What does it mean to be a Credit Flow Investor?
Other Links:
MZM Money Velocity Leading Economic Indicators
Credit Economy Chart Currency Selection
Delusion and Investment Behavior Earthquakes, Minksy Instability and Tides
Fed Action, Real Rates, and Price Stability Forces of Deflation/Inflation
GDP Components, Recessions, and S&P 500 Housing Market Index, MEW and Housing Starts
Payroll and Inflation Perfect and Felicity Foresight
Reversion to the Mean and Market Time
Time Frame and Randomness USD, Gold, and Oil Prices
Overview
[Before every recession, fly to safety lest the mountain topples on thy head.]
The worst case is what matters when engaging in a policy - the worst case is far more consequential than the forecast itself. The Black Swan p162
The aim of this site is to list a number of charts indicating investment opportunities and to outline my investment strategy. By creating this web site, I enforce a discipline on myself to keep them updated.
As debts mount and debt to GDP ratios climb, there is a danger of falling into debt deflation. As Keynes called it, the people lose their animal spirits and fall into a liquidity trap. It's followed by hoarding and a shrinking of economic activity over a long period. The precipitant is always a recession because this event shrinks GDP and thereby the ability of the borrower to service or take on new debt. The debt/GDP ratio (debt = credit) shows the relationship of debt to its ability to service that debt. I liken it to the sand-pile that builds higher and higher.
Climbing a Mountain ...Updated (End of 2007)
Europe, Canada, UK and Australia all have similar charts! The US debt/GDP figure in the 1920s showed a similar run-up with a collapse (at 160% in 1929) starting in the early 1930s as bankruptcies spiraled upwards (debt/GDP eventually hit 260% in 1933). Japan showed a similar trend in the 1980s breaking into deflation in the 90s. However, Japan broke into deflation at a high number, 600%.
See Household Debt Selected Countries
Imagine a man who makes 50k per year and has 300k in debts. Now a few years pass and he has 600k in debt. Wouldn't he be more likely to throw in the towel or at least not borrow any more? If he simply ceases to borrow more, the economy will contract. It is so dependent on new credit.
Eras of easy credit are followed by tight credit and crisis/recession. We become more vulnerable as the debt to gdp ratio climbs that a crisis of scale reduces monetary policy to no effect.
Approaching Liquidity Trap. When does it occur?
On every cycle the system convinces people that more and more debt is
acceptable. You gradually creep up your debt and as everyone is doing it,
you feel fine. Like the frog analogy in the boiling pot, if you increase the
temperature by 1 degree every minute, the frog doesn't notice. After 80
minutes, he's boiling.
Before central banks, a crisis would arise when an individual bank failed due to over-lending, corruption, stupidity, etc. The central bank was created to 'bail out' these banks and stem crises. Curiously, the Fed was created in 1913 and the Great Depression happened anyway in the 1930s.
Monetary policy facilitates credit. Normally, it doesn't create credit per se except to fund government deficits. Although the Fed backs its members in a crisis at its policy rate. The policy rate is used as a signal to the lending community to accelerate or decelerate their lending.
Most credit is issued by the private banking sector (out of 40T in credit about 1T is currency or cash and 8T is owed by government). By facilitating excessive lending, credit can be diverted away from long term capital and job growth and fall into assets. The Economist talks of the economy being dependent on asset bubbles and a "wealth" effect. Unfortunately, asset markets are prone to sudden meltdowns after long periods of credit expansion.
Because the US is the source of most credit and the world's net consumer, I believe the event will start in US and spread from there as in the 1930s. For the US and Europe, I can't say when this trend breaks down. Will the US break at 350%, 600% or higher? I can only guard against the bad credit event by flying to safety before every recession.
So the economy oscillates between increasing deflationary/inflationary threats until it falls into 1 of 3 situations-
1) Mild deflation fought with 0% Fed rate over a 10-20 year period. There will be many deceptive rallies in assets.
[Example here is Japan 1990-on. 'Solution' favoured by modern central bankers and democracies. Best investment over period is treasury bonds.]
2) Whiff of deflation, followed by hyperinflation. Examples are Germany 1920s, Russia, Argentina.
[These systems were not credit driven, so unlikely for US, Europe, etc. Best investment is gold.]
3) Rapid deflation. Examples are 1930s US/UK and many times in 1800s.
[Unlikely today, the Fed is highly interventionist and aware of this problem. Best investment is treasury bonds.]
As seen below, US is not at Japanese levels yet although household debt as % of disposable income is. I believe we are currently in an increasing oscillation mode eventually falling into situation number 1 (mild deflation). It's very hard to hyper-inflate a credit economy as the bond market senses it and interest rates rise thereby aggravating the situation (this is probably why Japan hasn't done it). Because I don't know which recession causes number 1, I guard against it by running to treasury bonds before a recession. Nobody knows how far these asset bubbles could fall in a collapse.
Japan is replacing private debt with government debt. But the high debt level still leaves Japan in mild deflation and a recession every 2-4 years. Japan is spending 17% of tax revenue just to service the public debt so even Japan is not near a hyperinflation. The US or Japan would get close to a hyperinflation if the GDP contracted by 50% for example.
