FINANCE & ECONOMICS

Buttonwood

With one bound…

Jul 30th 2009
From The Economist print edition


The stockmarket recovery still faces some serious tests












Illustration by S. Kambayashi




FACING certain death, Batman can always produce just the right tool from his utility belt and leap to safety. The stockmarket seems to be working on the same trick. In March shares were spiralling relentlessly downwards. But the Dow Jones Industrial Average climbed back above the 9,000 level on July 23rd and London’s FTSE 100 index rose for 11 trading days in a row to July 27th, equalling its best-ever run. Most of the world’s stockmarkets are now in positive territory for the year.

Such rises need to be set in context. The Dow passed 9,000 for the first time back in April 1998 and it is still a long way below its peak of 14,165, reached in October 2007. The speed of this year’s rally in part reflects the scale of the previous decline. Nevertheless, the change of mood is remarkable, given that earlier this year many feared a repeat of the Depression.

Two factors are commonly cited as being behind the rally. The first is a growing conviction that the worst of the economic downturn is over. Although second-quarter GDP data have so far been mixed (disappointing in Britain, better than expected in Singapore), forward-looking data such as purchasing managers’ surveys are generally encouraging.

The second factor is the second-quarter reporting season in America. According to Morgan Stanley, 57% of companies in the S&P 500 index to have reported results have beaten expectations. Only 25% have disappointed. It is worth remembering, though, that profits are still depressed. Earnings were 28.8% lower than in the same period of 2008. Leaving out financial firms, they were still 16.7% down.

The rally may also be benefiting from at least two virtuous circles. The first is that leading economic indicators usually include the stockmarket itself as a key component. Recent improvements in these indicators—the euro-zone figures rose by 1.5% in June, for example, on the back of similar increases in April and May—are in turn taken by equity investors as a bullish signal.

The second factor is more technical. David Shairp of JPMorgan Asset Management says that lower stockmarket volatility is reducing the perceived risk of investing in equities, relative to bonds. In turn, volatility tends to fall when the stockmarket is rising.

The relative attraction of equities may be the key to the rally. The return on cash is many countries is virtually zero. Long-dated government bonds yield 3-5% in America and the euro zone. Many investors are nervous about the volume of issuance and the potential for inflation. At the end of 2008 these low yields did not matter: investors were more concerned with the return of capital than the return on it. They are now becoming less risk-averse and heading back to equities and to corporate bonds, where spreads (the excess interest rate paid to investors to reflect higher risks) have fallen despite more defaults.

How long-lasting will the recovery be? Its scale has hurt one bullish argument for shares: that they are historically cheap. At their March lows they did appear attractive on two long-term measures—the cyclically adjusted price-earnings ratio (which averages profits over ten years) and the “q” ratio (which compares the market value of companies to the replacement cost of their assets). After the rebound, Andrew Smithers, an economist, reckons the American market is about 20% overvalued on these gauges.

The period when shares were a bargain was remarkably short. As Jeremy Grantham, a veteran investor, has remarked: “After 20 years of more or less permanent overpricing of the S&P, we get five months of underpricing. There is no justice in life.” Mr Grantham’s lament reflects an underlying problem: valuation often fails to be a good short-term guide to the stockmarket’s prospects.

The big issue for the market may arrive, ironically, if the bulls are right. If economic recovery does occur in 2010, it will be because the authorities have thrown everything, from tax cuts to quantitative easing, at the problem. At some point they will have to withdraw the stimulus. How will consumers cope if both taxes and interest rates are rising at the same time? American consumer confidence has already declined in each of the past two months, even though rising share prices are normally good for sentiment.

If governments and central banks do not tighten policy, government-bond investors may take fright, pushing up yields and tightening monetary conditions on their own. In short, there are plenty of risks. Batman may win every hand but equity investors should still fear the Joker.

Copyright © 2009 The Economist Newspaper and The Economist Group.

REVIEW & OUTLOOK

AUGUST 1, 2009

Poised for a Rebound

The good-bad news in second-quarter GDP

The bad news in yesterday’s second-quarter GDP is that the recession was even deeper than previously thought. Or should we say that is the good-bad news. Because that pain is now largely past, the very steepness of the decline means that the economy is now poised for a sharper rebound, or at least it should be if the history of recessions is any guide.

