Big Picture Overview

Unfortunately I can't add an attachment but I recently received a quarterly review from Hoisington Management (Thanks Nathan). I am not an economist and it focuses a little more on economics than I typically do but it touches on some big themes that I thought made it very interesting. If someone wants it, feel free to email me. Here are some highlights.

The beginning of what will surely be considered the greatest credit event since the 1930s emerged in 2007 with the discovery that derivatives multiply bad credit. The "seizing up" of credit markets resulted in a worldwide reduction of credit issuance from $2.5 trillion in the 2nd quarter to $1.3 trillion in the 4th quarter...... A supply shrinkage of over $1trillion is enough to shift the supply curve to the left, resulting in a bond price increase and lower yields in high quality fixed income securities. This more than offset an increase in inflationary expectations, and was most likely the proximate cause of the sharp reduction in Treasury interest rates in the latter half of 2007.

I have mentioned a couple of times that I am starting to think that because of the credit crises that the bond market is not telling the whole story. The story it is telling is tainted because of capital preservation concerns. The paragraph above said the same thing in an economist language, "a supply curve shift." They think this will continue, not because inflation concerns will go away or even slow but because their will be a decreasing supply of high quality options as demand increases.

In this environment, short-term interest rates will continue to move downward, reinforced by several reductions in the administered Federal funds rate. The long end of the Treasury market will benefit from two factors. First, investor desire for risk-free assets will increase at a time when default rates will be soaring on other fixed income securities. Second, the overall reduction in credit market instruments will mean fewer alternatives for those desiring a fixed rate of return. By the end of 2008 we would expect new record low yields in Treasuries for this cycle.

One very interesting point from this newsletter I have only partly thought of is the falling money velocity. The thing I found really interesting is that compared to historical standards, according to Hoisington, is it has much further to fall.

Under the right conditions, private sector activities can mitigate, and possibly overwhelm, actions taken by the Federal Reserve. Historically, swings in velocity have neutralized changes in the money stock many times, and currently appear to be having a profound affect on nominal GDP. During the past six quarters velocity has declined from 1.930 to an estimated 1.902 in the final quarter of 2007. At the same time, the annualized six quarter growth rate of M2 has accelerated to 5.9% from 4.3%. The interaction of these two forces has slowed the nominal growth rate to 4.9%, or 1.7% lower than the six quarter annualized growth rate prior to the peak in velocity a year and a half ago.

Velocity is functionally related to the rate of increase in financial innovation, rising when innovations are occurring rapidly. Due to innovations in mortgage finance that made mortgages available to households previously deemed not credit worthy, as well as the spread of collateralized debt obligations (CDOs) and structured investment vehicles (SIVs), velocity increased from 1.82 in 2003 to its peak of 1.92 in mid 2006. With these innovations dramatically reversed, velocity is likely to continue to fall significantly.

Over the very long run, the level of velocity tends to revert to its average. In spite of the recent modest declines in velocity, the latest level is far above the post 1959 average of 1.80. Even with further declines at a conceivable 2% annual rate, velocity would not return to its post 1959 average until the first quarter of 2010, providing a meaningful offset to money growth. Indeed, at a 4 ½% growth rate in M2, a rise of 2 ½% in nominal GDP could be expected—a pace that would not cover inflation. Real GDP would turn negative and cement recessionary conditions. The downturn in velocity and the persistent inverted yield curve suggest that the Fed remains behind the cumulating economic weakness.

I don't care what the numbers are or care whether something comes in at 4.2% or 4.5%. What you have above is a bunch of details or economic issues that alone are really not worth that much but the big picture it can give as you go look for individual ideas is huge. Focus on the themes. Value guys do not do this near enough in my opinion. I think the mispricing of bonds compared to equities will last alot longer than most people think because of what was touched on above. This also greatly bolsters my theory that there is really nothing different from the Tech Bubble in 2000 and the Financing Bubble in 2007. Both saw the initial cracking in the Feb March time frame (coincidence), 9 to 18 months after the initial cracking is when the biggest depreciation will occur in prices (we are currently in that period), both will take 3 years or so to work out with 18 months to 36 months entering into a buying opportunity of a lifetime. It will be different of course but it seems to be rhyming nicely. This bubble is scarier with fewer prices to hide though because of how it affects everything else. The tech bubble didn't really touch something like trash collection or toothpaste. The current unwinding bubble does because it makes capital more expensive for fringe borrowers (a trash company needing another trash processing facility) and because of the dramatic decrease in available credit and overall economic spending power by consumers and businesses alike.