It’s Not Deleveraging But Inflationism, Stupid!

A popular analyst recently wrote in his weekly outlook that the underlying theme of today’s environment should be known as “It’s the Deleveraging, Stupid!”

Deleveraging is technically accurate if the argument is centered on the contracting credit activities of the private sector of the US economy.

But focusing on deleveraging isn’t correct, it’s misleading. That’s because the private sector isn’t the only part of the US economy.

On the contrary, since the crisis surfaced, US government’s share of the US economy has exploded.

From CFR.org

One must realize that even prior to the crisis that the trend of the US government’s contribution to the economy has already been expanding, albeit gradually.

The crisis only hastened the process.

From Business Insider

Well even in the labor market, government employment has now surpassed the private sector.

In short, it would be a terrible mistake to fixate on the private sector when government’s role in the economy has been capturing a fairly substantial share of the economic pie.

Laissez faire, anyone?

So is the US government also experiencing a "deleveraging"?

From Paul Kedrosky (March 2009)

Based on the overall credit picture of the US, the answer is clearly NO.

Total credit has surpassed 350% of the GDP of which the US Government’s leverage has virtually topped the private sector. And that was in 2008, at the height of the crisis! It should be more today.

Obviously, a bigger government translates to bigger spending.

From Heritage Foundation

This means that spending has to be financed by higher taxes, by borrowing or by printing money.

Since higher taxes won’t be politically appealing considering the frail state of the economy, then the palpable recourse is to borrow or let the printing press rip!

Yet speaking of government, until this point we have not seen signs of deleveraging.

From Heritage Foundation

But we are obviously seeing debt building up…leveraging by deficit spending and not deleveraging.

Of course, like many deflation proponents Japan’s lost decade has been made as a popular example of what the US outcome might be.

From McKinsey Global Institute

While everyone in the investing community seem to know that Japanese internal savings financed its debt burdens, what everyone don't seem to realize is that Japan’s policy priorities had been far different from the US.

Forget about Japan’s bubble bust as being “isolated”, the important difference is that Japan policies didn’t have to bother with much of the world.

The US, on the other hand, being the world’s primary foreign currency reserve, has had to deal not only with its own economy but importantly work to uphold its status as the world’s monopoly provider of the medium of exchange for international payment and settlement.

From Federal Reserve Bank of Atlanta

In short, the global banking system and its attendant liquidity required for most of its transactions, greatly depends on the US dollar (Federal Reserve), which has equally been dependent on its own banking system to facilitate this transmission.

Therefore, US authorities have had to face two competing priorities, particularly the banking system (its global seignorage status) or its economy.

They made a choice and it was to rescue the banking system-so it can provide liquidity to the world and retain the privilege of being the world's monetary hegemon.

Of course, US authorities has repeatedly justified that its banking system is a vital part of the US economy, if not THE economy.

And that’s the reason why the Fed lent, spent and guaranteed some $11.6 trillion (as of September 2009), to the sector.

This implies that resources had to be redirected to the banking system which have been drained from the real economy.

This massive act of redistribution epitomizes not deleveraging, but inflationism.

And as we said above, bigger spending requires financing from debt or the printing press, if taxes is the least available option.

But considering that its banking sector’s balance sheet had been stuffed with rubbish but labeled as 'AAA' assets during the days of delusion, a solution has to be made.

Hence Bernanke like a good student of the Great Depression resorted to what he deemed as the most effective strategy to deal with this problem. His solution is to use the magic wand, the nuclear or the Helicopter option.

So by the waving of his magic wand, this would now allow him to “hit two birds with a single stone”….

From the Federal Reserve of Cleveland

The quantitative easing program or what the Cleveland Fed euphemistically calls as the “Fed credit easing policy tools” is simply the printing press!

By buying assets of the banking system, the banks get a reprieve, aside from buying time to build up capital. By manipulating the mortgage and treasury markets (even possibly the stockmarkets) the banks earn from spreads. By pushing up asset prices the animal spirits are reanimated. People go out and borrow and spend again, hurray!

Central bankers once ridiculed Zimbabwe’s Dr. Gideon Gono but apparently his formula seem so chic these days, such that Dr. Gono must have felt exonerated.

So does this signify as “deleveraging”?

Again the answer is NO.

Credit Bubble Bulletin’s Doug Noland who recently dissected on the Federal Reserve’s 3^rd Quarter Flow of Funds has this to say, (bold emphasis mine)

``Once again, system Credit expansion was almost completely dominated by federal borrowings. For the quarter, federal government debt expanded at 20.6% annualized, down from Q2’s 28.2%, Q1’s 22.6%, and Q4 2008’s 37.0% SAAR. Domestic financial sector Credit contracted 9.3% SAAR, an improvement from Q2’s 12.5% contraction. Foreign sector U.S. borrowings expanded at a 14.9% rate, the strongest since Q1 2008….

``Over the past year, Treasury debt expanded $1.743 TN, or 30.2%, to $7.521 TN. Treasury borrowings were up $2.270 TN, or 43%, in just five quarters. And despite the contraction in overall mortgage borrowings, outstanding GSE MBS expanded $408bn, or 8.3%, over the past year to $5.30 TN. In the past eight quarters, GSE MBS expanded $1.057 TN, or 25%. For the quarter, GSE MBS expanded $481bn SAAR. In just five quarters, combined Treasury and GSE MBS expanded an unprecedented $2.810 TN. “Flow of funds” data continue to confirm the Government Finance Bubble thesis."

So yes, there is no quibble, the private sector has been deleveraging.

