The Great Escape

This week's letter is going to focus on finance and the economy. As Bernakne says, we don't have the sensation that the economy is falling off the table anymore but I doubt we are close to being out of the woods. I'll explain why after I bring you up to speed on a few items that I wrote about previously.

Green Beret Challenge Update: Captain Weathersby (it's official, he's back in) and I did our APFT for the second time. I scored 276/300, which was much better than my first attempt but FIVE points short of my ranger buddy! I was dominated in the sit-ups and, despite a solid two-mile run, couldn't bridge the gap. Suppose that real Rangers do lead the way. I'm looking for a rematch around Memorial Day. You can follow my progress on my twitter page.

Not sure where my Ranger buddy will end up but if you, or a friend, might end up in Afghanistan then I highly recommend two books, The Seven Pillars of Wisdom and The Places In Between. Coming from a Western society, it is impossible for us to understand the baseline standard of living of our adversaries. My definition of suffering is above the Taliban's standard of living. Lawrence's book provides particularly good insights into a tribal society fighting a fluid war.

Cranking up my focus on the weights has resulted in noticeable changes to my body -- who ever would have suspected that 25 hours of weekly aerobic exercise was catabolic...

I'm ~172 lbs and slowly climbing -- I think my optimal 'soldier' weight would be ~178 lbs (73 inches tall). That's in terms of strength vs endurance -- obviously there is a material cost in run speed from tossing 15+ pounds on my frame. I'm giving my feet a break and not running much.

While I am really enjoying the strength training, my brain chemistry gets screwed up if I don't maintain moderate aerobic exercise -- gym endorphins seem different than exercise endorphins. So I am not totally anabolic with my training -- I am still tossing in a weekly long session.

Haven't taken any strength supplements -- thought about creatine during my current max strength phase but haven't used any. So far a little bit of whey, some Vit. C and a lot of eggs!

The Great Escape
A quick review of financial first principles...

• Profit and Loss Statement -- Revenues less Expenses equals Net Profit
• Balance Sheet -- Assets less Liabilities equals Net Assets
• Cash Flow Statement -- links the P&L to the B/S by way of cash inflows and outflows

From my desk, the global challenge that we are facing is Balance Sheet in nature - specifically, we have overleveraged our economic system. The pain that we are witnessing is a result of adjustment mechanisms.

We have not been living off Net Profits -- we have been living off cash generation from increasing our Liabilities, which had secondary effects of bidding up asset values. There was massive balance sheet inflation fueled by easy money.

Our governments are doing a good job at preventing a total collapse of system - that is the reality of what we face. However, our problem is due to excessive liabilities, therefore, government won't be able to solve the fundamental issue. Government will only be able to prevent total collapse while the private sector adjusts to the new reality.

Let's look at what's happening and tie back to first principles:

Government Stimulus -- this pumps up the P&L side of the economy, specifically our capacity to spend. States, Cities, citizens... we are cutting back like crazy, national authorities are stepping into the gap. The spending is filling a gap and reducing the decline, I don't expect to see growth as a result.

Bank Lending -- Congress is tracking bank lending and asking Geithner why banks aren't lending. Everybody knows why. The banks are insolvent -- their assets (our loans) aren't worth what they are holding them on their balance sheets. The regulators have changed the rules to buy the banks time.

Central banking authorities are providing, essentially, free money to the banking system to help it recapitalize and replace the massive amount of liquidity that went "poof" when the shadow banking sector disappeared.

The problem with trying to recapitalize over time is that the scale of the overleverage is such that additional profits are unlikely to close the gap. Allow me to illustrate with an example.

Assets = $100
Debt = $90
Net Assets = $10
Debt : Equity Ratio = 9x (90/10)

The issue facing many banks is their balance sheets looked more like...
Assets = $100
Debt = $96
Net Assets = $4
Debt : Equity Ratio = 24x

Now, if global assets come off by, say, 25% then the bank's loan portfolio might fall by 10% -- it's not a 1:1 decline. This is what the regulators are checking when they do "stress tests". Our balance sheet now looks like...

Assets = $90
Debt = $96
Net Assets = -$6, whoops insolvent

So we change the rules and pretend that economy is going to go back to the way it was. However, take a look at the stock market; or Vegas real estate; or commercial property; or commodities... ask yourself how long it is going to take us to get back to the peak. I don't see it.

Also, the bank's liabilities have not stayed constant, they have increased substantially because they had to pull a ton of off-balance sheet financing back into their main balance sheets (an effect of the collapse of the Shadow Banking sector).

This is the long answer to my advice a few months ago to steer clear of financials.

So how do we get out?
We can't escape a debt trap by creating more debt. Where many of the pundits have it wrong is that the government isn't growing liquidity with the increase in the central bank's balance sheets -- the government is replacing the liquidity that is rapidly disappearing from the private sector.

There are a few ways out:

Inflate the assets: reduce the real value the excess debt via inflation. Politically, this is the least painful method but if inflation gets out of hand then things get VERY ugly (think Zimbabwe). The magnitude of deflationary effects may prevent this adjustment mechanism - don't let Congress have oversight over the Fed - independent central monetary authorities have a much better shot than the House of Representatives at maintaining the value of our money.

Reduce the debt: the General Growth bankruptcy may have been a turning point - we had a massive bankruptcy and the markets didn't fall out of bed, expect more to follow. Remember that there are two sides to every financial transaction -- during a corporate write-off through insolvency, the lenders take a hit by the value of their asset falling.

This is why we need to stabilize the financial sector first -- the real-economy adjusts with write-offs flowing through the financial-economy.

Repay the debt: traditionally, we repay our debts. Over the last 25 years, we grew accustomed to refinancing our debts. In a world were refinancing is difficult, we need net profits to repay our debts -- the recession is squeezing profits for companies and individuals. So if we avoid large inflation, then it would be reasonable to expect a prolonged period where growth is reduced due to a collective need to pay down debt. Note too, the Federal Government is unlikely to be able to run a $10 Trillion deficit as a long-term strategy.

So what's going to happen? What to do?
I have no idea on the future but financial first principles indicate a few things:

John Mauldin made a great point a month ago: in a bear market your benchmark return is zero.

Implications:

• Take a close look at everything, and everyone, that is a net cost.
• If you are a "net cost" at your firm then best to get yourself into a role where you have a clear profit association. This is the safest place to be in periods of rising unemployment. Make sure your firm understands your net profit contribution.
• Expect significant price pressure - Endurance Corner charges $25 per week for coaching and provides a team of four professionals. We're not trying to grow the market -- we are taking share from people charging 4-20x our rates. Regardless of your field, there are going to be new competitors coming at your from all sides.
• Deleverage - it amazes me that people hold debt for the a tax write off. My cash is yielding ~2% right now. Why the heck would I want to pay anything for an interest tax deduction? Asset values are going down.
• Cash and profit-streams are highly valuable - collectively, we spent 25 years living off asset inflation - the new reality will see a swing to cash generation.

In terms of maintaining motivation and psychological strength -- in your personal life, be aggressive with write-downs and cost cutting. I swung the ax hard on myself and my portfolio. Take the pain in one massive swing. Most of us are not built to withstand a series of negative reports.

By writing down my balance sheet aggressively, cutting hardest on my personal expenditure and taking rapid action in my personal life... I placed myself in a position where I could add back a little every so often. The nice thing about our psychology is that frequent positive actions have a disproportionately favorable impact on us.

Examples (they sound silly but they work):

• We increased our water service by ten gallons per month;
• We increased our date night budget by $25;
• We are doing a family camping trip May.

Net cost ~$50 per week and I feel like I am winning!

gordo