January 23, 2012
Dodging a Bullet, from a Machine Gun
Leading economic evidence continues to teeter at levels that have always and only been breached in recessions, but the sharp deterioration we initially observed late last year has been followed by modest stabilization - though still near the area that has historically marked the entry to economic contraction. The uncertain outcome and the incomplete view evoke a line from Leon Russell - "I'm up on a tightwire, one side's ice and one is fire... but the top hat on my head is all you see."
We can respond to the easing of downward momentum in several ways. We could pound the table about recession risk, based on the fact that previous breakdowns of the same magnitude in leading indicators have always resulted in recessions. Alternatively, we could emphasize the more favorable recent data and abandon our concern about recession, particularly because of the significant decline in new unemployment claims (though there is a great deal of seasonal impact here, and new claims also tend to be lagging indicators by about 3-6 months - see Leading Indicators and the Risk of a Blindside Recession ). The problem with both of these responses is that, in our view, each would overstate the case, and grasp at interpretations that are not supported by the data.
The interpretation best supported by the data is that recession risk remains very high based on the leading evidence and the typical outcomes that have resulted, but that the rate of deterioration has eased significantly, and it is simply unclear whether this is a temporary pause or a reversal. Rather than overstating the case one way or another, we remain strongly concerned about recession risk, but recognize the recent stabilization and the potential for a low-level continuation of that. On the indicator front, the economic data over the coming week could be informative (especially the introduction of the Conference Board's revised LEI, the Chicago Fed National Activity Index, and unemployment claims), but if the new data also muddles around near the flat-line, it will essentially reinforce the overall view that the global economy is close to slipping into recession, but is at least temporarily stabilizing.
Importantly, the recession risk we're observing is evidenced in a wide variety of indicators, various sets which we've reviewed in a number of recent weekly comments (see Dwelling In Uncertainty ). For example, the chart below shows three widely-followed leading indicators: the OECD (Organization for Economic Cooperation and Development) Leading Economic Indicator for the total world, the OECD LEI for the U.S., and the ECRI (Economic Cycle Research Institute) Weekly Leading Index growth rate. All are presented in standardized form - zero mean, unit variance. The blue shaded areas are actual U.S. recessions. The yellow brackets depict what we call a "discriminator" - a variable that strongly discriminates between two groups of data, in this case recessions versus expansions. This particular variable shows the points in history when all three of those leading indices were below -0.5 (based on standardized values), and the average of the three was less than -1.0. Recessions have always produced this condition, and this condition has only been associated with recessions. Notably, this discriminator is active at present.
Despite the record of this and other indicators, we have to suspend the inclination to view recession as a certainty. It's still possible that this instance is different, and that the modest stabilization we've seen in recent economic data will be sustained enough to avoid a recessionary outcome. But in my view, the downside risk is high, and it entirely strains the evidence to say that we can discard recession concerns on the basis of the more comfortable data points we've seen in recent weeks.
Getting in is easier than getting out
My impression is that the recent stabilization is owed to a large extent to various central bank actions, primarily by the European Central Bank (ECB), that eased immediate liquidity pressures from the banking system late last year. Though many observers seem to be under the impression that the ECB has not yet "stepped in," this is really only true in the sense that the ECB has limited its direct purchases of distressed European debt. More broadly, the ECB now has a larger balance sheet - relative to European GDP - than the Federal Reserve has relative to US GDP.
We aren't convinced that the ECB or the Federal Reserve can get themselves back out. It's easy to initiate a "liquidity operation" by creating new reserves and taking securities - be they government bonds or mortgage obligations - as collateral. These actions seem to have no cost or consequence, because people are eager to hold some sort of asset that doesn't default, so monetary velocity simply falls in exact proportion to the increase in the money supply. And as long as people believe that the central banks can reverse their operations - so that the money being created is not a permanent addition to the money stock - there is no observable impact on inflation.
[Geek's Note: The value of one unit of a currency is the marginal utility of the expected long-term stream of "monetary services" provided by that currency unit - as a means of payment and store of value - divided by the marginal utility of goods and services. A dilution of the value of one currency unit is commonly observed as inflation. People are willing to exchange real goods and services for currency not just because they believe the next person will value the currency, but because the next person believes that the next-next person will value it, and so on. Even a large increase in the stock of money may not be inflationary provided it is expected to be purely temporary, because as with any discounted stream of future amounts, the total value is largely carried in the long-term "tail" of that stream, not in the first few years].