The economy contracted by only 1% at an annual rate in the quarter, but the Bureau of Economic Analysis report was even more interesting for its growth revisions in previous quarters. Last year’s third quarter was revised downward by a remarkable 2.2-percentage points, to a negative 2.7% rate. This means the recession began in earnest in July and August, which follows the spike to $145-a-barrel oil and the collapse of Fannie Mae and Freddie Mac, and it accelerated in September with the fall of Lehman Brothers and its aftermath.

To put it another way, the 2008 financial panic quickly—almost instantaneously—triggered a panic in real goods, which sent the economy tumbling down. The rapidity of that reaction is a perverse compliment to the flexibility of U.S. producers, who reacted almost on a dime to the rout in the financial system. Companies pared back production to liquidate their inventories so fast that the bottom fell out of the economy in last year’s fourth quarter and the first part of 2009.

We’ll never know for sure, but it seems probable that the recession that formally began in late 2007 would have remained far less destructive had our financial plumbers done a better job of preparing the shaky financial system for the rough weather. Last year’s commodity spike—a reaction in part to reckless monetary policy—and Washington’s failure to build financial firewalls after the fall of Bear Stearns look to be major culprits in making the recession worse than it needed to be. This is where we’d most fault Ben Bernanke’s Federal Reserve and Hank Paulson’s Treasury.

The encouraging news is that the Adam Smith washout of recent months has now set the economy up for a comeback. The need to rebuild inventories of everything from cars to furniture will by itself help to lift GDP for the rest of 2009. The housing market looks to be bottoming, which means residential construction will also make a contribution to growth. Net exports (less imports) added some 1.4-percentage points to GDP in the second quarter and should also provide a lift the rest of the year.

What didn’t seem to make much difference is the “stimulus.” Transfer payments did climb sharply by 7.4% in the quarter, reflecting the likes of jobless insurance. These payments offset declines in worker compensation, but they didn’t do much for consumer spending, which declined by 1.2% in the quarter. In any event, these transfer payments are temporary and thus do nothing to promote the investment and risk-taking that are the only way back to steady growth and prosperity.

With a recovery on the way, the real question is whether we’ve laid the groundwork for such a durable expansion. Having been down so long, the economy should be in for a nice, long ride up. Even the Great Depression was followed by a notable rebound—until the bill for its government excesses came due in the mid- and later 1930s.

In this recession, Washington has reflated the economy with record spending and monetary easing that couldn’t help but spur some recovery. The issue is what happens when the price of that reflation comes due in higher taxes and higher interest rates. Political uncertainty also continues to hang over risk-takers, and on that point it has been fascinating to see the latest Wall Street rally coincide with the political troubles of ObamaCare. If it collapses, we might see Dow 10,000.

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved

August 1, 2009

Op-Ed Contributor

Why Own When You Can Lease?

By DANIEL ALPERT

BY providing financial institutions with enough capital to survive (and even thrive) over the past year, the federal government prevented the global economy from grinding to a halt. But it may also have unwittingly encouraged banks to slow the resolution of delinquent, defaulted and underwater loans secured by homes and commercial real estate. Such “extend and pretend” behavior does little except delay losses — which helps explain the recent crop of prediction-beating, market-rallying bank earnings reports — while prolonging and worsening the damage done by bad loans.

Just this week, the White House met with a gaggle of mortgage company executives to discuss why their loan modification programs have been so ineffective. In fact, a recent study by the National Bureau of Economic Research illustrates that these programs haven’t been ineffective so much as unused: only 8 percent of seriously delinquent borrowers have received any form of mortgage modification and fewer than 3 percent of such borrowers received a concession on principal or interest payments from their lender. By contrast, about 50 percent of those seriously delinquent loans had foreclosure proceedings initiated against them. That’s a record rate of 1.9 million foreclosure filings in the first half of this year.

