Blog Update

After quite the party throughout the Olympics here in Vancouver, capped off by a brilliant victory in men's hockey (take that!), I have had some time to evaluate how I am using my time to maximize the return on my existing skills and to simultaneously build skills that can be used in the future. Long-time readers of this blog know that this blog itself has generated no income, nor was it ever intended to do so. Income has been generated by my own speculative activities and some writing assignments for local financial firms.

Five years ago I made a decision to pursue an education on my own terms. A practical education filled with real-world experiences and a "learn by doing" mentality. My other option was "what everyone else was doing." Going to university, racking up $100,000 plus of debts and coming away with a piece of paper declaring my competence. This piece of paper, I was told, would increase my earnings potential by about 20% for the first 10 years of my working life, at which point it would become more or less irrelevant. The math didn't make any sense. With the interest on the debt, even a high starting salary wouldn't pay it off in ten years. And to top it off, I was surrounded by people who already had degrees but couldn't find work in their trained fields. They went back to coaching tennis or doing security. It really was an easy decision.

Over the past five years I have done proprietary trading for a small financial institution, managed my own account, operated this blog, attained a number of professional certifications in the financial services industry, and spent countless hours reading and researching economic theory, business cycle theory, economic history, the financial markets, capital flows and anything in between that interested me at the time. I have had the luxury of doing all this while living for extended periods of time in Europe and South America, gaining important cultural insights. I'm 27. I have no debt and a little stash of savings.

Far from suggesting that I can't learn anything else (the more I learn, the more I learn how little I know), I have indeed reached a point where this sort of self-directed process has met the law of diminishing returns. It has come time for me to apply what I have learned in another fashion.

I again had two options. The financial services industry was where my training naturally directed me toward. But being under 30 with my qualifications only gave me access to a few entry level positions. Positions abound for "investment advisors" at all the major institutions in Canada. They could just as accurately title the position "Shameless Mutual Fund Salesperson", because that is what they do: siphon their customers into a "balanced" portfolio of instruments that garner the highest sales fees possible. I couldn't, in good conscience, resign myself to this pitiful existence. Alternatively, I could be an "Investor Relations Representative" for a small junior mining company. Being paid primarily in stock options, whose value is dependent on some geologist finding a hot hand? Thanks, but no thanks.

So the option remaining is to use my financial background by pursuing small business development. And as it turns out, there is a family business in need of a new manager. It has a stable earnings flow and significant potential for expansion. Starting now, the majority of my time will be spent improving this business.

What this means for my readers, unfortunately, is that regular updates to this blog will no longer be a priority. I will continue to read a good amount of financial news, and thus, should have no problem keeping the "recommended reading" links updated regularly. Surely, I will at some point get antsy and feel like I should write something (or rant about something). Gone will be watching the markets tick-by-tick as I have for these past 5 years. Perhaps eliminating this short term oriented habit will help me gain a different perspective of the markets.

I'd like to thank my long-time readers for their support, encouragement and advice. I have, indeed, gleaned as much insight from your feedback as I have provided to others. And that was my entire motive of this little project.

Thank You!


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Update 06.10

A week of choppy trading saw the major indices gain about 1 percentage point. There were violent swings in both directions as rumours swirled in Europe of the Greek fiasco. If you've been reading my links on a daily basis, you've probably got a pretty good handle on the issues. I'll summarize the most important points here:

1) The ECB is constitutionally forbidden from acting unilaterally to assist any one nation or group of nations
2) The IMF has a US veto over use of funds and the issue is too large for them to handle
3) Germany and Holland and Scandinavia cannot assist Greece because
i) politics - Germany underwent austerity to facilitate the EU's formation - telling them now to bailout profligate nations is politically impossible
ii) bailing out Greece will immediately lead to eyes laid on Portugal. Then Spain, Ireland, Italy, UK, France, etc.
iii) moral hazard is obvious
iv) adding the debt burdens of Club Med will put Germany's implied debt burden in just as poor shape as Club Med itself. Interest rates on Northern debt would rise
4) Letting Greece fail would cause a cascade of sovereign failures
5) Bank exposure to Greek debts in Germany, France, Switzerland is huge and enough to paralyze their credit markets
6) Nobody can devalue in a monetary union
7) Austerity in Greece, Portugal and Spain is apparently not an option. Workers refuse to accept lower wages. Politicians are resorting to pointing fingers, citing fear mongering and rumour spreading

All routes lead to collapse of the monetary union. Germany bails out one, they must bail out all of them. This will incite political and financial collapse in Germany. Let one fail, the rest will fail by way of precedent and private banks all go down with them. Austerity is politically impossible (unemployment is already sky-high for example). Austerity in socialistically-minded economies will lead to complete depression.

Yet most market analysts continue to believe that "something will get worked out." It is only their optimistic mindset that supports this view, not any kind of sound logic. And the buoyancy of markets is reflective of this. The second leg down in the Great Credit Crisis will be led by the unwind of this baseless optimism toward solutions that don't exist.



See above the multiple 10-15 point swings last week on their way to nowhere. As I often repeat, "oversold conditions can work their way off by either time, price, or both." This week's choppy rise has successfully rooted out many of the oversold readings, and it has done so without inflicting much technical damage to the downtrend.

Also notice the evident complacency among traders, who, despite violent swings in both directions last week put a much lower price on options. Implied option volatilities are worth 23.3% less on the 1075 close friday than they were at about 2:30pm the previous Friday with the S&P at 1044. If that sounds excessive, it's because it is.



We'll see if the greater downtrend prevails this week. Another week of gains would likely put it in jeopardy.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Note To Readers

Posting will be light over the next few weeks. The Olympics have rolled through my neck of the woods. I took a part-time gig just to be a part of the action, which has naturally turned into full-time with more responsibility than planned. I'd also like to spend some time mingling with the foreigners, etc. Oh, and I'm battling chronic tonsillitis. Nice!

I'll at least keep the links updated and some charts on the weekend, but suffice to say I'll only have one eye on things. I'm sure you'll all be totally lost without me.

I kid.


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Update 05.10

I'm a little late this week, but with the benefit of Monday's session, I think we have some added evidence for the beginning of a multi-month decline. The character of this latest selloff has a different feel than either the July or October selloffs. I would venture to guess that if I asked people a month ago that we'd have an unemployment rate of 9.7% and GDP growth of 5.7% (annualized), the stock market would be squeezing shorts into oblivion and trudging yet higher toward the heavens.

Not so. Apparently, good news only mattes when, well, when it matters. If the stock market goes down, then the good news doesn't matter and something else does. Got it? Right. Perhaps it is best to pay greater attention to the bigger fundamental picture and what the market does, rather than the monthly or weekly data. People decide what stocks are worth based on their emotions. And their emotions appear to be directed by something other than the monthly data. The best explanation I have found for this phenomenon is that people merely take their emotive cues from each other - oscillating between optimism and pessimism.

