So it looks like our concluding remark of the previous edition, anticipating the “utter.. rout (of) those who bet against the resiliency of the US economy”, is turning out to be more on target than we could have imagined. The Euro crisis seems to have been bundled into an appropriate haz-mat container, strapped to Doc Brown’s flux capacitor and transported to some indeterminate point in the future, and the economy has once again displayed its ability to shrug off manifold toxins and keep stumbling along. Investors of the bearish persuasion, who seemed totally in control in the opening moments of Q3, have indeed been utterly routed. Unless a really plausible competing narrative develops in the next few weeks (keep an eye on the Congressional spending cuts tax force), my sense is that all those managers who got under-invested over the course of Q2 will be chasing performance into the New Year. Once again, optimism has paid off splendidly.
It is that matter of optics (how we choose to look at things), that difference between optimism and pessimism, that is perplexing us today. We find ourselves torn between the two. Our economy is at once marvelously resilient and debilitated by a host of maladies, mostly parasitic in nature. It is “early” with respect to a Bull Market in the generational sense, but perhaps getting late in the game in a more tactical, cyclical sense (i.e., 2.5 years off the bottom). I would suggest that coping with this conundrum comes down to recognizing the inherent errors in these two perspectives. Of late, the error of the pessimist has been to underestimate the resiliency of our economy and the body politic. Optimists have prevailed because the error of this pessimism has been revealed in the decent sales and earnings of large swathes of corporate America and the ability of European leaders to dance the dance of forestalling the fitful entropy that has been their lot since time immemorial. But this takes nothing away from an equally troubling error on the part of the optimist, to underestimate the impediments to economic growth that will be dealt with, to the short term detriment of economic growth, over the next decade and beyond. So while it just now paid off to discount pessimistic notions, we disregard the optimist’s error at perhaps an even greater peril (especially if our objective is absolute as opposed to relative returns).
The optimist’s error disregards the inevitable undoing of what has been called the 1950 Moment, that point in time when U.S. stood astride the rest of the world with the only industrial base that had not been bombed halfway back to the Stone Age. This allowed us to have policies that built around a compact between Big Business and Big Labor, to grow government spending faster than the economy and borrow against the future in the expectation that our wealth would continue to grow inexorably. It worked splendidly for two decades and we could almost get away with it for another, but our relative stature as it stood at mid century was, indeed, only a moment. The 1970s precipitated a recognition of global competition that rendered that industrial policy obsolete, and the 1980s were all about the undoing of Big Labor and, in the private economy, the Bismarckian notion of defined benefit pensions. It took a couple of decades, but with a very few notable exceptions (i.e., Big Three automakers, and look how that turned out) it was a remarkably successful transformation. We continued to be a big, strong country, a generous people growing steadily richer, and could still afford many indulgences, especially on the public sector side of the economy. Or so it seemed, as with the passage of time the sense of entitlement and largesse, helped along not so much by incomes as by net worths rooted in home equity and 401(k) balances, outstripped the actual wealth generating capability of the economy.
We need to be very mindful that 2008 induced a discontinuity that like the c. 1974 realization that we had to re-tool and reorient in order to compete in a global economy will require at least a decade of painful, contentious adjustment. It is not as if we, as a people, have suddenly been impoverished. We are still in the aggregate a rich and resourceful people. It’s just that just that many millions of us are not as wealthy as 2006 made it seem, and millions more will be coming to that realization as the great post-Crash adjustment rolls on. The disconnect that has become too unsustainable to ignore is between the discipline of the private sector over the past two decades versus the obfuscation and lack of accountability of the public sector spending. In terms of how this plays out over the next decade or so, I am inclined to optimism. It’s the getting there a day at a time that will wear on us as investors. There will be the political theatrics, as defenders of the status quo decry the heartlessness of those who are just looking for a little accountability and perhaps a bit of cost/benefit analysis. The larger issue, though, will be that the necessary right-sizing or even dismantling of presently bloated public sector enterprises will be a persistent drag on GDP growth (both the G in C+I+G and some of the C as head counts are reduced and pensions evolve in the direction that the private sector started down thirty years ago).
