“To Everything There is a Season (turn, turn, turn)”

Published April 2012

As the Birds quoted King Solomon, everything has its cycles.  The whole verse goes:  “To everything there is a season, and a time to every purpose under heaven.”  The chapter goes on to give examples of times and seasons:  “A time to be born, a time to die; a time to plant, and a time to reap; a time to break down and a time to build up….” (Ecc: 3:1)

One of the complaints of current-day market/Fed/economy watchers is:  the Federal Reserve is attempting to either short circuit or extend portions of the natural economic cycle –    beyond the normal   tenure of that cycle.  The natural cycle of our economy looks something like this:

Where the level of real output goes through a series of ups and downs including:

  1. Recovery (growth)
  2. Peak
  3. Recession (slow or negative growth)
  4. Trough (repeat)

And, hopefully, the troughs and the peaks move higher so as to provide a general growth trend as the economy moves forward.

The problem currently is, the Federal Reserve has decided to either shrink or eliminate entirely the Recession and Trough phases of the economic cycle.  So here is what our current alternative looks like:

  • Recovery (weak growth)
  • Fed adds stimulus
  • Recovery (still weak growth)
  • Fed adds more stimulus
  • Recovery (still weak growth)

And so on…

The problem with this approach is, that  when you add stimulus you take resources from the taxpayer or from other endeavors both private and public and throw that money into an area of the economy or service that may not allocate the capital on an efficient basis.  Case in point, the government’s recent investment in Solyndra solar panels exemplifies the improper allocation of taxpayer’s money.  The government loaned Solyndra solar company $500 million in guarantees, instead of allowing the true economic benefit of the business to generate opportunities in the capital markets.  As we all know,  shortly after making these huge governmental loan guarantees, Solyndra went bankrupt.  Their product was not economically viable.  A product also has a cycle which looks something like the following:

It’s a force of nature that as we enter springtime, a time for sowing (either naturally, or by planting a seed), summer (growth), fall (harvest) and voila! We have produce.  When someone decides they like the growth phase of the cycle best and attempts to extend that portion of the cycle – anomalies begin to occur and other phases are altered permanently.

The Fed has decided that the death phase of our economic cycle is not appropriate on their watch.  So instead of accepting death as indeed a necessary part of the cycle, they have put fresh clothes, new capital, and good tax dollars into endeavors that need to completely die – instead of allowing the marketplace to take care of itself.  One of the major problems has been that the government has gotten their fingers into too many pies.  While the FDIC insurance program has been successful, the tear down of the Glass-Stiegel wall between commercial and investment banking has not.  All of a sudden, the taxpayer finds himself backing investment banking risk-taking instead of providing a backup support for a depository insurance plan that guaranteed some basic level of insurance to depositors.  Instead, we provided guarantees of AIG credit default swaps into the coffeurs of Goldman Sachs.  How did we get so far afield?

Japan is the poster child for extending their economic cycle.  When Japan’s real estate bubble burst in the 1990’s, the banking regulators allowed the banks to bury the under-collateralized loans for years.

Subsequently, the death cycle of Japanese real estate is still going on, 20 years later. One of the phenomena of the Japanese real estate bubble is their financial schemes.  Financing of these highly-prized properties extended to, in some cases, 100 years.   So, if you can’t sell the property with 30-year financing, extend the terms of the notes beyond anyone’s natural lifetime: perpetual property (sounds like a mausoleum)

Financing for home buying in the US began with much shorter term notes and gradually moved now to 30 years.   The US is better than most.

At the height of the S&L crisis in the 1980s, regulators decided that these assets were better off in stronger hands, they initiated the Resolution Trust Corporation, which gathered, packaged and sold assets acquired by the FSLIC (S&L government insurance program).  This all happened over a 3-4 year period of time which allowed a successful death phase to clean up the bad projects and under-capitalized developments and allowing the economic cycle to reengage into the next cycle of birth, growth, maturity, and death phases – as it did with the technology era when new companies, technologies, software and hardware took over the business world.

