From Seekingalpha.com - "Where We Should Be Investing: The Paradox of Thrift

Post by Steve Waldman
July 31, 2008
http://seekingalpha.com/article/88220-where-we-should-be-investing-the-paradox-of-thrift

Over the weekend, Paul McCulley offered a thought-provoking piece (hat-tip to Justin Fox, Brad DeLong), which starts with a discussion of the "paradox of thrift":

For those of you who might not recall, the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income – the fountain from which savings flow.

There's a hidden assumption in the "paradox of thrift" that really ought to get teased out more often. It is true that one person's spending is another person's income. But it does not follow that an increase in saving translates to a decrease in aggregate income. There are two kinds of spending, consumption and investment. Laying a subway line adds to somebody's income as surely as buying a Ferrari does. Ordinarily, nearly all savings are actually spent on investment goods, and there is no "paradox of thrift". What is "saved" is really spent on current production of future capacity, and there are plenty of paychecks to go around. There is no "fallacy of composition": individually and in aggregate, today's thrift lays the groundwork for tomorrow's abundant consumption.

However, for this to work out, two things must be true: Today's savings must be invested in projects that will actually generate future wealth, and savers must believe they will retain a stake in the increased wealth commensurate with the size and wisdom of their investments. We have a financial system in order to make these facts true. If the investment industry is capable of finding or initiating projects likely to satisfy future wants, and if financial claims are predictable and stable stores of value, we need not trouble ourselves over the paradox of thrift. The issue only arises when the financial system breaks down. When investors lose faith in the quality of available investments or their ability to collect the proceeds (in real terms), they pull out savers' Plan B: precautionary storage. They buy gold, or oil, or art, or whatever, and they keep it, generating scarcity rents for those who can offer perceived value stores, but very little in the way of general income and employment. Precautionary storage, not thrift itself, is the villain of the tale.

The vulgar Keynesian prescription is to encourage consumption, when a dynamic of precautionary storage takes hold. And in extremis that might be a good idea, because if all everyone does is hoard, it's hard to figure what to invest in, except maybe storage tanks. But it's much better to develop a financial system that actually performs, that identifies fruitful projects and allocates claims fairly. Storage eats wealth, while productive enterprise creates it. People know this. No one "invests" in gold or oil when a financial system is working. They do so when it is broken. Like now.

Encouraging people to go shopping in order to help the economy is not "second best" policy. It's a desperate last resort. We're not at a point where there's so little economic activity that we can't foresee future wants. We're at a point where people are beginning to shift from investment to storage because of a well-deserved loss of confidence in the financial system. Encouraging consumption now is nihilistic. It feeds into a vibe (I feel it personally, do you?) that saving is so uncertain and money so volatile that one might as well spend, 'cuz who knows what tomorrow might bring. The right way to sustain aggregate demand and maintain current income is to figure out what we should be investing in — not stocks, bonds, or CDOs, but factories, windmills, or schools — and then to put current resources to work. Our financial system is failing spectacularly because it erred grievously. It built homes and roads and sewers that oughtn't have been built, it "invested" in vacations and plasma televisions, and it paid itself handsomely for doing so. That's not a problem we can spend our way out of. To fix the financial system we have to change it, not rally to its support. We will know we've put things right when thrift is something we can celebrate, when we save because we are excited about what we are creating rather than frightened by what we might lose.

Time to Take Our Medicine - Financially Speaking

The following is from Kenneth Rogoff, Financial Times. I agree with his premise, once we solve the credit crisis; but until then our medicine dosage needed to correct our problem(s) needs careful oversight, for without oversight we will face a dramatic negative impact. His solution would be effective if we were faced with a traditional supply side recession alone, but when you add our current credit crisis, the solution follows short.


The world cannot grow its way out of this slowdown, by Kenneth Rogoff, Financial Times: As the global economic crisis hits its one year anniversary, it is time to re-examine not just the strategies for dealing with it, but also the diagnosis underlying those strategies. Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services? If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.

The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast. ...

Absent a significant global recession..., it will probably take a couple years of sub-trend growth to rebalance commodity supply and demand at trend price levels (perhaps $75 per barrel in the case of oil...) In the meantime, if all regions attempt to maintain high growth through macro­economic stimulus, the main result is going to be higher commodity prices and ultimately a bigger crash in the not-too-distant future.

In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up. In the US, the growth imperative has rationalised aggressive tax rebates, steep interest rate cuts and an ever-widening bail-out net for financial institutions. The Chinese leadership, after having briefly flirted with prioritising inflation..., has resumed putting growth as the clear number one priority. Most other emerging markets have followed a broadly similar approach. ... Of the major regions, only ... the European Central Bank has resisted joining the stimulus party... But even the ECB is coming under increasing ... pressure as Europe’s growth decelerates.

Individual countries may see some short-term growth benefit to US-style macroeconomic stimulus... But if all regions try expanding demand, even the short-term benefit will be minimal. Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.

