The Pragmatic Capitalist's  Instablog

We're slowly beginning to piece together the puzzle of insider selling that has been so pronounced throughout the rally.   By now we all know that the uptick in the economy has been mostly stimulus based.  We also know that businesses are still seeing deteriorating top line growth and unsustainable growth via cost cuts.   These have been the primary reasons for our skepticism regarding the sustainability of the rally and the economic upturn.   As the market soars higher insider selling has been confounding to say the least, but the recent comments from Ken Langone and the Business Roundtable Survey essentially confirm what we have long thought: the rally is built on quicksand.  Of course, we're not the only ones who think the rally is built on quicksand (see here & here for more from Peter Thiel and David Rosenberg).

There are only two real precedents for the deleveraging cycle that the U.S. economy faces today: 1) The Great Depression & 2) Japan in the 90’s (I am excluding Sweden from this exercise due to their small size – what’s wrong with a Swedish model is always worth a read, however).   I have said that the current deleveraging cycle is actually not all that similar to the Great Depression – primarily because our economy is much more mature and stable, and also because there are certain safeguards in place that help prevent such an event from occurring again (the FDIC is a great example).   The similarities to Japan, however, are quite frightening.   Goldman Sachs recently wrote a piece noting the same thing with a few counterarguments.  Just how similar to Japan is the current deleveraging cycle in the United States?   Let’s take a closer look:

By now we all know that government’s around the globe have implemented the largest single stimulus plan in the history of economics.  There is no doubt that the global stimulus plans have been highly effective.  What is less certain is how much of the underlying structural problem we have actually solved with these programs.  Let’s not forget – debt got us into this mess and much like the Great Depression and Japan, it is unlikely that short term stimulus will solve these long-term structural debt problems.  In fact, you could argue that much of what governments have done have actually made the problems worse.  Unfortunately, we haven’t solved the problem of excess debt and all the stimulus does is prolong and delay the eventual day of reckoning with this mountain of debt.   Comstock does a wonderful job of detailing these long-term issues.

Much of the recent stock market optimism has been based on the supposed bottoming of real estate prices.  As regular readers know, I am more skeptical than most of the recent housing stability.  Every year we experience strong seasonal trends in housing that give investors hope during the spring and summer buying seasons.  The price of lumber is an excellent example of such seasonality.  As you can see in the following chart lumber prices have spiked in each of the last three springs/summers despite the worst housing environment in the post-war era.

Dshort has an excellent chart out comparing the road to recovery using the rebounds that occurred following similar bear markets.  Excluding the 1929 data, I’ve used the S&P 500 oil crisis recovery and the tech crash to calculate potential future returns.  Assuming a total recovery of 61% (the average) from the bottom we can expect just 8.2% total returns in the coming 2 years after the incredible 5 month run we’ve already experienced.  That’s a whopping 4% compound annual growth rate.