August 8, 2011
Recession Warning, and the Proper Policy Response
As of Friday, the S&P 500 was below its level of early November 2010, when the Federal Reserve initiated its second round of quantitative easing. Aside from a brief bump in demand that kicked the recession can down the road a bit, the U.S. economy is not measurably better off. Meanwhile, countless individuals in developing countries have been injured by predictable commodity hoarding and global price instability. The Federal Reserve has leveraged its balance sheet by over 55-to-1. As policy makers look to address the abrupt deterioration in U.S. and global economic prospects, we should ask ourselves: Do we really long for more of the Fed's recklessness?
I began drafting this update in a fairly measured way, but on further reflection, I think it is time to be blunt. The economic evidence now suggests that the U.S. and the global economy are again entering recession. Technically, this is not a "double dip." The National Bureau of Economic Research, which officially dates the beginning and end of U.S. recessions, was very clear about this last year - noting that it would view any future economic downturn as a new recession, not as a continuation of the one that ended in June 2009. Aside from that technicality, a renewed economic downturn would reflect the very same fundamental imbalances, and resulting economic weakness, that our policy makers failed to address in the first place. For most Americans, the recession never ended.
If there is one crucial point that should not be missed, it is this: the fundamental source of our economic challenges, from joblessness, to unresolved housing strains, to sovereign debt crises, is that our policy makers have repeatedly opted for fiscal band-aids and monetary distortions instead of addressing the core problem head-on. That core problem is simple: the careless encouragement of asset bubbles, and the refusal to restructure bad debt.
Encouraged by inappropriately easy monetary policy and lax regulatory oversight, the U.S. went on a debt-financed binge of consumption and unproductive investment that lasted nearly a decade. When that binge collapsed, policy makers ignored the fundamental need to restructure bad debt, and instead fought tooth and nail to defend bondholders and lenders who had extended credit carelessly. We are now left with a global financial system where the debtors are incapable of making good on those debts, and governments around the world are frantically trying to prop up bad debt with public funds and monetary policies aimed at distorting the financial markets even further.
The economy is an equilibrium - consumer spending is stagnant not only because unemployment is high but also because debt burdens remain daunting. Businesses are reluctant to hire because they don't see the likelihood of sustained demand. This isn't a problem of tax uncertainty, regulations, or budget worries - it's a low-level equilibrium produced by consumers trying to deleverage and businesses reluctant to hire without the promise of demand. Many workers can't even move elsewhere to accept job openings because they are locked into their current homes. Very simply, barring the emergence of some new economic sector that produces a tremendous supply of desirable new goods and simultaneously produces enough employment to generate the income to buy those goods, we're unlikely to get around the employment problem until we address the debt issue directly.
Restructuring debt does not necessarily mean debt "forgiveness" and it does not always mean "default." It means that the payment structure is changed in a way that makes it possible for the debt to be serviced over time. In the housing market, we don't need government bailouts nearly as much as we need government to act as a coordinating mechanism. Since the housing crisis began, I've proposed the creation of "property appreciation rights" to restructure mortgage debt (see the second portion of Handicapping QE3 for detailed mechanics). These would essentially break mortgages into two pieces, one representing the prevailing market value of the home, with the remaining amount of the mortgage being a marketable claim that the lender would have on future home price appreciation, which could be pooled and administered by the Treasury without the need for subsidies. While lenders would likely earn less on the mortgages than if those mortgages were actually good, and borrowers would pay more on those mortgages than if they walked away from their homes, the credit strains and uncertainty in the housing market could be addressed, foreclosures could be averted, the markets could clear, and the economy could move forward.
