In this video interview, Chris Wood, CLSA’s Asia strategist and author of the top “Greed & Fear” newsletter, shares his views on global markets with CNBC.
Click here or the image of the report to read Wood’s full report that precedes his appearance on CNBC below.
Wood said: “My view is that there is an inevitable endgame as a result of all this massive spending of taxpayer money in the West and Japan to bail out bankrupt banking systems, so in my view unfortunately the end game will be systemic government debt crisis in the western world.
“It will probably happen in Europe and will climax in the US, and I am expecting on a five year view the collapse of the US Dollar paper standard … The key reason why that is the endgame is that this credit crisis we saw in the west in 2008 and 2009 has simply been deferred, because 95% of the so-called government policy solutions to deal with this crisis have simply been to extend government guarantees.
“So the problem has been transferred from the private sector to the public sector. It is just a matter of time before investors revolt against these sovereign guarantees … The crisis is going to happen first in Europe. The US will be the endgame.” (Hat tip for transcript: Zero Hedge.)
In this excerpt from his annual letter, investing great Seth Klarman describes 20 lessons from the financial crisis which, he says, “were either never learned or else were immediately forgotten by most market participants.”
One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the “depression mentality” of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea.
Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.
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Twenty Investment Lessons of 2008
Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
When a government official says a problem has been “contained,” pay no attention.
The government – the ultimate short-term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.
Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.
False Lessons
There are no long-term lessons – ever.
Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.
There is no amount of bad news that the markets cannot see past.
If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.
Excess capacity in people, machines, or property will be quickly absorbed.
Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.
In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.
The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.
The government can indefinitely control both short-term and long-term interest rates.
The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost. (Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)
Forget the Eurozone for just a minute. Japan’s problems are big: Toyota is a major exporter/employer. Last year 48% of all new standard passenger vehicles sold in Japan were Toyotas (or its Lexus brand). The WSJ article describes Toyota’s status in Japan as the following:
In short, Toyota is to Japan what General Motors Corp., in its heyday, was to America. And for a beleaguered country that has suffered a series of institutional blows in recent months - the collapse of the long-ruling political party, the bankruptcy of its champion national airline, a renewed bout of deflation - the global humiliation of Toyota may be the most psychologically damaging blow of all.
Psychological blow, what about an explicit economic blow! Toyota is certain to drag the only Asian G7 economy down, since auto exports are big in aggregate export income.
Japan’s single largest export category in December was, of course, manufacturing: 22% of total exports. And a huge 14% of the total value of exports in December came from motor vehicles (auto sales, that is - separate from parts).
The Japanese economy grew 1.14% in Q4 2009 with a huge 0.67% contribution from exports. The second major contributor was private consumption, which added 0.39%. Going forward, consumption and export contributions are likely to wane from the major Toyota recall campaign that is under way.
First the direct export channel will probably crumble as demand for Toyota cars derails. Second, there will be a lagged labor market effect. Sure, workers will be needed to address the recalls; but the loss in hours stemming from a drop in sales is likely to be much larger, and the net jobs effect negative.
Toyota is a major employer in Japan that currently has 320,808 employees and has already shuttered doors (at least temporarily) inother countries. It’s only a matter of time before the effect hits the home labor market.
From UBS Financial Services: Cashin’s Comments, February 5 early am
Greece Fire Leads To Flight Into Dollar Resulting In A Global Margin Call – In early afternoon with stocks, gold and oil flat on the canvas, we sent the following email to some trading friends:
Panicky unwinding of dollar carry trade acts like a global margin call which we suggested weeks ago. Europe a swirl with rumors and speculation. Will there be general strikes in Greece? (Recall ugly street rioting that lasted for months after police killed that youth.) Portugal tries to sell equivalent of Treasury Bills and only gets bids on 60%. Similar concerns and speculation on others in the STUPID acronym.
Euroland starting to sound like U.S. markets between Bear Collapse and Lehman. Looming weekend heightens angst. All we need is a geo-political event to cause a full flight to safety into dollar sparking more margin style liquidation across asset classes. Cross your fingers. Run rate at 1:00 is 1.6 billion.
At the time, the S&P was beginning to break below the critical 1070 support area. There were fears on the floor that a significant breach of that support might trigger trapdoor selling from stop orders and algorithms.
