The Federal Reserve flow of funds accounts for US Households (Table F.100) clearly reveal the forces that drove the recovery in equity prices in the first half of 2009.

By comparing the flow of funds in the year 2007 (at the top of the bubble), with the flows in Q2 2009, a dramatic shift in investor behavior is evident.

Briefly, continued high levels of personal income, combined with lower taxes and historically low interest rates caused by Fed policies, along with fear of hard times to come and the need to save, resulted in a massive shift of funds out of fixed income investments into equities.

These statistics seem to contradict the dismal picture painted in the mass media.

However, by using commonsense and the Fed flow of funds statistics, the forces that influenced equity prices in the first half of 2009 are revealed.

Populist stimulus measures encouraged savings rather than spending

Both the Bush and Obama administrations pushed small amounts of money directly into the hands of consumers in an attempt to revive the economy in 2008 and 2009.

The theory, apparently, was that the public would spend these tiny payments, which in turn would cause businesses to produce more to meet demand, leading to rehiring and increased employment.

However, the public, frightened by rapid collapse of securities and real estate markets in 2008, and by dire warnings from the White House of a coming Great Depression — the haranguing of political operators not constrained by any need for historical accuracy — logically concluded that the prudent course would be to not spend money, but to save it for worse days to come.

The Federal Reserve, for its part, decided that lowering interest rates to almost zero would somehow encourage businesses to invest and create new jobs — presumably ignoring the terrifying behavior of a Congress that approved trillion dollar spending bills, without reading them, while favoring programs that would impose higher taxes on small businesses — the principal creators of jobs in the United States.

Rather than create new jobs, businesses became more productive, getting rid of marginal workers and holding on to the best.

Despite the success of the economic fear-mongers in getting the Democrat Party into the White House — the first president without any palpable executive experience — an over-whelming majority of Americans still had jobs and were willing to work harder to keep them.

Increasing the minimum wage resulted in sky-rocketing unemployment for young people — in the case of young black males reaching 50%!

The collapse of credit markets in the last semester of 2008 and the need for banks and other financial intermediaries to de-leverage as quickly as possible, restricted the flow of capital to business — despite the low interest rates.

Here are the figures that show household income, taxes, and savings in 2007 and Q2 2009:

Federal Reserve Release Z.1 F.100 Households and Non-Profits

US$ billions (Annual rates)	2007	Q2 2009
Household income	11,894.1	11,986.8
Personal tax	1,490.9	1,083.9
Effective tax rate	12.53%	9.04%
Personal savings	178.9	545.5
Savings rate	1.50%	4.55%

Here we can see that the tax savings doled out in the various stimulus packages did not result in greater spending, but in greater savings.

Only about 10% of the tax stimulus went into consumption — the rest was saved.

Furthermore, despite rising unemployment, household income did not shrink compared to 2007.

Switching from fixed income investments to equities

Not only did individuals save more in Q2 2009, but they shifted funds away from fixed income assets into corporate stocks.

Federal Reserve Release Z.1 F.100 Households and Non-Profits

US$ billions (Annual rates)	2007	Q2 2009
Net flows (annual basis)
Checkable deposits and currency	-68.5	217.3
Time and savings deposits	422.7	-183.2
Money market fund shares	232.3	-147.8
Credit market instruments	468.3	-647.6
Sub-total (Fixed income and cash)	1054.8	-761.3
Corporate equities	-794.2	288.1
Mutual fund shares	244.4	683.0
Sub-total (Equities and Mutual funds)	-549.8	971.1

This table shows a remarkable change in the behavior of ordinary American investors between 2007 (before the Crash of 2008) and in Q2 2009 (after the Crash of 2008 and the introduction of Obamanomics).

The investment behavior in 2007 is easily explained, since it fits a pattern observed since 1982:

1. In 2007, corporate executives were selling huge amounts of stocks (over $ 794.2 billion, annual rate) in order to take profits on their stock options. The main buyers were corporations with buyback programs approved by the executives themselves. See: The Great Misleading, a critical essay on the stock buyback movement.
2. After the Crash of 2008, stock buybacks dried up due to lack of corporate funds. Stock prices fell to the point that most executive stock options were “under water”. Consequently, equity sales related to the exercise of options virtually ceased. There always were individual purchasers of equities, even in the buyback era, but the amount of such purchases was hidden by massive sales due to executive options. By Q2 2009, without executive options, 288.1 billion in net equity purchases became visible. The flow of funds accounts don’t indicate whether this amount was greater or less than underlying equity purchases in 2007.

	Bad credit and inflation threaten securities markets

3. In 2007, individual investors still trusted Standard & Poor’s and believed that money market funds were safe. The table shows that in 2007, investors were taking money out of demand deposits and cash to buy longer term credit instruments.
4. In Q2 2009, investors no longer trusted the credit standing of longer term issuers, moving money out of agencies, municipals, corporate bonds, and money market funds, into government guaranteed bank deposits and cash. Extremely low short-term interest rates encouraged this transfer.
5. Massive, undisciplined spending authorized by the Obama administration in January 2009 cast serious doubts on the future of the US dollar, with a high probability of inflation. Individual investors acted rationally by moving away from medium and long term debt, in anticipation of the coming inflation.
6. Individual investors, having suffered massive paper losses in equities in the Crash of 2008, held on to their long-term mutual funds, moving additional funds from fixed income into equities in the expectation of a market recovery. In part, this reflected continued belief in the Common Stock Legend, and in part a speculative reaction to the extreme lows of the Crash of 2008.

