MarketVVizard's Market Thoughts
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» Normxxx - Re: China
In response to message posted by MarketVVizard:China has been building and stocking warehouses with no real prospects of end-sales for some time now (about 1 year?). That can go on for just so long as the foreign investments pour in, but the potential for an economic crash rises exponentially. Can they avoid a repeat of 1997? Who knows?
-- posted by Normxxx
» MarketVVizard - From Morgan Stanley's Andy Xie in Hong Kong
From Morgan Stanley's Andy Xie in Hong KongInvestors are almost unanimously bullish on growth and bearish on the dollar. Consensus is still focusing on emerging markets, especially Asia, and commodities — a highly successful strategy last year. I believe that the opposite will turn out to be true in 2004. The market appears to be mixing China's secular story with the Fed rate cycle; half of China's economic strength last year was cyclical, in my view.
As the Fed kept the funds rate at an historical low and signaled that the rate would remain low for the foreseeable future, it sparked financial speculation, especially in the real estate market, on an unprecedented scale. This resulted in strong momentum in the global economy and triggered massive speculation in stock markets, especially in emerging markets sensitive to commodity prices.
Upward momentum in the global economy due to financial speculation is peaking out, in my view. First, China is implementing policies to rein in the massive speculation in its property market, which has accounted for most of the increase in demand for commodities in this Fed cycle. Hence, commodity prices could come under pressure in the weeks to come.
Second, the Fed became uncomfortable with the rampant speculation in financial markets and withdrew the promise not to increase the Fed funds rate for a `considerable period of time'. The threat of higher interest rates would cool the speculative fervor in financial markets and trigger some unwinding of the leverage that has built up in the past two years. Thus, liquidity conditions should deteriorate from here even if the Fed keeps the rate stable for now.
Still Cyclical
The global economy has had a massive upturn in the past two years, reflected by the surge in Asian exports, even though the US economy turned up convincingly only in 2003. The genesis of this upturn was the aggressive reduction in interest rates by the Fed in 2001, which caused liquidity in the US to surge. The impact on financial markets was temporarily suppressed by the bearish sentiment post the Nasdaq bubble bursting and 9/11.
While the bearish sentiment suppressed the impact of the Fed monetary easing on the US, it impacted China immediately; China's domestic credit surged by 73% over 2001–03, funded mostly by capital inflows. As the spreads between US and China's interest rates turned negative, significant amounts of Chinese capital returned home and overseas Chinese added to this by purchasing Chinese properties. The massive credit surge funded an investment boom; China's fixed investment rose by 68% over 2001–03.
China's investment demand was the trigger for the recovery in the global economy in this Fed cycle, in my view. The resulting positive sentiment translated much of the surplus liquidity in the system into financial speculation, which eventually pushed up demand in the US, Europe and Japan. The demand from these economies for Chinese exports reinforced the recovery cycle, triggering more investment in China.
The central role of China's investment in this cycle caused many, if not most, investors to believe that something new was happening. One popular theory is that China's investment has entered a phase of high and autonomous growth on the back of its urbanization program.
I believe this view is erroneous. China has a secular urbanization story. But its strength is heavily influenced by the Fed cycle. China's export success has made it the first stop in any liquidity surge in the world. This is why its money supply has become so sensitive to the Fed cycle. I believe that half of China's investment strength was due to the Fed-inspired liquidity boom.
China Will Not Follow Southeast Asia
Many investors accept that China's investment boom is partly cyclical but believe that it could sustain high growth for one or two more years, because the country is still not short of money, i.e., its foreign exchange reserves are rising. The Fed-related booms in Mexico and Southeast Asia burst only when their foreign exchange reserves began to fall.
The above reasoning, however, does not take into account the Chinese government's preoccupation with preventing crises. Of course, China could allow its property sector to continue growing at 25% for two more years and then crash like Thailand did in 1997. However, the Chinese government is reining in its extended property sector precisely to prevent such an outcome, which could have inventory of two year's sales by 2006 even with the restrictive policies in place, in my view.
