Vigilant Investor

Nick Vardy is a well respected guru by most of Wall Street. He’s posted up a mocking critique of those of us contemplating the worst of what’s transpiring in the U.S. economy at the moment. The issue at hand is the consequence of “cry wolf syndrome”, where decades of warnings about horrid Fed policy and decadence in finance were, bluntly, way too early, causing mainstream analysts and bulls to dismiss them entirely as poppycock.

We’ll address Vardy’s comments below, piece by piece:

The Global Financial Crisis Of 2008 by Nicholas Vardy

Here we are yet again in the midst of another “global economic crisis.” From the hilltops of Davos, Switzerland, Morgan Stanley’s permabear Stephen Roach has shouted warnings of potential economic “Armageddon.” Superinvestor George Soros designated the current state of the global economy “the worst market crisis in 60 years.” Bill Clinton labeled it “the biggest financial crisis since the Great Depression” — even as global stocks responded by slumping 7.7% in January — the worst start to an investing year since Morgan Stanley began publishing data in the 1970s.

Uhh, but Stephan Roach has largely been right in his predictions since 2003, and where he erred was in underestimating the credit bubble’s blow-off. Soros has been similarly correct. Clinton? Well, opportunists always know when to hop on a bandwagon!

Bottom line, though, who do you trust? Those who failed to see any of this coming and were conceitedly dismissing warnings as crazy talk? The same ones who then failed to comprehend how severe the implosion would be, and whose advise encouraged investors to overextend and lose $ billions if not $ hundreds of billions?

But before you liquidate your financial assets, buy gold bullion, and move to a cave in Montana, you may wish to consider that current predictions of global economic collapse may be simply hyperbole. It has happened before. Clinton’s quote above actually refers to the collapse of Long Term Capital Management in 1998 — right before NASDAQ clocked an 88% gain in 1999.

Clinton’s a politician and a particularly adept one at saying whatever he needed to placate his power alliance. He’s a lousy example. However, what’s the point of bringing up the NASDAQ’s huge gains in 1999? Most who participated in that run-up gave that gain and a whole lot more back the following three years. Indeed, this was a bubble of insane proportions and who on earth can credibly use that as part of their defense for the health of today’s credit bubble economy?

Nor does this global crisis stand up to the scrutiny of historic comparison. Remember the S&L crisis in the early ’80s? It cost the U.S. economy about 3.5% of GDP — about 5x the size of subprime write-offs so far. Or how about the dark days of 1981, when the Federal Reserve drove its key interest rate to 19% in an effort to whip inflation? Bill Clinton’s “Great Depression of 1998″ doesn’t even merit mention.

Oh, if only this were the worst of where we’re going. Vardy is comparing the totals of past carnage events to the early innings of this situation. That’s comparing apples to oranges. Just wait until commercial and retail real estate start their problems, and then revolving credit. And, heck, we’re still lucky if we’re midway through in the housing collapse. And then there is the gargantuan counterparty risk fiasco looming in the gargantuan $ mega trillion credit derivatives market. Just you wait!

Global Financial Crisis: The Current State of Play

Comparing economic statistics is inevitably a “glass is half empty” versus “glass is half full” kind of game. Both Pollyannas and Cassandras can marshal endless statistics to support their version of events. But since it’s the Cassandras’ views that are the flavor of the day, let’s look at some “glass is half full” statistics on the U.S. economy.

Before we go on, let’s not forget the recent record of the sober analysts who warned of problems looming in the subprimes and mortgage markets when the “glass half full” crowd was as risk indifferent as ever, crowing about a cup flowing over with profits.

Companies in the U.S. private sector added 130,000 jobs in January and the unemployment rate eased to 4.9%.

Labor stats, by design, are statistically smoothed to disregard short term bumps. However, the government itself acknowledges that their own stats will come up short due to the smoothing when, in reality, assumed job growth that carries on from the good times and into the bad are added to the reported stats, when in fact the opposite is true — but smoothed out. We’ll wait and see what happens on the job front, but already this year the numbers are finally catching up with reality. After all, news flash after newsflash recent is about job cuts, not the opposite.

Moreover, we must also keep in mind the politicization of job numbers being reported. No longer do we live in a world where able bodied adults of sound mind who are not working are counted among the unemployed. Only those actively seeking work are considered party of the work force (meaning, if you give up looking for work, you’re considered discouraged and not counted), while urban areas with high, chronic unemployment are weeded out as anomalies. Much of this was adjusted under Clinton’s administration, although the monkeying with the figures goes back to JFK. Estimates of joblessness by the old methods are as high as 13% , which is a number calculated the same way we would have calculated unemployment during the Great Depression when it was 25%.

