Putting it all Together: Managing Money as you Peer into the Abyss

Eiad Asbahi's picture

Articles of Discussion:

Peering Into The Abyss
Looking Beyond The Fiscal Stimulus
Investment Implications


Investors face a serious dilemma, and it is not about the validity
of the existence of ‘Green Shoots’. We are certain that the
unprecedented government policy response to avert a depression-era
collapse of our financial system will go hand in hand with an
unprecedented number of unintended consequences, perhaps manifested by
loss of confidence in the dollar, inflation and possibly both.

Peering Into The Abyss

Stocks have put up a fierce showing, rallying in taunt of investor
fears from the S&P 500 March low of 676. Accompanying such vast
swings in market action are vast swings in investor and financial media

Our view is that while stocks are fairly valued by historical
standards and slightly undervalued relative to other asset classes,
they are uncomfortably overvalued given an assessment of highly
possible potential downside scenarios. Specifically, should financial
market participants behave as they did in other times characterized by
similar economic fundamentals, the amount investors are willing to pay
per $1 of corporate earnings (i.e. the P/E multiple) could very well be
cut in half (or more), resulting in S&P levels of 450-650. In other
words, we may very well be staring into an abyss.

We are living a global economic contraction that has been on par in
magnitude with the Great Depression.  We have collected an immense
volume of data, but prefer not to debate this here; rather, we would
like to turn that task over to two professors:

A Tale of Two Depressions

We concur that our current experience feels quite different
from that felt during the Great Depression. The United States is no
longer the global repository of marginal industrial capacity, now
transfixed in the Far East; hence, our economic system is less prone to
catastrophic jolts to Industrial Production than those of our emerging
market cousins. And more current data shows the Chinese economy making
new highs in terms of economic activity and, in its new role as global
locomotive, driving sharp rebounds in Emerging Asia economic growth.

Still, in the US we are confronted with immense economic headwinds.
We believe that household sector debt service levels have reached their
tipping points and that this will have major implications on future
consumption growth. This doesn’t bode well for a consumer-driven
economy wherein the consumer makes up 70% of US GDP.

Our view is that the private sector will continue moving away from
profit maximization and toward debt minimization. Already the private
sector has begun to deleverage even in the face 0% interest rates: The
Fed has been rendered incapable of stimulating credit creation due to
an absence of credit-worthy borrowers, rendering traditional monetary
policy, based on fractional reserve banking, ineffective. While it has
succeeded in alleviating the shortage in the supply of credit, it no
longer has the ability to stimulate the demand for credit -- the
private sector has tapped out.

Further, the diversion of money from consumption to savings/debt
paydown manifests itself as a deflationary gap, pushing the economy
toward a new, contractionary equilibrium until the private sector is
too impoverished to save. (Note that while ‘unemployment’ is still
below 10%, the U-6, or the broader underemployment metric is at 16.8%,
6.5% higher from one year ago.) Capitalism is based on capital
formation (i.e. lending and equity investing); the level of activity in
capital formation has peaked and naturally reversed course. In this
type of economic dynamic, we will not see self-sustaining growth until
private sector balance sheets are repaired, thus re-paving the way for
sustainable growth in capital formation.

As such, we are intrigued, yet unsurprised, by the stock market’s
behavior. Having extensively studied the economics of deleveraging and
the depression era itself, we are reminded of its 6 rallies measuring
between 21% and 48% (in a total bear market that measured 89%), each
caused by an increasingly larger dosage of government stimulus.

Still, we spend a lot of time thinking about what could change our
outlook and looking for holes in our reasoning, especially in light of
our stark counter-stance to the consensus. We have also spent a lot of
time studying how bear market rallies in the past have manifested
themselves, and they tend to resemble the current experience, a strong
move thrust off short-term orientated wishful thinking such as 'Green

So, what is fueling it?

