As reluctant as I am to admit this publicly, I was recently reading an old publication that was a collection of economics articles written at the time. In the preface to the book, written in 1971, the authors wrote the following:
"[G]iving the world capitalist system the prospect (though of course not the assurance) of two or three more decades of relative stability, would require the U.S. ruling class to moderate its ambitions and demands to a degree that it has so far shown no signs of being willing or able to do. A leadership that has consistently failed to understand what it was getting itself into in Indochina and which not only has not been able to extricate itself but even now is permitting the Nixon administration to plunge in deeper without the slightest prospect of achieving anything but more disaster - such a leadership can hardly be counted on to cooperate in finding viable solutions to the infinitely more complex problems which now face the world capitalist system."
And that's from 1971 - ouch! Now try this updated version (changes in italics):
"[G]iving the world capitalist system the prospect (though of course not the assurance) of two or three more decades of relative stability, would require the U.S. ruling class to moderate its easy money and deficit spending habits to a degree that it has so far shown no signs of being willing or able to do. A leadership that has consistently failed to understand what it was getting itself into in Afghanistan and which not only has not been able to extricate itself but even now is permitting the Obama administration to plunge in deeper without the slightest prospect of achieving anything but more disaster - such a leadership can hardly be counted on to cooperate in finding viable solutions to the infinitely more complex problems which now face the world capitalist system."
Double-ouch!
Wednesday, December 2, 2009
Sunday, November 29, 2009
Time to Play Contrarian?
I was writing my own piece on this topic for my next blog post, but Barron’s said it for me this week (from Barron's Daily Round-up, November 27, 2009):
"…unemployment officially is 10.2% and 17.5% when those who can't find full-time work or have stopped looking are counted. Meantime, despite the Fed's massive easing of monetary policy, credit continues to tighten, as its most recent survey of lending officers showed.
"But with liquidity shut off from the real economy, it has flowed into asset markets and into the so-called carry trade -- borrowing at the near-zero interest rate resulting from the Fed's federal-funds target of 0-0.25% to invest in anything else that provides a higher return. And with the dollar losing value steadily against foreign currencies, it has literally paid to borrow to invest in anything else, with the key exception of the Japanese yen. Since it became cheaper to borrow in dollars than yen, greenbacks have become the key funding currency for carry trades.
"The cracks have not been all papered over from the output from government printing presses in the U.S. and elsewhere. While that liquidity did stanch the bleeding that followed last year's crisis, it also helped levitate U.S. equity markets nearly 60% from their lows. And the riskier the asset, the greater the gains, from small-cap stocks to junk bonds to emerging markets.
"But those trillions have not cured the underlying debt deflation at the root of the economic crisis. In past cycles, the reliquefication by central banks could be counted on to pump-prime the economy. Borrowing and lending would resume after having been restrained by tight monetary policy, and a new cycle would start.
"After the bursting of the debt bubble, the process isn't working. It may have stoked a speculative binge in commodities, currencies and risky securities, but the real economy continues to labor.
"As it does, grandiose projects such as Dubai World collapse under the weight of their huge debts. Risk, previously suppressed successfully by policy actions, begins to increase.
"That, in turn, forces the curtailment of risk positions, from hedge funds to Wall Street proprietary trading desks. Hedging costs rise, forcing further reductions of positions in a vicious circle. As year-end approaches, the willingness to hold risk positions is reduced still further, exacerbating the process."
I could not have said it better myself. And combine all of that with the fact that many people expect capital gains tax rates to be higher in 2010 than in 2009, and you could see a lot of profit taking between now and year-end. That could make for an ugly December for the stock, corporate bond, and commodities markets, but probably means that Treasuries and the dollar will surprise on the upside (where else can the money go?). Of course, as I have said many times before, logic can tell us with some comfort level what will eventually happen, but predicting the timing of this or any other market movement is nearly impossible. Still, it looks prudent to trim risk-asset positions here, and it's tempting to take that money I was saving up for Vegas next month and bet on the dollar and Treasuries for the rest of the year...
"…unemployment officially is 10.2% and 17.5% when those who can't find full-time work or have stopped looking are counted. Meantime, despite the Fed's massive easing of monetary policy, credit continues to tighten, as its most recent survey of lending officers showed.
"But with liquidity shut off from the real economy, it has flowed into asset markets and into the so-called carry trade -- borrowing at the near-zero interest rate resulting from the Fed's federal-funds target of 0-0.25% to invest in anything else that provides a higher return. And with the dollar losing value steadily against foreign currencies, it has literally paid to borrow to invest in anything else, with the key exception of the Japanese yen. Since it became cheaper to borrow in dollars than yen, greenbacks have become the key funding currency for carry trades.
"The cracks have not been all papered over from the output from government printing presses in the U.S. and elsewhere. While that liquidity did stanch the bleeding that followed last year's crisis, it also helped levitate U.S. equity markets nearly 60% from their lows. And the riskier the asset, the greater the gains, from small-cap stocks to junk bonds to emerging markets.
"But those trillions have not cured the underlying debt deflation at the root of the economic crisis. In past cycles, the reliquefication by central banks could be counted on to pump-prime the economy. Borrowing and lending would resume after having been restrained by tight monetary policy, and a new cycle would start.
"After the bursting of the debt bubble, the process isn't working. It may have stoked a speculative binge in commodities, currencies and risky securities, but the real economy continues to labor.
"As it does, grandiose projects such as Dubai World collapse under the weight of their huge debts. Risk, previously suppressed successfully by policy actions, begins to increase.
"That, in turn, forces the curtailment of risk positions, from hedge funds to Wall Street proprietary trading desks. Hedging costs rise, forcing further reductions of positions in a vicious circle. As year-end approaches, the willingness to hold risk positions is reduced still further, exacerbating the process."
I could not have said it better myself. And combine all of that with the fact that many people expect capital gains tax rates to be higher in 2010 than in 2009, and you could see a lot of profit taking between now and year-end. That could make for an ugly December for the stock, corporate bond, and commodities markets, but probably means that Treasuries and the dollar will surprise on the upside (where else can the money go?). Of course, as I have said many times before, logic can tell us with some comfort level what will eventually happen, but predicting the timing of this or any other market movement is nearly impossible. Still, it looks prudent to trim risk-asset positions here, and it's tempting to take that money I was saving up for Vegas next month and bet on the dollar and Treasuries for the rest of the year...
Wednesday, November 18, 2009
20-20
Hindsight’s a bitch. I was cleaning out my (overcrowded) Outlook folders and came across an old email from my friend Jayson at 10:53 p.m. on March 10, 2009. In hindsight, we now know that the prior day’s close of 676.53 for the S&P500 on March 9 turned out to be the nadir of the bear market. The next day (the 10th) the S&P jumped over 6% on good news from Citibank, and Jayson’s email to me that night said “So is the bull back?” In all of my infinite wisdom, I responded to him with the following (this will prove once and for all that I am not doing this blog to impress anyone with my market-timing skills):
Is the bear dead? Maybe – at the very least the market had gotten insanely oversold and needed a bounce. In the bigger picture:
BULLISH: Copper prices have turned up noticeably over the past seven days. It is not a big move yet, but if it continues that is very bullish. Note that copper prices turned up a week before yesterday’s stock market bump.
BEARISH: Economic news is still 100% bad (e.g. UTX news, WSJ p. B1). I do not count C’s announcement yesterday of operating profit in February as good economic news. They borrow from the fed at about 0% and lend at much greater than 0%. A monkey can make an operating profit in those conditions – they will still show a loss this quarter after marks and reserves. The fact that the market moved up so big on this silly news just shows how oversold the market was. Also bearish last week was increasing LIBOR and widening spreads in the debt markets.
BOTTOM LINE: It doesn’t feel over to me. It is hard for me to believe that such a ridiculous piece of “news” as Vikram Pandit’s remarks at Citi marked the end of the bear market. On the other hand, copper has been a very good indicator of market bottoms in the past, and if it keeps moving up then I will have to concede that the bear is probably dead. Also, if auto sales stabilize or turn up in March then that would also be very bullish (note they will report a huge drop vs. prior year’s March – the key is what happens to the seasonally adjusted annualized run-rate in March 09 vs. Feb. 09). Also watch for any other glimmers of economic good news.
So what have I learned from this? Two things: First, I should not have doubted copper. As I discussed below in my post “Anatomy of the Bear” on March 4, copper prices turning up marked the bottom of all four great bear markets of the 20th century, and so far it is one-for-one in the 21st century (and I’ll give Jayson credit for being one-for-one for at least asking the question at the right time). Second, and perhaps more important, this is yet another reminder of knowing what we don’t know. Bear market bottoms occur when everyone is sure it has farther to go. It is worth remembering that the same applies to bull market tops.
Is the bear dead? Maybe – at the very least the market had gotten insanely oversold and needed a bounce. In the bigger picture:
BULLISH: Copper prices have turned up noticeably over the past seven days. It is not a big move yet, but if it continues that is very bullish. Note that copper prices turned up a week before yesterday’s stock market bump.
