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Sunday, 6 April 2008

The Weekly Report - 6th April 2008

The Weekly Report

5th April 2008

Welcome to the Weekly Report. This week, I stick my nose in where it ain't wanted. (again)We get down in the dirt about deflation and we look at some stocks and wonder why and I show you my long term indicators.

Now, I'm not one to boast, really I'm not. No one enjoys the likes of me stuffing "I told you so" remarks down reader's throats. There comes a time when it does become slightly unavoidable. Is it ego, a demand of recognition? Is it a desire to be kingpin, the ultra guru? Frankly my dear, I don't give a damn, as long as my readers get something that helps make life as an investor /trader easier then my attitude is "so what?"

What a week that was, Dow up, then down, up again…..stop! Hindsight - blah! This is the Collection Agency, we pride ourselves on looking forward, not back. Where do I look, how far forward? The Occasional Letter looks 6-18 months ahead, soon it'll be looking for some buy opportunities. The Weekly Report is more short-termism, with the aim of looking for opportunities in the next few weeks.

Speaking of readers it is time for an update. Now most of you know I'm a blogger, no fund to sell, no angle to push, I really don't care what you buy and sell. I'm not bothered. I'm googlable but I don't really exist beyond those that read me at some rather classy sites. Yes that was me being a creep.

Here is my world coverage over the past 2 months, remember, I'm an unknown, a blogger:

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If it's green, someone visited. I know, I'm amazed too, my grammar is awful! Around 16000 people have read my stuff in the past 2 months. Some may scoff at such figures, I don't. I would like to thank you all, I had no idea my "stuff" was that readable. As much as I can be, I feel slightly humbled.

"Enough" I here you cry and being one not to spit in the face of a crowd, lets get on with it.

There has been a war of words between Gary North and Steve Saville about whether the Fed is inflating or deflating. I have absolutely no connection with either writer and have no interest in badmouthing either of them. I am sure both have a loyal following and I do know both make interesting points.

Here is my roadmap, unchanged these past 5+ years:

  • "A recap of the scenario:
    bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation."

If you read that 5 years ago, you would have pegged me as a survivalist or a gold-bug. Now you can pick your appropriate position. How did I know such tremors were coming? Simple, I studied the very same things Ben Bernanke studied, he became a bald academic, I became a bald blogger. I am better looking though.

Back to the GN/SS spat. I looked on, an interested observer in all matters inflationary and deflationary and decided to strip the argument back to its core. From what I could see this was a difference between M1 and MZM as to which held the key to inflation/deflation signals. So I went to the Fed.

St Louis to be exact, mainly because I like Poole, his St L Fed site is excellent; I do hope his successor keeps the access to facts as open as Poole did. Its worth reading up on William Poole, he may well surprise you. I digress, again:


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This is a chart of MZM (green), M1(orange) and CPI(blue), using the base of 1982, as CPI was rebased in 1982/84 according to St L Fed statistics. Everything is based on the left side, pure figures. You know what's coming next:

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Same chart with CPI based on the left axis and M1 and MZM on the right axis with the same baseline of 1982. Astute readers can know see why I stick my nose into uninvited areas. Is any measure of "M" a worthwhile measure of inflation trends?

Inflation is not purely a monetary phenomenon. We all know if you over-print cash notes you encourage a debasement and a monetary inflation. What isn't so understood (except by some and believe it or not, the Fed) is that in a fiat monetary system, reliance on growth using leverage for the expansion of credit, is the true driver of inflation/deflation.

It's simple and easily understood if you think of greed. It is also why a fractional GOLD backed currency won't work.

I have $10, I lend it to my bank as a "savings" deposit. The Bank uses the deposit as an asset, lending on that asset by a factor of 10 (leverage). The bank lends out $100 backed by the original asset. The Hedge Fund borrows (credit) $100 from the Bank and utilising margin (further leverage), raises positions in markets notionally worth $1000.

The economy is booming, thanks to my $10. I am a capitalist hero. One day I decide to take my $10 out of the Bank to spend on a battery powered radio, to alleviate my boredom whist mowing the lawn.

Does the Bank have to unwind the leveraged lending based on my $10? No, it can count upon other deposits, savings, to replace the capital base.

This is all well and good during the good times. What happens when all my neighbours decide they would rather own assets than leave cash on deposit? We know already, thanks to the 3 day collapse of Bear Stearns. Banks fear above all else a run, where depositors decide they would rather have their cash in hand than in the Bank. You can see why they fear such a run, mass withdrawals would force the unwinding of leverage, a call on the loans made. That means the Hedge Funds would have to unwind their positions, to enable repayment to the banks. You get the picture. Another angle would be to look at productive workers, paid for their labour and depositing wages into the Bank. If the Banks had a shortfall of received wages the same problem would occur, Banks would no longer have the fractional base to enable their lending. Less workers, less deposits.

