As I try to do on a weekly basis on my blog, Scott's Investments, I try to highlight some of the better economic/investment related reads for the week. Generally, when discussing long term economic growth prospects and the prospects for the US equity market over the next 1-5 years there seems to be a building chorus of skepticism and defensive posturing from the investment thinkers I read on a regular basis.
Asset bubbles are strange animals. Ideally, you would like to punch the air out of them early before they become a real danger but, in practice, it is not quite so simple. Ben Bernanke and Alan Greenspan have actually both argued that asset bubbles cannot be detected and monetary policy should therefore not in any way be used to offset suspected bubbles.
I am not sure I agree with the two gentlemen, but that is less relevant for now. What is important to understand is what happens once the asset bubble bursts. In my experience, almost all post-bursting bubbles share two characteristics:
- At the very least, asset prices revert to the mean, although many actually overshoot on the downside.
- A long (and often painful) period ensues, where asset prices gradually claw back lost value. History suggests that this period is measured in years and sometimes in decades; never have asset prices recovered from a deflated bubble in just a matter of months.
The recent collapse of residential property prices - at this point still more advanced in the US than in Europe - is a classic asset bubble which is now deflating. The reason I have decided to write about it this month is because the “green shoot” campaigners are missing a hugely important point about the effect that falling US property prices are going to have - not just on the US but also on the global economy.
Recovery will prove temporary
Make no mistake. I always expected and continue to expect an economic revival later this year, which unfortunately will prove temporary. There are many good reasons to expect such a short-term recovery, as I discussed in detail in the April issue of this letter. However, it is what happens afterwards that I worry about. The economic uplift is likely to last no more than one or two quarters after which we will have to face more gloom and doom.
There are at least two reasons property prices are so important to the overall economy. The first reason has to do with leverage. There has been a lot of talk about de-leveraging in recent months, and the consensus seems to be that most of it is now behind us. Perhaps, in the narrowest possible sense, that is correct.
But leverage is not confined to hedge funds and banks. Many private households run heavily levered balance sheets as a result of their home ownership and it is this leverage that is rapidly growing at the moment. Why is that? Because leverage is a function of both the numerator and the denominator and, as American home owners are about to find out for the first time, falling property prices can have a devastating effect on your balance sheet.
Secondly, property wealth has become an important part of many people’s lives. In both the US and the UK (and in numerous other countries as well) many people have directed their savings towards property in recent years, and no small part of the profits have been recycled into the economy through equity withdrawal schemes. This has created a level of consumption which cannot be sustained if property prices do not continue to rise.
As noted in the March and April letters, there is a good chance that GDP will post a positive print in the fourth quarter of this year, and maybe in the third quarter. However, the most important issue in the next 12 to 15 months is whether the rebound in the second half of 2009 and first half of 2010 will gain enough traction to launch a self sustaining economic recovery. The short answer is no one knows. What we do know is that the drag to GDP from housing, inventories, and exports will be less in coming quarters. And, with the push coming from the stimulus plan, there will be a positive GDP print in the fourth quarter, if not the third quarter. Although most of the ‘growth’ will be statistical nonsense (less bad confused as actual growth), most economists will be satisfied since they assume that an increase in GDP automatically means a lasting recovery will follow. This view overlooks the many cyclical and secular hurdles that collectively threaten to transform the U.S. economy in coming years....The combination of all the cyclical issues is daunting. The extraordinary weakness in the U.S. labor market will pressure consumer spending well into 2010. The record level of excess capacity will narrow profit margins, delay and limit companies’ need to increase business investment, and restrain hiring. The banking system, from large banks down to community banks, will remain stressed through 2010, which will limit the availability of credit and result in higher lending rates. States will be forced to lower their spending and raises taxes, which will offset a portion of the federal fiscal stimulus plan. And the synchronized nature and depth of the global recession means there is no place to hide. Although China and India are in far better shape, they represent less than 10% of world GDP.