BEARISH: Economic news is still 100% bad (e.g. UTX news, WSJ p. B1). I do not count C’s announcement yesterday of operating profit in February as good economic news. They borrow from the fed at about 0% and lend at much greater than 0%. A monkey can make an operating profit in those conditions – they will still show a loss this quarter after marks and reserves. The fact that the market moved up so big on this silly news just shows how oversold the market was. Also bearish last week was increasing LIBOR and widening spreads in the debt markets.
BOTTOM LINE: It doesn’t feel over to me. It is hard for me to believe that such a ridiculous piece of “news” as Vikram Pandit’s remarks at Citi marked the end of the bear market. On the other hand, copper has been a very good indicator of market bottoms in the past, and if it keeps moving up then I will have to concede that the bear is probably dead. Also, if auto sales stabilize or turn up in March then that would also be very bullish (note they will report a huge drop vs. prior year’s March – the key is what happens to the seasonally adjusted annualized run-rate in March 09 vs. Feb. 09). Also watch for any other glimmers of economic good news.
So what have I learned from this? Two things: First, I should not have doubted copper. As I discussed below in my post “Anatomy of the Bear” on March 4, copper prices turning up marked the bottom of all four great bear markets of the 20th century, and so far it is one-for-one in the 21st century (and I’ll give Jayson credit for being one-for-one for at least asking the question at the right time). Second, and perhaps more important, this is yet another reminder of knowing what we don’t know. Bear market bottoms occur when everyone is sure it has farther to go. It is worth remembering that the same applies to bull market tops.
Thursday, November 5, 2009
Easy Money
Earlier this week, after hearing and reading a variety of pundits opine about when the Fed will raise rates, I wrote a draft of a piece that remarked that (IMHO) long before the Fed decides to raise the much-watched and oft-discussed Fed Funds Rate they will likely begin shrinking their balance sheet, which exploded last fall from $900 billion or so (which had been remarkably steady for many many months) to over $2.2 trillion in a matter of two months. While I still think that will be the case, the Fed’s statement yesterday makes it very clear that the Fed has no intention of doing any of this any time soon. They plan to keep buying securities (mainly debt securities such as Agency bonds) and keep interest rates low, low, low.
Also yesterday there was an article in the WSJ titled “Fears of a New Bubble as Cash Pours In.” The title pretty much tells it all, but here is one example: “Asian stock prices are shooting up, in part due to low interest rates in the U.S. Investors looking for higher yields are borrowing in U.S. dollars and then pouring that money ‘into countries that are growing more rapidly,’ said Stephen Cecchetti, chief economist at the Bank for International Settlements, the central banks' central bank, which warned early of the last asset bubble and is beginning to do so again.”
Judging from both the WSJ article and the Fed’s policy statement it appears that policy makers can’t connect these dots, so I will state the obvious. Since the mid-1990’s, central banks around the world (led by our own Federal Reserve) have followed the decades-old dogma that as long as inflation is subdued they can keep interest rates very low to drive economic growth. The problem is that they look at CPI and PPI as the only measures of inflation. Modern economic theory was developed during a time when excess liquidity flowed into the hands of producers and consumers who bought intermediate and consumer goods with the excess money and drove up prices, creating inflation in the PPI and CPI. When the central banks saw this inflation, they knew it was time to tighten monetary policy. But it doesn’t work that way any more.
Since the mid-1990’s, the excess liquidity still flowed into the hands of producers and consumers, but they no longer used it to buy products as measured in the PPI and the CPI. Instead, they invested in assets – stocks (late 90’s), real estate (early-mid 2000’s), oil and gas (mid-late 2000’s), treasury bonds (last year), or gold (now) – or they just leave cash on the corporate balance sheet. Part of the switch from products to assets has been due to the baby boomers planning for their upcoming retirement, while part has been due to competition from low-cost foreign producers (China) keeping product prices so low that it both prohibits domestic producers from raising prices and also disincents them from making more products. As a result, there has been massive investment in and inflation of assets, but the Fed doesn’t consider that “inflation” because the CPI and PPI only reflect product inflation, not asset inflation. Therefore, the Fed and the other central banks around the world will continue to keep rates low and monetary policy loose for the foreseeable future.
But eventually that will change, and one of two things will happen. One possibility is that the Fed and other central banks wise-up at some point and tighten monetary policy. This would likely deflate all sorts of bubbles, from gold to Asian real estate, and would also adversely affect less “bubbly” assets like stocks and domestic real estate. In the long run this would be healthy, because it would finally ring the excess leverage out of the system (that almost happened a year ago, but the Fed was so effective at reflating that it never really happened).
The other possibility is that the Fed continues to let excess liquidity feed these various asset bubbles. Many people predict that this will lead to horrible inflation, and that is probably true for a while at least, but asset bubbles typically eventually end differently. Usually they end by deflating quickly and violently in a somewhat deflationary manner. Perhaps the bond market will (finally) start demanding higher yields, forcing interest rates up in spite of the Fed’s free-money policy, or perhaps some other event will have the effect of yelling “fire” in the crowded theater. But I would expect that one way or another, after perhaps a period of bad inflation, we will still end up (eventually) back with a deflationary contraction that sends almost all asset prices downward.
This makes for an incredibly difficult investment environment. On the one hand, we could see another “bust” next year, while on the other we could have an inflationary easy-money party for many years before the bust. When the inevitable deflationary contraction finally comes then the clear winner for investment portfolios will be Treasuries, but if you buy them today you risk getting killed by several years of easy-money inflation that erodes their value. If instead you plan for inflation by buying risk assets set to capitalize on easy money, then that will backfire badly if the Fed wakes up and tightens any time soon. And if you are looking to me (or anyone else) for the magic answer then you will be disappointed. As I have said before, the best we can do is to know that we don’t know, which in this case means try and plan for both.
Also yesterday there was an article in the WSJ titled “Fears of a New Bubble as Cash Pours In.” The title pretty much tells it all, but here is one example: “Asian stock prices are shooting up, in part due to low interest rates in the U.S. Investors looking for higher yields are borrowing in U.S. dollars and then pouring that money ‘into countries that are growing more rapidly,’ said Stephen Cecchetti, chief economist at the Bank for International Settlements, the central banks' central bank, which warned early of the last asset bubble and is beginning to do so again.”
Judging from both the WSJ article and the Fed’s policy statement it appears that policy makers can’t connect these dots, so I will state the obvious. Since the mid-1990’s, central banks around the world (led by our own Federal Reserve) have followed the decades-old dogma that as long as inflation is subdued they can keep interest rates very low to drive economic growth. The problem is that they look at CPI and PPI as the only measures of inflation. Modern economic theory was developed during a time when excess liquidity flowed into the hands of producers and consumers who bought intermediate and consumer goods with the excess money and drove up prices, creating inflation in the PPI and CPI. When the central banks saw this inflation, they knew it was time to tighten monetary policy. But it doesn’t work that way any more.
Since the mid-1990’s, the excess liquidity still flowed into the hands of producers and consumers, but they no longer used it to buy products as measured in the PPI and the CPI. Instead, they invested in assets – stocks (late 90’s), real estate (early-mid 2000’s), oil and gas (mid-late 2000’s), treasury bonds (last year), or gold (now) – or they just leave cash on the corporate balance sheet. Part of the switch from products to assets has been due to the baby boomers planning for their upcoming retirement, while part has been due to competition from low-cost foreign producers (China) keeping product prices so low that it both prohibits domestic producers from raising prices and also disincents them from making more products. As a result, there has been massive investment in and inflation of assets, but the Fed doesn’t consider that “inflation” because the CPI and PPI only reflect product inflation, not asset inflation. Therefore, the Fed and the other central banks around the world will continue to keep rates low and monetary policy loose for the foreseeable future.
But eventually that will change, and one of two things will happen. One possibility is that the Fed and other central banks wise-up at some point and tighten monetary policy. This would likely deflate all sorts of bubbles, from gold to Asian real estate, and would also adversely affect less “bubbly” assets like stocks and domestic real estate. In the long run this would be healthy, because it would finally ring the excess leverage out of the system (that almost happened a year ago, but the Fed was so effective at reflating that it never really happened).
The other possibility is that the Fed continues to let excess liquidity feed these various asset bubbles. Many people predict that this will lead to horrible inflation, and that is probably true for a while at least, but asset bubbles typically eventually end differently. Usually they end by deflating quickly and violently in a somewhat deflationary manner. Perhaps the bond market will (finally) start demanding higher yields, forcing interest rates up in spite of the Fed’s free-money policy, or perhaps some other event will have the effect of yelling “fire” in the crowded theater. But I would expect that one way or another, after perhaps a period of bad inflation, we will still end up (eventually) back with a deflationary contraction that sends almost all asset prices downward.