The Institute for Supply Management’s index of manufacturing activity rose to 50.7 in January — back above the 50 threshold that indicates expansion consistent with GDP growth of roughly 2%. Nearly 93% (!) of purchasing managers said that turmoil in financial markets was having no effect on their companies’ ability to obtain regular or additional financing. That situation indicates that the turmoil is restricted to Wall Street and subprime households.

True, that after rip roaring performances in Q2 and Q3, the U.S. economy has stumbled. But a look behind the headline numbers is revealing. Good news came from the consumer sector (spending increased by 2%), business investment (jumping 7.5%), and exports (up 3.9%). It was declines in residential investment (down 23.9%) and in inventory investment that almost wiped out those gains. All of this indicates that the economy stands less at the precipice of the next Great Depression than at a cyclical purging of excesses — particularly in the housing sector.

Who said anything about a Great Depression? No doubt severe times lie ahead, but our circumstances are far different than in 1931 — worse in some cases. But many of us are talking not of depression, but stagflation.

Let’s see where things are going. Far too much of GDP has been measuring unbacked credit expansion, not actual real production. That’s not to say manufacturing won’t get a boost from exports with the weakening dollar. However, much of our production abilities have been off-shored in recent decades, and many of those that remain are still hamstrung by the artificial construct of legislative, regulatory and tax anchors that hold them back from truly competing effectively — Something that’s not about to change because it disenfranchises Congress from being the toll collector in the great game of power.

Global Financial Crisis: Professor Bernanke’s Report Card

Aware that the financial crisis could spread to other sectors, the Fed has moved remarkably aggressively, cutting rates by 1.25 percentage points in eight days — a rate-cutting spree almost unheard of in central banking history. The Fed now has cut rates five times by a cumulative 2.25 percentage points — and there is no sign that the Fed is done. Thanks to the maneuverings of Hank Paulson, George Bush soon will sign a bill that will pump some $150 billion into the American economy for U.S. consumers to spend. That kind of coordination between fiscal and monetary authorities is as unprecedented as it is both prompt and impressive.

Does this not speak volumes of the Emergency those in power happen to see, but perhaps don’t’ care to speak too loudly of?

Besides, the sloppy assumption Vardy is making here is that this “impressive” action will actually solve the problem. What Vardo is celebrating is flat out inflation of credit and money supply. In December of 2007, banks commercial and industrial loans grew by nearly 11%, while total bank loans and leases were just under at 10.8%. Imagine what will happen now that the Fed has greased the skids with more easy credit?

These experts focus on their belief that bubbles are the consequence of Minsky moments, where good times begets reckless thinking and excesses that eventually create bubbles that collapse. The line of reasoning goes that this is the infallibility of free markets, where the animal spirits made famous by Keynes are unleashed to cause havoc on the poor economy… Therefore, the noble cape wearers at the Fed and Treasury step in to manage the business cycle.

The error of consensus thinking is that it fails to understand that the current problems — the massive clustering of business and personal financial errors that are being revealed as the tide sweeps out were caused by government intervention in the first place. Absent the absurd below market rates supported by the Fed in the first place that artificially expanded the pool of savings for loan at below-market rates, the housing bubble now unwinding would never have been able to get out of control. Rates would have risen, naturally warding off unsustainable business projects. What’s possible at 5% may not be possible at 7%, and what’s possible at 7% may not be possible at 9%. This natural culling of recklessness is the byproduct of self-regulating rates, the real cost for free market money.

The obvious signs of crises we now witness are provoking even larger doses of centrally planned (both Fed and Congress) intervention. In other words, the prescription from these economic doctors is nothing but more doses of the very pathogen that caused the problems in the first place. Of course, if history is any guide, the new problems they create will then lead many to clamor for yet more centrally planned solutions, and the cycle will only worsen.

Sure, the Cassandras are vilifying the Fed’s actions. Bernanke has been criticized for everything from pandering to Wall Street traders to still being behind the curve. But opinions are like a nose — everybody has one. The current din of criticism against Bernanke is a lot like baseball fans, screaming “throw the bum out” at the game or venting their frustrations on post-game AM radio talk shows. But it’s a lot easier to criticize than to step up to home plate and swing the bat.