But NO, the government isn’t.

Instead what Doug Noland calls as “Government Finance Bubble thesis” alternatively means inflationism...again.

Bottom line: I hate to say this, but I’ll simply borrow or paraphrase the sarcasm imbued in the title used by the popular analyst, ``It’s not deleveraging, but inflationism, stupid!”

Velocity Of Money: A Flawed Model

``Economics is a social science. Econometric models spit out results that lack the accuracy of chemistry experiments and the precision of mathematical equations. Central bankers are forced to deal in the realm of the touchy-feely all the time. If their work could be reduced to an equation, we wouldn’t a) need them or b) find ourselves in the mess we’re in now.” Caroline Baum Central Banks Can Do Better Than Just Mopping Up

Zero Hedge’s Mr. Tyler Durden comment of ``And instead of this excess money hitting broader aggregates such as M2 or MZM, it is held by the banks, who proceed to buy securities outright on their own, either Treasuries or Equities. Apply the proper "money multiplier" to get the monetary impact on the S&P 500, as a result of the banks not lending these excess reserves, and instead simply speculating with it, and you will likely get the increase in the market cap of the S&P since the launch of QE” provoked my inquisition to mainstream’s allure to use money velocity as benchmark for arguing the case for deflation.

Velocity of money is the turnover (circulation) rate of money in terms of transactions.

It is assumed that a low money velocity, which means lower rate of circulation, can only support lower prices.

Yet if US banks have indeed been directly speculating, and if such activities haven’t been registering in money aggregates, as postulated by Mr. Durden, then the whole premise built around the inefficacy of monetary policies seems tenuous because statistics have not accurately captured such bank speculations in the asset markets.

Besides, Velocity of Money is a statistical measure based on the Keynesian consumption model, where spending equates to income.

The idea is more spending would result to higher prices and higher national income and or higher economic growth.

This is an example from wikipedia.org,

``If, for example, in a very small economy, a farmer and a mechanic, with just $50 between them, buy goods and services from each other in just three transactions over the course of a year

Mechanic buys $40 of corn from farmer.

Farmer spends $50 on tractor repair from mechanic.

Mechanic spends $10 on barn cats from farmer

``then $100 changed hands in course of a year, even though there is only $50 in this little economy. That $100 level is possible because each dollar was spent an average of twice a year, which is to say that the velocity was 2 / yr.”

In short, velocity of money measures transactions only and not of real economic output.

Moreover, it is also implies that money printing or increasing systemic leverage as the key driver to an increased velocity of money.

From the Austrian economic perspective, this concept is pure flimflam.

Henry Hazlitt wrote ``What the mathematical quantity theorists seem to forget is that money is not exchanged against a vacuum, nor against other money (except in bank clearings and foreign exchange), but against goods. Hence the velocity of circulation of money is, so to speak, merely the velocity of circulation of goods and services looked at from the other side. If the volume of trade increases, the velocity of circulation of money, other things being equal, must increase, and vice versa.” (bold emphasis mine)

Similarly Ludwig von Mises scoffs at the concept, ``They introduce instead the spurious notion of velocity of circulation fashioned according to the patterns of mechanics.” (bold emphasis mine)

Figure 5: Hoisington Management: Velocity of Money

Some deflation exponents say that the two major forces, which drove up the velocity of money, which has characterized the previous boom (see figure 5), particularly financial innovation and leveraging, will be materially less a factor in the post boom era.

The general notion is that the collapse of the shadow banking system and the deleveraging in the US households and its banking system would lead to deflationary pressures from which the government or the central bank inflationary policies won’t be able to offset.

That is from a mathematical standpoint, from which presumes to capture all the variables of human actions. Unfortunately, these macro based math models don’t reflect on reality, because it can’t impute the cause and effect, before and after outcomes of human decisions.

Other reasons why I think velocity of money is a flawed model?

One, such outlook depends on the accuracy of each and every variable that constitutes the equation, such as money supply. If Mr. Durden is correct, then velocity of money model automatically crumbles.

Two, it disregards the impact of pricing dynamics on the marketplace, e.g. how will lower prices impact demand?

Three, it discounts man’s adoptability in acquiring technology [see earlier post, Technology's Early Adoptor Disproves Deflation]

Fourth, such measure focuses entirely on the leveraging of the financial sector and leaves out the contributions from the real economy.

Fifth, it treats the economy as a homogeneous constant (single form of capital, labor and output), from which excludes the evolving phases of the interlinkages of the marketplace, governments and technology.

Lastly, it oversimplistically omits the transmission mechanism from the interactions of the US (policies and economic activities) with the world.

As Professor Arnold Kling observed, ``Structural models do not extract information from data. Instead, they are a method for creating and calibrating simulation models that embody the beliefs of the macroeconomist about how the economy works. Unless one shares those beliefs to begin with, there is no reason for any other economist to take seriously the results that are calculated.” (bold emphasis mine)

Or as Warren Buffett on warned on depending on models, ``Our advice: Beware of geeks bearing formulas.”

Why Geither's Toxic Asset Program Won't Float

There are many reasons for us to share the distrust with the apparent misplaced optimism credited to Tim Geither's Public-Private Investment Program or PPIP. Chief among them are issues on market price discovery and distorted incentives from government subsidies.

Nonetheless, I'll leave it to the experts debate on it.

But aside from technicality issues the following charts should explain why this program isn't likely to attain its goals...

One, leveraged loans defaults are likely surge.