This makes for an incredibly difficult investment environment. On the one hand, we could see another “bust” next year, while on the other we could have an inflationary easy-money party for many years before the bust. When the inevitable deflationary contraction finally comes then the clear winner for investment portfolios will be Treasuries, but if you buy them today you risk getting killed by several years of easy-money inflation that erodes their value. If instead you plan for inflation by buying risk assets set to capitalize on easy money, then that will backfire badly if the Fed wakes up and tightens any time soon. And if you are looking to me (or anyone else) for the magic answer then you will be disappointed. As I have said before, the best we can do is to know that we don’t know, which in this case means try and plan for both.
Monday, October 26, 2009
Knowing What We Know
Regardless of the claims made by the multitude of pundits and prognosticators on CNBC and elsewhere, no one knows what the stock market will do tomorrow, or next week, or next month (unless they have inside information, which seems to be disturbingly common judging by the headlines lately). The best an honest investor can do is to know that he doesn’t know.
What we do know, however, is that in the long term the market can not go crazy in one direction forever. If the economy grows an average of 4% every year, then the stock market can not forever grow at 8%, nor will it forever grow at 1%. It can do either of those things for years at a time, but as it does it gets more and more disconnected from economic reality. You might say that the market is tethered to the economy with a rubber band – it can stretch the rubber band in either direction for a while, but eventually it snaps back (and usually overshoots in the other direction).
Similarly, the economy itself has, for a very long time, trended to a fairly steady growth curve. It also gets stretched above or below this trend growth for years at a time, but (so far at least) it has consistently reverted to the trend line, again as if tethered by a rubber band.
Some very smart guys at an outfit called Crestmont Research have done a lot of work on this. They have calculated a trend line for S&P500 earnings that has proved to be extremely robust over time. In fact, the trend line in 1975 predicted that 2013 trend earnings would be $79.59, and now with 24 more years of data the trend line is basically unchanged, trending to 2013 earnings of $80.01. You can get all the details at http://www.crestmontresearch.com/pdfs/Financial%20Physics%20Presentation.pdf.
This research also looks at average P/E’s for the market, and finds that when the pricing environment is benign (i.e. there is neither severe inflation nor deflation) then market P/E’s have historically averaged approximately 16x. (Deflation or severe inflation both drive average P/E’s meaningfully lower.) A 16x P/E multiple implies a return of about 6% (1/16) for stocks, which seems reasonable when inflation is low and under control.
We can utilize this knowledge of these trends to craft a successful investment strategy. We can have some comfort level that when inflation is contained then over time the S&P500 will tend to revert back to a price level of around 16X trend earnings. When the S&P500 falls significantly below that, it is a long term buying opportunity, and when it rises significantly above that level it is likely a good time to sell. Of course this does not guarantee stocks will go up after you buy them, since the rubber band could stretch even further to the downside, but over time this approach should outperform the market’s trend line.
So where are we today? Trend S&P500 earnings for 2009 are about $65, and around $68 for 2010. A 16x multiple of these earnings implies an S&P 500 price range of 1040 to 1090. Friday’s closing level was a hair under 1080, so for the long run at least stocks appear to be fairly valued. My gut is that in the short-term the rally will extend upward for a while longer, but every time I think something like that I have to remind myself that in the short run, the best an honest investor can do is to know that he doesn’t know.
What we do know, however, is that in the long term the market can not go crazy in one direction forever. If the economy grows an average of 4% every year, then the stock market can not forever grow at 8%, nor will it forever grow at 1%. It can do either of those things for years at a time, but as it does it gets more and more disconnected from economic reality. You might say that the market is tethered to the economy with a rubber band – it can stretch the rubber band in either direction for a while, but eventually it snaps back (and usually overshoots in the other direction).
Similarly, the economy itself has, for a very long time, trended to a fairly steady growth curve. It also gets stretched above or below this trend growth for years at a time, but (so far at least) it has consistently reverted to the trend line, again as if tethered by a rubber band.
Some very smart guys at an outfit called Crestmont Research have done a lot of work on this. They have calculated a trend line for S&P500 earnings that has proved to be extremely robust over time. In fact, the trend line in 1975 predicted that 2013 trend earnings would be $79.59, and now with 24 more years of data the trend line is basically unchanged, trending to 2013 earnings of $80.01. You can get all the details at http://www.crestmontresearch.com/pdfs/Financial%20Physics%20Presentation.pdf.
This research also looks at average P/E’s for the market, and finds that when the pricing environment is benign (i.e. there is neither severe inflation nor deflation) then market P/E’s have historically averaged approximately 16x. (Deflation or severe inflation both drive average P/E’s meaningfully lower.) A 16x P/E multiple implies a return of about 6% (1/16) for stocks, which seems reasonable when inflation is low and under control.
We can utilize this knowledge of these trends to craft a successful investment strategy. We can have some comfort level that when inflation is contained then over time the S&P500 will tend to revert back to a price level of around 16X trend earnings. When the S&P500 falls significantly below that, it is a long term buying opportunity, and when it rises significantly above that level it is likely a good time to sell. Of course this does not guarantee stocks will go up after you buy them, since the rubber band could stretch even further to the downside, but over time this approach should outperform the market’s trend line.
So where are we today? Trend S&P500 earnings for 2009 are about $65, and around $68 for 2010. A 16x multiple of these earnings implies an S&P 500 price range of 1040 to 1090. Friday’s closing level was a hair under 1080, so for the long run at least stocks appear to be fairly valued. My gut is that in the short-term the rally will extend upward for a while longer, but every time I think something like that I have to remind myself that in the short run, the best an honest investor can do is to know that he doesn’t know.
Monday, October 19, 2009
Forget all the screaming about socialism. Have we fixed anything?
My good friend Jayson Bales' most recent investing newsletter really got my attention because he used (brace yourself)… the S word! That’s right, SOCIALISM! It reminds me of that musical where the musical instrument salesman warns the town they’ve “got trouble, right here in River City!” (Jayson and many of you are probably too young to get that reference.) “Socialism” is a very polarizing word that is getting thrown around a lot these days. No one in the U.S .says they support socialism, and yet millions of people are passionately fighting to stop it from becoming our new system of government. While the whole ideological debate may be interesting (if you can call the screaming matches a “debate”), as a practical investor it doesn’t do me much good. I want to know what it all means for my portfolio, now and in the future. (WARNING: Even though I have put most of the really hard core academic and economic materials in a longer and more technical Appendix at the end – which I expect most people will skip – I am going to make you suffer through one slightly academic and boring paragraph here at the start. Trust me, it’s not that bad and it will be worth it. Here goes…)
Broadly speaking, every boom and bust is caused by the same factors, both economic and human, and our recent boom and bust was no different. On the economics side, all through the boom monetary policy was very loose (the Fed kept interest rates very low for a very long time) and fiscal policy was very stimulative (massive deficit spending). These factors fueled the boom to absurd and unsustainable levels. On the human side, the optimism fed on itself as rampant speculation and excessive leverage by both individuals and corporations became the order of the day. History shows us that not only will the free market eventually correct this situation on its own, but left alone it will brutally overcorrect. As was seen in the Great Depression (and many other lesser known busts in the 1800’s and early 1900’s), without government intervention the money supply plummets and government spending shrinks (if limited by tax revenues) which feeds on itself on the way down just as the bubble did on the way up. Investors lost their life savings held everywhere, even in banks, and the economy sharply contracted. The Depression lasted a decade with unemployment of 25%, shantytowns in every city, and soup kitchen lines stretching for blocks.
So call me a socialist (I dare ya! Besides, I think I look in good in a beret) but I can’t fault the government this time around for saying we couldn’t let that happen again. They saved the banking system at all costs, the Fed printed huge sums of money and we have instituted massive government spending. We can talk about whether each of these actions has been good or bad for America, but as an investor it is hard to argue with a 50%+ rebound in the stock market. And unemployment of 10% doesn’t seem that bad compared to 25%. Clearly it wasn’t perfect, but doing nothing would have been a disaster for our investment portfolios and the economy.
But now, as an investor, I am worried. Because the same conditions that led to the “roaring ‘20’s” and the Great Depression, and that led to our recent boom and bust, are still in place. The whole debate now raging about whether the government is doing too much (we’re all becoming socialists!) is dangerous because it risks distracting our elected officials from some really important things that need to be addressed. The reality is we don’t need the government to do more, and we don’t need them to do less, we need them to do some different things (quality, not quantity).
Unlike today (so far at least), in the 1930’s meaningful changes were made to the conditions that caused the whole mess. It was unnecessarily painful and harsh and awful, but the severe contraction of the money supply and the failure of the banking system forced individuals and companies to eliminate their excessive leverage and speculation. And the length and severity of the Depression burned this lesson into people’s consciousness. Those who survived the Great Depression NEVER forgot. But just in case they might forget, the government went several steps further and in the 1930’s passed a variety of regulatory reforms to prevent the recurrence of such financial speculation and leverage (and even outright fraud). Basically, in the 1930’s the government did little to alleviate their then-current pain and suffering, but focused a lot of effort on how to prevent a recurrence of it in the future.
