spent picking my spots among the retailers on the short side. The parallels to technology in 2000 are extraordinary on a macroeconomic, microeconomic, valuation, and sentiment basis. I cannot emphasize this enough.
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