A friend and client alerted me to an article in The Washington Post by Pulitizer-prize winning Steven Pearlstein, which cautions that we face another financial crisis in the short term.  As warning signs, he cites (1) corporate mergers & acquisitions are strong, almost all with borrrowed money, (2) private equity deals are closing at nine times cash flow, far above the traditional five times, (3) junk bonds are sell easily, too easily, (4) “dumb” money from dumb investors is rushing into equity funds, (5) analysts everywhere are too sanguine and glowing in reassurance, and (6) commercial real estate lenders are underwriting future rents instead of current rents.

All of these warning signs are the result of the continued cheap credit or easy money policies of Fed.  As we are at the end of the credit cycle, he recommends we sell everything and invest solely in cash!

While I agree with much that he said, there are some reservations.  For instance, I wish he had referenced Hyman Minsky, the great American economist, who studied why credit bubbles invariably expand until the point (called the Minsky Moment) when it collapses suddenly.  Deflating a credit bubble slowly is difficult but not impossible.  It just requires more discipline than we have seen from the Fed before.

While Pearlstein agrees that the innovative actions of the Fed were essential to “warding off another Great Depression,” he argues that the Fed is much too concerned about unemployment.  Continuous large increases to money supply will not help the long-term unemployed, so it must be time to start extricating the Fed from its dominant role in the economy, allowing the market to operate more normally.  I agree the Fed needs a smaller role but am less critical because the Fed is legally required to be equally concerned with unemployment and inflation.  This is known as the “dual mandate.”  To be fair, I think he should have given the Fed some credit for the tapering of quantitative easing.

He is silent on the Fed’s war against deflation, which is a much bigger problem than too much inflation.  It is easier to decrease inflation than to increase it.  The massive increase in money supply was designed as much to fight deflation as unemployment.  You cannot understand the Fed’s actions without understanding this.

I was curious about his concern that commercial real estate lenders were underwriting future rents instead of current rents.  This is not new nor unusual.  Lenders underwrite cash flow for the life of the loan, not today.

His advice to sell everything and invest in cash said nothing about gold, which is a more traditional hiding place.  There must be a reason he said nothing about it.

Don’t forget that it is impossible to prove a negative, i.e., that a financial crisis is not imminent.  While financial crisis are more rare than recessions, two have never appeared so closely together, which doesn’t mean it could not happen — it just hasn’t happened yet.

He closes with “We prefer the risk of lost opportunity to lost capital.”  Being invested in only cash right now risks losing future appreciation in stock values.

My problem with his advice is that it is a 100% bet — you are betting everything on one outcome.  I don’t think that is prudent.  Being prepared to act quickly is more important.  When you read of a derivatives collapse, it is time to raise some cash.  When you hear of a second derivatives collapse, it is time to sell everything but not until then.  Sure, you may lose a little money on the way down, but that is the cost of not making 100% bets.

If you’d like to read his excellent article, here is the link: