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Escalation Clause

November 8, 2010


Good morning. Huge gains for the market last week, with the SPY’s up 3.6% to close at 122.72. This was primarily due to the announcement by the Fed on Wednesday that they were going to peg the so-called quantitative easing (QE II) at around $70B per month to a total of $600B. I think this number is in excess of the “street” number of $500B and I suspect the $70B per month is a little more aggressive than most thought before the announcement. In addition, we had a positive 151,000 jobs number rather than the 60,000 that had been expected. As frosting on the cake, the Fed announced that they would consider letting banks (with the usual caveats) start paying dividends, all in all sort of like Christmas early for the market, most of it almost entirely due to moves made in Washington.

It is a tough time for the so-called fundamental traders, and sort of a giddy time for the momentum traders, meaning those who buy just because things are going up. We have seen rapid, almost melt up, sort of increases in some sectors. Take the gambling casinos, for instance, where stocks like Las Vegas Sands (LVS) are trading up over $37 (246%) on the year despite ten losing quarters in a row (before this one) and a revenue per share number of less than $10. I guess you just keep buying and repeating to yourself “Macao, Macao.” It does cause an interesting conundrum if you are one that feels that something trading $52 should have some possibility (in your lifetime) of making, say, $4 per share and sending you a check for $1.50. It is always hard to run with values that are hard to quantify, the trick is to be there for the run and get out without overstaying your welcome.

What is causing this sudden bout of giddiness? We seem to have gone through this before with the dot-com bubble early last decade and the spike in 2007 caused by the Fed throwing money at an economy that has some structural issues and is not ready to grow at the pace desired. We need to understand the magnitude of what Washington is doing to the economy. First of all, they have been somewhat disingenuous in what we are being told. The Fed announced that they are, in essence, going to begin quantitative easing. The truth, however, is that they started two months ago, with the Money Supply (M2) up at an almost 8% annual rate in those two months. In the last 12 months, between July 2009 and July 2010, M2 was up roughly $160B (1.9% annual rate roughly equal to growth in economy). In August and September the growth increased to $105.7B (7.4% annual rate). The numbers the Fed is now talking about, $70B per month (even if you assume no multiplier effect whatsoever) would drive the annual growth rate well over 10%. That is a dramatically high number, especially if you think (like I do) that most of the woes in the economy woes are structural and not cyclical.

The stated idea is to drive interest rates down, the underlying theme being to weaken the dollar and make the U.S. more competitive on the world economic stage. The risk is that the extra money causes inflation, which would put us back into a late 70’s-early 80’s type of stagflation and increase the borrowing costs of government dramatically. You do have to ask yourself why anyone would lend money longer term at a 3-4% number if you think the dollar (and the Fed is telling us directly) will be worth way less when you are repaid. Have people simply forgot what inflation means to the various sectors of society? Right now the government is making the bet that the news media is going to cheer (and have the population fall in) to the argument that is good news that XOM rose in value, but not worry about the effects of the 15 cent increase in gas prices. I also have to point out that in those days (1975-1988) there was sort of an infrastructure in place just for dealing with inflation, most of which now is dismantled. In my Pullman days all of our contracts with purchasers of rail cars contained escalation clauses, where every quarter we (actually was my job) to calculate the amount of inflation and add it to the contract price. The unions had a similar clause in their contracts, maybe not every quarter, but they essentially received increases as inflation went up. In my area (finance, but essentially any area without such a contract) we did not participate in the same manner and essentially lost ground every year. The effects are very uneven, and very hurtful to those without pricing power, or without a contract (usually union) that anticipates inflation, or governmental employees, meaning most of us.

In my opinion (despite the absurd changes the recent election will supposedly bring) inflation right now will deliver a serious further blow to the middle class that still exists. I think we have had some serious stealth inflation already, look at how airfares have had serious double-digit increases this year (to go along with health care, tuition, and drugs). No one’s return on risk free money has gone up at all; at least in 1980 people were getting 8-10% on passbooks. Also, nobody is even remotely suggesting that the average worker will be able to demand a wage increase equal to this new inflation rate in addition to any increase based on productivity or merit. The squeeze will be to those in competitive industries, regular workers, and those who will see their costs of inputs to their products increase faster than their finished goods, meaning most of us.

What exactly is quantitative easing? It is really nothing more than the Federal Reserve printing money, something that (in theory) only they can do. The Fed essentially goes into the open market and buys assets (usually government bonds) in the open market, with the check they write to pay for them money that was just created. For instance, PTI may have a client who wants to sell a $100,000 bond he or she has held. We go into the market and sell it, not really knowing that the buyer might have been the Federal Reserve, and that the $100,000 check we receive for our client is ”new” money. It gets even more bizarre in times like this, when the Treasury (not to be confused with the Federal Reserve) is actively in the market borrowing in their somewhat separate attempt to stimulate the economy. So the whole circle goes like this. The Treasury, since the government is spending roughly a hundred million more per month than they are receiving in the form of taxes and fees, goes into the open market and sells governmental bonds, in essence “borrowing” money from someone either foreign or domestic. So the Treasury takes in money and issues bonds in exchange, something they have been doing a lot of for the last several years. What is new, this week, is the Fed stepping up their activity of going out and buying back (maybe the stuff just issued by the Treasury) bonds with recently made up new money. So the full deal now has the customer now holding new money and the bonds issues by the Treasury now being held by the Federal Reserve, and the Treasury owing the Federal Reserve. What the bleep! This cannot be a solution to anything, but in the short term some of that money will head into the market and it will all feel good until it does not. Add to that the disaster that would befall the government if the interest rate on all this debt were to ratchet up significantly due to inflation.

It is hard for me to even imagine the risks these people (elected officials and the droves of non-elected people pursuing these policies) are willing to assume with the mistakes falling on us. The gap between their governmental salary and pension largess and the rest of the citizenry has gotten so large that I think it is affecting their judgment (the Tea Party will be soon co-opted as well). It will not be over it seems, unfortunately, until the Middle Class is relegated to a mere historical anomaly.

So how about trading it? One thing for sure is that I need to stop looking so much at value and concentrate a little more on momentum. The good news is that the puts we use to protect positions are coming down some in value. The bad news is that the dip I am looking for to put money to work at a more reasonable price is so far not happening. If everybody knows that in an inflationary environment the standard idea is to be involved in assets and not be in cash, why am I hesitating? The reason is that this “everybody knows” idea was exactly wrong for most of the period of inflation in the late 70’s. Why could that be? The reason is that you start to be impacted by decreases in value due to higher interest rates. If you have inflation eventually the rates of interest go up to reflect that inflation, and if interest rates are 10% the value of an income stream is worth half of what it was if the interest rates are 5%. For example, if you have non-growth type of stock, say a utility, that pays you $2 per year like an annuity, its value at 5% return would be roughly $40. If that rate were to increase to 10% with everything else staying equal the value would now only be $20. Obviously, they (the utility) might be able to play the inflation card with the regulators and get rates raised and still maintain the $40 price by doubling rates, but not everyone will be so lucky. The point is that increasing interest rates lowers values, not increases them. In the 70-80’s inflation era you wanted to be in assets coming out of the era, not going in.

So the trick here seems to be to get long the market to take advantage of the initial euphoria to the Feds actions, but get out before everyone else figures out what the real long-term effects might be, then be short probably. It is a challenge, but we are going to have to get it done.