This past week presented more signs that, at least with respect to common stocks, the great liquidation sale of 2008 is winding down. Knock on wood, but since December 2 (the day after that precipitous end to the prior week’s holiday-muddled rally), the volatility isn’t what it used to be. “18% either way in three or so days” so typical since mid September seems to be over, and really outsized moves by individual stocks (like 25%+ in a day) are quite predominately to the upside.
What was really striking about the week is the reaction to the unremitting stream of lousy news. The geniuses at the news wires and the chronically-insecure-about-their-future in the business sell-side analysts keep shoveling out the despair, but the Market is having none of it. Tech is up nicely in the face of all kinds of news about inventory glut and reduced guidance. Friday morning was especially instructive in this respect. We were greeted not only with the usual litany of lay-offs and the prospect of Chicagoland scandal sapping the effectiveness of the new Administration before it even gets started, but two hammer blows of uncertainty. Once again, but on an apparently unprecedented scale, a number of wealthy individuals learned in an up close and personal sort of way that if an investment advisor’s returns seem too good to be true, they are probably aren’t. And the futures market flinched mightily at the inability of the US Senate and the United Auto Workers to come to terms. These developments probably account for why the Market seemed to have a relapse on Thursday afternoon. But after a familiar gap down opening on Friday, it quickly found its feet again, and with Tech leading the way (despite a peculiar funk creeping into MSFT) moved nicely higher for the day.
One hopes that the number of families who entrusted all or even most of their savings to an apparent Ponzi schemer operating under the halo of Wall Street respectability is only a fraction of the apparent total. There is tragedy in this that is not to be made light of, widows and orphans suddenly rendered into poor widows and orphans. That said, this unfortunate episode does illustrate the limitations of applying the “wealth effect” to economic prognostication. I am big believer that perceived changes household wealth will affect consumer behavior above and beyond changes induced by changes in income. As with any principle, though, it is easy to stretch it beyond usefulness and unto distortion. Many, if not most households in the US are more affected by things like fuel prices than by the value of real estate or stocks. To the extent wealth destruction affects them, it is income related, the loss of employment as more affluent (though less affluent than they used to be!) households opt to take back tasks they used to outsource (lawn care, child care, food preparation, auto detailing, etc.) This is not to say that there are not tens of millions of households cutting back their expenditures because their declining home equity and/or 401 makes them feel poorer, but that there are tens of millions more for whom asset bubbles are a spectator sport probably not worthy of their attention. But what about that million or so households that make up the “upper crust”, the sort of folks who get invited into a deal like this Wall Street luminary apparently offered? If someone had $10MM and it all got lost in a “by invitation only” Ponzi scheme, their spending behavior would certainly change. But what if only half of their $10MM was in the scheme, would they really start living all that differently? Eating any less? Taking the bus? One supposes that there might be a few putative heirs reconsidering early retirement (or considering the possibility of a J-O-B in a whole different light) but as far as moving the needle on what shows up in the accounts of economic activity, it doesn’t seem likely that the instantaneous immolation of several $B in savings of this sort will be a system-rocking event. We hear a lot about wealth effects, and these effects are real, but to the extent that the changes in wealth are concentrated in relatively few (out of 100MM+) households, they are likely to be over estimated, both on the way up and when the “wealth” is finding its way back into the “thin air” from whence it came.
The stand-off over life support for the US auto industry brought to mind that this “day of reckoning” has been a very long time coming. Much of what is going on here is so wrapped up in posturing and politics that it is not worth commenting on. I remember some 35 years ago, when cars and the inconvenient reality of having to go to work were very much on my mind. OPEC was just starting to reorder a few economic assumptions, and the Japanese were showing up with little Hondas, Toyotas and Datsuns that ran like tanks and didn’t need much gas. They were leveraging their success with reasonably priced “rice rocket” motorcycles (ad jingle c. 1968 “..and the world’s biggest seller is priced about two-fifteen. And don’t you know, you meet the nicest people on a Honda!”) There weren’t a whole lot of jobs around, but some of the best paying and least demanding jobs were in unionized industries. Trouble was, you had to know someone in the union. Everyone who gave it a minute’s thought understood that the US automakers had inherited a strong position, but were saddled with higher cost labor and structural inefficiencies imposed by union work rules. As the Seventies wore on, there was much anxiety about whether Detroit could compete with the Japanese. So point #1, this crisis that dominated the week’s headlines did not exactly sneak up on us. Even a callow youth could see way back then that if there was anything at all to the notion of a more global economy, it was only a matter of time before the Detroit model would take its place in the proverbial ashcan of history.
