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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
psychology.

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
Shoots'.

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
    restructuring.
  • 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.

 

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Wed, 08/05/2009 - 21:55 | 26627 Anonymous
Anonymous's picture

Your comment "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."

I almost never hear a discussion about another topic closely related to the consumer debt factor, which is that so much stuff has been purchased with all the debt, that even if the consumer debt disappears, the consumer may be set for at least 5 years. How many computers, wide-screens, cars, etc, purchased during the boom need to be replaced? All that debt bought a lot of stuff that simply won't have to be replaced for a long time. The consumer debt met a great deal of long-term demand. Between the pay down on the debt and the lack of need to replace things, I think we are in for a very long haul.

Wed, 08/05/2009 - 10:37 | 25673 Anonymous
Anonymous's picture

This

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.

Is very reminiscent of Richard Koo's modestly titled Holy Grail of Macroeconomics. Koo concludes forcefully that the Japanese extended their Great Recession by focusing on deficit reduction many years too early, rather than waiting for fiscal stimulus to help companies pay down their debt and move back to profit-maximization. By that logic, a second stimulus is all but required. Even if you buy that logic, the big question mark is this: the Japanese asset bubble may have been bigger than ours (I haven't seen a true comparison of these), but they were an net exporter in basically boom times. We are a net importer in bust times, so even if our bubble is smaller, Koo's logic would seem to suggest that we are in for a LONG period of stagnation.

Wed, 08/05/2009 - 10:20 | 25644 SWRichmond
SWRichmond's picture

"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."

Another threat to capital formation: the destruction of the value of USD.  What good are savings if the currency you are saving becomes worthless?  Will inflating away the debt makes saving pointless (asked and answered)?  If so, does this mean a replacement currency is likely?

 

"Many investors, if represented by the financial media, have failed to adjust from the vanquished paradigm..."

Paradigm shifts are never broadly identified as they occur.  Never; most people get run over by them.  This one is no different.

 

"There is a record amount of cash sitting on the sidelines"

Didn't we just talk about this?

 

"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)."  Then later: "We expect Treasury yields to remain at depressed levels for the remainder of the economic restructuring."

Given current pressure in the Treasury market, these two statements are exclusive, unless the author takes the position of many dollar advocates: our fiat doesn't suck as bad as everyone else's.  Which he appears to take, except for this: "Investors should protect themselves against the risk that US policymakers will not prevent erosion in the value of the dollar."

Which is it?

 

Anony 25473:

"If the government can prop this up by borrowing money that don't exist and can't be paid back, then there is no such thing as money today."

The "store of value" function of money is the one that is not enforced.  As such, IMO there IS no such thing as money today, at least not that folds.  The store of value function is what gets in the way of central bankers, like the Constutition gets in the way of the statists. 

Wed, 08/05/2009 - 18:16 | 26442 KevinB
KevinB's picture

Not all fiat currencies are junk. The CAD$ continues to do well, even though the governor of the Bank of Canada has made noises recently about intervening to slow its rise. In general, the federal government for the last 14 years has been moving to get its financial health in order. The current bust has put an end to that, but the Prime Minister tells us he will go back into budget surplus once the economy recovers. Of course, it helps that the PM is an economist, not a community organizer.

Wed, 08/05/2009 - 05:13 | 25473 Anonymous
Anonymous's picture

where did you get this? Out of the old paper bin? The US has economic growth while China has taken all the production? Is paper shuffling to for paper shuffing growth? The statements about stocks is assinine, as if earnings were real or meant a damn thing. The dividend yield on the SPX is back to 2.2%, which is less than 75% of the old all time pre-bubble high. The banking system is being propped up by phony accounting and the truth is that the US system is in much better shape than the ballyhooed Chinese system. If the government can prop this up by borrowing money that don't exist and can't be paid back, then there is no such thing as money today. Maybe that is why the Japanese are chronically broke?

Wed, 08/05/2009 - 02:36 | 25444 ED
ED's picture

Two of the most sensible suggestions I've heard the last 10 months have been calling a force majeure and anullment of all derivative contracts and the cancellation of all private debt.

It seems to me, in Willy Coyote terms, everything else are just ponderings when all that's left to do is to hit the ground - will a head or arse landing work best?

Wed, 08/05/2009 - 01:19 | 25396 Anonymous
Anonymous's picture

On the TSG weekly newsletter (http://tradesystemguru.com/content/blogcategory/34/68/), Matt Blackman quotes David Rosenberg, Chief Economist Gluskin, Sheff in a note to clients July...