Selling did take the S&P through the support but there was no aggressive follow-through. Nevertheless, stocks closed hard on their lows, grateful that the bell ended the pain.
Decoding The Email – For months we have voiced concern about the growing level in the “dollar carry trade”. Speculators and traders had been borrowing dollars at near zero rates to finance positions in gold, oil and U.S. stocks, among other things. In setting up the carry trade, they would often short the dollar for currency protection.
Back in December, we told Carl Quintanilla that we felt the greatest risk to the market would be a flight to safety into the dollar. If, for example, there was a key geo-political event (Israel/Iran?), the resultant rush into the dollar would result in the equivalent of a global margin call. We said it could drive the Dow down 1000 points in a day. Yesterday, there was a rather mild rush into the dollar and we lost 270 points in a day.
The reference to Greece is self-explanatory. The failed Portuguese auction could have sold the entire offer but at much worse price. Only 60% of the offering received “proper” bids. The “stupid” acronym apparently refers to Spain, Turkey, Ukraine, Portugal, Italy and Dubai (although there are substitutes).
The allusion to analogies with the environment between Bear and Lehman should be self-evident. Then it was financial firms that were the subjects of rumors and contentions. Now it is sovereign nations.
Thursday’s action clearly demonstrated the dominance of the dollar’s influence across asset classes. Let’s hope no geopolitical surprise pops up.
Cocktail Napkin Charting – As noted, the support at 1070 held for a while before clearly yielding as we moved into the final hour. The selloff re-ignited Elliot Wave speculation that we may have begun severe corrective wave C. I wroteyesterday that the market might show its hand by Tuesday. We’ll stick with that timeframe. For today, the napkins look for support in the S&P around 1050/1053. Violating that level could heighten probability that wave C has, in fact, begun. First resistant is broken support at 1070/1075, with a backup at 1087/1092.
Some Eye-Catching Headlines on Bloomberg:
• “Taleb says ‘Every Human’ should short U.S. Treasuries” (Nassim Taleb of Black Swan fame says shorting treasuries is a “no-brainer” given Fed and Obama policies.) [stay tuned for more on this in Zero Hedge shortly]
• “Biggest Bubble in History is Growing every day” (William Peske on China’s currency reserves)
• “Payrolls probably increased in January…..” (Speculates that this morning’s number may show growth)
A Personal Crusade – While it’s too late to do it this year, I think we should seek to turn Super Bowl Sunday into Super Bowl Saturday. It would be great for the economy. More parties in more places with a chance to sleep in the next day. If you agree, email the NFL.
Consensus – Payrolls may set the tone if the dollar behaves. If the dollar moves, it will dominate the action. Stay very,
very nimble and stimulate the economy by hiring a kid to shovel the snow.
Trivia Corner
Answer - The apples are 25 cents a pound and the apricots are 75 cents a pound.
Today’s Question - Heir today, gone tomorrow. The ancient King of Numeria had a favorite stallion who grew old and was dying. The king offered each of his three sons half the entire kingdom if he would bring a fresh apple to the ailing horse exactly half the time the horse had left. If a son accepted the challenge but was off by more than one day, that son would be out of the will and banished. The oldest son declined saying no one knew how long the horse would live. The youngest son agreed and declined also. The middle son smiled, took the challenge and won easily. What did he probably do?
And the obligatory history lesson:
On this day in 1895, America was in a funny financial spot. Well, it was a bit over a hundred years ago today - so - I guess you deserve an explanation. Let me see….if I remember what Sister Herman Joseph taught me - that different America of a century ago looked something like this:
The economy appeared to be struggling. There was a Democrat in the White House. Congress was divided and squabbling, hostily and uncivilly. Some thought the debates were so coarse and rude they spoke of forming a new political party. Technology was the new mantra even after a bumpy start and telecommunications were exploding (in use if not profitability). Much of the country was in the grip of unusual and extreme weather. And…oh yeah….I almost forgot….suddenly folks had begun talking about gold….can you imagine “gold!”
Anyway, despite what pundits of the day thought, gold had begun to rise. Now, in 1895, the old U.S. was on the old “gold exchange standard.” That meant, whether citizen or foreigner, if you thought public policy was not to your liking, you could hand in your green pictures of dead presidents and get gold - real, glistening, bite into it to check it, gold.
As hard as it is for us to believe today, a goodly number of those citizens distrusted what they saw in Washington. Gold rose and soon began to bubble and the dollar began to slide. The rush to exchange dollars might deplete the gold of the U.S. Treasury and cause a default. Imagine - a time when the government wrestled with the question of default.
So - to avoid chaos - the President sought the help of the one man who could control the banks, who could calm Wall Street, who - in short - could find a way to halt the run on the dollar and government reserves. (No Virginia, it was not Ben Bernanke - there was no Federal Reserve.) Thus, on this day in 1895, the President of the U.S. sat down with a certain J.P. Morgan seeking the latter’s help in saving the country.
Morgan allowed as how he might just happen to know one fellow who could put the government into default that very afternoon. (The President never asked if it was Morgan, himself.) Morgan conveniently recalled some obscure Civil War legislation that allowed the President to issue bonds to buy gold. The same law said the bonds could be sold secretly (without bidding). But who would buy them. Well, Morgan allowed as how it was probably his civic duty (along with that of his syndicate) to not only buy the new secret bonds but to buy up some gold and recycle it to the Treasury for the dollars he paid for the bonds. And all this for just a small commission.
To mark this anniversary recall the words of Warren Buffett - There’s always a silver lining -or was that Jimmy Buffett.
There was a lot of buzz about gold on the floor yesterday but none of it was about a scarcity of the yellow metal.
This article is a guest contribution by John Kicklighter, Currency Strategist for DailyFX.com.
Any doubts that the market has forged higher without the support of stable fundamentals should be completely dispelled after this week’s sharp reversal. Even if this recent slump in investor sentiment doesn’t ignite into a true reversal of capital flows; the simple fact that the markets retraced so aggressively and in tandem stands as testament to the fear that lies just beneath the surface.
• The Dollar Takes Off and Dow Falters – Risk Appetite is on the Verge of Collapse
• When Sentiment Falls Apart Correlations will Tighten and Momentum Increase
• How Over Extended are the Market and What are Fair Fundamental Values?
Any doubts that the market has forged higher without the support of stable fundamentals should be completely dispelled after this week’s sharp reversal. Even if this recent slump in investor sentiment doesn’t ignite into a true reversal of capital flows; the simple fact that the markets retraced so aggressively and in tandem stands as testament to the fear that lies just beneath the surface. What’s more, there are plenty of fundamental reasons to be concerned about the state of the markets or more precisely the conviction of those participants that drove the supposed high-yield / high-return asset classes to their over inflated levels. Among the long line of fundamental concerns that have slowly eroded the foundation of the most aggressive influx of speculative capital in history, we have non-existent yields, government efforts to restrain capital interests and the withdrawal of vital stimulus among many other factors.
In gauging the threat of a significant retracement going forward, we need only pick our poison. Every major asset class has its own benchmark that is ready to suffer the ravages of risk aversion. In the Forex market, many prominent carry-based currency pairs have already marked critical breaks and reversals. The dollar has taken meaningful steps towards true recovery. Now, we await the clear break of the Carry Trade Index. The same conditions exist in more speculator-responsive markets. The Dow Jones Industrial Average broke out of a 300-point range for the first time in two months. In commodities, gold has overwhelmed a trend that has defined the metal’s bullish drive for more than five months now. These markets are at the very edge and require only the slightest gust of fundamental wind to transform a retracement into a true change of trend.
What could motivate investors to throw in the towel and either book profit or unwind failing positions? The most basic force at work will be fear itself. Should the more prominent benchmarks pitch into a clear downtrend, market participants will require little motivation to exit the market. Remember, it wasn’t long ago that the these markets suffered their worst crisis in modern history. While the collective memory of the markets is short; there is little doubt that traders will heed the warning signs and attempt to preserve any returns they have made over the past year. So, in these terms; all we need is a catalyst. There are plenty of sparks to push sentiment over the edge. The most recent threat to speculation comes in the form of government regulations and restrictions. These past two weeks, China has taken meaningful steps to limit leverage and aggressive speculation to prevent a potential bursting of an asset bubble.
