April 6, 2009
Fighting Recklessness with Recklessness
Last week saw a continuation of the impenetrably misguided policy response to this financial crisis, which seeks to address the downturn by encouraging more of what got us into this mess in the first place. The U.S. Treasury's toxic assets plan, for instance, looks to "leverage" public funds (with the FDIC providing the "6-to-1 leverage") in order to defend the bondholders of mismanaged financials who took excessive leverage. At the same time, the Treasury plans to limit the "competitive bidding" to a few hand-picked "managers" who will be encouraged to overpay thanks to put options granted at public expense. This is a recipe for the insolvency of the FDIC and an attempt to bail out bank bondholders using funds that have not even been allocated by Congress. The whole plan is a bureaucratic abuse of the FDIC's balance sheet, which exists to protect ordinary depositors, not bank bondholders.
On Thursday, the stock market cheered a move by the Financial Accounting Standards Board (FASB) to relax FAS-157 (the "mark-to-market" accounting rule), allowing nearly insolvent financial companies to use more discretion in the models they use to assess fair value. Of course, the irresponsibly rosy assumptions built into these models have been a large contributor to this near-insolvency, because they virtually ignored foreclosure risks.
Notably, the one thing policy-makers have not done is to address foreclosure abatement in any serious way. The only way to get through this crisis without enormous collateral damage to ordinary Americans is by restructuring mortgage obligations (ideally using property appreciation rights), restructuring the debt obligations of distressed financial companies (ideally by requiring bondholders to swap a portion of their debt for equity), and abandoning the idea of using public funds to purchase un-restructurable mortgage debt ("toxic assets"). See On the Urgency of Restructuring Bank and Mortgage Debt, and of Abandoning Toxic Asset Purchases.
Look. You can play hot potato with the toxic assets all day long, and only outcome will be that the public will suffer the losses that would otherwise have been properly taken by the banks' own bondholders. You can tinker with the accounting rules all you want, and it won't make the banks solvent. It may improve "reported" earnings for a spell, but as investors who care about the stream of future cash flows that will actually be delivered to us over time, it is clear that modifying the accounting rules doesn't create value. It simply increases the likelihood that financial institutions will quietly go insolvent. I recognize that the accounting changes may reduce the immediate need for regulatory action, since banks will be able to pad their Tier 1 capital with false hope. But we have done nothing to abate foreclosures, and we are just about to begin a huge reset cycle for Alt-A's and option-ARMs. As the underlying mortgages go into foreclosure, it will ultimately become impossible to argue that the toxic assets would be worth much even in an "orderly transaction."
Meanwhile, in a bizarre convolution of reality reminiscent of Alice in Wonderland, the Financial Times reported last week: "US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury's $1,000bn plan to revive the financial system." And why not? They can put up a few percent of their own money, and swap each other's toxic assets financed by a bewildered public suddenly bearing more than 90% of the downside risk. The "investors" in this happy "public-private partnership" keep half the upside while ordinary Americans take the downside off of their hands. Some partnership.
With regard to the economy, there is quite a bit of optimism that the recent market advance represents a forward-looking call that the economy will recover in the second half of the year. Indeed, some analysts have noted that year-over-year consumer spending has only declined very slightly, hailing this as evidence that economic concerns are overblown. The difficulty is that consumer spending has never declined on a year-over-year basis, except in this downturn, so that slight decline is actually the worst showing for consumer spending in the available data. Likewise, capacity utilization has plunged to levels seen only in 1974 and 1982, both which were accompanied by far deeper valuation extremes than at present.
I recognize that given the depth of the recent decline, it seems as if stocks must be at once-in-a-lifetime valuations. Unfortunately, this is an artifact of the previous level of overvaluation. The depth of a bear market often has a loose relationship with the extent of the prior bull market (and particularly with the level of valuation of the prior bull), but there is very little relationship between the depth of a bear market and the subsequent bull.
If we assume that the long-term fundamentals of the economy have not been affected in any meaningful way by this economic downturn, then stocks are most likely priced to deliver long-term returns between 9-11% annually over the coming decade, with outlier possibilities of as much as 14% if the market ends the coming decade at historically overvalued levels, and as little as 4% if the market ends the coming decade at historically undervalued levels. Far from being once-in-a-lifetime values, prospective 10-year returns on the S&P 500 are not far from their historical norms here. Stocks are about fairly valued.
The only way that stocks could be considered extremely undervalued here is if we assume that the record profit margins of 2007 (based on record corporate leverage) are the norm, and will be quickly recovered. While we never rule out the potential for surprising strength or weakness in the markets or the economy, the assumption that profit margins will permanently recover to 2007 levels is equivalent to assuming that the past 18 months simply did not happen.
Still, given sufficient evidence of broad improvement in market action (which we take as a measure of risk tolerance and economic expectations), we wouldn't fight the combination of roughly fair values and a willingness of investors to bear risk. We've been carrying small "contingent" call option positions for a good portion of the recent advance. This helped to compensate for our low weightings in financials, homebuilders and other low-quality sectors that have enjoyed frantic short-covering. Still, with only about 1% of assets currently in those calls, our stance is still characterized as defensive here, as we are otherwise fully hedged. Again, we won't fight a broad improvement if it continues sufficiently, but if I were to make a guess, it would be that the potential downside in the S&P 500 from these levels could approach 30-40%. That is not a typo, and it is not a possibility that should be ruled out.
I have no idea how long investors will remain enthusiastic about trillion dollar band-aids and eroding the integrity of our accounting rules. I do know that at the end of the day, what matters is the long-term stream of deliverable cash flows that investors can actually expect to reach their hands. It's exactly that consideration that makes it clear that we will sink deeper into this crisis until we observe debt restructuring on a large scale. If we don't restructure the debt, the debt will fail, because for many borrowers, the cash flows aren't there, and it is not possible to service the debt on existing terms.
As of last week, the Market Climate for stocks was characterized by fair valuations (modestly but not significantly undervalued on measures based on prior earnings, still overvalued on measures that do not rely on a reversion to above-average profit margins in the future). Market action is demonstrating some favorable signs, particularly evident in breadth-based measures such as advancing versus declining issues, and we are willing to carry some call option exposure on that basis, but the overall price-volume behavior still appears more consistent with a standard bear market rally punctuated by periodic short-squeezes. Suffice it to say that we've got some amount of exposure to further market strength, but that we are skeptical that the recent advance has important information content about a pending economic recovery. So far, it looks very much like the interim advances often observed during periods of ongoing market weakness.
In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and relatively neutral yield pressures. The Strategic Total Return Fund continues to have the majority of its assets in medium term Treasury Inflation Protected Securities, with about 25% of assets allocated across precious metals shares, foreign currencies, and utility shares. I continue to believe that it is too early to purchase distressed corporate debt - the view that this sector is a bargain is predicated on the belief that the economy has worked its way through this deleveraging cycle and is ready to rebound in the months ahead.
Interestingly, though there is a lot of chatter in the stock market about the hope for improving economic conditions, it seems that the bond market didn't get the memo. Credit spreads have moved sideways or have even widened in recent weeks, including corporate-corporate spreads like AAA versus Baa. Many credit default swaps actually blew to new highs last week, though the additional jump the day before the FASB announcement seemed to me to be a speculative pop on the possibility that the FASB would leave mark-to-market alone. In any event, the non-uniform features of the recent advance don't appear particularly healthy. One gets a stronger signal about investors' risk preferences when a stock market advance is coupled by broad sector leadership (not just battered junk stocks), narrowing credit spreads, and a wide range of other elements of market action.
New from Bill Hester:
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