Of course, part of the reason that policy makers have protected bondholders at every turn is the constant fear-mongering that the financial system will implode if bondholders suffer any loss. Look - the stock market has just lost about $1.5 trillion in market capitalization, and we might just be getting warmed up. The idea that bondholders are sacred is ludicrous - it's just that the financial companies are very powerful, vested interests. As Sheila Bair, the outgoing head of the FDIC recently noted about the 2008-2009 crisis (see Sheila Bair's Exit Interview ): "'We were rarely consulted. They would bring me in after they'd made their decision on what needed to be done, and without giving me any information they would say, 'You have to do this or the system will go down.' If I heard that once, I heard it a thousand times. 'Citi is systemic, you have to do this.' No analysis, no meaningful discussion. It was very frustrating.' ... As she thinks back on it, Bair views her disagreements with her fellow regulators as a kind of high-stakes philosophical debate about the role of bondholders. Her perspective is that bondholders should take losses when an institution fails. When the F.D.I.C. shuts down a failing bank, the unsecured bondholders always absorb some of the losses. That is the essence of market discipline: if shareholders and bondholders know they are on the hook, they are far more likely to keep a close watch on management's risk-taking."
As for sovereign debt, Greek spreads presently reflect a 100% expectation of default within the next two years, with Ireland and Portugal not far behind. Italy (whose debt/GDP ratio is well over 100%) has less extreme credit spreads, but is actually the most troubling because of its relative size. So long as the crisis is contained largely to Greece, European leaders are likely to continue what they perceive as heroic attempts to stem the crisis. The real problem is that each new attempt to impose austerity on the fiscal side, in order to protect bondholders, imposes real economic costs on ordinary people in these countries. Normally, overly indebted countries have the ability to print money and devalue their currencies in order to reduce the real burden of excessive debt. But countries in the European monetary union do not have the ability to issue their own currencies, so in order to make the debt whole, ordinary citizens are being forced to endure austerity that in some countries is increasingly looking like depression.
For Europe, the struggle of citizens in peripheral nations, and the burden on Germany and France in particular, will continue until the debt is restructured. There is no graceful way to do this, but one option is what might be called "redenomination by fiat." Essentially, these governments would break the existing covenant to pay their debts in Euros, and would instead redenominate the obligations in their own national currencies, which they would then predictably devalue to the point where they were capable of servicing the debt. This is what peripheral economies do, and have always done, in response to excessive debt burdens. Moreover, remember that the value of the Euro itself is not determined by Greece per se, but by price levels and interest rates among countries who are members to that currency. A departure of Greece and possibly other peripheral European nations would not necessarily make the Euro weaker, but might instead help to ensure its status as a durable currency. So to the extent that the key member countries of the Euro pursue fiscal and monetary stability, exit of peripheral countries from the Euro area does not imply a "collapse" of the Euro itself. Meanwhile, restructuring would be far kinder to the citizens who continue to suffer economic austerity in order to make bondholders - who knowingly took risk and lent at a spread - whole.
The way that our policy makers address the recent weakness in the markets will tell a great deal about the prospects for a durable recovery. If the policy initiatives focus on subsidizing bad debt on the fiscal side, and distorting the financial markets on the monetary side, it would be best to use whatever short-term enthusiasm those proposals provoke as an opportunity to further reduce risk. The best policy responses are those that relieve some constraint on the economy that is binding. Another round of policies geared to creating an even larger sea of zero-interest liquidity, re-igniting asset bubbles, or further lowering already depressed Treasury yields, would be a signal of panic and incompetence from the Fed. If policy makers instead push to facilitate debt restructuring, coupled with pro-growth fiscal responses (e.g. R&D investment incentives, full funding of the National Institutes of Health, productive infrastructure investment, etc), yet another drawn-out cycle of distortion and crash might be avoided.
