The most important economic principle

On a dark cold winter day in Hyde Park, Illinois, in a small stone eating hall, it became crystal clear. I was fortunate enough to eat with a visiting professor named Marvin Goodfriend. Professor Goodfriend was a vice president at the Richmond Federal Reserve but was teaching graduate students at the University of Chicago. I happened to be one of them. It was another in a long line of miserable winter days in Chicago, and we were hunkered down in the cafeteria of one of the many gargoyled buildings that create the feeling of dread and loathing at the U of C. We were talking about the economy and economics when he turned and smiled his glinty smile and said:

“Profits go to zero.”

Professor Goodfriend went on. The cycle is always the same. We experience a technological breakout or advancement. A huge profit opportunity or window is created. However, the window does not stay open forever. The profits are always being eroded. The market can become saturated. Large markets draw competition, and prices of raw materials and labor get driven up. The erosion takes place in several different ways, and at different rates, but the profits will move toward zero- until the next technological breakout.

I don’t know if professor Goodfriend , who was very young in 1988, remembers our lunch. He had many students and probably talked to many of them, as he was quite popular and extremely nice. I will never forget that lesson, although the specific conversation is fragmented. The concept that Profits go to Zero guides my decision making on a daily basis. I always anticipate the opportunity, or window, will not remain open forever. Whether it be a business venture or an investment, we should always evaluate the decision with this underlying tenet. If the market is still growing, then profits can grow, but marginal profits will be under pressure.

An excellent way to think of this is to think of a fish swimming upstream. Just staying still results in the fish moving backwards. If he wants to stay in the same place, he must swim, and to advance he must swim harder.

There is an old joke, that the only fish that goes with the current is a dead fish. That’s kind of how I feel about companies in saturated and highly competitive industries. They’re dead fish.

On a country-wide scale and for that matter a global scale- we are all dead fish. The whole world is saturated and highly competitive. All countries are helping to saturate the markets. We have more than triple the global capacity for cars than the current market. We make computers now that are 100,000 times faster than the computer I used while at the U of C, and they cost half as much. We have seen the prices of copper and steel, and other industrial metals increase; we have seen the prices of labor in Asia and Europe increase. The profits of the world are dropping. This is the source of the global recession.

Until we have an enormous technological breakthrough which can boost the economy of the world, the United States, with the world’s highest standard of living is going to face more economic hardship.

The politicians and bankers are wasting our money and resources on the same rather archaic technologies of the past. The thought that team Obama is proud to announce that their stimulus package involves repaving roads makes me shudder. Infrastructure maintenance will stimulate nothing; it’s just a form of government subsidy. Spending hundreds of billions of dollars on washed up, out-dated concepts will only lead to a weakened federal balance sheet and more competition in those well trampled arenas. The government needs to facilitate technological advancement and help to develop opportunities. The administration should not concern itself with companies that are no longer able to swim in their respective currents. The individuals who work at these institutions should have access to resources. Resources the government should provide to re-educate and assist the individuals- help them advance, and find their next opportunity. We should never think of a corporation as being made up of individuals. The corporation is a not a citizen who should be protected. The corporation is a nexus of rules that is created to create a profit. Once it is no longer capable- break it up, and assist the individuals who are impacted.

Profits go to zero, corporations go to zero. We should not be surprised or shocked or remorseful. Let them go, and move forward. The alternative path leads to lower standards of living, as the government wastes our resources on unhealthy and bloated companies that can not compete any longer. The companies use every tool at their disposal to be saved- including the heart wrenching plea- “we will put so many people out of work.” Our government should respond to the corporation with the retort- “Our citizens will be assisted, good bye.”- let the ship sink, but save the souls on board.

Joy to the world – Peter

Tags: economics, globalization, inventions, Obama, Profits go to zero., recession, University of Chicago

A "Head and Shoulders" pattern exists in US equities.

US Equities are showing a Head and Shoulders pattern

The pattern suggests a sell-off back to the level indicated on the chart.

This pattern is quite easily recognizable. The pattern consists of a first rally, which forms a”shoulder.” Then there is an even higher rally which forms the “head” and, finally, a third rally that fails to achieve a higher high. This third attempt to rally is described as the second shoulder. The failure of the rally results in a large sell-off back to the start of the original rally.

