Leveraging And Deleveraging: Beauty Or The Beast? by Steve Blumenthal, Capital Management Group

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“The economy is like a machine.  At the most fundamental level it is a relatively simple machine.  But many people don’t understand it – or they don’t agree on how it works – and this has led to a lot of needless economic suffering…

Seeing the economy and the markets through this ”transactions-based” perspective rather than seeing it through the traditional economic perspective has made all the difference in the world to my understanding of what is going on and what is likely to happen.

It lets me see what is actually happening and why it’s happening in much more granular ways than the traditional way of looking at things.

Because money and credit, and through them demand, are easier to create (or stop creating) than the production of goods and services and investment assets, we have economic and price cycles.

This different way of looking at the economy and markets has allowed us to understand and anticipate economic booms and busts that others using more traditional approaches have missed.”

-Ray Dalio

Susan handed me a cup of coffee this morning and asked, “What are your writing about today?  Interest rates?”  She was really poking fun at me.  How do we simplify this stuff in a way that makes sense?  I said, “well kind of” adding that this week it is about “beautiful deleveraging or ugly deleveraging.”  “I’m not sure I know what you mean”, she said.

So today I’m writing to Susan and through her hopefully I can paint a picture of the deleveraging forces that are underway and how they impact all of us.  My hope is that I can keep it simple enough and present in a way that makes sense to the layperson so that you can share some of this with your family and, if you are an advisor, with your client.

We all want to make the great call, nail the timing and make money.  I believe Susan and most individual investors for that matter expect us to get it right – all the time.  And that’s the rub.  Not going to happen.  Perfect is impossible in this game of investment risk but I think we can get fairly close on directional trends.  And we can position to take advantage of opportunities and use viable tools to protect us against significant loss.  Understanding the larger forces in play and where we sit at any point in time within an economic cycle can serve us well.  So where are we today?

We are at the beginning of a debt deleveraging cycle.  I wrote in OMR a few weeks ago about three big risks I see: a European sovereign debt crisis, an emerging debt crisis and a coming high-yield default crisis.  I went into additional detail in a piece I wrote today for Forbes titled, How To Profit From Runaway Debt And The Next Global Recession. (Click here to view the piece).

But the debt mess is much broader than the above.  It is global and it will be unwound.  I believe the most important question today is: Will the deleveraging be a beautiful deleveraging or an ugly deleveraging?  This may be the most important factor, at this point in time, for us to understand and get right.

“Susan,” I said, “do you remember the ‘no interest’ credit card offerings and all the mortgage refinancing’s that took place when money was easy?”  That credit was money used to drive and inflate the economy.  That is a leveraging up cycle.  Borrow from the future and spend today.  You can get a sense of how that drove economic expansion.  But leveraging cycles reach a point where many borrowers hit an end point.  Spending slows for them and, if too many borrowers reach that point around the same time, the economy slows for all of us.

She remembered when my sister had to declare bankruptcy.  My sister was earning $50,000 per year and was able to borrow from her home and borrow on credit cards enabling her to spend $70,000 per year.  Credit card debt reached $75,000, at some point soon after the gig was up.  Like my sister, when an economy collectively reaches this tipping point it begins a deleveraging cycle.  Absent a meaningful increase in wages, spending slows and the pay down of debt begins.  Thus, deleveraging.  When the global economy collectively reaches this point at the same time, economic activity slows, global trade slows and deleveraging takes hold.  That is where we are today.

Deleveraging, deflation, recession, inflation or depression?  How the current cycle plays out depends on the amount of debt (how large) and how governments (through tax policies, spending and the types of spending) and monetary authorities (central banks, printing, security purchases), investors and individuals behave.

The seminal question is: will it be beautiful or ugly? Beauty or beast?

It has been an interesting week.  Mario Draghi disappoints (offering not enough QE – the euro rallies) and Janet Yellen signals a December lift-off (though just a tiny little move – can’t risk an all-out global capital flight to the U.S. dollar).  The fundamental problem is unmanageable debt (see the debt-to-GDP charts below).

Without getting too deep into the weeds, you can begin to see the depth of complexity that exists in order to soft land this puppy.  Currency games, central bankers, politicians, taxes, trade tariffs, negative interest rates, QE, global capital flows.  Each country attempting, in its own self-interest, to land its debt-burdened plane in bumping conditions.  How do I explain this to Susan, my family, my team and my friends?  It is more like a plane coming in hot for a landing with two engines out: will the landing be beautiful or ugly?  It’s the multi-trillion dollar question.  My sister’s plane landed in some form of bankruptcy.  It was a bit bumpy but she’s in much better shape now.

You’ll also find the most recent valuation metrics.  With a Median-PE of 22.2 on November 30, 2015, the market is richly priced.  Here is a quick look at other periods of high PE and what the corresponding annualized returns were 10-years later (note the red arrows).  The green arrows show the low PEs.  Green light, red light.  You get the picture.

deleveraging

I hope you find this information helpful in your work.  Please let me know if you have any questions.  Okay, grab a cup of coffee and jump in.

Included in this week’s On My Radar:

  • How The Economic Machine Works – Leveraging’s and Deleveraging’s (Ray Dalio)
  • Debt-to-GDP by Country
  • A Quick Look at the Most Recent Valuation Metrics – Equities Remain Richly Priced
  • Stuffing Balls, Slippers and the Nana Bag
  • Trade Signals – Seasonal Tendencies, Trend Better, Don’t Fight the Tape or the Fed is Now Neutral

How The Economic Machine Works – Leveraging’s and Deleveraging’s (Ray Dalio)

In past posts, I’ve shared with you a link to a relatively short animation of How The Economic Machine Works.  You can view it on YouTube here.  I had my daughter watch it (with great feedback).

Today, I provide a link to a 305-page PDF that goes into great detail (Click here to view piece).  I know – it’s long.  Who has time read and digest it all?  I loved

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