During the period of easy credit in the early 1990s, Mexico and Southeast Asia mistook foreign investors' enthusiasm for emerging markets as true indicators of their costs of capital and used foreign liquidity to leverage up to improve economic growth. When the Fed cycle turned, the resulting liquidity outflows caused the currencies to collapse and led to financial crises.
Most Southeast Asian economies experienced rapid increases in foreign exchange reserves during the period of low US interest rates in the early 1990s; their currencies came under intense appreciation pressure. With the benefit of hindsight, the pressure on their currencies was just a bubble.
China's macro story bears an uncanny resemblance to what we observed in Southeast Asia 10 years ago. Foreign trade, investment and foreign exchange reserves are all rising rapidly, capital misallocation is occurring on a massive scale and foreign investor sentiment is dominated by excessive optimism; profits are usually associated with price rises or arbitrage rather than business fundamentals.
Some investors believe that China's property sector isn't a bubble because hundreds of millions of Chinese want to move into cities from villages. One could have made the same argument in Southeast Asia 10 years ago. However, with house prices at about 10 times urban household incomes, it is farfetched to believe that hundreds of millions of migrant workers could purchase urban properties.
If China doesn't watch for inventory accumulation in the property sector and/or excess capacity formation in commodity industries, it could end up like Southeast Asia did 10 years ago, even though it could maximize growth for another two years. The Chinese government wants growth to support job creation. But it is more sensitive to stability. That is why it is implementing aggressive tightening measures to rein in the property sector before inventory mirrors what it was in Thailand.
If China curtails its investment excesses before the Fed tightens, it could avoid a Southeast Asian-style financial crisis. However, it also means that the commodity cycle turns down before the Fed hikes interest rates; the historical relationship between the Fed and commodity prices could mislead this time.
Does the Fed Care About Bubbles?
The Fed has not tried to rein in financial bubbles in the past. This is why, when CPI inflation is low, investors assume that interest rates will not rise. This perception is vital to financial markets, as increasing leverage has become a primary source of profit in the global economy, i.e., borrowing short-term money at low interest rates and buying higher-risk assets.
The Fed policy provides fertile ground for financial bubbles when disinflationary forces are powerful — as they have been for the past 10 years due to technology and globalization — since it would allow liquidity to overflow despite a strong economy and asset inflation. Thus, every Fed cycle creates a bubble and borrows growth from the future. The current cycle is no different in this regard.
A significant change occurred last week when the Fed signaled that the period of low interest rates could end soon. The announcement puts financial markets on notice that the leveraging game could become unprofitable. There are various interpretations for the Fed's actions. My two cents are that it was concerned about rampant speculation. The Fed's change in its wording is equivalent to tightening, as it would cause some leverage in the financial markets to unwind.
The High Beta Party Is Ending
As China and the Fed tighten, the high-beta party of rising commodity prices and a falling dollar is ending. Some financial accidents may happen as leverage comes off; commodity markets, in my view, could see some accidents in the coming weeks.
A major financial crisis in emerging markets could be avoided this time for two reasons. First, the Fed funds rate will likely peak at a much lower level than before. Most forecasts put the Fed funds rate below 4% by end-2005. Second, the capital flow in this Fed easing cycle was not dominated by borrowing in foreign currencies. Most of the increase in foreign exchange reserves in emerging markets has come from higher terms of trade for commodity economies and portfolio flows into stock and currency markets.
I am calling for a soft landing in the emerging markets this time around. My call is dependent on China's pre-emptive tightening of its property boom. As long as China's property prices decline by 10% or less, I believe a soft landing could be achieved.