The Researchrecap.com quotes a Moody's study (chart above from researchrecap)

``“Given tight credit markets, a worldwide economic slump, and a deteriorating issuer ratings mix, we expect default rates on leveraged loans will continue to climb in 2009, while recovery rates are expected to fall further,” said Sharon Ou, Assistant Vice President in Moody’s Credit Policy Default Research Group.

``Moody’s U.S. leveraged loan default rate ended 2008 at 3.5%, up from the 0.3% recorded in 2007.

``The ratings agency forecasts that 11.1% of U.S. leveraged loan issuers will default by the end of 2009.

``First-lien loan recovery rates fell to 63.4% at the end of 2008, down from 68.6% at the beginning of the year. By comparison, senior unsecured bond recovery rates dropped from 61.8% to 33.0% during the same period." (bold highlight mine)

Next, Fitch Ratings says losses in Residential Backed Mortgage Securities will rise further, see above chart.

The Researchrecap.com wrote, ``A dramatic rise in delinquencies has led Fitch Ratings to raise its average loss estimates for recent vintage jumbo prime mortgage pools to between 3 and 5 times higher than its previous estimate...

``In analyzing recent prime mortgage performance Fitch found that:

``Loans with multiple risk attributes such as limited income documentation and second-liens, are defaulting at rates approximately three times that of loans without those characteristics;

``A growing percentage of prime borrowers have lost all home equity due to declining home prices. Borrowers with negative equity in some recent vintage mortgage pools are approaching 50%;

``After adjusting for home price declines to date, loans estimated to have no equity in the property are defaulting at rates approximately three times that of loans estimated to have equity remaining.

``In addition to high default rates, recovery rates on defaulted loans are also trending downward."(bold highlight mine)

Lastly, Commercial Mortgage delinquencies are likely to worsen, see above chart.

The Researchrecap wrote, ``Commercial mortgage delinquencies rose sharply in February, driven by retail properties and lodging, according to Standard & Poor’s Credit Research, which lowered ratings on more than 200 commercial-backed mortgage securities during the month.

``The delinquency rate in February for U.S. CMBS rose to 1.57 percent from 1.39 percent in January.

``The amount delinquent is rapidly approaching the $10 billion level, closing February at $9.68 billion. The amount delinquent has increased by over 40 percent since the start of 2009, but the rate of growth slowed in February."(bold highlight mine)

The Commercial Mortgage Backed Securities could be the next tsunami of the serial deflating debt bubble.

According to the Wall Street Journal, ``Commercial real-estate debt is potentially more dangerous to the financial system than debt classes such as credit cards and student loans because of its size. The Real Estate Roundtable, a trade group, estimates that commercial real estate in the U.S. is worth $6.5 trillion and financed by about $3.1 trillion in debt. Partly because the commercial real-estate debt market is nearly three times as big now as in the early 1990s, potential losses in dollar terms loom larger.

``According to an analysis of bank financial reports by The Wall Street Journal, the broad shift to real-estate lending can be seen by comparing commercial real-estate loans -- including both mortgages and construction loans -- with banks' so-called Tier 1 capital, a key indicator of a bank's ability to absorb losses. In 1993, less than 2% of the nation's banks and savings institutions had commercial real-estate exposure exceeding five times their Tier 1 capital. By the end of 2008, that had risen to about 12%, or about 800 financial institutions. A higher ratio means a thinner cushion for loans that go sour.

And in contrast to residential mortgages which had been held by a few but largest banks, the general "community based" banking system seems highly exposed to the probable deterioration of commercial loans-as banking capital hasn't kept pace with the identified risks.

Again the Wall Street Journal, ``Of $154.5 billion of securitized commercial mortgages coming due between now and 2012, about two-thirds likely won't qualify for refinancing, Deutsche Bank predicts. Its estimate assumes declines in commercial-property values of 35% to 45% from the peak in 2007. That would exceed the price drops in the downturn of the early 1990s.

``The bank estimates the default rates on the $700 billion of commercial-mortgage-backed securities could hit at least 30%, and loss rates, which figure in the amounts recovered by lenders, could reach more than 10%, the peak seen in the early 1990s.

``Besides securities backed by commercial real-estate loans, about $524.5 billion of whole commercial mortgages held by U.S. banks and thrifts are expected to come due between this year and 2012. Nearly 50% wouldn't qualify for refinancing in a tight credit environment, as they exceed 90% of the property's value, estimates Matthew Anderson, partner at Foresight Analytics. Today, lenders generally won't loan over 65% of a commercial property's value.

``In contrast to home mortgages -- the majority of which were made by only 10 or so giant institutions -- hundreds of small and regional banks loaded up on commercial real estate. As of Dec. 31, more than 2,900 banks and savings institutions had more than 300% of their risk-based capital in commercial real-estate loans, including both commercial mortgages and construction loans."(bold highlight mine)

So if "toxic" asset prices will remain under pressure, the PPIP won't be enough to provide support as a wider range of loans are likely to crumble from the pressures of the combined weight of economic weakness and persistent financial sector eleveraging.

Private investors who are aware of the situation might see this as tantamount to "catching a falling knife"- and may refrain from participating- even if the private sector's risk participation is said to be only 7% while the rest is guaranteed by the goverment. Otherwise this should translate to huge taxpayer losses.

Hence, we can expect Geither's plan to probably expand coverage or introduce more innovative forms of bailout packages-all at the expense of US taxpayers-or for the US government to print more money to make up for the financial blackhole.

