Stimulus Scenarios

May 31, 2011

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Good morning. The market rallied back last week to finish virtually flat, the SPY finishing down .10 to finish at 133.51. That leaves it down 2.1% from the April close of 136.43 with one day to go in May. The market seems to be stalled here (although it is rallying so far this morning) for any number of potential reasons. Other than the employment number for March, which showed a surprising gain in employment, most of the economic numbers have pointed to growth slowing. Quite obviously there have been some weather issues (cold weather, floods, you name it), and the Japanese earthquake caused some spillover effect in manufacturing and sales here, so some slowing is probably to be expected. The question is how much is attributable to those outside shocks, how much is real slowing, and how much growth should there be given the extraordinary stimulus. These are tough economic questions to answer, and I defy anyone, given the uncharted stimulus waters we find ourselves, to tell me the nature of the current growth vs. stimulus equation. We have 100+B per month in fiscal stimulus, being financed by QEII and very loose monetary policy, and the best the economy can do is the 1.8% growth reaffirmed for the first quarter? I can think of no other time in my years of investing where intelligent people (although still with strong opinions) can’t even agree on where we are economically, let alone where we are going. We have sort of covered some of this before, but the decision of how we are doing, given the impending end of QEII, is crucial.

I will make a stab at where I think we should be if things were going well. Assume the fiscal stimulus is roughly $100B per month, and that is roughly 8% of the average monthly GDP of $1.25T. The normal effects of that level of borrowing (higher interest rates as the market becomes saturated with government debt) is being muted by the Federal Reserve QEII policy of pouring $600B in the economy in roughly eight months. When the Treasury goes out to borrow the $100B per month they are borrowing, approximately half from domestic lenders and half from foreign lenders, they are really putting two separate dynamics to work. On the domestic side, borrowing from the person down the block, they are essentially substituting government spending for private spending. According to classic Keynesian Theory, with positive personal savings rates, there is a net stimulus by doing this because the government will not have a savings rate (far from it) so you gain in spending the amount the private sector would normally save. I would say that in today’s world the savings rates are pretty low, so we can probably forget the net stimulus here. We are just replacing private by government, not a good trade generally. The second part, the 50% we are borrowing from external governments and foreign people, now that is a horse of a different color. We are essentially mortgaging the future to others while making the bet that the added stimulus will become accretive and self-sustaining.

Most followers and proponents of this sort of stimulus will talk of a multiplier effect, if you add $1M to the economy by, say, building a bridge, you should expect that the money spent on the bridge will be spent a second time on support in the area of construction, on housing for workers, food, etc. Various theories and various situations might have people coming up with different multiplier numbers, but no one would probably argue that the increase to the economy would by “only” the $1M spent on the bridge. In our current situation the $50B being spent per month (proceeds of foreign borrowing only) is only helping to generate $22.5B per month in growth ($15T x .018 / 12). That number is atrocious, especially since QEII is supposedly is ending soon. What conclusions are possible here? Conclusion number one would be that the stimulus is not working very well, maybe that somehow the spending is being allocated so poorly (maybe with so much fraud and “shrinkage” along the way so as to be almost a total waste). Maybe so much of the spending is being allocated to foreign entities (like kitchen services in Iraq) that the benefits stay overseas and never have a chance to multiply here. Could government be that useless and wasteful that they can’t even spend money in a way to benefit the economy? Possibly.

Conclusion number two is potentially way worse. That argument would say that the stimulus is actually working, that it has saved the banks, put the financial markets back on track (market going up), and is creating slow (but hopefully steady) growth. If true, that the stimulus is working as designed, it must also be true that the real growth in the economy without the stimulus has to be negative, and by a significant number, say 2-2.5%. If that is true we are looking at a severe double dip recession if the stimulus is withdrawn, not to mention the fact that we now owe piles of money we have to service and “maybe” at least think of paying back one day. It would be my fervent hope (and anyone else’s that cares about the U.S.) that this current iteration of government stimulus has been a total failure, for if that is true then removing it should not be a significant problem. Otherwise, maybe I do not want to even think otherwise.