There is no argument to be made against the overextended market. Raising the reserve ratios, tightening loan requirements and other steps are no doubt reasonable; but their effectiveness in this stage of the game is too little, too late. And, China (the objective of a sizable percentage of the market’s most speculative funds) isn’t the only country bearing down on the volatile capital markets. US President Obama recently announced proposals that would limit the size and risk profile of the nation’s largest banks. This is a reasonable and direct step for a country that has been rocked by the failure of ‘too-big-to-fail’ firms; but there is little doubt that the side effects of such policy would be to reduce leverage and liquidity. Furthermore, these steps are being taken at the exact same time that the world’s policy makers are withdrawing the stimulus that has been so essential to market’s recovery to this point. As it was, there were concerns that speculators would be able to stand on their own when stimulus and guarantees were removed. Now they are looking at restrictions.
Written by: John Kicklighter, Currency Strategist for DailyFX.com.
Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.
The charts below, courtesy of Bespoke, show that the preferred stock and high-yield bond markets have been surging since the beginning of December.
Bespoke said: “Since the Lehman Brothers’ collapse on September 15, 2008, PFF is actually up 12.91%, while HYG is down just 2.89%. With preferreds and high-yield bonds now at or near pre-Lehman levels, how long will it take for common stocks to get there as well? As shown below, the S&P 500 is still 8.7% below the 1,251 level it closed at on September 12, 2008.” Is it just a question of time?
Barry Ritholtz shares an interesting note on the rally in the dollar. The MACD has turned up and crossed over, signalling that traders and U.S. dollar carry-traders are nervous about their short positions in the dollar. With the Japan-easing underway, its possible that during the course of the year, the yen will replace the dollar as the primary funding currency. Time to bet on a return of volatility in risk assets.
On another note, the Canadian dollar is set to weaken relative to the greenback, should the rally in the dollar gain traction.
We know that “Short the US Dollar” has been a crowded trade for some time now. And, after falling 41% from 2001 to 2008, the fat part of the collapse has already happened.
Will it continue? That’s what today’s chart looks at.
How likely is it that the rest of the world will stand idly by and allow: a) US manufacturing competitiveness a huge advantage via weak currency?; 2) Massive US debt to be inflated away through dollar weakness?
Quite possibly not, as other currencies engage in a race to the bottom. The chart below suggests a dollar rally is in the offing: >
Adam Hewison strikes again with the ten-thousand-foot-view of the market with three new technical analysis videos on the Dollar Index (DXY), Crude Oil, Gold - These are relevant analyses given that crude and gold are both priced in US dollars:
The above chart is Adam showing the declining trend of the US Dollar Index along with the positive (standard) MACD Divergence… and the recent positive trendline break. As such, his video is entitled:
“The crude oil market continues to soften and is now close to some important levels that I think we should look at. In my new video we look at what is happening in this market right now and what we expect to happen in the future.
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As we have indicated in our earlier posts, we are now in the official “silly season” for trading. What I mean by that is the markets will be very thin, choppy and can be moved by a relatively small amount of money.”
Finally, Adam posts a quick 3-min update on Gold strangely titled:
We are already in the “silly season” and what I mean by that is after December 15 most traders are not serious about the markets and they’re not committed to any large positions for the balance of the year.
As you will see in the video, gold has fallen back to an area that should provide support, however it will remain choppy and thinly traded for the balance of the year.”
This article is a guest contribution by Vitaliy Katsenelson*, Portfolio Manager and Director at Investment Management Associates in Denver, CO.
December 15, 2009
In the bull market that preceded the collapse of Lehman Brothers and the financial crisis, equity valuations reached some very frothy levels.
The correction that followed lasted only until March, and since then the S&P 500 index and the FTSE Eurofirst 3000 have risen more than 60%. Even in spite of the post-Lehman correction, equity markets have been in a secular range-bound phase since 2000.
Investors must understand the dynamics of range-bound markets and the best ways of investing in such an environment.
Secular market cycles
Let me lay out my thesis for secular (long-term, longer than five years) market cycles.
Ask an investor what the stock market will do over the next decade, and he’ll tell you his expectations for the economy and earnings growth, and that will turn into his projection for the market. However, this kind of thinking looks at the half of the equation that explains stock market (and individual stock) returns, while completely ignoring a very important variable that is responsible for a significant part of stock returns: valuation.
Mathematically, stock prices in the long run (not minutes or days, but years) are driven by two factors: earnings growth and (it’s a very important and) changes in valuation (P/E ratios). Once you add a return from dividends, you’ve captured all the variables responsible for total return from stocks.
