tetsuoblog

Venti Earl Grey with 1 bag & reading over Rosie’s comments for the morning (if you don’t follow Gluskin-Sheff’s chief investment strategist, you must), and noticed something I not only disagreed with, but that just so happens to be logically incorrect.  This is a rarity.

The quote:

The real question is the veracity of any labour market upturn and whether it manages to take the unemployment rate down to levels more consistent with a normally functioning economy. The total unemployment and underemployment rate stands close to 17% and a record 40% of the unemployed have been without work for over six months, so they will need to be retrained and retooled.It is hardly a bold call to say that the employment conditions in the U.S. are stabilizing.

The bottom line is that the U.S. economy is currently about 12 million jobs shy of being at full employment and as such it will likely take anywhere from 5 to 10 years to get back to the prior pre-recession peak in the employment-to-population ratio. This is a signal to us that deflation will be the primary theme for some time to come. Safety and income at a reasonable price (SIRP) will be one way to play this theme.

Now, let me preface all of this with the following: this post is ultimately about posturing – we want to be prepared for rare events that carry extreme impacts.  These are the ones that matter, that determine whether we will be bankrupt or billionaires, whether we thrive or perish.  This is the true nature of risk management – don’t be a turkey, but don’t prevent yourself from getting lucky, either.   Swing for the fences, but beware the possibility something too high and tight (wear a helmet).  Enjoy the sun, but be prepared for the chance of zombies.  You get the point…

With that in mind, the standard rule is to not say things to the effect of “all swans are not black” when history has already shown us a black swan.  In this case, it is simply a fact that Weimar Germany simultaneously experienced both high rates of unemployment and hyper-inflation.  So there’s your black swan.  Beware…

I think this point is well-worth digging into a little further (but not too much).  Post-War Germany, by all rights, should have experienced massive decreases in asset price values.  Value is a simple thing to estimate in a vacuum – present value formulas and all the rest.  And any reasonable application of such formulas to any number of German assets should have kicked out valuation figures after the First War that were far below those prior the War.  Germany had been defeated, thrown into internal disarray, and saddled with massive debts.  Free cash generation should have been at levels not seen for generations.  So asset prices should have fallen.  Why, then, did Weimar Germany experience hyper-inflation of Zimbabwe-like proportions?

The answer is simple: inflation (and by extension, deflation) is a monetary phenomenon that can occur with complete independence from most of the fundamentals we use to measure cash generation – which in turn help us determine asset values, and, in a sense, prices.  How much value a currency can acquire is completely dependent upon the perception of that currency’s value (I know, I know – duh).  The key here is that this really has very little to do with the ultimate VALUE or utility of the thing that is being acquired (i.e. the bird that’s in the hand).  Instead, it has almost everything to do with the perceived worth of the currency that’s being traded for the value-generating asset (i.e. the two that’re in the bush).  That value is dependent upon – far more than any other factor – the balance between supply and demand for the currency in question.

Now, back to Dave’s statement.  Do I think Dave is wrong on the merits?  Well, there are two parts to that.  Do I think unemployment will remain high?  Yes.  Do I think that asset values are still overstated?  Broadly-speaking, yes.  Do I think the price-mismatch gives us comparatively little reason to worry about inflation – or more worrisome, hyper-inflation?  Absolutely not.  With the supply of dollars continuing to rise in the face of a shrinking economy, and with the knowledge that hyper-inflation has reared its ugly head in an environment with similar characteristics, you simply cannot rule such a thing out.

Enjoy the sun – but don’t forget your zombie attack kit…