Right now, everyone feels panicky about the situation in Greece, Portugal and Spain. But these problems are not new. They've been problems for a good 5 years now. The difference is that people are now paying attention to them. But I am sensing a great deal of complacency about the nature of this decline. Most sound completely certain that it is only a minor correction. And this gives me greater reason to believe that a far larger decline is upon us. See the chart below where a survey of 140 newsletter writers shows quite a decline in bullish sentiment, yet a far smaller increase in bearish sentiment. Notice how the two typically inversely correlate perfectly. But this time, we see a very strong resistance to the idea of becoming outright bearish.

(Data as of last Tues)


Elliott Wave patterns have been extremely compelling on the way down. This is in contrast with the October selloff, where one had to stretch to count 5 waves down and when it rallied, it rallied very compellingly. The bounces on this selloff have been weak and overlapping. The implication is that a 3rd of a 3rd wave down is just beginning. Support resides in the 940-980 range. This count from Daneric's Elliott Wave Blog looks like the most probable from my perspective.



The Euro/Yen cross has been a reliable indicator for risk aversion over the past few years. While I feel that trend will break at some point, it still bears watching.



Gold needs to hold the 200 day EMA to avoid significant technical damage. I think a test of the April lows at $865 is a best case scenario.



The weekly chart of oil is not looking pretty. I've pointed out the bunched up moving averages before, and they usually portend a major move in one direction or another. I still think we see new lows for oil as speculators unwind their positions. A sustained break of $70 would be very bearish.




Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Themes For 2010 - 6 - Final Thoughts

Last month, I ran a series of pieces detailing my outlook for credit markets, the economy, asset markets, and government interventions in them.

The overarching theme was that a secular shift had occurred in 2007 toward the reduction of debt and leverage within our economies. 2008 was the point of recognition. In 2009, we experienced a barrage of "fix-its." Most of these programs were designed to either conceal the actual problem, transfer the obligations to others, and to otherwise re-instill confidence in asset price valuations. The natural tendency for market participants to fluctuate between pessimism and optimism resulted in the perception that these programs had worked and that "normalcy" had returned.

But our concept of "normal" had been skewed by the previous secular shift, which was anything but normal. Its duration of over 3 decades was sufficient to eliminate the memories of how a normal economy actually functions. Indebtedness had replaced the role of savings; speculation the role of investment; consumption the role of production.

A number of factors enabled this shift: the fall of Soviet Russia, globalization, productivity enhancing technological advancements, booming demographics, and most importantly, the implicit and explicit government guarantees doled out to the financial services industry.

A number of those factors have reached their points of maximum impact. Others are already reversing. The first baby boomers began retiring in 2007. The impact of this will increasingly show its effects on markets as they liquidate their assets to pay for their retirements. Globalization grew to the point that the social ramifications of its imbalances will force a retrenchment. The cyclical nature of international trade is well documented. And technological progress, while it will always continue, has not experienced the type of long-term investment necessary to garner returns seen in the 90's and 00's.

The only constant is change. But while most are afraid of change, I prefer to embrace it. Every decade sees enormous secular shifts in our markets, yet most analysts, pundits and economists spend a majority of their time trying to figure out how we can avoid, or blunt the effects of such shifts. It is an exercise in futility. I don't expect to be able to alter people's irrational fear of change. I can only point to it in hopes that some can capitalize on it early.

I will reprint the conclusions from the previous installments in this series.

Part 2 - Credit Markets

On the whole, credit markets have not recovered. In fact, in many areas credit quality has continued to deteriorate unabated. A pending supply of low grade mortgage recasts, along with an overhanging inventory of underwater mortgages will likely force a continuing deterioration in loan performance and further house price declines. Despite accounting shenanigans that allow banks to value their assets at whatever they like, banks' lending ability remains constrained, while the ability and willingness to borrow is also under pressure. The overall amount of debt outstanding is also constraining the economy's ability to lend its way out of the recession. Even with historically low rates, the high level of debt gives us a servicing ratio that constrains our ability to invest in productive capacity.

Part 3 - The Economy

We are most likely (as of June '09) in the midst of a technical recovery as defined by GDP. But this masks the rot underneath the surface. Consumer credit and income growth are contracting. As such, personal consumption expenditures will likely remain depressed for some time. Short term gimmicks like "cash for clunkers" and homebuyer tax credits may provide incentives for consumers to delay their deleveraging, but the cost of the programs add to the overall debt burden, which needs to be paid with interest. High debt servicing burdens hinder our ability to invest. In the long run, these programs are detrimental to GDP - even though they may provide relief in the near term.

Structurally high unemployment will likely persist, as those who have recently fallen out of the workforce will join it again upon improving job market fundamentals. This will serve as a drag to economic robustness, but should keep wage pressures low for a considerable amount of time. Declining wages will increase productivity and likely bring about a revival in the US goods-producing industries that have shed jobs for 3 decades.

The picture I have painted above is very deflationary. Combined with contracting credit markets, valuations of financial assets should decline to reflect their weak earnings potential. I will discuss the implications of a rebalancing economy and contracting credit on asset markets later this week.

Part 4 - Government

A vast majority of the $23.6 Trillion in bailouts, swaps and guarantees has been directed toward supporting home prices. For the most part, they have failed. The natural course is quite obviously for home prices to continue declining toward levels commensurate with incomes and revenue generation ability. The expiration of many temporary "kick the can down the road" schemes, along with a flood of Option-ARM and Alt-A recasts, will significantly hamper bank balance sheets and eventually force further credit writedowns. Populist anger toward big bank favouritism will also limit the government and the Fed's ability to enact further legislation favourable to banks.

Part 5 - Asset Markets

Credit contraction and asset price deflation are two peas in the same pod. As I believe credit contraction is unavoidable over the long-term, I also see lower asset prices ruling the roost. In many cases, a return to historical valuation levels would imply drastic reductions in prices. This should be viewed in a positive light. Lower asset prices enable lower wages, which restore competitiveness and lays the foundation for a robust economic recovery. Whether this happens in 2010 is to be determined. But I feel that the probabilities are strongly in favour of such a scenario.

With all that in mind, I'll proceed to my "Themes for 2010." The normal qualifications are required. Some of these themes will be correct, others will be laughably false. Such is the nature of prediction in a dynamic system. Many of these themes are very long-term in their nature. While pressures may build, many may not necessarily "peak" in their effects until many years down the road. For example, this will be the third year that I have highlighted the stresses in state and municipal governments. I have not necessarily been wrong in the past two years, as the problems have continually grown in both their size and realization in the mainstream. Indeed, it will likely take many more years for a long-term solution to be found. Such is the case with much of the below.