-- posted by MarketVVizard
» MarketVVizard - Anyone who took a position today is straight up gambling in my o
Anyone who took a position today is straight up gambling in my opinion (not that there's anything wrong with that
)Tomorrow's Employment Report has to deliver a surge in nonfarm payrolls to bring back confident buying. Street expects +165,000 to +175,000 zone (which is somewhat low if we are in a recovery) vs. last month's +1,000. No one seems to have any conviction on what to expect, or if last month's shocker will be revised. The herd is desperately seeking a leader. I guess I wouldn't be surprised to see an OK jobs report with a rally but who knows? Any way you slice it I think tomorrow's market action will be a key short term indicator of where we are headed for the next week or two.
-- posted by MarketVVizard
» MarketVVizard - This could be better than the stock market :)
Remember when Admiral Poindexter proposed the Defense Advanced Research Projects Administration to develop a futures market in terrorist events? The media erupted with harsh criticism followed by his swift resignation. It seemed I was a lone voice defending the concept which the media obviously did not understand. Well now it has become reality._________________________________________
Bush or Kerry? You Bet!
By Donald Luskin
January 30, 2004
I LOVE MARKETS. Just think of all the things they make possible. Whenever there's a way for people to trade with each other, they always find ways to make money and reduce risk. So whenever market principles get applied in new ways, the world becomes a better place.
Right now it's happening in the realm of politics. Readers of this column know I believe that politics is the No. 1 force acting on the stock and bond markets — but this is something else again. It's a market in politics itself.
It's called Tradesports.com [VViz: What a disappointingly short-sighted name for the site!]. When you first visit the site, don't make the mistake of thinking that this is some online betting parlor. This is a sophisticated futures market. No, you won't find contracts on pork bellies. You'll find contracts on an astonishing variety of events — sports events, market and economic events, news events, and political events. Even terrorist events!
Let's take a look at the most actively traded futures contract on Tradesports.com, the contract on George Bush winning the 2004 U.S. presidential election. Right now that contract trades an average daily volume valued at about $1 million.
Here's how it works. The day after the November elections, the contract will expire. It will be priced at 100 points if Bush is reelected, and zero if he is not — and 100 points equals $10 per contract.
As of this writing, it's trading at 71. If you bought the contract at 71, and Bush is reelected, you'd make 29 points (because then the contract would expire at a value of 100). Those 29 points represent $2.90 per $10 contract — so if you had bought 1000 contracts your total profit would be $2,900.
Of course, as in any futures market, for every buyer there has to be a seller. Or more precisely, for every long there has to be a short. In this example, the short would lose 29 points, or $2.90 per contract.
But suppose Bush loses. Then the contract would expire at a value of zero, so the long would lose $7.10 per contract, and the short would gain $7.10 per contract. By the way, both sides pay a commission of 4 cents per contract for every trade.
Tradesports.com trades similar contracts on dozens of political events. For example, there are contracts on every Democratic hopeful, so you can speculate on which one will win each state primary, and other contracts for the party's nomination.
What can you actually do with these contracts? Well, if you're smart, you can make money.
Small fortunes were made by people who dared to buy a penny-stock called John Kerry just before the Iowa caucuses. After the upset, his nomination contract went from two to 65 — a 3,250% return in a matter of days (now, after New Hampshire, Kerry is trading at 68). At the same time, after Iowa, the Dean contract went from 78 to 11 (they don't call him "the Internet candidate" for nothing — that was a genuine dot-com-style stock crash). He's now at 8.5.
But as with all markets, there's more than just the speculative profit motive. All of society benefits from the information embedded in prices at Tradesports.com, because these prices reveal the world's best estimate of the probabilities of various future events. It's the ultimate poll.
For example, that Bush reelection contract priced at 71 points is telling us that, right now, Bush has a 71% probability of being reelected. Traditional opinion polls tell you only what percentage of voters say they will do in the future; polls don't give you the probabilities of various outcomes.
Knowing the probabilities helps people make better decisions about how to invest and how to hedge. That's why Admiral Poindexter assigned the Defense Advanced Research Projects Administration to develop a futures market in terrorist events. He thought that would be the best way to help Homeland Defense, national security and intelligence officials get a handle on what the risks are out there.