Increased savings, plus the above factors, go a long ways towards explaining the stock market bounce in the first half of 2009.

Is the 2009 bounce sustainable?

The flow of funds accounts for Q2 2009, extracted above, also suggest the reasons that the early 2009 bounce is not sustainable.

1. The Obama health and cap-and-trade programs contain elements that will result in substantially higher taxes, direct and indirect on the American people. This will lead lead to higher unemployment and perhaps greater incentives to save for coming worse times.
2. Sooner or later, the “spending is stimulus” programs of the Obama administration will result in higher inflation, raising interest rates on short-term money market funds and crashing medium and long-term bond markets. Inflation also tends to favor lower price-earnings ratios in equity markets, resulting in falling stock prices, at first.
3. Corporate executives are still sitting on huge quantities of stock options that will become valuable if stock prices rise. If stock prices continue to rise to pre-Crash levels, executives will start selling stocks into the market. If credit continues tight, corporations won’t have the cash to support executive options with stock buybacks. This places a ceiling on continued equity price recovery.
4. Baby boomers, with equity portfolios already severely damaged by the Crash of 2008, will be anxious to sell stocks as soon as prices begin to reach pre-Crash levels.
5. The anti-capitalist slant of the Obama administration and the Democrat-controlled Congress, in the final analysis, is not conducive to a long-term rise in stock prices. Obama shows no indication, so far, of “moving to the center”. Although the President’s popularity is falling rapidly, the earliest date at which the current administration can be out of office is 2012.

If the Obama administration insists on continuing current policies, portending high inflation and increased unemployment, the United States may indeed be in for a Great Depression.

However, fortunately, unlike in the 1930s, a US President is now subject to term limits and the majority of voters are not union members.

We’ll see …

On August 12, 2009, the US Federal Reserve indicated that it intended to stay the course, postponing effective action that might ward off high inflation once the Obama “spending is stimulus” money hits the fan.

Non-independent Fed Chairman Ben Bernanke, running for reappointment, is not anxious to adopt strong, anti-inflationary measures that might be unpopular. The Obama administration desperately needs rising employment statistics to boost the President’s sagging popularity, while postponing the advent of inflation until after the 2010 elections.

Former Chairman Paul Volcker, renowned for his tough taming of inflation during the Reagan administration, has been neutered to a powerless position on Obama’s economic advisory board, giving the President political cover of the Volcker reputation, without substance.

Both Larry Summers and Tim Gaithner have gone on national TV to announce that Obama’s “spending is stimulus” actions would result in higher taxes. What this means is that Americans can expect to see both high levels of inflation with depressed employment (the result of higher taxes).

So, what this seems to indicate is that sometime in the future the US economy will hit a transition point when inflation will begin to kick in with a vengeance. Interest rates will soar. The value of long-term bonds will plunge. Equities will be squeezed by stagnant sales due to the continued recession and high borrowing rates.

Navigating the transition to an inflationary economy

The Federal Reserve’s record of timely action to prevent inflation is not encouraging, and barring something really dramatic (like Paul Volcker resigning from the President’s panel in protest), it seems that a transition to stagflation is in the cards.

The spread between short-term and long-term interest rates is now high and increasing. As the tipping point into inflation gets closer and closer, this differential should increase even more. In the process, holders of medium and long-term bonds will experience a loss of wealth.

At some point, long-term debt is likely to sharply fall in value. When inflation kicks in, the price of long-term bonds will stay down for a long time. Leveraged holders of medium and long-term debt will suffer severe losses.

Those who managed to take out long term mortgages on their homes at today’s bargain rates will suddenly appear to be financial wizards.

Companies that wait too long to ameliorate their over-extended positions will finding bond financing far to expensive and will have to consider raising cash by selling equity (forcing down stock prices) or by rolling-over short-term debt (forcing up short-term interest rates).

This means that rates on money market funds and short-term CD should rise as inflation hits, while prices of medium and long-term debt fall.

See: Money market funds will tell us when inflation is here.

A possible strategy for survival

If this scenario plays out in real life, the survival strategy today (August 2009) would be to get out of long-term securities (stocks and bonds) and hold quality money market funds. This means losing current income from current rates on longer term bonds and potential profits from a possible continuation of the rally in stocks.

However, history offers many examples of sudden changes in market perceptions. The question is whether the transition to inflation will be gradual, say over two or three years, or sudden — in two or three months.

For well over a year, there were many warnings of a potential crash in equity prices, but the actual event happened suddenly in September-October 2008, leaving investors with little time to exit.

See: Buyback Bubble Pops! The Long Ways Down …

Now, it may seem counterintuitive to go into cash in the expectation of inflation, since everyone knows that holding cash offers no protection against inflation. However, the logic here is somewhat different.

