July 31, 2006
Anatomy of a Punch Line
“I had a mud pack facial done. For three days, my face looked much better. Then the mud fell off.”
“Guy walks into a bar with a frog on his head. Bartender says, ‘Hey, where'd you get that?' Frog says, ‘I dunno. It started out as just a little bump on my behind.'”
“Guy goes to the doctor and says, ‘Doc, when I touch my head it hurts. When I touch my arm it hurts. When I touch my leg it hurts.' The doctor looks at the guy and says ‘I think you've broken your finger.'”
“I'd like to pass away like my grandfather, who died peacefully in his sleep. Not like his screaming passengers.”
Stand-up comedian Greg Dean says that jokes work by leading the listener along one story line, and then unexpectedly switching to a second story line. The first story is built on some key assumption, which the punch line shatters. At the center is a “connector” – something that can be interpreted in at least two ways. Interpreting it one way, you have the target assumption for the first story (e.g the mud was already off, the frog belongs to the guy, the body parts hurt, the grandfather was sleeping in bed). Reinterpreting the connector causes the listener to jump to the second story.
When you hear a joke, that sudden shift from one story line to another is funny. When you're learning a new subject or doing research, a lot of the fun is in the “aha” moments when you discover something that suddenly changes how you look at things.
In the financial markets, a sudden shift by investors from one story line to another can be either devastating or rewarding, depending on which story line your investment position reflects. If you're heavily dependent on the first story line, it's no fun at all if other investors suddenly reinterpret the facts and decide that something else is going on.
Presently, for example, investors are moving along a “story line” that goes something like this: the Fed has gone through a long tightening cycle that is starting to have its effects. With its job now done, the Fed is likely to stop. From here, we'll probably see somewhat slower economic growth, but also slower inflation and maybe even lower interest rates. So the “end of the tightening cycle”, combined with sustainable but slower economic growth, slower inflation, and moderating interest rates should lead to an “expansion in P/E multiples” from their currently “attractive” level. End result: new life to the bull market.
Investors should be so lucky. Unfortunately, it's likely that every one of these assumptions will be violated.
On the subject of valuations, I've noted that the apparently benign valuations quoted by many analysts are based on forward operating earnings that contain a very strong assumption of continued high profit margins. Moreover, these forward operating P/Es are being compared either with values from the past decade alone, or with historical average P/Es based on trailing net earnings. Suffice it to repeat that when S&P 500 earnings have been close to their long-term 6% peak-to-peak growth trendline (as they are currently), the average price/peak earnings multiple has been about 9. The current price/peak earnings multiple is about double that. While this hardly implies that valuations must or will decline to their historical averages, it does imply that stocks continue to be priced to deliver unsatisfactory long-term returns.
On the economy, as I wrote in my May 15 market comment, “Stagflation is based on two factors. First, historically, and internationally, it's not the rate of money growth per se, but the growth of government spending as a share of GDP (particularly spending that doesn't add to the productive capacity of a nation), that drives inflation pressures. Second, the enormous current account deficit means, by definition, that a substantial portion of U.S. gross domestic investment is currently being financed by foreign capital inflows. There are only two ways out of this deficit – invest less domestically, or save more domestically. Given a profligate fiscal policy and a low propensity to save among U.S. households (saving more requires income growth to outpace consumption growth), “saving more” is probably not a likely source of adjustment. More likely, we'll adjust a good part of the current account deficit through weakness in U.S. gross domestic investment (mostly via a housing slowdown, in my estimation).”
“In any event, the U.S. has virtually zero likelihood of enjoying a sustained ‘investment boom' anytime soon – whatever growth we observe in capital spending is likely to come from a contraction in housing investment, leaving gross domestic investment relatively flat. So ‘stagflation' isn't an outside chance, but a reasonable likelihood here. My impression is that the Fed will have a fair amount of difficulty with this outcome, as central bankers have always had.”
Last week's GDP report was clearly consistent with stagflation pressures, with GDP growth coming below expectations and inflation figures coming in above expectations. In fact, that's been the general trend of the bulk of economic reports in recent months.
Investors are tenuously sticking to the first story line – moderating growth with no risk of recession, moderating inflation, beliefs that stocks are reasonably valued, and hopes for an end to the tightening cycle. Yet the data are actually consistent with a second story line – emerging (though not imminent) recession risks, persistent “structural” inflation, rich valuations, probable contraction of profit margins, and an incoherent Fed policy that is likely to become even more incoherent in attempting to battle weaker economic growth and persistent inflation simultaneously (not that I believe Fed actions will be effective in any event).
While it's reasonable to expect that the Fed will indeed pause at its next meeting, the more important issue is that investors are probably adopting the wrong story line here.
If and when they shift to the second story line, it probably won't be funny.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. On a shorter term basis, the market is again overbought. There are few times that I have any sort of opinion about short-term market action, but overbought conditions in unfavorable Market Climates (and oversold conditions in favorable Market Climates) are among the exceptions.
Some of the worst market outcomes on record have followed on the heels of overbought rallies in periods when both valuations and the overall quality of market action have been unfavorable. In my view, Friday's rally on a distinctly stagflationary GDP report represented a good opportunity to do some lightening up of stock market exposure for investors who have not already done so, and would not easily tolerate a decline of 30% or so in the major indices.
That's about as “bearish” a comment as you'll get from me. As usual, of course, no forecasts are required. Our investment position is based on prevailing, observable evidence regarding valuations and market action. It's always possible, of course, for the market to recruit enough quality in its internal market action to warrant a more constructive investment stance. For now, no such evidence has emerged. Until it does, we will remain defensively positioned.
While the conflicts in the Middle-East are certainly unhelpful to both commodity price stability and the economic climate, I think it's wrong to assume that these conflicts are either driving current market outcomes, or that favorable resolutions will particularly help the markets. The conflicts merely provide the occasions and catalysts by which probable market outcomes actually manifest. Once stocks are richly valued, and particularly once the quality of internal market action deteriorates, negative outcomes themselves are largely baked in the cake.
In bonds, the Market Climate was characterized last week by relatively neutral valuations and relatively neutral market action. The Strategic Total Return Fund continues to carry an overall portfolio duration of about 2 years, mostly in Treasury inflation protected securities, with about 12% of assets in precious metals shares. It is not at all clear that investors should form their expectations for inflation based on their expectations for economic growth. When inflation has behaved in that sort of “cyclical” way in the past, it was actually because monetary velocity itself was cyclical (that is, velocity declined substantially as the economy slowed as people built up cash balances and sought safe haven in Treasuries). Given the possibility that foreign countries will reduce the pace at which they absorb U.S. government liabilities, it's likely that velocity will remain stable – that is, that money will remain something of a “hot potato.” In that case, we could expect to see slower economic growth accompanied by stable or even accelerating inflation.
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