Currency Crack-Ups And Stein’s Law

Stein’s law states that “If something cannot go on forever, it will stop.” Mother Nature could soon be enforcing Stein’s law in both the equity and currency markets.

“If something cannot go on forever, it will stop.”
- Stein’s Law

This week we’ve been digging into the inflation/deflation question - laying out causes and effects, describing the various forces at work.

One of the things that’s become clear is that there is no simple “pick one” type resolution. The answer to whether we have inflation or deflation is “both.” In the short run, we are seeing inflation on Wall Street even as the real economy (as determined by things like wages, jobs and small business prospects) runs aground.

And in the longer term - i.e. the next few months, quarters and years - we are less likely to see a clear “winner” than to witness an ongoing wrestling match.

In other words, we could see repeated handoffs in terms of inflationary/deflationary sentiment. Inflation could take the lead for a while… then the deflationary mindset could roar back… then inflation could jump up off the mat and dominate once again.

Another way to think of it is like a giant game of pong. (Remember that old Atari video game with the paddles and the round controls?) When inflation progresses to a certain point, it runs into a wall and sentiment reverses. Then deflation takes over, progresses for a while, and the same thing happens. It hits a wall and the ball bounces back the other way.

Flouting Stein’s Law

Wall Street’s fondest desire would be to inflate paper assets to the moon (and perhaps send the dollar to zero in the process). If they could get away with sending the Dow straight to 20,000, I imagine they’d be happy to do it. Paper asset inflation, in practical terms, is an effective means of wealth transfer from the unaware many to the skilled and connected few.

As always, the dangers in this maneuver are being ignored. The games go on for a simple reason, deeply grounded in human nature: incentives trump ideals. The incentive is always more important than the ideal. (People who put ideals first have simply found a way to incentivize themselves with positive emotional feedback, stemming from the support of said ideals as part of an identity and a lifestyle. This is not a pursuit Wall Street types give all that much thought to.)

But regardless of desire on the part of the players, the bid ‘em up game has limits. You can only push things so far before the absurdity levels get too high to sustain. And the game gets harder as valuations become ever harder to justify.

Take a wonderful company like Apple (AAPL), for example. As of this writing, Apple’s stock is trading above $200 per share, representing a market cap of $184 billion.

Apple, basically a high-end consumer products company, is now worth $20 billion more than General Electric (GE) at current levels. Just think about that for a minute. Or if you really want to bend your brain, think of it like this: Apple is now worth more than 50% of Exxon Mobil (XOM).

It must be said, your humble editor loves his iPhone. And Apple’s sales numbers have been excellent. But how much sense does it make to put a whopping 32x earnings multiple on a company already deemed half the size of Exxon? Elephants do not sprint like gazelles. That is why, in more rational markets, 30-plus multiples are assigned to small companies with a real shot at exponential growth - not erstwhile giants.

And as Stein’s law points out, that which cannot go on forever must stop. The market can detach from reality for extended periods of time, but reality always comes barging back in to crash the party again.

That’s why secular bear markets create charts like the one below. Even if you’ve seen it before, it’s worth pondering once again:

View Larger Image

As the subhead points out, “the swings are much more dramatic than most investors realize.” Why does this happen? The basic chain of logic runs something like this:

• A speculative bubble collapses, leaving mountains of debt in the aftermath of a credit boom.
• Wall Street cheers as Washington pulls out the stops on all kinds of stimulative measures.
• Euphoric feeling feeds on itself as investors convince themselves the worst is over.
• As the reality of a long, hard slog emerges, it becomes obvious the market is overvalued.
• Pessimism retakes the lead. Stocks head into sharp decline, possibly testing old lows.
• Washington redoubles its efforts. Investors cheer again, anticipating a new bull market…

Currency Counter Measures

Another major driver for this rally has been aggressive selling of the U.S. dollar. Seemingly half the planet has gotten in on the play. Upward movements in both equities and the oil price have become dramatically correlated to downward movements in the buck.

Not only has the USD become the new “carry trade” vehicle (in which dollars are sold to fund speculative purchases elsewhere), sovereign governments on multiple continents are now issuing large quantities of U.S. dollar-denominated debt. This is the same maneuver that led to the Asian currency meltdown 12 years back. It is also a gorgeous setup for a massive, massive short squeeze.

The assumption here is that the dollar can decline without limit, forever and ever amen. But the traders and speculators aggressively pressing the dollar carry trade at this late date have forgotten about outer limits and Stein’s law.

The trouble with a perpetually free-falling dollar is two-fold. If you are the United States, the relentless rise in energy, food and raw materials prices slowly strangles your already weakened economy. If you are one of any number of other exporting countries, the sharp rise in your own currency (vis-à-vis the falling greenback) threatens to smother your export industry and stunt your growth outlook.

That is why Canada, America’s neighbor to the north, warned this week that the Loonie (aka Canadian dollar) is getting too strong for the Canadian economy to handle. The Canuck Buck at 97 U.S. cents is a tonic for some Canadian businesses, but a poison for many others.

Meanwhile authorities in Europe, where “zombie” banks are as big a problem as the United States, have expressed similar grave concerns over export sectors in peril. And Brazil took punitive taxation measures this week to put a lid on speculative “hot money” flows that threatened to overheat the economy and drive the real (Brazil’s local currency) too high.

On Again, Off Again

For the Western world, the mountain of debt is always there, looming down on us. After a quarter-century of leveraging up, the overwhelming pressure to deleverage will be persistent and last for years. We can see this pressure in ongoing real economy trends. As some have noted, for instance, this “jobless” recovery is on its way to becoming a “job-loss” recovery. (The Atlanta Fed recently reported that levels of permanent job loss - as opposed to temporary cuts with an expectation to rehire - have reached a new record high and continue to climb.)

And as we have already seen, Washington and Wall Street will do outrageous things to counter these persistent deflationary pressures. Most of the measures taken will not work. Or, worse yet, they will appear to work in the short run, but in reality simply cause greater problems in the long run.

This is where the back-and-forth play between inflationary and deflationary sentiment comes from. Waves of stimulus come into the market, propping things up and creating illusory signs of recovery. Investors grow optimistic and bid up assets, stoking general perceptions of inflation. Then the wave of stimulus recedes by necessity as asset valuations go too far and the system threatens to shake itself apart… and without its stimulus prop, the market succumbs to deflationary reality again.

Hair of the Dog

The 2009 build-up of stimulative excess is exceptionally alarming given what is likely to happen next.

If one understands the natural pattern of secular bear markets, one can see how the process is a sort of necessary cleansing… a gradual moving toward the point where enough of the debt has been worked off, enough of the excesses liquidated and new productive wealth generated, to get things moving again.

So far, the efforts taken by Western governments (and China too, to the degree Beijing has copied Washington) have only delayed the cleansing process, encouraging a greater build-up of speculation and debt in the very manner that got us in trouble in the first place.

Instead of addressing reality, we have taken the “hair of the dog” approach - greatly increasing the risk that the dog will bite us again. The dollar carry trade situation is especially explosive because of the dollar’s link to equities, the unsustainably high valuations of export currencies among various U.S trading partners, and the aggressive manner in which everyone has piled into the dollar carry trade.

In sum, be prepared for some potentially wild swings - and be careful out there.

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