During the last two centuries, every time we had a long-lasting bull market the market what followed was not a bear but a range-bound, sideways market. (The only notable exception was the decline during the Great Depression.) This happened not because of some hidden, embedded magical pattern. No, there is no practical joke being played on gullible humans; it happens because our emotions get the best of us. Yes, emotions! Secular bull markets start at low, below-average P/Es. A combination of earnings growth and P/E expansion (which is a simple reversion towards the mean) bring spectacular returns to now jubilant investors.
Then the investors get overexcited about stocks and drive valuations (P/Es) to above- average levels.
P/E expansion is a powerful tailwind and a significant source of the returns during secular bull markets, but high P/Es can create a headwinds. When they start to fall, they curtail returns during secular range-bound markets. As P/Es stop expanding at the very late stages of a secular bull market, investors who were accustomed to above- average returns grow less than thrilled with lower rates of return. The higher the P/Es, the more difficult it is for stocks to continue to climb, as earnings growth alone cannot keep the secular bull market going. Returns from stocks decelerate to below the levels investors have learned to expect, and investors gradually migrate from stocks to other asset classes.
Welcome to a range-bound market!
Emotions now shift into reverse. P/E compression is like gravity pulling stocks down, where earnings growth is the force that counteracts its effects. All the benefits from earnings growth are gradually offset by constant P/E compression (the staple of range- bound markets). P/Es mean-revert from above to average to below-average levels. Stocks go nowhere for a long, long time in the process.
I discuss this topic in great detail with plenty of charts and tables on myContrarian Edge website.
US equity markets remain locked in a range-bound state
In the US, economic performance has not been significantly different during range- bound and bull markets. That is, as long economic performance was not far from its average state we had either range-bound or bull markets. However, when you coupled high (above-average) valuations with long-term economic contraction, you had a secular bear market. This is exactly what took place during the Great Depression (and has taken place in Japan from the late 1980s until today).
In secular bear markets, economic growth does not offset a price/earnings (P/E) mean reversion; declining earnings add fuel to the fire and supersize the decline in P/E, thus causing stock prices to decline over a protracted period of time.
In the last (1982-2000) secular bull market P/Es reached their highest level ever. Today, nine years into a range-bound market, US stocks are still at above-average valuations. If over the next few years the US economy doesn’t achieve positive nominal earnings growth, we may slide into a secular bear market.\
The Fed is throwing an enormous amount of liquidity into the economy, yet it has very few tools to deal with deflation (you can make borrowing virtually costless, but borrowers may still choose not to borrow or to spend). The Fed is much better equipped to fight inflation: it can make money very expensive, and expensive money curbs spending. Thus, historically the Fed was willing to err on the side on inflation - be it in consumer prices, housing, commodities, or the stock market (”Bubbles-R-Us”). (In part we are paying today for the Fed’s handling of the 2001 recession: Alan Greenspan took interest rates to a very low level and kept them there for too long, starting a bubble in real estate.)
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Current Fed actions may have the unintended consequence of promoting another bubble in stocks. I believe it will be harder to achieve a broad market bubble, since the more you stimulate the less effective stimulus becomes, over time; but I can see how a few sectors may (and already have) bubbled up.
The Fed and politicians will likely err on the side of overstimulating the economy, as the career risk for taking the economy back into recession through constrictive monetary policy is too great.
The exit strategy from a range-bound market
Will my observations continue to play out in the future?
In my book Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007), I inadvertently created a framework that explains the mechanism behind stock market cycles. As things change over time one thing remains the same: our emotions will make us overexcited about stocks, and this will drive stocks to above-average levels, giving us cause to be underexcited (I think I just made up a new word), which will result in treacherous periods of range-bound markets.
If it were not for our emotions, stocks would always hew very close to their value levels (a normalized P/E of 15) and secular market cycles would not occur. I am oversimplifying; but if it were not for emotions, returns from stocks during short, intermediate, and long-term periods would be identical to their earnings growth.
Human emotions don’t let valuations (P/Es) remain in their average state of 15, and so they are driven to extremes, on both sides of the mean. Returns from stocks over short (one year) and intermediate terms (5, 10, or 15 years) may have a significant disconnect from their earnings growth. And the disconnect between earnings growth and stock market returns may persist for decades, or even longer.
