Monday, June 18, 2012

Monday Morning Economic Assessment

The US Industrial economy advanced again last week (if pipeline scheduling is correct), while consumption turned and went positive for the first time in weeks.

The Production Index (In terms of its 28-day moving average of gas-flow scheduling into US industrial facilities) put in its second up-week in a row, gaining to 124.7 (from last weeks revised 124.1). In its raw dailies (above) the week started slightly soft, then strengthened steadily as the week progressed.

The Consumption Index broke its five-week loosing spell, rising to 141.7 (from last weeks 141.3). In its dailies the measure was strong most of the week then softened into the weekend. Against seasonals (which argue for slowing) the week did very well overall.

The Inventories measure (the cumulative weekly difference between the Production Index and the Consumption Index), continued its long-term decline.

All-told, (for the first time in months), internals are supportive, with food-group scheduling backing bullishly backing off of its highs before the turn in consumption while the extremely-defensive industrial sector continues to tread well behind the reviving consumer sector.

These "Economic Assessment" posts, started about four years ago in the midst of the "great recession", have run for quite a while since their introduction. But its been quite a while since I have written on the methodology behind them. Feeling that it has been too long since discussing the foundations of these posts (and my own investment strategies and philosophies) I started an explanational series with last weeks post, and this week will get into my own theories on the US economic cycle.

When I started investing (in the late 70's... when president Carter was president and hired Paul Volker, who was to reshape Federal-Reserve policy into what it was today) the economy was a morass of stagflation, with interest rates, unemployment, and inflation all exceeding 10%. At that time I tried to learn the principles behind monetarism, and held to them until well past the turn of the century.

Monetarism seemed to make a lot of sense... treating money as a commodity, and regulating its supply to counter demand (theoretically to control inflation) made sense. When you look at any raw commodity, when under-produced its price spikes and when overproduced its price crashes. It made perfect sense to think of money as any other commodity. Limit its supply and its "price" (inflation) goes the way you want it to. Cap the money supply, and you cap inflation.

However, as time went on, strange things began to happen. Debt of all kinds skyrocketed. Interest rates plummeted. The economy, which once (under Keynesian theory) was stimulated by a drop of the prime rate to 10%, or stimulated by small amounts of deficit-spending, in time became like a disease drug-resistant patient, to the point where today, even <1% interest rates and trillion-dollar-US-deficits can't seem to stimulate it.

Then, as I developed my present modeling and started to study patterns both within my own modeling doubts grew about monetarism. My own views simply did not work. And (like any trader that has to change his or her belief system and strategies to keep from getting crushed by the markets) I had to alter my theories. Today, my economic perceptions, while working quite nicely to time and profit from changes in economic trends, are quite radical, and I am very much the "outlier" today in my thinking.

My first "revelation" (forced change in thought) was to foreign trade imports. Conventional wisdom was that the enormous us trade-deficit is caused by US consumer-demand for foreign goods, benefited by substandard foreign-wage systems, that undercut US industrial competitiveness. However, I could not completely wrap my mind around that thinking. If such imbalances did exist, than why would not free-market systems (such as currency-exchange rates) correct for it. And what about foreign "dumping"? Why would a foreign corporation want to sell below cost (take a loss) to sell to the US. Loosing money is not the way that businesses prosper.

Then in my own studies, there was an issue of timing. Why, when foreign trade statistics or exchange rates changed, did not the gas flows not change likewise in a rational manor? And why did changes to foreign statistics lead changes to industrial gas-flows (if US consumer-demand was to blame for the foreign trade deficit) and not vice-versa?

Then it occurred to me... like in the commodities markets (where escalation in price can be caused by EITHER a rise in demand OR a drop in supply), foreign trade-deficits could likewise be triggered by either the buy-side (demand for foreign goods) or the sell-side (demand for US cash).

Suddenly, foreign dumping made sense. It was not US demand for foreign goods, but foreign demand for US dollars. It was foreign interests that wanted US dollars so much that they were willing to take a loss to get those dollars. The loss on dumping was the "commission" on the trade that they were willing to make.

And then there is monetarism... which (in its theory) wants to hold the actual count of dollars created (or printed) to a fixed amount. If the US money supply stays fixed, and demand for it grows, you have an imbalance that raises the value of the dollar (which makes the price of foreign goods even cheaper), pumps the US-foreign trade deficit, drains money from the US populace, and therefore slows the US economy. Like a string of dominoes, the markets, economies, and governments of the world reacts, and a cycle is set up...

The figure above is what I believe is happening, not only to the US, but to much of the "western world" as well, including Europe. It is a "death-spiryl" where foreign-demand for US dollars (See "1." above) drains dollars from the US, slowing its economy, and creating a need for stimulus (on the part of the Federal Reserve or US Government) to revive the US economy.

In the meantime, those dollars (that went overseas in exchange for foreign goods) accumulate in foreign accounts (and foreign central banks where they are converted). Eventually those foreign banks (to get a return on those dollars) seek to reinvest those funds back into the US (a quarter of a percent in interest is better than nothing), giving the US (and US Government) ample funds from which to borrow.

Then there is the US economy. As the US economy drains of US dollars (and its economy slows), and as the Federal-Reserve refrains on creating new money (to control inflation), pressure mounts on the US government to "do something". The easy-out is for the US Government to connect that pool of growing foreign-held US dollars to US consumers. The US government borrows, deficit spends... all problems solved! Foreign governments now have their funds invested and are making a return, US consumers have new cash to invest, and the cycle repeats.

And around and around it goes !

Timing of economic cycles, therefore, is led by timing of US Government Deficit-Spending (and those rare occurrences of US Federal-reserve acquiescence to quantitative easing).

Next week... dealing with that cycle... as an investor.