I explained the head and shoulder pattern in this CNBC video from Wednesday:

Joy to the world – Peter

Tags: CNBC Video, investing, recession, stock market

Credit is inelastic.

Groucho Marx had a famous line: “I never would want to belong to a club that would have someone like me for a member.”

I take it one step further: I would never lend money to anyone who would need to borrow from me.

Lending and borrowing are essential to a healthy and successful economy.

Lending requires trust and insight. People must be thoughtful in their lending decisions. Lending cannot be made without proper due diligence. Even if we are absolutely confident in the borrower’s integrity and desire to pay back the money, we must question his ability. Maybe the borrower is an ignoramus, who has a flawed business model. The lending decision must consider the macro-economic environment and how it will impact business owners and entrepreneurs. These owners are often so highly focused on their respective companies that they could miss the forest for the trees. Lenders cannot afford to take people at their word.

Borrowers must remain credit-worthy. For argument’s sake, let’s say a certain loan is questionable at 10%. For instance, you wish to borrow one million dollars, with the promise of repaying the million AND $100,000 of interest at the end of one year. The people decide they wish to pass. How can you sweeten the deal?

The borrower can’t offer to pay 20%!

If it looked unlikely that the borrower could get the $100,000, how does the promise of $200,000 make the deal any more feasible? The lender makes a GO or NO GO decision based on the creditworthiness of the deal (we hope), and the interest rate charged is arrived at after that decision is made. The borrower’s burden would only be greater if charged a higher interest rate. If they can’t make 10% – they certainly can’t make 20%.

This inability to borrow becomes a vicious cycle, as credit-worthiness deteriorates and borrowing costs increase. The higher costs eat into margins and weaken the financial standing of the entity. Driving borrowing costs even higher…

Once firms or industries or even individuals are caught in this quagmire, it usually ends in bankruptcy. Lenders often continue to lend to creditors with the misplaced hope that they will turn it around, or because they gave so much of themselves, they no longer can remain in business themselves.

Credit formation, credit markets, borrowing and lending- is advanced citizenship. In order for it to work, everyone must be credit-worthy. The cheaters and abusers of the system hurt everybody. The entire credit crisis facing the world today could have been avoided if the lenders had done a better job of scrutinizing, and the entire thing could have been avoided if the borrowers paid back their obligations.

Now our government is lending good money after bad. They changed the FASB rules and removed “Mark to Market” accounting rules so they can justify making bad loans. They are not being diligent, or scrutinizing, they are printing money and throwing it at the problems. The lending function has been corrupted.

We have jumped in the raging sea.

Joy to the world- peter

Tags: accounting, borrowing, credit, Groucho Marx, interest rates, lending

Why can't we feed the birds?

Why can’t we feed the birds? It is amazing how fast hundreds of people will jump down my throat when I ask. They all screech- “They Will Get Fat and Lazy and Become Dependent on You to SURVIVE!”

Kids, Grownups, and even Democrats understand the argument. If you provide a form of sustenance or aid to a population of animals, the animals’ behavior changes- they get lazy and stop providing for themselves. We can’t provide for them forever, and when left up to their own devices, they will not be able to be self-reliant. Another, often missed issue, is that birds who are fed often become strong and drive out other successful species, thus disrupting the natural order.

(This argument is so easy, it almost makes it itself.)

SOoooooo… how come we keep voting for more and more aid and benefits for populations of human beings? (a known animal- not a vegetable or mineral) Aren’t we concerned that we will cause them to become dependent? Aren’t we concerned that by voting for more mortgage finance resolutions, we are aiding an industry that needs to be less fat and lazy? Government should not help businesses, industries, or even individuals by simply feeding them dollars.

The Obama Stimulus Package is a great big bag of birdseed.

It will make some groups survive for a short term. It will aid some at the expense of other successful companies. It disrupts the natural order.

If only the birds voted. They would really have it made. They could get rid of those pesky signs and be living the life of Riley.

Tags: economics, mortgages, Obama, recession, stimulus

Current State of the Markets

On CNBC’s Squawk Box this morning, I gave an analysis of the current state of the markets.

The FED must keep interest rates steady. Mortgage portfolios are like a shopping cart that constantly needs to be realigned. Intruiged? Watch the video for my full interview.

Tags: CNBC Video, convexity, Fed, hedging, housing market, interest rates, mortgages, stock market