- a resumption in the trend toward deleveraging and falling prices for most liquid assets (stocks, commodities and corporate bonds)
- a consequent rise in the US Dollar Index, perhaps very substantially so as credit contracts
- decreasing global trade and a continuation in protectionist measures, primarily directed toward China
- outright collapse of China's bubble-economy as foreign capital flees. Chinese officials blame everyone but themselves
- movement toward surplus for America's trade deficit
- sovereign debt concerns roil Europe, the Middle East and perhaps even Japan
- state and municipal debt concerns accelerate, pitting unions and pensioners vs. everyone else
- another leg down in North American real estate prices - especially Canada's largest markets
- growing dissent within the Obama Administration as populist anger disables government's favourable treatment of the FIRE industry ahead of midterm elections
- falling salaries for sports stars and actors/entertainers as discretionary spending wanes on event tickets
- relative bright spots will include South America (specifically Brazil, Chile, Colombia and Peru) and personal wireless devices.
- the US manufacturing industry begins a revitalization

Regardless of what happens, I wish my readers a prosperous 2010!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Must Read Articles 05.10

If you're wondering what all the hubbub is about Greece, Portugal and Spain, I've grouped together a set of articles that explain the situation lucidly. Like most of the world's economic problems, it can be summed up by the simple phrase "there's too much debt." But in Europe, individual governments are restrained from printing money to temporarily relieve the stress. The only other cited cure is for public and union workers to take massive pay cuts in order to regain competitiveness. Socialist-leaning governments in these countries are not treating that like a legitimate option and appear to be losing control. They've now resorted to blaming their problems on "speculators." Euro-skeptics have always said this would eventually prove to be the undoing of the Euro. Right now they're being proven correct in spades.

While most of the focus lies on government debt, please remember that private banks in this region are even more susceptible. Credit default swaps (CDS) on Portuguese banks, for example, are up 30% today. That's no small potatoes. And Europe's banking system is just as systemically intertwined as is America's. If Club Med banks start going down, the big northern banks will likely follow.

The only actual solution to this problem is the only one everybody seems to agree is "not a solution." Debt repudiation.

Spanish Canary in the European Coal Mine (Rolfe Winkler)

If PIIGS Could Fly (Neils Jensen, Absolute Return Partners via Credit Writedowns and John Mauldin)

Should Germany Bail Out Club Med or Leave the euro Altogether? (Ambrose Evans-Pritchard)

Funds Flee Greece As Germany Warns of "Fatal" Eurozone Crisis (Ambrose Evans-Pritchard)

And now for some other issues:

Demand For Loans Weakens Again in Fed Senior Loan Survey (Mish)

It is easy to blame banks for not lending money to people who "need" it. President Obama does it all the time. But the problem is not that banks won't lend, it's that there's nobody willing to borrow that is remotely credit-worthy.

Saving, Asset Price Inflation and Debt Induced Deflation (Michael Hudson, via mannfm11)

Hudson follows a similar train of thought as Steve Keen. Neither are Austrians. They both maintain that Keynes was misinterpreted and combined with destructive "equilibrium based" theories. This is the most compelling of non-Classical Liberal theories I have come across.

On Depreciation, Malinvestment and GDP as a Gross Number (Ed Harrison)

All things I like to talk about. GDP is calculated based on aggregate spending data. Not all of that spending is worthwhile and beneficial. In fact, some of it is downright harmful. Eventually, that must be realized. The process of realization is otherwise known as "recession."


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Update 04.10

Continuation to the downside in equity, commodity and foreign currency markets as the total decline now exceeds the late October selloff in both duration and degree. Market character was very bearish all week, as large cap indices trended down, making a series of lower highs and lower lows. The Nasdaq, Semiconductors, Transports and Small Caps all underperformed the broader market.

The fall has occurred in conjunction with the start of earnings season. So one would be led to believe that earnings have been very poor. They would be wrong. From CNBC:

Of the 220 (~44%) S&P 500 companies who have reported Q4 results, 78% beat estimates, 8% were in-line, and 14% were below estimates.

Even optimistic earnings expectations have been surpassed, yet the market has "sold the news" apparently. Or perhaps it was just going to fall anyway and people have thus ignored earnings and focused on other perceived "catalysts." This has most noticeably been the case in the large-cap tech sector with GOOG, AAPL, QCOM among others beating expectations, but being sold in the aftermarket and experiencing a continuation of that selling in subsequent days. This is the "change in market character" that I have been awaiting for numerous months now.

Two quarters ago, I mentioned that the boost in earnings was, in many cases, merely a reflection of cost cutting, inventory restocking and increased productivity from employers terrified of losing their jobs. I argued that without a recovery in consumer balance sheets, employment, capacity utilization and private fixed investment, the recovery in corporate profits would prove temporary.



The above chart includes preliminary estimates for private fixed investment in Q4. Nothing too spectacular. So I am wondering if analysts are starting to look out a few quarters, knowing that the temporary boosts will have worn off, and seeing that recovering to trend growth is going to be a very difficult task...?

The moment said analysts look away from their mathematical models, which naturally forecast a recovery to trend growth as a given, is the moment they start to rethink the assumptions they have made. And when they do that, present equity valuations simply do not make sense - especially at the point of the business cycle they believe we are in (trough).

Looking at this socionomically (ie. a Prechterian PoV), it all makes a lot of sense. We have people switching from interpreting every piece of information as a positive to now questioning those interpretations, while increasing public anger toward public officials and bankers is growing rapidly. (See the continuous revelations of the AIG-NY Fed-Goldman dealings). At the same time, we are seeing strongly impulsive moves down in the stock market, while corrections are occurring in sharp, overlapping waves, and often peaking in the futures market overnight before selling-off toward the open. If a "P3" move down is going to happen as Elliott Wave Theory seems to strongly suggest, then this is precisely the type of environment one would expect.

Staying on the Elliott Wave theme, I should note that it is not always the best tool to use. I find that if the pattern cannot be immediately identified as obvious, then other TA methods should be used instead. But if I look at a pattern and see the waves immediately, I lend a much larger weight to their validity. Take for example a multi-year chart of the USD Index. The dollar completed a very evident 5 waves up during in '08, followed by a 3 wave decline in '09, and has now turned up quite violently. If a 3rd wave up is what's coming, it should be sharper and longer than the previous up wave. And this is precisely how one would expect it to begin. I've been calling for par with the Euro for a couple of years now. The chart below suggests that is what we'll see.



Let us not forget the carry trade that was a popular idea a few months ago, but seems to be forgotten right now. Those that are losing money on the stock market selloff are in many cases also losing on the currency side. With emerging markets selling off over 10% and the US Dollar higher by 7%, the pain is being felt more than a 6.7% S&P correction would otherwise indicate.

The Volatility index moved sharply higher last week, but sold off without a corresponding recovery in stock prices. This demonstrates complacency among options traders and could require them to panic and cover their bets should the divergence persist much longer.



Lastly, this is a chart of the percentage of stocks above their 200 day moving average. Notice that this is the type of indicator that moves in long waves, oscillating between many above and then many below. Further correction should be forthcoming.



Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Must Read Articles 04.10

Note: I'll hopefully get my final "Themes" piece out this weekend or early next week. Sorry for the delay. I've been inundated.

This week's must read articles

Taibbi assaults criticizing wall street populism meme (Yves, Naked Capitalism)

Indeed, this is getting to me too. Somehow the tables got turned on common sense. Now, anyone who criticizes Wall Street is simply labeled a "populist" thereby inferring a depart from rationality. Not all populism is wrong-headed.

The total debt relative to GDP trumps everything else (Comstock Funds)

Comstock picks up on many of my themes, primarily private sector debt deleveraging. They see a reduction in the amount of private debt from $40 Trillion to 20 or 30. I agree.