Banks, of course, typically lose more money by foreclosing on a home than by renegotiating the principal of a loan — but, as foreclosure timelines often run 12 to 18 months, that loss takes far longer to show up on their balance sheets. As a result, banks are pushing the mess (and the attendant additional losses) well into 2010 while they maintain the fiction that borrowers will be able to repay severely underwater loans in full. Banks are even beginning to turn down borrower requests for immediate “short sales,” in which homeowners sell for whatever they can get and then give all proceeds to the lender, because this, too, means that the bank must record a principal loss at once, rather than down the road.

The sheer magnitude of the debt bubble — doubling to $11 trillion in home loans and adding tens of trillions in total American debt in the past decade — along with the collapse of real estate prices, make it extremely unlikely that any of these houses will recover their value soon enough to mitigate the losses embedded in banks’ balance sheets. And by stretching out the time over which banks will continue to have their capitalization hit by losses, banks cannot soon fulfill their mission of providing new capital for the recovery and growth of the economy. Fearing for their own solvency, banks are instead salting away enormous, record-setting reserves.

To put the bubble behind us, we need to place mortgage lenders on a path to settling up with underwater homeowners. One of the few viable ways to do this is for banks to accept the voluntary surrender of deeds and then lease the homes back to their former owners. The former homeowners should then retain a right to purchase their homes back at fair market value, after, say, five years, during which time they would need to get their financial affairs in order.

Congress could pass legislation, within the bounds of constitutional protection of contracts, that would require lenders to provide such a lease-back arrangement to any borrower who wants one. The former homeowners would pay rents set in accordance with local rates (which in almost all cases would be considerably lower than the total of their former bubble-era mortgage payments, taxes and insurance premiums).

Homes subject to such lease-back arrangements might also enjoy some unique tax benefits, like accelerated depreciation, and be eligible for mortgage financing from Fannie Mae, Freddie Mac or the Federal Housing Administration. This would spur an investment market that would help lenders get the properties off their balance sheets by attracting investment in leased-back homes.

Those homeowners who are gainfully employed and less underwater require a different solution. The administration needs to move beyond a policy encouraging mere payment modifications and toward one pushing hard for a renegotiation of principal based on lower, post-bubble values. In exchange, lenders would share in any eventual sales profits — a restructuring similar to the debt-for-equity swaps imposed by the government on some creditors of General Motors and Chrysler.

If banks can’t bring themselves to do that, then the loans should be sold to those of us in the private sector who will. That’s what the firm I work for is already doing: buying the few distressed loans banks will sell and offering principal modifications that help keep people in their homes.

I realize I am proposing the biggest controlled debt restructuring in history, and I expect none of these suggestions will be welcomed by banks, which would be forced to recognize their losses sooner rather than later. Nevertheless, banks need to be freed of the bad loans embedded in their balance sheets — if not for their need or willingness to do so, than for the economy’s need to have it done.

Daniel Alpert is a managing partner of an investment bank.

Copyright 2009 The New York Times Company

Thoughts from the Frontline Weekly Newsletter

The Great Reflation Experiment

by John Mauldin

July 31, 2009

The question we have been focused on for some time now is whether we end up with inflation, or deflation, and what that endgame looks like. It is one of the most important questions an investor must ask today, and getting the answer right is critical. This week, we have a guest writer who takes on the topic of the great experiment the Fed is now waging, which he calls The Great Reflation Experiment.

One of my favorite sources of information for decades has been and remains the Bank Credit Analyst. It has a long and storied reputation. One of their enduring themes has been the debt super cycle. Investors who have paid attention to it have been served well. I am taking a little R&R this weekend, but I have arranged for my friend Tony Boeckh to stand in for me. Tony was chairman, chief executive, and editor-in-chief of Montreal-based BCA Research, publisher of the highly regarded Bank Credit Analyst up until he retired in 2002. He still likes to write from time to time, and we are lucky enough to have him give us his views on where we are in the economic cycles. Gentle reader, we are all graced to learn from one of the great economists and analysts of our times. Pay attention.

Central bankers do. You can read his extensive bio at www.boeckhinvestmentletter.com and I will tell you how to get his letter free of charge at the end of this letter. And, he told me to mention that his son Rob is now helping him write, so there is a double byline here. Now, let's just jump in.