Just a short note on equity markets…

``There is an even deeper reason to reject the long run as a guide to future investment policy. The long-run results we can discern in the data of stock market history are not a random set of numbers: each event was the result of a preceding event rather than an independent observation. This is a statement of the highest importance. Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical. There is no predestined rate of return. There is only an expected return that may not be realised.”- Peter L. Bernstein Insight: The flight of the long run

At the start of the year, we propounded the scenario where 2009 could likely manifest some divergences in the global equity markets.

Despite the continuous decline in the major US equity bellwethers, we seem to be seeing some marginal proof of such transitioning.

Figure 7: stockcharts.com: Emerging Divergences Among Global Equities?

Although pressures from the worsening recession in the US continues to weigh on most Emerging Market bourses, the degree of decline hasn’t been as steep or as deep, based from December 23^rd of 2008, as shown in figure 7.

Probably this could be because most EM bourses fell steeply more than US benchmarks in 2008. As discussed in Black Swan Problem: Not All Markets Are Down in 2008!, In 2008, the US fell 38.49%, Chile lost 22.13%, Brazil 41.22%, Malaysia 39.33%, Thailand 47.56%, Indonesia 50.64% and the Philippines 48.29%.

In fact, the current losses of the US bellwethers seem to match, if not exceed, the losses attained by some of these bourses at their lows.

Nonetheless we seem to be seeing some outperformers: Chile lost only 22.13% during the dramatic meltdown in 2008 but is already slightly up on a year to date basis. We also see Venezuela (growing signs of dictatorships gaining acceptance?) and Colombia among the other Latin American honor roll.

Across the ocean, we have Morocco and last year’s member of the 3 amazing bourses which defied the tide, Tunisia as another hotshot. This, despite the global economic woes affecting their exports and tourism revenues, aside from a sharp slowdown in the national economic growth.

To quote Marion Mühlberger of Deutsche Bank, ``So it looks as though Tunisia cannot decouple completely from the global financial crisis but is unlikely to suffer any major economic or banking crisis”. Probably not in terms of traditional economic metrics but certainly has “decoupled” in terms of financial markets performance in 2008.

Not that we believe that this is anything about “economic recovery”, but from the monetary viewpoint, the potential response stems from the impact from we believe as the liquidity spillover or our “spillage effect” from the collective attempts by central banks and governments to inflate asset markets and the economies. Governments are essentially driving the public to speculate and turbocharge asset inflation.

As we noted above, the losses have vacuumed most of the liquidity generated by global authorities, although last week’s surge in select commodities as oil (+11.82%) and copper (+7.7%) seem to validate our supposition of a prospective spillover. Albeit Gold’s (6%) decline could be indicative of an emerging rotation, or possibly, rebalancing of the Gold-oil ratio which has surged to record levels in favor of gold.

Figure 8: PSE: Sectoral Performances

Finally we seem to see the same signs of divergences even in the Philippine Stock Exchange (figure 8).

Based on sectoral performance on a year to date basis we see commercial industrial (pink-up 15.27%) and the mining sector (green up 11.75%) outperforming the rest of the field- Property blue (-9.47%), banking black (-10.79%), holding red (-1.51%), all maroon (+1.17%) and service orange (+1.34%).

The surge in the commercial industrial has been powered by energy stocks.

The Phisix (-.03% year to date) continues to drift sideways which implies a likely bottoming cycle, despite the October like performance in the US. This seems largely due to the diminished scale of foreign selling activities which may have validated our assessment of the deleterious impact of forcible selling or delevaraging to the local equity market, regardless of fundamentals.

Nonetheless, if we see a continued rise by the present market leaders, then this “inflationary driven” run may start to spread over to the broader market. And people may start to read market prices as “justification” of an economic “recovery” and pile on them; even when this may be due to sublime responses to monetary policies.

However, we will need to be further convinced with technical improvements on some key local and select benchmarks, aside from key commodity prices and similarly progress in domestic market internal activities.

Phisix: The Fantasy Of The 2008 "Window Dressing" Year End Rally

“If most of us remain ignorant of ourselves, it is because self-knowledge is painful and we prefer the pleasures of illusion.” Aldous Huxley (1894-1963), English Writer

We learned that some local experts recently opined that if a rally should occur in the Philippine equity markets this month, this would likely be driven by so called “Window Dressing”.

Window Dressing according to Investopedia.com is ``A strategy used by mutual fund and portfolio managers near the year or quarter end to improve the appearance of the portfolio/fund performance before presenting it to clients or shareholders”.

So after the recent rout, where the Phisix have chalked up 48% losses year to date and 51% since the credit bubble imploded last July, how should we expect “to improve the appearance” of portfolio funds to lift the market?

In our view, either such expert/s have been living on a different planet or have completely lost rationalizations to explain away market actions.

Why?

1. Lost in the understanding is the process called debt deflation or deleveraging.

During the previous boom, asset values in the global financial zoomed due to massive speculations underpinned by an easy money environment or the moneyness of credit. Remember, banks based their lending on the value of the collateral and the lending process enhances the value of such collateral. Hence the entire process of lending and collateral values becomes a self-reinforcing feedback loop.

So in boom periods, rising collateral values allow for more lending which again translates to even higher collateral values…until the whole becomes unsustainable and reverses.

Today, the process of lending and collateral values could be seen as similar to a “global margin call” where falling collateral values compels lenders to tighten either by asking for more collateral to secure outstanding loans or forcibly liquidate assets in order to pay for such loans. The whole feedback loop, thus, accentuate the downward spiral in asset values which all of us have been witnessing today.

2. Lost in the understanding is that the finance industry and fund managers are the main conduits of the deleveraging process.

