Monday, February 4, 2008

A Few Words About Inflation

"Well I'm not the world's most masculine man
but I know what I am and
I'm glad I'm a man and so is Lola,
Lo-Lo-Lo-Lo-Lola
Lo-Lo-Lo-Lo-Lola"
- The Kinks ("Lola")

Is he glad he's a man and is Lola glad he's a man or is he glad he's a man and glad Lola is (really) a man? Which way is up? Gotta love the ambiguity. Speaking of ambiguities...

Inflation is a fact of life in any economic system. In the U.S., we think (well, the Federal Reserve thinks) that if inflation is ~3% or lower that it is “acceptable” and “under control”. But even at “just” 3%, prices will double in 24 years (Rule of 72). People in their 50’s will live long enough to see prices double. But inflation is not linear and every person’s inflation experience is different because we aren’t all buying the same goods and services.

Another problem with inflation is that the government cooks the numbers. Imagine that!

· You may have noticed over the past few years that when inflation figures are reported that you typically hear a figure for “core inflation, excluding volatile energy and food”. This is such a crock. Can you think of anyone you know who does not purchase energy and food? Energy and food are certainly part of my core basket of goods and services.

· The application of so-called “hedonic adjustments” was initiated during the Clinton years. Hedonic adjustments are concerned with the effect that the march of technological innovation has on prices. As an example, personal computers have gotten cheaper and cheaper over the years. The government decided that this improvement should be reflected in the calculations for inflation, thus the price of personal computers have essentially a negative impact on the official numbers.

And finally, probably the least-appreciated impact of inflation is the purchase of goods and services that do not yet exist! Think back 10 years – how many people had cell phones? How many people had MP3 players? How many people had a broadband internet connection at home? Did you ever imagine that you would want – let alone need - to purchase a personal paper shredding device? We could go on for several pages with examples. The point is that we don’t know what we don’t know. What will all these unknown items cost us? All of these unknown goods and services will be things that we will want to buy or for which a need will be created (e.g., identity theft = personal shredders).

If you are interested in how the books are cooked, visit Shadow Government Statistics at http://www.shadowstats.com/ .

[full lyrics here: http://www.lyricsfreak.com/k/kinks/lola_20079021.html]

Questions? kimm@sweetwaterinv.com


Word o’ the Day: Finance (ABC’s of Financial Planning)

“Money, get away
Get a good job with more pay and you’re O.K.
Money it's a gas
Grab that cash with both hands and make a stash
New car, caviar, four star daydream,
Think I'll buy me a football team”
- “Money” (Pink Floyd)

You could substitute the word “Subprime” for the word “Money” in the song. The subprime crisis – while enormous in its reach and deep in its impact – is but the latest in a long list of financial excesses perpetrated by the so-called Masters of the Universe (see Tom Wolfe’s Bonfire of the Vanities – read the book though, the film was excremental). If you delve into the personnel at any major financial firm you will find an enormous number of people with MBA after their name. These people spend their waking hours figuring out how to make something from nothing – they are the alchemists of the modern age.

Finance used to be pretty simple: structuring Initial Public Offerings (IPOs) of stock and structuring offerings of corporate and municipal bonds. There were always excesses of some kind of course – where there’s money there are always predators to be found. But still, it was a pretty straightforward endeavor – structure financing for a business or government endeavor and fund it by finding people (investors) to invest.

As time went on, finance became more exotic, creating ways for investors (mostly institutional investors) to play both sides of the market, creating hedges for shorting (making money when an investment declines in value), building the proverbial “better spreadsheet” and engineering more and more ways to arbitrage minute differences in markets around the world. Tools created included: Hedge Funds of all shapes, sizes and flavors, Hedge “Fund of Funds” as diversification, Private Equity Funds, Commodity Pools, Private Financing, and on and on. What was truly created? Fees for fund originators, fund salespeople and fund operators.

Players in the current Subprime charade (Bill Gross of PIMCO referred to it as “…the pyramid scheme, chain letter driven structure of modern finance…”) were driven by fee income generated at every step of the transaction. At the bottom of the pile is the lowly mortgagee, the person upon whose timely monthly mortgage payments the upside-down pyramid rests. So what happens to all the spreadsheet models when this person and many of his similary-situated brethren fail to deliver? No monthly payments equals no cash flow to the investors holding the bonds and derivative securities built on top of the timely monthly payment. The upside-down pyramid falls over, crushing the “new car, caviar, four star daydream”. And the “football team” too.

Questions? kimm@sweetwaterinv.com

[View all lyrics here: http://www.azlyrics.com/lyrics/pinkfloyd/money.html]