Some central bankers argue that there is nothing to worry about as long as wage growth remains tame. ... But as goods prices rise, wage pressures will eventually follow. ...

What of the ever deepening financial crisis as a rationale for expansionary global macroeconomic policy? ... Inflation stabilisation cannot be indefinitely compromised to support bail-out activities. However convenient it may be to ... bail out homeowners and financial institutions, the gain has to be weighed against the long-run cost of re-anchoring inflation expectations later on. Nor is it obvious that the taxpayer should absorb continually rising contingent liabilities...

For a myriad reasons, both technical and political, financial market regulation is never going to be stringent enough in booms. That is why it is important to be tougher in busts, so that investors and company executives have cause to pay serious attention to risks. If poorly run financial institutions are not allowed to close their doors during recessions, when exactly are they going to be allowed to fail? ...

The need to introduce more banking discipline is yet another reason why the policymakers must refrain from excessively expansionary macroeconomic policy ... and accept the slowdown... For most central banks, this means significantly raising interest rates to combat inflation. For Treasuries, this means maintaining fiscal discipline rather than giving in to the temptation of tax rebates and fuel subsidies. In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn.

Home Prices Rising?

Existing home sales fell 2.6% in June to a seasonally adjusted annual rate of 4.86 million units. New home sales slipped 0.6% to 530,000 units. While most on the Street and in the business press insist on clinging to the pessimistic view that home sales are plunging to Depression-era levels, we see the glass as halffull. The median price of homes is on the rise, which may suggest that conditions are in the early stages of forming a bottom. We’ve noticed that when economic indicators bounce around month-to-month after a prolonged period of strength or weakness, a peak or a trough is usually forming. The median price of previously owned homes has increased for four consecutive months, including a 3.3% increase in June. Meanwhile, the median price of a new home increased 1.4% in June, its third increase in the last six months.


Source: Argus Research Market Watch, July 28, 2008

Second-Quarter Earnings Update

As of July 23, about 38% of S&P 500 companies had reported second-quarter earnings — including most of the major Financials. Earnings thus far are down 28% from the second quarter of last year, due largely to a 97% decline from Financials. Some broad trends have emerged from banks. First, revenues have generally held up better than we expected this quarter. The steeper yield curve has helped net interest margins and many banks are still growing their core loan portfolios (though they are downsizing the balance sheet overall). Banks with diverse sources of fee revenue have held up best. Expense discipline is also muchmore evident this quarter as deep staff cuts and cancelled or delayed capital investments are starting to bear fruit. But those positive trends are being overwhelmed by broadening deterioration of credit, especially residential mortgages and related commercial loans. Losses, problem assets and loss reserves continued to increase at a rapid, and in many cases accelerated, pace.


Source: Argus Research Market Watch, July 28, 2008

the Big Mac Index

In May we posted a brief discussion of the Big Mac Purchase-Power Parity ... Here's our last discussion of the Big Mac PPP ... the Economist has a terrific graphic representation of the current Big Mac Index on their website here. Be sure to check it out! We think its a terrific - and understandable - guide to exchange rates.

Outliving Your Retirement - a New Study on the Increased Risk

According to a new study by Ernst & Young - middle class America faces retirement in poverty.

The following are findings from a recent Connecticut study of middle-income households:

• Three-quarters will outlive their assets; for those that are within seven years of retirement.
• The above percent increases to 90% if the retiree does not have an employer pension plan.
• For those 65 year-olds who have recently retired, nearly 60% can expect to outlive their assets. And if they don’t have a pension plan the number jumps to 80%.
• Study can be found at: http://news.reutersadvicepoint.com/news/read_lexisnexis.cgi?story=823199532

So, why are they at risk of outliving their assets?

• Longer lives
• Volatile investment returns
• Decline in employer pension plans

In addition people tend to greatly underestimate how much they need to save for retirement. Why is that? We have found that there are three distinct spending phases in retirement. During Phase One — or as we call it the “Travel Phase”, lasting 3 to 7 years — retirees can expect to spend 90 to 110% of what they were making prior to retirement. Phase Two — the “Relaxation Phase”, lasting the next 10 to 15 years — spending decreases dramatically to 40% to 60% of pre-retirement spending range. Phase Three — the “Assistance Phase” — health care becomes a big issue and spending jumps dramatically back to 80% to 100% of pre-retirement income.

Today’s retirees should expect to spend 20 to 25 years in retirement. When social security was first implemented the average age of a male was 58 years and female approximately 63 years. Now that number has increased by 20 years.

A comprehensive financial plan can help you analyze different retirement scenarios. It is well worth the investment in time & money. Be sure to work with a qualified provider; I suggest one who has a fiduciary responsibility. For more information on this see my website: www.crewcapital.com

Consumer Inflation Climbs

The Bureau of Labor Statistics reported a 1.1% surge in headline retail inflation during June — the greatest monthly gain in a quarter of a century! Over the last year, the overall pace of consumer price inflation is up 5.0%. The gain — in no surprise — was the result of a 6.6% jump in energy prices and a 3.8% increase in transportation costs. Excluding food and energy, the so-called core rate rose a less troubling 0.3%, or 2.4% over the last 12 months. Unfortunately, there is little that the Federal Reserve can do to combat growing inflation. A rate hike simply isn’t a possibility given the turmoil in the financial markets and banking system. The only option for the Fed is to talk tough about the dangers of a rising general price level.