Compare that to our current situation, which is the exact opposite – we fixed the short term pain but have done nothing to prevent its recurrence. To lessen the short term pain, we did not allow the money supply to contract, government spending increased, and the banking system was rescued. Those were all good things (at least for the short run), but as a result no one has learned any permanent life lessons. Give the stock market another big up year in 2010 and we’ll all be partying again like it was, well… 1999! (or 2006). This makes it even more troubling that the government has put nothing in place to address the CAUSES of the boom and bust. So far we have gone for the quick and easy pain relief without addressing the root causes (so surprising in a country where liposuction and stomach bands are more popular than healthy eating and exercise).
The implications for an investor are clear. If the government does not take action to address the conditions that caused the boom and bust (conditions that still exist today – loose money, deficit spending, and ineffective to nonexistent regulation of financial firms, financial products, and financial markets) we will have another bust, and the next one will be worse (more like the 1930’s). If the government can gradually tighten the money supply and cut back on spending as the economy strengthens, and also reinstate and update the regulatory reforms made in the 1930’s (Congress actually repealed many of these in the last decade) then the markets will be a safer place, and we may be able to have a sustained period of very slow economic growth. The astute investor will watch the news closely, ignore all the ranting about socialism, and see what, if anything, the government does to prevent the next crash. Anyone who is really hard core can read the appendix below to see what, specifically, to watch for.
APPENDIX (for the truly hard core investor or economics buff):
This appendix lists the specific steps the government needs to take to address the causes of the boom and bust and prevent its recurrence. Watch for them in the news. If most of them happen we can all start sleeping better. If not, then vigilance is the watch word as we embark on another boom and bust cycle, and this time the bust will be even worse.
1. As the economy strengthens, the Federal Reserve needs to begin tightening the money supply.
The Fed must do this quickly enough (to avoid fueling another boom that will lead to another bust), but not too quickly (to avoid sending us back into another recession before we really get out of this one). This is as much about the Fed shrinking its balance sheet as it is about higher interest rates – both will be required. This will be a tough needle to thread, but Ben Bernanke understands what must be done. I am reasonably confident he will pull it off.
2. As the economy strengthens, the Federal Government needs to begin reducing deficit spending.
Just as the Fed must do with monetary policy, the Federal Government must do with fiscal policy, reigning in deficit spending quickly enough to prevent the next boom and bust, but not so quickly as to squash the current recovery. Sadly, neither Democrats nor Republicans have much of a record for reducing government spending over the last couple of decades, so success here seems more difficult.
3. Congress needs to reinstate and update the regulatory reforms made in the 1930’s.
The Securities Act of 1933, The Banking (Glass-Steagall) Act of 1933, and The Securities Exchange Act of 1934 were designed to ensure that there would never be another Great Crash and Depression. These reforms worked for many decades, but in the past decade some important provisions were repealed by Congress. Of the reforms that remain, new technologies and clever traders have enabled financial firms to legally circumvent most of them. Congress’ success in fixing this could go either way, since the changes below would be popular among individual investors and the population as a whole, but most would be vehemently opposed by the big financial institutions and other entrenched interests. If the Fed gets step #1 (above) right, and the Congress fails on #2 (above), then the implementation of the changes and reforms listed below could be the deciding factor that determines whether we manage a period of relative safety for investors, or we face another boom and bust that makes the pain and suffering of 2008-2009 pale by comparison. Here is what to look for:
a. Reinstate the Uptick Rule: Enacted in 1938, repealed by Congress in 2007, this rule prevented speculators from driving stocks of sound companies down to such absurdly low levels that it caused their lenders to panic, which can lead to bankruptcy for the company.
b. Prevent Financial Institutions from Getting “Too Big to Fail”: In 1933 the Glass-Steagall Act enacted a prohibition on banks owning Wall Street brokerage and trading firms that was quite effective… until Congress repealed it in 1999. There are many different ways to accomplish this, but one way or another we need to prevent financial institutions from getting so large that they can bring down the whole system.
c. Regulate Hedge Funds: The Securities Act of 1933 contained a variety of registration and disclosure requirements designed to prevent the “blind pools” and shady operators that were doing serious damage to the markets and to real companies. But by the start of this decade hedge funds and some companies (some legitimate, some just plain frauds) had figured out how to exploit certain exemptions (some might say loop holes) in these regulations. They need to be re-tightened, and any remaining exemptions based on dollar thresholds should be indexed to inflation so they don’t become obsolete over time. At a bare minimum, far more disclosure should be required from hedge funds and financial and operating companies that act like hedge funds.
d. Regulate or Prohibit Dark Pools, Naked Access and High-Speed Trading: Without going into all of the complicated details, these are new ways in which the big boys (or more accurately, the big boys’ computers) trade massive amounts of stock in a matter of milliseconds based on information and market access that is not available to the general public. These practices, currently completely legal and unregulated, are not only dangerous but are just plain unfair.
e. Implement Meaningful Margin Requirements for Derivatives: Margin requirements for stocks were as low as 10% in the 1920’s, and that was a major contributor to the problems, but since the 1930’s they have generally been set at 50% or greater. The problem is that in the 1990’s and 2000’s, trading technologies and clever traders developed a variety of new products that let you play the market with low (<10%) or even no margin requirements. Products like Credit Default Swaps and other derivatives let investors bet against a company for pennies on the dollar. These new products need meaningful margin requirements, just like stocks.
f. Increase Margin Requirements on Leveraged ETF’s or Prohibit Them Completely: ETF’s have become popular enough to move the entire market, but an ETF with three-to-one leverage and the current 50% margin requirement effectively allows investors to bet on $6 of stock for every $1 invested.
g. Put Some Teeth in the Prohibition on Naked Shorting: Normally, when you sell a stock short (sell a stock you don’t own) you must actually borrow it from someone who owns it before you can sell it. To borrow it, you need collateral (cash or securities worth at least 50% of the value of the securities you are borrowing). But big players often sell short (again, often computers do the dirty work, not humans) and then cover (re-buy the stock) in massive amounts and over very short time frames. As a result, they never have to actually show that they borrowed the stock before they sold it, because they re-buy it so quickly. This allows them to make massive short-term bets against a stock without putting any hard cash on the line up front. While in theory this practice is prohibited, this prohibition currently lacks meaningful teeth and enforcement.
h. Increase Financial Institutions Capital Requirements: Perhaps the most obvious lesson of the last boom was that banks and other financial institutions did not have nearly enough capital (basically equity) to survive the write-downs they were required to take when asset prices collapsed, hence the need for so many government bailouts. One of the simplest and most obvious reforms needed (and the one fought most vehemently by the big banks) is to increase the capital requirements so that next time, things can go a farther south without blowing up the entire financial sector.
i. Increase Deposit Insurance Levels: Because they aren’t indexed to inflation, the limits on FDIC-insured bank accounts have become so low that they no longer effectively prevent runs on the bank, as was the original intent back in 1933. Increased bank capital requirements would offset the liability increase to the government from doing this.
j. Stiffen Regulation and Disclosure Requirements for Consumer Credit and Residential Mortgages: No discussion of how to fix this would be complete without addressing the absurd levels of leverage that individuals incurred through mortgages, home equity loans, and credit card debt. First, disclosure requirements on all forms of consumer debt should be increased so that no one, no matter how uneducated, can ever claim that they signed up for a loan that turned out to be completely different than they expected. Every lender should be required to provide easy-to-read disclosures in big print saying “Here are all the fees we can charge you” and “Here is how much and how quickly your interest rate and payments can change,” and every borrower would have to read and sign those disclosures before they get the loan. Furthermore, some practices are just so toxic that perhaps they should be banned altogether, such as loan-to-value ratios of 110% on mortgages or absurdly low “teaser” rates of interest.
Broadly speaking, every boom and bust is caused by the same factors, both economic and human, and our recent boom and bust was no different. On the economics side, all through the boom monetary policy was very loose (the Fed kept interest rates very low for a very long time) and fiscal policy was very stimulative (massive deficit spending). These factors fueled the boom to absurd and unsustainable levels. On the human side, the optimism fed on itself as rampant speculation and excessive leverage by both individuals and corporations became the order of the day. History shows us that not only will the free market eventually correct this situation on its own, but left alone it will brutally overcorrect. As was seen in the Great Depression (and many other lesser known busts in the 1800’s and early 1900’s), without government intervention the money supply plummets and government spending shrinks (if limited by tax revenues) which feeds on itself on the way down just as the bubble did on the way up. Investors lost their life savings held everywhere, even in banks, and the economy sharply contracted. The Depression lasted a decade with unemployment of 25%, shantytowns in every city, and soup kitchen lines stretching for blocks.