Is there any string of reasons why I can support conclusion number one, other than hoping number two is not the case. I think so. I can think of three significant reasons right away why the stimulus has been next to useless, or less useful than planned (much more politically correct wordage). The first reason is the foreign drain, and by that I mean money spent either overseas to foreign companies or to foreign divisions of U.S. companies that do not repatriate the profits (or spend the money on Americans). For example, if we have U.S. Service personnel man the kitchen for an Army base in Iraq we are paying U.S. citizens, and the proceeds are probably saved (minus the part spent on leave) or are sent home for family here. If “we” hire the foreign arm of Brown and Root to run the kitchen, who knows who they might hire for how much, and the profits probably never see here (forget for a minute the outrageous price we are probably paying to the politically connected hack). Anything like this on any kind of scale would act to significantly degrade the expected multiplier effect. I would say stopping this sort of spending would not cause our economy to slow in the slightest.

The second reason, I believe, is the serious mis-calculation of the wealth effects of the zero interest rate policy the government is “using” to finance the deficit spending. The Fed has been very complicit in the fiscal stimulus on the cheap, meaning that they have flooded the economy with money so as to minimize the interest cost of the Treasury borrowings. That comes at tremendous cost to those with money balances. In fact, my research shows (thanks to the Associated Press) that the total wealth of U.S. households minus houses is roughly $36.4T. Of course the net wealth is less than that, as you have to subtract loans of all types. However, just focusing in on the wealth number, in normal times those “deposits” would be earning somewhere around “conservatively” three percent interest. That number is now close to zero, so the average household is being “penalized” virtually any income of money balances to keep government costs down, re-float slimy banks, and benefit counter-productive corporate takeovers. That income “penalty” amounts to around $90B per month that people are not earning, almost the same amount that the government is pouring in with fiscal “stimulus.” Add to that the drain in wealth that is still happening monthly on the housing values, and the only thing you have growing is the government. Wasn’t there something in the Bible about somebody giving and taking away?

My third reason is just the general inefficiency of how the stimulus has been handled. Out of the gate the rush caused the most “shovel ready” projects to go ahead, seemingly without regard for whether they were a total waste. The $300+M project across the street from the PTI offices looks to me to be a total waste, and could (in my mind) been way better spent on a new lock or two on the Illinois River that would speed barge traffic for 50 years. Money given to states and municipalities to temporarily keep people employed (while probably having a multiplier effect) did nothing but put staffing and levels of pay discussions off for a few months. I think this administration is totally in love with every possible program that greases a supporter along the way, good for the supporter but maybe not the rest of us. In conclusion, I think a solid case can be made that the current stimulus might be so poorly thought out and administered that its gradual wind-down will not cause the economic slow down one might normally expect from the numbers alone. If I am wrong, and the stimulus is in aggregate working, we could be in a world of hurt very shortly if or when it is withdrawn.

As for how to trade it, in the long term your positioning would depend on what you think of the economy going forward. If growth were to slow appreciably, as some of the recent numbers indicate, I do not think you can count on even the multi-national companies to continue to grow earnings in that environment. So, even if we want to remain invested (and I think we do) we should have some protection in place. It also means that maybe a further out bullish call spread with high cash reserves might be the model portfolio for a while. We are also committing (through the PIP) some funds to the XLE on dips, as it is one of the few indices that have a relatively even volatility skew going out in time. The rest of the market still has this “steady today and for a little while, but danger out several months” pricing in the options that I find very sobering. It sure makes me want to make some profits on something fairly short-term, then live to fight again. The good news is that we are getting some two-way trade in some of the more short-term spreads we like to do. Despite the lack of return to cash balances I do not mind having some money in cash here, I think we are within a few weeks of some very solid opportunity, which may turn out to be to the downside. The sudden drop in commodity prices might be followed by a post QEII drop in stocks, I would like to participate to the downside and put available cash to work near the bottom. That would be nice.