August 15, 2011
Two One-Way Lanes on the Road to Ruin
First, a quick review of market conditions. Short-term measures of market action became extremely oversold mid-week, and investors took the Fed's latest statement as an occasion to launch a fairly typical "fast, furious, prone-to-failure" rally to clear those conditions. Beyond that, however, the full ensemble of evidence remains negative at present, and we remain defensive as market internals have collapsed, our Recession Warning Composite is fully active, credit spreads have blown out as in 2008, advisory bullishness is excessive and has paradoxically increased, and valuations remain too rich.
There are certainly developments that could move us quickly to a more constructive investment stance, but the most promising one would involve a deeper decline, coupled with significant turn toward bearish sentiment and then a reversal from negative to positive breadth. While we focus more on aligning ourselves with prevailing conditions than on distinctions like "bull" or "bear" (which can only be confirmed in hindsight), strong reversals from negative to positive breadth can be useful in identifying the potential for multi-week advances during what are, in hindsight, continuing bear markets. Unfortunately, those reversals don't tend to hold if overvalued and overbullish conditions are in place. This is particularly true given that typical pre-recession conditions are active, because further advances are likely to be used as selling opportunities.
It is important to recognize that the S&P 500 is presently only about 13% below its April peak, and the word "only" deserves emphasis. Our valuation impressions align fairly well with those of Jeremy Grantham at GMO, who puts fair value for the S&P 500 "no higher than 950" - a level that we would still associate with prospective 10-year total returns of only about 8% annually. I would consider investors to be very fortunate if the market does not substantially breach that level in the coming 12-18 months. Wall Street continues its servile attachment to forward operating earnings, seemingly unconscious that the perceived "norms" for the resulting P/E are artifacts of a bubble period. The fact is that historical periods of overvaluation and poor subsequent long-term returns correspond to forward operating P/E multiples anywhere above 12, while secular buying opportunities such as 1950, 1974 and 1982 map to forward operating multiples of only 5 or 6 (based on the strong correlation but downward-biased level of forward operating P/E ratios, when compared with multiples based on normalized earnings - see Chutes and Ladders for a graphic).
The composite of recession warning evidence we observe here (year-over-year GDP growth of just 1.6%, S&P 500 below its level of 6 months earlier, widening credit spreads versus 6 months earlier, yield curve spread at 2.2%, Purchasing Managers Index at 50.9, year-over-year nonfarm payroll growth below 1%) falls into a Recession Warning Composite that has been observed in every recession since 1950, and has never been observed except during or immediately preceding a recession. European growth has also stalled abruptly, and the latest read on consumer confidence (University of Michigan) collapsed to levels not seen since 1981. It is worth noting that while the weakness in the summer of 2010 generated enough indications of oncoming recession to prompt the Federal Reserve to kick the can down the road by initiating QE2, the Purchasing Managers Index never deteriorated below 54.4, and the print on real GDP was still 3.5% year-over-year growth. Needless to say, our concern about oncoming recession is even stronger today.
Without question, one of the notions buoying Wall Street optimism here is the hope that the Fed will pull another rabbit out of its hat by initiating QE3. That's a nice sentiment, but it does overlook one minor detail. QE2 didn't work.
Actually, that's not quite fair. The Federal Reserve was indeed successful at provoking a speculative frenzy in the financial markets, which has now been completely wiped out. The Fed was also successful in leveraging its balance sheet by more than 55-to-1 (more than Bear Stearns, Lehman, Fannie Mae, Freddie Mac, or even Long-Term Capital Management ever achieved), and driving the monetary base to more than 18 cents for every dollar of GDP - a level that requires short-term interest rates to remain below about 3 basis points in order to maintain price stability ( see Charles Plosser and the 50% Contraction in the Fed's Balance Sheet ). The Fed was indeed successful in provoking a wave of commodity hoarding that affected global supplies and injured the poorest of the poor - particularly in developing countries. The Fed was successful in setting off a very predictable decline in the value of the U.S. dollar. The Fed was successful in punishing savers and the risk averse, and driving investors to reach for yield in risky investments that they would normally avoid were it not for the absence of yield. The Fed was successful in provoking those with strong balance sheets to pay down existing higher interest-rate debt, and in creating an incentive for those with weak balance sheets to issue more of it at low rates, resulting in a simultaneous deterioration of credit quality and compensation for risk in the financial system. The Fed was successful at boosting the trading profits of the banks that serve as primary dealers, by announcing precisely which securities it would be buying prior to Treasury auctions, and buying them on the open market a few days later from the dealers that acquired them. The Fed was successful in creating a portfolio of low yielding securities that will be almost impossible to disgorge without capital losses unless the Fed holds them to maturity. On proper reflection, the list of the Fed's successes from QE2 is nothing short of stunning.