So call me a socialist (I dare ya! Besides, I think I look in good in a beret) but I can’t fault the government this time around for saying we couldn’t let that happen again. They saved the banking system at all costs, the Fed printed huge sums of money and we have instituted massive government spending. We can talk about whether each of these actions has been good or bad for America, but as an investor it is hard to argue with a 50%+ rebound in the stock market. And unemployment of 10% doesn’t seem that bad compared to 25%. Clearly it wasn’t perfect, but doing nothing would have been a disaster for our investment portfolios and the economy.
But now, as an investor, I am worried. Because the same conditions that led to the “roaring ‘20’s” and the Great Depression, and that led to our recent boom and bust, are still in place. The whole debate now raging about whether the government is doing too much (we’re all becoming socialists!) is dangerous because it risks distracting our elected officials from some really important things that need to be addressed. The reality is we don’t need the government to do more, and we don’t need them to do less, we need them to do some different things (quality, not quantity).
Unlike today (so far at least), in the 1930’s meaningful changes were made to the conditions that caused the whole mess. It was unnecessarily painful and harsh and awful, but the severe contraction of the money supply and the failure of the banking system forced individuals and companies to eliminate their excessive leverage and speculation. And the length and severity of the Depression burned this lesson into people’s consciousness. Those who survived the Great Depression NEVER forgot. But just in case they might forget, the government went several steps further and in the 1930’s passed a variety of regulatory reforms to prevent the recurrence of such financial speculation and leverage (and even outright fraud). Basically, in the 1930’s the government did little to alleviate their then-current pain and suffering, but focused a lot of effort on how to prevent a recurrence of it in the future.
Compare that to our current situation, which is the exact opposite – we fixed the short term pain but have done nothing to prevent its recurrence. To lessen the short term pain, we did not allow the money supply to contract, government spending increased, and the banking system was rescued. Those were all good things (at least for the short run), but as a result no one has learned any permanent life lessons. Give the stock market another big up year in 2010 and we’ll all be partying again like it was, well… 1999! (or 2006). This makes it even more troubling that the government has put nothing in place to address the CAUSES of the boom and bust. So far we have gone for the quick and easy pain relief without addressing the root causes (so surprising in a country where liposuction and stomach bands are more popular than healthy eating and exercise).
The implications for an investor are clear. If the government does not take action to address the conditions that caused the boom and bust (conditions that still exist today – loose money, deficit spending, and ineffective to nonexistent regulation of financial firms, financial products, and financial markets) we will have another bust, and the next one will be worse (more like the 1930’s). If the government can gradually tighten the money supply and cut back on spending as the economy strengthens, and also reinstate and update the regulatory reforms made in the 1930’s (Congress actually repealed many of these in the last decade) then the markets will be a safer place, and we may be able to have a sustained period of very slow economic growth. The astute investor will watch the news closely, ignore all the ranting about socialism, and see what, if anything, the government does to prevent the next crash. Anyone who is really hard core can read the appendix below to see what, specifically, to watch for.
APPENDIX (for the truly hard core investor or economics buff):
This appendix lists the specific steps the government needs to take to address the causes of the boom and bust and prevent its recurrence. Watch for them in the news. If most of them happen we can all start sleeping better. If not, then vigilance is the watch word as we embark on another boom and bust cycle, and this time the bust will be even worse.
1. As the economy strengthens, the Federal Reserve needs to begin tightening the money supply.
The Fed must do this quickly enough (to avoid fueling another boom that will lead to another bust), but not too quickly (to avoid sending us back into another recession before we really get out of this one). This is as much about the Fed shrinking its balance sheet as it is about higher interest rates – both will be required. This will be a tough needle to thread, but Ben Bernanke understands what must be done. I am reasonably confident he will pull it off.
2. As the economy strengthens, the Federal Government needs to begin reducing deficit spending.
Just as the Fed must do with monetary policy, the Federal Government must do with fiscal policy, reigning in deficit spending quickly enough to prevent the next boom and bust, but not so quickly as to squash the current recovery. Sadly, neither Democrats nor Republicans have much of a record for reducing government spending over the last couple of decades, so success here seems more difficult.
3. Congress needs to reinstate and update the regulatory reforms made in the 1930’s.
The Securities Act of 1933, The Banking (Glass-Steagall) Act of 1933, and The Securities Exchange Act of 1934 were designed to ensure that there would never be another Great Crash and Depression. These reforms worked for many decades, but in the past decade some important provisions were repealed by Congress. Of the reforms that remain, new technologies and clever traders have enabled financial firms to legally circumvent most of them. Congress’ success in fixing this could go either way, since the changes below would be popular among individual investors and the population as a whole, but most would be vehemently opposed by the big financial institutions and other entrenched interests. If the Fed gets step #1 (above) right, and the Congress fails on #2 (above), then the implementation of the changes and reforms listed below could be the deciding factor that determines whether we manage a period of relative safety for investors, or we face another boom and bust that makes the pain and suffering of 2008-2009 pale by comparison. Here is what to look for:
a. Reinstate the Uptick Rule: Enacted in 1938, repealed by Congress in 2007, this rule prevented speculators from driving stocks of sound companies down to such absurdly low levels that it caused their lenders to panic, which can lead to bankruptcy for the company.
b. Prevent Financial Institutions from Getting “Too Big to Fail”: In 1933 the Glass-Steagall Act enacted a prohibition on banks owning Wall Street brokerage and trading firms that was quite effective… until Congress repealed it in 1999. There are many different ways to accomplish this, but one way or another we need to prevent financial institutions from getting so large that they can bring down the whole system.
c. Regulate Hedge Funds: The Securities Act of 1933 contained a variety of registration and disclosure requirements designed to prevent the “blind pools” and shady operators that were doing serious damage to the markets and to real companies. But by the start of this decade hedge funds and some companies (some legitimate, some just plain frauds) had figured out how to exploit certain exemptions (some might say loop holes) in these regulations. They need to be re-tightened, and any remaining exemptions based on dollar thresholds should be indexed to inflation so they don’t become obsolete over time. At a bare minimum, far more disclosure should be required from hedge funds and financial and operating companies that act like hedge funds.
d. Regulate or Prohibit Dark Pools, Naked Access and High-Speed Trading: Without going into all of the complicated details, these are new ways in which the big boys (or more accurately, the big boys’ computers) trade massive amounts of stock in a matter of milliseconds based on information and market access that is not available to the general public. These practices, currently completely legal and unregulated, are not only dangerous but are just plain unfair.
e. Implement Meaningful Margin Requirements for Derivatives: Margin requirements for stocks were as low as 10% in the 1920’s, and that was a major contributor to the problems, but since the 1930’s they have generally been set at 50% or greater. The problem is that in the 1990’s and 2000’s, trading technologies and clever traders developed a variety of new products that let you play the market with low (<10%) or even no margin requirements. Products like Credit Default Swaps and other derivatives let investors bet against a company for pennies on the dollar. These new products need meaningful margin requirements, just like stocks.
f. Increase Margin Requirements on Leveraged ETF’s or Prohibit Them Completely: ETF’s have become popular enough to move the entire market, but an ETF with three-to-one leverage and the current 50% margin requirement effectively allows investors to bet on $6 of stock for every $1 invested.
g. Put Some Teeth in the Prohibition on Naked Shorting: Normally, when you sell a stock short (sell a stock you don’t own) you must actually borrow it from someone who owns it before you can sell it. To borrow it, you need collateral (cash or securities worth at least 50% of the value of the securities you are borrowing). But big players often sell short (again, often computers do the dirty work, not humans) and then cover (re-buy the stock) in massive amounts and over very short time frames. As a result, they never have to actually show that they borrowed the stock before they sold it, because they re-buy it so quickly. This allows them to make massive short-term bets against a stock without putting any hard cash on the line up front. While in theory this practice is prohibited, this prohibition currently lacks meaningful teeth and enforcement.
h. Increase Financial Institutions Capital Requirements: Perhaps the most obvious lesson of the last boom was that banks and other financial institutions did not have nearly enough capital (basically equity) to survive the write-downs they were required to take when asset prices collapsed, hence the need for so many government bailouts. One of the simplest and most obvious reforms needed (and the one fought most vehemently by the big banks) is to increase the capital requirements so that next time, things can go a farther south without blowing up the entire financial sector.
i. Increase Deposit Insurance Levels: Because they aren’t indexed to inflation, the limits on FDIC-insured bank accounts have become so low that they no longer effectively prevent runs on the bank, as was the original intent back in 1933. Increased bank capital requirements would offset the liability increase to the government from doing this.
j. Stiffen Regulation and Disclosure Requirements for Consumer Credit and Residential Mortgages: No discussion of how to fix this would be complete without addressing the absurd levels of leverage that individuals incurred through mortgages, home equity loans, and credit card debt. First, disclosure requirements on all forms of consumer debt should be increased so that no one, no matter how uneducated, can ever claim that they signed up for a loan that turned out to be completely different than they expected. Every lender should be required to provide easy-to-read disclosures in big print saying “Here are all the fees we can charge you” and “Here is how much and how quickly your interest rate and payments can change,” and every borrower would have to read and sign those disclosures before they get the loan. Furthermore, some practices are just so toxic that perhaps they should be banned altogether, such as loan-to-value ratios of 110% on mortgages or absurdly low “teaser” rates of interest.