When the media got wind of Poindexter's idea, they made it seem so whacky that it was immediately abandoned. Yet Tradesports.com is up-and-running right now with exactly the same concept. Before the U.S.-led coalition invaded Iraq, Tradesports.com listed contracts on whether Saddam Hussein would be in power as of particular dates in the future. Today there are contracts on whether Osama bin Laden will be apprehended, and on the color-coded terror alert level in the U.S. at year-end 2004.
What use is all of that to investors? For one thing, Tradesports.com's contracts are an objective barometer of what the market is thinking about various risks. A year ago, when the U.S. was still undecided about whether and how to invade Iraq, the markets were buffeted by volatile moves that the media never failed to blame on imagined investor perceptions about the chances of a war. Well, with Tradesports.com, there's no need to imagine. Just look at the changes in prices of the Saddam contracts, and you can see for sure whether the market's assessment of the probability of war went up, down or sideways that day.
Remember that this election year as the media begins to attribute market moves to the market's perception of Bush's reelection chances. The Tradesports.com contracts will tell us for sure what the market really thinks about that — so when we see the Dow rise or fall 150 points on a particular day, we can start making more intelligent judgments as to why.
Of course, the most straightforward use of the Tradesports.com contracts is simply to trade them. Let's say you think Bush will be reelected, and that the market will go up as a result. So ordinarily you'd buy stocks based on that — and that would be an entirely legitimate investment strategy.
But that's two propositions in one, isn't it? You could be right on Bush, but wrong on the market for any number of reasons. But at Tradesports.com, you can separate those two propositions, and just speculate on Bush (or against him, if that's your call). Of course, when you separate the propositions that way it feels more like "gambling" and less like "investing," but if you think about it rigorously I defy you to articulate any real distinction.
Speaking of gambling, I won't offer an opinion on whether it's legal for Americans to use Tradesports.com. Tradesports.com is domiciled in Dublin, Ireland, where it's entirely legal. There, it isn't regulated either as a gambling site or as a futures exchange — it falls in between the regulatory cracks, as all great innovations seem to do. As Chief Executive John Delaney put it — invoking an Irish expression — "The law doesn't come within an ass's roar of knowing what to do with us."
Let me just say that I am unaware of any specific legal reason for Americans not to participate. I've opened a Tradesports.com account, but I haven't used it so far. I don't have any particular legal concern about it. I just haven't found the contract I want to invest in yet.
But believing as I do that politics moves the market, it's only a matter of time before I fire up my laptop, go online and put my money where my mouse is. I love markets!
-- posted by MarketVVizard
» MarketVVizard - new bull?
<img src=http://www.jsmineset.com/images/equitymu...>
-- posted by MarketVVizard
» MarketVVizard - Hussman
February 9, 2004Eat More Hay. Ten Million Horses Can't Be Wrong.
John P. Hussman, Ph.D.
All rights reserved and actively enforced.
In October 1999, a few months before the recent stock market bubble peaked at Nasdaq 5000, Alan Greenspan brushed off concerns that stocks were overvalued with the following statement:
“To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific investments that make up our broad price indices of stocks and other assets.”
To anybody with a firm grip on market history, that statement was great entertainment. It reflected exactly the sentiments that existed just before the 1929 Crash. As J.K. Galbraith wrote in his book The Great Crash, 1929, the influential Joseph Lawrence of Princeton also defended the market's valuation at the time, saying:
“The consensus judgment of the millions whose valuations function on that admirable market, the Stock Exchange, is that stocks are not at present over-valued. Where is that group of men with the all-embracing wisdom which will entitle them to veto the judgment of this intelligent multitude?”
Eat more hay. Ten million horses can't be wrong.
One of the important things to remember about markets is that they involve a certain amount of “feedback.” Rising prices encourage risk taking, and risk taking encourages rising prices. The converse is true for declining prices. If the feedback is particularly strong, you can get bubbles and self-fulfilling plunges, but most of the time, feedback simply reinforces existing trends without destabilizing the market.
