June 29, 2009
Green Shoots and a Grain of Salt
Housing starts are soaring! Up 17% just last month! So trumpeted a perma-bullish financial news anchor last week, hailing the news as the portent of an economic rebound. Guest analysts were quick to talk about turning the corner, and moving through the "bottoming process," while some even expressed concern that the rebound in housing starts was so strong that it might create inventory pressures by adding to the stock of homes too quickly.
Let's take a breath. Economic reports - especially growth rates - can be very misleading when they are not placed into context. Below is a chart of U.S. housing starts since 2003 (thousands, monthly data at an annual rate). See that little 78,000 home uptick in the chart in the last data point - the little bit of statistical noise that is smaller than even the typical 119,000 standard deviation of month-to-month fluctuations? There's your boom in housing starts.
Unfortunately, the issue is far larger than a simple exaggeration of economic news. No, it's extremely important to remember that sustained economic expansions are primarily driven - not by growth in consumer spending (which is very, very smooth over time) - but by growth in gross investment and durables of the large, debt-financed variety: housing, autos, equipment, factories, capital spending, and so forth. A 50% jump in housing starts here, to an annual rate over 800,000 units from the current 532,000, would still only be consistent with zero sustained growth in GDP.
That's not to say that we can't observe positive GDP growth in the next quarter or two. Unlike past recessions, consumers have uncharacteristically cut back on even nominal consumption - reflecting what they evidently see as a permanent downward revision in their expected lifetime income (U.S. consumer spending patterns are very consistent with the Friedman and Modigliani's permanent income hypothesis). To the extent that consumers abandon these concerns, we may very well observe some recovery in consumer spending sufficient to generate one or two positive GDP figures. Unfortunately, by late this year, we will begin a monstrous second-wave of adjustable mortgage rate resets, which will likely result in greater foreclosures, debt losses, and housing market pressures.
The key fact is that we have significant economic headwinds before us, and we should be careful to take our green shoots with a grain of salt. No piece of economic news, even a strong employment figure here or there, is likely to flip the switch that makes the problems all go away. It would be one thing if stock valuations were at a level that deeply discounted significant and ongoing negative news, but on the basis of normalized earnings, the S&P 500 is actually slightly overvalued here, and is likely to deliver long-term returns over the coming decade of only about 7.8% annually. An economy that is prone to disappointments, coupled with a market that requires a lack of them, is not a good combination.
Similarly, we are skeptical about things that cross our desks urging us to forget the economy's debt fundamentals and break into a chorus of Zippidee-Doo-Dah. Last week, for example, I was treated to a report on the so-called "Golden Cross" - the event where the 50-day moving average of the S&P 500 crosses above the 200-day moving average. Next to a carefully compiled set of dates were the purported returns of the S&P 500 over the following 1, 3, and 12 months. As one moves down the report, the analyst either figured that investors would no longer pay attention or forgot how to operate a calculator, so one-year gains of 100%, 200% and more were piled into the average (the figures were about 10 times the true returns).
While it's generally true that bull markets are largely spent above the 200-day moving average, it doesn't actually follow that taking 50-day / 200-day crossings as discrete buy and sell signals is unusually profitable, lacking other methods to get you out near the peaks or to avoid whipsaws. Suffice it to say that the true record of those "Golden Cross" signals is bronze at best, with actual 1, 3 and 12 month total returns in the S&P 500 (since 1940) coming in at 1%, 3% and 14% on average. Even those figures, however, benefit from three particular instances where the S&P 500 gained over 40% over the following year - those instances were 1942, 1953, and 1982 - each which began at multiples of just 7-8 times normalized earnings (not the current multiple of nearly double that). Excluding those three instances, the subsequent returns from the Golden Cross are no better than throwing dice.
In short, beware of analysts bearing indicators that all is suddenly well, and check their facts.
As of last week, the Market Climate for stocks remained characterized by modest overvaluation and mixed market action. Our best estimate remains that the S&P 500 is currently priced to deliver 10-year total returns in the area of about 7.8% annually. That's not a terrible expected return, particularly relative to the yields presently available on bonds, but my impression is that expected long-term returns here come with a great deal of shorter-term risk in the intervening months, quarters and even years. On a very short-term basis, the market may benefit from favorable end-of-month and pre-holiday seasonality this week, but we wouldn't speculate on that basis. Beyond that, I expect that over the course of the coming quarters, we will observe fresh economic difficulties, and eventually prices that fully reflect those difficulties and also assume their permanence.
If you think about the major peaks that we've seen in recent years, they were points where the permanence of unusual economic conditions was taken as a given. That's what gave us the 2000 technology peak. It's what gave us the 2007 peak. It's what gave us the oil price peak. It's what gave us the housing peak.
Importantly, that same feature - assumed permanence of unusual conditions - is what has historically given us the best generational buying opportunities, particularly in 1982. At extreme peaks, investors cannot imagine being out of stocks. At extreme lows, investors can't imagine what will ever make them or the economy perform well again. My impression is that the structure of the current economy, with debt burdens, employment difficulties, and fiscal imbalances, lends itself to the eventuality of that sort of thinking by investors.
Of course, we'll also be willing to accept some amount of market risk on the combination of improved valuations and better market internals. I've noted frequently that the price-volume internals of the recent advance has been much more consistent with a short-squeeze and normal retracement, than of a fresh high-sponsorship bull market. In any case, if the current advance is destined to progress into a bona-fide bull market, we'll observe it in stronger internals - sustained bull markets simply don't sustain without that occurring. So some combination of better valuations and/or improved market internals could prompt us to accept a moderate amount of market risk. Still, until we see investors broadly anticipating and discounting the second wave of mortgage resets, we most probably will not be inclined to take an unhedged exposure to market fluctuations. There are landmines between here and there.
In bonds, the Market Climate last week was characterized by relatively neutral yield levels and still generally unfavorable yield pressures. In the Strategic Total Return Fund, we currently carry an average duration of about 3 years, largely in TIPS, with under 20% of assets allocated to foreign currencies, precious metals shares, and utility shares.
New from Bill Hester: Secular Bear Markets and the Volatility of Inflation
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