That said, it’s not like Detroit and the UAW sat and did nothing and hoped things would get better. The industry certainly came up with a number of compelling products along the way, and the quality gap (as one recollects, say, Ford Pinto versus Toyota Corolla) has been relegated to the realm of the subjective, if it exists at all. Whatever blame might be heaped on senior management has to reckon with the fact that two of the Big Three have CEOs who only very recently came to the auto industry. (I got to know Alan Mulally when he was at Boeing, and if anyone can fix Ford, it’s him.) I think what has happened is that a long time ago union leadership defined its mission as being a “prudent parasite”, extracting as much nourishment from the host as it can without actually killing it, exercising just enough restraint and cooperation so that, hopefully, it lives until “after we’re gone”. Up until very recently, they were doing a good job at this. Those fellows who graduated high school (sans academic effort, as “the job” was waiting for them) and started at Ford or GM at about the time I was trying to decide on a major and Honda Civics were starting to roll off of ships are probably retired by now (if their lifestyle choices haven’t put them in the grave). If it was all just a delaying action, give them high marks.
As I look at the global auto industry, there is no reason there could not be a couple of successful US based companies producing lots of vehicles close to their markets, which would include right here in the US. I believe the problem can be boiled down to unwillingness on the part of union and political leaders to recognize the “understanding” between capital and labor has one foot rooted in a bygone era. That era was Pax Americana. Like much of American industry, the auto industry of sixty years ago found itself astride a world still smoldering from world war. The US industrial heartland was about the only place on earth that had not been bombed halfway to the Stone Age (or never got more than about halfway out of the Stone Age). Given the rising economic tide and dearth of competition, it was not irrational for management to share the fruits of prosperity with all of the stakeholders. Trouble is, as the decades slip by, things change. This was apparent only thirty years along, when Japanese imports meant little cars made far away. It started getting obvious when Chrysler had its near death experience. In the mean time, other industries either disappeared from the US or evolved away from what only made sense before Pax Americana gave way to globalization. And one of the most salient aspects of this evolution was around post retirement benefits, especially medical. Not every industry, and certainly not the municipalities and such that have the rate payers by the collective short hairs, but by and large, survival has dictated that very deliberate steps be taken to limit or eliminate this seemingly bottomless source of liability.
I am a bit concerned that what is really going on with the high drama of “saving Detroit” is that you could fix the whole thing, for another business cycle or two anyway, if you could make the retiree health care liability “go away”. Actually, I suspect that if you could rationalize some work rules, ditto the dealer networks and “contain” the retiree obligations, and not muck it up with overly ambitious mandates a la solar powered cars, you could probably end up with a couple of reasonably profitable entities. These are big, no, make that humongous, “ifs”. The mischief afoot is that this dire situation de jour is “Exhibit A” as to “why health care needs to start being handed over to the government”. We can argue it to death, like we have with human caused global warming, but if we take action in the form of a government program that would make “break the log jam” and allow the auto industry to recover, then our stocks will start to go up again and everything will be alright. Like the man said, “Never let a crisis go to waste”. How this plays out over the next couple of months will have much to say about the ever evolving relationship between the government and the governed.
Saturday, December 13, 2008
Saturday, December 6, 2008
What Time is It, Really?