It has been said that history doesn’t repeat itself but often rhymes. To the extent that 2008 rhymed with 1974, we would do well to recognize that while profit opportunities abounded, it wasn’t until 1982 that the Bull Market became recognizable, and even that was a fleeting event. Even the election in 1980 of the sort of president many of us are wishing and praying for today did not really work its way into equity valuations (at near record lows in 1982) until his stay in office was nearly over. This was in large part because the cure (Volcker’s medicine for inflation) was painful and protracted. The cure for the massive disconnect between how we manage the wealth generating part of our economy and how we manage the wealth redistributing part of the economy will be at least as painful and probably a lot more fractious. It will involve millions of households having to re-invent themselves economically. People seem to be figuring this out, as seen in the increased savings rate. It is going to take a couple of election cycles at least to come to terms with large and in some case spectacularly corrupt institutions before the economic drag (i.e., their stakeholders coming to terms with a diminished call on the collective wealth) runs its course. It will happen throughout government, at all levels, and nowhere will it be more apparent than in what we call Education. From the dubious benefits of Head Start to the $1T scandal that is student loans, and at all points in between, this money sucker has failed us. Its reform is absolutely necessary, in terms of both fiscal solvency and renewing our economic competitiveness in a world that will only get more so. Getting there will take most of the rest of our lives, and it will hurt.
Pessimists have just paid a heavy price for not allowing for their inherent optical bias. Optimists, which would seem to include the vast preponderance of successful investors, would do well to not disregard the consequences of even the most positive developments over the next several years. History might not repeat, but it tends to echo. 2008 was a moment a lot like 1974. If history is echoing the way I suspect it is, we have years to go before this generational Bull Market feels like a Bull Market for more than a few fleeting moments at a time (moments that will prove to be good times to raise cash in anticipation of the next time the pessimists slip the leash).
Friday, October 28, 2011
Friday, October 14, 2011
Why the Bull Market Just Resumed
What a difference a new page on the calendar seems to have made! The Market ended Q3 11 with a bad case of the dry heaves, and the persistence of that mal de mer through dozen or so trading hours of Q4 and was eerily familiar. So was the broad, relentless advance that has since followed. (It’s like “we’ve seen this movie before, but can’t remember when.") The VIX has turned back into a wasting asset, and maybe gold has, too. So what happened? Two things: it became apparent that Greece is not going be like Lehman Brothers, and it got way too obvious that the US economy, while far from vibrant, is a whole lot more resilient than we were giving it credit for.
Considering the damage done to the life savings of so many mid-and-upper income households since May, and the sheer ugliness of the political spectacle that kicked that wealth destruction into high gear in August, one would think that some kind of “wealth effect” would have registered in retail sales and other such economic indicators. Even those of us not wedded to a doom & gloom narrative figured that consumers were supposed to take stock of their straightened circumstances and dial their spending down. Instead, we were inundated with data from the likes of auto makers, Costco, Nordstrom and and plethora of other retailers that showed nothing of the sort. Far from rolling over and dying, the economy seems to be picking up a little steam. Not as much as it needs to, but definitely contra what you would think happens when portfolios take the hit that we just went through. Perhaps a reconsideration of the “wealth effect” (WE) is in order.
The WE recognizes that households will spend not just as a function of income but of perceived wealth. Households that accumulate financial assets, even in the form of retirement plans or home equity, come to regard those assets as a source of income, if only prospectively. Having enough “to get over the finish line” is important, if only subconsciously, to all be the most profligate or obtuse householders, and they will save (divert income from present consumption) or dis-save (run up credit card or home equity debt) accordingly. When assets have been been amassed, are rising in value and, importantly, households expect that increase to continue, households might rationally spend more than their current incomes. This was the hallmark of the Tech Bubble years, when “home equity as ATM” and “my 401k going up 20% forever” defined the spirit of the moment. The WE also mattered when the fallacy in the logic (inexorable double digit returns) melded with the evaporation of portfolio values. It mattered again in 2008, when the Bear Market of a lifetime took hold and the Housing Bubble was ruptured.. But this time, we get a -20% whack coupled with a heightened sense of futility in terms of being able to secure a decent return “for the duration”, and so far, hardly a ripple. What happened?
