The Mass of Markets

I am not here to pick any fights this week. Nor to tell my readers how all the more famous investors and economists of the world are getting it wrong (they must be doing something right since they are famous, and I am not quite so much).  Instead I want to focus on some interesting statistics about markets and economies that can help frame a perspective about markets. The size of different markets, along with the size of different market participants, is something that is little talked about in the main stream investment mediums. This is what I am calling the Mass of Markets, and in some future post may be so brave as to try and detail these relationships; but first, a primer.
It is widely known that the U.S. GDP, overall measure of economic activity, weighs in at about $14.5 Trillion.



Below is a chart from the International Monetary Fund IMF on how this compares to rest of the world.

For 2009

As you can see, the whole of the European Union, added together, is a larger economic market than the United States by a couple Trillion dollars. Also note that in 2010, it is widely accepted that China has surpassed Japan as the second largest national economy in the world.

It is also fairly well known that we have a debt problem here in the United States and currently have a National Debt that comes it at around $12 Trillion. This is akin to a household having a debt load of roughly 80% of its annual income. We also find that we run a budget deficit of 10% of GDP. This means that our debt load is growing right now at about $1.5 Trillion per year. 

The question is; when does this burden break our backs? Well, by comparison Japan has a Debt load of roughly 180% of its GDP and can still find willing lenders in the open markets. While we do not want to emulate Japan, (remember some of my last posts on deflation talks), this does show that an economy may not fall apart under this kind an even greater debt load. Someone should poll the Japanese and find out how their standard of living is. From what I have read, the citizens of Japan are not rioting in the streets.  In fact, they are still the biggest purchasers of their governments debt.  Japanese sentiment is a topic for another day.

Now look at this. The total mortgage debt load in the U.S. weighs it at $14.9 Trillion as of the last quarter of '08 (according to the federal reserve). This means that there are more households owing more money on their homes than all the goods and services sold in the United States (sounds incredible until you stop to think about the number of households in the country). Of this nearly $15 Trillion, $9.2 Trillion has been pooled, sliced and sold off on secondary markets. This is what is called securitization; the mortgage bonds that were the ignition of our global financial crisis.

The important thing to remember about this is that back in 2007 and 2008, when some of the pools that contained what I call NINJA (No Income No Job or Assets) loans, and those people began having trouble paying back those loans, we experienced what Mohammad El-Erian, CEO of PIMCO referred to in his book, When Markets Collide, as a Market for Lemons. A Market for Lemons is an economic theory that suggests if you have one or two terribly problematic cars on a used car lot, the price of the good cars can also be brought down by the fear the customer has of getting sold a "lemon". This is exactly what occurred in the $9 Trillion dollar market for securitized mortgage loans. People were afraid of getting sold junk and the whole market seemed suspect.

Some people said that the problem would be contained in housing. Well its hard to see of a $9 Trillion dollar market not having an impact on the greater economy. For comparison purposes here are some other market figures.

Market Cap of the Wilshire 5000 (actually over 6000 companies in the U.S.) - $12.7 Trillion

The biggest 500 of those, the S&P 500 - $10.2 Trillion

Total U.S. Bond market in 2008 weighed in at around $33 Trillion. We can add in another $5 Trillion or so of additional government debt and money market instruments that have been added in the last two years.

The largest U.S. corporation in terms of market capitalization is Exxon Mobil (XOM) at $310 Billion.  In second place is Apple (AAPL) at $252 Billion.

The value of all the gold ever mined in the world stands right now at about $6.3 Trillion based on a price of around $1250 per troy ounce.  Five years ago that was a less than a $2 Trillion market.

What does all this mean?  It means that the more massive a market, the bigger its gravitational pull on other markets.  For instance, if Apple gets some bad news and Ipads dont sell as well as they expected, the whole market index can feel a hit.  However, a small bio-tech company can go out of business without so much as a headline.

This same relationship plays out in bigger markets.  Many big investors will point out the fact that, while the stock market is a lot sexier, the Bond market really calls the shots in the economy.  This is, in part, because as the biggest and most liquid market in the world, it has a deeper and more far reaching effect on people.  Now we can talk all day about the structural differences in the different markets, but the point remains that mass should not be over looked.

Investors would do well to remember Newton when venturing into the global financial market arena.