In order to build some context around the abrupt plunge in the stock market last week, I want to start this week's comment with a paragraph from our comment Simple Arithmetic two weeks ago:
"The markets are an equilibrium where every share sold has to be matched with a share purchased. From an equilibrium standpoint, the worst market outcomes are always those associated with rich valuations, a deterioration in valuations from a fundamental standpoint (economic concerns, earnings disappointments, or weak guidance), and a break below widely-followed technical thresholds. The difficulty at those points is that you can get supply from both value-conscious and technically-driven investors, which is an incompatible combination because somebody has to be induced to buy. The only way to establish equilibrium in that case is for stocks to decline by enough to turn the value-conscious sellers into buyers, which essentially requires a free-fall. Importantly, that's not meant as a forecast. Rather, the point is to be alert for events that have the simultaneous effect of disappointing expectations from fundamental investors and also triggering breaks of technical 'support.'"
A large number of those "support" levels converged around the 1280 level of the S&P 500 - those included the 200-day moving average, "neckline" support of a putative head-and-shoulders pattern (we aren't much for charting, but the pattern was obvious enough to be widely noted by technicians), as well as other convenient ways of defining trends, such as "trendline" and "fanline" support.
Last week, I reviewed the rapidly deteriorating condition of our Recession Warning Composite . While year-over-year GDP growth has dropped to just 1.6% - a rate that has been followed by a new recession in 10 of the 12 times it has occurred since 1950 - I preferred evidence from a wider set of market and economic measures. I noted "we would require only modest deterioration in stock prices and the ISM index to produce serious recession concerns."
With the pixels barely dry on that weekly comment, the ISM reported Monday that its Purchasing Managers Index dropped unexpectedly to 50.9, the slowest pace in two years. That report, coupled with an early slide in the S&P 500, completed the remaining holdouts (conditions 2 and 3) of the Composite. Coupled with the slowdown in year-over-year GDP growth, the composite of economic and financial evidence we presently observe has always and only been associated with ongoing or immediately impending recessions. This is not an opinion or a viewpoint, but a fact of the data. "Always and only" is the Bayesian equivalent of "certainty" (a Bayesian is someone who, vaguely expecting a horse, and glimpsing the tail of a donkey, concludes he has probably seen a mule).
I emphasize the word "composite," because there is simply no single, infallible indicator of oncoming recession. In order to infer information from noisy data, you have to combine multiple lines of evidence to amplify the "signal" and suppress the "noise." This is what we do in our ensemble modeling (where I can be justly criticized for the time it took to acceptably solve our "two data sets" problem). It's what we do in our stock selection. It's even what we've applied in our research on autism genetics . Any single indicator, whether it is GDP growth, the Shiller P/E, the forward operating earnings yield, the ISM index, the position of the S&P 500 versus its 200-day moving average, the jobs number, or anything else, is invariably subject to random factors that reduce its information content. The only way to get at the "truth" is to look for a convergence of signals that share common information components but whose "noise" components aren't terribly correlated with each other. The problem at present is that multiple lines of evidence suggest more than just a "healthy correction" in the stock market, or a "soft patch" in the economy.
Investment strategies and market equilibrium
Returning to the idea of market equilibrium, one way to conceptualize the activity of the stock market here is to think about the interaction of various players that is needed to continuously match purchases with sales. At this point, it may be useful to break fundamentally- and technically-oriented investors into further divisions based on their long-term or short-term inclination.
We can think of four groups of investors: long-term and short-term fundamentally oriented investors, and long-term and short-term technically oriented investors. We'll review market conditions from the perspective of each, and what events might cause them to change their positions.
On the valuation front, we view stocks in terms of the normalized discounted stream of long-term cash flows that investors can expect to receive for the price they pay, and that calculation requires the use of normalized earnings and other fundamentals. As a result of last week's decline, the S&P 500 ended Friday priced, by our estimates, to achieve an average annual 10-year total return of about 4.9%, which is an improvement from the 3.4% level we observed a few months ago, but is nowhere near what would reasonably be viewed as undervalued. Jeremy Grantham at GMO puts a "fair value" figure for the S&P 500 at about 920. We prefer to think in terms of expected returns, and a 920 level would equate to 10-year prospective (nominal) returns in the range of 8-9% annually. That would not be a disappointingly low expected return, but would certainly not rival the valuations we've typically observed at bear market troughs historically.