I think the most important conclusion is that the WE is a lot like opium, a real kick for a first time user, but subsequent doses have to be a lot higher. In the latter half of the Nineties, the economy really was goosed but all those folks who for the first time in their lives looked at the value of their nest eggs and the rate they seemed to be growing and assumed they could spend 100%+ of income and still be set for life. For many of them, based on the data at hand, that was a rational choice. Then when it swung the other way after Y2K, the error of overspending (i.e., borrowing against assets and future cash flows) had to be corrected, which meant discretionary spending got throttled back until at least some balance sheet repair could be effected.
What’s different about 2011 in terms of how the WE would register is that spending already got dialed way down (three years ago already) and really didn’t get dialed back up. The diversion of income from spending to balance sheet repair (i.e., paying down credit card balances) didn’t have to happen because not many of the households who do that have had the time or the means to bumble down that path again. The trading down at retail, the eating out less often, that hit with a bang when Panic and the recession took hold might have reversed a little, but only a little. We also haven’t see a lot of lay-offs, because most companies got themselves in pretty lean shape already. So this time, there really wasn’t a lot of potential energy (think of the way thunderstorms build up) for the WE to dissipate. What’s more, it is quite likely that whatever damping effect it was having in August and September was being more than offset by the “getting back to normal” within industries that took a cautious tack following the supply chain disruption that was the earthquake in Japan. The resolution of that uncertainty seems to have counted for more in terms of economic activity than the fact that investors were reminded, once again, of the inherent folly of presuming upon the future.
We have just been reminded that the economy is a very resilient beast. It is sick, seemingly weighed down by an inexorably growing mass of parasites, but it has an amazingly strong constitution. However far away it is from optimal health, it is further than we think from being at death’s door. This certainly does not mean we can take its continued viability for granted. Indeed, vitality will not become evident until there is at least a prospect of a change in regulatory regime and a diminution of uncertainty with respect to how the fruits of enterprise will be taxed. While the substantive changes that would restore our economic to vibrancy will happen over the course of years if not decades, I am quite optimistic that once the Market gets even a little conviction about this as a probable outcome, it will begin to anticipate it.
The other big change since 9/30 seems to be the emergence of a big boot to kick the can that is the Euro problem way down the road. This problem, that well-intentioned but flawed concept of a single currency among disparate, sovereign states, will not be going away, but it can go dormant for a while. And more to the point, its flaws now exposed, it can be rendered less of a threat than we have all imagined it to be. Here is where the comparison of Greece with Lehman kicks in. The demise of those banks three years ago was a shock almost no one saw coming. It mattered a lot that up until July 2007, only a very few sharpies had questioned the perspicacity of the AAA ratings that had become the implicit guarantor of so much highly leveraged regulatory capital. Or that practically no one had considered the unintended consequences of applying “mark to market” rules to assets that for all intents and purposes were not meant to be liquid (i.e., held to maturity). It was all such a surprise, fraught with potential outcomes that even the most experienced of us could only imagine. “Shock and awe” was real, not merely a metaphor.
So, a year before it happened, who knew that LEH would end up unable to meet its obligations? Conversely, who hasn’t known for years that Greece is a deadbeat nation? Insofar as it has been nearly eight years since it was revealed that Greece lied to get into the EU, it is hard to believe that there is a creditor out there who has not done all they can to mitigate an eventual default (or quasi default in the form of a “haircut”). 2008 was like a forest with a lot of dead wood lying about, having accumulated for years, and the idea of a lightening strike having only occurred to a few cranks (or talked to death for so long we quit thinking about it). The situation in Europe may also fairly evoke a lot of dead wood, but lightening has been in the air for years already, and a whole lot of scrambling has gone on to create firebreaks and otherwise push the combustible matter into neatly separated piles.
The wildfire metaphor (perhaps helped along by what we have been through here in Central Texas this year) is also apt to the question of “contagion” spreading to the US banking system. Like the “toxic” assets of three years ago, I think “contagion” is a bad metaphor, intended to arouse and confuse rather than enlighten. (A lot of money got made buying so-called toxic assets, which were only toxic if you bet your career on an erroneous assumptions about what they were really worth, as opposed to waiting for the fire-sale prices that at least some clever folks were able to get.) In considering just how vulnerable our financial system might be, we should bear in mind that it has been a very long time since the proverbial pendulum started its swing from wretched excess to the opposite extreme. To the extent that the suspect assets and dampened economy are housing related, it has been five years since the party that caused the hangover ended. I reckon that moment to Hurricane Katrina, as I had put a house on the market in Upstate New York (in a time and place where weekenders had been the enthused buyers at the margin) shortly before that national media event. The change in the tone of the real estate market, once that sobering distractor had passed, was palpable. The downturn was yet to become apparent, but the party was definitely over. This means we have had going on five years to not only de-leverage but to see an evolution in that asset category we call mortgage backed securities. Loans made during the boom have either defaulted or been paid down and/or refinanced at rates that are lower than any of us dared to imagine in 2008. Mortgage loans made since 2008 were subject to a degree of rigor that was not present for the four or so years prior to that.
