January 28, 2008
As anticipated, the Fed initiated a large "intermeeting cut" on Tuesday morning, which helped the stock market to dodge a bullet. Unfortunately, my impression is that the bear is toting a semi-automatic with a full clip of ammo.
With the disclosure that a single trader incurred billions of losses for Societe Generale, a fairy tale has emerged that the whole market selloff last week was somehow driven by the unwinding of that position. On that, I have to concur with SocGen's CEO Daniel Boutin that the whole idea is absurd. At bottom, it reflects Wall Street's desire to "explain away" the market's weakness in hopes that it was an anomaly that is now behind us.
The truth is that the recent market weakness is a continuation of deterioration that has been underway since July. While I've viewed the market as being richly valued for some time, I have rarely used the word "warning" as frequently, or have been as vocal about potential risks, as I have in recent months:
A Who's Who of Awful Times to Invest: ../wmc/wmc070716.htm
Market Internals Go Negative: ../wmc/wmc070730.htm
The Problem with Financials: ../wmc/wmc070903.htm
Warning - Examine All Risk Exposures: ../wmc/wmc071015.htm
Expecting a Recession: ../wmc/wmc071112.htm
Critical Point: ../wmc/wmc071119.htm
Minding the Hinges on Pandora's Box: ../wmc/wmc080107.htm
It is sheer denial to believe that the market's recent weakness and the Fed's response was just an overreaction to a decline caused by SocGen's unwinding. Moreover, as I noted on December 17 comment " there is one particular scenario that would be ominous in my view. That would be if we see a relatively uninterrupted series of declines that breaks cleanly through the August and November lows, followed by a one-day advance of 200-400 Dow points. That's a script that markets tend to follow pre-crash. Though it's not a strong expectation or forecast, it's something worth monitoring, because we've started to see the pattern of abrupt jumps and declines at 10-minute intervals that is often a hallmark of nervous markets."
From my perspective, that's largely the script we observed last week. Short-term market movements are demonstrating a form of chaotic instability that has generally indicated growing contagion rather than independence among investors. The most important difference between current market conditions and prior crash events is the behavior of interest rates. For example, rates were rising persistently before both 1929 and 1987. The clear downtrend of interest rates may turn out to be a saving grace here, given that the market's most spectacular losses featured hostile rate trends. Still, the best interest rate action has been in Treasuries, while credit spreads have been pushing to new highs, so the favorable trends in Treasury yields are partly a symptom of growing default risks in other areas.
My continued concern is that numerous market plunges have been indifferent to both interest rate trends and even valuations, with the main warning flag being deterioration in the quality of market internals, as we observe at present. Both in the U.S. and internationally, "singular events" tend to occur well after internal market action has turned unfavorable, and prices are well off their highs.
Though I don't want to put too much emphasis on intra-day behavior, if you examine tick data or daily ranges before major declines both in the U.S. and elsewhere, you'll generally see price movements become chaotic at increasingly short intervals even before the event itself. One way to describe it without mathematics is to spin a quarter on the table and watch (and listen to it) closely - you'll observe a similar dynamic at the abrupt point that the coin moves from an even spin to an irregular one, and again just before it stops. If you imagine a pen drawing out its movements, you would see it tracing out faster and faster circles as it moves from stability to instability.
We've been open to a fast clearing rally, which we observed as a 7% surge from intra-day low on Tuesday to intra-day high on Friday, on waning volume. At present, I have no pointed views about short-term market direction. Valuations are better than they were a few months ago (though still generally rich), but none of the risks that have concerned me in recent months have diminished.
As usual, no forecasts are required. If we partition market history into "bins," the current, observable evidence regarding valuation and market action belongs to a bin that has historically been associated - on average - with a negative return/risk profile. Accordingly, the Strategic Growth Fund is fully hedged. The dollar value of our shorts never materially exceeds our long holdings, but we did reinforce our hedges on that "clearing rally" late last week, which bolsters our defense against fresh market weakness without exposing the Fund to a net short position in the event that the market recovers further. For now, the Market Climate remains negative and the Fund is fully hedged. Our investment position does not rely on market weakness, but we do allow for it at present.
How much of the stimulus will be saved? All of it
One of the ways that analysts talk about the just-enacted "fiscal stimulus" is by asking the question "How much of the stimulus will be saved?" To some extent, this is the wrong question, because if you think about it from the standpoint of equilibrium, the answer is obvious: exactly all of it.
The reason is simple. In equilibrium, every security issued must be held. If the government issues $150 billion of new debt to finance its outlays, then by pure accounting identity, exactly $150 billion of savings must be absorbed from someone to purchase that debt.
The trivial way for saving to absorb the stimulus would be for the Treasury to offer $150 billion in bonds, and also issue people $150 billion specifically for the purpose of buying those bonds. That's an instant wash. But even if the dynamics are different, the end result must be the same - someone must end up holding the new debt.
