Then the various governments (State and Federal) offered cash gifts to people who would install energy saving "devices" such as solar hot water systems and/or ceiling insulation. Again, the intentions were supposedly honorable. Al Gore and the IPCC had convinced everyone that carbon dioxide was "bad" so they wanted to reduce Australia's dependence on coal fired electricity whilst at the same time stimulating the economy. What was the impact of this?
There were other examples, but you get the picture.
Question: Given the above, will unemployment continue to grow?
Answer: In all likelihood, yes, particularly within the US economy. And, given that the US economy is the largest in the world, this seems likely to cascade into other countries.
Why?
The answer is multi dimensional. In the first instance it has to do with a phenomenon called "monetary inflation". The United States Federal Reserve (an institution whose very existence flies in the face of Article 1, Section 8 of US Constitution) has the ability to create money out of thin air - without any Congressional supervision whatsoever. When you "inflate" the money supply of a nation, you are creating what economists describe as an inflationary environment.
There are three possible outcomes of monetary inflation:
The bottom line is that debt levels always rise following monetary inflation. If it's not government debt levels then it's personal and/or corporate debt levels. Usually it's all three.
The chart below shows "total debt outstanding in the United States, both secured and unsecured, as a percentage of GDP" .Source: www.newamerica.net/publications/policy/overcoming_americas_debt_overhang_case_inflation
The debt levels are a direct consequence of the activities of the US Federal Reserve, which was formed in December 1913, nine months before the outbreak of World War I.
The above begs the following question: When does a country reach the point when its debt levels are too high to be sustained?
The pragmatic answer to that question is: When the level of delinquencies becomes chronic and continues to rise despite economic stimulus.
At the end of the day, rising delinquencies are typically driven by rising unemployment. When you have chronic and rising unemployment, it doesn't matter what the prevailing levels of interest rates may be and it doesn't matter whether or not you "refinance" your debts. If you are unemployed, you will not have sufficient income to make either interest or capital repayments.
Additional to the above, there are a couple of "nuances" (some nuances!):
Is it possible that the US Federal Government's income stream from taxes could rise to cover its expenditures? The answer to this question, once again, boils down to the anticipated level of unemployment.
So let's look at unemployment from a different perspective.
The following is a quote from a recently published article by Frank Shostak. (See: http://mises.org/story/3697)
"A weakening in the growth momentum of lending has taken place despite central banks' massive monetary pumping. Commercial banks in major economies are finding it more attractive to sit on the newly injected money rather than lend it out."
The article is entitled "Does a Liquidity Trap Pose a Threat" and I would strongly recommend that readers take the time to read this article very carefully
What Frank is talking about in this article is the meaning of "real" savings. Here is another quote:
"once the economy falls into a recession on account of a falling pool of real savings, any government or central bank attempts to revive the economy must fail. Not only will these attempts fail to revive the economy, but they will deplete the pool of real savings, thereby prolonging the economic slump."
Let me try to explain this in layman's terms (given that I am a layman as opposed to an economist)
Assume that Joe Sixpack earns $60,000 a year and assume that he is one of the lucky employed in an environment where the government statistics admit to 9.8% unemployment but the real figure is probably higher.
His $60,000 a year is spent on things like mortgage and other debt repayments, clothing, food, schooling for his kids, medical expenses, entertainment.
Now, in an environment where there is a growing delinquency in debt servicing and/or repayments, the US Government tries to stimulate the economy by printing US Dollars. But there are inadequate "real savings" to back these new dollars. As a consequence, the pool of real savings is depleted further and the dollar loses value.
Even if the US Dollar doesn't "appear" to fall in value (in terms of the US$ index), raw materials which are crucial to the maintenance of a buoyant economy start to rise in price in US$ denominated terms. From the US's perspective, the most important of these is oil given that 90% of all transport within the US is powered by oil. Below is a chart of the price of oil (courtesy Decisionpoint.com)
Note how the price of oil started to rise in early 2009 after the US Fed began to man the printing presses like there would be no tomorrow.
Unfortunately, when the oil price rises, this adds to the cost of transport for Joe and it also adds to the cost of other things that Joe buys that also have transport costs as part of their cost structure (like fruit and vegetables and meat).
Eventually, Joe can't come out on his $60,000 a year anymore. But he's in a bind. He can't go to his boss to ask for a raise in salary because his boss is firing people in order to cut wage costs. Maybe Joe will be seen as a trouble maker and he will also be fired.
So Joe does the only thing he can. He cuts back on purchases of non essentials. In turn, this translates, eventually, to a downward pressure on economic activity across the entire country and on GDP.