By Tony Boeckh and Rob Boeckh

The Crash of 2008/9 should be seen as yet another consequence of long-term, persistent US inflationary policies. Inflation doesn't stand still. It tends to establish a self-reinforcing cycle that accelerates until the excesses in money and credit become so extreme that a correction is triggered. The bigger the inflation, the bigger the correction. Once a dependency on credit expansion is well established, correcting the underlying imbalances becomes extremely difficult.

Reflation has occurred after each major correction, and this one is proving no exception. Return to discipline in the current environment would be too painful and dangerous.

Once on the financial roller coaster, it is very hard to get off. Moreover, the oscillations between peaks and valleys become increasingly large and unstable.

Policymakers, money managers, and most forecasters have argued that the crash was a "black swan" event, meaning that it had an extremely low probability of occurrence. That is grossly misleading, as it implies that the crash was so far beyond the realm of normal probabilities that it was unreasonable to expect anyone to have foreseen it. That argument has been used to justify the widespread complacency that prevailed in the years leading up to the crash. Policymakers are still failing to recognize the systemic causes of the crash and seem to believe that enhanced regulation will prevent history from repeating. While it is true that regulators were asleep at the switch or looking the other way, they were not the cause.

The Debt Super Cycle

The real culprit is the US debt super cycle, which has operated for decades, mostly in a remarkably benign manner. The inflationary implications of the twin deficits (current account and fiscal), as well as the steady increase in private debt, have been moderated by the integration of emerging markets into the global economy. The massive increase in industrial output from China, India, and others has enabled persistent credit inflation in the US to occur with virtually no consequence to date (other than periodic asset price bubbles and shakeouts). How long the disinflationary impact of emerging-market productivity growth will persist and how long these nations will continue loading up on Treasuries, will be instrumental in determining the course that the Great Reflation will take.

Tougher regulation is surely appropriate, but it will not stop the next inflationary run-up unless the system is fixed. In the final analysis, newly minted money and credit must find a home somewhere.

Some Background on US Inflation

Inflation, to be properly understood, should be defined as a persistent expansion of money and credit that substantially exceeds the growth requirements of the economy. As a consequence of excessive monetary expansion, prices rise. Which prices go up and at what rate depends on a number of factors. Sometimes it is the prices of goods and services that are the most visible symptom of inflationary pressures. That was the case in the 1970s when the Consumer Price Index (CPI) hit a peak rate of 14% per annum.

Sometimes it is the prices of assets such as homes, office buildings, stocks, or bonds that reflect the inflationary pressure, as we have seen in more recent years.

When inflation becomes pervasive, and other conditions are supportive, it can engulf a whole industry. We saw this in the financial sector in the period leading up to the crash. The supporting conditions or "displacements," to use the terminology of Professor Kindleberger, were financial innovation, deregulation, and obscene profits and salaries. These drew millions of bees to the honey. All great manias are accompanied by malfeasance, in this case the biggest Ponzi scheme in history and many other lesser ones. It is relatively easy to steal when prices are rising and greed is pervasive.

Overspending and a general lack of prudence always become widespread when a mania infects the general public. Rational people can do incredibly stupid things collectively when there is mass hysteria.

The origins of post-war inflation go back to the late 1950s and early 1960s, though some would take it back much further. In the 1960s, the US dollar started to come under pressure as a result of US inflationary policy and foreign central banks' ebbing confidence in their large and growing dollar reserve holdings. The US responded with controls and government intervention in a number of areas: gold convertibility, the US Treasury bond market, the Interest Equalization Tax, and, ultimately, intervention on wages and prices. These moves clearly flagged to the world that external discipline would be subjugated to domestic employment and growth concerns. The policy was formalized when the US terminated the link between gold and the dollar in August 1971, essentially floating the dollar and setting the US on a course of sustained inflation. Of course, the dollar floated down, which, among other things, triggered the massive rise in general prices in the 1970s.

The next episode of credit inflation began in the 1980s, paradoxically triggered by the success of Paul Volcker's move to break the spiral of rising general price inflation through very tight money. He succeeded famously, and the CPI headed sharply lower along with interest rates, setting the stage for the massive US debt binge and the series of asset bubbles that followed. It was easy for the Federal Reserve to pursue expansionary credit policies while inflation and interest rates were falling.

