Financial Muscle: February 2011

Monday, February 28, 2011

Deflation

Recently we have heard a lot about the potential for economic deflation. This blog post will be about defining what deflation really is and taking a look at the big picture to evaluate whether it is a true threat or not. More after the jump...

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Deflation: What It Is

It is actually pretty simple. It is when prices generally decline in the overall economy. It hasn't happened too often. During the period from about 1922-1938, during the Great Depression, deflation is what helped make it "Great". When prices decline as a result of a lack of demand, workers are laid off in order to lower costs. This spirals out of control to the point where economic activity slows dramatically. When this happens, since it is a cycle, wages typically fall and the Federal Reserve Board really runs out of ammo to stimulate the economy. They can lower interest rates as much as they want but they can't go below zero. Additionally, everyone circles the wagons and resists raising capital because it probably wouldn't help their bottom line anyway.

How Close Are We to This?

Over the last 12 months our consumer price index, a proxy for overall inflation, has risen by 1.1%. Take out food and energy and it only rose 0.7%. That's pretty low. As you know, that Fed is trying to stimulate our economy through lower interest rates and supplying banks with as much money as they need to lend. Banks, for good reason, are hesitant to lend loosely from fear of ~~getting hammered by the regulators~~ reducing their capital ratios with non-performing loans.

There are several factors that could have significance in propelling us into a deflationary spiral if they were to simultaneously go the wrong way: oil prices, food prices, the dollar, and the unemployment rate. I'm going to discuss in some detail those I think are likely the most important: the dollar and the unemployment rate.

We have run a current account trade deficit as long as I can remember. In 2010 the US current account trade deficit rose to about 3.5% of gross domestic product from about 2.5% a year before +40%. Clearly, we are not competitive with the rest of the world in several key areas. We are importing the majority of our oil which we use to drive our not-so-competitive economy. Combinations like this do not work in our favor. Occasionally, the flight to quality increases the value of our dollar, but long-term our dollar value trend is down since about 2002. We are more stable now, but we are not gaining much ground. A lower dollar makes our goods less expensive for overseas buyers, but it still reflects the fact that we are buying more than we are selling. Please know that there are many more factors affecting the dollar’s value. The price reflects their combination effect, though.

It is estimated that gross domestic product growth of somewhere between 4% and 5% might decrease our unemployment rate by about 1% per year. Currently we are sputtering along at less than 4% (unusually low for this phase of a recovery). Our growth rate could improve dramatically because economic recoveries typically gain steam at an increasing rate for while. However, there still appears to be a bit of a headwind in the face of corporate America.

Real Estate

Real estate value underlies many of these issues. In many areas of the US may have declined by as much as 25%. Does Japan ring a bell? Are we going to replay their economic disaster? From 1990 through 2005 land values dropped as much is 70% in some places. Additionally, the Nikkei index (Japan's most well-known stock index) had jumped 237% between 1984 and 1989. Subsequently it dropped 78% by the end of 2002. It is currently only about 10,600 -- over 20 years later. (Source: Global Financial Data) We are likely in better shape than they because our asset prices didn't have as far to fall. We also have a much more diversified economy and we have a higher population growth rate which is a natural demand stimulator over time. However, unless our government gets its fiscal act in order we could be in line for a very long slow growth period.

The federal reserve board statement of January 26, 2011 weighed in on our current situation with this quote: "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period."

Going Forward

The Fed’s actions tell me that we are not out of the woods. If we were, they would be targeting rates at a more normal level. Economic recoveries can produce surprisingly fast stock market recoveries. They can also produce surprisingly big declines. If investors are inclined to gamble before many of the pieces are in place, this is probably the time. Regarding their serious money, however, until sound reasons for a robust economic recovery appear they should not be lulled to sleep.

In a blog in the near future I expect to discuss stock market gains against the backdrop of our very slow economy.

Take Care,

Chris

Tuesday, February 15, 2011

Financial Muscle Special Report: Egypt: Upside Down Pyramids

The rioting and general taking to the streets and the resulting increasing oil price has surprisingly not unraveled our markets to any great extent at the time of this writing. This is surprising given the elasticity of our markets to bad news in the recent past. I monitor the VIX, which is a reading of stock market volatility. It shows a reading of around 17 which is pretty low. Why have market participants not reacted more? More after the jump...

This is something that has been brewing for some time. It appears that the unrest is fairly universal in Egypt. Hosni Mubarak represents the National Democratic Party. Since 1967 they have had “State of Emergency” powers. That tells me most of what I need to know. With power concentrated in the hands of a few in the ruling class, eventually a population has had enough. The most they can do is throw rocks, cause havoc, and be generally unruly as they do not have widespread access to firepower to overthrow their perceived oppressors. The root of their troubles appears to be economic. Their annual gross domestic product per person is around $6,200 according to JP Morgan. The similar US statistic is approximately $40,000. Their unemployment rate is perpetually high. Elections appear to be rigged with the National Democratic Party gaining over 80% of the electoral seats. Eventually the masses become fed up and they are doing it now. What are our risks in the marketplace?

There is not so much a risk to oil shut-off from Egypt. They are not a major world producer. The bigger oil risk is when those who oppose non Muslim control of anything move in to take advantage of the power vacuum. This is a real risk. I will take the conservative stance and assume that it will happen to some large extent. Could this disrupt the oil flow? Perhaps. More likely is that it will create the perception of risk and oil prices will rise. They appear to have already risen in reaction to the unrest. Since we are forced by regulation to import the majority of our oil, we will be affected by prices and disruption. According to the International Energy Agency, a $10 increase in oil price has the potential to cut US GDP by 0.3%. Oil prices affect our economy similarly to a tax. They increase the cost of consuming and doing business as they are passed on ultimately to the consumer. JP Morgan estimates that a GDP growth rate of 5% is necessary to cut the unemployment rate by 1%. You can then imagine that with oil’s price increasing, the outlook for our recovery slows by a not insignificant amount.
All of this is used in the portfolio recommendation process.