These past few weeks have found us looking way back at Market history, and savoring the imminent undoing of what has become yet another “only game in town.” Disparate times seem to lead us to take disparate measures. The extent to which the past couple of months have seemingly undone what a couple of decades might have taught us about gauging Market sentiment, we find ourselves feeling as if we have been looking for something really important through the wrong end of the telescope. This causes many of us to start reading more widely than usual, or at least tuning in differently. In my case, the idea of being in “a cyclical market within a secular market trend” struck a chord. In the past, I have from time to time found the study of longer cycles to be an interesting diversion, but insights thus gained have tended to slip way into the background, if not all the way out the back door. There is something there, be it the “seven fat years, seven lean years” alluded to in the Bible, or sixty year Kondratieff wave theory or any number of not totally implausible ideas about the Tao notion that “every extreme condition contains the seeds of its opposite”. Most likely, it is about immutable human propensities to forget past lessons and the pains they inflicted. Every generation must learn anew, and all but fatal wounds turn into scars, which fade with time. The events since September, an interlude wherein palpable fear of the unknown supplanted mere anxiety about the health of the economy as the mental state of that all important investor at the margin, has caused many of us to revisit our understanding of “what time it might be” in terms of Market cycles that tend to be “too big to see”.
Over the course of the Twentieth Century, the Market (as measured by the DJIA) went through three cycles we can call “secular”, or The Market Cycle That Matters. Each of these cycles was characterized by a long and fairly steady rise that ran something on the order of 16-17 years and culminated in a manic phase, a long term Bull Market. This was followed by a very unpleasant undoing of the wretched excesses (in terms of both capital allocation and investor expectations) that accumulated during that rise, a Bear Market. What is less evident to the casual observer is that rather than making an obvious and quick transition from Bear to Bull and then back, there tends to be an era of “going nowhere in a hurry”, lots of fluctuation but little to change over several years. (Eight or so years of carnage followed by eight or so years of apprehensive psychological recovery) The 1930s was really three distinct Bear Markets, the first of which only lasted about 70 days. Likewise, the Bull Market that can be dated from 1949 essentially peaked in early 1966 and then experienced three bear Markets, the most memorable being 1973-74 within an eight year span. The years that followed are remembered as “going nowhere”, but in fact the Market rose dramatically from late 1974 until well into 1976, then experienced another decline before settling into a funk that would not be relieved until August 1982.
If one looks at the past Markets closely, there is a clear tendency after a severe downturn for it to make a very strong recovery and then settle back and be somewhat range bound for several years. It did so from 1938 (when the New Deal quit “working” and the economy relapsed) until 1949, with the range being 100 to 150 until 1945, as the outcome of the war was becoming obvious). At this point the range shifted to 175 to 225. (It was the interjection of a World War, that dreadful "consumer of consumers", that stretched out the aforementioned “eight or so years of… healing” to about eleven.) It broke out of this range in the midst of a recession and never looked back, experiencing its most meaningful downturn shortly after the son of a purported bootlegger became President. The Market would again be range bound after 1966, but this time the range was 650 and 1050 and would encompass several serious bear markets. It would be 1982 before the Market rose decisively above 1000. What followed was an extended rise not unlike the ones that ended in 1929 and 1966, and ending in early 2000. What strikes me now, as we approach nine years since the Tech Boom fizzled out, is that considering how long it took for the Market to “find its feet” after the prior secular Market peaks, it was unrealistic for us to expect the excesses that accrued over 17 or so years would be wrung out by a single Bear market that ran for two or so years. As the past fifteen months have made abundantly obvious, that downturn was no more efficacious in resetting the cycle for another Bull Market than were the Crash in 1929 (the 70 day sell-off that was followed by a brisk recovery and then the Mother of all Bears that lasted into 1933) or the two Bear Markets in 1966 and then from late 1968 to 1971.
