It is interesting that the Federal Reserve has committed to holding interest rates near 0 percent until 2014 even as consumer inflation measures surge above its long-term target. Obviously, Chairman Bernanke believes that the uptrend in these metrics will not continue. However, if consumer inflation measures do move meaningfully higher, Bernanke would be faced with a challenging dilemma. Would he choose to hold rates at excessively low levels and risk the development of a debilitating surge in inflation, or would he choose to start raising interest rates and risk plunging a fragile economy back into recession? It will be important to monitor these metrics carefully during 2012.

Said Ataman Ozyildirim, economist at The Conference Board: “This fourth consecutive gain in the LEI reflected fairly widespread strength among its components, pointing to somewhat more positive economic conditions in early 2012. The LEI’s increase in January was led not only by improving financial and credit indicators, but also rising average workweek in manufacturing. These both offset consumers’ outlook about the economy, which remained pessimistic, though slightly less so. Meanwhile, the CEI rose again in January as employment, income, and sales data all point to improving current economic conditions despite a lack of contribution from industrial production.”

Added Ken Goldstein, economist at The Conference Board: “Recent data reflect an economy that started the year on a positive note. The CEI shows some small signs of economic strengthening in the fourth quarter and continued to point in this direction in January. The LEI suggests these conditions will continue and could possibly even pick up this spring and summer.”

Since rolling over in late 2011, the LEI has rebounded and moved up to a new post-recession high in early 2012. The Economic Cycle Research Institute (ECRI) Weekly Leading Index (WLI) has also rebounded off of its recent low in late 2011, although the reaction has struggled to advance during the last four months.

The rebound in leading data trends during the last few months suggests that the likelihood of a recession during early 2012 is decreasing, although we are almost certainly not entering a period of strong, persistent economic growth. Notice the extreme volatility experienced by the WLI since the last recession. Those violent whipsaws are indicative of massive structural imbalances that will continue to drive extreme moves in the financial markets. Excessive debt will constrain economic growth for the foreseeable future and the Federal Reserve will likely continue to flood the system with liquidity in an attempt to combat deflation, but the foundation for the next structural growth cycle will not be created until we stop focusing on temporary fixes and address the underlying problems.

Technical indicators are moderately bullish overall on the daily chart, favoring a continuation of the rally. However, the advance from December is extremely overextended on a short-term basis and it will almost certainly be followed by a violent overbought correction.

The strong move higher since the beginning of the year provides another example of how market behavior itself usually provides the most reliable indication of future direction. In late December, cycle analysis identified an important long-term inflection point at congestion resistance in the 1,260 area. The formation of another short-term cycle high would have forecast a return to the October lows and favored the development of a severe cyclical bear market from the May 2011 high. Alternatively, a strong move above the 1,260 level would have forecast additional short-term strength in early 2012 and favored a return to previous highs of the cyclical bull market from March 2009. The bullish scenario developed during the first week of January and the S&P 500 index has surged nearly 8 percent since then, returning to the cyclical high.

As always, perspective is important, and although the short-term view remains bullish, the big picture displays a secular bear market in the middle stage of its development. The cyclical bull market from early 2009 has been an extreme move and the next correction will almost certainly be equally violent. Cyclical uptrends that occur during secular downtrends have an average duration of 33 months, so the 36-month-old rally from March 2009 could terminate at any time, if it has not already done so in April 2011.

The forthcoming correction will provide the next assessment of cyclical bull market health and we will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers.

Happy New Year, Lacy. And thanks for sending all those charts to background me for our conversation. I have to say the first one stopped me — showing debt as a percentage of U.S. GDP all the way back to 1870? What data goes back that far?

Dr. Robert Gordonat Northwestern Universityhas been very helpful to me, recreating a lot of data. The National Income and Product Accounts (NIPA) from the Bureau of Economic Analysis (BEA) only start in ’29. But NBER (the National Bureau of Economic Research) funded two studies, one by Christina Romer and the other by Robert Gordon, to estimate the nation’s GDP back to 1870. So we have those data sets. They’re not identical, obviously, but what most economists do, including me, is use an average of the Romer and the Gordon estimates, which seems to work out pretty well.

Still, I suspect most folks looking at a line on a chart interpret it as “historical fact” instead of as an estimate based on spotty data on the workings of a very different economic environment.

Well, what the profession is saying is that economic propositions need to be tested and verified over as complete a sample as possible. Admittedly, some of these earlier periods, you didn’t have a central bank; you didn’t have an income tax; you had various political regimes; sometimes you were on the gold standard, sometimes you were off. The point is, most people feel that these institutional differences shouldn’t obscure the verifiable observation of basic economic relationships. So you want to test this over as much time as you possibly can and I think that’s a reasonable proposition. Anyway, that’s my approach, and that’s increasingly the approach in the profession.

I was just noting that what we actually know about the economy in days gone by is lot squishier than terms like “data sets” or lines on charts seem to imply. But clearly, observations over short times can be misleading.

Absolutely. Take the subject of debt. If you confine your analysis to post-war period, you only have one major debt-dominated cycle and that’s the one we’re currently in — and have been in for a number of years. But if you go back far enough, you have three more. You have the 1820s and 1830s. You have 1860s and 1870s and then you have 1920s and their aftermath. Sometimes it’s essential to take your analysis back as far as you possibly can.

Sure. Doesn’t your second chart, on the velocity of money [below], show how none other than Milton Friedman was misled into thinking that it was a constant because he only looked at post-war data?

That’s correct and, in fact, I was misled along with him because I was also doing analysis based on the post-war data. Friedman’s period of estimation was basically from the 1950s to the 1980s. Well, if you look at the velocity of money in that time period, it’s not a constant, but it’s very stable around 1.675. So if you tracked money supply growth then, you were going to be able to get to GDP growth very well. Not on an individual quarterly basis, but even the individual quarterly variations were not that great. Until velocity broke out of that range after we deregulated the banking system. Now, velocity is breaking below the long-term average and it’s behaving exactly like Irving Fisher said, not like Friedman said, absolutely.

What a perfect example of the difference your frame of reference can make.

Yes, Friedman even said Fisher was the greatest American economist, and I think that is correct. Fisher had a broader understanding of the economy in a very, very critical way and in a way that I don’t think either Friedman or John Maynard Keynesunderstood it, and even a lot of contemporary economists, such as Ben Bernanke. Keynes and Friedman both felt that The Great Depression was due to an insufficiency of aggregate demand and so the way you contained a Great Depression was by your response to the insufficiency of aggregate demand. For Keynes, that was by having the federal government borrow more money and spend it when the private sector wouldn’t. And for Friedman, that was for the Federal Reserve to do more to stimulate the money supply so that the private sector would lend more money. Fisher, on the other hand, is saying something entirely different. He’s saying that the insufficiency of aggregate demand is a symptom of excessive indebtedness and what you have to do to contain a major debt depression event — such as the aftermath of 1873, the aftermath of 1929, the aftermath of 2008 — is you have to prevent it ahead of time. You have to prevent the buildup of debt.

And that your goose is cooked if you don’t you cut off the credit bubble before it overwhelms the economy?

Yes, and Bernanke is thinking that the solution is in the response to the insufficiency of aggregate demand. That was Friedman’s thought. That was Keynes’ thought and most of the economics profession has traditionally thought the same way. They were looking at it through the wrong lens. Fisher advocated 100% money because he wanted the lending and depository functions of the banks separated so we couldn’t have another event like the 1920s.

You’re saying that Fisher argued againstfractional reserve banking?

Yes, and so did the people that more or less followed in Fisher’s footsteps, principally Charles Kindleberger and Hyman Minsky. Minsky felt that the way you prevented a major debt deflation cycle was to keep the banks small.

Prevent them from ever becoming too big to fail in the first place?

Right. Don’t let them merge. You don’t want them to get big. I actually gave a paper with Minsky once, in 1981, in which he advocated that position. Kindleberger was very precise in “Manias, Panics, and Crashes,” when he said that when you have a small credit problem, or many small problems, some say, you don’t want the Federal Reserve to respond. Because if the central bank comes in and bails out a small problem, then that will be a sign to those who want to take more risk that they don’t need to be cautious — they can always count on the central bank to come in and bail them out. If they do, Kindleberger said— and this was in ’78 — then the future crisis will be even greater. “A free lunch for speculators today means that they’re likely to be less prudent in the future. Hence, the next several financial crises could be more severe.”

Too bad nobody paid attention.

So we came along and we bailed out Long-Term Capital Management in the late 1990s.

Not to mention the banks that got in trouble in Latin America in the early ’80s, the entire S&L sector in the early ’90s.

Absolutely. You could even include the bailout of Chrysler in 1980, because that was a signal to the automobile companies and to their unions: “Do what you want. If you get in trouble, the U.S. taxpayer’s behind you.” But the Chrysler bailout and the LTCM bailout were very small. I mean, LTCM was a $3 billion problem. That’s a quaint number today. Yet the Fed came in with all its big guns blazing. They used monetary policy to ease the pain. A debt buildup was already underway, but the Fed greatly facilitated it and encouraged it. So, it seems Fisher and Kindleberger and Minsky were right. The only prudent way you can deal with these huge debt problems is to prevent them from building up in the first place. The response after the fact matters some, but it’s not the route you should go.