It is beyond comprehension why anyone would wish for more of this recklessness.
Two one-way lanes on the road to ruin
The reason we are facing a renewed economic downturn is that our policy makers never addressed the essential economic problem, which was, and remains, the need for debt restructuring. There are two one-way lanes on the road to ruin, and these - in endless variation - are unfortunately the only ones on the present policy map:
1) Policies aimed at distorting the financial markets by suffocating the yield on lower-risk investments, in an attempt to drive investors to accept risks that they would otherwise shun;
2) Policies aimed at defending bondholders and lenders who made bad loans, which they now seek to have bailed out at public expense.
Government policy can act in two ways. It can alter the distribution of resources, and it can act as a coordinating mechanism to bring about ends that would be difficult to achieve through voluntary cooperation. Both functions are necessary to some extent, but the hallmark of good policy is that it preserves pro-growth and pro-social incentives (saving, investment, innovation, work, and a discerning approach to risk), protects individual liberty (as Hayek wrote, "socialism can only be put into practice by methods of which most socialists would disapprove"), and operates to relieve constraints that would otherwise be binding.
Think about Fed actions in this context. Ten-year Treasury yields were already below 3% before Bernanke breathed a word about QE2. Treasury bill yields were already at just 15 basis points. Mortgage rates were already low. A long record of historical evidence was available to demonstrate that every 1% move in stock prices has only a 0.03-0.05% impact on real GDP, and a transitory one at that. Banks already held a trillion dollars of idle reserves on their balance sheets. How could a policy targeted at further suppressing yields and distorting financial markets possibly be viewed as a way to relieve binding constraints? How could an economy already plagued by "moral hazard" possibly benefit from the belief that the Fed had provided a "backstop" for speculative risk-taking? With interest rates already at zero, what possible intent could increasing the stock of zero-interest assets by $600 billion have, except to provoke investors to "reach for yield" by accepting greater risk without the material likelihood of durable reward?
Ben Bernanke's objective of distorting the investment opportunity set and suppressing all risk aversion is dangerous, and is ultimately hopeless as a strategy to improve economic performance. In our view, the prospect of QE3 is questionable, and would be unlikely to draw the same market response as QE2 anyway, given that investors now have more information about its ineffectiveness. The latest iteration of Fed distortion was last week's explicit promise to suppress interest rates for two more years, until mid-2013. Even that action was met by more opposition from FOMC members than any other decision under Bernanke's tenure. Nevertheless, the promise to extend zero interest rates for two more years is simply a further attempt - now becoming desperate - to distort the financial markets by dressing up the same pig with lipstick and a flirty dress.
Meanwhile, investors continue to hold similar hope that policy makers will take us down the other lane, which is to defend bad debt with public funds. In Europe, there might have been a kernel of sensibility a year ago to pursue short-term stabilization as a way to buy time to prepare for debt restructuring among peripheral, highly indebted countries such as Greece. But this time has been wasted, and as a result, there is increasing pressure to shift from restructuring (often called "burden sharing" there), to central bank purchases of bad debt and attempts to construct a full bailout package. Periodic news of tentative agreements on this front will undoubtedly provoke short-term relief rallies in the financial markets. Ultimately however, credit spreads continue to imply a virtually certain default of Greek debt, and I expect the eventual exit of peripheral members of the European Monetary Union from the euro. This would actually contribute to the durability of the euro under its fiscally stronger members, but it would also be chaotic, so we can expect at least a year of convulsive efforts to push off that outcome.
In the investment markets, we view securities as claims on a long-term stream of cash flows that will be delivered to investors over time. It is that stream of deliverable cash flows, not next year's predicted operating earnings, and certainly not the market price of the security itself, that actually forms our view of "value" that is intrinsic to each security.
Similarly, economic "wealth" can be conceptualized as the expected stream of goods and services that an economy can produce and command over time. This is how consumers set their spending decisions - not based on the day-to-day value of their stock portfolios, but rather on the basis of the long-term amount of goods and services that they believe they can command over their lifetime. This is what Milton Friedman and Franco Modigliani called "permanent income." The smoothed response of consumption to permanent income is the reason that consumption is actually the most stable category of GDP, and is responsible for only about one-third of year-to-year swings in GDP growth despite representing over 70% of total spending.
