The “Knowing History” Approach

May 26, 2009

Good morning. Another in a string of very odd weeks for the market, as a huge up move on Monday of 2.8% in the SPY (235 Dow points), continuing to a high of 92.80 on Wednesday (4.6%) gradually eroded and finished with the SPY up only .31, or .3%. The Dow gave up 227 points of Monday’s strong move as the week wore on, finishing off 315 points from the Wednesday high. The VIX closed the week at 32.63, down .48 on the week, but touched a low of 26.56 last Wednesday at the rally’s peak. That level was last seen last September 15th. Is the bloom off the huge rally? Was this just a large bear market rally (the high of 92.80 on Wednesday did not exceed the May 8th high of 93.22) that has now run its course, or are we just entering a trading range for awhile before breaking to new highs? To be determined, but surely every savvy trader able and willing to buy near the lows of March has covered or hedged bullish positions by now. New money chasing the market early last week could have seen losses in excess of 4%, not a great start for a new investment.

The great economic debate, and the source of a few emails from clients, currently is whether the “extreme” amounts of money being thrown at the economy will cause a big inflation problem down the road. Certainly that view was seen in the movement in the 30-year Treasury bond, as an almost 3% sell off in that Bond last week has raised the return from 4.08% to 4.39%. As an added shock, the news that the government debt of Great Britain had lost its AAA status caused people to question the safety of U.S. debt. Are we headed down that road, is a situation like the phenomenon of the Weimar Republic (German government during the Depression complete with hyper-inflation, inability to pay debts, and actual organized burning of worthless currency) our likely future? To hear some of the talking heads tell it we are surely going down that road, but are we?

I have mentioned it before, but all this debate is centered on the history of the Great Depression. Everyone is familiar to some degree with the fact that the stock market crashed in October of 1929 and generally that marked the start of the Great Depression, although Economic Theory has come to conclude that the real cause (at least of the severity of the contraction) was that the then Federal Reserve allowed the money supply to contract dramatically during the crisis (I believe something in the neighborhood of 24% in six months). A lot of this contraction was due to individual people and businesses losing their equity deposited in banks that went under (a problem really continuing for a few years). Anyway, the same theory holds (just ask Ben Bernanke) that if the same situation were to present itself one of the mistakes the Fed should not make is to let the money supply contract to any meaningful extent, and it is a mistake this Fed has not made. The Fed is being helped this time by laws (like insurance of bank deposits) that have allowed individual accounts to be secure even though the banking system as a whole is less than healthy.

The problem with the knowing history approach is that the lesson sort of ends there. No one knows what would have happened in the 30’s if the Fed had been more aggressive at maintaining the monetary base, other than it would have helped some. A lot of people would still have been (like now) broke; declining conditions overseas would have cut exports dramatically, and a lot of businesses would still have slowed or been out of business altogether. If money had been jammed into the system it surely would have helped (especially the part about the totally uninvolved losing their life savings in a bad bank), but (like now) it would not really have made whole someone who lost all his or her money in the ‘29 Crash (or had all their savings in LEH stock this time). There would be money in the “system” but it would not flow necessarily to those in the most need.

Would it (the maintenance of the monetary base in the early 30’s) have helped enough to keep the rest of the world out of a Depression? Doubtful. Would it have stopped the unemployment rate from going to 25% in 1933 from 3.2% in 1929? Probably, but would it have gone to 6% or 22%? That is the part no one knows, and since the economic “cure” was not applied the efficacy of the cure remains undetermined. If the money used to re-float the system had not helped the actual recovery to any great degree, would it have just caused the additional problem of inflation as some are predicting now? All these are serious questions, and to a large extent we are heading into uncharted waters. It makes it even more difficult not only to plan the course of the economy and to take risk in any legitimate business, but to invest as well.

What is my guess? I actually think the Fed has done a pretty good job at performing their main function, that of maintaining the monetary base (or money supply). What we are learning is that in times of extreme stress that is a very difficult thing to accomplish. I am not sure that in the Great Depression the Fed (especially with the losses in uninsured bank deposits) would have been able to maintain the money supply. I question whether they had the tools to achieve that goal even had they been so inclined. Now all you hear is how much money, trillions of dollars, the Fed is “throwing” into the system. You also hear (from those unable or unwilling to read the numbers) how we are in danger of hyperinflation. The actual numbers tell another tale. Even with the incredible effort of “throwing” money the money supply (M2) has grown “only” 8.5% in the last 12 months, high considering the economy but hardly in the hyperinflation area. In the last three months M2 has actually dropped on a seasonally adjusted basis.

What that tells us is how much effort it takes, and how much money, to just maintain the monetary base in times of a business contraction. Huge amounts of money have been wiped out due to decreases in stock prices, losses in home equity, and decreases in paychecks, and the Fed has pulled out every trick just to stay ahead to a moderate degree. If they continue to expand the amount of money in the system by 8% a year and the economy continues to stagnate or shrink will inflation begin to be felt? Probably, but I doubt on a level now being predicted. The big problem is getting the economy going, and while the Fed is helping by doing the right things from their end it is surely no cure by itself. I really do wonder, and it makes me very nervous now, how much doing everything perfectly in the minds of modern economists would have helped in the Great Depression. I am on board with the part about it certainly would have helped, but maybe not on board with the degree of the improvement.

How should we be investing? In case the inflation bulls are more right than I think we need to be very careful about any investments, like long-term bonds, that are sensitive to increased interest rates going forward. We saw last week in the Treasury bonds how much they can go down with even a relatively small gain in the interest rate. I also think we should remain vigilant to downside risk in the market, especially given the size of the recent run-up. In keeping with that theme, many of the participants in the PIP program saw your protective puts rolled up a strike. Most also notice that we are not in a huge hurry to commit all excess cash at these levels. I suspect we may get another chance lower, but even if we do not the trend in the out month puts we use for protection is lower, so the costs to protect the new positions continues to go down. For those that did not notice the 2008 highs were put in on May 19th, somewhat eerily similar to last Wednesday’s high (May 20) and subsequent turnaround. Let us hope it is not an omen. In any case, we will continue stay protected while looking to participate in case a new bull market is upon us.