  • Many investors, if represented by the financial media, have failed
    to adjust from the vanquished paradigm of low inflation, stable credit
    creation, and robust economic growth. We consider but choose to ignore
    the noise.
  • A lack of suitable alternatives: With interest rates remaining
    low, the value of stocks on a relative basis is appealing. Indeed,
    whether measured against Treasury-bond yields or corporate-bond yields,
    the stock market appears not only fairly valued but perhaps even
    relatively cheap.
  • Chasing performance: There is a record amount of cash sitting on
    the sidelines. The rally is now feeding on itself as investor pressure
    not to lose has been replaced by pressure not to miss out. That fear
    leads to speculation, not investing. In other words, fear is
    manifesting itself as greed. (We suggest reading Seth Klarman's elaboration of this matter.)
  • The marked improvement in economic growth, or what has been
    described as the emergence of ‘Green Shoots’: US growth has gone from
    falling at a -6% rate to improving at a sluggish but improved -1% and
    investors seem to be discounting continued acceleration into the
    future. To assess the validity of this generalization, it is important
    to identify the source of the turnaround.

Looking Beyond The Fiscal Stimulus

We are of the opinion that the effect on growth from the stimulus has been understated.

Effects of Stimulus on Growth Underappreciated

But the nature of
the stimulus is transitioning from transfers and tax cuts to infrastructure
projects and, hence, the growth impact is about to recede rapidly.

Growth Impact Receding

By most measures the economy is far and away from anything remotely
resembling a self-sustaining recovery. As a result, there exists a
large hole in the economic engine and a need to fill it with large and
ongoing public sector increases in the money supply, credit creation
and spending. We predict the pressure to mount on policy makers for a
second round of stimulus in the coming months (and very likely further
rounds over a multi-year time span).

Investment Implications

Portfolio Structure: **

  • Shorten portfolio duration: Given the steep rise
    in equity valuations (and concurrent increase in risk), we believe that
    a stance focused less on growth and more on capital preservation is
    warranted. We are structuring our portfolio with a low net equity
    exposure and are focused on identifying opportunities in shorter
    duration bonds and event-driven investments (bankruptcies, risk
    arbitrage, liquidations).

Areas of opportunity: **

  • Global banking sector to continue to contract: We are now
    entering phase two of the credit cycle, and believe that losses in the
    banking sector’s late-cycle assets have just begun. Specifically, we
    expect substantial going-forward economic deterioration and credit
    losses in commercial and industrial, construction, and commercial real
    estate loans and have identified a number of overpriced regional banks.
    Additionally, we have identified a number of attractive shorts in
    European banks with unruly exposure to Eastern Europe.
  • Attractively priced hedges against global financial instability and a weaker dollar:
    Investors should protect themselves against the risk that US
    policymakers will not prevent erosion in the value of the dollar. The
    magnitude of the dollar’s depreciation against other currencies is
    likely to be outpaced by its fall against real assets. We have
    identified a number of producers of commodities trading below the cost
    of production. Additionally, junior gold miners were indiscriminately
    crushed in 2008: We see a phenomenal valuation-based opportunity in one
    trading cheaply on a free cash flow basis, having adequate resources to
    fund years of further exploration and with a very attractive potential
    for further upside.
  • Treasuries: Bearish consensus will likely be proved
    incorrect. Households currently own $8.8 trillion of equities, $7.7
    trillion of deposits and cash (earning next to nothing in yield), and
    $273 billion of treasury notes and bonds. Even with China and other
    traditional foreign purchasers becoming skittish about U.S. debt
    purchases, given the unprecedented volatility and riskiness on display
    in equities, it is only a matter of time before the U.S. consumer moves
    to allocate more and more wealth to this least represented holding (at
    the expense of cash and equity allocations). We expect Treasury yields
    to remain at depressed levels for the remainder of the economic
  • Credit conditions for small companies remain inordinately tight, prohibiting business growth:
    The inevitable failure of CIT will only exacerbate the problem. The
    provisioning of debt or equity growth capital, both in very short
    supply, could at some point in the future become exceedingly lucrative.

Risks To Our Outlook **
We view the primary risk to our outlook to be that reflexivity, or the
interplay by which the real and financial economies feed off one
another, takes hold whereby incremental improvements in household
balance sheets due to rising asset prices, through the wealth effect,
induce economic relevering. Although it is highly likely that it will
take much more effort on the parts of the Fed and Treasury to
counterbalance the tendency toward private sector delevering, we allow
the data to speak for itself.