Over, say, thirty years in the US (it takes that long for bull and range-bound markets to cancel out each other), returns from stocks will be in line with economic growth.
The role of technical analysis and market timing
About a month after my book came out I regretted its subtitle, “Making money in range- bound markets.”. People assumed that I knew what the range was, and the name also implied that I use technical analysis. “Sideways markets” would have been a more accurate description, but what’s done is done.
Secular market cycles are full of many cyclical bull and bear markets; the last range- bound market, which started in 1966 and ended 1982, had five cyclical bull and five cyclical bear markets. It is impossible to succeed at short-term market timing, as you have to get two things right: the short-term economic numbers and the market’s response to them, which in many cases may be irrational.
What I propose in the book (and practice at my firm) is active value investing. Instead of being a market timer, I’m a buy-and-sell investor, with a focus on valuing individual stocks.
Positioning against a decline in the dollar
Though problems in the US are well-known, I am not a long-term dollar bear (though, as a hedge, we own some stocks that would benefit if the dollar continued to decline).
If the dollar is to fall, one must ask what against currency will it fall?:
The Japanese yen? Japan has its own, more immediate crisis: its economy has been in recession since the late 1980s, it has one of the oldest populations in the developed world, and its savings rate has declined greatly and is still falling. Japan has been trapped in a zero-interest policy that it may not be able to sustain for much longer. Its debt-to-gross domestic product is second only to Zimbabwe’s, and even a small increase in interest rates will put a significant pressure on its budget. So the yen is not it.
As I have written previously, Japan was on the stimulus bandwagon for more than a decade; and with the exception of government debt-to-GDP tripling, Japan has nothing to show for it . Its economy is mired in the same rut it was in when the stimulus marathon started. It had a hard time giving up stimulus because the short-term consequences were too painful. Also, Japan is proof that a low (zero) interest-rate policy loses its stimulating ability over time and turns into a death trap for the economy as leverage ratios are geared to low interest rates. Now, even a small increase in interest rates (say, from 1% to 2%) would be devastating for Japan’s economy.”
The US is not Japan: our housing and stock market overvaluations were not as extreme; our corporations are in much better shape (though consumers are in worse shape); we are not xenophobic, thus our population is growing through immigration; we don’t have a significant cultural issue of “saving face” to overcome. Thus, although we sometimes don’t let bankrupt companies go bankrupt to the degree we should - at least not since Lehman - creative destruction is allowed to exist to a far greater degree here than it was in Japan.
The euro? The euro blankets a collection of 20+ countries with very different interests. As John Mauldin put it, and I agree, the euro was created for prosperity, not adversity. Europe has its own demographic issues, such as high unemployment. So I am not betting on the euro against the dollar, either.
The Chinese renminbi? The People’s Republic of China is neither the people’s nor is it a republic. Despite its economic progress, China is still a communist country with a totalitarian regime and limited human and property rights. The Chinese government made the choice of growth at any cost even if projects don’t (or barely) cover the return on capital. It has done so at the cost of undermining the purchasing power of its people by manipulating its currency, keeping it significantly undervalued. I’ve written a lot about significant Chinese economic problems will likely surface down the road.
Lately I’ve been hearing chatter of “nominating” the Chinese currency to reserve currency status. This is unlikely to happen for the reasons I’ve just mentioned, and also it goes against the Chinese business model. As long as the Chinese model is to be a low-cost producer and exporter to the world, reserve currency status is off the table. If the rest of the world decides to park their money in the Chinese currency, it will drive the renminbi up and decapitate China’s export industry.
Maybe the Russian ruble? Unfortunately, Russia is a a one-trick petrochemical pony. The natural resources of Russia are more a curse than a blessing, as they detract capital from and hinder development in non-commodity industries.
What’s happening in the US isn’t good for the dollar, but I’m not sure the rest of the world is in a much better position.
Gold closed up $1.10 yesterday to scale a fresh high of $1,165.80. Amazingly, this was the 14th higher close of the last 15 sessions..
It doesn’t take much analysis to conclude that gold is overbought, at least in the short term, but here is Richard Russel’s (Dow Theory Letters) answer to the question “Should I buy more gold here?”.