While we’re dealing with these cyclical issues during the next two years, there are a number of secular problems looming. As I have discussed numerous times over the last two years, the biggest problem is the increase in debt from $1.60 for each $1.00 of GDP in 1982, to $3.53 in 2008. Debt has been growing faster than the economy for more than three decades. This is unsustainable. It’s like trying to gain weight by eating your own leg. The other complicating factor is that the cost of money has fallen from 15% to 20% in1982, to today’s generational lows, so the debt burden can’t be lessened through lower interest rates. We’re going to have to fix this the old fashioned way – save more, and spend less.
And Welsh's Thoughts on Stocks:
Most of the time, perception and reality run parallel, especially during periods of economic stability. But when change accelerates, perception and reality often diverge. In late 2007, the perception was that the U.S. economy would avoid recession, since the Fed was handling the sub-prime credit problem, and global growth was expected to remain healthy.
When the reality proved far different, the stock market sold off hard in this first quarter of 2008. Since early March, the rally in the stock market has been sustained by the perception that the economy will be in much better shape later this year. This has led investors to dismiss and ignore any negative news, and seize upon any less bad news as proof a recovery is on its way.
This theme has led investors to buy commodities like oil, copper, natural gas, silver and gold (the reflation trade). In financials, it has caused treasury bonds to be sold, and corporate and junk bonds to be bought, along with stocks.
Some strategists, who believe markets have paranormal characteristics, point to these trends, as confirmation a recovery is afoot. When investors consider a loss of 539,000 jobs as good news, there is a decent chance that the perception of when the economy will recover is ahead of the reality, especially when the real loss of jobs likely approached 750,000. This suggests the market is vulnerable.
Since I expect GDP to turn positive in the fourth quarter, my expectation has been that the rally from the March low would take an up, down, up form. The down portion likely began after the S&P reached 930 on May 8. I had thought the S&P might have a quick rally to 940 once it closed above 878. A ‘normal’ pull back would bring the S&P down to 830-850. Anything much deeper will depend on a pickup in selling pressure.
After this correction, the market should rally as investors refocus on the potential of GDP turning positive later this year. However, the next few weeks could be a bit tricky, since I believe the economy remains in worse shape than the V-shape crowd realizes. In recent weeks there has been virtually no selling pressure. This has been a bit surprising, but underscores how convinced institutions are in the second half recovery story. Although not likely, the market could spike higher, if the S&P closes above its 200 day average near 940. If it does, selling into that strength would be a good idea.
If the rebound in GDP later this year is not strong enough to overcome the cyclical and secular headwinds we face, the perception that a real recovery will take hold in 2010 will confront a stark unpleasant reality. This will lead to another large sell off. Continue to use a trailing 1.5% stop on the high yield bond funds recommended in March (FAG1X +18.0%, NNHIX +6.1%, VAGIV +7.8%).
The pattern in the dollar index suggested it would fall to at least 82.50. With talk of the Dollar being replaced as the world’s reserve currency, sentiment has turned fairly negative. After the early March high the Dollar, it fell 7.00 points, and then rebounded to 86.86, an almost perfect .618% of that decline. An equal drop from 86.87 targets 79.87. It’s possible that the Dollar is completing the correction from the March peak. Traders can buy the dollar below 79.80 on the cash, using a close below 79.10 as a stop.
I have been negative on Treasury bonds for months. The yield on the 10-year Treasury bond has risen from 2.04% last December to 3.38%. Traders can buy when the yield is above 3.44%, using a close above 3.62% as a stop. Lower the stop to 3.44%, if the yield subsequently drops to 3.23%, and sell half if the yield falls below 3.1%.