Still, that feedback means that when prices are high, you can be certain that a great number of investors are convinced that prices should be high. When prices are low, you can be certain that a great number of investors are convinced that prices should be low. For that reason, relying on consensus views is rarely a useful investing strategy.
We occasionally receive notes about this fund holding or that, noting a variety of difficulties and a consensus of negative views about the security. Our response is simple – it is not typical for great value stocks to be well-liked. To the contrary, securities that are highly regarded by the consensus are often those that are priced for perfection, and are at risk for devastating losses if disappointments arise.
All of this came to mind as I read a recent article in the Wall Street Journal, reassuring investors that despite high valuation multiples, stocks might not be overpriced:
“To the relief of those who think stocks are fairly priced, however, the numbers are still lower than at the height of the bubble. In early 2000, the Nasdaq 100 traded as high as 165 times trailing earnings.” The article then quoted the calming opinion of a money manager, saying “I don't think we necessarily have to take it to excess this time.”
Has this become our standard? Have investors really come to tolerate anything short of the most extreme valuations in history?
P/E Ratios, Apples, and Oranges
On the basis of price/peak-earnings (popup: Why we use peak earnings), the S&P 500 currently trades at a multiple of nearly 22. Except for the year 2000 bubble peak, the highest multiples seen historically were in 1929, 1972 and 1987, each at no higher than 20 times peak earnings.
Of course, it has become fashionable to base P/E multiples not on reported earnings, but on estimates (always excessively optimistic) of future operating earnings. On that basis, the forward operating P/E is about 18, a figure which is always reported along with a statement that the historical average P/E is about 15. On that measure, analysts argue, valuations might be a little rich, but the difference can be explained away based on interest rates and the like.
I've always had a particular disdain for operating earnings, which do not adhere to generally accepted accounting principles and can be disturbingly arbitrary. Worse, as Cliff Asness of AQR Capital ( www.aqrcapital.com ) notes, the “historical average P/E of 15” isn't based on operating earnings, but on trailing earnings. Since forecasted operating earnings are generally much higher than trailing earnings, P/E ratios based on forecasted operating earnings are invariably lower than P/E ratios based on trailing earnings. Asness writes:
“Despite this, many bullish commentators blithely compare today's forecasted operating P/E to the historical average trailing P/E. They are trying to pull a fast one. The historical median “forecasted operating” P/E has been 12.1 since 1976 so the current figure is indicating that stocks are not a little, but a lot more expensive than the norm for the last 28 years.
“Furthermore, the 1976-2003 period was marked by higher than normal valuations. Consider that the median trailing 10-year P/E is 16.9 over the 1976-2003 time period, but when you go back to 1871 it falls to 15.4. Therefore, it is not a big leap to guess that the true long-term median “forecasted operating” P/E would be about 15.4/16.9 lower, or about 11.0, if we had that data further back in time.
“Therefore, today's “forecasted operating” P/E is dramatically higher than our best guess of a comparable long-term historical average. Basically, in an honest comparison, not playing fast and loose with the numbers, P/Es of any stripe are very high versus history (and please don't stare straight at dividend yields or you might go blind).”
Cyclical vs. Secular
So valuations are problematic for the market. Still, as we are always careful to note, overvaluation does not imply that stocks have to decline in the short term. Rather, overvaluation implies that stocks are priced to deliver very disappointing long-term returns.
Though I don't use the terms “bull market” and “bear market” in any practical way (for instance, trying to decide whether the market is in one or the other, which is fruitless), the terms can be useful shorthand. It is difficult to imagine that the recent bear market was “it” in terms of clearing the excesses of the bubble. More likely, the year 2000 peak ushered in a “secular bear market.” That's not a single bear market, but a series of full market cycles – a “cyclical bear market” followed by a “cyclical bull market” – in which each successive bear tends to settle at lower and lower levels of valuation. Historically, secular moves involve 3 or 4 full market cycles. At the end of a secular bear, stocks achieve a final and durable low (think 1982) that often ushers in a new secular bull. Historically, these puppies have been about 17-18 years in duration.