Please feel free to contact me at 952-230-1340 if you have any questions or concerns.

Take care,
Chris

Thursday, February 3, 2011

Your Financial Muscle February 3, 2011 Volume 2011-1

Welcome to the first post of Your Financial Muscle! This will mostly take the place of the quarterly newsletter known as News from the Front. The quarterly newsletter is a large undertaking and is prone to running out of room. So, in the interest of quick, timely information and a format that can be added to, the blog offers the best of a few worlds. I say a few because there are times when a blog will simply not provide the continuity necessary. For example, when the topic is too large and important to skimp on the size of the writing, or if there are too many charts for our own good, a blog just will not cut it. I will fall back on News From the Front special reports that will be attached to FinancialMuscle.com. Keeping you informed of what is real, material, and important is what this site is all about. So, keep it handy.

To keep it handy you have a few choices: make it a favorite, make my website a favorite because there will be a link to it from there very soon (www.privatewealthadvisorsllc.com), friend me on Facebook.com (Give me a few days to be there), follow me on Twitter.com (Give me a few days to be there). All of these locations will have links to here and will be updated when there is a post. In the future, I expect to provide you with podcasts of the same information for the drive home.

It has taken me a while to get “social” but when I get…I really get. Your information flow from me will increase many fold in the near future due to these changes. If you have any trouble getting on any of these sites, just call Angie and she will walk you through it.

I am really looking forward to sharing back room information with you. I want you to know that there is a mountain of consideration that goes into your portfolio and the financial analysis I do. I am hoping this format helps you know what I know.

So with that, lets GO!!!!

Hyperinflation, Currency, and Other Scary Things

"I just want to say one word to you - just one word.... 'Plastics.'” from The Graduate

We have fiat currency. Nothing backs it other than confidence. Where do we get confidence in it? Generally from the strength of our economy compared to all others. When our confidence is shaken like the last two and one half years, it is no wonder that currency substitutes have become a hot topic. Just turn on your radio for a half hour and you will likely hear multiple advertisements for currency substitutes. Let’s dig deeper, though. When does a currency likely collapse from lack of confidence?

Option1: Government overthrow: I am not worried about this at this particular moment.
Option 2: Hyperinflation could cause a currency collapse, but it did not in the late 1970s and in the early 1980s. But, do we really have a similar situation now?

Inflation in and of itself is an everyday occurence. Normally, inflation of 2-3% is condidered necessary to reach full employment - assumed to be 5-6% unemployment. Hyperinflation occurs when inflation is raging in an uncontrolled manner to the point where the Fed does not feel confident reeling it in. Surprisingly, I am not too concerned about hyperinflation right now. I am more concerned about deflation, as is the Fed. Let's break apart inflation into its main components:

Wages

Deficits

Dollar

Wages: the single most important component of national income is wages, they account for about 62% of all national income. If wages go up so does spending and so does money creation. Wages can have an enormous impact on inflation potential. The reality check is best thought about in terms of some key questions to bring this factor close to home: How many people do you know receiving big raises? Likely none or almost none. You probably know more people out of work or working two or three jobs to stay afloat. At just under 10% unemployment it is unlikely that wages will increase dramatically anytime soon. There is ample evidence that we will have high unemployment for years to come, but that’s another post. So, what about the deficit?

Deficits: There is no question that the deficit is high. You would think that wage expansion is not necessary because the printing of money is creating enough dollars in the system to stoke inflation. The real numbers say that the relationship between money supply and inflation does not exist like it used to. We remember a time in the 1970s when inflation ate our collective lunches. Then, economic output as measured by factory utilization was maxed out. The administration fed more dollars into a maxed out system and inflation had nowhere to go but up. Production of goods and services had nowhere to go. So, more dollars chased a relatively static number of goods and services. Now, things have changed. Industrial production in the US is only at 74.8% according to the Federal Reserve Statistical Release. Additionally, economists think that the amount of money in an economy is not as crucial as it used to be. They have found that contrary to decades ago, credit and debit cards make it easy to base spending habits on things other than physical dollars in your drawer. The ease of the transaction makes it possible to base purchase decisions on things like how much you want to work for it, how much you are spending, and how much you want to borrow at a given time. Transaction ease has changed the landscape of modern commerce and inflation potential.

Dollar: So, how does a falling dollar lead to inflation? The conventional wisdom is that cheaper dollars lead to higher import prices. It takes more dollars to buy a, say, British pound, making the Rolls Royce more expensive. So let’s say that that actually happens. Surprisingly, imports are only 16% of our GDP. Let’s say that the dollar falls by 10%. So economy-wide the Rolls (the proxy for all imported goods in this example) increases dollars necessary by 1.6% overall. It is not really that much of a problem.

Show Me the Money!

Let’s look at how we spend our money (GDP):

According the Bureau of Economic Analysis, here is the make up of GDP:

2010 Annualized GDP (based on 3 quarters of 2010) $14,750 (trillions)

Personal consumption $10,383

Investment $1,895

Imports $2,399

Exports $1,897

Government: federal, state, and local $3,023

The elephant in the room for inflation purposes is personal consumption. Unless something miraculous occurs, personal consumption is in for a long slow growth spell just based on unemployment alone.

The next post will be on deflation and why the Fed is far more concerned about it than inflation. Please call me if you have any questions or comments.

Take care!

Chris