What we are witnessing is not a shortfall in the ability of innovative structures to enable credit. What we are seeing is the beginning of the destruction of the fractional base of Banks. I could go on, mentioning the shortfall in expected corporate profits over the next quarter or 2 as judged by the S&P500. My astute and clever readers have already jumped ahead to that conclusion.

Back to the central question, is the Fed inflating or deflating? Amazingly, it is doing both, thanks to the newly introduced "Facilities":

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Above is something I rustled up earlier in the week. To my eye, the Fed is inflating the amount of Treasuries available to both Banks and Primary Dealers and debasing their worth by swapping them for cheaper assets. On the other hand the Fed has been extremely active with the Permanent Open Market Operations, selling treasuries and absorbing cash from the markets. The Fed is walking along a very loose tightrope, where each step is producing vibrations that affect all market participants.

It would seem the Fed is set on a course to provide solvency to Banks and Primary Dealers, by lending assets that can be used to raise/roll borrowing from Banks who are only willing to lend on AAA assets. This is far beyond the ability of MZM and M1 to measure. Such slow moving indicators are unable to capture the true intentions of the Fed as it provides the replacement for the Commercial Paper markets.

Let us gaze upon the graphs for M1, M2 and MZM:

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Where M1 has remained in a tight range for the past 11 Quarters, the sudden acceleration in M2 and MZM points to a reflation BEYOND cash.

  • M1 is defined as all coins and currency held by the public including travellers cheques, checking account balances, NOW accounts, ATS accounts and balances in credit unions.
    M2 is defined as all of M1 plus savings and small time deposits, overnight repos at commercial banks, and non-institutional money market accounts.
    MZM is defined as all of M2 minus time deposits but including money market funds.

Yes, we are back to the Fed and its Facilities again. M2 and MZM include overnight repos at commercial banks. Since the credit crisis burst open in the summer of '07, the Fed has made ample use of repos. Indeed when the crisis intensified in October '07 and again in January '08 the Fed enlarged the amounts and frequency of repo arrangements.

It is quite clear that M2 and MZM are reflecting this. M1 does not include such actions as those carried out by the Fed. Repos can only be viewed as credit, newly created by the exchange of assets. Cash itself is not printed, there is no need. All that happens is a bank can swap assets to increase the notional amount it holds in its reserve and meet reserve requirements. Only if the repo was made permanent, with assets remaining at the Fed, could the Bank issue currency.

It is at this point I agree with Gary North, consumers are not seeing a reflation in wages or income, actual cash in the economy has been remarkably stable over the past 3 years. If one considers the loss of spending power of each dollar, then without an increase in the amount of physical cash, consumers are already in a deflationary cycle as the amount of cash after liabilities is falling. An inflation of prices must never be confused with an inflation of monetary supply, consumers are suffering a deflationary lack of cash when compared to the requirements demanded by an increase in the PRICE of goods.

For the consumer this is clearly unsustainable. Eventually the consumer will hoard resources and only use cash to pay for essentials. Regardless of the Fed pumping assets into Banks and Primary Brokers who use the largesse to fund their own borrowings, the consumer will find it extremely difficult to access credit. Without credit consumers will be unable to expand spending as reliance on increasing wages is obviously misplaced.

Here we have the roots (and they run deep) of a major deflationary period. I have opined before that I saw a two track America, one where consumers where crushed by deflationary forces whilst "International USA" continued to offer acceptable returns in exchange for it debt. That moment may well be playing out in front of us now.

Here is a chart of 2 inter-related phenomenon; Consumer Prices (blue) and Total Retail Sales (red):

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Here is a classic example of prices rising when goods are in demand. If you look closely, you can see that retail sales lead CPI, dips in sales slows and at times reverses CPI.

An adage I have for this is it doesn't matter how high prices go if there is no demand for goods. The goods will either be re-priced lower to stimulate demand or the production of the goods is stopped if the venture becomes unprofitable. It is the lack of cash that causes (spending and therefore) sales to drop. How the amount of cash consumers own is decreased is important. If more cash is required to pay taxes or service debt then the expenditure is onerous on the consumer balance sheet, no asset is exchanged. If the consumer chooses to spend more money buying assets, then at least there is an asset owned. If however the asset is depreciating in value, including assets bought using debt then the net worth of the consumer suffers a double blow.

Housing is suffering from the same effect. Now we see it in retail sales. You can see why tax rebates have been lined up, it is an attempt to stave off a deflation in sales. If it works it will have a lagging inflationary affect on CPI.

The problem though is whether consumers will spend tax rebates or save them. If rebate cash is used to pay down debt or placed on deposit there will be no stimulation to sales. CPI will drop. Here is a close up of the same chart:

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The tax rebate effect can only be temporary even if it does stimulate spending. Without an expansion of credit or an increase in wages sales will continue to drop. What are the chances of credit conditions changing in the medium term or wages increasing during a recession?