From that perspective, what we saw in the 2000-2002 “bear market” wasn't a final purge of excesses, but the first of a series of bear markets. We've now seen a good, solid cyclical bull market to follow, but one that has taken valuations back to 1929, 1972 and 1987 category extremes (indeed, price/dividend and price/book multiples far exceed anything seen at those prior extremes). It's certainly not necessary for stocks to immediately roll back into a new cyclical bear market, but the potential – even probability – that this move could be aging is something that investors should not ignore.
In short, buy and hold investors have a problem. Stocks are priced to go nowhere over the next decade, but they are almost certain to go nowhere in an interesting way. With valuation multiples currently very extreme (and inexplicable on a historical basis even factoring in interest rate conditions and the like), investors should remind themselves that further market gains would be based on continued interest by investors to take risk (speculative merit), not because stocks represent an attractively priced stream of future cash flows (investment merit).
Market Climate
The Market Climate for stocks remains characterized by unusual overvaluation, but still moderately favorable market action. In the Strategic Growth Fund, our investment position continues to allow for a very broad range of outcomes. The Fund remains fully invested in a widely diversified portfolio of stocks, with about half of that exposure hedged against the impact of market fluctuations. In addition, we continue to hold a “straddle” – both put and call options – and added to the call side on the market weakness early last week.
Essentially, a substantial market decline would kick in the put side of that straddle, taking the Fund to a roughly 70% hedged position (meaning that we would expect to be exposed to only about 30% of any extensive market loss), while we would expect to participate almost fully in a substantial market advance here. The primary risk would be a sideways movement in the market in which market volatility is less than the volatility priced into the options. In that event, the Fund would risk “time decay” of just over 1% of assets, which is what we have invested in that straddle here. Again, I wouldn't advise doing this at home, since the positions have to be managed carefully in order to exploit the time premium we've purchased, but this is fairly standard stuff for us.
In the Strategic Total Return Fund, we added some additional exposure in precious metals shares on price declines early last week. Our exposure in this area is still only modestly above 5% of assets, but it does provide useful diversification not linked directly to interest rate movements. The overall duration of the Fund is just under 2.5 years, meaning that a 100 basis point move in interest rates would be expected to impact the Fund by about 2.5% on the basis of bond price fluctuations.
S.A.P.s
A final note on the employment report, which showed a disappointing 112,000 non-farm jobs created in January. The Department of Labor had this interesting line in the report (italics added):
“Retail trade employment increased by over 76,000 over the month, after seasonal adjustment. The industry lost a total of 67,000 jobs in November and December. Weak holiday hiring in general merchandise, sporting goods and miscellaneous stores meant that there were fewer workers to lay off in January, resulting in seasonally adjusted employment gains for the month.”
That's almost Orwellian. Essentially, the seasonal adjustment adds jobs to the January figures to correct for normally heavy losses of temporary jobs after the holidays. But since there were so few of these jobs actually created during the holidays, those January layoffs didn't occur either. As a result, the seasonal adjustment results in a gain of 76,000 fictional jobs for January. These aren't real jobs because they aren't real people. Let's call them “Seasonally Adjusted People.”