That’s great, in theory. Except that it isthe route we went. Once again, we didn’t prevent the excessive buildup of debt, so now we have to deal with pressing deflationary forces.

That’s why Fisher wanted to segregate the lending and deposit-taking functions of the banks.

Does that sound a mite like Paul Volcker, daring to suggest banning the banks’ speculative proprietary trading activities — and getting nothing but grief from the industry for his efforts?

Well, that’s right. Fisher couldn’t get it done, either. And warned that we would do it again. I had a brief acquaintance with Kindleberger; I didn’t know him well, but I knew him and he was helpful to me. He taught Ken Rogoff. And, in fact, “This Time, It’s Different” is really a quantification and verification of a lot of the qualitative themes that Kindleberger expressed. My sense was that Kindleberger thought that once the economy got into over-trading, there was no one who was going to stand in its way.

Over-trading?

That was the old-timey term that Kindleberger used. He said there are three phrases of behavior as you move toward manias, panics, and crashes. The first phase is over-trading, where you start buying assets at prices far beyond their fundamentals. People enjoy this phase, because initially it boosts income and raises wealth and so forth. So it becomes very irrational. Then you get to what he called the discredit phase, where the smart people start pulling their funds out. Then you get what he called revulsion. The classical economists used those terms: Over-trading, discredit, revulsion. As I said, I got the impression from Kindleberger that once you get into that over-trading phase, there’s no one who is going to stand in the way of it.

Why stand in front of a freight train?

Especially when it doesn’t seem to be in anyone’s interest to stand there. Regulators, banks, companies, investors, everybody’s having a good time; profits are being made, employment is strong.

So we’ve just seen.

No one dealt with the credit excesses in the subprime market, until the crisis hit. And no one dealt with the excessive speculation in the financing of the railroads in the middle of the 19th Century, or in the financing of the canals and turnpikes and steamship lines in the 1820s and 1830s. Nor did anyone step in to try to stop the foolishness that was going on in the 1920s.

Kindleberger took it all the way back to the tulip mania, and I’d venture that wasn’t the first time in human history when an auction market got out of hand.

That is correct. Absolutely. You push things beyond their fundamental value. But this isn’t the conventional economic view of debt and it’s important. I sent you some quotes contrasting conventional wisdom with this newer understanding.

I noticed you picked something Bernanke wrote to illustrate conventional wisdom—

I chose that Bernanke quote [below] because Bernanke addressed the Fisher – Kindleberger theme in the early part of this century — and that’s when we really needed Bernanke to say something and to do something. But as you can see, Bernanke rejected Fisher and Kindleberger in his book, “Essays on The Great Depression.” And notice that he doesn’t reject Fisher because he says Fisher’s data is flawed. He doesn’t reject Fisher because Fisher’s argument is flawed or Kindleberger, either. He rejects them because an excessive buildup of debt implies irrational behavior.

Debt and Economic Activity — Conventional View

“Beginning with Irving Fisher (1933) and A. G. Hart (1938), there is literature on the macroeconomic role of inside debt. Hyman Minsky (1977) and Charles Kindleberger (1978) have in several places argued for the inherent instability of the financial system, but in doing so have had to depart from the assumption of rational economic behavior. Footnote: I do not deny the possible importance of irrationality in economic life: however, it seems that the best research strategy is to push the rationality postulate as far as it will go.”

-Ben S. Bernanke (2000). Essays on the Great Depression, pages 42-43.

Vs. New View

“The U.S. economic recovery has been weak. A microeconomic analysis of U.S. counties shows that this weakness is closely related to elevated levels of household debt accumulated during the housing boom. The evidence is more consistent with the view that problems related to household balance sheets and house prices are the primary culprits of the weak economic recovery. King (1994) provides a detailed discussion of how differences in the marginal propensity to consume between borrowing and lending households can generate an aggregate downturn in an economy with high household leverage. This idea goes back to at least Irving Fisher’s debt deflation hypothesis (1933).”

-Federal Reserve Bank of San Francisco Economic Letter January 2011. Atif Mian University of California Berkeley, Haas School of Business and Amir Sufi, University of Chicago Booth School of Business.

“Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the result can be a disaster. For individual households and firms, overborrowing leads to bankruptcy and financial ruin. For a country, too much debt impairs the government’s ability to deliver essential services to its citizens. Debt turns cancerous when it reaches 80-100% of GDP for governments, 90% for corporations and 85% for households.”

