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Hello Marc, Thanks for your comments and tagged stocks. Your point of view might help me rein in my overall bearishness ("The sky is falling and we're all going to die."), as well as my bullishness on gold. Well, I do have my stops in place. Good luck with that CFA thing. At least you have a good excuse for not writing more lately! Don

From an economic standpoint I am more then a bit confused by your belief that the slight rise in the value of a dollar is a positive sign. Either the uptick is a short term random event or if strengthening continues the beliefs of the most bearish economists gain credibility. I note that as of today 2/21 the Feds latest reading shows the economy continues to contract. Do you believe that the Fed can use monetary policy to limit or moderate a recession? It can't be done by lowering the discount rate. Liquidity and insolvency are two different things not to be confused with one another. The economy has moved from a prolonged period of hyperinflated credit to the present state of credit deflation. This is a different "animal " that has to be dealt with very gingerly or else the economy could collapse. The Feds finally came to realize the potential outcome when they lowered the discount on an emergency basis.

Thanks for your response, Pablo. As I stated, I find a stabilization and recovery of the dollar to be a slight positive for the market in the near and intermediate term (3-18 months if I had to pinpoint the timeframe). I would disagree that continued strength in the dollar would lend credibility to the argument we are facing a prolonged and deep economic downturn. On top of the technical analysis hinting at a bottom in the dollar, several fundamental rationales support a stronger dollar in 2008. I think we'll see a sizeable rally (7+%) vs the Euro and Pound due to purcashing power parity, pressure on European exports, US budget deficit and total debt (as a % of GDP) lower than much of the EU, and, despite the current environment, a view that the US is a safer haven and exhibiting greater growth potential. In terms of how I expect this to play out in the market is for SWF's and foreign investors to start feeling more comfortable about investing in US equities. So on a company specific basis, we certainly won't see earnings improve across the board (in fact, just the contrary). But, we'll have more funds sloshing around, keeping liquidity up and, if anything, cause some PE expansion. Without jumping around too much, my bullish lean is predominantly based on PE expansion as opposed to greater than expected earnings.

Turning to the Fed, I do believe their actions coupled with the actions of the present administration will keep the US from falling into a true recession. I actually expect GDP to expand in EACH quarter this year. Of course, this goes against consensus (intrade has odds pointing to a 64% chance of a textbook definition of a recession sometime this year).

I completely agree with your "hyperinflated credit to credit deflation" comment. And unfortunately, we're fighting the credit debacle in all the wrong ways. As my colleague stated quite succintly, "We're treating a credit hangover with Jack Daniels". In the longer run, we're setting ourselves up for a great deal of trouble. However, the intense cutting of the discount rate along with massive injections of liquidity will help the markets (credit and equity) get by.

An article on topic:



As a gold bug, my ears always perk up when the potential for deflation is discussed. I agree with Profs. Succo and Pomboy that we've had several years of hyperinflation hidden in asset price inflation. I'm aware that gold does poorly in the beginning stages of deflation. That said, I don't believe that deflation can occur until the Fed really panics, runs its printing presses 24/7 and fails to inflate. In my opinion, deflation cannot occur until the Fed takes rates to 0 and fails. It's hard to imagine how the dollar would not collapse before deflation takes hold. It seems to me that talk of deflation is premature. Am I missing something?



Thanks kindly for your insights. Happy holidays to you and yours.



Best regards,

Minyan Dennis



Minyan Dennis,



Your statement assumes that in fact the Fed is "’in control’’ here which is manifestly is not. The idea that the Fed directly controls the creation and destruction of credit is termed the potent director's fallacy.



While the Fed certainly does intervene in the market for capital (by adjusting its cost) its effects are largely a function of the prevailing appetite for risk. Where providers (banks) and users (consumers, corporations, investors) of capital (read: credit) are risk seeking like they have been since 2001-2002, the Fed’s easy money policies have a multiplier effect through the economy and financial markets.



We have seen this writ large in tech in 2000, housing in 2005-2006, and credit securitization up until August 2007. But when those collective appetites go from risk seeking to risk averting, there is simply nothing the Fed (or administration) can do to stop the process of asset renormalization (which is a fancy term for write-downs). In the US, the economist Nouriel Roubini has been steadfast in his assessment that an insolvency crisis (which is most definitely what we are facing here) cannot be cured with lower Fed Funds rates. I couldn’t agree more. What cures a deflation is marking down the previously high valued assets to their new (much lower) market-determined price. Certain ABX indices trade at 20 cents on the dollar – an 80% decline for assets that traded at nearly par early in 2007.



What the above suggests is that we are in a deflation now. The write downs you see by Citigroup (C), HSBC (HBC), Washington Mutual (WM) et. al plus the 30%+ decline in asset back commercial paper volume since August 1 is in fact a deflation of the most serious kind. What you have not yet seen en masse is this credit deflation rolling downhill into the regular economy – into CPI, into PPI, into wages. Having such a massive – unprecedented – destruction of credit that we have seen worldwide not make its way from the financial economy to the ‘regular’ economy would be unprecedented in any cycle in any country at anytime in the modern financial era.



Lastly, we must differentiate between a currency hyperinflation – which is what is going on now in Zimbabwe and what happened in Germany under the Weimar Republic – from a credit hyperinflation – which is what happened in the US prior to the great depression and in Japan from mid 1980s to 1991.



They are vastly different things for reasons both theoretical and practical. Suffice it to say that a credit deflation – which I think is taking place as I write - is the vastly more probable path after a credit hyperinflation than is another credit hyperinflation or a currency hyperinflation (which is what you are suggesting the Treasury would be doing if they started running the printing presses).



Further, should the Treasury start printing actual greenbacks like the government of Zimbabwe is printing their currency now, the wholesale – and immediate – selling of USD-denominated securities (read: treasuries, agencies, etc) by international investors would immediacy raise domestic US interest rates, thus exacerbating the credit crisis even more by preventing debt holders (of which there are very, very many in the US) from paying off their existing debts as well as forestall any new debt demand since the cost of capital would then be so high. Thus, even if the Treasury (remember the Fed cannot print money – all they can do is create incentives for market participants to take more credit) were to print currency, the effect – immediate effect – would be a devastating increase in domestic interest rates which would exacerbate the very process of credit deflation they are trying to avoid.



Thus, you can see why I say that all roads lead to a devastating deflation in the US (and very likely the rest of the world, which has been equally drunk on credit this decade).



As for your query about the USD; ironically enough, a significant credit deflation increases the demand for (and value of) the USD against almost all goods and services (and other fiat currencies) precisely because a deflation is an attempt to ‘’get liquid’’ – in the form of short term treasuries (see the US yield curve for supportive evidence on this idea) and in the form of cash and cash equivalents. In a credit inflation (2001-2007) the value of the USD fell rapidly. In a credit deflation, the opposite should happen.



The last paragraph states what has happened during prior episodes of recession driven by credit contaction. The dollar rises in value as other asset classes fall until an equilibrium is reached .When that equilibrium is reached the recession comes to an end. The revaluing of assets has already begun. Home prices have come down. Banks and investment firms have written down the value of paper held. We are now only at the beginning. The ecoonomy must continue to contract until a stable balance is attained.



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