The Ultimate Game Changer: Why 2009 Will Be Worse Than 2008 (Part 1) 25 comments
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In the last 2 weeks it seems that the bulls are coming out of the woodwork. Don’t get sucked into the idea that you should chase this rally! What may appear to be a light at the end of the tunnel is probably a train. No one seems to have a good idea of what earnings might be, yet all of a sudden, bullishness abounds. Very well managed companies are guiding down multiple times early in a quarter, with no improvement in sight, yet the fast money crowd doesn’t seem worried.
I’ve watched the credit bubble popping events unfold in the context of a volatile history. I’m cognizant of the fact that is has never paid to stay very bearish for long as America is a remarkably resilient nation – we’ve overcome Herculean challenges like the depression and WW1 and Korea and Vietnam and oil embargoes and gulf wars and internet bubbles and more. However, none of these challenges compare to what decimation this credit bubble popping has wrought.
I view the stock market game as a probabilistic field of sorts. We effectively consider what’s known and unknown and try to estimate the expectancy of the potential outcomes with our incomplete information. Looking at what’s happening economically is scary – the pace and magnitude of decline in economic activity and leading indicators has been historic.
Perhaps an arguably crude analogy can put this in the proper light. The first analogy I could think of is the initial phase of hurricane Katrina. Strong winds struck and rattled a lot but the damage appeared to be well contained and surmountable initially. It wasn’t until the insurance in the form of a levy failed that we realized that we were in a heap of trouble and needed to do something about a potential catastrophe turning probable, however, we had no reference point to help us understand the magnitude and the duration of the destruction and its painful aftermath.
Today the big question revolves around how bad earnings will get and what the nature and timing of a recovery might be so we can decide whether the market is cheap or expensive relative to such a base case scenario so we know how aggressive we should be and how much market risk we should take on. The idea being that if we reasonably estimate/approximate what the next 12 months earnings yield and longer term growth rate might be, we can also craft reasonable expectations of what the central tendency of stock prices might be in the year or two ahead.
What’s more is that none of the bulls seem to have a clue as to how and when the personal incomes and corporate earnings (which I assume would support a sustainable stock market recovery) is likely to manifest. And it also seems as if everyone is expecting that multiples should be similar to what we’ve experienced in recent history, despite the glaring fact that the game has changed such that when the growth needle moves noticeably it wont be very significant unless we start from lower bases still.
In prior bear markets and recessions, much damage was done but the lifeblood of markets, (ie. Liquidity and credit) remained in tact. Credit markets remained functional and countercyclical monetary and fiscal policy acted upon the supply side and demand sides of the economy and helped get the cogs of capitalism turning again. Textbook Keynesian dynamics – when consumers and the private sector lack the will or ability to spend, Uncle Sam increases everyone’s allowance and the Fed makes financing your spending easier and cheaper.
Meanwhile, the banking system facilitates stability and an eventual recovery as enterprising Americans take advantage of apparently depressed asset prices, goods and services prices, labor prices and capital prices. That, more or less, is how the cycle plays out and a new growth cycle is born in the ashes of the last bust. The key here is that the banking system is willing and able to facilitate commerce and inject the lifeblood of the economic growth to markets. It’s not only about keeping otherwise viable businesses solvent with the help of credit; but also sowing the seeds of economic expansion which yields jobs, income, wealth creation, and improved asset prices.
The credit bubble that has popped changes the game more than most appreciate. Many think it is a matter of time that things return to whatever normal they thought was in the markets but I’m afraid that is more than a tad presumptuous. Our economy is in a literal downward spiral and the conventional countercyclical remedies are either impotent or insufficient to mitigate the seemingly exponential headwinds because the banking system has become dysfunctional and permanently impaired. Life as we knew it is over because the real pie is actually much smaller than anyone thought and it will not grow like it did in the past because credit, lending, saving, risk taking and investing behaviors will change for a generation. You are likely to see less, more costly credit, more saving itself constrained by real income, less risk taking and less, and more conservative investing.