The unraveling debt deflation phenomenon has basically been vented on the financial markets.

And this has visibly caused the market’s miseries today here or in Asia (see Figure 1) or elsewhere.

Figure 1: IMF: Fleeing Foreign Capital

According to IMF’s Kenneth Kang and Jacques Miniane (all italics mine),

``But given the region's large trade and financial integration with the rest of the world, investors' views of Asia soured as the global turmoil intensified and perceptions grew that the global economy was in for a major slowdown. Large net equity outflows have driven down stock prices sharply. Asia-focused hedge funds have been among the worst performers worldwide, with their returns consistently below those of other emerging market funds.

``Capital outflows have also significantly weakened currencies in some countries, notably India, Korea, New Zealand, and Vietnam. And several countries have responded by intervening to support their currencies, in stark contrast to the past several years, when most Asian countries were concerned about the rapid appreciation of their currencies.

``With the rise in global risk aversion, Asian governments, corporations, and financial institutions have found it more difficult to access the global financial markets. Countries with banking systems that rely more on wholesale financing and less on retail deposits (Australia, India, Korea, New Zealand) have experienced a higher rise in borrowing costs, partly because of concerns they will face difficulties rolling over their debts. As a result of these tightened conditions, the region's private external financing has fallen sharply.”

And because the process of deleveraging equates to forcible liquidations in order to reduce debt exposure, this means that global fund managers have likewise been retrenching to meet redemptions or to simply cut losses.

So we see this in hedge funds…

From Bloomberg, ``The global hedge-fund industry lost $64 billion of assets in November, with an index tracking its performance declining for a sixth month as economies in Asia and Europe joined the U.S. in recession, Eurekahedge Pte said…

``Hedge-fund industry assets peaked at $1.9 trillion in June, data compiled by Chicago-based Hedge Fund Research Inc. show. Investment losses and withdrawals may shrink that amount by 45 percent by the end of this month, according to estimates by analysts at Morgan Stanley.”

And in the mutual funds…

From ICI.org, ``The combined assets of the nation's mutual funds decreased by $1.087 trillion, or 10.2 percent, to $9.600 trillion in October, according to the Investment Company Institute's official survey of the mutual fund industry.”

And we can’t expect the local counterparts to immediately replace them considering that the industry has been quite underdeveloped, where according to Icap,com, ``total of 22 mutual funds in the country. Six (6) of these are bond funds, five (5) are equity funds, while the remaining ten (10) are balanced funds while one is a money market fund” and even if we add the domestic bank based UITF counterparts.

3. Finally, market inefficiencies brought about by the dynamics of the sheer scale of liquidations aside from tax angles could factor in negatively for the US markets which could spillover to other markets…

That’s if we heed former fund manager Andy Kessler who warns the public to ``stick wax in your ears and don't listen to the market until February.”

Quoting Andy Kessler (Wall Street Journal):

``-Tax-loss selling: Whenever you have a loss in a stock -- and who doesn't -- it's always tax smart to sell it, take a tax loss and either buy something similar or wait 30 days and buy the original one back. December can be an ugly month of indiscriminate selling. The December effect will be huge this year.

``- Mutual-fund redemptions: Mutual funds are also dumped for tax losses. When the stock market is down in the morning, it's usually because of mutual-fund redemptions…

``- Mutual fund cap-gain distributions: To make matters worse, in December mutual funds do capital-gains distributions. In a down year like 2008, you would think there are no taxes to pay. Think again. Legg Mason's Value Trust, run by Bill Miller, outperformed the market for 15 years by buying many "unvalue" names like Amazon. As investors redeem, he is forced to sell many of these stocks originally purchased at very low prices, triggering huge capital gains in a year his fund is down 62%. You can almost guarantee investors also will sell more of these funds to pay their unexpected tax bill.

``- Hedge-fund redemptions: Instead of overnight selling like mutual funds, hedge funds typically require 45 days' notice for investors to get out of a fund. They've been furiously selling since September to raise cash to pay investors. This usually shows up as a set of stocks that just go down and down and down with no obvious explanation.

``Rubbing salt in hedge-fund wounds is the fact that Lehman Brothers was a prime broker to many hedge funds, holding their shares. While Lehman's bankruptcy was not a problem in the U.S., in England the policy is to freeze accounts until the mess can be sorted out. There are billions in assets locked in this bankruptcy, and hedge funds are forced to sell positions in the U.S. and elsewhere to raise cash, exacerbating the downside here.

``By the way, when hedge funds are down for the year, they work practically for free until they make up the loss. We'll see hedge funds close and stocks liquidated as -- no surprise -- hedge-fund managers like to get paid.

``- Margin calls: Whenever stocks go down sharply, you quickly find who owns them with debt. We have seen spectacular margin calls, a requirement for more capital to cover share losses. Chesapeake Energy CEO Aubrey McClendon unloaded 33 million shares to cover losses. Viacom CEO Sumner Redstone had a forced sale of $400 million in Viacom and CBS shares because of a margin call on other stocks. You can bet many not-so-public margin calls are behind many huge price drops. These usually take place in the last 30 minutes of trading.”

Overall, the fundamental premise that global and local fund managers will provide for a temporary facelift for the Phisix doesn’t square with global trend of rising risk aversion, client and fund redemptions and or perhaps tax induced selling.

If the Phisix and global markets should rise, it is likely because long term investors will take over short term players or take advantage of the collateral crisis related losses or even perhaps take refuge in stocks as “store of value” in a world where global central banks have been racing to collectively devalue their currencies.