In the mean time, the population continues to grow and evolve in its preferences about where it will live, and the housing stock continues to wear out. My sense is that while it could be decades, if ever, before, “home equity as generator of wealth” is what it seemed to be for H2 of the Twentieth Century, five years is probably enough to wash out a preponderance of the excess. Six or seven just might be enough for us to start to see a few recent, howling headwinds turn into modest tailwinds, economically speaking. The time that “housing bubble and its aftermath” can be seen as a vulnerability has largely passed. In the mean time, expect Earnings Release Season, Q3 11 to utterly rout those who bet against the resiliency of the US economy.
Considering the damage done to the life savings of so many mid-and-upper income households since May, and the sheer ugliness of the political spectacle that kicked that wealth destruction into high gear in August, one would think that some kind of “wealth effect” would have registered in retail sales and other such economic indicators. Even those of us not wedded to a doom & gloom narrative figured that consumers were supposed to take stock of their straightened circumstances and dial their spending down. Instead, we were inundated with data from the likes of auto makers, Costco, Nordstrom and and plethora of other retailers that showed nothing of the sort. Far from rolling over and dying, the economy seems to be picking up a little steam. Not as much as it needs to, but definitely contra what you would think happens when portfolios take the hit that we just went through. Perhaps a reconsideration of the “wealth effect” (WE) is in order.
The WE recognizes that households will spend not just as a function of income but of perceived wealth. Households that accumulate financial assets, even in the form of retirement plans or home equity, come to regard those assets as a source of income, if only prospectively. Having enough “to get over the finish line” is important, if only subconsciously, to all be the most profligate or obtuse householders, and they will save (divert income from present consumption) or dis-save (run up credit card or home equity debt) accordingly. When assets have been been amassed, are rising in value and, importantly, households expect that increase to continue, households might rationally spend more than their current incomes. This was the hallmark of the Tech Bubble years, when “home equity as ATM” and “my 401k going up 20% forever” defined the spirit of the moment. The WE also mattered when the fallacy in the logic (inexorable double digit returns) melded with the evaporation of portfolio values. It mattered again in 2008, when the Bear Market of a lifetime took hold and the Housing Bubble was ruptured.. But this time, we get a -20% whack coupled with a heightened sense of futility in terms of being able to secure a decent return “for the duration”, and so far, hardly a ripple. What happened?
I think the most important conclusion is that the WE is a lot like opium, a real kick for a first time user, but subsequent doses have to be a lot higher. In the latter half of the Nineties, the economy really was goosed but all those folks who for the first time in their lives looked at the value of their nest eggs and the rate they seemed to be growing and assumed they could spend 100%+ of income and still be set for life. For many of them, based on the data at hand, that was a rational choice. Then when it swung the other way after Y2K, the error of overspending (i.e., borrowing against assets and future cash flows) had to be corrected, which meant discretionary spending got throttled back until at least some balance sheet repair could be effected.
What’s different about 2011 in terms of how the WE would register is that spending already got dialed way down (three years ago already) and really didn’t get dialed back up. The diversion of income from spending to balance sheet repair (i.e., paying down credit card balances) didn’t have to happen because not many of the households who do that have had the time or the means to bumble down that path again. The trading down at retail, the eating out less often, that hit with a bang when Panic and the recession took hold might have reversed a little, but only a little. We also haven’t see a lot of lay-offs, because most companies got themselves in pretty lean shape already. So this time, there really wasn’t a lot of potential energy (think of the way thunderstorms build up) for the WE to dissipate. What’s more, it is quite likely that whatever damping effect it was having in August and September was being more than offset by the “getting back to normal” within industries that took a cautious tack following the supply chain disruption that was the earthquake in Japan. The resolution of that uncertainty seems to have counted for more in terms of economic activity than the fact that investors were reminded, once again, of the inherent folly of presuming upon the future.