If you further consider that the government sector may not spend as much as everyone thinks; the outlook dims even more. It seems that everyone thinks that the federal government will spend without limit and backstop anything and everything such that a recovery is likely to come much sooner than leading economic indicators seem to suggest. I hate to burst your bubble but I think that as conditions deteriorate further in the next 3-6 months, it will become increasingly clear that government spending levels are also unsustainable and the focus is thus likely to turn to smarter/more efficient spending which will “shift priorities” and “limit waste”. So a lot of the incremental new deal type spending is likely to be offset but budget cuts elsewhere. Additionally, I think many are underestimating the extent of belt tightening at the state and local level.
At the same time individuals are likely to voluntarily and involuntarily curtail spending because the game of lending anything to anyone is also over. A great deal of economic activity happens because credit is available – no credit means that business, spending or investment doesn’t get done. A generation that was enabled to spend well in excess of its means will have to learn how to save. People will still want to buy houses, cars and other big ticket items but the no money down game has changed such that saving will increase which is good longer term but obviously will defer consumption accordingly. Surprisingly few Americans have the ability to put 20% down on a $300,000 home. One of the scariest things (because I don’t know how to quantify it) is the idea that in order to manage the massive credit expansion from a personal balance sheet perspective, the pie must continue to grow meaningfully. This generation has accumulated very significant debt service burdens which are obviously unmanageable from a cash flow perspective but also will act to crowd out future spending and investment. This is likely to act as an another albatross of sorts; especially if baby boomers try to salvage whats left of their retirement nest eggs/prospects by saving more.
Yet market pundit after market strategist after CNBC guest seems to think the “THE” bottom is in. Very oversold in the context of time such that a very sizeable rally on the order of a good stock market years returns sure, but “THE” bottom? I doubt that very much – it’s possible but highly unlikely in my view. I certainly wouldn’t bet on it because I think it’s much more likely that the next big move from here is NOT up. Don’t believe the hype! Focus more on managing your risk instead of missing out on something unlikely to happen. Stocks don’t typically do well when guidance and estimates are being missed.
I’ll be back soon with some more ideas which I hope make my points clearer and also a few ideas both long and short that I think can do well to make your stay in the house of pain more comfortable. To be continued (in part 2)…
Disclosure: None
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This article has 25 comments:
Even necessities are hit. 6 weeks between haircuts instead of 4 weeks; those treads look OK for another few months; 4000 miles between oil changes, instead of 3000, etc. Anyone who doesn't see the seachange in consumer attitudes( the all important psychological shift )is blind.
This stock rally is for taders only.
Specifically, with unemployment rate that could approach 10%, dramatic reduction in consumer spending tied to upcoming credit card / unsecured credit blow-up, more corporate bankruptcies, and weak foreign markets, what are the best investment strategies?
Also, what's your view on the potential of China being the catalyst to lead global economy out of current recession. Jim Cramer seems to think this is feasible scenario, but how exactly does the US consumer (responsible for 2/3 of US GDP) benefit from China stimulus (going to their own infrastructure build out, education for rural areas, banking / housing support, etc, etc)?
Thank you
So while I don't disagree with your statement:
"Today the big question revolves around how bad earnings will get and what the nature and timing of a recovery "
that assumes that the market is going to be driven by economic activity. There's at least an arguing point while that is the case in "normal" times-- these are not normal times, and something else may be in store
. . . to me, the "big question" is: "When does the weight of dollar creation hit the markets?" "Helicopter Ben" long ago pointed out that the Federal Reserve has a printing press. At some point, if you're holding cash or Treasuries, the mountains of supplemental dollars lead you to want to trade those dollars for assets . . . and equities have earnings, but they also have assets.
Take a Weyerhauser, owning zillions of acres of timberland. They could be analyzed as a company exposed to construction-- in which case, earnings will be lousy, and performance will be lousy. Or they can be considered as an owner of land and timber. At what price and at what point do you say "I'd rather trade my dollars for an ownership stake in land and timber, because I think land and timber will be more valuable in dollars in the future?"
That's not an earnings call, that's an asset value/currency value call.
