Brynjolfsson concludes that the United States is at the edge of a deflationary cliff; one false step, he says, and down we go. Because the consequences of a deflationary spiral are so awful, the Federal Reserve Bank has chosen re-inflation as the lesser of two evils. The Pimco strategy folks believe that the transition from 20 years of disinflationary policies to a reflationary future will be a long and bumpy road. They expect that monetary policy will be as easy as it needs to be for as long as it takes. Ultimately they believe the Fed will succeed-hence the attraction of TIPs as a defense against the prospects of a return to inflation. (Principal payments on TIPS are indexed to the CPI.)
Like Grantham, Brynjolfsson referenced the P/E ratio for ten-year "normalized" earnings on the S&P 500. In referring to that index as the "Pension Industry Standard Bearer," he noted that despite the three-year bear market it is still priced at an extreme, just under the 1929 levels. In raising the likelihood of continuing P/E compression, his chart also showed that downtrends of this nature have historically tended toward a full standard deviation below normal before a trend reversal got underway. His summary advice to investors is to work longer, save more, spend less and invest with a bias to preserving capital complemented with "smart risk plays." In other words, business as usual is not a winning strategy for the current environment.
Doug Noland, financial markets strategist at David W. Tice and Associates, was the symposium's third Cassandra. He manages the financial sector short positions for the Prudent Bear Fund. Noland's talk was "A Bubble Waiting To Burst, or Why The Bear Market Is Not Over Yet." He maintains that consumption in recent years has been artificially inflated by fiscal and monetary stimulation. Loans are being extended without appropriate credit controls, leverage is at unprecedented levels and speculation is rampant in equities, bonds and real estate. The credit bubble, Noland feels certain, will end in tears.
The essential reason that credit has gotten out of control, says Noland, is that lending is no longer dominated by the regulated banking system as it had been for generations. In that environment, leverage was limited by law and excesses were self-correcting (loan defaults reduced a bank's reserves which reduced its lending capacity). The explosive growth in the last 25 years of a poorly regulated securities-based credit system loosed an unlimited supply of lendable funds. Because of this distortion, the demand for loans seems to have lost its influence on interest rates; debt has doubled in the last five years while interest rates have plunged. The economy has become so dependent on consumer loans that the Federal Reserve is actually hostage to the system's need for liquidity; by accommodating the credit bubble for fear of unleashing a deflationary decline in demand for goods and services, it is only making the credit bubble worse and its future consequences more drastic.
Our present asset-based lending system is self-reinforcing; swelling credit drives up the market price of assets, which permits greater loans. Freddie and Fannie are classic examples. It is an "anchorless system," Noland maintains, and once it has gathered momentum there is no way to stop it until it explodes.
Will the Fed successfully turn us away from the deflation threat? It is impossible, says Noland, for the Fed to generate inflation that is more or less evenly spread over the economy. Some sectors will see inflation (health care, education, natural gas, homes in California) while others will suffer deflation (manufacturing, technology, homes in Dallas). The dollar will continue to weaken because the credit bubble is worse in the U.S. than elsewhere; hence we will suffer commodity inflation and we will import inflation in manufactured goods.
Our real economy (output of goods and non-financial services) is just not competitive in a global sense. The Fed is helping increase the global supply of dollars in the face of a shrinking demand for them; eventually we will have to exchange goods for goods (eliminate our trade deficit) which could be the beginning of the end of the Fed's dangerous game. Noland recommends (in addition to his fund) avoiding dollar exposure and being long in high-quality foreign bonds and gold. For reams of charts and data, see www.prudentbear.com.
Does Anybody Care?
You remember Cassandra from Greek mythology. She had fantastic powers of prophesy and accurately foretold many calamities. But Apollo was jealous of her, so he arranged that anyone who heard her predictions would not believe them. Hence, they succumbed to every disaster despite her timely warnings.
I was reminded of this curse of Apollo during afternoon breakout sessions at the Undiscovered Managers Symposium. Each group of about a dozen attendees (mostly independent portfolio managers/financial planners) were encouraged to share in an informal setting how they were receiving the presentations and how the information might or might not influence the way they were structuring client portfolios. I only experienced one of these groups, since they were conducted simultaneously, so my observations may not be reflective of the larger group experience.
Nevertheless, for what it is worth, I would note two impressions from the group of which I was a part. First, how little we discussed the material presented by the featured speakers; the impression I got from participants was that this was gloomy and depressing stuff, hence nothing one would want to dwell on. And second, that these well-paid portfolio managers seem to have altered their style very little since before the bear market began three years ago.