One might counter that the Treasury could sell $150 billion in bonds and the Federal Reserve could purchase them, creating $150 billion in new base money. Unfortunately, the entire U.S. monetary base is only $847.6 billion, up from $837.7 billion a year ago. Far from the notion that the Fed has created oceans of liquidity in the past year, the fact is that the U.S. monetary base (which is the only monetary aggregate the Fed controls with its open market operations) has increased by less than $10 billion. There's no shortage of previous weekly comments on this website that explain the distinction between repo rollovers and true increases in Fed "liquidity." The simple fact is that $150 billion is far beyond the capacity of the Fed to monetize without provoking a currency crisis.
Government itself is a zero sum game. The proposed "fiscal stimulus" amounts to the government issuing additional debt to some individuals in the economy, and allocating the proceeds to others. The only relevant issue is whether adding to the Federal debt in order to redistribute purchasing power will bring resources into use that otherwise would lay idle; whether the redistribution of purchasing power will relieve some constraint that would be binding in the absence of the program, in a way that ultimately increases economic activity.
The hope is that moving money from one pocket to another will make us wealthier.
That's not a particularly "Keynesian" way to look at a fiscal stimulus, but Keynes didn't worry much about debt, much less productivity. Keynesian theory is fundamentally the study of economics without the assumption of scarcity. If you look at Keynesian models of recession, the operative assumption is that investment is fixed and "trapped." By virtue of the savings-investment identity, this implies that total national savings are also fixed, so that attempts to save a greater fraction of income are futile, and will only result in lower GDP. In that context, government spending solves a "coordination failure" that the economy can't solve on its own.
Algebraically (we'll ignore foreign trade and "autonomous" consumption here), Keynes' model basically looks like this:
Y = C + I + G (GDP equals consumption + investment + government spending)
C = cY (consumption is some fraction of income)
which can be rearranged to give
Y = (I + G) / ( 1 - c)
That last equation represents the full force of accumulated macroeconomic knowledge on the average politician and Wall Street analyst. It says that if government increases spending by $1, GDP will increase by a "multiplier" equal to 1/(1-c). That little "c" is the fraction of new income that people spend on consumption (their "marginal propensity to consume"). So for example, in Keynes' world, if c = 0.75, every dollar of new government spending will produce $4 of new GDP. It also produces 0.25 x $4 = $1 of new savings to automatically finance the deficit spending.
As I've said many times before, if economics is the study of how scarce resources are allocated, Keynesian theory is not economics. There are, of course, modifications that include taxes, IS-LM versions that include monetary policy, and so forth, but the basic structure is hardly different. Keynes essentially looked at recessions as points in time when people suddenly and irrationally decided to save more, so the automatic policy response was simply to get them to consume more. But while the naïve simplicity of Keynes' framework (and the ability to scribble it on a napkin) has made it a highly popular way of thinking about economics, it is not a realistic theory on which to base the policy decisions of the largest economy in the world.
Keynesian theory is challenged by a variety of well-established results in economics. Most important is that people choose their spending plans to achieve a relatively smooth path of future consumption. As a result, a temporary increase in income is generally spread over a long horizon, while permanent changes in income result more quickly in permanent changes in consumption.
This principle (due largely to Friedman and Modigliani) became something of a political football itself last week, as some used it to advocate for a permanent reduction in taxes as a way of temporarily stimulating spending. That effort didn't get very far. People understand that if the government runs a higher deficit today, it will eventually be offset by higher taxes or reduced purchasing power in the future, so even a "permanent" reduction in taxes will not be effective in boosting consumption if that reduction in taxes isn't offset by a reduction in expected future government spending.
If the government issues Treasury bonds and uses the proceeds to make tax rebates, it simply effects a transfer of savings from one party in the economy to another. A "fiscal stimulus" is not new money, but a redistribution of resources that relies on the hope that the new recipients will direct the money more productively than those who did the saving. Remember, people don't save by stuffing their money under a mattress. Rather, they typically invest it, so the savings are ultimately intermediated to a spender - even if that spender is the Federal government. The real question is not how much of the "stimulus" will be saved, but the extent to which the redirected resources of the economy will be used more productively than they would have otherwise.
Before enacting a "stimulus package," it would be helpful for Washington to recognize that a policy that loosens a particular constraint is only effective if that constraint was previously binding on the behavior of individuals or companies. If the Keynesian problem is that people want to save but investment is stuck, then R&D subsidies with a tight sunset timeline would be a good way to directly promote productive investment and channel savings into economic activity. That said, I don't think the problem with the economy is a sudden desire to save. It's a shift in the composition of demand away from the mix of goods and services (particularly housing and debt origination) that was previously desired. There's not a whole lot fiscal policy can or should do to bring back the "good old days" of irresponsible lending and housing bubbles. Once a market becomes overvalued - in stocks, bonds, or housing - either falling prices or poor long-term returns become inevitable.
For most families, the most binding constraint right now is not the ability to spend out of current income, but the ability to service debt. A temporary boost to current income is likely to be spread out in a way that best allows that family to operate under its constraints, which means that the predominant use of this "stimulus" will be for debt service. This may very well provide the economy with a modest reduction in credit strains, but it certainly won't avoid delinquencies and foreclosures. Most mortgage obligations will swallow down the entire rebate in a single month. Outside of bailing out credit institutions and creating a huge moral hazard problem down the road, there's not a whole lot that will solve the problems except time and writeoffs.