“It is amazing that anyone would go long an equity market with a reported P/E multiple of 700x but that is indeed what we have on our hands. The end of the recession and the onset of a sustainable recovery, as we saw in 2002, are not the same thing. So this could still end badly but we will await confirmation signs that this is more than a very flashy bear market rally before shifting gears.”

I am not sure how he calculates 700x earnings. However, we know that stock prices are increasing faster than earnings. And this cannot be sustained before a major correction. Perhaps in October?

Tue, 08/04/2009 - 22:50 | 25242 Anonymous
Anonymous's picture

I do not profess to be expert in financial matters, and I find myself quite disconcerted with the apparent eventuality of a cataclysmic release of the forces that attempt to oppose and balance each other in the equity, forex, and bond markets. The succinct logic of your analysis is extremely helpful to a foundering amateur like myself. please keep up the good work.

Tue, 08/04/2009 - 18:46 | 24935 robbonds
robbonds's picture

Bullish on Treasurys - and the fact that its the contrarian view makes me more certain im right!

Tue, 08/04/2009 - 17:45 | 24814 jwthomps
jwthomps's picture

For many people there is No Other Good Choice.

They have looked into the abyss. 

If Green Shoots are not real, then life as they

have known it is over. 

They are fighting very hard.

 

Tue, 08/04/2009 - 17:02 | 24739 I need more cowbell
I need more cowbell's picture

"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." WRONG. The Chinks have their own bad lending bubble going, not real economic activity.

Your "cash on the sidelines" point. WRONG. See ZH article from a day or two ago.

Otherwise, pretty reasonable article.

Tue, 08/04/2009 - 16:58 | 24733 Anonymous
Anonymous's picture

straight from the cnbs school of journalism and the valley girl school of logic.....

although this is an opinion piece to which everyone is allowed at least one, i think that the author went back for seconds and thirds....

how can one say that stocks are fairly valued when the majority of evidence and fears so expressed do not support future earnings growth of any consequence? on the one hand the author argues for a contraction of the consumer led economy which i would think implies lower earnings for at least 2 more quarters while consumer companies restructure along with a contracting banking sector which has recently fueled 40% of sp500 earnings but on the other thinks that 16x earnings is reasonable??...and if you leave behind the last two near normal quarters from 2008 to look at 6 month trailing earnings, it would appear that we have much higher p/e ratio than 16x.

i don't get how stocks can be fairly valued at 16x earnings in such a market....

i would like to see evidence that future earnings growth justifies a high p/e of 16x....one does not turn from -32% earnings to 10-15% earnings growth which under the best of circumstances is an impressive feat.....

Tue, 08/04/2009 - 14:23 | 24341 Anonymous
Anonymous's picture

What is going to cause the growth contribution of stimulus to become negative in 2010?

Tue, 08/04/2009 - 23:10 | 25267 Anonymous
Anonymous's picture

Debt service on the 780 billion.

Wed, 08/05/2009 - 12:07 | 25807 Anonymous
Anonymous's picture

Quick calculation:

Interest at 3.5% on the $780B stimulus would only be $27B. That is less than a 0.2% drag on a $14T economy. The graph shows ten times that amount.

Tue, 08/04/2009 - 13:35 | 24229 Alexander Supertramp
Alexander Supertramp's picture

"The evidence suggests that government intervention is just one factor among many affecting stock returns, and that an above-average degree of intervention is not necessarily associated with below-average returns."  – Weston Wellington

“The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”  – Warren Buffett; August 6, 1979 when the S&P 500 closed at 104

Deal with it.

Tue, 08/04/2009 - 17:01 | 24738 Anonymous
Anonymous's picture

the operative phrase is "not necessarily"

unfortunately we have negative mpd which correlates
with continued economic decay and demand
destruction engineered by government "intervention"

weston is a man of impaired visual acuity...

but i do agree that under normal circumstances
fear and uncertainty create magnificent buying
opportunities if indeed the economy is structurally
sound.....with great structural changes in
store, i am not sure that is a fair assumption.

Tue, 08/04/2009 - 16:45 | 24711 Anonymous
Anonymous's picture

I'm afraid your analysis is faulty. At that time the fed wasn't pumping money into goldman via the NY fed and having them buy stocks to prop up the market. The authors point is that based upon his understanding of history the market should in fact be much lower.
therfore, on a risk reward baisis, stock aren't the place to be. But one can never underestimate the power of the fed

Tue, 08/04/2009 - 14:32 | 24354 Anonymous
Anonymous's picture

above-average
say ffffing what!

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