-The Real Effects for Debt by Stephen G. Cecchetti, M. S. Mohanty and Fabrizio Zampolli. September, 2011. Bank for International Settlements, page 1.

Well, hello!

That’s the world I live in. You, too, probably.

To mention that what can seem rational on an individual level can be irrational when an entire economy does it.

We see it all the time, every day of every week. And yet Greenspan’s rejection of the danger of an excessive buildup of debt in his book put him in a different mindset, not just in evaluating the events of the 1930s, but when it came to understanding what was going on in the early part of this century, up to 2006 and ’07. Because he thought he could respond to a debt problem and contain it. But that was not at all what Fisher taught. Fisher said you have to prevent a debt deflation ahead of time. That’s a very powerful, critical, difference. What Fisher is saying is that once you get into this extremely over-indebted situation, and the prices of assets begin to fall, these two “big bad actors,” those are the terms he used, control all or nearly all other economic variables. Then, if you attempt to respond to the problem by leveraging further, it’s counterproductive.

The identification of stock market secular context and inflection points can be accomplished through careful study of fundamental, technical, internal and sentiment data. For example, our Secular Trend Score (STS) has correctly identified every secular turning point since the market crash in 1929. The following graph displays the long-term view of the STS along with the last four signals.

From an investment perspective, secular bull markets are much easier to navigate than their bearish counterparts. A simple strategy of investing heavily in stocks at the beginning of the secular uptrend and then buying the subsequent dips will produce excellent average annual returns during the 10 to 20-year lifespan of the bull move, especially if all dividends are reinvested and allowed to contribute to compounding. On the other hand, secular bear markets are characterized by violent cyclical swings higher and lower that engender equally violent swings in mainstream sentiment. The average investor has a tendency to keep moving in and out of the stock market, usually giving up hope near cyclical lows and becoming euphoric near long-term highs. Overall, the stock market performs very poorly during complete secular bear cycles. For example, during the 12 years since the current secular bear market began, the S&P 500 index has produced a compound annual return of only 0.8%, which assumes the reinvestment of all dividends along the way.

Of course, there are many opportunities to profit during the violent cyclical swings, but it is important to recognize that these are trading opportunities only. Again, a minimum time frame of ten years is required to evaluate investment merit. Cyclical trends typically have durations of two to five years, so they are too short to provide properly characterized investment opportunities. Any market analysts who have suggested that stocks were an excellent “investment” any time during the last 12 years were either ignorant of the secular context or did not have a full understanding of investment merit.

Although the secular bear is extremely difficult to navigate psychologically, there are sound investment strategies that outperform the stock market by a wide margin and require very little monitoring and maintenance. For example, our model investment portfolio, which was created just before the start of the current secular bear, has produced an annual compound return of approximately 11% since inception.

This performance was obtained by recognizing the secular shift in 2000 and then positioning for the development of a 10 to 20-year bear market by investing primarily in high quality bonds, commodities, precious metals and currencies. The lesson is simple, but powerful. Secular bear environments are very different from their bullish counterparts, as are the investment strategies required to maximize potential returns and minimize risk in each environment. Therefore, in order to invest successfully over the long run, it is imperative to properly characterize and understand secular context. Although it is often difficult to maintain focus on the big picture, it is the key to amassing investment wealth consistently over time.

The uptrend has begun testing long-term congestion resistance near previous highs of the cyclical uptrend from early 2009. A weekly close well above the bull market high near 1,365 would confirm a breakout and forecast additional intermediate-term gains in early 2012.

With respect to intermediate-term cycle analysis, the second Half Cycle High (HCH) of the cycle from early October is overdue, so it is unlikely that the S&P 500 index will be able to break out to sustainable new long-term highs until the initial rally phase of the next cycle.

The forthcoming correction will provide the next assessment of cyclical bull market health and we will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers.

Although real housing values are still trending lower, we are seeing bottoming behavior in the data trends that usually precede the development of a low in prices. The following graph from Calculated Risk displays the long-term views of single-family home starts, new home sales and residential investment.

Notice that all three trends have been consolidating at current levels for more than one year following the violent declines from 2007 to 2009. This behavior suggests that price is preparing to bottom as well, although it is important to note that the developing cyclical low will almost certainly be very different in character from all of the previous “normal” lows displayed on the graph above. Again, the last housing bubble was the largest, by far, in US history as shown on the following graph of real home prices from HousingStory.net.