Several years ago, Joel Slemrod and Matt Shapiro (former colleagues at the University of Michigan) estimated that only about 22% of the tax rebates provided during the last recession were directed to consumption, with the bulk going to savings and debt service. Given the much higher debt burdens today, I don't expect this instance to be much different. In the end, the U.S. economy will carry a larger amount of U.S. Treasury debt, and a somewhat smaller amount of mortgage and credit card debt than it would have in the absence of the fiscal stimulus.
Still, policy makers can only do so much given that the Federal government is already running enormous deficits and the U.S. has such a deep current account deficit that we are happily selling off our productive assets to foreigners (e.g. "sovereign wealth funds") to stay afloat. The piper does eventually get paid.
In any event, we can expect that however the "fiscal stimulus" is spent, we will observe an increase in the U.S. federal deficit, as well as an increase in the U.S. current account deficit (or at least a smaller decline than we typically observe during recessions) because the U.S. has for the past decade relied primarily on foreign capital inflows to finance growth in investment and government spending. To the extent that a portion of the rebate is spent on consumption goods, "consumption smoothing" will probably be a factor. Most likely we'll observe that by some amount of increased demand for durable items such as consumer electronics, computers, and home improvements.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. While the market remains generally oversold, the sharp mid-week clearing rally removed the ability to anticipate further strength as a probable outcome. Presently, the Strategic Growth Fund is fully hedged. The objective of our hedges is to mute the impact of market fluctuations, not to eliminate all risk by precisely offsetting our stock holdings. As is always the case when the Fund is hedged, our primary source of risk, as well as our primary source of expected return, is the potential for our stock holdings to behave differently than the indices we use to hedge.
The Fund currently has intentional overweights in sectors including consumer stocks (including consumer discretionary), technology, and healthcare. The Fund has less weight in financials and industrial cyclicals than the indices we use to hedge (primarily the S&P 500, the Russell 2000 and the Nasdaq 100). All of these relative weightings are built from the "bottom-up" - by investing in individual stocks that reflect some combination of favorable valuation and market action. We also constrain these weightings from the "top-down" - by limiting our exposure in any particular sector to a level that produces an acceptable level of overall "basis risk" versus the indices we use to hedge. Importantly, we observe a great deal of dispersion even within individual sectors, so among technology and consumer stocks, for example, many stocks reflect very favorable combinations of valuation and market action, while others appear almost ridiculously overvalued.
I am not an advocate of "investing by caricature" - choosing groups from the top-down that have done well in past economic downturns, without any analysis of how the underlying stocks are valued. Still, given our bottom-up approach, it may be helpful to know that behind the two "knee jerk" defensive sectors - consumer staples and healthcare - the next best performing sectors during recessions since 1973 have been consumer discretionary and information technology. Ned Davis Research notes that on the basis of relative performance during recessions, the "batting average" of consumer staples and healthcare has been 100%, while consumer discretionary has outperformed 80% of the time, and information technology only 40% (but by a substantial margin when it does). In contrast to 2000-2002, which was a terrible period for the hypervalued tech group, and a period where our exposure to that sector was virtually nonexistent, my impression is that technology stocks are currently a very appropriate area to moderately overweight. Our use of the NDX as part of our hedge reflects the belief that our specific holdings are better situated than the average index member even within the tech sector.
It's generally the case that a good number of stocks achieve their bear market lows during the initial phase of a market decline and then scrape along their lows for a while (although with good strength relative to the major indices), while stocks that dominate the indices often hit their downside stride well after the average stock has turned down. As I've noted before, increasing dispersion in the valuations of various stocks and sectors tends to be a favorable development because it tends to improve the potential for good stock selection to perform differently than the major indices. It isn't always comfortable when a particular overweight gets hit harder than the market for a few days, but we expect that from time to time, and it's a short-term risk that we've typically been compensated for over the long-term.
In bonds, the Market Climate last week was characterized by unfavorable yield levels and relatively favorable yield trends. Credit spreads widened yet again, which reinforces the downward pressure on Treasury yields because investors appear to be pricing in heightened default risk. We saw a massive "dropout" in Treasury yields that quickly reversed later in the week. That's a pattern we should expect to continue - a "safe-haven" compression of Treasury yields on increasing economic concerns, abruptly relieved by periodic upward spikes - most likely on inflation data, which I would expect to remain persistent until perceptions of a recession are well established.
Despite the overall downward bias of this sort of trading range, it appears unlikely that long-term Treasury investors will ultimately be willing to sustain a 3.5% yield to maturity over the next decade. So there is undoubtedly an element of "speculation" in the Treasury market, based on the lack of default risk. That prevents us from taking more than a short-duration exposure of about 2 years in this market, still mostly in TIPS. Again, I would expect that the inflation compensation element will become less useful at the point that a recession is clearly established, so straight Treasuries will eventually become appropriate.
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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