My conclusion is that investors will do well to look to the latter half of the 1970s for a clue as to what the next few years are likely to look like. As in 1974, we are now about eight years into the Bear Market That Matters. In the previous BMTM, the first eight or years (1966-74) were characterized by the worst declines since the 1930s, punctuated with brief but spirited recoveries. The next eight (1975-82) differed insofar as the price movement became somewhat more muted and with less of a downward skew. There was money to be made, but it wasn’t easy. If “buy & hold” worked (and it certainly did in many instances) it probably had to be “buy & hold & forget about it for awhile”. As in that era, there will be great opportunities in the months and years just ahead, but only for the strong-of-stomach. Having spent the last eight years living through two Bear Markets of epic proportion (especially if one considers the carnage in the NASDAQ (2000-02), which arguably evolved into a more representative index than the thirty stocks that make up the DJIA), we can probably get to a decent answer to the “What time is it with respect to the market cycle that matters?” question. It sure looks to me a lot like early 1938 (in a weak and slowing economy, with three big sell-offs in the past eight years and world war looming) or 1974, in the wake of three sell-offs in the past eight years, in the midst of a struggling economy, with Jimmy Carter, the Ayatollah and disco looming in the future. I expect that in the very near term, we will see a rally in stocks not unlike that which characterized the 16 or so months that followed December 1974, which will be fueled by yet another undoing of yet another “only game in town”.
The only game in town? Repeatedly over the course of my investing career, from real estate and energy stocks at the end of the 1970s to, oh my, real estate in 2005 and energy stocks in 2007, some asset category or industry emerges at a time when nothing else seems to be working. Tech stocks enjoyed similar status at the end of the millennium, when stocks of what I was then referring to as the Real Economy were stagnating toward 1982-like valuations. For a season, but only for a season, something becomes what seems like “the only game in town”. Invariably, it ends ugly, like a party that started out nice but then there were far more guests than were actually invited and soon the actual invitees are long gone and the thing finally sputters to an end with much pain, indigestion, ruined reputations and strained relationships.
So what is TOGIT as 2008 draws toward a close? Seldom has the phrase “no place to hide” been more apropos than in the last ninety days. TOGIT has either been US Treasuries or being a short seller. In both cases, the well-remarked progression from innovators to imitators to idiots is very well advanced, but for the moment, the quiet exit of what remains of the innovators is being masked by frenzied inflows from the latter category. At some point, it will become evident that the game is over. In the case of the UST, one of the broadest and most liquid of securities markets, the rush for the exits will be interesting but not likely to resemble Wal-Mart on the morning of Black Friday. Such is not the case for many heavily shorted stocks in the equity market. There is a lot of money sitting on the sidelines (e.g., the big hedge funds that got very liquid over a year ago and so are not the ones making the financial obituaries we are treated to almost every day) These guys are always looking for the next game, and when it comes to games traders play, squeezing the shorts is an old standby that comes back into vogue as soon as it gets obvious that the prevailing bias is no longer turf-ward.
There really is smart money out there (smart enough it cash out and sit and wait, that is) and one of the things that defines smart money is the ability to recognize when seekers of “easy money” have overdone it and then find a way to take advantage of it. We have already seen a few instances of stocks (HIG & TLB come to mind) that doubled almost instantly in response to some development that, charitably speaking, did little more than make them “not such great short ideas after all”. The same smart traders who make a business out of knowing who is being forced to sell and then aggravating the situation with some sales of their own also make it their business to know what stocks have high short ratios (number of trading days worth of volume needed to cover the short interest). This game got a lot easier when they took away the 'uptick rule in back on more or less the same day the fun started in July 2007. No sane observer believes that short selling “caused” the mess we are in, and there can certainly be honest differences of opinion about the degree to which false rumors passed along by short sellers might have been the difference between life and death for the likes of Lehman Brothers, Merrill and Bear Stearns, as well as how such actions should be punished, if at all. However, only a nut cake free market ideologue or an “operator” with a guilty conscience (or more likely, an urge to cling to some pretense of respectability) would deny that short selling does exacerbate volatility during the season when fear crowds out rationality. (It was not puritanical spite that, at the suggestion of the aforementioned rum-runner, who apparently was a bit of a market “operator” as well, imposed the “uptick” rule in the first place. Its removal was encouraged by academics who, based on data from an era of record low volatility, assured us was a meaningless hindrance to free and efficient markets.) Up to a point, the short interest performs an important and healthy function, but like seemingly everything else about the Market, it can and does find a way to get overdone. This is especially true when it starts to seem as if it were the only game in town and the "easy money" crowd piles in. These things end predictably, so predictably that a 50%+ rise in the Market over the next year or so, with very little if any improvement in the economic or earnings outlook, would not surprise this grizzled old observer of human fatuity one bit.