Home values will not rebound in typical fashion during the forthcoming cyclical uptrend. Instead, they will likely move sideways as the market continues to integrate the massive oversupply introduced during the speculative frenzy of the bubble years. The healing process is underway, but it will take many years to repair the damage that was inflicted last decade.

However, during that time, the velocity of M1 money has plunged from a high of 10.37 in late 2007 to 7.09 in late 2011.

Essentially, velocity measures how fast money changes hands, providing a gauge of economic activity. In basic terms, when velocity declines sharply even as supply is being introduced at an unprecedented rate, the implication is that the added liquidity is not engendering economic activity. This is what “pushing on a string” looks like. As economist Paul Samuelson once observed:

You can lead a horse to water, but you cannot make him drink. You can force money into the system in exchange for government bonds, its close money substitute; but you cannot make the money circulate against new goods and services.

Accordingly, the M1 money multiplier has remained well below the 1.0 level during the last three years.

Again, the Federal Reserve can attempt to spur economic activity by introducing monetary stimuli, but they cannot force banks to increase their loan and investment activity. The velocity and multiplier data trends clearly demonstrate that the newly introduced M1 supply is simply remaining idle in places like bank reserves. Federal Reserve Chairman Bernanke understands the dilemma, but he would prefer to deal with any problem except deflation, so he has committed to flooding the system with liquidity for the foreseeable future and worrying about the consequences later. In fact, he has even admitted that his intention is to inflate risky asset prices. Recall that when the second quantitative easing program was introduced in late 2010, Bernanke stated in no uncertain terms that one of the primary goals of the program was to inflate the stock market. The following quote is from an article written by Bernanke and published in the Washington Post in November 2010.

Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. … And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

There is no question that the measures taken by the Federal Reserve during the last three years have fueled appreciation in the stock market, so, from that perspective, the programs have been a success. However, it must be noted that equity gains fueled primarily by government stimuli can be erased as quickly as they are created. The liquidity operations that have produced the huge spike in M1 since 2008 have created massive structural imbalances that will continue to drive violent moves both higher and lower as the system attempts to return to a state of equilibrium.

More importantly, there is absolutely no evidence to support the assertion that higher stock prices meaningfully support economic expansion. Historically, a 1.0 percent increase in the S&P 500 index has been accompanied by GDP growth of approximately 0.04 percent during the same year, 0.04 percent growth during the next year, and it has a negative correlation during subsequent years. However, for better or for worse, the Federal Reserve appears to be locked into this course of action for the foreseeable future. The recent announcement that interest rates would remain “excessively” low until at least 2014 suggests that Bernanke believes he has the tools and expertise required to prevent these unprecedented structural imbalances from engendering massive economic disruptions when they are purged from the system some years from now. Seeing as no central bank in history has been able to accomplish that feat, we have our doubts.

As expected, the new methodology had a meaningful impact on the trajectory of the LEI during the last four years. Notice the significantly increased magnitude of the decline during the recession in 2008. Additionally, the rebound accompanying the current economic “recovery” only managed to return to the peak in 2000. Finally, the revised index has struggled to advance during the past year and the uptrend is on the verge of turning lower. Overall, these benchmark revisions reflect the tepid nature of the recovery and suggest that the economy remains vulnerable.

There are no certainties in the financial markets, only possibilities and their associated probabilities. The key to long-term success as both an investor and a trader is to remain aligned with the likely scenarios while protecting yourself from the unlikely ones. The historically reliable leading data that we monitor continue to signal that a return to economic contraction is likely in 2012, so we will remain defensive until provided with compelling evidence to the contrary.

Additionally, the negative divergence between Treasury yields and stocks continues to signal caution. While the S&P 500 index is testing highs of the rally from October, the 10-year Treasury note yield is holding slightly above long-term lows. This divergence warns that the stock market is vulnerable to the development of an abrupt, severe correction.

With respect to cycle analysis, the move higher today nearly generated a cycle low signal, indicating that the Beta Low (BL) may have formed yesterday. A move up to new short-term highs during the next few sessions would confirm that the beta phase rally is underway and favor additional short-term strength.

From a big picture perspective, the environment of elevated long-term volatility that was initiated by the stock market crash in 2008 continues to drive violent moves in both directions. Every advance and decline since May 2008 has been extreme in character and the latest rebound off of the low in October 2011 is no exception.

The strong move higher in January has changed the character of the long-term breakdown that occurred in August 2011 when the S&P 500 index closed below support at the lower boundary of the cyclical bull market from 2009. Price behavior during the next two months will provide an important signal with respect to long-term direction, so it will be important to monitor the stock market closely. We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers.