Articles of Discussion:
Peering Into The Abyss
Looking Beyond The Fiscal Stimulus
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:
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.
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.
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).
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.