Over the course of the Twentieth Century, the Market (as measured by the DJIA) went through three cycles we can call “secular”, or The Market Cycle That Matters. Each of these cycles was characterized by a long and fairly steady rise that ran something on the order of 16-17 years and culminated in a manic phase, a long term Bull Market. This was followed by a very unpleasant undoing of the wretched excesses (in terms of both capital allocation and investor expectations) that accumulated during that rise, a Bear Market. What is less evident to the casual observer is that rather than making an obvious and quick transition from Bear to Bull and then back, there tends to be an era of “going nowhere in a hurry”, lots of fluctuation but little to change over several years. (Eight or so years of carnage followed by eight or so years of apprehensive psychological recovery) The 1930s was really three distinct Bear Markets, the first of which only lasted about 70 days. Likewise, the Bull Market that can be dated from 1949 essentially peaked in early 1966 and then experienced three bear Markets, the most memorable being 1973-74 within an eight year span. The years that followed are remembered as “going nowhere”, but in fact the Market rose dramatically from late 1974 until well into 1976, then experienced another decline before settling into a funk that would not be relieved until August 1982.
If one looks at the past Markets closely, there is a clear tendency after a severe downturn for it to make a very strong recovery and then settle back and be somewhat range bound for several years. It did so from 1938 (when the New Deal quit “working” and the economy relapsed) until 1949, with the range being 100 to 150 until 1945, as the outcome of the war was becoming obvious). At this point the range shifted to 175 to 225. (It was the interjection of a World War, that dreadful "consumer of consumers", that stretched out the aforementioned “eight or so years of… healing” to about eleven.) It broke out of this range in the midst of a recession and never looked back, experiencing its most meaningful downturn shortly after the son of a purported bootlegger became President. The Market would again be range bound after 1966, but this time the range was 650 and 1050 and would encompass several serious bear markets. It would be 1982 before the Market rose decisively above 1000. What followed was an extended rise not unlike the ones that ended in 1929 and 1966, and ending in early 2000. What strikes me now, as we approach nine years since the Tech Boom fizzled out, is that considering how long it took for the Market to “find its feet” after the prior secular Market peaks, it was unrealistic for us to expect the excesses that accrued over 17 or so years would be wrung out by a single Bear market that ran for two or so years. As the past fifteen months have made abundantly obvious, that downturn was no more efficacious in resetting the cycle for another Bull Market than were the Crash in 1929 (the 70 day sell-off that was followed by a brisk recovery and then the Mother of all Bears that lasted into 1933) or the two Bear Markets in 1966 and then from late 1968 to 1971.
My conclusion is that investors will do well to look to the latter half of the 1970s for a clue as to what the next few years are likely to look like. As in 1974, we are now about eight years into the Bear Market That Matters. In the previous BMTM, the first eight or years (1966-74) were characterized by the worst declines since the 1930s, punctuated with brief but spirited recoveries. The next eight (1975-82) differed insofar as the price movement became somewhat more muted and with less of a downward skew. There was money to be made, but it wasn’t easy. If “buy & hold” worked (and it certainly did in many instances) it probably had to be “buy & hold & forget about it for awhile”. As in that era, there will be great opportunities in the months and years just ahead, but only for the strong-of-stomach. Having spent the last eight years living through two Bear Markets of epic proportion (especially if one considers the carnage in the NASDAQ (2000-02), which arguably evolved into a more representative index than the thirty stocks that make up the DJIA), we can probably get to a decent answer to the “What time is it with respect to the market cycle that matters?” question. It sure looks to me a lot like early 1938 (in a weak and slowing economy, with three big sell-offs in the past eight years and world war looming) or 1974, in the wake of three sell-offs in the past eight years, in the midst of a struggling economy, with Jimmy Carter, the Ayatollah and disco looming in the future. I expect that in the very near term, we will see a rally in stocks not unlike that which characterized the 16 or so months that followed December 1974, which will be fueled by yet another undoing of yet another “only game in town”.
