They’re Back…..Bubbles

April 24, 2010

Like the Energizer bunny, the march upward is moving into nosebleed territory–the S&P500 rose 2.1% last week.  The VIX (or fear) index, although lower, did not fall a great deal. 

There was very little economic data released last week.  The leading indicators rose, but primarily because the equity markets have risen.  Producer prices jumped more than expected, but the core PPI did not; it matched the low consensus figure.  Initial jobless claims remained elevated, at 456,000.  Durable goods orders fell, when they were expected to rise.  Existing and new home sales both jumped more than expected, but both rose–once again–because of the government’s terribly misguided home buyer credit.  This credit will expire (finally) next week, and the artificial boost to home sales will erode over the next two months.  More ominously, existing home inventories rose, suggesting that downward price pressures will only get stronger.

Technically, the overbought conditions in the S&P are reaching levels last seen at the peak in 2007, as well as in 2000 and 1987.  To say that there’s more downside risk than upside risk in the S&P is an understatement.  The daily charts are still screaming negative divergences–where prices remain high but other indicators are already well below their recent high levels.  The weekly charts are a bit stronger, but are also extremely overbought.

Jeremy Grantham, the founder and head of the GMO which manages more than $100 billion in capital, recently gave an interview with the Financial Times where he basically calls the stock market rally in the US and much of the world a bubble.  He adds that the emerging markets and commodities are also in bubble territory. 

In fact, he asserts that in bubbles like the one we’re in today, the prudent course of action is to protect investors, or else risk ruining one’s career. 

Grantham blames the Fed for blowing another bubble, and for dooming the economy to the damage that will inevitably result when the bubble breaks.

He marvels at the Fed’s ability to generate another bubble so soon after the after the tech and housing bubbles.  Normally, he says, more than 20 years separate bubbles because of the painful memories in the minds of investors.

And finally, he asserts, “the US market is now thoroughly expensive again.” 

As difficult as it is to sit out the dance, a prudent investor–just as in 1987, 1999 and 2007–must prepare for the inevitable downturn.  

Leaving the party early might lead to the loss of some current return.  Leaving the party late might lead to the loss of one’s career and lifetime savings.

Why Another Crisis is Inevitable

April 17, 2010

The seemingly non-stop melt-up in the S&P500 stopped last week.  The S&P dipped 0.2%, but on strong volume which continues to signal that the equity markets are vulnerable to a stronger selloff.  The VIX index also jumped up almost 14%.  This supports the idea that the market is jittery and could retreat violently because many stockholders may not be as hedged as they were a year ago.  So for these folks, if prices fall some more, the fastest way to minimize damage would be to sell.

The macro data was mostly weak.  US trade figures came in worse than expected.  This multi-decade imbalance–where we import much more than we export–has yet to be corrected.  Consumer prices, both headline and core, were muted, implying that there’s very little inflation at the end-user level.  Retail sales were better than expected, but as many economic analysts pointed out, this was in part due to the spare cash available to millions of homeowners who’ve stopped making their mortgage payments.  Initial claims spiked to 484,000–much higher than the consensus estimates; continuing claims (with emergency and extended figures included) are hovering near record highs–10 million.  Housing starts were better than expected, but only because apartment starts jumped; starts for single family homes actually fell.  Consumer sentiment fell sharply, when it was forecast to rise.

The technicals are still screaming overbought, on both the daily and weekly charts.  The week ended with a sharp sell off; if this continues next week, the overbought levels could be further corrected.

At the George Soros sponsored Institute of New Economic Thinking, the former chief economist at the Bank of International Settlements, William White, presented some insightful thoughts on how policy makers around the world–and especially in the US–attacked the most recent recession, and why this approached is doomed to fail.

At root, White pointed out that economists pulled out cyclical tools to fix a secular problem.  The secular problem is the massive accumulation of total debt over the last 3o years.  And this debt load was built up across multiple business cycles.

But when our current balance sheet recession hit, our leaders applied cyclical tools–fiscal and monetary stimulus–but did NOTHING to address the underlying structural problem, the massive debt load. In fact, they made it even worse, by pumping up government debt.

The chart below highlights the limits of the cyclical tools.  As debts rise (as a percentage of GDP) and as the Fed pushes down short-term interest rates, we rapidly approach a terminal state where there is no more room to push debt loads up and rates down.  The Fed cannot lower rates below zero, making it impossible for the economy to take on more debt (at ever lower rates) without incurring the risk of default. 

So monetary policy is becoming ineffective.  And the private and public sectors will be forced to deleverage. 

The problem is that broad deleveraging is easier said than done.  Ideally, it’s done gradually to reduce the negative impact of lower incomes, which lowers GDP and lowers the ability to pay down debt in the first place. 

And history suggests that deleveraging rarely follows the ideal path.  Instead, public and private sectors typically de-lever most effectively by defaulting.  And defaults typically lead to bankruptcies and sovereign debt crises. 

This is why another crisis is inevitable.

World’s Central Bank Sounds Alarm

April 10, 2010

The gravity defying melt-up continues to push up the S&P which gained another 1.4% for the week.  Volume was light on all four of the up days; volume was heaviest on the one down day.  The VIX index slipped solidly into complacency territory; it dropped down to levels last seen in May 2008, well before the Lehman implosion.