The interesting part of all this is if consumers do save the tax rebate then M1 will not increase as savings and small time deposits are calculated in M2/MZM. Thus savings could cause a display of supposedly inflationary tendencies in M2/MZM. M1 would only increase if the savings ( or the tax rebate itself) were used to buy goods or services.

The actions taken by the Fed and the US Treasury will either distort CPI or cause a misreading of inflation if M2/MZM are used. The latter would be a grave mistake as the consumer would not have increased their spending power. The increase in M2/MZM would be a combination of increased use of credit by banks and an increase in savings by consumers.

The following chart shows the relationship between Sales and Industrial Production for Durable Consumer Goods:

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Sales and Production are linked, it shows that the compensation given to workers for their labour is used to buy products, amongst other uses. The correlation is particularly noticeable prior to 1991. However since 1991 an inequity between spending power and production has appeared. It is my contention that increased productivity was a function of the slowdown of compensation in real terms and spending was boosted by an increase in the use of credit allowing sales to continue to rise.

This is a form of mal-investment, were credit has replaced true efficiencies in production. Purchases were not made from savings (workers earnings) but from earnings of yet unrealised worker compensation with a forward CPI and risk premium added.

With the standards for credit now at much tighter levels seen since 1991 this mal-investment is beginning to bite. Although this has consequences for consumer spending power, the real problem will lie within Corporate balance sheets. Reduced income will make the servicing of corporate debt much more difficult as we have seen in the Financial Sector. "Liquidity injections" from overseas investors have high rates of interest and with income streams falling, increased productivity and the ability to service debt can only be achieved by lowering costs.

If a production system is reliant on the use of credit to expand and that facility is removed then the results of previous bouts of debt fuelled expansion cannot be carried forward and offset against expected future income. Either the debt is repaid or defaulted.

Can increased productivity re-light consumer spending? It would appear not:

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And it's a tactic that's already been tried. Notice the increase in productivity in 2007 did not re-ignite sales. It's most likely that the 2007 increase was a function of cost savings, rather than expansion.

On a more practical front, how can an investor use such information to aid their strategy?

Avoid debt on company balance sheets. An investor should get into the habit of checking the ratio of company debt to income and reserves. If you can find a company selling essential products that carries no debt on its books you are on the right lines. If you can find a company that also has saved its profits and is only willing to expand using its savings you may have found a good opportunity.

We finish off with a look at some charts and wonder why investors are buying financial sector stock. Is the recent rebound in financials worth buying into or watching? I leave that decision up to you, I don't do recommendations but as you have read, my filter for acceptable buys would discount the sector. You may well have a different take on the situation, my only advice would be to do your research with extra diligence. I have no positions in shares in the following charts and will not take a position on them for some time.

Firstly my Dow Daily Chart, used for long medium length trends:

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We are near the top of the sideways trading range(down arrow) that has been in force since January. For the first time in 4+ months we have a neutral reading, with 3 days of support at the pink, median line (up arrow). Whilst calling direction from here would be a bit silly, at least with a neutral scenario we can take cues from breaks of support/resistance from here.

Citi, I have removed the down channel as we have broken out. Citi is trying to break above the MA but might be forming a rising wedge:

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Goldman is at the upper end of its down trend channel and finding resistance at the MA. Strong support at $163:

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Gold, an update from last week. The down arrow shows the attempt last Monday to regain the MA which failed. Gold found support in the $885 area on a closing basis. This level now becomes important support for future moves. I would need to see a higher high and support from the MA before looking for upside:

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That's it for this week.


Anonymous said...

this is the first article that has made good sense to me for a long time ( no offence to other 'nearly as good articles'!)
borrowing has just been too too too easy, i had £800,000 of debt and no job!!
I sold out when everyone was saying 'property never goes down'. i am now sitting on a pile of cash waiting to pick up the pieces.
if the japs couldn't inflate their economy why should the fed be able to do it. if people can't borrow, it won't happen, and i agree, that's where we are now.

Peter V said...

I'm not an economist, but I have been reading everything I can find on the markets lately(that seems to be based on rational thought and analysis anyways). This article got me thinking: Could there be a relationship in the increased disparity of income between the working class and the investment class we have seen in the last 10-20 years. Where the majority of income in the working class goes to spending and saving, a greater percentage of income in the upper class goes to speculation. So as a certain percentage of the work force started controlling a greater and greater percentage of all income, the lower classes kept their spending up by using credit. (This further consolidates wealth) At the same time there is more wealth at the top being invested in stocks. So securities go up in value, while the income that had provided profits to the companies is replaced by credit. Once the credit runs out we get where we are now: the spending class has nothing to spend, and securities are highly overvalued.

Is some optimal dispersion of wealth between speculation and actual spending that may not allow for as rapid growth, but a more stable economy over the long term?