“To those of us who bought gold a year or five ago, gold looks expensive now. But is it really expensive? Does the US have too much debt? Can the dollar avoid a collapse? Those are questions I cannot answer. As I write tonight [Friday], gold futures are up over $17. By any standard, gold appears to be overbought. But wait - I’m wondering whether gold is on the edge of its third, speculative phase and whether it is starting to go parabolic. If gold is going parabolic, then there’s no such thing as ‘overbought’. Gold will continue to rise until it’s exhausted. And ultimately it will rise higher than almost anyone is expecting.
“I’ve written before that my experience in big primary bull markets tells me the item in question will advance further than anyone thinks reasonable or even possible. If gold is entering its third phase, I have no idea where it’s heading and neither does anyone else.
“Furthermore, if gold is close to going parabolic, all you can do is close your eyes and place your buy order. Waiting for a big gold correction is going to be a frustrating wait. You just have to pull the trigger and buy it. When the primary trend is up, the bull market will usually bail you out of most of your mistakes (and, of course, you will make mistakes).”
Mr Russell may very well be right, but I would still be reluctant to buy now, especially when considering gold’s “high pole” on the point and figure chart below, indicating the metal is overdue for a pullback.
I have always been a proponent of buying a notoriously volatile asset like gold on downward reactions, which are bound to happen from time to time - even in a well-defined bull market. That’s the way I will play it.
According to CityWire, he argued that we were in a secular bear market that began in 2000 and has some years to run. “In secular bear markets, the buy-and-hold approach to investing is a ‘disaster’, he says, citing the experience of 1966-82 in which the Dow Jones Industrial Average went through five strong rallies and ended up back where it started. It’s not all bad news - the current cyclical rally has a few months yet to go with up to 20% upside, based on historical patterns - but will be tough going, Ritholtz warns,” reported the website.
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In part two of the interview Ritholtz discusses the state of the US economy, why the US government should have let the banks collapse, and why inflationary fears are misplaced.
Source: Richard Lander, CityWire, November 24, 2009.
A new book by Anne Heller about Ayn Rand, and her philosophy of objectivism is making rounds these days, re-igniting the relevance and debates about Rand’s 1957 bestseller “Atlas Shrugged.”
Like many others before, the first time I read Atlas Shrugged it changed my life. It clarified my understanding of the world we live in, of the business world, of markets, and particular spoke to me about the obstacles of starting and building a business, and the kinds of people who could either help or hinder the entrepreneurial process. If you have not read it, you should. It is a great and epic story of what Rand felt was going wrong in America, and to a very large degree, it has been prophetic of the economic collision we are currently facing.
In her preface, Heller notes “Because most readers encounter her (Rand) in their formative years, she has had a potent influence in three generations of Americans.” I was 15 when a friend lent me The Fountainhead (he let me keep the book, a Signet paperback costing $3.50). I liked the novel, but was mystified by Dominique and Roark’s relationship. Though impressed by Anthem and We the Living, it was Atlas Shrugged that knocked me sideways.
If you are at all entrepreneurial about your business, Atlas Shrugged will clarify the world for you, move you, and speak to you.
In a Wall Street Journal column, last year Stephen Moore discussed the prophetic nature of Rand’s 50 year old multi-decade bestseller.
For the uninitiated, the moral of the story is simply this: Politicians invariably respond to crises — that in most cases they themselves created — by spawning new government programs, laws and regulations. These, in turn, generate more havoc and poverty, which inspires the politicians to create more programs . . . and the downward spiral repeats itself until the productive sectors of the economy collapse under the collective weight of taxes and other burdens imposed in the name of fairness, equality and do-goodism.
In the book, these relentless wealth redistributionists and their programs are disparaged as “the looters and their laws.” Every new act of government futility and stupidity carries with it a benevolent-sounding title. These include the “Anti-Greed Act” to redistribute income (sounds like Charlie Rangel’s promises soak-the-rich tax bill) and the “Equalization of Opportunity Act” to prevent people from starting more than one business (to give other people a chance). My personal favorite, the “Anti Dog-Eat-Dog Act,” aims to restrict cut-throat competition between firms and thus slow the wave of business bankruptcies. Why didn’t Hank Paulson think of that?
These acts and edicts sound farcical, yes, but no more so than the actual events in Washington, circa 2008. We already have been served up the $700 billion “Emergency Economic Stabilization Act” and the “Auto Industry Financing and Restructuring Act.” Now that Barack Obama is in town, he will soon sign into law with great urgency the “American Recovery and Reinvestment Plan.” This latest Hail Mary pass will increase the federal budget (which has already expanded by $1.5 trillion in eight years under George Bush) by an additional $1 trillion — in roughly his first 100 days in office.