Source: Argus Research, Market Watch, July 18, 2008

Stock Market’s Price/Sales

In tougher times, valuation measures based on earnings can send misleading signals as “extraordinary” items and charges begin to pile up. Investors and analysts often differ over what items are truly extraordinary and which are not. Valuation measures based upon book value can also be misleading especially when companies are having difficulty, as banks are, in valuing their assets. As a result, revenues are probably the least subject to interpretation by analysts and/or manipulation by management. Below, we chart the market value of the S&P 500 against the trailing 12-month sales for the companies in the index. At a current ratio of about 1.3-to-1, the price/sales ratio of the market is as low as it has been since the previous bear market bottomed in October 2002 and again in March 2003. However, the market traded at a discount to its trailing 12-month sales through the mid 1990’s, when the ratio began to surge to its bull-market peak of more than 2.5-times.


Source: Argus Research Market Watch, July 17, 2008

Trade Deficit Narrows

The Commerce Department reported a narrowing in the trade deficit during May, which will help boost overall economic growth in the second quarter. Make no mistake, trends in the trade picture have helped keep the U.S. economy from a prolonged and deep economic recession. During May, total U.S. imports increased 0.3% to a seasonally adjusted annual rate of $217.34 billion, while exports jumped an impressive 0.9% to $157.55 billion. Over the last 12 months, exports climbed 17.8% and imports were up 12.5%. These movements resulted in a 1.2% narrowing of the trade deficit to $59.79 billion. Since aggregate demand will benefit from the narrower deficit, there’s a good chance that second-quarter GDP could top 2.0% — a far cry from results that would be associated with the recession predicted by so many Wall Street economists.

Source: Argus Research Market Watch July 15, 2008

Price/Cash Flow Ratio for S&P 500

We use multiple valuation models for the S&P 500. Most of our models suggest that stocks are as a cheap they’ve been in years — though you don’t have to look too far into the past to realize that they could get cheaper still. Below, we have charted the ratio of the S&P 500 market cap, or price, to its cash flow for the trailing 12-month period. The S&P 500 currently trades for about 10.2-times its cash flow, just above the bear-market low of 9.2-times in October 2002. Indeed, this ratio has ranged from 10- to 12-times since mid-2002. However, throughout much of the 1990’s and up until early 2007, the S&P 500 traded below 10-times its cash flow and as low as 6-times.


Source: Argus Research Market Watch, July 14, 2008

Consumer Spending, Confidence Diverge

Many pundits are claiming that the consumer is as upset with economic conditions as any time since the Great Depression. Based on the consumer surveys, some actually believe we are experiencing a depression. But low postings in the consumer confidence measures don’t always result in contractionary spending. The primary reason is that consumers don’t always do as they say. It’s one thing to say that the outlook is gloomy – with record gasoline prices and an uncertain jobs climate, it is – and another to actual stop spending altogether. Despite these low readings in confidence, consumers continue to spend at a brisk pace. Second-quarter spending is shaping up to be up around 1.7% — not bad given the many contractionary forecasts on the Street. If realized, there would be 66 consecutive quarters of positive consumer spending — confirming the argument that consumers don’t put their money where their mouth is.


Source: Argus Research Market Watch, July 8, 2008

Dividend Yields Still Low

With banks slashing their dividends (a trend that is likely to continue for some time yet), the dividend yield for the S&P 500 remains a paltry 2% — this despite a major retreat in stocks in recent weeks. Developed markets in Europe still provide 3%-4% dividend yields, a factor (along with the weaker U.S. dollar) that has led to a narrowing of valuation multiples between these indices in recent years. As the chart below demonstrates, dividend yields have been in a decline since the long-term bull market in stocks began in the 1980’s. Companies increased their payouts coming out of the 2000-2002 bear market, but not by enough to meaningfully reverse the longterm downward trend. Instead, companies increasingly opted to use leverage to buy back their own stock. While stocks are now cheaper, leverage is less available — so a shift back to increasing dividend payouts could be in store.


Source: Argus Research Market Watch, July 7, 2008

No Where to Hide; First Half Wrap Up

http://seekingalpha.com/article/83835-global-market-performance-nowhere-to-hide?source=d_email#

Paulson's Recent Economic Comments

The current economic downturn has further to go, but U.S. growth should pick up by the end of 2008, U.S. Treasury Secretary Henry Paulson said Thursday in a BBC interview. Spiking oil prices, the credit crunch and a slumping housing market are all contributing factors. Paulson conceded the impact of the global credit crunch could have been minimized by better regulation of U.S. banks.