1) Manufacturing just tanked big-time in December.
2) The ADP job loss number was 693,000...more than a tad bigger than expected. ADP hasn't always been the most accurate with its numbers...but given what has been going on, it sure seems to fit this time.
3) We still haven't bottomed morally -- Madoff walks, baseball players are still signing $100+ million contracts to play a game. Somehow, these are both very grim indicators of a bubble society which still isn't placing its value on the right things nor demanding (and receiving) justice.
On Jan 07 11:56 AM Debt Junkie Scum wrote:
> Spot-on. It is a historical turning point both financially and culturally.
> There are so many deluded pundits on CNBC and in the papers urging
> people to buy, they have no care and conscience.
>
> Thank you
Both in the own way have told the truth.
Both expect huge sacrifice.
Both receive unquestioning support of the populous.
Neither effectively communicate the size of the problem to the masses.
Nobody understands what they are letting themselves in for.
Unfortunately the lessons that America needed to understand, it will now learn whether it likes it or not. Everything on the scale starts at very bad and it gets worse from there. Stimulus can soften the initial impact, but it won't solve the problem. It could be equated to dropping behind enemy lines with a parachute. Probably better than with no parachute, but not much.
Having said that if the infrastructure gets sorted that at least will be a plus.
> creation hit the markets?" "Helicopter Ben" long ago pointed out
> that the Federal Reserve has a printing press. At some point, if
> you're holding cash or Treasuries, the mountains of supplemental
> dollars lead you to want to trade those dollars for assets . . .
> and equities have earnings, but they also have assets.
>
> Take a Weyerhauser, owning zillions of acres of timberland. They
> could be analyzed as a company exposed to construction-- in which
> case, earnings will be lousy, and performance will be lousy. Or they
> can be considered as an owner of land and timber. At what price and
> at what point do you say "I'd rather trade my dollars for an ownership
> stake in land and timber, because I think land and timber will be
> more valuable in dollars in the future?"
>
> That's not an earnings call, that's an asset value/currency value
> call.
Excellent point, on a good article
> at what point do you say "I'd rather trade my dollars for an ownership
> stake in land and timber, because I think land and timber will be
> more valuable in dollars in the future?"
>
> That's not an earnings call, that's an asset value/currency value
> call.
It requires gray matter. Thank you, Allen.
Its interesting to me that the Fed and Treasury aren’t more worried about a potential dollar crash given the circumstances. Finally, pegs and currency boards are out of the question – that would be tantamount to telling the Chinese and European Union that we give up so we’re handing in our keys to the global economic kingdom and taking our place aside the Greeks (no offense to the Greeks and the Romans). The real longer term threat in this regard is that the Euro takes big reserve currency market share and/or meaningful market share of the global petrodollar economy. If arab people keep getting pummeled, and/or the dollar and economy falter, I would not be surprised to see a lot more oil priced in euro and yen (if the Yuan ever becomes fully convertible, they’d take Yuan as well.
On your point about an whether the market (which is a collection of stocks) will be driven by economic activity and earnings or is an asset value/currency call: my point was the bulls started running despite the fact that no one seems to have an idea what earnings might be – earnings matter, if earnings on the S&P500 turn out to be $40/share in 2009, you can bet your bottom dollar that we’ll have a zero chance of hitting GS’s laughable 1200 target. If growth is slower in the next 25 years than it was in the last 25 years (very little doubt in my mind it will be), why should investors expect the S&P500 to sustain a high teen multiple?
Lastly, I like your thinking on when one might trade ever cheapening dollars for equities and other assets. However, I think the WY example is a special case in that other industries can’t sell assets like WY, because they need their assets to operate and generate the cash flow needed to remain a going concern. A lower dollar should aid all hard assets (including dirt), but if it happens in the context of our gigantic fiscal and monetary stimulus faltering, then WY shares are likely to be pressured because their earning power and asset values are declining. I doubt they will get credit if they are selling assts in a distressed fashion and I wonder where the buyers would come from if few have down payments or credit.
