1937, a Primer

In the late 1920’s we had a massive credit bubble collapse, we then loosened the money supply and increased Federal spending to help improve the situation.   In the later part of this decade we had something similar. 

Here is what happened in 1937.

First, the Fed tightened monetary policy.  Starting in 1936 and through 1937 the Fed doubled reserve requirements (the amount of cash a bank must hold relative to its liabilities).  You can see how the money supply dropped here.

Less money = less lending = less borrowing = private sector contraction = recession. 

Now it is possible that if Federal government spends money it can counteract the drop in the private sector, along with an increase in exports (GDP = private consumption + private investment + government spending + net exports).

Did the Federal government spend in 1937?  Nope.  They also raised taxes.  

So to conclude, things were starting to look better later in the 1930’s; however, the Feds tightened monetary policy and decreased spending.  In my next post I will cover the fallout from that and why I think it’s dangerous to follow a similar path now.

The Debt Deal is Done – Yay

I am glad a deal got done, but I am not yet willing to throw a party with magicians and piñatas. 

I will start good news:

• We won’t default, which I viewed as political issue, not a solvency issue.
• The spending cuts won’t be drastic and immediate like Greece.   

And now the bad news:

• The USwas still get downgraded, although I am not sure how bad this actually is for interest rates.
• It showed how poorly we are governed.  I don’t think anyone in Washington came out looking good after this.  Politicians took something simple and necessary and turned it into a school yard name calling contest.
• The deal signifies any future stimulus is probably out of the questions.  As I have mentioned before I think short-term spending is still needed. 

I think how you evaluate the deal depends on your perspective.  If you evaluate it on a possible catastrophe being avoided then it’s a huge success.  However, if you take Armageddon out of the equation as I did (I never thought we would reach that point), the apparent removal of fiscal stimulus from the equation is not a good thing.

Note:  I didn’t mention anything about long-term fiscal health because I couldn't find an objective point of view.  So if you find one feel free to forward it along.

Commodity Bubble?

John Hussman recently showed the chart below:

As chart notes, commodity prices over time have not risen indefinitely without pulling back to flat or neutral returns.  This isn’t to say commodities can’t rise further, as bubbles can continue much longer than expected.  Ray Dalio, founder and chief investment officer of Bridgewater Associates, notes the commodity bubble can last “until China and those countries become too tight, and that's probably not until late 2012”.

It appears that commodities are a bubble and will pullback at some point.  The combination of easy monetary/fiscal policy, market psychology, emerging markets demand, supply shortages, etc. have certainly helped elevate prices over the last decade; however, it doesn’t seem likely that commodities can continue in this uptrend forever.  The big question is when the bubble will begin to deflate and that is anyone’s guess.  Regardless, commodities can still play the role of diversifier or inflation hedge in the portfolio. 

Active versus Active: Is That Really the Issue?

We get inundated by research, which compares active management - managers who try  beat a certain benchmark - against passive management - managers who try to mimic a certain benchmark.

Most of the research presents a compelling conclusion for the use of all passive or all active managers.  However, after a good hard look, the evidence that supports such claims is highly skewed.  In my opinion, "There are three kinds of lies: lies, damned lies, and statistics." It’s easy to make the case for passive or active when you cherry pick the data.  The reality is that there are sound reasons to use each.

I do find a compelling case to put one kind of management at the bottom of the list – the closet indexer.  The closet indexer is a manager who is classified as active, but in fact holds a lot of stocks, keeps sector weightings close to that of his or her benchmark, and/or rarely deviates from the benchmark.  There is no reason to pay active management fees, which are higher than passive management fees, for someone who by and large will perform relatively close to the index.

That isn’t to say I want my active managers taking an inordinate amount risk.  However, I do want them to earn their fees by doing diligent research, creating value, and beating the index over a full market cycle.  If an active manager simply owns the same securities in the same weighting as the index, he or she can’t beat it.  

The Debt Ceiling is Stupid II

Raising the debt ceiling should be simple.  We print our own money so in my view we technically can’t default.  Thus, this is NOT a solvency issue.  We pass the debt ceiling increase, create more money, and pay our bills.  

Instead, this is a political issue. The Republicans want cuts in spending in order to raise the debt ceiling.  Fair enough, increased spending and excessive money printing certainly have the potential to be inflationary and cause interest rates to rise. 

However, neither inflation nor interest rates are an issue now and much of the Federal Debt issue seems to by cyclically induced by the financial crisis and “Great Recession”.  This is why I think the spending compromise should focus more on cuts long-term while increasing stimulus spending in the short-term.

So when I take into consideration our current issues with spending (listed above) and the consequences of not passing the debt ceiling, I can’t think a deal won’t get done.  Right now we are witnessing a partisan standoff where next year’s election and appealing to ideologues take precedent over pragmatism at the expense of the American people.

Update: A deal is done and Rome lives another day as our heroes save us from disaster.