April 27, 2009
Money Doesn't Grow On Trees
After a sharp decline on Monday of last week, the market spent the remainder of the week recovering much of the loss. Overall, price/volume behavior continues to be uninspiring, leaving it still difficult to infer that investors have adopted a robust preference toward risk taking. The strongest characteristic of market action here is breadth (advances versus declines), but that also contributes to a variety of popular overbought indications, such as the number of stocks over their 50-day averages (which recently peaked above 80%, about where prior bull market rallies have tended to fail), and the McClellan oscillator and summation index, which are also fairly extended.
That's not to say that stocks have to decline here, but having failed so far to recruit much in the way of strong volume sponsorship, there is not much speculative merit to market risk, and only a modest amount of investment merit on the basis of valuations. Even if profit margins sustainably recover to above-average levels in the years ahead, stocks are priced to deliver probable total returns of about 10% annually over the coming decade. The idea that stocks are “once in a lifetime bargains” ignores the fact that this bear market began at strenuously overvalued levels on record profit margins – conditions that are not likely to return naturally in a deleveraging economy. Investors are taking the depth of the decline as a measure of the probable subsequent gain, but historically, the market doesn't work that way. There is little relation between the depth of a bear market and the strength of the subsequent bull.
A persistent element of hope in recent weeks has been the notion that bank operating earnings are “healthy.” To a large extent, this reflects the same sort of investing-on-hope that we saw during the dot-com bubble, the housing bubble, and other brief periods of delusion. The fact is that operating earnings look “healthy” because the only charge to earnings for credit losses is a discretionary “provision” that has been running behind actual defaults one quarter after another. Worse, last week, we learned that the Treasury actively encouraged fraudulent reporting from Bank of America, failing to disclose losses at Merrill Lynch to its shareholders when it was acquiring the company. The Wall Street Journal ran the following bit of testimony, under oath, from Bank of America head Ken Lewis:
Lewis: I was instructed that “We do not want a public disclosure.”
Q: Who said that to you?
Q: Had it been up to you, would you (have) made the disclosure?
Lewis: It wasn't up to me.
Q: Had it been up to you.
Lewis: It wasn't.
As a result, instead of Merrill Lynch's bondholders taking a loss on their bonds, or swapping their debt for BofA equity, those bondholders will now be made whole for all of the losses that Merrill incurred, with 100% principal and interest, right alongside of the bondholders of BofA that are being protected. That's what these bureaucrats want during their stint in government service, that's how they advise our elected officials, and then their revolving door takes them right back to Wall Street. This thing is run by investment bankers and corporate bondholders for the benefit of investment bankers and corporate bondholders.
Now, assuming that the government is able to persist in misusing public funds and abusing public trust in order to protect the bondholders of these institutions from losses, it's reasonable to ask: Could the banks eventually “earn their way out” of their losses over the longer-term?
To answer that question, you have to think in terms of equilibrium. Even holding GDP constant, the earnings to recover the losses have to come from somewhere, which implies a redistribution away from where they were going before. Really, money doesn't grow on trees. We've got an economy running with outstanding debt of about 350% of GDP. Even a moderate percentage of that as loan losses will represent a significant share of GDP. To reallocate enough funds to fill that hole, we would have to keep deposit rates near zero, and corporate lending rates high, so that financial institutions would earn a persistently wide spread, or “net interest margin.” Over the short-term, that's what's been happening, so ironically, banks are more “profitable” today than they probably will ever be. Unfortunately, that “profitability” is an artifact of a) unsustainably wide net interest margins, and b) a failure to adequately book losses, at the encouragement of government bureaucrats.
Consider the economic landscape. The U.S. government is running huge deficits, selling debt to foreigners in order to make the bondholders of mismanaged financial institutions whole. This will put a claim on our future national output and allow foreign owners to scoop up U.S. businesses in the years ahead. We are also running a large current account deficit (though somewhat smaller than in recent years thanks to a collapse in U.S. gross domestic investment).
In order for U.S. financial institutions to earn their way out of the losses, they will have to accrue and retain an amount on the order of 25% to 35% of GDP. From where will they reallocate that amount? Well, prior to the recent earnings downturn, corporate profits were running at about 8% of GDP, a figure that was already based on unusually high profit margins (the sustainable norm is less than 6%). The personal savings rate was about zero, but has increased to about 4% as consumers have scaled back consumption. If banks were able to sustainably charge high interest rates on loans and pay low interest rates on deposits, the earnings of the banks would come at a cost to what would otherwise have been retained: corporate earnings and private savings. Essentially, savers will earn less, and corporate borrowers will pay more. To accrue 25-35% of GDP to cover the debt losses (which is a mainstream estimate, not a worst-case by any means), you would have to persistently depress non-financial corporate profits and personal savings by about 25% for well over a decade.
So yes, we can indeed abuse the U.S. public in order to make the bondholders of U.S. financial institutions whole and protect them from any losses. This was the policy of the Bush Administration, and has tragically become the policy of the Obama Administration as well. By doing so, we will commit our future production to foreign hands, or we will commit about a quarter of U.S. non-financial profits and personal savings to these bondholders for at least the next decade.
We can also allow bureaucrats to commit public funds that have not even been allocated by Congress, which is what we have done. We have all become dangerously de-sensitized the the sheer volume of money being tossed around here, and the potential for enormous fraud, misappropriation, cronyism, and misuse.
What we cannot do is create all of this out of thin air. Understand that the money that the government is throwing around represents a transfer of wealth from an unwitting public to the bondholders of mismanaged financial corporations, even while foreclosures continue. Even if the Fed buys up the Treasuries being issued, and thereby “monetizes” the debt, that increase in government liabilities will mean a long-term erosion in the purchasing power of people on relatively fixed incomes.
To a large extent, the funds to defend these bondholders will come by allowing U.S. businesses and our future production to be controlled by foreigners. You'll watch the analysts on the financial news channels celebrate the acquisition of U.S. businesses by foreign buyers as if it represents something good. It's frustrating, but we are wasting trillions of dollars that could bring enormous relief of suffering, knowledge, productivity, and innovation in order to defend bondholders of mismanaged financials, and nobody cares because hey, at least the stock market is rallying. If one thing is clear from the last decade, it is that investors have no concern about the ultimate cost of the wreckage as long as they can get a rally going over the short run.
For my part, I remain convinced that without serious efforts at foreclosure abatement (ideally via property appreciation rights), mortgage losses will begin to creep higher later this year, surging in mid-2010, remaining high through 2011, and peaking in early 2012. To believe that we are through with this crisis or the associated losses is to completely ignore the overhang of mortgage resets that still remain from the final years of the housing bubble.
No real change in market conditions here. As of last week, the Market Climate for stocks was characterized by mixed valuations. Earnings-based valuations that assume a sustained recovery to above-average profit margins are moderately favorable, but measures that assume normal historical profit margins in the future still suggest that stocks are overvalued. Market action remained tepid from the standpoint of trading volume and sponsorship, but we do observe generally good breadth as measured by advance-decline statistics. In bonds, the Market Climate remained characterized by moderately unfavorable yield levels and relatively neutral yield pressures. The Strategic Total Return Fund remained positioned largely in Treasury Inflation Protected Securities, with about 25% of assets allocated between precious metals shares, foreign currencies, and utility shares.
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