-- posted by MarketVVizard
» MarketVVizard - The Last Vigilante
Bill GrossYou don’t hear much about the bond market vigilantes anymore. They sort of rode off into the sunset a few years back, either having forgotten their role or perhaps having grown accustomed to their impotence in an era where deflation instead of inflation was public enemy number one. Their glory days were probably a little overrated anyway. Vigilantes are essentially lenders and decades ago when they first gained their reputation there were no inflation protected TIPS or real return commodity funds for a bond investor to send a message with. It was either bonds or cash, and the price of cash was set by the Lone Ranger at the Fed who was heading up the posse. All the rest of us sort of rode along, whoopin’ and a hollerin’, shootin’ our guns in the air like we were gonna lasso and hogtie those inflationary varmints. But we were kind of acting. Paul Volcker was the man, the Vigilante, and later I suppose it was Alan Greenspan, although to me he now seems more like Barney Fife than the Lone Ranger. I write this in half jest if only to introduce the notion that Volcker’s Wild West was a lot different than that of Greenspan’s today. While both marshals were entrusted with the dual responsibility of controlling inflation and maintaining a sound economy, Greenspan’s economy is a completely different one than the one Volcker rode his white horse into in 1979 and out of in 1987. Greenspan’s economy is a globalized economy, filled with negative vibrations revolving around substitution of cheap Asian and Latin American labor for workers here at home. It is an economy full of technological wonders such as the Net, cell phones, high-speed data transmission, and the like. We may not be able to go to the moon anymore, but things down here on mother Earth are certainly movin’ and shakin’. These changes have completely altered the perspective of our High Sheriff and Chief Vigilante. Now there are legitimate questions as to the natural rate of domestic unemployment in a globalized world, the sustainable level of productivity in a technology tinted economy and the resultant effects they have on inflation and economic growth – the Fed’s two primary responsibilities. It is not an easy assignment, this job of Chief Vigilante in the year of 2004.
And it’s not one, as I have pointed out in Outlooks past, where you can afford to risk bludgeoning the economy with sharply higher interest rates as Volcker did in the early ‘80s. It may appear more prosperous than that of the “rust belt” ‘80s but its foundation is much weaker because of high levels of debt throughout the private and now the public sector. The Lone Ranger has been replaced with Barney Fife for good reason. We need someone afraid of his own shadow these days because there are shadows aplenty to contend with. Because beyond the risks of globalization and the blitz of technological change, I would argue the most critical reformation in the past twenty years since Volcker’s prime has been the transition of the U.S. from a manufacturing/to a service/to a finance-based economy within the span of two decades. Purists will perhaps rightly quarrel with the chronology or maybe even the logic, but it seems to me in any case that the critical difference between then and now is that profits and employment – 2/3 of the critical constituents that a Fed Vigilante must protect (inflation being the third) – are now primarily a function of the amount of debt/leverage and its cost. Because this is so, we currently reside in a finance-based economy. This is no longer
My intent here is not to create another set of media sound bites by unearthing “GE” or jesting with a Barney Fife/Alan Greenspan comparison. Greenspan is a good man and a well-intentioned public servant. He believes he is a modern-day vigilante – fighting deflation instead of inflation and he had a point for a while back in 2002. GE is a great company with a near century of “progress.” But they, as well as yours truly and PIMCO have sort of skipped down this yellow brick road of capitalism, paved not with gold, but with thick coats of debt/leverage that require constant maintenance in the form of lower and lower interest rates. I’m arguing the case that Volcker in effect was perhaps the first and last Vigilante. Greenspan, GE, Gross? Vigilantes? We’re sort of all in this finance-based economy together, are we not? While Greenspan has blessed it and GE has taken advantage of it, PIMCO has facilitated it. Who makes it possible to refi all those mortgages by holding $100 billion of them in PIMCO portfolios? 0% car loans? Who makes it possible by snapping up asset-backed securities at LIBOR plus yields? GE’s swaps? PIMCO’s got the same side of the trade.
But folks, all blame aside, I must tell you in advance that this story or movie does not have a happy ending. In terms of timing it may not be high noon, but High
Chart I
Chart II
Visible proof of a finance-based economy is offered in Charts I and II which point out the growth in
But so-called vigilantes would counter by pointing to consumerism and the ongoing cycle of buying ephemeral “things.” They would suggest that we have hardly invested wisely – witness the millions of miles of still unutilized fiber optic cables and the farcical parade of the “dot coms” as recently as a few years past. They would then top it off with an observation that Republican Bush with his Republican Congress seem to observe no limits whatsoever in the budget. $500 billion may only be a start if in fact we’re going to the Moon, Mars, and beyond. The CBO in fact has just conservatively estimated a $2 trillion addition to the national debt over the next decade.