How do we cut through the rhetoric and determine if we are in fact falling into deflation? I believe that it's imperative to be on the right side of this event. One theory has this event followed by a currency debasement or hyperinflation. Although thus far, Japan has bailed out its companies with more government debt and not cash or money printing - no hyperinflation. Russia, Argentina, and 1920s Germany had hyperinflation but their systems were not credit driven. You buy houses in these economies with cash. How do you enforce credit schemes in these economies?
I believe that we are in an interim period where we oscillate between rising credit issuance and deflation threats. As the debt to GDP ratio mounts, the risk of deflation rises. The fed also knows this and seeks to fight the deflation with more and more credit facilitation. The fed does fall into 2 strategies, however, of inflation or deflation fighting. It's important to recognize which mode they're in and judge the market accordingly. Given the risk of an extreme deflation, it only makes common sense to err on the side of caution.
As we all know, you can't grow your debt faster than your income or spending forever. Eventually a limit or "puke" point is reached. However, we cannot say which credit event will precipitate the collapse. Gold bugs always say it's just around the corner but they've been saying that for 20 years! On the other hand, stock market Pollyanna's say the economy is always just fine and we should ignore the debt or other negative issues.
Since I can't trust the "salesmen" of either side, I seek to have an open mind and judge each recession or slowdown. Since the 1930s, the economy has not experienced debt deflation or hyperinflation despite the hyperbole of either side's proponents. I want to develop indicators of the dominant forces in deflation and inflation. By tracking these charts, the economy can be understood as having a deflationary or inflationary bias. The correct investments for each environment can then be purchased or sold.
I think of the problem facing the Fed as a giant lever. The lever size grows as the debt/GDP ratio grows. After each cycle/recession, the Fed must respond with more and more stimulus to get the economy going. Eventually, the lever breaks.
From Robert Zielinsky, Lehman Brothers Tokyo 1989, commenting on Japan's economy in the 80s:
"All the growth was coming from financial gains in the market or lower interest rates...and so it was a vast circle of money but there was no real basis, no economic reality for the boom that Japan had."
I'll let Lee Hsein Loong, former Deputy Prime Minister of Singapore, state the solution to the problem. He is talking to a reporter in regards to the Asian crisis of the late 90s:
“...So don't let your banks go lend recklessly. Don't allow bubbles to get out of hand. Keep prudent measures, sound economic policies which will inspire confidence and maintain confidence, so in a crisis people will know that you will stay the course and won't panic and be up and off. It's easier said than done, but these are the principles you have to follow.”
And another solution (wikipedia), William McChesney Martin, Jr. was the ninth and longest-serving (1951-1970) Chairman of the United States Federal Reserve. His most famous quote about his central banking philosophy was that the job of the Federal Reserve is "to take away the punch bowl just as the party gets going," referring to the need to raise interest rates when the economy is at its most active.
I don't believe the Fed or any other Western government will entertain such measures until the crisis hits. In fact, Asia has done little to change themselves after the crisis in the late 90s except to borrow and export more to America and Europe. As such, investors need to be on-guard and protect their capital as we don't know the recession that will precipitate the crisis.
I also challenge the assumption that the government will 'always' bail out investors. At some point, I suspect the politicians will talk like Roosevelt in the 30's about the evil money changers, etc. Why issue credit to support a bunch of investors when I can build highways and bridges? Japan has followed its deflation with lots of 'make-work' jobs and plenty of public works construction. This will buy a lot more votes with less money than bailing out investors.
On the other hand, from “the collapse of complex societies” p58, “Colin Renfrew (1979) argues that under stress complex societies lack the option to diversify, to become less specialized. By doing more of what may have caused the problem in the first place, the breakdown of the system is made inevitable.”
There are four inputs and two outputs of my investing method.
Inputs
1) Credit Acceleration/Deceleration
What are the Credit Growth Rates?
How Effective is New Credit?
Spreads
2) Price Changes ('early' instability when buying, 'late' instability when selling, stability 'wait')
3) Leading economic indicators and S&P 500 operating earnings
4) Reversion to the mean or Value
A) Value Investing and Portfolio Bias: Inflationary or Deflationary
Also Permanent Portfolio
B) Hedged Position also to preserve mental capital
Credit Acceleration/Deceleration
What are the Credit Growth Rates?
US credit growth has been falling since Q1'06. A recession is pending. Europe has accelerated. A worsening real estate market in Europe will show in this chart soon. Japan's 'official' credit growth is 1%. Gee...no hyperinflation here.
Total Credit Growth...Updated 2008 Q1
Household credit, the largest component, is dropping rapidly. Notice below how households kept borrowing faster and faster from 2000-2005. This cushioned the last recession, 2001. Now federal government is stepping up its credit growth.
