Tuesday, March 31, 2009

Fork On The Road

When you come to a fork in the road....Take it
(Yogi Berra)

Where are we going? Or, to be more to the point, where is the US economy is going? Todd Harrison of minyanville.com thinks that we have two possible outcomes: hyperinflation or deflation and depression.

I think that there are more possibilities and they are more nuanced. It's more like a real fork, we have four scenarios. They are listed below in reverse order of probability, estimated by me. As usual, I retain the right to be wrong and anybody is free to disagree with me.

Small note about money mass. People are talking (I'd say shouting) about huge amount of money issued by Fed and how it can cause high inflation. But they completely ignore even bigger amount of money destroyed in the crisis (credit contraction = money destruction) and sharply reduced money velocity. They also ignore the carry trade and the role it can play in the crisis.

Inflation and stagnation = stagflation

First of all, I should say that I don't believe that hyperinflation is possible in US in the nearest future. There are several different definitions, but the lowest defines hyperinflation as 100% or more in three years, the highest as 50% a month. I lived through 30% a month inflation and it's not pretty. But you need high wage inflation to get hyperinflation, and US companies don't raise wages and salaries now. They are more likely to cut them.

High inflation (up to 15% a year) might be possible. There are two possible sources of such inflation: wage inflation and commodity inflation. Wage inflation is off the table, commodity inflation needs growing economy, which is not here. However, combination of excessive money supply and commodity shortages, real or perceived, can create high inflation. Fed in such case will be forced to raise rates and maybe reserve requirements, killing any possibility of recovery for a while.

We don't have any inflation to speak of. In the Q4 2008 we had significant deflation. Inflation in the first two months of 2009 is very low. People are cutting expenses, prices are falling on many goods.

Probability: less than 10%

Japanese disease (Zero growth with zero inflation or low deflation)

This is much more dangerous. Japan fell into this trap in 1989 and still can't get out. There was hope, triggered by increased trade with China, but it was killed by current crisis. This is probably the longest depression in modern times in one country. This year we are celebrating 20 years since it started.

We started in 2007 almost like Japan: real estate market crash, total inaction of government and Federal Reserve, multiple claims by powers that be that "crisis is contained". Which led me to believe that we are going the same way, and I wrote an entry which predicted that by 2009 interest rates will be below 1% (here). But latest developments show that US is not Japan. Companies are laying off workers, banks don't pretend that everything is OK, bankruptcies are on the rise, so there is normal reaction of economic subjects to the crisis.

It's still a possibility, especially if there is a lack of political will. The biggest unknown is the interaction between inflation and carry trade. In case of Japan, carry trade consumed most of the money issued by Central Bank. Fed's declaration of quantitative easing is a very good development, in Japan it took government and Bank of Japan more than 10 years to start it.

Probability: around 15%.

Great Depression 2.0

I wrote about this possibility many times. This article explains my views on the problem and has links to my other articles. I'm starting to believe that we have a fighting chance to avoid this scenario. Ben "Helicopter" Bernanke is doing his job. The only problem I have with it is that he is late every time. So probability remains relatively high, around 30%.

Great Recession

I think it was Melissa Lee from CNBC who coined this definition first. Maybe I'm wrong. In this scenario, decisive actions of government and Fed prevent US economy from falling into scenarios 2 and 3 and lead to relatively quick, also painful, recovery in the beginning of 2010 or even in the end of 2008. This scenario seems to be more and more likely to me lately. Government and Fed are not kidding, measures adopted are radical and decisive. Do they have enough political will? It look like Fed is fighting to increase money mass with all tools available (well, I'd like to see temporary reduction of reserve requirements, which would increase money mass and also improve situation of many banks, making them liquid immediately). It's a little bit scary, because Fed might be forced by some information we don't know yet, so I'm waiting for minutes of the last meeting with impatience.

Best proof of this scenario would be if current stock rally continues for some time. If Dow Jones can keep running over 13 days moving average and bring it over 50 days MA, it will be a huge success. But even if this rally is another bear market rally, even if we get a new lows in summer or fall, things aren't looking as bad as they did in the beginning of March. Bonds are improving, and it's more important than stock market. Historically, bonds recovered first during recessions. If we don't get any unpleasant surprises, stocks should be up from now in the end of the year.

Probability: 45%.


I'm changing my stance because facts have changed. I was thinking Great Depression 2.0 scenario for more than a year. Now I think that we can get away with Great Recession.

From investment point of view, this is a change from bear market behavior to bull market behavior. In bear market, you sell the rips. In bull market, you buy the dips.

I am going to put more money to work in April and May. Mostly in tech, because there are a lot of tech companies which are swimming in money and don't need credit. But also in financials, because they are beaten almost to death and government is clear that they won't be allowed to fail.

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