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.