Mean Reversion

Ten days ago, Goldman's Peter Oppenheimer published the "Long Good Buy, The Case For Equities", a big research piece, full of pretty charts and witty bullets, which actively urged the rotation out of bonds and into stocks, yet not only marked the peak of the market so far, but drew ridicule even from the likes of CNBC. More importantly, it has generated a plethora of questions from the muppets (aka Goldman clients) themselves, who are wondering how Goldman can be both uber bullish, and yet still have a 1250 S&P 2012 YE price target, as per the other strategist, David Kostin ("We expect the S&P 500 will trade at 1325 by mid-year (-5.6%) and 1250 in 12 months (-10.9%)."), or said otherwise, just how is it that Goldman is having its cake and eating it too? Below is David Kostin's attempt to justify how the firm can pull a Dennis Gartman (and virtually any other newsletter and book seller - after all what better way to say one was right than to have all bases covered) be both bearish and bullish at the same time.

Spain's honeymoon with its new government is over.

We (and Charles Biderman) have previously discussed the seasonal adjustments to NFP data, which while potentially credible in a releveraging context, is far less meaningful when used on apples to apples basis for months in which there is material wholesale deleveraging and record warm weather. Yet the rub lies precisely in the seasonal adjustment, which for January and February has "added" nearly 4 million jobs based on nothing but historical regression patterns, and the "beats" represented less than 5% of the total addition, implying even a modest miscalculcation would have had a huge impact on market, and political, interpretation of the data (as explained here). Today, it is the turn of Art Cashin, quoting Lakshman Achuthan, to provide his take on "unadjusted seasonal adjustments."

Back in early February, Zero Hedge was among the first to suggest that abnormally warm temperatures and a record hot winter, were among the primary causes for various employment trackers to indicate a better than expected trendline (even as many other components of the economy were declining), in "Is It The Weather, Stupid? David Rosenberg On What "April In January" Means For Seasonal Adjustments." It is rather logical: after all the market is the first to forgive companies that excuse poor performance, or economies that report a data miss due to "inclement" weather. So why should the direction of exculpation only be valid when it serves to justify underperformance? Naturally, the permabullish bias of the media and the commentariat will ignore this critical variable, and attribute "strength" to other factors, when instead all that abnormally warm weather has done is to pull demand forward - whether it is for construction and repair, for part-time jobs, or for retail (and even so retail numbers had been abysmal until the just released expectations meet). Ironically, while everyone else continues to ignore this glaringly obvious observation, it is Bank of America, who as already noted before are desperate to validate a QE as soon as possible (even if their stock has factored in not only the NEW QE, but the NEW QE HD), that expounds on the topic of the impact of record warm weather. In fact, not only that, but BofA makes sense of the fact why GDP growth continues to be in the mid 1% range while various other indicators are representative of much higher growth. The culprit? Global Warming.

Confused why every asset class is up again today (yes, even gold), despite the pundit interpretation by the media of the FOMC statement that the Fed has halted more easing? Simple - as we said yesterday, there is $3.6 trillion more in QE coming. But while we are too humble to take credit for moving something as idiotic as the market, the fact that just today, none other than Goldman Sachs' Jan Hatzius came out, roughly at the same time as its call to buy Russell 2000, and said that the Fed would announce THE NEW QE^TM, as soon as next month, and as late as June. Furthermore, as Goldman has previously explained, sterilization of QE makes absolutely no difference on risk asset behavior, and it is a certainty that the $500-$750 billion in new money (well on its way to fulfilling our expectation of a total $3.6 trillion in more easing to come), in the form of UST and MBS purchases, will blow out all assets across all classes, while impaling the dollar. Which in turn explains all of today's action - dollar down, everything else (including bonds, which Goldman said yesterday to sell which we correctly, at least for now, said was the bottom in rates) up. Finally, as we said, yesterday, "In conclusion we wish to say - thank you Chairman for the firesale in physical precious metals." Because when the market finally understands what is happening, despite all the relentless smoke and mirrors whose only goal is to avoid a surge in crude like a few weeks ago ahead of the presidential election, gold will be far, far higher. Yet for some truly high humor, here is the justification for why the Fed will need to do more QE, even though Goldman itself has been expounding on the improving economy: "The improvement might not last." In other words, unless the "economic improvement" is guaranteed in perpetuity, the Fed will always ease. Thank you central planning - because of you we no longer have to worry about either mean reversion or a business cycle.