The economic case against Bernanke/ (Steve Keen)

Keen dismantles Bernanke's adherence to faulty interpretations of the causes behind the Great Depression. Irving Fisher lost nearly his entire net worth betting against the possibility of depression in the 30s. His reasoning was the same as Bernanke's is now. After some reflection, Fisher concluded that debt does matter, and that its growth led to an unnatural perception of stability. A stability that was later revealed to be a bubble, followed by a bust. Bernanke appears desperate to re-learn Fisher's lesson.

Update on residential investment (Calculated Risk)

Being one of the leading indicators for economic recovery, residential investment is obviously an area to keep an eye on. But even more important is the ramifications for major banks with trillions in mortgage assets on their books (and off). They are hoping for a recovery in home prices to make these bad loans whole again. The data does not support such a scenario. In fact, prices are again falling and subsidy infused activity is now drying up.

The debt monster may threaten governments more than corporations (Econblog Review)

EBR notes that the cost of insuring against default for many of our largest conglomerates has fallen below that of insuring against sovereign default.

With that, I would also note that sovereign CDS spreads for troubled countries in southern Europe are absolutely blowing out. Bond spreads are doing the same. Greece, Portugal and Spain are in the most trouble - in that order. This is a problem that doesn't appear to be going away. I doubt it comes to a head in the near term. They'll likely find a half-measure or two before the inevitable occurs.

Related to that are long-term issues with Japan. See the video below from Kyle Bass.



Ever wonder why there is never agreement on anything when it comes to economics or finance? You'll be happy to know this is nothing new. In fact, the same arguments have been going on for more than a century. I doubt it will ever be resolved, as people have different value structures toward stability, freedom, wants/needs, etc. The video below explains it well and in a very entertaining format. Enjoy!



Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Update 04.10

Whack! Just like that, nearly 3 months of slow, grinding gains were eliminated in three days of trading. The selling intensified into the close on Friday. It seem that every time three days of selling close out a week, analogies to 1987 get thrown around. While I don't expect anything like that to occur anytime soon, this is indeed the type of action one would expect to see if "the big one" still lied ahead. Long periods of perceived stability breed complacency.

And the last few months of trading have certainly given the impression of complacency as most stocks have returned to their cyclical high valuations, despite earnings that remain in the dumps compared to their cyclical high earnings of '07. Many have also taken it for granted that banks are earning their way out of trouble, completely ignoring the multi-trillion dollar portfolios of toxic assets that are temporarily held off-balance sheet. While most have just assumed that FASB will never grow a pair big enough to enforce GAAP, they seem to forget that eventually these distressed debt instruments mature. So unless home prices start rising again soon, these losses will be realized eventually. Unfortunately for them, home prices have begun falling again (as of the most recent Core Logic numbers from November). The overhang of inventory (ie. shadow inventory) has clearly started to matter again.

Isn't it funny how things that seemingly "don't matter" all of a sudden become important? Like sovereign debt problems. Or funding crises at state and municipal pension funds. Or sour commercial real estate loans causing small regional banks to fail at an increasingly rapid rate. Or skyrocketing delinquency rates on credit cards, HELOCs, and FHA/Fannie/Freddie loans. It costs money to maintain these operations. One way or another, resources are being redirected from what they would otherwise be doing toward trying to plug these black holes. And this misallocation of resources is precisely what will keep the economy from recovering - just like Japan but without exports to fall back on.

This week's selloff may not be in reaction to these cumulative imbalances finally exacting influence on the stock market. After all, as I'll show below, internals are in better shape while oscillators are more oversold than during their late October corrections. This could be just another correction. Until markets display a change in character, it would be wrong to assume another leg lower has begun. Then again, after 10 months of gains, markets may have sufficiently done their job to turn even bears cautious.

Now, some charts:

S&P Daily. Selloff only takes this average back to the bottom of its trend channel. Notice how the RSI is lower than at any point since the rally began. Does this signify a buying opportunity? Or is it a signal of the higher intensity of the selloff and thus a change in market character? I suppose it depends on how one looks at it.



Similarly, Crude Oil has been trending in its own channel, but while stocks are a good 15% higher than their June highs, oil has not yet signaled any increasing industrial demand since the summer (when many contend the recession ended). There is a confluence of support between $70-72.50.



And internals. Most remain in stronger positions than at their July and early November cyclical lows. Again, this could be indicative of strength, or could simply mean they have further to fall before finding support.

Advance/Decline Volume Ratio


Advance/Decline Issues Ratio


% of stocks above their 50 day moving average


Put/Call Ratio


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Must Read Articles 03.10

Starting this week, I'll begin posting a brief list of what I consider to be the last 7 days' most important reads. For those that have been utilizing my "Recommended Articles" widget on the right-hand side of the page, you'll notice that I sometimes add notes to the end of articles I find to be particularly noteworthy. As I do read a copious amount of information on a daily basis (my Google Reader account tells me I go through more than 100 blog posts, newspaper articles and reports daily), I try to share only 10% of that in the sidebar. For most people, I can understand even that is excessive and too cumbersome to delve through daily. And to be honest, for most people with a more long-term focus, I don't see how reading more than a few articles per week would be very beneficial.

As such, I'll be pulling out just a few of the "Must Read" articles and posting a quick caption on their importance. I'll try to do this mid-week as it is warranted.

Must Read Articles of the past week:

A Contrarian View of China - Corriente Advisors (hat tip reader Roger)
Corriente gives an in-depth but easy to read presentation on the state of affairs in China. The consensus of China's situation (plenty of savings, solid growth, booming domestic market, etc) is incredibly one sided. And this report tears many of those misconceptions to shreds. As we know, the consensus is rarely right - especially on matters as opaque as China's debt and currency markets. I find their take compelling.

Debt and Deleveraging - McKinsey (ht Rolfe Winkler)
Lengthy and Exhaustive, a team of researchers has compiled a list of more than 40 historical examples of deleveraging across many countries since the Great Depression. As the title suggests, McKinsey believes our excessive debt levels will result in a prolonged period of deleveraging. But they go one step further and attempt to identify precisely which sectors within the various economies are most likely to undergo this process. They argue that among four primary ways to deleverage (austerity, inflation, default, and growth) we are most likely to take the most common among them - which is austerity. I think default is a higher probability than they're willing to admit. Well worth the read - if only for the intro (pp 9-17).

A Measurement of the Economy - Annaly Capital Management
Annaly challenges the wisdom of relying on GDP for an accounting of the nation's health. They prefer to look at "what the nation earns, rather than what it spends." I agree with this, as it cannot be exogenously influenced as easily. With this metric, they look at tax receipts and conclude that a recovery is unlikely until people start producing, and thus earning, more.

To us, a rebound in GDP only reflects a rebound in consumption, and today’s consumption is fueled to a large extent by growth in government spending, incentives and, most significantly, borrowing. A rebound in tax receipts, sans tax increases that stymie economic activity, would reflect growth in our country’s earning power.

Option-ARM Update - Calculated Risk
As the title suggests. A short recap of what's to come for recasting Option ARM mortgages - which in most instances were just as poorly underwritten as subprime mortgages.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Themes For 2010 - 5 - Asset Markets

In the last three installments of this series I have covered the credit markets, the economy and the government's influence on each.

