Fear Of Borrowing Or Fear Of Lending…or Both?

One of the reason that I continue to be cautious on the market is the huge potential that exists for a prolonged period of deflation.

With low interest rates and a massive buildup in liquidity the question I am asking is why has the economy not responded more positively?

One reason could be that banks are not lending because they are concerned about the current quality of risk they have on the books. Liquidity losses its intended effect when banks are reluctant to lend.

On the other hand we also have reluctance on the part of corporations to increase their debt burden. Those that do so are attempting to tie up longer term arrangements at higher rates of interest. Certainly this is a clear sign of corporate uncertainty.

General Electric is without doubt a proxy for the U.S. economy by virtue of its broad diversification. They have just converted a massive amount of commercial paper debt to more stable long term bank borrowings, at higher rates of interest. I think this foretells a coming crisis in the commercial paper market that could have banks fearful of major defaults. Who do you think is holding all that commercial paper, and who has guaranteed it?

The consumer and the real estate markets have been the pillars of strength in the economy and their staying power is now very questionable. The consumer savings rate is near 0% yet he supports both markets.

Once there is increasing competition for shrinking markets coinciding with a reluctance to lend and a reluctance to borrow the forces of deflation begin to take their toll. Mountains of borrowed funds have to be paid back and without a bit of inflation to mask inefficiency, the task becomes increasingly difficult.

I mentioned that I did not think the Fed would be raising interest rates any time soon and it appears that Mr. Greenspan has confirmed that view. The Fed Chairman seems to be talking up the real estate market making it is clear that he fears the consequences of that bubble bursting while he is still in office. So consumers, carrying the biggest burden of debt ever, are being encouraged to keep spending and borrowing in the interest of maintaining and supporting productivity gains. Those gains created the perception that there would never be a slowdown in consumption. The result is an overcapacity in just about every area of manufacturing, including those areas where China is the lowest cost producer.

Creative Accounting

The other sign that deflation is a bigger risk to the economy than inflation is the fact that the last few years of disinflation have exposed a growing number of companies who have been using creative accounting methods to keep up appearances.

Another is the sudden righteousness of CNBC. At this late stage they insist that analysts state whether or not they own the stocks they promote. It actually makes no difference, but it is a sign for the times.

Another is the questioning of the integrity of everyone on Wall Street. The tide is receding so fast that its exposing many in the water without suits on. These things do not happen when the market is in an impulsive state of growth. That growth was gone before Henry Blodgett became uncomfortable, and before 'pro forma' earnings reports became an abuse.

While the short term direction of the stock market seems uncertain to me, the big picture much clearer. The primary trend continues to be negative. Excessive borrowing, spending and consumption will have to be corrected in a major way before the next great advance takes place.

Conservative Optimism

In the mean time it is possible to make money in the stock market as long as expectations are realistic and strict money management rules are followed. It is not surprising to me that the growing trend is towards the more conservative hedge fund type of trading activity. That in fact is what we have been doing for a long time.

More and more our trading on the long side of the market focuses on those companies that pay good dividends. In fact our biggest exposure and our biggest dollar loss is in a long position in Cable & Wireless. The average cost is just under $12 and the current price is $8.94 The dividend yield based on its current price is in excess of 13%. This makes it a bit more palatable. In addition the balance sheet is very healthy.

Colin completed his first real estate development at age twenty-eight, another five by age 34. His first won the Govenor General's Award of Merit for Architecture. As a Manufacturer he formulated, the popular O'Rileys Rum Cream.
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