The only game in town? Repeatedly over the course of my investing career, from real estate and energy stocks at the end of the 1970s to, oh my, real estate in 2005 and energy stocks in 2007, some asset category or industry emerges at a time when nothing else seems to be working. Tech stocks enjoyed similar status at the end of the millennium, when stocks of what I was then referring to as the Real Economy were stagnating toward 1982-like valuations. For a season, but only for a season, something becomes what seems like “the only game in town”. Invariably, it ends ugly, like a party that started out nice but then there were far more guests than were actually invited and soon the actual invitees are long gone and the thing finally sputters to an end with much pain, indigestion, ruined reputations and strained relationships.
So what is TOGIT as 2008 draws toward a close? Seldom has the phrase “no place to hide” been more apropos than in the last ninety days. TOGIT has either been US Treasuries or being a short seller. In both cases, the well-remarked progression from innovators to imitators to idiots is very well advanced, but for the moment, the quiet exit of what remains of the innovators is being masked by frenzied inflows from the latter category. At some point, it will become evident that the game is over. In the case of the UST, one of the broadest and most liquid of securities markets, the rush for the exits will be interesting but not likely to resemble Wal-Mart on the morning of Black Friday. Such is not the case for many heavily shorted stocks in the equity market. There is a lot of money sitting on the sidelines (e.g., the big hedge funds that got very liquid over a year ago and so are not the ones making the financial obituaries we are treated to almost every day) These guys are always looking for the next game, and when it comes to games traders play, squeezing the shorts is an old standby that comes back into vogue as soon as it gets obvious that the prevailing bias is no longer turf-ward.
There really is smart money out there (smart enough it cash out and sit and wait, that is) and one of the things that defines smart money is the ability to recognize when seekers of “easy money” have overdone it and then find a way to take advantage of it. We have already seen a few instances of stocks (HIG & TLB come to mind) that doubled almost instantly in response to some development that, charitably speaking, did little more than make them “not such great short ideas after all”. The same smart traders who make a business out of knowing who is being forced to sell and then aggravating the situation with some sales of their own also make it their business to know what stocks have high short ratios (number of trading days worth of volume needed to cover the short interest). This game got a lot easier when they took away the 'uptick rule in back on more or less the same day the fun started in July 2007. No sane observer believes that short selling “caused” the mess we are in, and there can certainly be honest differences of opinion about the degree to which false rumors passed along by short sellers might have been the difference between life and death for the likes of Lehman Brothers, Merrill and Bear Stearns, as well as how such actions should be punished, if at all. However, only a nut cake free market ideologue or an “operator” with a guilty conscience (or more likely, an urge to cling to some pretense of respectability) would deny that short selling does exacerbate volatility during the season when fear crowds out rationality. (It was not puritanical spite that, at the suggestion of the aforementioned rum-runner, who apparently was a bit of a market “operator” as well, imposed the “uptick” rule in the first place. Its removal was encouraged by academics who, based on data from an era of record low volatility, assured us was a meaningless hindrance to free and efficient markets.) Up to a point, the short interest performs an important and healthy function, but like seemingly everything else about the Market, it can and does find a way to get overdone. This is especially true when it starts to seem as if it were the only game in town and the "easy money" crowd piles in. These things end predictably, so predictably that a 50%+ rise in the Market over the next year or so, with very little if any improvement in the economic or earnings outlook, would not surprise this grizzled old observer of human fatuity one bit.
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