It's useful to keep in mind that while prospective 10-year returns, by our own methodology, surpassed 10% annually at the 2009 trough, that level has historically been no material barrier to even lower valuations and higher prospective returns - though hindsight is not kind to us in the 2009 instance. Also, in view of other periods of major credit crisis, we know that prospective returns also reached 10% annually in 1931 (after reaching slightly negative projected returns at the 1929 peak). In that instance, of course, the S&P 500 continued to lose about two-thirds of its value before it reached its ultimate low in 1932. Suffice it to say that while these 10-year projections have a significant historical record of accuracy, they don't provide much guidance for horizons shorter than 3-4 years - except that low levels are associated with inevitable difficulty, and high levels are associated with eventual relief. The repeated erasure of meaningful market returns over the past decade basically reflects the market's failure to durably establish reasonable valuations during this period.
The upshot, at present, is that long-term, value-conscious investors are not likely to be significant sources of demand at present valuations, though they are nearly certain to scale bids in at lower levels, particularly if valuations begin to suggest historically normal prospective long-term returns. We're not even close just yet.
So on the fundamental side, the main source of demand is likely to be value-conscious investors who have what we would call an "erroneous and myopic" view of valuation - largely the cadre of investors who take their cues from the ratio of price to forward operating earnings. As I noted in Chutes and Ladders , despite the fact that forward operating earnings aren't defined under GAAP and have a history only since the early 1980's, it is easy to show that the multiple typically runs about 60% of the Shiller multiple. Given that Shiller multiples above 20 have historically represented significant overvaluation, the corresponding "overvalued" figure for forward operating earnings works out to only about 12, while the deep value points such as 1950, 1974 and 1982 map to price-to-forward operating multiples of only 5 or 6. Moreover, investors who use this metric seem almost intentionally oblivious to the fact that current estimates of forward operating earnings have the assumption of sustained record profit margins embedded within them.
Nevertheless, there are undoubtedly investors who are quite willing to assume the highest profit margins in U.S. history, and are equally willing to ignore the need to use different norms for price to forward operating earnings than have historically applied for price to trailing net earnings. Those investors see the market as quite cheap here, and until the early indications of oncoming economic weakness actually make their way into analyst estimates of future operating earnings, those fundamental investors are likely to be one source of demand here.
On the technical side, we can also distinguish (at least conceptually) between investors having short-term and longer-term technical outlooks. One of the sources of short-term demand, particularly around various prior support levels, are short-term technical investors who respond to short-term dips and measures of significant "oversold" conditions. Last week, we saw repeated bounces at various levels of prior "support" as traders bought into what appeared to be deeply oversold trading conditions. This was particularly true (and finally successful) on Friday, where we observed a 60 point swing in the S&P 500 from trough to peak as traders piled into a perceived "oversold" trade.
In contrast, investors who use technical information on a long- and intermediate-term basis are undoubtedly very concerned over the recent breakdown of market internals and violation of major support. The bulk of last week's decline probably reflected the rapid attempt to sell stocks as the markets clearly broke widely followed measures of support such as the 200-day moving average. To match this supply with demand, prices quickly dropped to the point where the combination of demand from myopic fundamental traders and bottom-fishing technical traders was sufficient to match sales with purchases. Still, without a firm grasp on historical data, it is easy to forget that overvalued markets can decline profoundly even after the market appears unimaginably oversold. The worst periods for the market have always been the product of extremely thin risk premiums coupled with a sudden increase in risk aversion.