Wednesday, June 24, 2009
What Letter is the Recession? It Depends on Your Time Frame.
Just finished reading an editorial by Nouriel Roubini, professor of economics at the Stern School of Business at NYU, predicting the current recession will be "V" shaped (sharp and deep with a quick reversal and sharp recovery), although he concedes the risks of a "W" are growing. It strikes me that all of these discussions on the "letter" shape of this recession are meaningless without a discussion of the time frame. For example, I would argue that anyone who thinks this recession is a V just has a short time horizon, because something comes after the V.
Stepping back for a moment to look at the big picture, it is clear that the country as a whole got way too leveraged, and now we must unwind that. I don’t think anyone would disagree with that. Households and corporations already started unwinding as fast and hard as they could (many by choice, many forced by their creditors), which is how recessions work. But this time the government is levering up as fast as it can to offset the household & corporate delevering. Eventually, as the Fed knows, they must pull out their leverage. First quant easing must be stopped. Then they must do the opposite (quantitative tightening) to sell all of the stuff on the Fed balance sheet back to the market. Meanwhile, rising interest rates (or the threat of them) will limit the government’s ability for additional deficit spending. So over time, monetary policy will have to become restrictive in the most direct sense (they can do whatever they want with the Fed Funds rate, but quantitative tightening is the most restrictive monetary tool in the Fed’s toolkit) and fiscal policy will also become more restrictive.
It is impossible to predict when this will begin and how long it will take. No one knows, because it will be decided by humans who do not themselves know what they will decide when the future comes. If they do it too fast, it will be a hard double-dip recession – a lower case V followed by an upper case V or L, with the second dip going way lower than the first. If they wait too long it will be an even bigger W, so big people will think it is a really big V, until inflation and reality finally drive the tightening that makes the second V or L look like a trip into the abyss. But I am an optimist, so I think the Fed will thread the needle, which means an “internet recession” – a lower case "www" – we just bounce around with stagflation like the 70’s, except more heavily weighted to stagnation than inflation.
Stepping back for a moment to look at the big picture, it is clear that the country as a whole got way too leveraged, and now we must unwind that. I don’t think anyone would disagree with that. Households and corporations already started unwinding as fast and hard as they could (many by choice, many forced by their creditors), which is how recessions work. But this time the government is levering up as fast as it can to offset the household & corporate delevering. Eventually, as the Fed knows, they must pull out their leverage. First quant easing must be stopped. Then they must do the opposite (quantitative tightening) to sell all of the stuff on the Fed balance sheet back to the market. Meanwhile, rising interest rates (or the threat of them) will limit the government’s ability for additional deficit spending. So over time, monetary policy will have to become restrictive in the most direct sense (they can do whatever they want with the Fed Funds rate, but quantitative tightening is the most restrictive monetary tool in the Fed’s toolkit) and fiscal policy will also become more restrictive.
It is impossible to predict when this will begin and how long it will take. No one knows, because it will be decided by humans who do not themselves know what they will decide when the future comes. If they do it too fast, it will be a hard double-dip recession – a lower case V followed by an upper case V or L, with the second dip going way lower than the first. If they wait too long it will be an even bigger W, so big people will think it is a really big V, until inflation and reality finally drive the tightening that makes the second V or L look like a trip into the abyss. But I am an optimist, so I think the Fed will thread the needle, which means an “internet recession” – a lower case "www" – we just bounce around with stagflation like the 70’s, except more heavily weighted to stagnation than inflation.
Wednesday, March 11, 2009
Is the Bear Dead?
Is the bear dead? Maybe – at the very least the market had gotten insanely oversold and needed a bounce. In the bigger picture:
BULLISH: Copper prices have turned up noticeably over the past seven days. It is not a big move yet, but if it continues that is very bullish. Note that copper prices turned up a week before yesterday’s stock market bump.
http://www.kitcometals.com/charts/copper_historical_large.html
BEARISH: Economic news is still 100% bad (e.g. UTX news, WSJ p. B1). I do not count C’s announcement yesterday of operating profit in February as good economic news. They borrow from the fed at about 0% and lend at much greater than 0%. A monkey can make an operating profit in those conditions – they will still show a loss this quarter after marks and reserves. The fact that the market moved up so big on this silly news just shows how oversold the market was. Also bearish last week was increasing LIBOR and widening spreads in the debt markets.
BOTTOM LINE: It doesn’t feel over to me. It is hard for me to believe that such a ridiculous piece of “news” as Vikram Pandit’s remarks at Citi marked the end of the bear market. On the other hand, copper has been a very good indicator of market bottoms in the past, and if it keeps moving up then I will have to concede that the bear is probably dead. Also, if auto sales stabilize or turn up in March then that would also be very bullish (note they will report a huge drop vs. prior year’s March – the key is what happens to the seasonally adjusted annualized run-rate in March 09 vs. Feb. 09). Also watch for any other glimmers of economic good news.
BULLISH: Copper prices have turned up noticeably over the past seven days. It is not a big move yet, but if it continues that is very bullish. Note that copper prices turned up a week before yesterday’s stock market bump.
http://www.kitcometals.com/charts/copper_historical_large.html
BEARISH: Economic news is still 100% bad (e.g. UTX news, WSJ p. B1). I do not count C’s announcement yesterday of operating profit in February as good economic news. They borrow from the fed at about 0% and lend at much greater than 0%. A monkey can make an operating profit in those conditions – they will still show a loss this quarter after marks and reserves. The fact that the market moved up so big on this silly news just shows how oversold the market was. Also bearish last week was increasing LIBOR and widening spreads in the debt markets.
BOTTOM LINE: It doesn’t feel over to me. It is hard for me to believe that such a ridiculous piece of “news” as Vikram Pandit’s remarks at Citi marked the end of the bear market. On the other hand, copper has been a very good indicator of market bottoms in the past, and if it keeps moving up then I will have to concede that the bear is probably dead. Also, if auto sales stabilize or turn up in March then that would also be very bullish (note they will report a huge drop vs. prior year’s March – the key is what happens to the seasonally adjusted annualized run-rate in March 09 vs. Feb. 09). Also watch for any other glimmers of economic good news.
Wednesday, March 4, 2009
Anatomy of the Bear
In his book, “Anatomy of the Bear,” Russell Napier studied the four greatest market bottoms of all time. He defined these by looking at the best returns over subsequent one to forty year time periods. In other words, he attempted identify the greatest buying opportunities of all time. Unfortunately, the lessons he found can not easily be distilled down into one short paragraph or three bullet points (perhaps some of the market’s current problems resulted from the expectation that everything can be). But in this case the lessons of history can be summarized in eleven bullet points which can be read in about ten minutes, so bear with me (no pun intended).
The four great market bottoms that Napier studied were August 1921, July 1932, June 1949 and August 1982. These market bottoms were the once (or maybe twice) in a lifetime buying opportunities for the market as a whole. Scientific study of these four bottoms revealed the following characteristics, which may be helpful indicators of the bottom of a major bear market (although note that other, less significant, market bottoms were not studied in this book, and therefore may have different traits). It certainly feels like we are heading for another one of these major bottoms. Interestingly, the data shows that some of the conventional wisdom that is being parroted by the pundits on CNBC and in the WSJ is not supported by history. Here is what Napier found:
1. The “q Ratio” (or “Tobin’s Q” for the Yale professor that came up with it) equals the total market value of a company (equity plus debt) divided by the replacement cost of all of its assets (net of liabilities). For the market as a whole, the q Ratio was below 0.3x at all four major market bottoms. This was the strongest correlation to all four exact market bottoms. Unfortunately, even though one can find published values for Tobin’s Q from various sources, its calculation requires that one know the replacement cost of a company’s net assets. This involves a fair amount of subjectivity and at best is only available months after the fact. Book value is often used as replacement value, but changing accounting practices for both depreciation and intangibles mean that this measure is different now than in the past, and in any event is never available in real time. MY CONCLUSION: At the end of the third quarter of 2008, the ratio was at 0.76 according to one source. While equity values have fallen since then (lowering Q), book values have also been written down significantly since that time (lifting Q). In December of 2008, Napier himself was quoted by Bloomberg as saying that by his calculations, a Q-ratio of 0.3x implies an S&P500 of about 400. Ouch!