The picture painted is one of a continuing deflation. This deflationary process should not be seen as "armageddon" or a "bottomless spiral" as some like to imply. It is a removal of excessive debt levels that will otherwise hamper the economy's ability to grow based on its typical catalysts: savings, investment, and production.

Governments, working in conjunction with their central banks, have attempted to remedy the adverse symptoms of recession with conventional and unconventional measures. The unconventional measures (massive bailouts, asset swaps, accounting shenanigans) will not and cannot prevent the eventual realizations of losses outstanding on bad loans and their derivatives. This reality will hinder banks' ability to lend at low rates to risky borrowers, thus cutting off one engine of typical recoveries. Conventional measures (low interest rates, fiscal stimulus) serve as a disincentive to save, and thus hinder the economy's desire to spontaneously and creatively adapt to a new environment.

Large investment houses, hedge funds, and analysts are assuming that the recession of 08-09 is a normal inventory retrenchment, rooted in overcapacity. Taken together with the conventional and unconventional measures noted above, they almost unanimously agree that a "V-shaped" recovery will ensue, as they have before. In 2007, they all unanimously agreed that there was no overcapacity, and therefore could be no recession. As they were proven wrong for ignoring the debt side of the equation then, so will they again. This was not a normal recession. It was brought on by a credit contraction for the first time since the Great Depression.

The unanimity of opinion on this matter should not be understated. Nearly every investment/business professional (+/- 90%) has received their education from the same sources that suggest a) credit growth/contraction has no appreciable impact on the business cycle or the structure of production; b) aggregate debt levels are irrelevant because "we owe it to ourselves." They are wrong on both accounts.

The mathematically based assumptions of these professionals not only influence their views on an imminent economic recovery to "equilibrium" or "potential output," but they influence their views on how asset markets in general will respond. Naturally, these mathematical models with all their flawed assumptions paint a very favourable picture for stocks, corporate bonds, commodities and foreign currencies.

Because I operate from a different perspective, focusing on debt and the effects it has on growth patterns, my views on asset markets are also different. I see the present (and pre-bubble) valuations of these assets as being determined on the availability of credit and thus the ability for people to borrow money for speculative purposes. Comparative valuation analysis of the past 30 years (during which credit growth was excessive) with the previous 100 years of data is supportive of this claim. To date, I have found no other explanation for these discrepancies.

The value of any asset is primarily owed to its ability to generate cashflow. The value of an apartment building is the amount of rents it can generate over the projected life of the building minus property taxes, maintenance costs, and depreciation. But over the past few decades a premium has been applied to this. Because interest rates have been held below the rate of credit growth, asset prices can reasonably be expected to increase. It is a simple calculation for speculators: if outstanding credit is expanding at 8% per year, then the price of an asset should rise to reflect the total amount of credit available to purchase it. But if interest rates are at only 5%, then owning the asset yields a greater return than a savings account.

Neoclassical economists assume that people make decisions based on aggregate levels of inflation (like the CPI). They use that assumption to fix the cost of money (interest rates). Again, they are wrong. People make decisions based on real-life scenarios like that described above, not nebulous, aggregate statistics. The result is that a massive premium has been applied to the value of all assets based on future implied rates of credit growth. That credit growth has hit a wall and is now contracting - as illustrated in Part 2 of this series. In 2008 and early 2009, asset prices successfully eliminated that future implied rate of credit growth from their valuation. But the efforts of governments and central banks have reapplied it by promising to fight credit contraction with all means necessary. Those efforts are failing. It is my contention that markets will eventually realize that credit expansion is not coming back anytime soon and asset prices will again need to readjust to more conventional valuation metrics.

Equities

To avoid being sensationalist, I will use the most conservative valuation metric available. The Shiller 10-year real P/E. It takes the last decade of operating earnings, and adjusts for inflation (CPI). Keep in mind that over the last decade, companies booked profits on many sorts of malinvestment like originating bad loans. That all gets counted under "normal operating revenues." But when the loans get written down, they are "one time charges" and therefore don't get counted.



Even using this valuation metric, it is apparent that stocks are at least 25% overvalued from their historical mean. If the economy is indeed in the early stages of a new business cycle as most suggest, then this overvaluation is unprecedented for that position. Valuations have always been much lower for the first few years of an economic expansion. The forward expectations for corporate profits to justify present valuations are out-of-this-world optimistic. David Rosenberg of Gluskin Sheff comments:

We should add here that on a Shiller real 10-year “normalized” earnings basis, the S&P 500 is now trading at 20x, which is 25% above the historical average of 16x. This is the same level of overvaluation heading into October 1987, though at the bubble peak in October 2007, the overvaluation gap was 70%. At the average of prior market peaks, the extent of the overvaluation is 50%. We are not saying that equities as an asset class is in a bubble but they certainly have moved to an overvalued extreme.

Moreover, as we have pointed out recently, what is “normal” is that every percentage point of nominal GDP growth translates into 2.5 percentage points of profits growth. Most economic forecasters see nominal GDP growth at 4% for this year. But strategists see, on average, 36% profit growth. But that 4% growth in nominal GDP is only enough to boost profits by 10%, if the normal relationship holds up. To see such low nominal growth and such strong profit growth is a 1-in-50 event. Maybe the economist and strategist at the Wall Street research houses should sit down with each other.

Analysts are expecting $75+ in earnings for 2010. Based on those estimates, and today's current S&P 500 level of 1148, stocks are trading at a P/E of 15.3. That is considered "fair value." Unfortunately, analysts are a fairly rosy-eyed lot. Even last year they expected to see around $77 in earnings. All they got, even with phantom profits at big banks from accounting breaks, was mid-50s. Again, the rate of profit growth needed to achieve this feat is unprecedented. Readers are free to take those projections at face value. But given the track record of these analysts, one would be wise not to.

So my view is that equity markets will correct to valuation levels commensurate with a trough in economic growth. This is heavily dependent on the credit markets, which are the basis for these present overvaluations. If credit continues to contract, then the inflated earnings from previous credit expansions will prove even more elusive. I project trough "operating" earnings (in a period of contracting credit) somewhere between $38-48. If trough valuation levels are applied to this (6 or 7 in the chart above, but we'll use 10 to be conservative), one can expect the S&P to bottom somewhere between 400-500. How soon that occurs depends largely on the rate of credit contraction, and the amount of time it takes to deleverage the economy sufficiently so that growth can take root from more sustainable levels.

I fully expect that certain sectors of equities and perhaps even certain markets (like South America) have very likely already put in major bottoms. But all assets worldwide are credit sensitive, so a prolonged contraction could still have very noticeable effects on even those areas that are recovering.

Real Estate

Perhaps more than any other asset, residential and commercial real estate is dominated by credit availability. For centuries it has been a common rule of thumb that homebuyers are able to afford 3x their household incomes for the purchase of their primary residence. Banks would almost never lend more than this. But this all changed in the 80's. As quantitative finance and exotic mortgages became normal practice, justifications were found to lend up to 10x one's income for the purchase of a home.

