The economic commentary article below authored by Peter Schiff perfectly summarizes why we are far from recovery.
While all the talk at present is about economic corners turned and markets charging ahead, no one is paying much notice to an American economy deteriorating before our eyes. These myopic commentators seem to be simply moving past the now almost-universally held conclusion that before the crash of 2008, our economy was on an unsustainable course. If these imbalances had been corrected, then perhaps I too would be joining in the euphoria. But evidence abounds that we have not veered at all from that dangerous path.
Last week, the Bureau of Economic Analysis reported that consumer spending as a percentage of U.S. GDP has risen to 71%, a post-World War II record. This level is notably higher than other wealthy industrialized countries, and vastly higher than the levels sustained by China and other emerging economies. At the same time, our industrial output is contracting, our trade deficit is expanding once again (after contracting earlier in the year), and our savings rate is plummeting (after an early year surge).
The data confirms that government stimuli are worsening the structural imbalances underlying our economy. The recent ‘rebound’ in GDP is not resulting from increased economic output, but merely from the fact that we are borrowing more than ever. That is precisely how we got ourselves into this mess. An economy cannot grow indefinitely by borrowing more than it produces. Not only is such a course untenable, but the added debt ensures a deeper recession when the bills come due.
This soon-to-be-called depression will not end until the pendulum of consumer spending habits swings violently in the other direction. This will be a jarring change, but it is the splash of cold water that we need to return our economy to viability. I believe that consumer spending as a share of GDP will need to temporarily contract to roughly 50% of GDP, before eventually moving toward its historic mean of 65%. Such a move would indicate a restoration of our personal savings, a decline in borrowing and trade deficits, and an increased industrial output. That would be a real recovery.
In the meantime, the higher the spending percentage climbs, the more painful the ultimate decline becomes.
Consumers and governments must spend less so their savings can be made available to businesses for capital investments. Businesses, in turn, will produce more products and employ more people – increasing domestic prosperity. However, rather than allowing a painful cure to return our economy to health, the government prefers to numb the voting public with a toxic saline-drip of deficit spending and cheap money.
The primary factor that enables our government to peddle economic snake oil is the dollar’s unique role as the world’s reserve currency, and our creditors’ willingness to preserve its status. By buying up dollars and loaning them back to us through Treasury debt, productive countries give American politicians carte blanche to play Santa Claus.
Ironically, as foreign governments finance our spending spree, they are simultaneously scolding us for our low savings rate. At the recent G20 meeting in Pittsburgh, all agreed – including President Obama – that resolving the global economic imbalances was a top priority. By definition, this would require Americans to spend less and save more. However, with foreign central banks continuing to buy our debt, the President has shown no political will to encourage this change.
Normally, if politicians run up the government deficit, voters soon suffer the unpleasant consequences of higher inflation and rising interest rates. Yet, if foreign central banks keep supplying the funds, these consequences are indefinitely postponed. As a result, there is no need for American politicians to ever make the tough choices required to solve our problems.
Instead, the burden may fall squarely on the citizens of those governments doing all the lending. The conflict is that within the creditor states, a vocal minority actually benefits from this subsidy (owners of Chinese exporters, for example) while the overwhelming majority fails to make the connection. Thus, foreign politicians have the same incentives as ours to keep playing the game.
The bottom line is that foreign governments can lecture us all they want about the need for prudence but if they keep lending, we’ll keep spending. Any parent knows that if you give your child a curfew yet never impose any penalties when it’s violated, it will not be respected. My gut feeling is that foreign governments are tiring of our conduct and on the verge of finally imposing some discipline. That means the dollar’s days as the world’s reserve currency are numbered, and the days of American austerity are about to begin.
Thursday, October 22, 2009
Thursday, October 1, 2009
The Eye of the Hurricane
Putting today's pullback aside, equity markets have continued their tear over the past several months with the S&P sitting comfortably above 1,000. The dollar index has fallen another 2% since my June post, providing additional support for equities. Although the rally extended further than I originally anticipated, as I was early calling for investors to short cyclical stocks, my original premise remains intact. The fundamentals have only gotten worse over the past quarter, and it's only a matter of time before equities begin to price in the actual economic state, not projected recoveries or wishful thinking. Below are the main drivers underlying the recent stock market run-up as I see them:
Government Capital Market Manipulation
The mainstream media has the general public convinced that equities are simply reflecting the improved economic state and inevitable rebound that is destined to take place over the next several quarters. The reality, however, is a little more sinister. Market observers agree that trading volume has been anemic over the past six months, so the rally is not as broad based as they would lead you to believe. Low volume makes the conditions ripe for government manipulation of the market. This is accomplished through open purchases of futures contracts in the open market with the assistance of large investment banks.
The chart below perfectly illustrates my point. This represents an S&P e-minis futures daily one minute chart for Friday, May 29. It was a sleepy Friday with no news released and very low trading volume throughout the day as depicted by the volume bars below the main line graph. In the last few minutes of trading, enormous buy orders hit the market with over 200,000 contracts purchased right before the market close. This volume spike immediately pushed the S&P up roughly 10 points for no valid reason. I am not a conspiracy theorist by nature, and I'm well aware of the program trading that often takes place near the end of the trading day, but this pattern has continuously repeated itself over the past several months. Downside volatility has disappeared while the major indices often closed right at the highs of the day. Even during the market meltdown in late 2008 and early 2009, equities experienced vicious upside volatility through short covering and government bailouts.
With a large percentage of Americans having seen their 401Ks decimated, I am not at all surprised to see the government try to restore confidence in the economy. It is also no accident that consumer confidence has risen with the stock market, but this correlation will prove short lived as unemployment continues to soar.
Massive Government Stimulus Programs
I underestimated the short term impact that the coordinated response of governments around the world would have on equities and economic activity. I am a strong advocate of free market capitalism and tend to analyze such programs from a longer term perspective. Long-term, debt based government spending adds no value and only serves to increase the national deficit. Although in the near term, such policies act as stimulant, akin to an addict getting his fix. The euphoria will wear off leading to a more violent crash once participants realize that despite the government's best efforts, the long term contraction has only been slowed.
The cash for clunkers program is a perfect paradigm for our current economic state. Some analysts have gone as far to suggest that the four year decline in auto sales may have reached a turning point with the success of the program. The government of course allocated billions it doesn't have to fund the program, representing yet another example of taking from the taxpayer (or borrowing from the Chinese in this instance) to artificially create an increase in auto sales. Even with the deep cuts made by the auto manufacturers over the past several years, the sad truth is that there are still too many dealers and too much excess capacity still remaining in the system. As a result, auto sales showed a nice bump over the past several months, but this only shifted future sales to the present.
I've had many people come up to me over the past several weeks pointing to the stock market's recent performance as an indication that the worst has past and we are on the road to recovery. They also point to the housing uptick and question my long term bearish stance on the economy. I have two words for these individuals.....just wait! The FHA is providing mortgage loans with as little as 3.5% equity that has resulted in 50:1 leverage on their books. Although this is better than the 100:1 leverage sported by the Fannie Mae and Freddie Mac, the risk has only been shifted from the private sector to the tax payer.
A brief note on my investment strategy. I do not buy or sell individual stocks but instead sell deep out of the money naked call options on stocks, commodities and broad-based equity ETFs. Through time decay on these options and proper risk management, I have not had one losing trade in 2009. However, it has taken me longer to realize my profits as a result of the market run-up. The early cyclical names that I highlighted in my prior post represent excellent shorting opportunities if you have the patience and the wherewithal to profit from the coming collapse in consumer spending. Consistent with my prior posts, I fully expect the S&P to drop below 500 by the end of 2010 with the only risk to my forecast being a weak dollar that artificially inflates equities.
Ask yourself these two questions: If the equity rally was for real, why is gold trading over $1,000/oz? Second, how in the world is cheap credit and increased personal spending going to lead us out of this "recession" when these were the primary drivers leading to the excesses in the first place?
Government Capital Market Manipulation
The mainstream media has the general public convinced that equities are simply reflecting the improved economic state and inevitable rebound that is destined to take place over the next several quarters. The reality, however, is a little more sinister. Market observers agree that trading volume has been anemic over the past six months, so the rally is not as broad based as they would lead you to believe. Low volume makes the conditions ripe for government manipulation of the market. This is accomplished through open purchases of futures contracts in the open market with the assistance of large investment banks.