We have just been reminded that the economy is a very resilient beast. It is sick, seemingly weighed down by an inexorably growing mass of parasites, but it has an amazingly strong constitution. However far away it is from optimal health, it is further than we think from being at death’s door. This certainly does not mean we can take its continued viability for granted. Indeed, vitality will not become evident until there is at least a prospect of a change in regulatory regime and a diminution of uncertainty with respect to how the fruits of enterprise will be taxed. While the substantive changes that would restore our economic to vibrancy will happen over the course of years if not decades, I am quite optimistic that once the Market gets even a little conviction about this as a probable outcome, it will begin to anticipate it.
The other big change since 9/30 seems to be the emergence of a big boot to kick the can that is the Euro problem way down the road. This problem, that well-intentioned but flawed concept of a single currency among disparate, sovereign states, will not be going away, but it can go dormant for a while. And more to the point, its flaws now exposed, it can be rendered less of a threat than we have all imagined it to be. Here is where the comparison of Greece with Lehman kicks in. The demise of those banks three years ago was a shock almost no one saw coming. It mattered a lot that up until July 2007, only a very few sharpies had questioned the perspicacity of the AAA ratings that had become the implicit guarantor of so much highly leveraged regulatory capital. Or that practically no one had considered the unintended consequences of applying “mark to market” rules to assets that for all intents and purposes were not meant to be liquid (i.e., held to maturity). It was all such a surprise, fraught with potential outcomes that even the most experienced of us could only imagine. “Shock and awe” was real, not merely a metaphor.
So, a year before it happened, who knew that LEH would end up unable to meet its obligations? Conversely, who hasn’t known for years that Greece is a deadbeat nation? Insofar as it has been nearly eight years since it was revealed that Greece lied to get into the EU, it is hard to believe that there is a creditor out there who has not done all they can to mitigate an eventual default (or quasi default in the form of a “haircut”). 2008 was like a forest with a lot of dead wood lying about, having accumulated for years, and the idea of a lightening strike having only occurred to a few cranks (or talked to death for so long we quit thinking about it). The situation in Europe may also fairly evoke a lot of dead wood, but lightening has been in the air for years already, and a whole lot of scrambling has gone on to create firebreaks and otherwise push the combustible matter into neatly separated piles.
The wildfire metaphor (perhaps helped along by what we have been through here in Central Texas this year) is also apt to the question of “contagion” spreading to the US banking system. Like the “toxic” assets of three years ago, I think “contagion” is a bad metaphor, intended to arouse and confuse rather than enlighten. (A lot of money got made buying so-called toxic assets, which were only toxic if you bet your career on an erroneous assumptions about what they were really worth, as opposed to waiting for the fire-sale prices that at least some clever folks were able to get.) In considering just how vulnerable our financial system might be, we should bear in mind that it has been a very long time since the proverbial pendulum started its swing from wretched excess to the opposite extreme. To the extent that the suspect assets and dampened economy are housing related, it has been five years since the party that caused the hangover ended. I reckon that moment to Hurricane Katrina, as I had put a house on the market in Upstate New York (in a time and place where weekenders had been the enthused buyers at the margin) shortly before that national media event. The change in the tone of the real estate market, once that sobering distractor had passed, was palpable. The downturn was yet to become apparent, but the party was definitely over. This means we have had going on five years to not only de-leverage but to see an evolution in that asset category we call mortgage backed securities. Loans made during the boom have either defaulted or been paid down and/or refinanced at rates that are lower than any of us dared to imagine in 2008. Mortgage loans made since 2008 were subject to a degree of rigor that was not present for the four or so years prior to that.
In the mean time, the population continues to grow and evolve in its preferences about where it will live, and the housing stock continues to wear out. My sense is that while it could be decades, if ever, before, “home equity as generator of wealth” is what it seemed to be for H2 of the Twentieth Century, five years is probably enough to wash out a preponderance of the excess. Six or seven just might be enough for us to start to see a few recent, howling headwinds turn into modest tailwinds, economically speaking. The time that “housing bubble and its aftermath” can be seen as a vulnerability has largely passed. In the mean time, expect Earnings Release Season, Q3 11 to utterly rout those who bet against the resiliency of the US economy.
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