As mentioned above, an asset's value is its ability to generate cashflow. This means rent for real estate. And at present valuations, most areas are still selling at 20x yearly rents or higher. Like stocks, average valuations for real estate are around 12-15 depending on the type and location of the property. We will likely return or sink below those levels prior to a bottom in real estate prices. For bubble areas like Vancouver, this means drastic price reductions or drastic rent increases. Because people can't borrow to pay rent, rents are determined solely by wages. Thus, the only way for this imbalance to be rectified is by either enormous wage increases or price declines. I'll let you figure out which is most likely.

One way or another, we will return to tried, tested and true mortgage practices. This means 3x average household incomes correlates with the average home price. It means mortgages are not issued without a 20% down payment. It means loans are only made if total debt servicing (including credit card, car loans, etc) accounts for less than 40% of one's income. And it means that owners of buildings buy them for their rental revenues - not price appreciation differential over the cost of borrowing.

Most would consider my projections to be apocalyptic. They are merely reversions to long-term historical means. If asset prices were at such levels for hundreds of years before, I can assure you that were they to go back to said levels the sky will not fall, the seas will not boil. And no, the earth will not be covered in eternal darkness (although for investment bankers, living hell may be an appropriate analogy).

Commodities

I am of the view that commodity prices are impacted by speculative credit flows. I also believe that a fair bit of "hoarding" has occurred in some markets, which has elevated commodity prices past levels that would likely prevail otherwise (read: China).

So to be consistent, I do expect commodity prices in aggregate to decline over the coming years. This decline should take prices back below their March lows. The recovery in the CRB just looks choppy and corrective.



Within the commodity complex, I continue to believe that gold and agricultural commodities will hold up best. But they will be far from immune should credit contract the way I believe it will. Should gold rise past $1160, I see a non-trivial possibility of a blowoff leg higher toward $1800. As of now, I am expecting lower prices over the next year.

Bonds

Corporate bonds are in the same boat as equities in my opinion. Excluding a couple dozen high-quality borrowers, most corporate issues are risk assets - largely dependent not on ability to repay principal, but on the ability to refinance at maturity.

Government bonds, on the other hand, are a different story. I can understand cases for both extremes on long term interest rates. Should sovereign concerns spread in Europe and elsewhere, risk premiums could begin to be priced in to US, UK and Japanese debt. But I also see the possibility of another "flight to quality" like we saw in 2008. I have no edge on this scenario, so the best I can offer is to stay away from long-term bonds and instead stick to shorter maturities.

Conclusion

Credit contraction and asset price deflation are two peas in the same pod. As I believe credit contraction is unavoidable over the long-term, I also see lower asset prices ruling the roost. In many cases, a return to historical valuation levels would imply drastic reductions in prices. This should be viewed in a positive light. Lower asset prices enable lower wages, which restore competitiveness and lays the foundation for a robust economic recovery. Whether this happens in 2010 is to be determined. But I feel that the probabilities are strongly in favour of such a scenario.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Market Update 03.10

A late week selloff resulted in negative performances across most major indices. Particularly interesting is the recent underperformance of prior star sectors. The Nasdaq failed to make new highs on Thursday and was the worst performing major index on the week. The large contributor to this phenomenon was the sharp selloff in the semiconductor sector. After reporting earnings aftermarket on Thursday that the media characterized as "crushing estimates," Intel stock immediately skyrocketed higher (5%) in the aftermarket. But it quickly ran out of gas. It closed the afterhours session back where it began, opened Friday morning lower, and continued to fall all day, closing down more than 3% on its highest volume of the past two years. Textbook exhaustion reversal on good news.

Intel has been one of the darlings of the technical recovery, nearly doubling since its bottom in March. Its earnings have kicked off "better than expected" earnings seasons in most quarters, setting the bar for everyone else. They have reported strong sales to nearly all groups - business, consumer and emerging markets - suggesting that technological investment may be higher than aggregate numbers suggest. As I wrote in my Themes for 2010, Part 3 article on the economy, I challenged the consensus that a recovery was going to be led by the consumer/credit growth and suggested instead that it would eventually come from investment. Thus, Intel (along with IBM, QCOM, CAT, and other makers of productive capital) are my bellweathers for a legitimate recovery.

See below a comparison of the Semiconductors Index vs. the Dow Industrials.





Readers should also notice that two other important earnings releases (Alcoa and JP Morgan) also disappointed last week. Keep in mind that the year-over-year comparisons this quarter are totally wacky. Q4 of '08 was writedown central for most companies. So the actual performance will be more interpretive than usual, and thus more liable to the sway of human emotions. I suggest readers take the time this week to listen to some conference calls and try to glean some info based on tone and CFO confidence.

That's all for now.


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Themes For 2010 - 4 - The Government

I'm loathe to add this section to a series of articles typically directed to investors and speculators. But it is undeniable that the government and central bank actions of the past few years have had large impacts on everyone's portfolio. To a certain extent, I support the idea that over the long-term, market intervention proves irrelevant. No force is larger than the market. So even though various interventions appear to have great short-term impacts on our investments, I don't think it is instructive to look at what the government "wants" to achieve over a 5 or 10 year period and structure a portfolio thereupon.

The government/central bank duo are herd followers by definition. Bureaucracies are inherently incapable of acting proactively. They are reactive. It is for this reason that centrally planned economies always fail. You may call the market interventions of the past few years (not forgetting those over decades prior that caused the crisis) whatever you like: socialism, corporatism, crony capitalism, kleptocracy. Whatever. The term used is not important (nor are many of the terms particularly useful after decades of redefinition). What is important is the immediate objective of nearly every intervention: Price Fixing

"I don't think it's a bad thing that the bad loans occurred. It was an effort to keep prices from falling too fast. That's a policy."

-- Chair of the House Financial Services Committee Barney Frank - Oct 9, 2009

Just to nip any allegations of conspiracy in the bud, the quote above illustrates the explicit nature of these price fixing objectives. Both monetarist and keynesian (aka. neoclassical) economists are literally terrified of falling prices. Therefore, they target positive rates of inflation on a year-to-year basis. Many classical economists suggest that it is precisely this price fixing that led to most of the excesses and imbalances precipitating the crisis in 2008. If prices were mandated to rise, why not borrow money to speculate on rising prices? That is the train of logic that I subscribe to, but I won't delve further into that debate, as considerable ink could be spilled.

Thankfully, for those of us who prefer to see markets discover prices on their own, we can take solace in the fact that never in the history of price fixing has it ever achieved its objective. Not once. The reason this is so, is that in order to keep prices either above or below the level they can be sustained by incomes and revenues, a greater and greater amount of capital is required to be directed toward this goal. Eventually the cost or the political implications of doing so exceed the implied cost of allowing the market price to prevail. The price fixing scheme collapses and prices revert toward equilibrium (toward - but they never arrive). The same holds true for monopolies.

In the meantime, however, prices can be influenced by these measures. Because it is widely acknowledged that it is real estate prices that led to the deterioration of bank balance sheets, and it is a collapse of the major financial institutions that politicians and central bankers are trying to prevent, most of the price fixing schemes are directed toward supporting home prices. Let's discuss some of the schemes being employed.

Asset purchases - both the Fed and Treasury have involved themselves in the buying of trillions in mortgage backed securities. This has obscured the rate of interest (to the downside) making homeownership more affordable.