Window dressing could possibly be an issue after the deleveraging phenomenon or when markets stabilize.

To argue otherwise seems living off a fool’s paradise, or as Sigmund Freud once wrote, ``Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces."

Has The Deleveraging Process Culminated? Where’s The Next Bubble?

``Many shall be restored that now are fallen and many shall fall that now are in honor.”- Horace, leading Roman lyric poet in Ars Poetica

Global markets rallied furiously over the week, setting stage for what perma bears call as the sucker’s rally. For all we know, they could be right. But I wouldn’t bet on them. Not especially when central banks start to use the first of its available nuclear option of monetizing government debt. Not when government central banks start running the printing presses 24/7 and begin a Zimbabwe type of operation.

We also don’t know to what extent of the forcible liquidations of the deleveraging process is into, what we do know is that governments are today starting to unveil their long kept ‘secret’ final endgame weapons. We appear to be at the all important crossroads. Will it be a deflationary depression outcome? Will it be a recovery? Or will hyperinflation emerge?

What we also know is that forcible liquidations from the ongoing debt deflation process have been responsible for the “recoupling” saga we are seeing today.

Figure 4 stockcharts.com: Gold leads Rally

In figure 4, compared to the previous failed rallies (2 blue vertical lines), gold, oil and commodities haven’t joined the bullish rebellion in global equities as shown by the US S & P 500 (spx), Dow Jones World (djw), and Emerging Market Index (EEM).

This time we see gold leading a broad market rally. The Philippine Phisix too has obliterated its 10.73% one week loss by surging 11.65% this week. And even our Peso has joined the uprising by breaking down the psychological 49 barrier.

In short, this week’s rally does look like a broad market rally. And broad market rallies usually have sustaining power.

The Philippine Stock Exchange’s market internal tells us that even during the other week’s meltdown, the scale of foreign selling appears to have diminished. It had been the local retail investor jumping ship. This week’s rally came with even less foreign selling even if we omit the special block sales of Philex Mining last Friday.

My ‘fallacy of composition’ analysis makes me suspect that perhaps the issue of deleveraging has ebbed, simply because as the US markets cratered to form a NEW low, just about a week ago, key Asian stocks as the Nikkei 225 ($nikk), Shanghai composite ($ssec) and our Phisix have held ground see figure 5.

Figure 5: Stockcharts.com: Asian stocks Show Signs of Resilience

To consider, even as streams of bad economic news keeps pouring in, as Japan has reportedly entered an official ‘technical’ recession or two successive quarters of negative growth, its main benchmark the Nikkei appear to be holding ground.

It’s been said that once a bear market has stopped being weighed by more streams of bad news or despite this they even begin to rise; this mean that markets may have digested all negative info and may have signaled that a bottom has finally been established. As we quoted Jim Rogers on a video interview, ``When people say it is over and when we you see more bad news and stocks stop going down. But when they go up on bad news, that’s when we are gonna hit bottom. We are not gonna scream I don't know."

Although it could be too premature to decipher recent events as a bottom, we’d like to see more improvement in the technical picture and even more participation from major benchmarks of the region (djp2) aside from sustained rise from the market leader-gold.

Furthermore, if indeed the deleveraging process is beginning to fade, then the next phase should be markets factoring in the repercussions from the recent credit crunch to the real economy. But considering the steep fall during the October-November carnage, it is our impression that most of these had already been factored in.

Moreover, the downturn in the real economy should reflect divergences because not all of the Asian region’s economy will experience recessions see figure 6.

Figure 6 IMF: Emerging Asia Quarterly Growth Forecast

As you can see from the IMF’s regional outlook, except for Industrial Asia (Japan, Australia and New Zealand) which is the only class expected to flirt with an economic recession 2009, the rest of Asia’s economic growth engine is expected to only moderate with the Newly Industrialized Economies (Hong Kong Korea Singapore Taiwan) experiencing the most volatility (steep fall but equally sharp recovery). Most of the Asia is expected to strongly recover during the second half of 2009.

Now if the IMF projection is accurate and if stock markets are truly discounting economic growth to the streams of future cash flows of companies, then we should begin to see today’s rally as sustainable, reflective of these projections and at the bottom phase of the market cycle.

This also means sans further deleveraging prompted liquidations, we could expect some stark divergences in market performances. Unless, of course the headwinds from the collective efforts to inflate impacts every asset class simultaneously, which we think is quite unlikely. But as we earlier said, the bubble structure in the US isn’t going to revive and that any new bubble will come from elsewhere, for example the US dot.com boom bust cycle shifted to the housing industry in 2003 as an offshoot to the inflationary policies applied against a deflating tech industry led market and economic bust.

Boom-bust market cycles always involve a change of leadership. And considering that gold has been the frontrunner during the recent bounce, we suspect that precious metals, energy, commodities, emerging markets and Asia as the next bubbles to blow.

Consumer Deflation: The New Fashion

``All the major institutions in the world trying to deleverage. And we want them to deleverage, but they’re trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that’s willing to leverage up. And there’s no one that can leverage up except the United States government.-Warren Buffett, Interview Transcript

This world is full of befuddling ironies.

Just last year, when consumer prices were rampaging skywards, we were told by media and their experts how “inflation” was bad for the economy. Today, as consumer prices has been falling, the same forces of wisdom explain to us how “deflation” has likewise been detrimental to the economy or perhaps even worst….

