Replaying 1929!

If the Reciprocal of Good is Bad, Then This Must Be...

One Over Virtuous Cycle

This week, I feel like a minister (or depending on your cultural background, a shaman), getting up before the flock to deliver a stern word of warning and exhorting you to live cautiously. Like a good preacher & teacher, I want to begin with a few words from the Good Book. However, the Good Book I refer to is not, in this case, the Bible. No, it is a collection of writings that has (unfortunately) far more influence over our secular lives. I refer to the writings of the Chairman of the Federal Reserve Board.

Today's scripture comes from St. Al's testimony before the Joint Economic Committee (of Congress) handed down on June 10, 1998. It is here that the Master reveals the gospel of Virtuous Cycles:

The strength of domestic spending has been fueled, in part, by conditions in financial markets. Although real short-term interest rates have been rising, equity prices have moved still higher, credit has been readily available at slender margins over Treasury interest rates, and nominal long-term interest rates have remained near the lowest levels of recent decades. Rapid growth of money this year is a further indication that financial conditions are accommodating strong domestic spending, although we still are uncertain how reliable that relationship will prove to be over time.

In short, our economy is still enjoying a virtuous cycle, in which, in the context of subdued inflation and generally supportive credit conditions, rising equity values are providing impetus for spending and, in turn, the expansion of output, employment, and productivity-enhancing capital investment. The hopes for accelerated productivity growth have been bolstering expectations of future corporate earnings and thereby fueling still further increases in equity values.

The essential precondition for the emergence, and persistence, of this virtuous cycle is arguably the decline in the rate of inflation to near price stability. Continued low product price inflation and expectations that it will persist have brought increasing stability to financial markets and fostered perceptions that the degree of risk in the financial outlook has been moving ever lower. These perceptions, in turn, have reduced the extra compensation that investors require for making loans to, or taking ownership positions in, private firms.

To a considerable extent, investors seem to be expecting that low inflation and stronger productivity growth will allow the extraordinary growth of profits to be extended into the distant future. Indeed, expectations of per share earnings growth over the longer term have been undergoing continuous upward revision by security analysts since 1994

Let's Rewrite Greenspan: Just for the hell of it, let's take the Chairman's remarks from then and reverse some of his key terms to see if we are now approaching a huge and potentially horrific reversal of fortunes. My reversals of His terms are in in bold italics so you can see where I've substituted terms. This is something I've told you about previously called the "Substitution Method of Learning". As you read through the reversals of terms, consider if you would feel correct if you delivered this "one over virtuous cycle" assessment to members of Congress early next year. My suspicion is that you would:

The recent developing weakness of domestic spending has been fueled, in part, by conditions in financial markets. Although real short-term interest rates have been leveled off, equity prices have moved still lower, credit has been less readily available at slender margins over Treasury interest rates, and nominal long-term interest rates have started to strengthen from the lowest levels of recent decades. The slowing growth of money this year is a further indication that financial conditions are beginning to restrain some domestic spending, although we still are uncertain how reliable that relationship will prove to be over time.

In short, our economy is seeing the end of a virtuous cycle, in which, in the context of subdued inflation and generally supportive credit conditions, rising equity values had provided impetus for spending and, in turn, the expansion of output, employment, and productivity-enhancing capital investment. The hopes for accelerated productivity growth are beginning to wane because of declining expectations of future corporate earnings and thereby fueling still further decreases in equity values.

The essential cause of the emergence, and persistence, of this reciprocal of the virtuous cycle is arguably the increase in the rate of inflation which obviously puts negative pressue on recent price stability. Developing high product price inflation and expectations that it will persist are bringing decreased stability to financial markets and fostered perceptions that the degree of risk in the financial outlook has reversed and is now moving ever higher. These perceptions, in turn, are starting to increase the extra compensation that investors require for making loans to, or taking ownership positions in, private firms.

To a considerable extent, investors seem to be expecting that the reversal of inflation and what has been largely illusory productivity growth will imply that the extraordinary lack of both earnings and of profits to be extended into the distant future. Indeed, expectations of per share earnings declines over the longer term have been undergoing continuous downward revision by security analysts since my testimony to this group in June of 1998, and certainly since George Ure's Aggregate Index peaked in March of 2000.

The notion that the Chairman could simply reverse some terms from a previous (very good) assessment, and use it again before congress isan intellectually interesting proposition. But mental gymnastics aside, the development of the warning clouds on the horizon is ay best ominous.

If you see storm clouds gathering, what can you do about it? Well, as you may have figured out from reading some of the materials elsewhere on this site, you could become very conservative in your approach to life. I've written down some thoughts on how to make risk-averse decisions in life in the "Personal Planning Guide" which you can find on the home page.

Nut, what about day-to-day stuff and the business of living? My moves may, or may not, turn out to be right over time, but here is my short list: I've gotten completely out of debt (with the exception of a small bank card account that I could zero out any time). We have a self-sufficient place to live and can travel regardless of economic conditions as we've chosen to live on a modest sailboat with "go anywhere" capability.

Two years ago, I made a conscious decision to leave the world of high tech - and cashed in my options because I wanted to be in a counter-cylclical business. I chose the field of education, because when the economy turns sour, people will need to improve their education. But that's not the only course available. There are lots of areas of life where you can find honest work and rest well at night knowing that a change in the faddish technology world won't leave you hungry and looking for a job. Such businesses as used car sales, health care, and even the grocery industry will all be relatively immune should the projection that we stand at the brink of another huge Depression - Depression Two - turn out to be correct.

I had two interesting experiences in the past week that I think you'll find interesting.

First, we bought a few Microsoft January 55 calls on the weakness in that stock. What occurred to me is that people are very slow to learn, and the buy the dips crowd is likely to come roaring back into the market early in the new year on the theory that if you buy quality firms, depsite the fact that they don't pay a dividend, you can't go wrong because the company will continue to appreciate in value.

I think this is one of the key charateristics of the developing Depression Two that you'll see for the next year or