The economy is not some monolithic machine that produces a single good that is either in or out of demand. Rather, it is a mix and continuum of goods and services that compete, complement, and substitute for each other in the face of constantly changing preferences, emerging from innovation, displacing existing products, and sometimes making whole industries obsolete. The way to expand the economic wealth of a nation is not simply to "stimulate demand" with fiscal policy, nor is it to distort financial markets with monetary policy. Rather, the way to achieve better economic performance is to focus on policies that expand innovation and productive capacity, particularly in sectors of the economy where there is likely to be latent demand (which may include infrastructure).
Presently, we should not judge policy actions by their ability to punish saving, indiscriminately promote spending, relieve fear by making bad debt whole, or promote credit for its own sake. Instead, we should judge each policy action by its ability to reallocate resources toward productive uses, and to accelerate the restructuring of hopelessly bad debt that was carelessly extended in the first place. Many "standard" elements of economic policy can be crafted toward these ends, including infrastructure spending, R&D credits, unemployment compensation, funding of NIH and other basic research, and so on. Restructuring mortgage debt by using Treasury to administer, but not subsidize, property appreciation rights would also be helpful (see the second portion of Handicapping QE3 ). By contrast, it is disastrously misguided to defend holders of bad debt, to distort financial markets, and to obstruct rather than facilitate the restructuring of excessive debt burdens.
During the 1930's, the Austrian economist Joseph Schumpeter captured the importance of productive investment nicely in his discussion of credit. The goal of lending activity is not the stimulation of demand per se, but rather the temporary relaxation of constraints in order to increase the stream of goods and services available to the economy:
"By credit, entrepreneurs are given access to the social stream of goods before they have acquired the normal claim to it. It temporarily substitutes, as it were, a fiction of this claim for the claim itself. Granting credit in this sense operates as an order on the economic system to accommodate itself to the purposes of the entrepreneur, as an order on the goods which he needs: it means entrusting him with productive forces. It is only thus that economic development could arise from mere circular flow in perfect equilibrium. And this function constitutes the keystone of the modern credit structure.
"The entrepreneur must not only legally repay money to his banker, but he must also economically repay commodities to the reservoir of goods - the equivalent of borrowed productive means; or, as we have expressed it, he must ultimately fulfil the condition upon which goods may normally be taken out of the social stream. The result of the borrowing enables him to fulfil this condition. After completing his business ... he has, if everything has gone according to expectations, enriched the social stream with goods whose total price is greater than the credit received and than the total price of the goods directly and indirectly used up by him.
"Loss always occurs if the entrepreneur does not succeed in producing commodities at least equal in value to the credit plus interest. Only when he succeeds in doing so has the bank done good business - then and only then however, is there also no inflation."
It is not the loan itself that creates wealth or economic benefit. It is the productivity of the loan. Though Schumpeter focused mainly on entrepreneurs, his views on credit weren't restricted to business lending. Even in the case of consumer credit (which is properly used to smooth the stream of consumption on the expectation of future income), there is an obligation that borrowers will produce future income in order to repay the debt. So even people who earn income from a paycheck are entrepreneurs in the sense that they are in the business of selling labor services. In effect, a good consumer loan still facilitates the later production of goods and services that can be made available to others.
Let's go back to the last line in Schumpeter's remark. Only when the lending ultimately results in a surplus of productive activity is the loan successful. Only then "has the bank done good business - then and only then however, is there also no inflation."
This point is crucial, because all of us are presently benefiting from the continued demand for default-free securities (specifically, U.S. base money and Treasury debt - which I do continue to view as default-free). It is only that demand that has allowed inflation to remain low despite the massive expansion of government liabilities far exceeding GDP growth, and of misallocated credit that has produced losses rather than surplus output. The overhang of mortgage obligations and sovereign debt, matched neither by current value nor future output, is an extraordinary threat. First, it contributes to keeping resources idle, because it forces consumers and whole nations to remain on a path of austerity and debt reduction rather than spending. At the same time, it prevents businesses from hiring, because they know that demand is not forthcoming. Finally, to the extent that we pursue policies that use public subsidies and money creation to make that debt whole instead of restructuring it, we can expect inflationary pressure in the back half of this decade, because the amount of credit created is not commensurate with the amount of productive capacity that has resulted from it.
Indeed, we have pursued policies that would be aptly described as Schumpeter's nightmare:
"Only in one other case could the banking world... arbitrarily determine the price level, not only without loss but even with profit: namely, if it pumped credit means of payment into the circular flow either by making bad commitments good by a further creation of new circulating media or by giving credits which really serve consumptive ends. In general, no single bank could do this. For while its issue of means of payment would not appreciably affect the price level, the bad commitment would remain bad and the consumptive credit become bad if it did not lie within the limits in which it could be repaid by the debtor out of his income. But all banks together could do it... The banks could do likewise if the state were to transfer the right to them in their interest and for their purposes, and common sense did not prevent them from exercising it."