The Great Reflation Experiment of 2009

Private sector credit, the flipside of debt, maintained a stable trend relative to GDP from 1964 to 1982 (Charts 1& 2). After that, the ratio of debt to GDP rose rapidly for the 25 years leading up to the crash, and is continuing to rise. The current reading has debt close to 180% of GDP, about double the level of the early 1980s. The magnitude and length of this rise is probably unprecedented in the history of the world. Even the credit inflation that was the prelude to the 1929 crash and the Great Depression only lasted five or six years.

Prior to government bailouts and stimulus, the panic, crash, and precipitous economic decline of 2008/9 were clearly on track to be much worse than the post-1929 experience. The pervasiveness of leverage - from banks to consumers to supposedly blue-chip companies - and the illusion of stability in the system, were fostered through the 25 years that this credit bubble has grown, basically uninterrupted. The speed and magnitude of the bailouts and stimulus - the end of which we won't see for a long time - aborted the meltdown. However, the story is far from over.

The Great Reflation Experiment ultimately has two components. The first is a rise in federal government deficits, debt, and contingent liabilities. The second is an expansion of the Federal Reserve's balance sheet. Both are unprecedented since World War II. US federal government debt is likely to reach close to 100% of GDP over the next 8 to 10 years, according to the Congressional Budget Office (CBO) and supported by our own calculations (Chart 3).

Anemic growth, falling tax revenue, increased government spending, and bailouts of indigent states, households, businesses, along with an aging population, will all undermine public finances to a degree never before seen in peacetime. According to CBO data, government debt could reach 300% of GDP by 2050 as contingent liabilities are converted into actual government expenditures. This massive peacetime deterioration in public finances will have grave consequences for living standards and asset markets, particularly in the longer run.

(click to enlarge)

In the short run, huge deficits and growth in government debt are necessary. They will continue to play a crucial role in deleveraging the private sector and in helping to fill the black hole in the economy that has been caused by the sharp increase in household savings. Further out, government deficits will put upward pressure on interest rates. However, much of the economy, particularly housing and commercial real estate, is far too weak to absorb an interest-rate shock.

Therefore, the Federal Reserve will have to monetize much of the rise in government debt, making it extremely difficult to unwind the explosion in the Fed's balance sheet and consequent rise in bank reserves - the fuel that could be used to ignite another money and credit explosion.

The bottom line is that the Fed is in a very difficult position. Its room to maneuver is either small or nonexistent, and the markets understand this. That is why there is a sharp divergence between those worried about price inflation and those fearing a lengthy depression.

Implications for Investors

Investors are also in an extraordinarily difficult predicament. From the peak in 2007, household wealth declined by about $14 trillion, over 20%, to the first quarter of 2009. Tens of millions of people had come to rely on rising house and stock prices to give them a standard of living that could not be attained from regular income alone (Chart 4). They stopped saving and borrowed aggressively and imprudently against their assets and future income, some to live better, some to speculate, and many to do both. That game is over.

(click to enlarge)

Pensions have been devastated and people's appetite for risk has declined dramatically. The return on safe liquid assets ranges from 0.60% to 1.20%, depending on term and withdrawal penalties. Reasonable-quality bonds with a five-year maturity provide about 4%. Bonds with longer maturities have higher yields but are vulnerable to price erosion if inflationary expectations heat up. As for equities, people now understand that blue chip stocks carry huge risk. GE, once considered the ultimate "bullet-proof" stock, dropped 83% in the panic, and Citigroup lost 98%. Revelations of massive fraud schemes have further damaged trust and confidence in markets.

Against this backdrop we offer a few thoughts.

First, an increase in price inflation as reflected in the CPI is a long way off. The degree of excess capacity in the world is probably the greatest since the 1930s, although excess capacity does get scrapped during recessions. Western economies will remain depressed for years, and China will also be important in keeping inflation down. Its capital investment is larger than the US's in absolute terms. It is currently 40% of GDP and growing at 30% per annum. Profit margins in China will probably get squeezed, which, together with the huge amount of underemployed labor, means that the Chinese will keep driving their export machine at full throttle, continuing to flood the world with high-quality, inexpensive goods.