The chart below perfectly illustrates my point. This represents an S&P e-minis futures daily one minute chart for Friday, May 29. It was a sleepy Friday with no news released and very low trading volume throughout the day as depicted by the volume bars below the main line graph. In the last few minutes of trading, enormous buy orders hit the market with over 200,000 contracts purchased right before the market close. This volume spike immediately pushed the S&P up roughly 10 points for no valid reason. I am not a conspiracy theorist by nature, and I'm well aware of the program trading that often takes place near the end of the trading day, but this pattern has continuously repeated itself over the past several months. Downside volatility has disappeared while the major indices often closed right at the highs of the day. Even during the market meltdown in late 2008 and early 2009, equities experienced vicious upside volatility through short covering and government bailouts.
With a large percentage of Americans having seen their 401Ks decimated, I am not at all surprised to see the government try to restore confidence in the economy. It is also no accident that consumer confidence has risen with the stock market, but this correlation will prove short lived as unemployment continues to soar.
Massive Government Stimulus Programs
I underestimated the short term impact that the coordinated response of governments around the world would have on equities and economic activity. I am a strong advocate of free market capitalism and tend to analyze such programs from a longer term perspective. Long-term, debt based government spending adds no value and only serves to increase the national deficit. Although in the near term, such policies act as stimulant, akin to an addict getting his fix. The euphoria will wear off leading to a more violent crash once participants realize that despite the government's best efforts, the long term contraction has only been slowed.
The cash for clunkers program is a perfect paradigm for our current economic state. Some analysts have gone as far to suggest that the four year decline in auto sales may have reached a turning point with the success of the program. The government of course allocated billions it doesn't have to fund the program, representing yet another example of taking from the taxpayer (or borrowing from the Chinese in this instance) to artificially create an increase in auto sales. Even with the deep cuts made by the auto manufacturers over the past several years, the sad truth is that there are still too many dealers and too much excess capacity still remaining in the system. As a result, auto sales showed a nice bump over the past several months, but this only shifted future sales to the present.
I've had many people come up to me over the past several weeks pointing to the stock market's recent performance as an indication that the worst has past and we are on the road to recovery. They also point to the housing uptick and question my long term bearish stance on the economy. I have two words for these individuals.....just wait! The FHA is providing mortgage loans with as little as 3.5% equity that has resulted in 50:1 leverage on their books. Although this is better than the 100:1 leverage sported by the Fannie Mae and Freddie Mac, the risk has only been shifted from the private sector to the tax payer.
A brief note on my investment strategy. I do not buy or sell individual stocks but instead sell deep out of the money naked call options on stocks, commodities and broad-based equity ETFs. Through time decay on these options and proper risk management, I have not had one losing trade in 2009. However, it has taken me longer to realize my profits as a result of the market run-up. The early cyclical names that I highlighted in my prior post represent excellent shorting opportunities if you have the patience and the wherewithal to profit from the coming collapse in consumer spending. Consistent with my prior posts, I fully expect the S&P to drop below 500 by the end of 2010 with the only risk to my forecast being a weak dollar that artificially inflates equities.
Ask yourself these two questions: If the equity rally was for real, why is gold trading over $1,000/oz? Second, how in the world is cheap credit and increased personal spending going to lead us out of this "recession" when these were the primary drivers leading to the excesses in the first place?
Tuesday, June 2, 2009
Smoke and Mirrors
Illusion #1: Nominal Returns
With today’s close, the S&P has soared 42% off of its most recent bear market low of 666 set in early March. However, during the same period, the dollar index has plummeted 11.4% from 88.5 on March 6 to 78.4 on June 2. So in real dollar terms, the S&P is up just over 30%. In my prior post, I stated that the S&P could run another 5% to 920 back when it was trading at 877. As of today, the S&P is up 7.7% from its May 1 close, surpassing my target by 2.7%. Should I admit defeat and move on? Not quite as the dollar index has shed 7.2% over the same period, resulting in a real dollar gain from May 1 – June 2 of only .5%. In other words, the S&P must pass 980 holding the dollar index constant at today’s levels to violate my original call. All of the gains enjoyed over the past month are an illusion, only making up for the loss in the dollar’s value.