It is shortsighted to view the actions of the Fed and the ECB as costless, because the difficult question comes later - whether they will be able to reverse their actions and shrink their balance sheets without major economic disruption. This will require the financial assets they presently hold (sovereign debt and mortgage securities) to be willingly absorbed back by the private sector. From my perspective, central banks are playing a dangerous economic experiment, that has its main constituency - the banking sector - as the primary beneficiary. Of course, if the Fed and the ECB are unable to reverse these transactions, or if any of the assets they hold lose value for any reason (sovereign default, counterparty failure, etc.) they will ultimately have printed enormous volumes of currency, not for public benefit, but to reduce the losses experienced by the bondholders of financial institutions.
In any event, the upshot is that we have to remain comfortable with uncertainty here, recognizing that the very recent data has been fairly stable, but also that leading indicators and very identifiable economic headwinds are still very challenging. The risks remain asymmetric, in the sense that the potential downside in the event of a downturn overwhelms the potential gains in the event of further stabilization. This is not a fringe view anywhere but on Wall Street. Indeed, the World Bank's just-released (January 2012) report on Global Economic Prospects warns that "developing countries need to prepare for the worst", observing:
"Capital flows to developing countries have declined by almost half as compared with last year, Europe appears to have entered recession, and growth in several major developing countries has slowed... The downturn in Europe and weaker growth in developing countries raises the risk that the two developments reinforce one another, resulting in an even weaker outcome. While contained for the moment, the risk of a much broader freezing up of capital markets and a global crisis similar in magnitude to the Lehman crisis remains. In particular, the willingness of markets to finance the deficits and maturing debt of high-income countries cannot be assured. Should more countries find themselves denied such financing, a much wider financial crisis that could engulf private banks and other financial institutions on both sides of the Atlantic cannot be ruled out. The world could be thrown into a recession as large or even larger than that of 2008/09."
"Importantly, because this second crisis will come on the heels of the earlier crisis, for any given level of slowdown its impact at the firm and household level is likely to be heavier. In the event of a major crisis, activity is unlikely to bounce back as quickly as it did in 2008/09, in part because high-income countries will not have the fiscal resources to launch as strong a countercyclical policy response as in 2008/09 or to offer the same level of support to troubled financial institutions... In the immediate term, governments should engage in contingency planning to identify spending priorities, seeking to preserve momentum in pro-development infrastructure programs and shore up safety net programs. Policymakers should also take steps to identify and address vulnerabilities in domestic banking sectors through stress-testing. Risks here include the possibility that an acute deleveraging in high-income countries spills over into domestic markets either as a cutting off of wholesale funding or asset sales. In addition, in the context of a major global recession the balance sheets of local banks could come under pressure as firms' and households' capacity to service existing debt levels deteriorate."
So despite the stabilization of immediate liquidity strains, we can readily observe that the main sources of economic headwinds (excessive sovereign and household debt loads, global fiscal austerity, weakly capitalized banking systems) have not been addressed in any durable, meaningful way. Even if the economy has dodged a bullet, the bullet is probably from a machine gun.
From an investment standpoint, it is similarly evident that investors have adopted a renewed willingness to speculate in recent weeks. I use the word "speculate" because on a valuation basis, we estimate prospective 10-year total nominal returns for the S&P 500 of just 4.7% annually (probably much less after inflation, as we expect increasing price pressures in the back half of this decade).
This 4.7% 10-year annual total return estimate would be less of a concern if our valuation methodology was less accurate historically. The exception to this record of accuracy was the much stronger-than-expected market performance in the decade from 1990 to 2000, associated with the late-1990's bubble, but even this was essentially an exception that proves the rule, as total returns since the late-1990's have been predictably dismal, as has the most recent 10-year total return from January 2002 to the present. I am not convinced that the dynamics of the U.S. economy have improved so dramatically since 2002 that our approach to market valuation - accurate both historically and as recently as the past decade - has suddenly lost its relevance.
[For an overview of our valuation approach, see Valuing the S&P 500 Using Forward Operating Earnings , The S&P 500 as a Stream of Payments , or numerous prior comments. For more on Wall Street's misuse of forward operating earnings, which is as rampant and naive as it is ineffective, see Long Term Evidence on the Fed Model and Forward Operating PE Ratios ].