2. The four great bear markets either took a very long time (more than a decade) or a very severe price decline (89% in the Dow from 1929 to 1932) to reach a long-term secular market bottom. In the three long bear markets (excluding 1929-32) equities became cheap slowly, taking an average of 14 years to move from peak to trough q ratios. Each of the four bear markets was a period of the market (gradually or quickly) becoming cheaper relative to corporate profits (particularly cyclically adjusted profits). In addition, real and nominal GDP expanded significantly during all three long bear markets, but corporate profit growth lagged growth in GDP. As a result, at the bottoms, cyclically adjusted P/E’s had declined to extremely low levels (4.7x to 11.7x trailing average five year earnings), and companies had room to both grow earnings (to catch up to GDP growth) and to expand P/E ratios. MY CONCLUSION: The current secular bear market began in the spring of 2000, so by this criteria, the current bear market (at 19 years old) may be nearing an end. Furthermore, by my own personal calculation, at 700 the S&P500 is trading at about 10.8x current normalized earnings (based on along term regression analysis), vs. a “normal” level of perhaps 15x. However, at its high in fall 2007 the ratio was 25x, or 1.67 above the 15x norm. If the market overreacts by a similar amount the other way, that implies a multiple of 9x (15 divided by 1.67), which based on 2009 normalized earnings implies an S&P500 of about 600. Ouch again!
3. In all four cases, the market did NOT bottom with “capitulation” of the bulls (where there is a final dramatic decline on high volume) as conventional wisdom today dictates. Instead, it was more like a marathon, with the weaker bulls gradually dropping out through attrition by the side of the road over a period of months or years. The bottoms were all preceded by a period of declines on low volumes and rises on higher volumes (although not necessarily that high in absolute terms). The final end of the bear in each case was a slump in equity prices on low volumes. After that, the new long-term up trend was confirmed by rising volumes at new higher price levels after the initial market rebound. MY CONCLUSION: How interesting that everyone on CNBC is looking for capitulation – a huge downdraft on massive volume. If this market is like the other four, that is NOT how this bear will end. The volume data for the NYSE has not really shown a sustained decline at this point. If volume trails off and then picks up again, this would be bullish. (Monthly S&P500 volume can be found at http://www.Economagic.com/chartg/sp/sp05.gif)
4. A material disturbance to the general price level was the catalyst to reduce equity prices to extremely cheap levels (high inflation and then deflation leading up to 1921, 1949 and 1982; just extreme deflation up to 1932). The deflation was particularly evident in declining commodity prices. This caused great uncertainty, reducing valuations. In all four cases, the end of the decline in commodity prices, particularly copper, marked the bottom of the great bear market. MY CONCLUSION: That first sentence certainly replayed itself leading up to this bust (think oil boom and bust, among others). Copper traded around $1/lb in 2004 and early 2005, and then in late 2005 and 2006 moved above $3. For most of 2006 through mid-2008 it traded between $3 and $4. In the last few months of 2008 it fell rapidly to around $1.50, where it has stayed relatively level ever since. Since Copper appears to have bottomed, this could signal this bear is about done. A new downturn would be bearish; an upturn would be even more bullish. A good source for copper prices is http://www.kitcometals.com/charts/copper_historical_large.html
5. All four bottoms occurred during a recession. Corporate earnings continued to decline for four to seven months after the market bottomed. In hindsight, in each case the overall economy (GDP) and the stock market bottomed at roughly the same time, but this was not much help to investors (given the lag and then subsequent revisions in the reporting of economic data). However, reports of auto sales starting to recover preceded each bear market bottom. MY CONCLUSION: Earnings and GDP known only in hindsight are not much help, but watch auto sales for an upturn, especially after the recent brutal downturn. February marked the lowest annualized auto sales rate (9.12 million vehicles) in the US since December 1981. I don’t have a good source for a nice chart on this, but the latest data can generally be found at http://www.aiada.org/newsroom/ or http://www.autoblog.com/category/by-the-numbers/.
6. At each bottom there was an increasing supply of good economic news and a significant number of bulls “banging the drum” for equities, but the market was indifferent to all of it. Conventional wisdom that says that the news at the bottom is universally bad is wrong. At the bottoms it was NOT true that all the news was bad, rather it was true that the market had continued to ignore an increasing amount of good news. MY CONCLUSION: There are a few on CNBC who think the time to buy is now, but very few. And there is pretty much no good economic news yet.
7. Also at the bottoms there were many commentators suggesting that the government’s worsening fiscal position (budget deficits, etc.) would prevent an increase in stocks (they were obviously wrong). MY CONCLUSION: That is sounding more familiar everyday.
8. Large numbers of individuals were shorting stocks at each bottom. Short positions increased to higher levels in the early stages of each bear market’s ultimate recovery, as shorts assumed it was a new opportunity to short at higher levels before the next decline (they were obviously wrong too). MY CONCLUSION: This is not that much help, since it is a bit vague and since good short interest data for the market as a whole is difficult to find, and is further clouded by the advent of short and ultra-short ETF’s. But it is interesting that this goes counter to the notion that short-covering triggers a recovery, since initially in the recoveries short interest increased.
9. Dow Theory worked as a good buy signal at each bottom, although Dow Theory is itself subject to a fair amount of subjectivity and interpretation. MY CONCLUSION: As Napier himself says this is somewhat subjective, but a move up in the Dow Industrials and Transports, together and on high volume, would be bullish.
10. Ignoring the 1929-1932 bear, the Federal Reserve’s first reduction in interest rates preceded the bottom by three to 11 months, during which time the market declined a further 10% - 20%. However, in 1929 this indicator failed miserably as the Fed cut interest rates very early in the bear market. MY CONCLUSION: This is probably not very reliable this time either, since (as in 1929) the Fed again cut hard and early in this recession.
11. A sell off in government bonds accompanied at least part of each bear market in equities. The bear market in bonds ended seven to 14 months before the end of the equity bear market, and in that time the equity market declined 6% to 42%. MY CONCLUSION: So far in this bear market, US Treasury Bonds have not been in a bear market, as ten-year notes traded to absurdly high levels (low yields) in late 2008. They have given some of it back so far in 2009, but yields are still quite low (prices are still higher than they were up until the fall of 2008). There are two possible interpretations of this. One is that Treasury Notes still need to suffer a bear market before the equity bear market ends. I do not think this is the case, since for that to happen, and then for the equity bear market to go on another seven to 14 months beyond that, seems unreasonable. A more likely explanation is that Treasury Notes have been a safe haven that have behaved more like gold in a crisis, and so you can’t really look for a bear market there. Certainly there has been a bear market in high yield corporates, as spreads to Treasuries widened significantly. For example, PIMCO’s high yield ETF (ticker PHK) had asset values begin to decline in mid-2007 until they bottomed in late 2008, down about 70% in 18 months (http://www.etfconnect.com/select/fundpages/gen.asp?MFID=108698). They have since stabilized, although not rebounded.
For what it’s worth, the author ended the book with his assessment of where we stood at the time in the fall of 2005. At that time, the market had not surpassed its 2000 highs, and his conclusion was that the rebound of 2003 – 2005 was just a short term (cyclical) bull market in a long term (secular) bear market. He pointed out that historically overvalued levels like we saw in 2000 are always followed by long grinding bear markets (or as in 1929 – 1932, by a not so long but really extremely severe bear market), which don’t finally end until equities become extremely undervalued.
Also, for what it's worth, I will add one more metric of my own. In mid-1982, the ratio of the S&P500 index to quarterly GDP (in trillions, seasonally adjusted) approached 32x. 32x fourth quarter 2008 GDP is approximately 450 for the S&P500. Double ouch! However in 1949 the level did not get nearly as low – in fact it bottomed around 50x, and 50x last quarters GDP works out to 710 for the S&P500, right about the current level. (GDP data can be found at http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=5&FirstYear=2007&LastYear=2008&Freq=Qtr).
CONCLUSIONS:
The data seems to indicate the current bear market should bottom somewhere in the 400 to 700 range for the S&P500.
Signs that the bear is dead:
A lethargic slump in equity prices on low volumes, followed by rising volumes at new higher price levels after the initial market rebound.
An upturn in Copper prices.
An upturn in Auto Sales.
An increasing supply of good economic news (initially ignored by the market).
Signs that the bear has a while to live:
Falling Copper prices
Flat to down auto sales.
All the economic news is bad.
The four great market bottoms that Napier studied were August 1921, July 1932, June 1949 and August 1982. These market bottoms were the once (or maybe twice) in a lifetime buying opportunities for the market as a whole. Scientific study of these four bottoms revealed the following characteristics, which may be helpful indicators of the bottom of a major bear market (although note that other, less significant, market bottoms were not studied in this book, and therefore may have different traits). It certainly feels like we are heading for another one of these major bottoms. Interestingly, the data shows that some of the conventional wisdom that is being parroted by the pundits on CNBC and in the WSJ is not supported by history. Here is what Napier found:
1. The “q Ratio” (or “Tobin’s Q” for the Yale professor that came up with it) equals the total market value of a company (equity plus debt) divided by the replacement cost of all of its assets (net of liabilities). For the market as a whole, the q Ratio was below 0.3x at all four major market bottoms. This was the strongest correlation to all four exact market bottoms. Unfortunately, even though one can find published values for Tobin’s Q from various sources, its calculation requires that one know the replacement cost of a company’s net assets. This involves a fair amount of subjectivity and at best is only available months after the fact. Book value is often used as replacement value, but changing accounting practices for both depreciation and intangibles mean that this measure is different now than in the past, and in any event is never available in real time. MY CONCLUSION: At the end of the third quarter of 2008, the ratio was at 0.76 according to one source. While equity values have fallen since then (lowering Q), book values have also been written down significantly since that time (lifting Q). In December of 2008, Napier himself was quoted by Bloomberg as saying that by his calculations, a Q-ratio of 0.3x implies an S&P500 of about 400. Ouch!