Thinking in terms of equilibrium is helpful in contemplating the "roadmap" of potential outcomes for the market here. First, technical traders are not a very persistent source of demand. A rally that eases the short-term oversold condition of the market and approaches prior levels of technical support would likely be met by profit-taking from short-term technicians and also selling from longer-term technical investors that missed the first opportunity to sell the break of major support. As for fundamental investors, those with a long-term view based on normalized cash flows are unlikely to be very interested here in the first place, and the economic evidence suggests that forward expectations are likely to deteriorate in the weeks ahead. So while stocks may look cheap to investors with an affection for forward operating earnings, those investors have to hope that earnings estimates remain static or improve, which appears unlikely. For all of these reasons, there is good reason to expect an imbalance of selling pressure to develop quickly in response to rallies that clear the oversold short-term condition of the market.
Less likely, but not impossible, would be an advance that couples significant improvement in market internals with better economic news. A particularly encouraging event would be a move above prior support levels that "holds" for more than a few sessions. While that whole set of developments would go against the evidence that we're seeing on the economic front, and would require a reversal of the deterioration we've seen in market internals, it would contribute to a short-term imbalance of buying pressure that would have to be offset by selling by fundamental investors and "contrarian" technicians selling into overbought conditions. That scenario wouldn't change the unfavorable long-term prospects for total returns, but can't be completely ruled out as a short-term event.
At present, the ensemble of evidence continues to suggest a negative expected return/risk profile for stocks. While the prevailing data is very troubling, we'll remain flexible as the data changes, and will respond to new evidence as it emerges.
As of last week, the Market Climate for stocks remained hostile, coupling overvaluation with stark weakness in market internals. We continue to see evidence of significant complacency, with bullish sentiment still well ahead of bearish advisors. From a Bayesian standpoint, the likelihood is that stocks have entered a bear market, and that last week was an opening salvo, not a parting shot. On the economic side, I am very hopeful that the composite of evidence for an oncoming recession is utterly wrong. Still, that hope is pitted against data that has always and only been observed during or just prior to economic downturns.
Again though, we'll respond to the evidence as it emerges. Significant repair of market internals isn't impossible, but that hope runs contrary to the gathering economic evidence we're seeing. A market reversal on high volume, disproportionately positive breadth, and coupled with deeply bearish sentiment, might also create some opportunity to accept a modest to moderate exposure to market fluctuations. That said, given the historical tendency of those rallies to come off of much more significant declines than we've observed thus far, I suspect that our next opportunity to accept exposure to market fluctuations will come at lower levels. I have little doubt that the best approach is simply to remain open to the data as conditions evolve, adhere to our discipline, and respond in proportion to the expected return/risk profile we observe at each point in time. Strategic Growth Fund remains well hedged here, while Strategic International Equity is about 20% unhedged, owing to the greater dispersion in conditions and valuations in foreign markets.
In Strategic Total Return, we clipped our portfolio duration back to just 1.5 years in response to the plunge in Treasury yields. While the downgrade of Treasury debt from AAA by Standard & Poor's is reflective of broader disdain for the political process on budget matters, my impression is that U.S. Treasury debt continues to have the lowest risk of default of any security in the world. Though there's some risk of very brief liquidity pressures in the Treasury market, I doubt that the broad community of bond investors would miss the opportunity to capture a higher Treasury yield in an increasingly uncertain environment.
Meanwhile, it is certainly a negative for savers, but a positive on the inflation front that Treasury bill yields collapsed back to zero last week after climbing to 0.10% just before the debt ceiling deadline. As I've noted before, given the present size of the monetary base, even short-term interest rates of more than a few basis points would create significant inflation pressure (see Charles Plosser and the 50% Contraction in the Fed's Balance Sheet ). Barring exogenous upward pressure on short-term interest rates, I continue to believe that the primary window of inflation risk is probably in the back half of this decade.Finally, from the standpoint of indicators correlated with the return/risk profile in precious metals shares, we continue to observe a very constructive ensemble of conditions. After clipping back our exposure in precious metals shares to about 15% in Strategic Total Return at the beginning of last week based on near-term risk factors, my expectation is to increase that position back toward 20% in the event that price weakness continues much further.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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