The devaluation of the dollar artificially improves equity performance given that real returns over the past month were less than 1%. America thinks in nominal terms, and the shrewd policy makers have developed an uncanny ability to pull the wool over the general public’s eyes. The average person watching TV every night sees a continuous stream of positive headlines and concludes that the economy seems to have turned the corner. All the while, national gas prices have soared over 50% in 2009 to a national average of $2.52/gallon on the back of lower refinery production and the weaker greenback. Note that each 1 penny rise in the retail price of gasoline costs American consumers $1B a year. Oil priced in gold will fall sharply once this most recent round of speculation reverses by mid-summer. In general, I believe that commodity prices will crash again as people realize that the anticipated economic recovery will not take place.
Illusion #2: Second Derivative Data
The main driver underlying Monday’s 2.6% rally was the better than expected ISM index of 42.8 against the consensus estimate of 42. Any reading below 50 still represents contraction, although new orders for the month rose above 50 for the first time in 17 months, which is the main data point that equities rallied on during Monday’s session. The Chinese manufacturing survey, also released Monday, showed growth for the third straight month and helped set a positive tone for trading in Europe and the U.S this week. I fully expected this economic uptick because of all the money that has been thrown at economies by governments worldwide. These stimuli coupled with second derivative economic statistics have and will create the illusion of improvement over the next several months.
Second derivative means the change of the change. For example, house prices are often analyzed by the change over the prior year or month. So if home prices fall 20% in May over the prior year, this means the real change from the peak is actually worse (maybe 30% lower than 2006) since home values had already started falling as of May of 2008. Eventually, the rate of decline will slow or show slight improvement because the comparisons will be made against depressed economic data. Markets are fixated on this second derivative data, but it only serves as noise over the long run because the trend will only continue lower. The talk by year end will shift from this change to fears of a double dip recession that will lead to the next leg down in the equity markets.
Illusion #3: The Emerging Market Mirage
The biggest smoke screen that I have seen recently, however, is the emerging market mirage. Many strategists believe that the Asian growth economies are going to lead the global economy out of this recession. As a result, many firms and individuals have emerged advocating full investment in foreign markets in order to shield investors from the low growth developed economies.
Chinese, South Korean, and Indian equities have sharply outperformed their American and European counterparts during the most recent bear market rally. The prevailing thought by money managers blindly throwing money into these markets is that this is where the growth lies during a potential economic rebound. This school of thought is flawed for several reasons:
1) Contrary to popular belief, these economies benefited from much of the fake growth that took place over the past decade fueled by cheap credit. As a result, the deleveraging process that still needs to unwind will impact these markets significantly.
2) These economies remain heavily dependent on exports. Thus, the decoupling theory, or belief that their domestic economies can more than offset the reduced demand in developed economies is ludicrous. Many U.S. equity bears continue to shift funds into emerging markets thinking that those economies have or will soon decouple from the U.S. economy. They point to the outperformance of the Chinese Composite, the Hang Seng index in Hong Kong and the Indian Sensex as these indices have outperformed U.S. equities during the most recent bear market rally. They conveniently exclude the fact that these indices had fallen much more sharply than U.S. indices as of November 2008. These strategists have concluded that China and India, sporting populations well in excess of 1B people each (or roughly 37% of the global population) will easily step in and replace the purchasing power of the U.S. I agree with this school of thought over the long term, however, it took decades for this relationship to develop, and it will not unwind over the course of several months.
At first glance, it is difficult to argue against the potential purchasing power of over 2B people in China and India, but of China’s 1.3B people, 130M live on less than $1 a day. Additionally, 8% of the Chinese population lives below the poverty line. Although Chinese GDP for 2008 amounted to $7.8T, 40% of its GDP was based on exports to the U.S., Japan, South Korea, and Germany. Unlike U.S consumption, which accounts for 67% of the economy, only 36% of the Chinese economy is based on consumption. This does not even begin to address the huge gap between the rich and poor in both China and India as their respective middle classes attempt to establish themselves. People also cannot ignore the practical environmental limitations of having over 2B people try to live an American lifestyle.
