El-Erian: It's the Levels, Stupid

PIMCO's Mohamed El-Erian warns that 'old ways of thinking' threaten the emergence of any sustainable recovery:

Today’s lack of appropriate anchoring frameworks appears to be exacerbating short-termism. The issue goes well beyond the still-limited appreciation of the multi-year realignment of the global economy, which is gaining momentum. It also relates to tendencies well-documented by behavioral economists – such as framing the problem wrongly and refusing to question past approaches.

Given all this, we would be all well advised to follow the admonition of Mervyn King. Last month, the governor of the Bank of England stated bluntly: “It’s the level, stupid – it’s not the growth rates, it’s the levels that matter here.” Investors have not yet accepted his insight that the absolute levels of income, debt, wealth and unemployment, not just the rates of change, are what matter today. They need to, and soon.

Analysis of key levels in the global economy points to important deviations between desired and actual levels. The outlook for major countries will continue to be driven by the levels of key variables, not their rate of recovery...

These considerations serve to accentuate the inconsistency between market valuations and the reality facing companies and economies. Today’s markets – be they industrial country equities or corporate bonds – have priced in vigorous growth for 2010. Valuations assume companies will be able robustly to grow earnings through higher revenues, not renewed reliance on the cost reductions that have propelled earnings in the past six months. For that, they are depending on what is likely to prove to be an elusive high-growth scenario for 2010.

The longer it takes for investors and the policy consensus to shift to the appropriate analytical framework – one that factors in levels rather than just rates of change – the greater the risk of disappointment in 2010. Mr. King’s insight will need to be more widely appreciated if the global economy is to avoid a growth and wealth relapse next year.

Comments

[Mark Bern:]

Very true! But going into 2009, we had the same situation. Wall Street, the newly elected President, and MSM all proclaimed that earnings would rise dramatically by year-end. Then the grinding down of estimates began. Every month it seemed like earnings estimates were lower than in the previous month.

As the process continued, the emphasis on earnings growth was replaced with "exceeding earnings estimates." Exceeding lowered expectations became easier as earnings targets were lowered. And voila! We have beaten expectation, the market is up, and all is well. Or is it?

In 2010, I expect more of the same. Going in, the pundits will tells us that earnings will soar. (Funny, isn't it, how they offer no sound reasoning or basis for their expectations other than the recovery has begun.) As 2009, full-year earnings are being reported, earnings estimates will be lowered again (silently, without the hoopla). And each month when there is something positive to be reported and all eyes are fixed upon that something, earnings estimates will be lowered and reports will be made public in an inconspicuous way, buried deep where few will find them.

By Q1 2010, the earnings expectations will be slightly above Q1 of 2009 (at best, maybe) and whether actual earnings beat or just miss, it will be announced as a step in the right direction. After all, remember what the full-year earnings estimates were for 2010 when they were announced in Q4 2009. Anything even close will be worthy of euphoria! Or, at least, that is what the public will be told.

The whole scam is a ploy to buy enough time to do two things: recapitalize the banks and let the recovery actually start to take hold. But the powers in charge of the public airwaves can only hold off the inevitable for so long. How far into 2010 will investors allow themselves to be lulled into dreamland, once again? That is the question.

And to the author's point, when reality sinks in that we are where we are and there really isn't going to be a spring back to where we once were or anything even close, the markets will find equilibrium at a lower level. Then we will probably see even tighter lending and even more bankruptcies. Then we will find out which companies are healthy and which ones are not. And then maybe the healing can begin.

Sep 29 01:56 PM

[CautiousInv...:]

What he is really saying is that any attempt to project a recovery from this crisis cannot be based upon statistics gathered from prior recoveries; this recession has been very unique and standing levels of unemployment, consumer debt, public debt and dubious bank assets must be systematically taken into account and "synthesized" into a forecast that keeps these constraints in balance. Further, it is a mistake to believe indications of a nascent recovery are anything more than the product of fiscal largesse; the levels of problems are too tall for any reversion of the mean to be taking place as quickly as some wish.

Sep 29 04:47 PM

[Pat C:]

Good article, Mark I can't wait to hear the hype about the year to year improvements in 4Q09 and 1Q10. The spin folks will somehow forget to mention that we are comparing to the worse 2 quarters of financial/economic results since the great depression. The levels are indeed the only thing that matters.

Sep 29 05:18 PM

[thiazole:]

But aren't you also one of the same guys saying that future earnings estimates are too HIGH and that is why stocks are over valued? You waffle more than John Kerry did on the Iraq war. Your position depends on whether you are talking about beating estimates or market valuation.
I have a more consistent position. Just like stock prices, earnings are improving from the bottom, but also just like stock prices they still have a long way to go before they reach their previous highs. When stock prices are down 30% from their previous highs like they are right now, I don't expect earnings to be back to the previous highs either.


On Sep 29 01:56 PM Mark Bern wrote:

> Very true! But going into 2009, we had the same situation. Wall Street,
> the newly elected President, and MSM all proclaimed that earnings
> would rise dramatically by year-end. Then the grinding down of estimates
> began. Every month it seemed like earnings estimates were lower than
> in the previous month.
>
> As the process continued, the emphasis on earnings growth was replaced
> with "exceeding earnings estimates." Exceeding lowered expectations
> became easier as earnings targets were lowered. And voila! We have
> beaten expectation, the market is up, and all is well. Or is it?
>
>
> In 2010, I expect more of the same. Going in, the pundits will tells
> us that earnings will soar. (Funny, isn't it, how they offer no sound
> reasoning or basis for their expectations other than the recovery
> has begun.) As 2009, full-year earnings are being reported, earnings
> estimates will be lowered again (silently, without the hoopla). And
> each month when there is something positive to be reported and all
> eyes are fixed upon that something, earnings estimates will be lowered
> and reports will be made public in an inconspicuous way, buried deep
> where few will find them.
>
> By Q1 2010, the earnings expectations will be slightly above Q1 of
> 2009 (at best, maybe) and whether actual earnings beat or just miss,
> it will be announced as a step in the right direction. After all,
> remember what the full-year earnings estimates were for 2010 when
> they were announced in Q4 2009. Anything even close will be worthy
> of euphoria! Or, at least, that is what the public will be told.
>
>
> The whole scam is a ploy to buy enough time to do two things: recapitalize
> the banks and let the recovery actually start to take hold. But the
> powers in charge of the public airwaves can only hold off the inevitable
> for so long. How far into 2010 will investors allow themselves to
> be lulled into dreamland, once again? That is the question.
>
> And to the author's point, when reality sinks in that we are where
> we are and there really isn't going to be a spring back to where
> we once were or anything even close, the markets will find equilibrium
> at a lower level. Then we will probably see even tighter lending
> and even more bankruptcies. Then we will find out which companies
> are healthy and which ones are not. And then maybe the healing can
> begin.

Sep 29 06:05 PM