That the fine economists at the San Fran Fed are known to spend good taxpayer money in order to solve such challenging white paper conundrums as whether water is wet, or whether a pound of air is heavier than a pound of lead (see here and here) has long been known. Furthermore, since the fine economists at said central planning establishment happen to, well, be economists, they without fail frame each problem in such a goal-seeked way that only allows for one explanation: typically the one that economics textbooks would prescribe as having been the explanation to begin with. Today, is in some ways a departure from the default assumptions. In a paper titled "Why is Unemployment Duration so Long", a question which simply requires a brief jog outside of one's ivory tower to obtain the answer, Rob Valleta and Katherin Kuang, manage to actually surprise us. And while we will suggest readers read the full paper attached below at their leisure, we cut straight to the conclusions, which has some troubling observations. Namely, they find that "the labor market has changed in ways that prevent the cyclical bounceback in the labor market that followed past recessions...  In addition, anecdotal evidence suggests that recent employer reluctance to hire reflects an unusual degree of uncertainty about future growth in product demand and labor costs."Oddly enough, this is actually a correct assessment: the mean reversion "model" no longer works as the entire system has now broken, and since the administration changes rules from one day to the next, companies are not only not investing in their future and spending capital for expansion, and hoarding cash, but have no interest in hiring: an observation that previously led to a surge in profit margins, yet one which as we pointed out over the weekend, has now peaked, and margins have begun rolling over, even as the rate of layoffs continues to be at abnormally high levels, meaning all the fat has now been cut out of the system. Yet it is the following conclusive statement that is most troubling: "These special factors are not readily addressed through conventional monetary or fiscal policies." And that is the proverbial "changeover" as the Fed has just acknowledged that both it, and Congress, are completely powerless at fixing the unemployment situation. In which case is it fair to finally demand that the Fed merely focus on just one mandate - that of controlling inflation, and leave the jobs question to the market, instead of making it worse with constant central planning tinkering which only makes it worse by the day?

While skimming the latest draft of the "TREATY ON STABILITY, COORDINATION AND GOVERNANCE IN THE ECONOMIC AND MONETARY UNION" or the EU fiscal draft in short, which is supposed to give Europe reason to rejoice as it says something about the ESM potentially being levered more than €500 billion (not absent additional funding of course, and we have seen how good the EFSF is in procuring capital), we have found the only two clauses worth noting. Which unfortunately show just what a farce this whole process truly is.

For anyone convinced that yesterday's S&P two notch downgrade of Spain to A is the last one for a while, we have some bad news: in Q4 Spanish unemployment soared by the most since the Lehman collapse, hitting what new PM Mariano Rajoy called an "astronomical" 5.4 million. This compares to 4.978 million people unemployed at the end of Q3 2011. Since the official number is not yet public and will be released on January 27 we will take his word for it. In which case it becomes clear that in Q4 the Spanish economy experienced a Lehman-like collapse, losing more than 400K people, or the most since the bankruptcy of Lehman brothers. In percentage terms this means that Spanish unemployment rose by a ridiculous 2%, or from 21.5% to 23.3%, in one quarter! And since Spain is a country of the Keynesian persuasion, we can only assume the number includes a whole bunch of meaningless birth/death and seasonal adjustments, but we'll leave it at that. Incidentally, it means that by the time the mean reversion exercise, with cost-cutting and what not is complete, Spanish unemployment will be well north of 30%, and 2 out of 3 people aged between 16 and 25 will be out of a job, if ot more. It also begs the question just what the real unemployment picture in the US, which lately has put the Chinese Department of Truth to shame, would be if reported on a realistic, unadjusted, and not "workforce contracted" basis. The chart below shows you everything you need to know.

We have now entered the fifth year of this Fourth Turning Crisis. George Washington and his troops were barely holding on at Valley Forge during the fifth year of the American Revolution Fourth Turning. By year five of the Civil War Fourth Turning 700,000 Americans were dead, the South left in ruins, a President assassinated and a military victory attained that felt like defeat. By the fifth year of the Great Depression/World War II Fourth Turning, FDR’s New Deal was in place and Adolf Hitler had been democratically elected and was formulating big plans for his Third Reich. The insight from prior Fourth Turnings that applies to 2012 is that things will not improve. They call it a Crisis because the risk of calamity is constant. There is zero percent chance that 2012 will result in a recovery and return to normalcy. Not one of the issues that caused our economic collapse has been solved. The “solutions” implemented since 2008 have exacerbated the problems of debt, civic decay and global disorder. The choices we make as a nation in 2012 will determine the future course of this Fourth Turning. If we fail in our duty, this Fourth Turning could go catastrophically wrong. I pray we choose wisely. Have a great 2012.

For anyone who still hasn't grasped the magnitude of the central planning intervention over the past four years, the following two charts should explain it all rather effectively. As the bottom chart shows, currently the central banks of the top three developed world entities: the Eurozone, the US and Japan have balance sheets that amount to roughly $8 trillion. This is more than double the combined total notional in 2007. More importantly, these banks assets (and by implication liabilities, as virtually none of them have any notable capital or equity) combined represent a whopping 25% of their host GDP, which just so happen are virtually all the countries that form the Developed world (with the exception of the UK). Which allows us to conclude several things. First, the rapid expansion in balance sheets was conducted primarily to monetize various assets, in the process lifting stock markets, but just as importantly, to find a natural buyer of sovereign paper (in the case of the Fed) and/or guarantee and backstop the existence of banks which could then in turn purchase sovereign debt on their own balance sheet (monetization once removed coupled with outright sterilized asset purchases as is the case of the ECB). And in this day and age of failed economic experiments when a dollar of debt buys just less than a dollar of GDP (there is a reason why the 100% debt/GDP barrier is so informative), it also means that central banks now implicitly account for up to 25% of developed world GDP!

Moody's is out with a comprehensive chart of defense spending since 1946 which shows that while over the years the average yearly amount spent on defense by the US government has been around $400 billion, in the past decade this amount has surged to an all time high of just under $750 billion. And while one can debate the reasons for why America spends 20% of annual revenues on military (and debate even more why this number has continued to surge under a Nobel Peace Prize winning president), one thing is rather certain: this number will decline in the coming months and years as Washington has no choice but to cut the defense budget. And while this will likely be a multi-year process, it will have substantial implications for not only the defense companies identified, but for their respectively supply-chains, resulting in hundreds of thousands and possibly millions of layoffs over the next decade as government-sourced revenue plummets and yet another layer of overhead will have to be trimmed.

When discussing central planning, as manifested by the policies of the world's central banks, a recurring theme is the upcoming reversion to the mean: whether in economic data, in financial statistics, or, as Dylan Grice points out in his latest piece, in luck. While the mandate of every institution, whose existence depends on the perpetuation of the status quo, is to extend the amplitude of all such deviations from the trendline median, there is only so much that hope, myth and endless paper dilution can achieve. And alas for the US, whose 3.5% bond yields are, according to Grice, primarily due to "150% luck", the mean reversion is about to come crashing down with a vengeance after 30 years of rubber band stretching. The primary reason is that while the official percentage of interest expenditures as a portion of total government revenues is roughly 10% based on official propaganda data, the real number, factoring in gross interest expense, and assuming a reversion to the historic average debt yield of 5.8%, means that right now, the US government is already spending 30% of its revenues on gross interest payments! And what is worse, is that the chart has entered the parabolic phase. Once the convergence of theoretical and real rates happens, and all those who wonder who will buy US debt get their answer (which will happen once the 10 Year is trading at 6% or more), the inevitability of the US transition into the next phase of the "Weimar" experiment will become all too obvious. Because once the abovementioned percentage hits 50%, it is game over.

In his latest letter, "In Defense of the 'Old Always'" GMO's James Montier takes PIMCO's trademark "New Normal" to task, and argues that the "Old Always" with its ever trusty mean reversion strategies work as well now as they always did. Summarizing his disagreement with what the investment implications of the New Normal are, Montier says: "For instance, Richard Clarida of PIMCO wrote the following earlier this year, “Positioning for mean reversion will be a less compelling investment theme in a world where realized returns cluster nearer the tails and away from the mean.” This certainly isn’t the first premature obituary written for mean reversion. During pretty much every “new era,” someone proclaims that the old rules simply don’t apply anymore … who could forget Irving Fisher’s statement that stocks had reached a “permanently high plateau” in 1929? Mean reversion is in some august company in being well enough to read its own obituary." The key defense for mean reversion Montier says, is the market itself: "we have witnessed some quite remarkable, and quite appalling, things – the deaths of empires, the births of nations, waves of globalization, periods of deregulation, periods of re-regulation, World Wars, revolutions, plagues, and huge technological and medical advances – and yet one thing has remained true throughout history: none of these events mattered from the perspective of value!" Which means: is this time really different? Have we passed some rubicon at which time not even the otherwise spot on observations of traditionally sensible analysts like Montier make sense? The answer is so far elusive. Yet in a universe in which true asset fair value can no longer be derived, and all valuations are wrapped in the enigma of trillions of monetary and fiscal stimuli, whose stripping is virtually impossible in a world in which everything is centrally planned, we just may have entered... the non-"old always" zone.