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The Difference Between 'What' and 'Why'

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If we look at the "what" we can get a fairly sanguine picture...if we look at the 'why' we get a different one.

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I mentioned yesterday the thought of "conditions," of looking at the backdrop of the U.S. economy and the world economy objectively and deductively, as opposed to inductively, in developing a thesis for investing.

It is the difference between saying "what" and "why."

If we look at the "what" (real interest rates are low, stock prices are high, companies are making money, volatility is low, companies have a lot of cash, overall inflation is moderate, budget deficits as a percentage of GDP is average), we can get a fairly sanguine picture of the global economy and the stock market.

But if we look at the "why" by deducing the nature of these statements we get a different picture.

Real interest rates are low because central banks led by the Federal Reserve of the U.S. have kept them artificially low for years by "printing" currencies. The only way to "print" money is to create debt. $40 trillion in debt in the U.S. has been created leading to bubbles in asset prices and this is why:

Stock prices are high. As credit expands, it is inflationary to asset prices as more currency drives nominal asset prices higher. When debt gets too high and crowds out the market, this process reverses and becomes deflationary. As credit expands, liquidity is injected into the system and...

Drives volatility lower. As volatility drops, investors feel alright with taking more risk and debt grows even more. This process of easy credit causes companies to create so much overcapacity that they don't need to build any more and...

Companies begin to slow spending and capex and their cash positions begin to grow. The lack of spending on new infrastructure puts pressure on labor costs as hiring slows. Add to this the pressures of globalization where really cheap labor is available and the pressures on labor costs intensifies. All that printing of currencies causing inflation in input prices like commodities is offset by declining labor costs and...

Inflation looks moderate. Of course it looks even more moderate with manipulations by our central bankers who started this whole process off. It is ironic that the market hasn't been worried about input costs - since those have not been passed off to the consumer - while it does worry about labor costs: the consumer is the laborer and customer of the company so the squeezing of the consumer from both ends is eventually deflationary. The government steps in and spends like crazy trying to keep things going and leads to...

Budget deficits. Budget deficits grow but look sanguine because they are measured against a growing GDP. Of course when GDP does drop, they begin to look horrible. Also, add to the fact that budget deficits as measured don't include things like the cost of the war and the truly gargantuan $44 trillion in future social security and Medicare liabilities and the picture quickly gets scary.

The bottom line is that economic expansion has been fueled by artificial credit expansion (not savings and investment). When the debt gets too big, and there are several indications such as percent of disposable income going to debt service and total debt relative to GDP being at levels never seen before, this artificial process starts to unwind. The market begins to not want more debt and to even pay back the debt. All that inflation turns into deflation.

Central banks are then inevitably left with the bad choice of accepting deflation or hyper-inflating. The problem with that is hyperinflation will eventually lead to a worse deflation in the end.

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No positions in stocks mentioned.

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