I said dirt that’s what they have dirt and trees. With opportunities in real estate selling below replacement costs, I don’t see builders rushing to buy WY’s land and build on it and hope the demand materializes. I think of it more as an asset allocation decision where yes, you do want to diversify out of dollars and dollar denominated debt, and especially treasuries b/c I think the Treasury and Fed won’t defend a declining dollar. But I don’t know if dirt is the way to go anytime soon if the dirt doesn’t generate income and its worth less in the near future. You might look at them as having a balance sheet issue similar to banks – liabilities are relatively sticky while asset values are plunging – if WY was more leveraged, equity would get obliterated if land prices further. I haven’t followed WY for a few years (very good company IMO, by the way) but a quick glance at the balance sheet lends comfort but I don’t know what their assets are valued at on those books – I would not be surprised if they would have to take charges and write offs if they sold land bought more recently at losses. I’ll want to own builders again for other reasons but not in a big way yet.
Thanks again for the comments; appreciate your insight.
On Jan 07 12:22 PM Crocodilian wrote:
> Here is the puzzle: We're having a deflationary crash, one which
> appears consistent with a hard money or currency board type system--
> and yet the floodgates on money are wide open.
>
>
> So while I don't disagree with your statement:
> "Today the big question revolves around how bad earnings will get
> and what the nature and timing of a recovery "
>
> that assumes that the market is going to be driven by economic activity.
> There's at least an arguing point while that is the case in "normal"
> times-- these are not normal times, and something else may be in
> store
>
> . . . to me, the "big question" is: "When does the weight of dollar
> creation hit the markets?" "Helicopter Ben" long ago pointed out
> that the Federal Reserve has a printing press. At some point, if
> you're holding cash or Treasuries, the mountains of supplemental
> dollars lead you to want to trade those dollars for assets . . .
> and equities have earnings, but they also have assets.
>
> Take a Weyerhauser, owning zillions of acres of timberland. They
> could be analyzed as a company exposed to construction-- in which
> case, earnings will be lousy, and performance will be lousy. Or they
> can be considered as an owner of land and timber. At what price and
> at what point do you say "I'd rather trade my dollars for an ownership
> stake in land and timber, because I think land and timber will be
> more valuable in dollars in the future?"
>
> That's not an earnings call, that's an asset value/currency value
> call.
On Jan 07 03:35 PM Malkiel wrote:
> If anything has been true for an entire generation, it's that the
> keepers of the cash--banks, credit cards, brokerages, mortgage companies,
> etc.--will find a way to introduce leverage back into the system.
> There's a system in place in which companies are run by the whim
> of ceo's who need to care only about the opinion of their lending
> banks and stock rating entities, making short-term numbers such as
> quarterly earnings more important than they should be and guaranteeing
> that the race to short-term gains will continue and that leverage
> will be the primary tool for getting there. Until reforms are put
> in place which demote ceo's back to employees and restore shareholders
> to their place at the table, the privileged insiders will continue
> to restructure the recovery to meet their needs first. Leverage
> will return, along with new bubbles and new artificial wealth. This
> may not be a bad thing if it's managed intelligently--but it must
> be managed, a totally hands-off approach won't do. In any event,
> all those people with seemingly wrecked credit from foreclosures
> and bankruptcies will be getting their credit card offers in the
> mail next year to start the karmic cycle all over again...
On Jan 07 02:11 PM bricki wrote:
> While it is clearly a time to be careful, the recommendation cuts
> both ways - be conservative both on the up and the down side. The
> ADP results have triggered a lot of pessimism, but we have seen these
> numbers be off by a factor of 3 before.
>
Interesting breakpoint. With median earnings at $50K or so, how many people could be expected to have more than a year's income ($60K) available for a home downpayment? Maybe they have that in IRA/401k, but deploying it for a home wouldn't be particularly prudent.
If we use the 3x rule of thumb (home=3x annual earnings), how many could put $30K down on a $150K home? My guess is not many.
And persuading newly-prudent lenders to help out with the process - the same way.
I hope it doesn't work, and there is reason to believe that the cash-strapped punters are not buying it ( pun unintended)