Therefore, investors who need income are probably safe holding reasonably high-quality bonds in the five-year maturity range. A bond ladder is a very useful tool for most people.

Holdings are staggered over, say, a five-year time frame, and maturing bonds are invested back into five-year bonds, keeping the portfolio structure in the zero-to-five-year range. In this way, some protection against a future rise in price inflation and falling bond prices can be achieved.

Second, massive monetary stimulus is good for asset prices in the near term (e.g. stocks, bonds, houses, commodities) in a world of very weak price inflation and a soft economy. That is true as long as the economy does not fall apart again, which is very unlikely given all the stimulus present and more to come if needed. Therefore, investors who can afford a little risk should own some assets that will ultimately be beneficiaries of the wall of new money being created and thrown at the economy.

There is a major risk to our relative near-term optimism, and that is the US dollar. Foreign central banks hold $2.64 trillion, overwhelmingly the largest component of world reserves. The US role as the main reserve currency country is compromised by its persistent inflationary policies and current account deficits, a subject high on the agenda at the recent G-8 meeting in Italy and referred to frequently by China, Russia, Brazil, and others. Foreign central banks fear a large drop in the dollar, which would cause them potentially huge losses on their reserve holdings. They don't want more dollars, and yet they don't want to lose competitive advantage by seeing their currencies go up against the dollar. To preserve their competitive position, they have to buy more when the dollar is under pressure. On the other hand, since the 1930s the US has never subjugated domestic concerns to external discipline. Officials may talk of a strong-dollar policy, but their actions always speak differently. Their attitude towards foreign central banks is, "We didn't ask you to buy the dollars." The US has typically seen such buying as currency manipulation to gain an unfair trade advantage.

The most likely outcome is a nervous dollar stalemate or, as Lawrence Summers once described it, "a balance of financial terror." The most important central banks will continue to hold their noses and buy the dollar to keep it from falling too sharply. However, this is a fragile, unstable situation, and the dollar must fall over time. Investors need to diversify away from this risk.

There are three obvious ways.

The first is investing in high-quality US equities that have a majority of their earnings and assets in hard-currency countries.

The second is investing in gold and related assets. Gold will probably remain in a tug of war for some time. On the negative side, it is faced with nonexistent global price inflation, even deflation, and a sharp decline in jewelry demand. On the positive side, concerns over U.S. monetary and fiscal debauchery will almost certainly heat up. As the odds of the latter increase, gold will be a major beneficiary, and investors should have a healthy insurance position in this asset class.

Third, most foreign currencies will also benefit from these fears, and hence investors can also protect themselves by diversifying into non-dollar assets in the best-managed countries. Some of these are emerging markets like China, which are liquid, in surplus, fiscally stable, and still growing well in spite of the global economic downturn. If and when the world economy begins to recover, and should price inflation stay low, asset bubbles are likely to recur. Where and when is always hard to tell in advance. Good prospects are in emerging-market equities, commodities, and commodity-oriented countries.

So, to sum up, in the next six to 12 months we look for a weak but recovering US economy, a continued deflationary price environment, pretty good asset and commodity markets, and continued narrowing of credit spreads. This view is based on the assumption that the new money created has to go somewhere, a stable to modestly falling dollar, and an anemic world economic recovery next year.

A buy and hold strategy has been bad advice for the past 10 years. The S&P is down 45% from its peak in early 2000. The investment world is likely to remain very unstable in the face of the difficult longer-run problems discussed above. Investors, whether they like it or not, are in the forecasting game, and forecasting is all about time lags. The exceptional circumstances of the current environment make any assessment of time lags extraordinarily difficult, and mistakes will continue to be costly. For that reason, holding well above average liquidity, in spite of the paltry returns, is sensible for most people whose pockets are not deep enough to absorb another hit to their net worth. They are in the unfortunate position of having to wait until the air clears a bit and more aggressive action can be taken with higher confidence. Warren Buffet has properly reminded us on numerous occasions that a price has to be paid for waiting for such a time, but then most of us aren't as rich as he is.

Have a great week.

Your going to mix in some sci-fi with the economics reading analyst,

John Mauldin
John@FrontLineThoughts.com

Copyright 2009 John Mauldin. All Rights Reserved