2. The four great bear markets either took a very long time (more than a decade) or a very severe price decline (89% in the Dow from 1929 to 1932) to reach a long-term secular market bottom. In the three long bear markets (excluding 1929-32) equities became cheap slowly, taking an average of 14 years to move from peak to trough q ratios. Each of the four bear markets was a period of the market (gradually or quickly) becoming cheaper relative to corporate profits (particularly cyclically adjusted profits). In addition, real and nominal GDP expanded significantly during all three long bear markets, but corporate profit growth lagged growth in GDP. As a result, at the bottoms, cyclically adjusted P/E’s had declined to extremely low levels (4.7x to 11.7x trailing average five year earnings), and companies had room to both grow earnings (to catch up to GDP growth) and to expand P/E ratios. MY CONCLUSION: The current secular bear market began in the spring of 2000, so by this criteria, the current bear market (at 19 years old) may be nearing an end. Furthermore, by my own personal calculation, at 700 the S&P500 is trading at about 10.8x current normalized earnings (based on along term regression analysis), vs. a “normal” level of perhaps 15x. However, at its high in fall 2007 the ratio was 25x, or 1.67 above the 15x norm. If the market overreacts by a similar amount the other way, that implies a multiple of 9x (15 divided by 1.67), which based on 2009 normalized earnings implies an S&P500 of about 600. Ouch again!
3. In all four cases, the market did NOT bottom with “capitulation” of the bulls (where there is a final dramatic decline on high volume) as conventional wisdom today dictates. Instead, it was more like a marathon, with the weaker bulls gradually dropping out through attrition by the side of the road over a period of months or years. The bottoms were all preceded by a period of declines on low volumes and rises on higher volumes (although not necessarily that high in absolute terms). The final end of the bear in each case was a slump in equity prices on low volumes. After that, the new long-term up trend was confirmed by rising volumes at new higher price levels after the initial market rebound. MY CONCLUSION: How interesting that everyone on CNBC is looking for capitulation – a huge downdraft on massive volume. If this market is like the other four, that is NOT how this bear will end. The volume data for the NYSE has not really shown a sustained decline at this point. If volume trails off and then picks up again, this would be bullish. (Monthly S&P500 volume can be found at http://www.Economagic.com/chartg/sp/sp05.gif)
4. A material disturbance to the general price level was the catalyst to reduce equity prices to extremely cheap levels (high inflation and then deflation leading up to 1921, 1949 and 1982; just extreme deflation up to 1932). The deflation was particularly evident in declining commodity prices. This caused great uncertainty, reducing valuations. In all four cases, the end of the decline in commodity prices, particularly copper, marked the bottom of the great bear market. MY CONCLUSION: That first sentence certainly replayed itself leading up to this bust (think oil boom and bust, among others). Copper traded around $1/lb in 2004 and early 2005, and then in late 2005 and 2006 moved above $3. For most of 2006 through mid-2008 it traded between $3 and $4. In the last few months of 2008 it fell rapidly to around $1.50, where it has stayed relatively level ever since. Since Copper appears to have bottomed, this could signal this bear is about done. A new downturn would be bearish; an upturn would be even more bullish. A good source for copper prices is http://www.kitcometals.com/charts/copper_historical_large.html
5. All four bottoms occurred during a recession. Corporate earnings continued to decline for four to seven months after the market bottomed. In hindsight, in each case the overall economy (GDP) and the stock market bottomed at roughly the same time, but this was not much help to investors (given the lag and then subsequent revisions in the reporting of economic data). However, reports of auto sales starting to recover preceded each bear market bottom. MY CONCLUSION: Earnings and GDP known only in hindsight are not much help, but watch auto sales for an upturn, especially after the recent brutal downturn. February marked the lowest annualized auto sales rate (9.12 million vehicles) in the US since December 1981. I don’t have a good source for a nice chart on this, but the latest data can generally be found at http://www.aiada.org/newsroom/ or http://www.autoblog.com/category/by-the-numbers/.
6. At each bottom there was an increasing supply of good economic news and a significant number of bulls “banging the drum” for equities, but the market was indifferent to all of it. Conventional wisdom that says that the news at the bottom is universally bad is wrong. At the bottoms it was NOT true that all the news was bad, rather it was true that the market had continued to ignore an increasing amount of good news. MY CONCLUSION: There are a few on CNBC who think the time to buy is now, but very few. And there is pretty much no good economic news yet.
7. Also at the bottoms there were many commentators suggesting that the government’s worsening fiscal position (budget deficits, etc.) would prevent an increase in stocks (they were obviously wrong). MY CONCLUSION: That is sounding more familiar everyday.
8. Large numbers of individuals were shorting stocks at each bottom. Short positions increased to higher levels in the early stages of each bear market’s ultimate recovery, as shorts assumed it was a new opportunity to short at higher levels before the next decline (they were obviously wrong too). MY CONCLUSION: This is not that much help, since it is a bit vague and since good short interest data for the market as a whole is difficult to find, and is further clouded by the advent of short and ultra-short ETF’s. But it is interesting that this goes counter to the notion that short-covering triggers a recovery, since initially in the recoveries short interest increased.
9. Dow Theory worked as a good buy signal at each bottom, although Dow Theory is itself subject to a fair amount of subjectivity and interpretation. MY CONCLUSION: As Napier himself says this is somewhat subjective, but a move up in the Dow Industrials and Transports, together and on high volume, would be bullish.
10. Ignoring the 1929-1932 bear, the Federal Reserve’s first reduction in interest rates preceded the bottom by three to 11 months, during which time the market declined a further 10% - 20%. However, in 1929 this indicator failed miserably as the Fed cut interest rates very early in the bear market. MY CONCLUSION: This is probably not very reliable this time either, since (as in 1929) the Fed again cut hard and early in this recession.
11. A sell off in government bonds accompanied at least part of each bear market in equities. The bear market in bonds ended seven to 14 months before the end of the equity bear market, and in that time the equity market declined 6% to 42%. MY CONCLUSION: So far in this bear market, US Treasury Bonds have not been in a bear market, as ten-year notes traded to absurdly high levels (low yields) in late 2008. They have given some of it back so far in 2009, but yields are still quite low (prices are still higher than they were up until the fall of 2008). There are two possible interpretations of this. One is that Treasury Notes still need to suffer a bear market before the equity bear market ends. I do not think this is the case, since for that to happen, and then for the equity bear market to go on another seven to 14 months beyond that, seems unreasonable. A more likely explanation is that Treasury Notes have been a safe haven that have behaved more like gold in a crisis, and so you can’t really look for a bear market there. Certainly there has been a bear market in high yield corporates, as spreads to Treasuries widened significantly. For example, PIMCO’s high yield ETF (ticker PHK) had asset values begin to decline in mid-2007 until they bottomed in late 2008, down about 70% in 18 months (http://www.etfconnect.com/select/fundpages/gen.asp?MFID=108698). They have since stabilized, although not rebounded.
For what it’s worth, the author ended the book with his assessment of where we stood at the time in the fall of 2005. At that time, the market had not surpassed its 2000 highs, and his conclusion was that the rebound of 2003 – 2005 was just a short term (cyclical) bull market in a long term (secular) bear market. He pointed out that historically overvalued levels like we saw in 2000 are always followed by long grinding bear markets (or as in 1929 – 1932, by a not so long but really extremely severe bear market), which don’t finally end until equities become extremely undervalued.
Also, for what it's worth, I will add one more metric of my own. In mid-1982, the ratio of the S&P500 index to quarterly GDP (in trillions, seasonally adjusted) approached 32x. 32x fourth quarter 2008 GDP is approximately 450 for the S&P500. Double ouch! However in 1949 the level did not get nearly as low – in fact it bottomed around 50x, and 50x last quarters GDP works out to 710 for the S&P500, right about the current level. (GDP data can be found at http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=5&FirstYear=2007&LastYear=2008&Freq=Qtr).
CONCLUSIONS:
The data seems to indicate the current bear market should bottom somewhere in the 400 to 700 range for the S&P500.
Signs that the bear is dead:
A lethargic slump in equity prices on low volumes, followed by rising volumes at new higher price levels after the initial market rebound.
An upturn in Copper prices.
An upturn in Auto Sales.
An increasing supply of good economic news (initially ignored by the market).
Signs that the bear has a while to live:
Falling Copper prices
Flat to down auto sales.
All the economic news is bad.
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