The cost of extending the death cycle for our housing finance industry, the derivative industry, and the banking industry is the misallocation of capital into industries which need to consolidate,  close, or otherwise be re-born. The restriction of capital that need resource allocation for new products, industries, and services will shape our lives for the next 20 years and the accumulation of more than $15 trillion in US government debt (which does not include the guarantees the legislature and administration has slung around on any program that needed a credit hit).

It would be nice to identify the new way of home financing that will replace the current model.  If you are one of the first investors in this new industry, you can get in on the birth phase of a new industry, product or service. The growth phase of these new industries have the greatest opportunity to create wealth before it bubbles and the government sees fit to get involved.

So that brings us to the investment markets.  There are both individual companies and industries in the throws of the growth phase, but many of these companies or industries get re-categorized, lumped in or otherwise ignored when the overall economy or market has a negative tone.

Where do we stand in our understanding of cycles with bonds?   Historically, bonds or fixed income investment rates have been tightly tied to the economic cycle.  As the economy entered a growth phase, there became a competition for capital and increased interest rates.  An owner of bonds would see the price of the instrument fall as interest rates rose.  But, most bond investors were in it for the long haul and received income from the instrument as the incentive to be invested.  The capital appreciation of a bond was only secondary to the actual interest thrown off by the investment.  The US has been involved in a Fed scheme to lower interest rates dramatically so more people would finance homes at these low rates.  But, it also impacts the saver.   So in any average time, interest rates would be described as being terribly low and bonds would not be considered a great investment (at these levels).  Why are investors rushing into bond funds, to the detriment of stocks?

Lack of trust. They don’t trust the Fed or the Administration with all these financial gyrations.  They want to make sure they receive their principal plus a little interest instead of putting their funds into the equity market and watching their account balances dwindle.

Maybe rates will remain low. (The last comment from the Fed is that rates probably won’t change until 2014).  As we don’t seem to be getting any place fast in this economy, investors are willing to risk the substantial downside because they realize much of the growth that is visible has been manufactured by the Fed and other governmental manipulations.

It all works much better when the cycle is allowed to work.  A company like Apple and many tech companies are taking advantage of these cycles – and you can see their success in the stock charts and company valuations. The reluctance of investors and the lack of trust in the government has kept stock from moving upwards too fast.  Our system of finance can be successful if wisdom is applied toward long-term solutions.  Warren Buffett is such a good investor because he can look at an investment and discern the phase of the company, industry, and economy and decide where to best allocate his resources.

So the challenge is:  1) finding a company, industry, sector of the economy which is expanding well enough that if the overall economy isn’t helping it, it’s products and markets still are increasing.  And, 2)  being able to time the ebbs and flows of the overall economy as to move into the market when the tide is low not high.  According to some observers, we bottomed in 2008 and we are in the recovery phase right now.  The real question is, did we allow enough of the death/winter phase to kill off those enterprises which are not viable in order to reallocate capital into new areas which are? (Kind of like getting a hard enough freeze so our bug population is not doubled over a mild winter).  Our biggest concern is that the propping up in various areas of the economy and programs will not be a seedbed for new areas of growth. Still throwing good capital at bad industries and programs looks like a formula for maintaining minimal to no growth for an indefinite period of time.  We can only watch and be ready.  What do we expect to see in the white’s of their eyes?  Hope.

When business begin allocating much of their stored up cash into capital projects. We will know that executives are putting their money where their mouths are.  That’s hope, not some pie-in-the-sky projection.

Certainly, more consistent tax policies and faith in the government’s abilities to take care of its own business would go a long way toward stoking confidence in a current system that seems to be, if not broken, warped.  For right now, equities have been climbing (during the first quarter) that wall of worry.  It has historically been a good year for investments during an election year, but as we have noted above, things aren’t normal.

Watch and be ready for changes in the wind, or, as Billy Preston belted it out, “Will it go round in circles?” Yes, Billy, yes it will.