1. When inflation hits, it may be sudden, not affording investors a chance to get out of bonds and equities.
2. The interest rates on money market funds can be expected to rise quickly when inflation hits, perhaps exceeding the rate of inflation.
3. Once money market fund rates confirm that inflation is indeed here with a vengeance, the investor can then reassess the situation, going back into bonds or equities as may seem advisable.

If an investor holds $10,000 in a bond yielding 10% today, and the interest rate suddenly jumps to, say, 18% when inflation hits, he or she will continue to earn income of $1,000 on that bond. However, by selling the bond today and going into cash, and then reinvesting after inflation hits at 18% in the same bond, the investor’s income would now be $1,800 — 80% more than simply holding the same bond.

There are reasons to suspect that the current rally in equities may not be sustained.

See: Formidable barriers to a bear market recovery

The storm flags are flying — warning of inflation. No one knows what will happen, however since the Crash of 2008 was a precipitous event, as was the enactment of the trillion dollar stimulus packages, it seems at least reasonable that the coming of inflation will also be quick and sudden.

So the question is, if you knew that inflation was suddenly to jump to 8% next month, how would you be best invested?

In August 1952, the famous Benjamin Graham published an article in “The Analysts Journal” entitled, “Toward a Science of Security Analysis”. The article was sufficiently important to be republished in “The Financial Analysts Journal” in January 1995.

Ben Graham definitely did not say the security analysis was a “science”, but his comments implied that he would like to have the discipline move in that direction. He specifically made comparisons to the use of mathematical techniques in “actuarial science” and suggested that the practice of bond ratings was somehow scientific in nature.

By the time of the Crash of 2008, the emanations of “science” had cast a cloak of statistical pretense over the profession of securities analysis, as this abstract of the article, “The Statistics of Sharpe Ratios” (Andrew W. Lo, Financial Analysts Journal, July 2002), indicates:

The building blocks of the Sharpe ratio—expected returns and volatilities—are unknown quantities that must be estimated statistically and are, therefore, subject to estimation error. This raises the natural question: How accurately are Sharpe ratios measured? To address this question, I derive explicit expressions for the statistical distribution of the Sharpe ratio using standard asymptotic theory under several sets of assumptions for the return-generating process—independently and identically distributed returns, stationary returns, and with time aggregation. I show that monthly Sharpe ratios cannot be annualized by multiplying by √12 except under very special circumstances, and I derive the correct method of conversion in the general case of stationary returns. In an illustrative empirical example of mutual funds and hedge funds, I find that the annual Sharpe ratio for a hedge fund can be overstated by as much as 65 percent because of the presence of serial correlation in monthly returns, and once this serial correlation is properly taken into account, the rankings of hedge funds based on Sharpe ratios can change dramatically.

Now this sounds very “scientific”, especially if one has no knowledge of the scientific method and tends to believe in astrology. However, on examining the underlying assumptions of Modern Portfolio Theory (see: Fallacies of the Nobel Gods), under the harsh prism of the scientific method, problems with this approach become evident.

The above abstract seems to criticize the use of the Sharpe ratio, as a serious subject, but would a real scientific journal waste time evaluating the tenants of Medieval Astrology?

Many non-scientific practices are useful

We take our automobiles to the repair shop when they break down and are thankful for the skill and knowledge of an honest, professional mechanic who can get the machine running again. However, few would consider the auto mechanic to be a scientist.

Actuaries calculate the life expectancy of classes of individuals, based on mortality tables, but would not attempt to predict how long a specific individual will live (unless the subject is already falling from an airplane).

Much of security analysis has the purpose of determining whether the value of a security in the future will be higher or lower than the current value. A honest, competent security analysts will make such estimates based on careful and laborious study of relevant facts, and present conclusions properly hedged as to the general impossibility of predicting the future (in a non-scientific field of endeavor).

This is a valuable and useful service in itself and does not need to be dressed up in the pretense of science to become more useful.

In fact, scientific pretense can actually mislead investors (and analysts themselves).

Where pseudo-science harms investors

Leading up to the Great Crash of 2008, millions of hours of analyst time were wasted on drawing up tables with betas, Sharpe ratios, and other mathematical gimmicks that did not actually contribute to the understanding of an issue, but instead gave investors (and analysts) a false sense of security.

I would argue that this time (and many more hours) could have been better served digging up the facts about specific issues and examining operational and legal details under the cold light of common sense.

For example, would billions have been lost on auction rate securities if analysts had spent more time carefully researching the details of these issues and asked hard “what if” questions about the actual functioning of the Dutch Auctions on which their liquidity was based?

The principal problem with the pseudo-scientific approach to security analysis is that the methods often give analysts an excuse to avoid the much harder research work of going back to original sources of information and digging and digging for more facts until all relevant issues have been examined.

See: A security analysts greatest challenge: Laziness

Illustrations: Wiki Commons: The first illustration is from the Aurora consurgens, an illuminated manuscript of the 15th century in the Zurich Zentralbibliothek (MS. Rhenoviensis 172) — a medieval alchemical treatise that contains thirty-eight miniatures in watercolor.