FHA balance sheet swelling - When it became apparent that Fannie Mae and Freddie Mac were essentially toxic waste dumps for bad mortgages and were put into gov't receivership, a new source of funds "needed" to be found - lest demand for mortgage securities fall and interest rates rise. Enter: The Federal Housing Administration. Their balance sheet skyrocketed and they became the buyer of a vast majority of MBS that were previously bought by Fannie and Freddie. Because Fannie and Freddie worked out so poorly, the obvious course of action was to do the same thing again - only this time, making the taxpayer the explicit buyer.

Foreclosure moratoria - numerous state governments and financial institutions have declared moratoria on foreclosures. By not allowing these foreclosures, people who are no longer paying their mortgages are being allowed to stay in their homes at no cost. The "logic" behind this is that foreclosures result in bank auctions which decimate property values, thus affecting bank balance sheets.

Modifications - numerous attempts to modify the existing delinquent or risky mortgages have all failed. They are trying to extend the mortgages even longer in duration, lower rates for the first few years, etc. Basically, they're trying to turn prime mortgages that never should have been issued into subprime or Option-ARM mortgages. Anything to avoid forgiving principal outstanding - because that requires balance sheet writedowns for the banks. Typically (and unsurprisingly), these modifications end up re-defaulting in ridiculous numbers (40-70%) after only 6 months or a year. But the purpose they do serve is to kick the can down the road. And they've been doing enough kicking to put any Detroit Lions punter to shame. Their hope is obviously that home prices will start rising again, bringing these homeowners back above water. They're dreaming.

Accounting shenanigans - Perhaps the most egregious example of market intervention has been the suspension of Generally Accepted Accounting Principles (GAAP). Admittedly, this is the one intervention I never expected in 2009. I should have known better. What has typically separated America from the rest of the world is accounting and balance sheet transparency. They threw all that away in 2009 when the US Treasury strongarmed the FASB (Federal Accounting Standards Board) to suspend FASB 157 (mark-to-market accounting). This allowed banks to value their assets at whatever price they wanted. Originally, this was going to be until yearend. Then it was extended. Had it still been in effect, as much as $5 trillion in "off balance sheet" assets would need to be revalued at their true prices. This would have made the big banks insolvent (again). This also facilitated greater market liquidity, better capital ratios, lower leverage ratios and therefore lower interest rates.

The above programs (and, to be sure, there are others) have only worked to a small extent. As of October, home prices have risen only modestly from their bottom. In year-over-year terms, they are still down approximately 6-7%. The stunning price declines of early 2008 were largely abated by the above programs. Indeed, the low interest rates encouraged many to buy their first home, move-up, or to change locations. Investors have also stepped in. I know of a number of folks here in Vancouver that have picked up vacation homes in Arizona and California. See below a number of different home price indices through October numbers.



Not exactly breathtaking, considering the many trillions of dollars that have poured into supporting prices. Surely, much of this will prove to be malinvestment, throwing good money after bad, averaging a losing trade, or whatever you want to call it.

So what of the future? If prices start falling, can't they just increase the size of the programs? Well, no. They can't.

The available pool of would-be buyers has largely already been exhausted. If someone hasn't accepted a near zero interest rate on a distressed property already, they're not likely to do so anytime soon. Additionally, the modification/moratorium games can only go on so long. After the banks offer remods, delay for months on paperwork and start to see 8 or 12 months of arrears build up, they will realize that not a penny more will be squeezed out of the mortgage. Foreclosure then becomes their best option.

But the real factor here is social mood. Populist anger toward the big banks is growing rapidly. It seems that every day we learn of one or more nefarious activities that went on between government, the Fed and the big banks. Backroom deals, non-disclosure agreements, acting with insider information, conflicts of interest, political favouritism, silencing dissidents, etc. Myself and a number of other bloggers were screaming from proverbial mountaintops that all of this was illegal and fraudulent. Nobody seemed to care at the time. They were scared. They had bought into the argument that "it had to be done... for the greater good."

But now, with the benefit of hindsight, the average person is starting to see what really occurred during those frantic days: a massive transfer of wealth from taxpayers to the financial industry. Yet the promised benefits - the unemployed getting their jobs back, investors getting their money back, etc - have not happened. In fact, as I pointed out in Part 3 of this series, the employment market continues to deteriorate. And now, gosh golly, the same financial firms are making money hand over fist and paying out bonuses like nothing happened! Taxpayers were duped. And they're pissed. President Obama's approval rating has plummeted faster than any president in the last 50 years. He makes speeches about "getting the money back from the banks" and literally nobody believes him.

An anecdote to illustrate the above: On occasion I post short rants on the CBC.ca comments forum below their articles. They have a feature that allows one to vote thumbs up or down on the comment. Usually I just post to get a feel for "the common man's" opinion. Being a libertarian in Canada doesn't often put me in good books of many, as Obama is likened to the second coming up here. But I posted in reaction to the recent plans for the Obama Administration to recover the TARP funds. I was harshly critical. I asked, "why such a focus on $800 billion, while the other $22.8 trillion in guarantees/swaps never gets mentioned?" My comment was met with unanimous approval. 88-0 last I checked. People aren't falling for this charade any more. And the Democrats are going to learn very quickly that if they don't start clamping down on the big banks, voters will clamp down on them next fall (yes, elections are only 10 months away).

The feasibility of introducing any more bailouts under these circumstances is nil. There will be violent rebellion before that happens again. Not only that, but the Obama Administration will face growing pressure to reverse as many of the bailouts as possible. They won't. At least not a significant amount. But the trend of social mood has sufficiently handicapped government's interventionist abilities. Likewise, it seems that a large portion of Americans have woken up to at least some of the Fed's activities. I see it likely that the Obama Administration will be held accountable for their actions as well.

Conclusion

A vast majority of the $23.6 Trillion in bailouts, swaps and guarantees has been directed toward supporting home prices. For the most part, they have failed. The natural course is quite obviously for home prices to continue declining toward levels commensurate with incomes and revenue generation ability. The expiration of many temporary "kick the can down the road" schemes, along with a flood of Option-ARM and Alt-A recasts, will significantly hamper bank balance sheets and eventually force further credit writedowns. Populist anger toward big bank favouritism will also limit the government and the Fed's ability to enact further legislation favourable to banks.





Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Themes For 2010 - 3 - The Economy

For last week's discussion of the credit markets click here. In it we discussed the state of the existing credit base as well as the supply/demand equation for new credit and refinancings. In both cases, we found that credit was contracting significantly - even while government encouragement of accounting shenanigans has been allowing financial institutions to value their assets at [essentially] whatever they want.

Today, we turn our attention to how this above state of affairs is going affect the US and Global economy as a whole.

To calculate the GDP of a nation, most feel a fairly simple equation can be made: GDP = C + I + G + (E -M). Private Consumption, Gross Investment, Government Spending and Exports less Imports.

I'm not a particular fan of this metric. First, because essentially any activity, no matter how wasteful, counts as a net positive toward "economic activity." As a result, we are encouraged by government to undertake all sorts of wastefulness in order to keep up the appearance of prosperity. Second, economic activity which has been financed by debt counts just as much as does that financed by savings. All sorts of malinvestments result from crazy debt ponzi schemes. Should this really be considered "growth"? Third, GDP is too aggregative for my liking. It does not tell me enough about which part of the structure of production economic activity is being directed toward. Is money being spent on raw materials for the use of a factory owner who wants higher quality/more durable products? Or is it being spent by the military for the construction of bombs? The use of each have directly opposite impacts on our overall wealth, once the materials are used. GDP does not distinguish.