As example we are told that declining consumer prices “aren’t just symptom of economic weakness” but are “destructive in and of themselves”. Why? Because as demand weakens and prices decline, companies cut employment and investment, slowing economic growth even further. Thus the chain of inference includes “falling earnings, a weak economy, and the hoarding of cash, fewer investors are willing to buy stocks during deflationary times.”

And the “deflation” theme has grabbed the headlines see figure 1.

Figure 1: Economist: The Deflation Index

According to the Economist, ``Back in August, only six stories in the Wall Street Journal, International Herald Tribune and the Times mentioned “deflation”. In November, there have already been 50, and new figures released this week will mean many more. America's consumer-price index fell by 1% in October from September as oil prices plunged, the largest monthly fall since the series began in 1947. Britain's inflation rate has also fallen from its record high of 5.2% in September to 4.5% in October, the biggest drop in 16 years.

For starters, falling prices basically reflect demand supply imbalance, where supply is greater than demand. Such conditions may be further prompted by either supply growing FASTER than demand or demand declining FASTER than supply.

Paradox of Savings And Growth Deflation

When prices fall because of technological innovation such as the mobile phones, the internet and others, these items become affordable and have rapidly been suffused into the society enough to make it an economic staple.

For instance, mobile phones are expected to hit an astounding 61% global penetration level according to the UN (Europe News) or about 6 out of 10 people will have access or be using mobile phones by this year. According to high profile economist Jeffrey Sachs, the diffusion of mobile communications will revolutionize logistics and education that should benefit the rural economy.

Quoting Mr. Sachs, ``The mobile revolution is creating a logistics revolution in farm-to-retail marketing. Farmers and food retailers can connect directly through mobile phones and distribution hubs, enabling farmers to sell their crops at higher “farm-gate” prices and without delay, while buyers can move those crops to markets with minimum spoilage and lower prices for final consumers.

``The strengthening of the value chain not only raises farmers’ incomes, but also empowers crop diversification and farm upgrading more generally. Similarly, world-leading software firms are bringing information technology jobs, including business process outsourcing, right into the villages through digital networks.

``Education will be similarly transformed. Throughout the world, schools at all levels will go global, joining together in worldwide digital education networks. Children in the US will learn about Africa, China, and India not only from books and videos, but also through direct links across classrooms in different parts of the world. Students will share ideas through live chats, shared curricula, joint projects, and videos, photos, and text sent over the digital network.” (underscore mine)

Moreover, falling prices should translate to more purchasing power.

So how can falling prices be all that bad?

The answer lies squarely on the Keynesian dogma of the “Paradox of Savings”. What supposedly signifies as virtue for individuals is allegedly (and curiously) a bane for the society. The idea is that when people save or withhold consumption, the underlying consequence would be a reduction in investments, employment, wages, etc. etc, thereby leading to a slowdown or even a contraction of economic growth. Seen from the aggregate top-down framework, less consumption equals less economic growth.

This has been profusely peddled by media and the social liberal school as basis for justifying GOVERNMENT INTERVENTION to conduct policies aimed at stimulating growth or rescue, bailout or other inflationary policies to avoid “demand contraction”.

Anecdotally, if savings is truly so bad for an economy then Japan should be an economic basket case by now, yet it holds some $15 trillion in household assets as of June, of which only 13.9% is in stocks and mutual fund and $7 trillion in bank deposits. This in contrast to the US where only 17% is in deposits and 50% is into stocks and pension funds (Washington Post). Japan’s high savings rate has even been reflected in public sentiment where a polled majority refuses to accept government offers to “stimulate” the economy (see Free Lunch Isn’t For Everyone, Ask Japan), as it had learned from its boom-bust cycle experience.

From the Austrian school perspective, the Japanese scenario can be construed as a “Cash Building Deflation” case. From Mises.org’s Austrian Taxation of Deflation by Joseph Salerno, ``Despite the reduction in total dollar income, however, the deflationary process caused by cash building is also benign and productive of greater economic welfare. It is initiated by the voluntary and utility-enhancing choices of some money holders to refrain from exchanging titles to their money assets on the market in the same quantities as they had previously. However, with the supply of dollars fixed, the only way in which this increased demand to hold money can be satisfied is for each dollar to become more valuable, so that the total purchasing power represented by the existing supply of money increases. This is precisely what price deflation accomplishes: an increase in aggregate monetary wealth or the “real” supply of money in order to satisfy those who desire additional cash balances.”

In addition, this Keynesian obsession with “aggregate demand” says economic growth should be associated with “inflation”.

Figure 2: American Institute For Economic Research: Falling US Dollar

Yet, if inflation is measured by means of the increase or loss of a currency’s purchasing power, then the US dollar’s appalling loss of purchasing power since the birth of the Federal Reserve in 1913 (see figure 2) shows that US economic growth hasn’t been primarily driven by productivity (productive economy=an environment of falling prices or “deflation” as more goods or services are introduced) but by inflationary policies or by money and credit expansion!

Note: the chart also exhibits that when the US dollar had been redeemable into monetary commodities (gold or silver), purchasing power of the US dollar tends to increase. Yes, this is defined as DEFLATIONARY ECONOMIC GROWTH or GROWTH DEFLATION (!)

Again from Mises.org’s Austrian Taxation of Deflation by Joseph Salerno, ``In fact, historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard.” (highlight mine)

Falling Markets: Debt Deflation Not Consumer Price Deflation

But savings isn’t about the absolute withholding of consumption. There is a very significant time dimension difference: it is a choice between spending and consuming today or in the future. Moreover, there are two types of consumption to reckon with; non productive consumption and productive consumption.

