Why The Glass Is Half Full

by: Calafia Beach Pundit

The world seems divided, these days, between those who are optimistic because lots of things have improved by more than expected, and those who are pessimistic because asset prices have increased by more than they should have. (I've been in the former camp for the past six years, in case there was any doubt.)

Here's how bad things were projected to be six years ago, as I noted in this post at the time:

Either the markets are right and the end of the modern world as we know it is right around the corner, or corporate bonds and stocks are absurdly, grossly and egregiously undervalued. I say that because the pricing today of corporate bonds and stocks assumes that we are entering a period that will be significantly worse than what occurred during the Great Depression of the 1930s.

At the risk of simplifying a complex subject, the Depression was largely the result of a massive contraction of the banking sector and money supply, a massive contraction of world trade set in motion by the Smoot-Hawley Tariff Act of 1930, a massive increase in government intervention in the economy, and a massive increase in taxes meant to offset a similarly massive increase in government spending. 1929-1933 was by far the worst period. The economy shrank by 26.5% in those four years, and prices on average fell by 25%. This was a nightmare for anyone with debt, since economic activity collapsed and dollars became much more expensive to acquire. By 1936, the peak year for cumulative defaults, about 14% of all corporate bonds were in default, according to the National Bureau of Economic Research, making it the worst corporate bond disaster in U.S. history.

According to Lehman data, the current level of spreads on investment grade bonds implies that about 9% will be in default within five years, and fully 70% of speculative-grade bonds will be in default. That further implies that 24% of all corporate bonds currently outstanding will be in default within 5 years. If only 14% of firms defaulted on their debt during the depths of the depression, what sort of economic conditions would it take for almost one-fourth to go out of business?

Tim Bond, an economist at Barclay's Capital in London, has calculated that the current level of spreads on corporate bonds (which is by far the highest ever recorded-600 bps on investment grade, and 1700 on high-yield bonds) implies 3-4 years of a 15% annual contraction in GDP. That would be about twice the average 7% annualized rate of contraction during the worst period of the Great Depression, 1929-1933.

According to my model of equity valuation, which I have discussed here, and which is a variant on the Fed Model and Art Laffer's model, the stock market is assuming that corporate economic profits (as calculated in the National Income and Product Accounts) decline by at least two-thirds over the next few years. In relation to GDP, that would put them 25% lower than the worst period (1974) since they were first measured (1959).
Any way you look at it, the pricing on corporate bonds and stocks today implies that the next several years will be the most disastrous in the history of the U.S.

In order to fully appreciate why that prediction is unlikely to prove correct, consider that not one of the key ingredients that precipitated the depression exists today. Although we do have a banking crisis, the Fed has taken incredibly aggressive steps to prevent a monetary contraction or deflation from occurring. Indeed, as I have noted repeatedly, there is more money and bank lending in the world today than ever before. World trade has expanded greatly since the depression, and an outbreak of widespread protectionism in the near future seems like a very remote threat. We have had some meaningful increases in government spending, but so far we have not seen any attempt to raise taxes.

What did it take for the past six years to be the buying opportunity of a lifetime? Simply this: the future turned out to be much better than expected, even though this has proven to be the weakest recovery in history.

Those who see the glass as half empty point to the Fed's massive Quantitative Easing program, and assert that the Fed has inflated asset prices by printing massive amounts of money. I think that view is groundless. The Fed hasn't been printing money. They've only been exchanging bank reserves (T-bill substitutes) for notes and bonds, in response to the world's almost insatiable demand for safe, risk-free assets.

Equities are up not because the Fed has been printing money, but because corporate profits have been setting all-time records for the past several years.

The economy is growing not because of government spending stimulus or monetary stimulus. It is growing in spite of all the stimulus. Government spending saps the economy's strength because government spends money much less efficiently and effectively than the private sector spends its own money. Monetary stimulus is powerless to create growth, because growth only results from more work, more investment, and more risk taking; growth can't be conjured out of thin air, it must be generated the hard way, by making the economy and its finite resources more productive. An economy can't spend or print its way to prosperity; prosperity has to be earned. Easy money doesn't help growth, it hurts growth because it creates uncertainty about the future strength of the dollar and the future rate of inflation, and all that, in turn, makes people less likely to take risks and invest in the future.

In a subsequent post I plan to review a series of charts documenting the remarkable extent to which the economic fundamentals have improved in just the past two years.