Austerity v. Stimulus: Why Neither Side is Right

We have an unfortunate economic situation on our hands that, while I do believe the worst has passed, is nowhere near being solved.  With a near 10% unemployment rate, that means we have approximately 15 million people in this country who are unable to find work.  You can see the stats as they are compiled by the Bureau of Labor Statistics by clicking this link.  We also have a rising debt load that threatens the prosperity of future generations.  While I am not normally someone who likes to get into policy debates, it seems that every economist, professor, investor, plumber, school teacher, and song writer, has an opinion on how the government should address this issue, and therefore I feel compelled to jump into the fray....in a sense.  What I would like to do is briefly sum up both sides of this debate, and then state why I feel its a fools argument to begin with.

Austerians:  The Economic Spartans

Austerians are those that believe the debt level of the United States is currently unsustainable.  The government borrows too much money and will very soon find itself in a position where willing lenders will be hard to come by.  Confidence will erode, bond prices will plummet as yields skyrocket, and economic armegeddon ensues.  This is the dramatic crash into a deflationary spiral which I wrote about a few weeks back, in the Lost Decade article.

The answer to this problem is very clear to the Austerians.  Slash spending immediately.  Take a hatchet to the budget and reduce the deficit through painful but needed cuts.  They believe we need to ratchet back our standards of living and live a more "Spartan" lifestyle.  This is really the only responsible thing to do after all.  Currently the U.S. is spending about 10% more than it earns in tax revenue.  Obviously if you spend more than you make you will max out the credit cards, home equity lines, and bank loans eventually, and then what do you do?

Stimulants: The Economic Crack Dealers

The Stimulants (for lack of a better term) believe that the only way to get people back to work is through stimulative actions on the part of the government.  This means more spending.  This means increasing an already high deficit in the budget and thereby increasing the U.S.'s overall debt load.  Their rationale for this is that the economy will continue to falter without some sort of meaningful job creation and job creation can only come when we have money moving through the system.  This means banks finally agreeing to lend money to small and mid-sized business so that they can expand their operations, and it means consumers not worried about losing their jobs through employers having to enact cost cutting measures.

Without this additional spending from the government, the fear is that prospects for growth in the United States will continue to decline.  Investors in the equity markets will continue to pull their money out of the U.S. stock market in search of higher potential growth prospects elsewhere.  Even though it is acknowledged that loose credit standards and high degrees of leverage is what got us into this mess, the thought is that cutting off an addict too abruptly can have disastrous effects.  The Stimulants (pun somewhat intentional) believe it is better to ween ourselves off of the borrowing addiction.

Who is on what side of the aisle?

For a great summary of this debate from some of the more respected residents of each camp, check out this article from the Financial Times.  I encourage everyone to check this out and read more in depth to each participants' view points.  These are all very intelligent and successful players in the global economic scene with widely varying viewpoints.

Conclusion:  The Winner is.....Neither!

The only true winners in this debate are those that argue against this argument.  The problem is that the issue is far from black and white.  The participants in this debate are arguing past one another, and neither side is nailing down the issue in that we need to find a way to do BOTH!  I have been surprised at some of the people who have emerged with this viewpoint.  Primarily Larry Summers, the director of President Obama's Economic Council.  I suppose it stands to reason that someone who is actually in the game, making decisions, can see the issue for what it is, instead of all these professors and economists playing armchair quarterback!

Can we find a way to stimulate the economy and balance the budget at the same time?  This is the challenge faced by the administration.  The solution will involve implementing smart policies that get the most "Bang for the Buck" in creating jobs, while at the same time eliminating wasteful spending.  We need to be selectively Stimulative and Austere.  Unfortunately, I'm not sure we can execute on this task.  Congress, right now, is more polarized than at any point in our history based on voting records of the last couple years.  Combine this with the fact that everyone in the government and the private sector alike will have different opinions on what spending programs can and should be eliminated, and its hard to see how we get this accomplished.
The bottom line is that temporary spending programs to get people back to work accompanied by a legitimate plan to get the budget balanced over time, is the only way to sustain economic growth while retaining the confidence of the bond market.  Again, my ties are with the entrepreneurs of this country and the small and mid-sized business owners.  This is the innovative soul of American business that can lead us out this malaise.

Let me hear your thoughts on the matter.

Keith