Stockman’s Cash Call: Our Response

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Readers can find Stockman’s piece here –“State-Wrecked: The Corruption of Capitalism in America”

 

David Stockman, President Reagan’s former budget director, is back in the news with a new book and an accompanying op-ed in the New York Times. The op-ed ran on March 31st on the front page of the opinion section under the provocative headline “State-Wrecked: The Corruption of Capitalism in America.” Needless to say, it garnered huge media attention. We encourage you to read it, and we’d like to share our thoughts about it.

We agree with much of what Stockman says about our nation’s checkered fiscal history, the scary trajectory of the deficit and the fact that both political parties are responsible for getting us to where we are today. Many of his economic forecasts are overly gloomy, however, we believe his investment recommendations in particular should be flat-out ignored.

Our biggest beef with Stockman is his recommendation that stock market investors go to “all cash.” This call is based partly on his belief that stock and bond markets around the world have been artificially inflated by central bank largess. We’ll grant him some portion of this argument. By design, the actions of the U.S. Federal Reserve and other central banks around the world have boosted asset prices. Zero Interest Rate Policy (ZIRP) and massive bond purchases have forced even risk-averse investors to scrounge for yield, driving up the prices of risky assets, including stocks.

However, Stockman makes no mention of valuation. The Fed may be endeavoring to inflate stock prices, but in our opinion their efforts have boosted share prices to fair value and no more. Based on our belief that the S&P 500 will report $104 in earnings for 2013, a 15X price/earnings multiple gets us to about 1560 as fair value. The S&P 500 index is currently at 1589, so it’s not overly expensive at current levels. In other words, the Fed may be cranking the printing press, but it has not driven the stock market to crazy valuation levels.

Stockman’s second argument for going to cash stems from his belief that worldwide money printing will lead to hyperinflation and global collapse. We also agree that we are living in a period of unprecedented money creation, as nations attempt to battle deflation by lowering the relative value of their currencies. This tactic, which is being deployed by Japan in a spectacular way, is designed to increase exports, thereby boosting domestic growth. We don’t like this trend, but unlike Stockman we don’t foresee a global market crash as a result.  To understand why we’re skeptical of the money meltdown scenario, we first have to discuss how money is created.

Fiat currency regimes, in which the value of money is driven by the market rather than the stock of some underlying asset (such as gold), allow governments to print money at will. The United States used to be on a gold standard, meaning that every dollar in circulation had some amount of gold behind it.  During the Great Depression the U.S. shifted away from a fixed amount of gold per dollar to a floating rate.  Then in 1971 Richard Nixon formally de-linked the dollar from gold, and the value of our currency was left to the open market.

For much of his article, Stockman rails against both fiat currency and money printing. Modern day money creation doesn’t actually mean cranking the printing press, although it can. To create money, the U.S. Federal Reserve increases the size of its balance sheet by edict alone. It purchases debt from banks and other institutions, including the Federal government, with newly created reserves. The Fed’s balance sheet has increased from $500 billion in 2008 to $3.2 trillion today via these so-called “quantitative easing” programs.

There is one very key difference today, however. In past eras of money creation, banks that sold U.S. Treasury bonds to the Fed immediately lent out the dollars they received. This has not happened this time around. Instead, banks are getting interest from the Fed for parking their money there – very little new lending has been going on. As these vast sums of new money have yet to flow out to the broader economy, we’re not seeing (nor do we expect) rampant inflation. In general, the money the Fed has created since 2008 is still sitting on the Fed’s balance sheet. We keep a sharp eye on the metrics that would signal that inflation in the overall economy is coming, and we haven’t seen it yet. Money velocity continues to fall, and commercial bank loan portfolios in aggregate are smaller than they were 4.5 years ago before the financial crisis.

To sum up, we agree with some of the less hyperbolic parts of Stockman’s argument, but we part ways when it comes to our thinking on stock market valuations and the odds of hyperinflationary collapse. Stocks are fairly valued, and there are few signs of excessive investor optimism. Furthermore, the signs of a hyperinflationary bubble that might lead to collapse are simply not there. From our perspective, the odds of the economy remaining in slow-growth mode are far higher than any hyperinflation scenario we (or any semi-famous former budget director) can dream up.

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