Business & Economics 101

[SharperDingaan]

 

Apply the well known economic demand function of D = C + I + G + (X-M) to today’s economic environment & most would argue that the majority of incremental demand (D) can only come from new Investment (I). Hence the repeated calls for business to step up to the plate.

 

As a business you can buy someone else & layoff/consolidate to reduce unit cost, replace/build new plant to reduce unit cost & sell additional widgets, or buy back shares to increase your EPS for a given level of business. Net of inflation, most folks expect the level of business to essentially stay flat over the foreseeable future. Buying someone else to increase market share & reduce cost is good for the ego - but a risky proposition. Buying back your shares is low risk - & makes you look like a hero.

 

Most believe that many businesses (outside of banking) are sitting on excess liquidity – relative to the debt/equity levels of yesteryear. The fact that yesteryears debt/equity levels were probably inflated is a convenient oversight.

 

Assume a business had 100M of debt capacity available, & used it to buy back its outstanding securities. They would want to buy at the lowest cost possible, & whatever common they bought would reduce their debt capacity - as it would reduce their equity base. They would want to buy after a market crash, offer a modest premium, & they would want to buy back their debt & prefs for less than what they issued them at. The business would demonstrate confidence in its long term outlook, recognize gains on the securities retirement, & bonuses would be forthcoming.  ....... But nothing would happen until after we have a crash, & the possibility of a crash has been removed.

 

If I’m the investor holding those shares; I’ll simply use the cash to either buy another investment in the secondary market, or retire debt. Both the business & I gain, but in either case the $ don’t go back into the economy. I didn’t invest in a new offering, & companies are repaying debt – not borrowing anew. The unemployed stay unemployed.

 

If you take this view - a crash is largely a given, & there is a preference for sooner versus later. Bonuses pay out at year end, & year-end write-offs are OK if you can show you’ve bought back securities at a premium, & at a gain. 

 

The fed has been repeatedly stating in more aggressive tones that they’ll do whatever it takes. The BOC has been repeatedly stating that they have concerns with the near-term prospective outcomes for the US economy.  Powerful people expecting difficulties, & incentives to fulfill the prophecy – cannot be a good thing.

 

What are we missing here ?

 

SD   

 

[txlaw]

Sharper, are you saying that you think there will be a crash because the Fed, the federal government, and other governments will wait until a crash happens before there is another round of QE and fiscal stimulus?

 

I hope that is not the case.

[SharperDingaan]

 

If we want the 'I' spend, we need either a crash or a 'managed descent' - & its highly likely that the cummulative 'I' spend would be much larger than any QE2 could be.

 

If the QE2 eased the damage in starting the 'I' spend, no one could argue that it was not a legitimate and effective use of policy. If the 'I' spend also produced employment (new plant) & either increased consumer spending, or reduced bank loans (investors using their sale proceeds), most would suggest that it was also very smart policy. 

 

We allready have the 100% writeoff (US) on new plant investment, & the 2 biggest US proprietory traders volunteerly closing their trading desks. How long can it really be untill we start to see QE2 ?

 

SD

[Uccmal]

SD, I am not sure I have got the gist of your thinking but there are some key elements missing:

1) Money is cheap on a long term basis.  Companies who are able, are not paying down debt but are borrowing at very cheap rates.    JNJ was one recently, IBM I think, FFH.  Consumers can get a five year mortgage for less than 4%.  Not since the 1950s, at least, has debt been this cheap.

2) Due to cheap debt provided by those who paying it off M&A is picking up.  This puts alot of fringe economy to work - I-bankers etc.  How much has BHP paid to cobble together a bid for Potash - 10-20 m - i'd wager.

3) Consumers have reduced their balance sheet debt.  Even a spark of a reasonable recovery and increased hiring should fuel some spending.  You were in Canada during the jobless recovery in the 1990s (I know I was - that is what fueled my obsesssion with investing - being off and on out of work for 7 years).  Look where Canada sits now.  

4) Econ101:  Bonds have rallied - in fact bonds have undergone the biggest rally of all time.  This leads me to believe we may head into the biggest stock rally in years.  Would I bet on that - I am fully invested but it is mostly in what I would classify as Blue Chips that should now be more resistant to a crash than ever.  They will be the first out of the gate on the way up.  That is already starting to show up with KO, KFT, HD, IBM, etc.

 

 

Some thoughts.

[Guest broxburnboy]

I'm inclined to take the view that a near term crash in the stock market is being talked up as part of the Fed/government's manufacture of consent to resume quantitive easing. The fear of depression/recession must be revived to overcome the opposition to a new round of bubble blowing in the bond market.

Consequently I envision a sharp near term drop in the stock markets and subsequent "flight to safety" to newly issued government debt. The desired end result is to generate another "recovery" from the fresh lows and the illusion of "happy times are here again".

I know this may sound like paranoid ramblings, but I have put my money where my mouth is.

[SharperDingaan]

 

Agreed long-term money is cheap but for most firms in the current climate (near-term) you extend term, increase the term/revolver debt ratio, & reduce carry cost - you dont borrow more. You're rewarded for improving the D/E ratio & using the carry saving to reduce debt. If you increase debt, you do it to buy back equity & increase EPS.

 

Agreed there is growing bias towards acquisition, however its only those with allready reduced D/E ratios & longer-term outlooks (exclude market makers). If you intend to hold the target for the long-term, the bigger risk is in not getting the prize versus what you paid for it. View todays P/E paid - as P/E(1+g)^n, & its not hard to see why the major names are in the market.

 

But notice that in both cases it would work a lot better, & more reliably pull in the 'I' spend, after a 'descent'. Assume a bumpy drop, & deliberate 'walkaways' to restablish the penalties for moral hazard, & the incremental cost of QE2 would also fall dramatically. Some of the existing commitments would simply recycle, & the last 18 months of treasury enhanced earned lending spreads in the banking sector would get used.

 

Why would you NOT do this ?

 

SD