The definition of savings according to the Austrian School, excerpting Gerard Jackson, (underscore mine)``The full definition is that savings is a process by which present goods are transformed into future goods, i.e., capital goods, that produce a greater flow of consumer goods at some further point in time. In short, present goods in the form of money are used to direct resources from consumption (the production of consumer goods) into the production of capital goods.”

When we put cash balances into a bank, the bank functioning as intermediary parlays such deposits into loans (for business or for consumers) or as investments in securities (private e.g. corporate bonds or public-local government e.g. municipal bonds or national government e.g. Treasuries). So essentially, our savings are channeled into the private sector or as financing to government expenditures.

Thus, the paradox of savings or the anticipated rise of savings rate in the US or in countries severely impacted by the deflating mortagage backed credit bubble, given the magnitude of government efforts to “cushion” or “rescue” the financial system and the economy, will effectively be utilized to finance most of these government programmes.

The negative aspect is not that the consumption ripple effect will result to lower economic growth but instead savings channeled into public/government consumption effectively crowds out private investments which should lead to LOWER productivity and thereby lower economic growth prospects.

Furthermore, when media discusses about consumption, it focuses on the consumers which accounts as the non-productive aspect of consumption.

A productive consumption is where one consumes in order to be able to produce goods. A baker who consumes food in order to bake is an example of productive consumption.

And non-productive consumption, as defined by Dr. Frank Shostak, is ``when money is created "out of thin air." Such money gives rise to consumption, which is not backed by any production. It leads to an exchange of nothing for something.”

In short, the recent boom in consumer spending hasn’t been on the account of spending for production but representative of an explosion of “nothing for something” dynamics or where a policy induced free money environment impelled the US populace to go into a massive speculative orgy, thereby giving the illusion of wealth from producing nothing and limitless nonproductive consumer spending. Of course many of these nothing for something dynamics has also spilled over to many developed countries.

Likewise, the recent account of falling prices or economic weakness hasn’t been a direct cause of retrenching consumers but as an offshoot to a reversal in the free money landscape and a bursting bubble. Thus the apparent economic weakness from a slackening of consumer spending signifies as symptom and not the cause.

Put differently, what makes falling prices or what media or the Keynesian perception of pernicious deflation is nothing more than DEBT DEFLATION!

Once more from Joseph Salerno’s Austrian Taxation of Deflation [p.13-14], ``The most familiar is a decline in the supply of money that results from a collapse or contraction of fractional-reserve banks that are called upon by their depositors en masse to redeem their notes and demand deposits in cash during financial crises. Before World War Two bank runs generally were associated with the onset of recessions and were mainly responsible for the deflation that almost always characterized these recessions. What is called “bank credit deflation” typically came about when depositors lost confidence that banks were able to continue redeeming the titles—represented by bank notes, checking and savings deposit —to the property they had entrusted to the banks for safekeeping and which the banks were contractually obliged to redeem upon demand…

``During financial crises, bank runs caused many banks to fail completely and their notes and deposits to be revealed for what they essentially were: worthless titles to nonexistent property. In the case of other banks, the threat that their depositors would demand cash payment en bloc was sufficient reason to induce them to reduce their lending operations and build up their ratio of reserves to note and deposit liabilities in order to stave off failure. These two factors together resulted in a large contraction of the money supply and, given a constant demand for money, a concomitant increase in the value of money.”

As you can see Salerno’s description of a Debt Deflation landscape as “depositors lost confidence that banks were able to continue redeeming the titles”, “revealed for what they essentially were: worthless titles to nonexistent property”, “threat that their depositors would demand cash payment en bloc”, and “a large contraction of the money supply and, given a constant demand for money, a concomitant increase in the value of money” have been all consistent and cogent with today’s evolving activities in the banking system, the global financial markets or the real economy.

As we have pointed out in many past articles as the Demystifying the US Dollar’s Vitality or It’s a Banking Meltdown More Than A Stock Market Collapse!, the collapse in the US mortgage market which accounted for as a major source of collateral for an alphabet soup of highly geared structured finance (e.g. ABS, MBS, CMBS, CMO, CDO, CBO, and CLO) instruments which likewise underpinned the $10 trillion shadow banking system, resulted to a near cardiac arrest in the US banking system last October, where banks refused to lend to each other reflecting symptoms of an institutional bank run (see Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?).

The sudden surge or “increase in the value of money” in terms of the US dollar against the an almost entire swathe global currencies (except the Japanese Yen) reflected its role as international currency reserve where its dysfunctional banking system incited a systematic “hoarding” of the US dollar, the unwinding of the US dollar carry trade or almost a near contraction of money supply (until the US government’s swift response see The US Mortgage Crisis Taxpayer Tab: $4.28 TRILLION and counting…).

Similarly such dislocations have been transmitted via synchronous selling and an astounding surge in volatility across global financial markets and an intense disruption in the $14 trillion trade finance market, all of which has combined to impact the global real economy.

The present selloffs in the global equity markets as reflected by the activities in the US markets have reached milestone levels see Figure 3.

Figure 3: chartoftheday.com: US Stock Market Corrections

The meltdown in the US markets have been on short, in terms of duration, but whose magnitude has been more than the average of the typical bear market losses.

Why should it be that a selldown be remarkably drastic if it were to account for only a consumer recession? The answer is it isn’t.

Thus, the so-called destructiveness isn’t about US consumers retrenching but an intense deleveraging process backed by the heuristic reflexivity concept of a self-feeding loop of falling prices=falling demand and vice versa.

Eventually false premises tend to be corrected.