Who’s right? Each side scores some points I suppose, but what seems obvious to me is that if debt stops growing at the same rate – if the slope of the trend line in Chart II tips over, then our economy will slow down, stagnate or worse. Who could argue that if debt as a % of GDP were still at 1980s levels as shown in the chart, that our consumption of things, our purchases of homes, our investment in technology, or our current government deficits would not be much smaller and our economic growth much lower. We are hooked on debt; we are a finance-based economy.
And so? Why not just keep on going. So far so good the New Agers would claim. What’s wrong with 400% of GDP or 500% of GDP? What’s wrong with dropping it from helicopters if we have to as good Ben Bernanke has suggested? Well, let me tell you what’s wrong. Debt levels and debt ratios have limits. When and if interest rates do go up, the servicing costs of an accelerating debt economy eventually bite the hand of its master. A true bond vigilante is a vigilante that knows that buying a bond, mortgage, or any of the innovative “O’s” that have popped onto the scene in recent years is really lending someone some money, someone else’s hard earned cash that they expect to get back in inflation-adjusted terms and then some. Lending is not mimicking some index or buying a hot new issue with the intention of flipping it to some other sucker when the spread narrows. It’s not gloating about being in the top decile of the money manager universe while producing less negative total returns than 90% of your competition. And it’s certainly not buying dollar denominated bonds with the ulterior motive of putting 20-30 million of your citizens to work a year à la the Chinese, or better yet, the Japanese. These investors may be clever, but they’re not vigilant. A bond market vigilante makes loans, she demands a fair inflation adjusted return and when that visibility shrinks, she seeks alternatives. My point is that at some point on this seemingly never ending ascent of debt/GDP, someone will say “no más.” Maybe it’ll be PIMCO and PIMCO think-alikes; maybe it’ll be foreign holders of bonds grown tired of currency/inflationary erosion of principal; maybe it’ll be risk takers in high yield/emerging market/levered hedge funds scared to death from a future LTCM crisis. Hard to tell, but I’m telling you it’ll happen, helicopter or no helicopter and with it will come an economic slowdown/recession unseen since at least the early 1980s when Volcker began his vigil. High noon.
Chart III
So far, I’ve confined this “finance-based economy” treatise to the growth of debt and the willingness of lenders to go along for the ride. The second rather simple explanation for our ongoing prosperity is that during this period of accelerating growth, the cost of the financing has gone down, down, down as shown in Chart III. Talk about productivity!
In a finance-based economy this IS productivity. Instead of cheaper and cheaper labor per unit of output, we have cheaper and cheaper interest rates per unit of debt. Long-term real interest rates have dropped from an estimated 9% in 1980 to 2.5% now. I hearken back to my argument about 0% loans and historically low mortgage financing rates. How much consumption would have taken place without these trends? The undeniable answer is “not as much.” Perhaps even “a lot less.” My point is that yields are about as low as they’re going to go. When you have negative real interest rates, even a half awake vigilante will “someday” demand redress, or a half awake Fed Chairman will “someday” be forced to rebalance, or a half asleep foreign central bank will “someday” switch to a basket of currencies which offer more protection via higher real rates of interest.
As real short rates climb from negative to only slightly positive (PIMCO’s longstanding forecast), this reversal in trend will be enough to call a halt to the higher and higher productivity of debt in a finance-based economy. Simply put, it means that borrowers will pay more in real terms, affecting consumption, home building and buying, business investing, and government deficits alike. The lower real interest rate “wind” at their backs will instead turn into a mild headwind. The economy will slow. It may falter. The timing is uncertain. For contrary thinking, pessimistic investment managers or economists, “someday” is often frustratingly “out there” like some phantom force in the X-Files. Still, it suggests caution as we move inexorably closer to our High Noon.
Readers wishing me to get to the bottom line or even jumping ahead of me to draw their own conclusions may find this “High Noon” parallel a little bit hard to digest even in PIMCO terms. Have I not been preaching the inevi
-- posted by MarketVVizard
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