Schumpeter was something of an optimist in that he dismissed this sort of nightmare, because he viewed it as "self evident" that such a possibility was "the chief reason why special legal restrictions and special safety-valves are actually necessary in practice."
Unfortunately, we increasingly have a situation where the entire thrust of our nation's economic policy is aimed precisely at "making bad commitments good by a further creation of new circulating media, or by giving credits which really serve consumptive ends." Those policies operate primarily for the benefit of banks and bondholders who made reckless and unproductive loans. To use Schumpeter's words, our public policy now operates "in their interest and for their purposes." It is the insistence of policy makers on making these bad loans whole, instead of restructuring the obligations, that is at the heart of our prolonged economic slump.
Undoubtedly, borrowers are also responsible for the losses, but it is always the lender and the investor who is responsible for judging the risk and character of the businesses and individuals to whom they extend credit. As Schumpeter noted "The entrepreneur is never the risk bearer. The one who gives credit comes to grief if the undertaking fails." When investors and lenders stop being mindful of risk, believing that somebody else will bail out the loss, the misallocation of resources does violence to the entire economic system.
A final note on the idea for which Schumpeter is best known. Schumpeter viewed the emergence of unusual profits, and their subsequent elimination through competition, as the essential driver of economic development. Schumpeter called this process "creative destruction" - a cycle where new innovations repeatedly emerge and displace older products and technologies. Early on, those innovations are scarce and very profitable, but those profits are eventually followed by "swarm-like" competition that expands the amount of the new activity, lowers its profitability, and at the same time contributes to economic growth. As Jeremy Grantham once noted, "if profit margins are not cyclical, capitalism is broken." In Schumpeter's words:
"And as the rise and decay of industrial fortunes is the essential fact about the social structure of the capitalist society, both the emergence of what is, in any single instance, an essentially temporary gain, and the elimination of it by the working of the competitive mechanism, obviously are more than 'frictional' phenomena, as is that process of underselling by which industrial progress comes about in capitalist society and by which its achievements result in higher real incomes all round."
In order for this process to be successful, however, Schumpeter was acutely aware that the required adjustments actually needed to be allowed during economic downturns. Businesses sometimes needed to fail. Debt sometimes needed to be wiped out. Employees sometimes needed to transition to other jobs and even occupations. "The real meaning of a period of depression," Schumpeter wrote, is "the struggle towards a new equilibrium position, which will embody the innovations and give expression to their effects upon the old firms."
"Consequently, there is, theoretically, depression as long as no such equilibrium is approximately attained. Nor will this process be interrupted by a new boom before it has done its work in this sense. For until then, there is necessarily uncertainty about what the new data will be, which makes the calculation of new combinations impossible and makes it difficult to obtain the cooperation of the requisite factors... The blunders and destruction cannot in general be corrected and repaired again, and they create situations which in turn have further effects, which must work themselves out... they are essential elements of the mechanism of economic development and cannot be eliminated without crippling the latter."
As noted at the outset, the Market Climate in stocks last week remained hostile, with valuations still rich, market action clearly negative, a paradoxical increase in advisory bullishness coupled with a reduction in bearishness, and recession warning conditions in place. If we were provided lower valuations and a shift to bearish sentiment, even market action identical to last week might be enough to warrant a moderate exposure to market fluctuations. The main problem here is that we essentially have nowhere constructive to go on the upside - advisory sentiment is already overbullish, and despite the recent decline, our 10-year total return projection for the S&P 500 has still only climbed to 5.1% annually. The ensemble of evidence remains steeply negative here. There are certainly many possible combinations of evidence that would be associated with a positive return/risk profile, on average. Unfortunately, we don't observe any of them at present, so both Strategic Growth and Strategic International Equity are well-hedged for now.
In bonds, we saw a nearly parabolic surge in long-term inflation-protected Treasury securities last week, bringing long-term real yields to a fraction of a percent. We used that spike to liquidate the majority of our holdings in that area. Passive investors in Treasury securities may very well earn flat or negative long-term real returns from present levels, but we see no reason to lock that prospect in. Strategic Total Return presently has a duration of only about 1.5 years, as the evidence suggests that risk is most efficiently taken in other areas, particularly in precious metals shares, where we boosted our allocation on weakness last week, back to just under 20% of assets.
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