Return on our investments and the overall wealth of our society is what most readers here are concerned with, not some nebulous GDP number. So for our purposes, we will try to delve deeper into the various components of GDP for clues as to whether our overall prosperity will be on the rise, or will contract further.

It should also be noted that there is a wide theoretical disagreement on the cause of the current recession. Most of economic orthodoxy believes that an economy is always at equilibrium. There is no such thing as "growing imbalances" to worry about. This way, they can turn the entire economy into a mathematical model and determine the correct inputs and functions to predict the future. When the crisis erupted in 2008, plunging asset prices completely discredited this mathematical approach to economics. But the neoclassical economists have useful little terms like "rogue waves" and "tail risk" to explain crises. According to them, this completely random wave is what hit the economy in 2008. Nobody could have predicted it. It also necessarily follows that because this was just some irrational exogenous shock, now that it is over we should experience a rebound back to "trend growth"

While this is the orthodoxy subscribed to by many, there are literally thousands of economists who think it is total lunacy. Many of these economists instead choose to pay attention to debt levels and their effects on the economy, or the endogenous nature of recurrent financial crises in all economies. They focus on demographics, international trade and changing social preferences. The predictive record of these economists has been orders of magnitude better than the neoclassical economists and their mathematical models. Other than cognitive dissonance, it behooves me why one would continue to ignore the former in favour of the latter.

Before I bore you to tears, let me get started.

The Consumer

It is no secret that the consumer's large impact on the direction of the economy has, in part, been influenced by the easy availability of credit as well as a social incentive to go into debt for the purchase of material goods. Last week, we saw consumer credit numbers for November. Total credit outstanding continues to contract at increasing rates. It should be clear that this is a secular trend, after hardly dropping much below zero in the postwar period. Consumer attitudes toward debt have clearly changed. And we should be careful to assume that discretionary consumer spending will lead the economy out of recession as it typically has. This is not a typical recession, where producers overproduce, causing supply gluts, affecting employment, prices, etc. The cause is credit based. Too much of it. So while the cause was different than most recessions, the cure will also be different. Below is a chart of consumer credit outstanding. It contracted a further $17.5 billion in November - a new record rate of decline.



Of course, not all of America's consumption growth has been based on credit growth. Much of it has been based on genuine income growth. But that income growth has been falling of late as well. See below, the decreasing income and sales taxes collected.



Both real incomes and consumer credit have been deflating. This bodes ill for future consumption. Most would consider this a bad thing. But, as we can see in the chart below, the US (and much of the West) have been consuming more than they produce for a long time. So long, that we have gotten used to it. Over time, consumption must equal production. And it appears that truism is finally playing out.



(chart from Jake at EconomPic Data)

He explains,

The difference between GDP (what the U.S. produces) and Gross Domestic Purchases (what the U.S. purchases) is net exports. Thus, the charting is easy, but the result of the chart is rather astounding. The net level of purchases over production peaked at more than $2500 per person (that is literally $2500+ in a single year for every man, woman, and child within the U.S.) in September '06. This has "collapsed" to "only" $1150 a head, but that $1350 less that each person in the U.S. has been able to purchase (without producing) is a real decline.

So where does that leave us? It leaves us with entire generations (starting with the baby boomers) that believe it is the norm to purchase more than one produces

Instead of lamenting this, I suggest we embrace it. As we do so, jobs will be lost in service industries and gained in manufacturing. This is a transition that could occur fairly quickly if wages were permitted to become more flexible. Americans have lost a large portion of their competitive advantage. As such, they must be willing to accept lower wages. Over time, this competitive advantage may be regained and wages will rise with it.

Employment

The breathtaking rates of job losses we saw throughout 2008 largely abated in the spring of '09. But contrary to the spin, the employment market has not been improving. It simply stopped getting progressively worse. (ie. the second derivative was improving while the overall picture was still deteriorating).

Last Friday, we received the nonfarm payroll data for December. The headline establishment survey number showed an additional 85,000 job losses. But the more revealing number comes from the household survey. There, we learn that 843,000 stopped looking for work and fell out of the workforce. That makes for a yearly total of 3.5 Million that decided to stop looking for work. Some of these are discouraged; some are back in school; others might be boomers retiring. But a large majority of them will be back looking for work as soon as there is demand for their services and this will keep a lid on wages for many years to come. Add that to a gradually growing population and we are painted a very bleak picture.



Companies may have stopped firing workers en masse, but they are nowhere near ready to begin hiring.



This structurally high level of unemployment does not portend well for the "V-shaped recovery" thesis.

The silver lining in this may be that as hours worked and labour costs have been falling, output has fallen less. This means that productivity has been increasing. People are having to work harder in order to keep their jobs. Businesses have likely also tried to eliminate wasteful spending. This is always a good thing.



Investment

We become wealthier by learning how to produce more with fewer resources. We also "accumulate" capital goods that are able to produce more of what we want. As people die, others inherit these capital goods and knowledge at no cost to themselves. As a result, every subsequent generation is wealthier than the previous. The only way to reverse this trend is by destroying capital goods. This is typically achieved through war, but can also occur by not sustaining equipment and allowing it to fall into disrepair.

In much of the postwar period until the early 80's, nonresidential investment was a leading indicator for the economy. But then consumers began to leverage themselves and consumption growth was the main driver for the economy out of recessions. I believe that we will be experiencing a return to the previous order, as consumer credit remains constrained for the first time in decades and the trade balance comes back into line.



Unfortunately, investment has been taking the brunt of corporate retrenching. But as wages remain low, and productivity rises, large investment projects may become more feasible in coming years. This may not be the key to a recovering GDP, but it is a key to an improving economy. Investment has a positive multiplier effect on future rates of growth. Debt fueled consumption and government spending typically have a negative multiplier effect.

Conclusion

We are most likely (as of June '09) in the midst of a technical recovery as defined by GDP. But this masks the rot underneath the surface. Consumer credit and income growth are contracting. As such, personal consumption expenditures will likely remain depressed for some time. Short term gimmicks like "cash for clunkers" and homebuyer tax credits may provide incentives for consumers to delay their deleveraging, but the cost of the programs add to the overall debt burden, which needs to be paid with interest. High debt servicing burdens hinder our ability to invest. In the long run, these programs are detrimental to GDP - even though they may provide relief in the near term.

Structurally high unemployment will likely persist, as those who have recently fallen out of the workforce will join it again upon improving job market fundamentals. This will serve as a drag to economic robustness, but should keep wage pressures low for a considerable amount of time. Declining wages will increase productivity and likely bring about a revival in the US goods-producing industries that have shed jobs for 3 decades.

The picture I have painted above is very deflationary. Combined with contracting credit markets, valuations of financial assets should decline to reflect their weak earnings potential. I will discuss the implications of a rebalancing economy and contracting credit on asset markets later this week.



Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.