This is fallacious thinking at its best. Sometimes “doing nothing” in the conventional context is actually doing something. That something is allowing the market to cleanse itself of the massive clustering of errors we now know exist so that our finite resources and stores of real savings can be more effectively allocated to where they’re needed. Obviously we never needed tons of condos in Miami, so what purpose do we serve by keeping those projects overpriced given their supply far exceeds demand? The same can be said for many assets –houses or otherwise — whose values grew to depend not upon naturally production-based demand creation, but rather simple money supply expansion.

The reality is that few of Bernanke’s most vitriolic critics were even smart enough to make it into an introductory economics class taught by Bernanke at Princeton — let alone to run the world’s most influential Central Bank.

The ultimate criticism of the “degreed” against the “non-degreed.” As if history is not rife with Academics with no real world experience forcing their theories onto the real world through legislation, only to screw things up. Besides, as Vardy’s own Long Term Capital Management example above demonstrates, even Nobel Prize winning Ph.D.s in economics can blow it, and fantastically so. We’re seeing the same hubris by degree having cost hundreds of billions so far this cycle (and lots more if we contemplate vanishing market values globally in equities…). Plenty of super geniuses models are failing as we speak.

And to assume that Fed policy is based on responses to such criticism would be as absurd as for baseball star Alex Rodriguez to walk over and hand his bat to an obnoxious, beer-swilling critic in the bleachers of Yankee Stadium to take his place at home plate. Thankfully, airline pilots guiding a plane through rough turbulence play to a less vociferous crowd.

Sorry. This analogy is simply meaningless drivel.  It presumes the Fed is infallible, and that it can actually do something to prevent the downturn.  It also presumes that we actually need the central planners at the Fed to price fix credit and money to save us from ourselves.  Oh, but if only Big Brother were big enough!  (Sheer Fallacy!)

Here’s the reality. Neither Bernanke’s interest rate cuts nor the federal stimulus package likely will hit the policy nail right on the head. But no real-time decision making is perfect. As John Maynard Keynes, himself an academic with plenty of real world experience, observed: “It’s better to be approximately right than exactly wrong.” The Fed can’t stop a downturn, but it can help it be short and shallow. This is a complex, fast-changing situation. Let’s give the Fed and the U.S. government some credit for acting swiftly and decisively.

As Daniel Boorstin observed in his book, The Discoverers, “The greatest obstacle to discovering the shape of the earth, the continents, and the oceans was not ignorance but the illusion of knowledge.” Those like Vardy are no doubt the smartest in the room, so to speak. But so, too, were those advising Kings and Popes centuries ago when the framework of man-made explanations of the laws of the earth supported geocentric explanations and flat worlds. Similarly, Vardy and crew are operating in a false paradigm that is failing before their eyes. Indeed, it was a powerful paradigm where the real economy could actually support — far longer than anyone could suspect — economic myths, such as “we can consume ourselves to riches,” “savings hampers growing wealth, ” and “debt begets riches without exception.”

Besides, let us not forget that the Fed and the banking system (which is functionally an extension of the Fed) is a money cartel / banking monopoly legally authorized to print money out of thin air, which they in turn get to lend into circulation at interest, and which they also have for fist dibs in highly profitable deal making.  Let us also not forget that Congress and this system are bedfellows; Congress has functionally legalized plunder — what we would define among private citizens, were they to do the exact same as our banking system, as “counterfeiting,” so that it may surreptitiously use a part of the proceeds to maintain political power because above-board raising of taxes to fund free lunches is not feasible. That these combined interests may not unnecessarily align with Joe Lunchbucket in Peoria and Johnny Independent Entrepreneur in Pittsburgh should come as no surprise to any of us but the most naive.

Global Financial Crisis: The Investment Strategy of the World’s Top Traders

So are things really that bad? What has gotten lost in the din is that credit markets have returned to normal. Foreclosures are at record levels, but aren’t as numerous as originally forecast. And even if policy responses by the Fed only slow the rate of decline in U.S. housing prices, that alone will already have a dramatic impact on U.S. economic growth. And the Fed has shown that it is willing to act quickly to reverse course and hike interest rates once it is clear that the economy is through this bout of weakness.