Lat week the author hereof published an article entitled "A Peter Pan Market" (See: http://www.financialsense.com/fsu/editorials/bloom/2009/0924.html). In that article it was explained what happens to corporate profits when a recession hits. But there was insufficient space to look closely enough at this issue. So, below the reader can find four tables which show more accurately what typically happens in the real world when a recession hits. (The reader is cautioned that these Tables are conceptual)
Table 1: A notional corporation's profit model before the recession hits
Table 2: After the recession hits and assuming no competitor reaction (7.5% fall in revenue arbitrarily assumed. Everything else remains constant)
Table 3: After the recession hits and assuming there is competitor reaction in the form of discounting. (5% discounting wins some sales and only 5% fall in revenue. Everything else remains constant)
Table 4: Optimistic. After the recession hits and assuming competitor reaction in the form of discounting. (5% discounting wins all sales back. No fall in revenue. Everything else remains constant)
The reader's attention is drawn to the line marked "Fixed Costs". They start off at 30% of revenue but they have been kept constant at $300. In reality, employers fight at two levels when a recession hits. At one level they try to protect their sales line by giving discounts. At another level they try to cut their fixed costs by retrenching staff amongst other things.
In the current economic environment, with historically high debt levels (and low real savings) the more the US Federal Government tries to stimulate via a US Fed assisted policy of monetary inflation, the more there will be an upward pressure on prices and the more there will be a downward pressure on revenue and an increasing propensity on the part of employers to retrench. Eventually, some employers will go into insolvency and the unemployment rate will rise further.
This is what Frank was talking about in real world terms when he said that. "Not only will these attempts fail to revive the economy, but they will [further] deplete the pool of real savings, thereby prolonging the economic slump."
Now, in the above context, let's look back into history. The market peaked on October 10th 2007 when the Standard & Poor Industrial Index hit a high of 1565.36.
At that time, as can be subjectively judged from the chart below, the P/E ratio of the $SPX (black line) was around 18X (courtesy DecisionPoint.com)
In rough terms, 1565/18 = EPS of around $87 a share.
But the tables above show that earnings might be expected to fall by between 30% and 66% if the revenue volumes fall by around 7.5% in real terms as a result of the recession. In broad brush terms, it seems likely that earnings are far more likely to be around the $45 - $50 level than the $87 level and, if this happens, Price/Earnings ratios will inevitably fall back to more "normal" levels of 10X - 15X . Oops!
The reader is once again cautioned that the tables above reflect a conceptual argument. The purpose of these tables is to demonstrate a point of principle. Regardless of whether profits fall by 30% or 50% or 66% the question is: "Can corporate profitability be expected to get back to previous peaks in the foreseeable future given that further stimulus by the US Federal Government is likely to give rise to increasing unemployment?
The short answer to that question is: No. Therefore, P/E ratios will very likely contract.
Conclusion
If you are of sound mind, and if you have any empathy with the above, you will probably not want to be invested in anything but "special situations" in the equity markets -- and you will probably want to avoid most debt instruments that are denominated in US Dollars. Additionally, you will probably also want to avoid leaving your hard earned savings in the US banking system that is "insured" by the Federal Deposit Insurance Corporation which, in turn, is funded by dollars printed by the US Federal Reserve.
What do we do about all of this?
On a personal level we should erase the word "want" out of our lexicons and we should focus exclusively on the word "need". Ask yourself: What do I absolutely need in order to survive what is coming down the turnpike?
If possible, you need to be debt free and you need to have an income that exceeds your expenditure.
If this is not possible, then you need to be prepared to dip into capital to augment your income for a few years. If you can't achieve this, then you need to cut back on your lifestyle by moving to a less expensive neighborhood and/or by living more frugally.
On a more macro level, you might want to investigate owning some gold as an insurance policy. Gold tends to hold its value in times of economic crisis.
On an even more macro level, you can buy a copy of my factional novel, entitled Beyond Neanderthal. This book may be a few years ahead of its time but it points a possible way forward. You can purchase a copy via Amazon or via the web link below.
The reader should understand that it is "energy" that drives the world economy and that fossil fuels passed their use-by date in the mid 1970s. In essence, the Fed has been printing money as a response to the fact that wealth creation activities which rely on fossil fuel energy input have become increasingly impotent. As a consequence, debt levels have exploded to unmanageable levels. That, in essence is why the world economy is now teetering. One alternative energy "driver" of the world economy may be nuclear fission. But it may not be. That is why I am now researching a second factional novel which will focus on nuclear fission. In the meantime, perhaps we might find ways of accelerating implementation of the vision articulated in Beyond Neanderthal
Brian Bloom
Author, Beyond Neanderthal
www.beyondneanderthal.com
October 3, 2009