Tuesday, September 8, 2009

This Ain't A Happy First Post

The following is a chart of the last 12 months of the Dow Jones Industrial Average, with some of my preschool drawings on it.

A quick look at the title of this post and the drawings on the chart and you can reckon that this is not a happy first post on what I see brewing in the US markets (with consequences to other international markets, of course).

Let's start off with some of what a random assortment of optimists are saying:

  • “Leading indicators are now strongly suggesting that a U.S. labor market recovery is just around the corner, with commensurately bullish implications for spending,” Barclays said in a note to clients this week.
  • "For stock traders, low interest rates act like oxygen fueling a fire."
  • "Interest rates are ridiculously low and will remain that way until inflation starts to pick up. When that will be is anyone’s guess as this relates to the second point about the believability of government figures. So if the Fed is banking on inflation, you should too. Bonds, money markets, and other fixed income vehicles are out. Stocks and commodities are in."
  • “Looking at the survey results in aggregate, we believe the stage is set for the world economy to gradually recover, driven in part by relatively benign inflation, rolling impacts from global stimulus packages and improving credit conditions,” UBS said in a note to clients this week

Essentially what a lot of the smarter optimists are saying is that with interest rates so low, money flooding into the markets, and government intervention, the economy has no where else to go but up. This is a la Milton Friedman's famous quote: "Inflation is Always and Everywhere a Monetary Phenomenon"

This concept is good, logical, and has been ably applied to previous cases. But as we've all seen, this recent financial crisis is not like other cases. The Fed can't just lower interest rates, provide monetary stimulus, pour money into the financial institutions, and solve this problem. You need a working financial system and this is where I think this crisis is critically different from previous cases.

Banks globally are cutting down on risk. The drivers behind this trend are basically government regulation and severe losses that banks took from the crisis. And with less risk taken, this means less money being lent out. As we all learn in Intro to Macro Principles, the money multiplier function of the banks is critical to the expansion of money supply and economic expansion. And right now, with banks cutting down on risk, increasing their tier one capital, the money multiplier is not being put to use.

So what needs to happen? Banks need to actually increase risk. Businesses then get more money to spend on expanding their capital and labor. More people will become employed to create more goods and provide more services. People will spend more. And then finally, we will gear back into economic expansion.

I need to stop reading stuff like this:

G20 toughens bank capital standards

Sat Sep 5, 2009 9:09am EDT

LONDON (Reuters) - Group of 20 finance chiefs agreed on Saturday to back a U.S. plan for banks to hold more and higher quality capital.

--some parts skipped--

"Banks will have tighter constraints on the high quality of core Tier One capital," the source said. "This means banks will have to hold more capital and higher capital to act as a buffer."

Under Basel II, a bank must hold at least 8 percent in capital, of which at least half must be in the form of top quality Tier 1 assets such as equity. Since the credit crunch, banks have become much more conservative and are holding much higher levels of Tier 1 capital.

Until I start reading more about the financial sector taking more risks and actually lowering their capital ratios, I'm not buying this ferocious rally that started in March. Volume was low in the most recent rapid rally in July and we're about to hit into some resistance. The path of least resistance is downwards.

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