For now, the credit markets — represented by the TED spread — are somewhat leveling, but thanks largely to the Fed’s new TAF system that allows banks to pledge collateral of substantially suspect quality in order to raise cash. We’ll see how the TED spread holds up if the Fed decides to remove the liquidity its added once the term expires. Don’t hold your breath, as the long term trend is only to expand money supply, which those who still reconstitute the broadest measure, M-3, estimate to be growing at about 15% right now. As if that’s a healthy byproduct, but the Varyd’s of the world don’t’ seem to comprehend how bubbles are actually the perverse manifestations of dislocating money from the productive wealth creators, reallocating it to areas it would not naturally go. In this case, Vardy is actually celebrating the reality that the Fed is keeping lousy condo deals, etc., etc., etc. afloat rather than allowing the market to more efficiently allocate those resources. That propping requires real wealth, wealth not generated from an oversupply of condos or overpriced housing in California, but from the real producers who will see their purchasing power continue to erode as this populist charade continues indefinitely.

Uncertainty means that it is reasonable to pull your horns in a bit — and diversify away from stocks, emphasizing a diverse group of assets that are less correlated to the stock market. The top hedge managers I know are more focused on playing defense until the dust settles. The most bullish signal is that investors are almost uniformly bearish. And it is precisely during periods of panic that the greatest fortunes are made.

A straw man for a conclusion. To paraphrase an investor I trust far more than Vardy (Warren Buffet), you are neither right not wrong because the crowd agrees or disagrees with you. Your are right because your data and reasoning are right. I’ll agree that when there is panic and chaos, opportunity is abundant, but contrarian thinking for the sake of contrarian thinking rings hollow to me.

My critique is nothing new. My final comment I’ll quote perhaps the most profound economist to have ever been ignored (for being too inconvenient to Wall Street’s big money printing machine, as well as the power of the Fed and Congress), Ludwig Von Mises, who wrote in 1949:

Public opinion has become convinced that such happenings are inevitable in the unhampered market economy. People did not conceive that what they lamented was the necessary outcome of policies directed toward a lowering of the rate of interest by means of credit expansion. They stubbornly kept to these policies and tried in vain to fight their undesired consequences by more and more government interference.

No doubt, inflation is an economic and moral evil to society. It impairs the pricing system in an economy, and distorts money’s purpose as a reliable medium of exchange. An economy is faked as easy credit and money encourages mismanagement and distortions as actors perceive growth opportunities that are nothing more than ginned up fallacy, the consequence of unsustainable inflationary redistribution. (Can you say “housing bubble?”) This causes terrible economic pain as a consequence, but unfortunately because of the illusion of knowledge, most people will blame the free market for their problems rather than the banking system. Yet readers should not forget that Henry Ford nearly ninety years ago pointed out that if the people truly understood the nature of their banking system, there’d be a revolution overnight.

In defense of Vardy, like the boy who cried wolf once too often, many in the “collapse crowd” were far too early with their warnings. In my own research I’ve found books from the 1970s, 80s and 90s all preaching a looming collapse, much filled with hyperbole. Yet lot’s not forget the lesson of crying wolf to the crowd that grew to ignore the shepherd boy who was eventually eaten: the wolf did exist despite the Vardy’s of the world suggesting it is fantasy.

And that’s the problem. Another analogy that I’ve used before is that of a coal mine with a faulty aging ceiling support system. It is human nature for the miners working in such a mine to use the fact that a ceiling has not collapsed as evidence that the ceiling is sound. In fact, each day that passes without a collapse is one more piece of long-term evidence supporting the view that the mine is safe. Yet, from a sober engineering perspective, each day that passes is exactly the opposite: one day closer to the inevitable collapse that will happen.

Again, that’s human nature. Now that the ceiling is in fact starting to drop rubble on the our economic miners, you’d think they’d take the time to rethink some of their assumptions. Rather, they simply dismiss the parts showing weakness and dropping with the simple fact that “the ceiling has worked for decades. ” So what’s the big deal?

And, so, here we have Vardy pot-shots on the wet blanket crowd as glass half-full Cassandras. Until then, expect more from those sharing the popular wisdom pulpit to take shots at our side. In the meantime, weight the evidence at your fingertips: who not only predicted the current crisis, but also its severity? Who do you think understands the fundamentals better? Those who missed the call by a mile — literally a $ billion mistake — or those who called it correctly?

The Fed policies now rolling out will have some impact — no doubt, especially since if the market and Wall Street believe enough in something, they can give it legs for a while. But lets not forget, the same effort gave us legs into the housing and credit bubble that’s still collapsing. If the Fed can pull this off, it will be sowing the seeds of its own demise, and likely over a dramatically shorter period than this most recent echo bubble reprieve from the start of the collapse that began in 2000.

Think it through!

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