Notably, our projections for 10-year S&P 500 annual total returns advanced above 10% at the 2009 market low. Anyone new to these weekly comments can fairly ask why we missed that opportunity by remaining defensive. It's worth repeating that our avoidance of risk in 2009 and early 2010 was driven by my insistence to "first do no harm" by stress-testing our hedging approach in Depression-era data and other periods of extreme credit strains. The problem in Depression-era data is that even once 10-year prospective returns reached 10%, the market actually declined by two-thirds from there. While our existing "post-war" models performed well overall in that data, with far less drawdown than a buy-and-hold approach, they still would have experienced much deeper drawdowns than I was willing to allow shareholders to risk. Once we were forced to contemplate the possibility of Depression-era outcomes, I insisted that our methods should withstand that level of stress.
Having adapted our hedging approach to a much broader set of data, we are less concerned about the potential for extreme economic outcomes that are "out of sample." At the same time, a material improvement in valuations should give us much broader ability to invest without defensive hedges in place.
We've recently seen some analysts crooning that present valuations are at the best levels we've seen in 15 years, which only demonstrates that a) they are using such noisy valuation models that they can't even distinguish between today's poor valuations and the better ones available at the 2009 trough, and b) they don't realize "the best in 15 years" is not even a compliment, as the S&P 500 has turned in total annual returns of just 5.3% over the past 15 years (3.7% over the past 14, 2.3% over the past 13, and 1.2% over the past 12). Stocks would have achieved even less were they not also overvalued today.
While the past decade-plus has made long-term investing seem virtually pointless, I remain convinced that this unusual period of rich valuations and predictably poor returns will come to an end within a small number of years, and that prospective returns will become available that adequately compensate investors for the market risk they are asked to accept (which has been the case for the vast bulk of market history). We are not there now, but even if valuations don't "wash out" durably, I expect that moderate-risk opportunities will become available in the interim, without requiring us to speculate in overbought, overbullish markets at rich valuations.
Over a shorter horizon, of course, we're familiar enough with the speculative inclinations of investors, and the pump-pump-pump rhetoric of Wall Street, that we have to allow for a continuation of speculative pressures, regardless of how many tears they will likely produce in the end. While we remain strongly defensive here, we may have some latitude to slightly soften our hedges over a period of weeks, provided that market internals remain firm and leading economic evidence is consistent with at least a stabilization of economic pressures. Given that our long-term outlook for returns remains poor, any softening of our hedges would mainly serve to reduce the negative impact that lopsided "risk on" speculation has tended to have on our portfolios from time to time.
Given the larger structural issues facing the economy, and with an overvalued, overbought, overbullish profile of market conditions in place, there's very little latitude for investment positions that could be considered "bullish." But our approach is to respond in proportion to the return/risk profile implied by the evidence at every point in time. While the potential negatives remain daunting, we can't ignore that more recent economic data has stabilized at least temporarily, or that investors appear to be adopting a speculative attitude toward risk-taking - reasonable or not. Still, there's a difference between getting out of the way of a bandwagon and jumping on board. If the present stabilization in the data continues, we expect to soften our hedges enough to avoid being run over on "risk-on" days, but not so much that we would tie our fate with speculators if, as remains too great a possibility, the road to Sunny Acres suddenly takes a turn into the canyon.
As of last week, the Market Climate for stocks remained characterized by an overvalued, overbought, overbullish syndrome. At the same time, we've seen at least temporary stabilization in economic data, and evidence of speculative pressure in stocks.
We know from historical experience that overvalued, overbought, overbullish syndromes have a tendency to produce an extended period of small incremental advances and marginal new highs, often followed abruptly by "air pockets" where the market can give up weeks or months of gains in a handful of sessions. As noted above, we don't have latitude here for bullish positions, but provided more benign data, we expect to modestly soften our hedges in order to reduce our vulnerability during periodic (if short-lived) waves of "risk-on" speculation.Strategic Growth and Strategic International remain defensive here. Strategic Total Return continues to carry a duration of about 3 years in Treasury securities, with about 12% of assets in precious metals shares, where the Market Climate remains positive on our measures, but where potential volatility remains high enough to discourage significantly a larger exposure to that sector at present.
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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