I still think August Gold has the potential to drop to $820.00-$845.00 in coming months. Last month, investors were advised to short Gold in a number of ways, depending on risk tolerances. The most conservative way would be to short GLD, which is the ETF tied to gold, or by buying DZZ, which is the 2 to 1 short gold ETF, or by shorting Gold futures, which is the most aggressive. Irrespective of the route, use a print of $1002.00 on August Gold as a stop. Short GLD above $94.00, buy DZZ below $20.70, and short Gold above $960.00.
Finally, a shorter Hussman Weekly Commentary for this week but still worth the read. He is increasingly defensive in his investments given the recent run-up in equity prices. Some excerpts:
Presently, however, the debate about the long-term economic fallout from this defense of bank bondholders is anything but academic. I recognize that I have been on a virtual rant about it in recent months, but the reason is that it is literally the most important fiscal and bureaucratic event that we are likely to observe in our lifetimes, and is very possibly the precursor to enormous future economic difficulties. You simply cannot have an economy lend out trillions of dollars in bad debt, and then make the lenders whole with public funds (while still facing a massive second wave of probable mortgage defaults) without destructive repercussions. There is very little chance, in my view, that the current downturn is over. We have enjoyed a nice reprieve – if over a trillion dollars in redistribution could not accomplish even a reprieve, it would be a surprise. It's clear that investors are hopeful that we can simply return to rich valuations, debt-financed economic expansion, and abnormal profit margins based on excessive leverage. From my perspective, this hope is as thin as those that we observed at the peak of the internet bubble, the housing bubble, and the profit margin peak of 2007.
As I noted last week, our risk measures have shifted from a borderline neutral stance to a fresh defensive stance. From a valuation perspective, stocks are slightly overvalued except on the basis of earnings-based metrics that assume a quick return to 2007 profit margins. Stocks are not richly priced, but they are no longer compressed in valuation. They are also no longer compressed from a technical perspective, and are instead overbought on a variety of measures. Without compression to allow prices to advance as a sort of “release valve,” the market now relies on actual improvement in the economy – not simply news that is “less bad than expected.” That's not to say that we can rule out such improvement, but at this point, the market relies on it. For our part, the average return-to-risk profile of the market, given current conditions, does not justify much risk taking. Moreover, in view of the larger picture of economic and credit conditions, the risks are lined up clearly to the downside. The stock market features unimpressive valuation, overbought conditions, and a reliance on positive surprises and easing risk aversion. That sort of market certainly can continue higher, but the potential for further return comes with a great deal of potential risk.
As of last week, the Market Climate for stocks was characterized by modestly unfavorable valuations and enough deterioration in (already tepid) price-volume action to place us on the defensive against potentially abrupt weakness. The Strategic Growth Fund does continue to carry just under 1% of assets in index call options as something of an “anti-hedge” to soften our defenses in response to any further market strength that might emerge, but our primary concern here is defending capital. Though the recent advance has not produced strong price-volume behavior on our measures, we've clearly observed much improvement since the lows, and I expect that this will make it much easier to recruit sufficiently favorable price-volume behavior in the months ahead. The ideal situation would be to observe a significant decline back toward the 700-800 area, which might provide a more durable base for subsequent strength. In any event, I expect that the market may remain in a very wide 25-35% trading range for some time – not just a few months. As I've noted before, a 1/3 retracement of the decline since the 2007 peak would represent a move to about 975, which is possible, but again, we would not speculate on that event, and for our part, we are mostly defensive here.
In bonds, the Market Climate last week remained characterized by modestly favorable yield levels and generally unfavorable yield pressures. I remain convinced that the enormous issuance of government liabilities we've observed is likely to result in a longer-term upward shift in the U.S. price level, but there is not an immediate reason to expect inflation pressure at horizons of less than a few years. That being the case, bonds – like stocks – can be expected to trade in a very wide trading range for some time, and we'll tend to extend our durations on further spikes in yields, while contracting them when yields decline significantly. For now, the Strategic Total Return Fund continues to carry a duration of just over 2 years, mostly in TIPS, with about 25% of funds allocated to precious metals shares, foreign currencies, and utility shares.