Daily Investment Interpretations

July 9, 2010

Is this rally a "dead-cat bounce" that's not worth trading?
    My investment advisory service is warning that so far, the current rally is looking technically like a "dead cat bounce" rather than a change in direction, and so far, it doesn't deem the rally to be worth playing
    The NASDAQ Composite added
21.05 points (0.97%) to finish at 2196.45. The Dow increased 59.04 points 0.58%) to close above 10,000 again at 10,198.03, and the S&P 500 climbed 7.71 points (0.72%) to end at 1,077.96. Oil oozed up $0.82 to $76.26 a barrel, while Gold ended at $1,211. The VIX fell 0.733 to 24.98.
Three schools of thought regarding the current slump:
    (1)  The IMF, the Federal Reserve, Warren Buffett, and Henry Paulson's Advantage Funds are predicting that the stimulus has worked and the recovery will slow, but will continue
    (2)  David Stockman and Todd Harrison are arguing (I think) that this is a plain, old-fashioned boom-bust cycle, and that the markets need to be allowed to recover without government intervention. (Presumably, there'll be a second leg of recession.) Otherwise, the economy will be right back where it started  in 2007, without paying down the enormous debt overhang that got us in this fix in the first place. Furthermore, "to get through it we have to go through it", and all the King's horses and all the King's men can do is to delay the inevitable day of reckoning.
    (3)  Paul Krugman has become the iconic lightning rod for a third position: namely, that we're on the brink of the U. S.' third Depression.
    This may be an oversimplification... for example, David Stockman may not have objected to FDR's fiscal stimulus program... but it gives us a framework to launch a discussion.
    Let's start with the Great Depression and see if we can get an idea regarding what actually happened. One school of thought (the Milton Friedman or "Chicago" or "monetarist" interpretation?) is that the driver of the Depression was the Fed's monetary policy: the Fed didn't "print" enough money fast enough from 1929 to 1932 to keep the Depression from getting out of hand. 
    David Stockman arrives at a different answer
David Stockman's Different Answer:
(1) What caused the Depression:
    The probable cause of the Depression, he thinks, was the unsustainable, debt-fueled boom of the Roaring Twenties. The 1920's saw the shift from public mass transportation to personal automotive transport. It also saw (I suspect) the rise of the suburbs, riding on the back of this new private transport system. A whole new generation of appliances from radios to refrigerators was manufactured and sold to a growing middle class. 
    This booming economy caused an over-investment in production and service capacities in response to the perceived market for goods and services. "In short, the Great Depression had nothing to do with fiscal policy mistakes because the "fiscal" [component] in question was self-evidently too small to make a difference. Instead, it was the product of a classic boom and bust cycle that originated in the inflationary finance policies of central banks -- first to fund the carnage of World War I with printing-press money and then to layer on the speculative merriment of the Roaring Twenties."
(2) New packaging of risk:
    "...Main Street Americans were introduced to the twin wonders of consumer installment credit and stock market margin accounts during the 1920s." 
    Consumer installment buying would have greatly expanded the potential for indebtedness for the "farm kids" moving into the cities from the country. Further, stock margin rules allowed 10:1 leveraging, permitting investment rookies to build highly unstable "houses of cards", setting the stage for the Crash of '29.
(3) The role of the Fed:
    With respect to fiscal influence, he reports that the federal government increased its spending by 50% between 1929 and 1932, from a mere 3.1% of GDP to a mere 4.6% of Gross Domestic Product (GDP) in 1932... both negligible contributions to the GDP. At the same time, the "stock of money fell by nearly 25% from late 1929 to January 1933 not because the Fed didn't make the reserves available but because, then as now, "the Fed found itself 'pushing on a string' in the face of massive loan liquidation owing to defaults and working capital contraction -- the same headwinds thwarting the Fed's hyperactive money string pushing today."
Bottom Line: David Stockman argues that the Fed was responsible for setting up the debacle from late 1929 to early 1933, but not for what happened during that collapse: i. e., Milton Friedman was wrong.
My own memories of the era:
    This picture squares with my own memories of the thirties and early forties. I can't remember seeing new construction before World War II. Also, in retrospect, a lot of what I saw around me in the 30's had been created in the 20's. 
    To give an idea just how bad the contraction was between 1929 and 1932, the Dow-Jones industrial Average fell from a high of 381 in the summer of 1929 to 41 in the summer of 1932.
Franklin Delano Roosevelt (FDR) and the New Deal
    Mr. Stockman has given one interpretation of the interval from late 1929 to January, 1933. What about the period after that from 1933 to World War II?
    Early in 1933, FDR announced his radical fiscal stimulus program, setting up various public works programs and guaranteeing sober men a job with, e. g., the Works Progress Administration (WPA: "We Poke Along"). A WPA job paid $50 a month, or about $9,000 a year by today's standards. It kept families from starving, but it didn't make them affluent. The Civilian Conservation Corps (CCC) was also established, providing jobs for young men just entering the work force. And there were other programs such as the Tennessee Valley Authority (TVA), which built dams and power-plants that provided flood control for the Tennessee River, and electrified the rural South. (TVA's rates are still well below those of most parts of the country. TVA is a federal agency.)
    Did it work? I'd say it worked resoundingly well. The economy, which had been sinking like a stone, as shown in the "Four Bad Bear Markets" chart below, suddenly began to rebound rapidly. Between 1933 and 1936, the stock market rose from 41 in 1932 to 200 in 1936. The change was dramatic, with no indication, in my opinion, that the cause was anything other than the FDR Administration's fiscal stimulus policies.
    In 1937, FDR & company made a terrible mistake. They listened to the deficit hawks and throttled back their expensive reconstruction programs. It was too early. The economy fell back into depression. Finally, in 1941 came the huge fiscal stimulus program called "World War II". After the war ended in 1945, after 16 years of deprivation, the economy boomed. Most of the nation's durable goods had to be replaced, and this was seamlessly followed by the "baby-boom".
    One of the analogies to the current efforts to jump-start the economy has been likened to trying to get a car up an icy hill by giving it a running start. If the car isn't moving fast enough when it starts up the hill, it may fail to reach the top, and may slide back down with potentially disastrous consequences.
    I think a closer analogy might be that of trying to re-light a big log when the fire has gone out. You have to pony up enough kindling to heat the log enough that it begins to burn again on its own. 
    This failure of FDR to complete what he started has been used to claim that fiscal stimulus doesn't work, and is being trotted out now to argue that fiscal stimulus never works (see: The New Direction Our Economy Is Headed), and that the current fiscal stimulus program has been a total failure.

To be continued.