The current economic strategy is right out of “Atlas Shrugged”: The more incompetent you are in business, the more handouts the politicians will bestow on you. That’s the justification for the $2 trillion of subsidies doled out already to keep afloat distressed insurance companies, banks, Wall Street investment houses, and auto companies — while standing next in line for their share of the booty are real-estate developers, the steel industry, chemical companies, airlines, ethanol producers, construction firms and even catfish farmers. With each successive bailout to “calm the markets,” another trillion of national wealth is subsequently lost. Yet, as “Atlas” grimly foretold, we now treat the incompetent who wreck their companies as victims, while those resourceful business owners who manage to make a profit are portrayed as recipients of illegitimate “windfalls.”
I found this speech by Comcast Spectacor Chairman, Ed Snider, in which he describes how as an entrepreneur, Atlas Shrugged changed his life and the lives of his children, that he went on to found the Ayn Rand Institute, in order to foster teaching Rand’s Objectivism in universities across America, because he saw that so many young Americans were clueless about entrepreneurism let alone what capitalism once was.
Part 1 - 9:13 minutes
Part 2 - 2:21 minutes
Also, if it interests you, here is the original footage of Ayn Rand’s 1959 interview with Mike Wallace:
On the 22-year anniversary of the 1987 stock market crash yesterday, stocks marched to one-year highs, with the Dow Jones Industrial Index reclaiming the 10,000 level and the S&P 500 Index breaking through 1,100 (although it then declined again to fall shy of this number by two basis points by the closing bell).
First, some comments from regular contributor Kevin Lane, technical analyst of Fusion IQ.
“The S&P 500, which recently broke above a downtrend line (purple line in the chart below), is closing in on its 50% retracement level from the 2007 peak to the 2009 lows near the 1,120 level. This level may cause some minor profit-taking and retracement; however, only a move below 1,000, which would put the S&P 500 back below its recently broken downtrend line and near-term support, would be viewed as a negative. So, until a break of 1,000 occurs, price trends remain up and pullbacks are to be viewed as minor market noise. Again only if 1,000 is violated does the trend turn more corrective.
“We continue to wait to hear investors embrace this rally as a clue it may be nearing a near-term exhaustion peak; however, the overriding theme remains that the market “needs to correct” or is “way overdue” to correct. To further that point we talked to two investors last week that were still “uninterested” and “not invested” in the market even after this large run-up. Our rationale for their apathy is that they are still scarred from last year’s collapse and made the assumption this rally was not real or would soon revert to the negative environment of 2008.
“Typically markets have this way of going to extremes to either scare all investors to the sidelines or seduce them to come back into the markets. The current run with its persistence is doing its best seduction routine to extract the last bit of capital from even the most ardent doubting Thomas.
“While we could be wrong we think the market will remain generally strong, defying consensus (as it has for the last three months), and entice the remaining sideline capital back into the pool. Only at that juncture when sideline liquidity or buying power is exhausted will we have a correction of any magnitude.”
Still from a technical perspective, Adam Hewison (INO.com) sounded a cautious note as explained in one of his popular technical analysis presentations. Click here to access the presentation.
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The current rally that commenced in March has lasted for 32 weeks. Interestingly, when considering the 32-week rolling rates of return of the S&P 500 Index the amplitude of the current cycle resembles that of the cycles of 1932, 1937-1938, 1974 and 1982 as shown in the graph below.
The question that invariably arises is what happened to the returns subsequent to the highs of the four previous cycles. The table below shows that the market mostly worked lower, but the last period was an exception.
All said, I am still following a cautious approach in anticipation of the market working off its overbought condition and fundamentals reasserting themselves. I will bide my time while the fundamentals play catch-up.
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WSJ What's News Midday Edition, March 12, 2010by The Wall Street Journal 12 Mar 2010 at 12:05pm
Consumer confidence levels dropped in early March. A federal judge released a scathing report on Lehman's collapse that raps executives, auditor Ernst & Young and banks for lapses that sparked bankruptcy.
Jeffrey Saut Daily Audio Comment Raymond James
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