The few economic data releases were mostly weak.  Consumer credit was projected to hold steady; instead, it cratered–falling $11.5 billion.  With 70% of the US economy depending on consumption, plunging credit levels indicate that any recovery in consumption is not around the corner.  Weekly jobless claims surprised to the downside. They were expected to fall; instead they spiked up to 460,000, again suggesting that the so-called recovery is on shaky ground.  The ISM services index came in slightly better than expected.

Technically, the S&P is still in a highly overbought position–on both the weekly and daily charts.  Both time frames are still signaling multiple negative divergences that are usually associated with a loss of momentum and upcoming price reversals.  We’ll see if next week brings us this pullback.

The Bank for International Settlements, the central bankers’ central bank, recently released a forward-looking paper titled:  The Future of Public Debt: Prospects and Implications.   The paper explored the question of how concerned “should we be about…high and sharply rising public debts?”  Because “So far, at least, investors have continued to view government bonds as relatively safe.”

The outlook was horrific:  “fiscal balances have deteriorated sharply, by 20-30 percentage points of GDP in just three years.  And unless action is taken almost immediately, there is little hope that these deficits will decline significantly in 2011.”

Also, the BIS reminds us that “the current fiscal policy has coincided with rising, and largely unfunded, age-related spending (pension and health care costs)”  which when combined with aging demographics, means that these debt-laden countries will have fewer working people (as a percentage of the population) available the soaring debts. 

Where does this lead?  The charts below reveal a grim picture.  The dashed red line is the baseline scenario (the expected case, with no changes).  In the US, public debt is on track to exceed 400% of GDP, and this even excludes unfunded Social Security, Medicare and Medicaid promises.  Adding these debts to the private sector (household and corporate debts) results in total debt to GDP that exceeds 1000%.

This is akin to a household earning $100,000 annually (most of which is spent on taxes, shelter, food and other living expenses–leaving very little for debt service) BUT which is laden with $1 million in debt.  Unless the family can borrow at near-zero interest rates, this debt load is unsupportable.  The family is bankrupt.

For the US, this projection is catastrophic.  Well before the US reaches such a debt level, it would suffer a funding and currency crisis.  In short, the US would default and our economic, social and political system as we know it would collapse.

The US, and much of the rest of the world’s economic powers, are heading toward the edge of a cliff.  This is 100% certain.  The math is indisputable.

The question is:  can our leaders (our politicians) muster the will and the courage to steer us away from the cliff’s edge?  

Economic history, according to Niall Ferguson, argues strongly that the answer is no.  This same problem is what brought down almost all empires over the last 2,000 years.

Let’s hope that this time is different.

Stock Market Valuation–A Long-Term View

April 3, 2010

The low volume push higher continued last week.  The S&P500 finished higher just under 1%.  Once again, the VIX (or fear) index did not confirm the price rise; the VIX finished the week virtually unchanged. 

The technicals are still pointing to dangerously overbought levels on the weekly charts.  When almost 70% of the stock trading is done by computers trading with each other, one has to wonder how much longer the melt-up can continue, especially without broad retail participation.  The daily charts have already started breaking down.  A clean top-formation has emerged and next week will determine if this breakdown is valid.

The economic data mostly weak.  Personal income was lower than forecast; personal spending came in as expected.  The bad news here is that reasonably strong recoveries normally propel incomes higher; instead, incomes are showing no signs of growth.  And without personal income growth, the economy will have a hard time expanding.  The Case-Shiller index showed a drop in home prices, raising well founded concerns that home prices could resume their steep declines.  Chicago PMI was lower than expected.  Factory orders were stronger.  Initial jobless claims came in as expected, but still well above the 400,000 threshold associated with job growth.  Nonfarm payrolls, at 162,000, were lower than the 200,000 expected.  And when temporary census hires, the birth/death adjustment and weather factors are removed, the month of March lost jobs.  Although the headline unemployment rate stayed at 9.7%, the broader under-employment rate (U-6) rose to 16.9%.  And confirming the weak results with personal incomes, the average weekly earnings fell 0.1% (they were expected to rise 0.2%).

Societe Generale recently analyzed the long-term price-to-earnings ratio using Robert Shiller’s adjusted earnings (he smooths earnings over ten years to smooth out volatile fluctuations).  The analysis focused on separating PE levels into five historical levels–the 1st being the most expensive, and the 5th being the least expensive (see the chart below).

The point, obviously, is that you’d prefer to be a buyer in the 4th or 5th categories, and you’d prefer to be a seller in the 1st or 2nd.

A couple of important observations.

First, the stock market fell into the cheapest quintile in eight separate decades  out of the 12 decades analyzed since 1881.  So a patient investor had many opportunities over a lifetime to buy stocks cheaply. 

Second, many of these cheap periods spanned months or even years.  In other words, an investor didn’t have to be glued to the daily ticks of the stock market to avoid missing the opportunity to buy cheaply; he or she could do so at almost a leisurely pace over dozens or hundreds of trading days.

So how did the lows of March 2009 compare?

As horrific as our financial crisis was (and still may be), the S&P500 NEVER reached the cheapest quintile.  And the S&P entered the 4th cheapest quintile, but only for about a week!

The conclusions are simple.  First, stocks today are in the most expensive quintile; this is not a safe time to buy and hold.  Second, unless history fails to repeat itself, unless this time is really different, then PE’s will sooner or later fall into the cheapest 5th quintile.  And finally, when they do, we will have plenty of time to buy stocks at these cheap levels.