Letter to Clients - February 2010 (Second Installment)

Note: We are publishing this blog post in three installments this week, because of its length. If you would like to read it in its entirety or send it to a friend, here is a link to a pdf file on Google Docs of the entire article: FI Letter to Clients - February 2010

If you would like to return to the first installment, click here.

Video Introduction (replay)

Here is where we left off in our first installment:

The structural defects that the financial crisis revealed have been there for a long time, and it is hard to reconcile how they existed all this time without being exposed. Similar to balancing on a high wire, all you need is a misstep or a nudge to knock you off. The nudge came in 2008, and the question quickly turned to how far down the safety net was, assuming there would even be one. The net, in the form of massive infusions of dollars from the government, finally appeared and indeed broke the fall.

We are all now enjoying the free flight of a rebound from the high-wire safety net. Certainly, investments held through the crash have recovered significantly, while investments made during the crisis (primarily in corporate bonds) have added considerable value. We could grow complacent and marvel at how conventional wisdom triumphed once again as it “paid to buy pain” at the lows in March of 2009. People who did so feel like heroes. But I’m not impressed. The risks of entering a second Great Depression were real and the fundamentals of those risks remain. The stock market is, indeed, lower than it was 10 years ago, and today we face much greater challenges.

The Dollar – Public Enemy Number One

A strengthening dollar allows us to buy more. That sounds like a good thing. Yet, as holders of dollars benefit from the prospect of buying more goods or stocks in the future, it also has the potential negative consequence of limiting future profits to those that produce or own those goods and stocks. In reality, we would all prefer a stable dollar, one that allows us to work and profit from the value of our talents and skills, while making purchases and investments with the confidence of predictable benefits.

Expectations of cheaper and cheaper dollars were built into the marketplace over many years, leading to widespread inflation in asset prices. This led businesses and consumers to not only spend the dollars they had as the price level rose, but to borrow from others and spend theirs as well. Borrowing money to buy assets that increase in value also has the effect of lowering the relative value of your debt obligations.

The miracle of our fractional reserve banking system, whereby every dollar deposited in a bank is lent out 10 times over, creates an ever expanding supply of credit when fueled by low interest rates (courtesy of the Federal Reserve and possibly a mercantilist Chinese economy – but that’s another topic entirely). Add to that the inventions of modern finance and a rapidly developing market for asset-backed lending, and you have increased the number of arteries that can deliver credit. Eventually credit is not used for sound investment, but it is used freely for consumption and mal-investment.

In reality, people borrowed more and received less in return, as their purchasing power slowly eroded. Eventually, all it takes is an unexpected failure in the system, a so-called “black swan" event, for the process to reverse itself. And when it reverses, the same mechanisms of lending upon lending that propagated the growth of credit in the beginning, similarly accelerate the contraction of credit.

So it is that we had a financial panic and a stock market meltdown beginning in late 2008. Hedge funds were forced to liquidate. The banking system seized up under the pressure of falling asset prices, threatening insolvency, which caused credit flows to come to a halt. The dollar rose by 30% versus major currencies and every day it was gaining in value relative to everything except risk-free government bonds (which have dollar-like characteristics). The value of outstanding debts began to swell relative to the value of plunging asset prices, which in turn motivated further selling. Just as the dollar was devalued, it quickly became overvalued.

The Great Depression era economist Irving Fisher called such changes in the value of the dollar “The Money Illusion”. Inflation leads to an oversupply of credit and a false indication of wealth whereas deflation leads to a lack of credit, choking off capital flows where they are needed, threatening a reduction in the standard of living. Important to understand, the dollar becomes overvalued when hoarding occurs in an unrelenting deflationary spiral. Human assets, our skills and talents to create and add value, eventually become devalued at the expense of a swelling dollar and a lack of capital. (After all, dollar bills are just pieces of paper. They need to be exchanged for something of value.)

Starting in late 2008, as in the Great Depression, we started cutting into the bone. Real value was being destroyed. We were stepping backward in the timeline of progress. People, as clearly identified by the skyrocketing unemployment rate, are increasingly unable to use their skills to provide for their families and contribute to the economy, failing to improve their financial future. Returns on capital are reduced while losses begin to eat away at net worth. A revaluation in the dollar is then appropriate, as fear and hoarding erode real economic growth.

Leading up to the crash in 2008, we had rampant inflation driven by excessive debt. At the bottom we were faced with, and indeed experienced, the debilitating effects of deflation. Correcting inflation is easier, if sometimes painful. Attempting to correct deflation is more difficult and much more painful.

The reason for this is the legacy of debt that the inflationary period leaves behind.

To be continued

Peter J. Falker, CFA

February 4, 2010

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