To recognize the relative importance of the credit sectors, GDP components 2006-
Households: Personal Consumption (70%), Residential Construction (5%)
Business: 11%
Government: Federal (7%), State and local (12%)
Trade: -5%
US Credit Components...Updated 2008 Q1
Another indicator for future lending is the Fed Loan Officer Survey. I include two charts, commercial and industrial lending standards and mortgage lending standards. In 1990-91, you can see a significant increase in mortgage lending standards which led to a large real estate bear market. Starting in 2000, C&I loan standards increased which led to the stock market melt down in 2000-2002. C&I standards are finally on the increase. I follow this indicator as it tends to have longs runs to it. When standards increase, they tend to tighten for 1-2 years.
C&I loan standards have been increasing; not a good sign for business spending.
Updated Oct'07
Notice that mortgage standards are rising quickly. Now above 1991 peak!
How Effective is New Credit?
It appears that complex societies suffer diminishing returns with increased complexity. In a sense, the credit velocity represents this diminished capacity. I consider the chart below, Credit Efficiency, as the number 1 indicator. If the money velocity falls to 0, monetary policy becomes ineffective.
This chart shows spending (GDP) that occurs for every marginal dollar of Credit. I pulled the data from the Fed Z.1 (credit creation) and BEA (GDP). Most charts or data for money velocity only show M1 or M2 money supply. They fail to incorporate all credit creation. Fortunately, the Fed tabulates all sources of credit in the Z.1.
Credit efficiency for 2007 is 16% down from 34% in 2000. For every dollar of new credit or debt, only 16% ends up in the economy. The rest is trapped in asset bubbles. Another way to put it is for every dollar of new GDP, $6 of new credit is required.
Credit Velocity...Updated End of 2007
As you can see, 2002 was in serious danger of falling into deflation hence the Fed's response of a 1% emergency rate. They saved the year however and we have seen a 3-4 year rebound. However, it's falling again now down to 16% before recession! We're in danger of a 2001 style problem. A 20% drop in credit efficiency in 08-09 leads to ineffective monetary and fiscal policy. Fiscal policy is also included in this chart as it includes all credit.
Every time a bubble deflates as in the 2000 stock market bubble, there's a danger of a correction or "earthquake" where the economy falls to deflation. We can't say whether the next recession will be the one to force this chart to 0. In our investing strategy, we must assume so given the risk involved! Better a year early than a day late.
US Treasury Spread
High Yield Spread to Treasuries (right)
Price Changes
The only reliable chart indicator is % change. Combine this observation with Minsky instability and you find that markets have a number of negative % changes followed by some years of positive % changes and vice versa. A large price change, a change from -ve to +ve, or a change from +ve to -ve indicate a possible trend change. If credit is accelerating, this is a buy signal. If credit is decelerating, this is a sell signal.
Long term dependence is also ideal (the chart makes some sense when looked at over a number of years). Some markets oscillate too much even over long periods. There are too noisy. You want to track the larger markets showing a trend persisting for a number of years (for example, commodities had been trending down for 20 years, then they showed a significant +ve % change in 2002).
Leading Economic Indicators...Updated Mar'08
http://www.conference-board.org/economics/bci/
I watch Leading Indicators 6 month average. Declines are everywhere. World economy follows US!
SP500 Earnings...Updated Q4'07
Year over year percent changes in S&P500 earnings are great leading indicators. Operating earnings are less volatile and can turn upwards before the market turns (see Q2'02 to Q4'02).
see "S&P 500 Earnings and Estimates," http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,0,0,0,0,0,5,9,0,0,0,0,0.html
One old style money supply I follow is the CurrDD or currency plus demand deposits (checking accounts). It tends to go negative before a recession. The 2002 period almost fell to recession.
Currently, it's negative. Recession is upon us. Most importantly the CurrDD should be growing DURING the recession.
CurrDD Year over Year Growth (Narrow Money Supply)...Updated Feb'08
Reversion to the Mean (Value)
Markets revert to the mean over time. For example, in a coin toss game you can have a "run" of 6 heads in a row. How much will you bet you'll get another 6 heads in a row? If you keep tossing, you'll converge on the mean of 50% heads, 50% tails.
Examples of Value at the time: HUI index 2002, DJ Utilities 2003, Housing Stocks 2001, Oil Stocks 2002, Aerospace and Defense 2003, Banking 2003
Which sector offered the best value at the time? DJ Utilities which had a yield of 10% in 2003. You were paid to wait and they were a pretty safe bet over the long run. Watch for another sector like this.
What is of value now? Not much of course. With historically high levels of liquidity, most value has been squeezed out of the market. Every asset has been going up. Which one has been negatively correlated?
The favoured investment for the moment is US long bonds. They are of value (negatively correlated to recent market movements), people are apathetic to them, show wonderful long term dependence, and an up-trend since 1982. The only clear long term dependence chart for this investment is the 1982 to today chart.
Even though you can keep this investment for a LONG time, you may want to lighten the position when opportunities like DJ utilities presents itself.
Short-term sell signs are:
1) Falling fed rate
2) After economic recovery, a rapid rise in CPI
3) Stocks Rising
Interesting Reading:
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