Those clamoring to gain emerging market exposure will see their portfolios decimated during the next wave down in the late summer and early fall. Expecting these economies to replace American consumption is akin to asking a high school student to support a family with their part-time mall job after both parents have been laid off. China and India will grow, but not until they have been weaned off the Western economies.
Given my thoughts above, I will highlight several key concepts underlying my current investment strategy:
1) I do not expect equity markets to pull back meaningfully until this fall, but I believe that certain names within the consumer cyclical, technology and financial sectors in the U.S. are now attractive shorts. For example, Goldman Sachs, Amazon, Google, and Apple all have rich valuations and have significant downside risk once investors realize that the economic recovery will not take place nearly as soon as expected.
2) If yields in the treasury market continue to rise, this will have an immediate and sharp impact on stocks. The yield on the 10-year note has already risen to over 3.6%, and that is with the Fed in the market purchasing treasuries. Investors (mainly China) continue to reallocate funds from longer dated notes to short term bills because of inflation concerns. This has resulted in widening spreads between bills and notes although mortgage rates remain artificially suppressed because of government controls and subsidies.
3) Starting in August, I will begin shorting basic materials and related stocks such as Rio Tinto. I decided to delay this strategy because commodities still have room to run as people continue to rotate out of the dollar and into hard assets.
4) I will short emerging markets in late August because they are not the safe haven that everyone assumes.
With today’s close, the S&P has soared 42% off of its most recent bear market low of 666 set in early March. However, during the same period, the dollar index has plummeted 11.4% from 88.5 on March 6 to 78.4 on June 2. So in real dollar terms, the S&P is up just over 30%. In my prior post, I stated that the S&P could run another 5% to 920 back when it was trading at 877. As of today, the S&P is up 7.7% from its May 1 close, surpassing my target by 2.7%. Should I admit defeat and move on? Not quite as the dollar index has shed 7.2% over the same period, resulting in a real dollar gain from May 1 – June 2 of only .5%. In other words, the S&P must pass 980 holding the dollar index constant at today’s levels to violate my original call. All of the gains enjoyed over the past month are an illusion, only making up for the loss in the dollar’s value.
The devaluation of the dollar artificially improves equity performance given that real returns over the past month were less than 1%. America thinks in nominal terms, and the shrewd policy makers have developed an uncanny ability to pull the wool over the general public’s eyes. The average person watching TV every night sees a continuous stream of positive headlines and concludes that the economy seems to have turned the corner. All the while, national gas prices have soared over 50% in 2009 to a national average of $2.52/gallon on the back of lower refinery production and the weaker greenback. Note that each 1 penny rise in the retail price of gasoline costs American consumers $1B a year. Oil priced in gold will fall sharply once this most recent round of speculation reverses by mid-summer. In general, I believe that commodity prices will crash again as people realize that the anticipated economic recovery will not take place.
Illusion #2: Second Derivative Data
The main driver underlying Monday’s 2.6% rally was the better than expected ISM index of 42.8 against the consensus estimate of 42. Any reading below 50 still represents contraction, although new orders for the month rose above 50 for the first time in 17 months, which is the main data point that equities rallied on during Monday’s session. The Chinese manufacturing survey, also released Monday, showed growth for the third straight month and helped set a positive tone for trading in Europe and the U.S this week. I fully expected this economic uptick because of all the money that has been thrown at economies by governments worldwide. These stimuli coupled with second derivative economic statistics have and will create the illusion of improvement over the next several months.
Second derivative means the change of the change. For example, house prices are often analyzed by the change over the prior year or month. So if home prices fall 20% in May over the prior year, this means the real change from the peak is actually worse (maybe 30% lower than 2006) since home values had already started falling as of May of 2008. Eventually, the rate of decline will slow or show slight improvement because the comparisons will be made against depressed economic data. Markets are fixated on this second derivative data, but it only serves as noise over the long run because the trend will only continue lower. The talk by year end will shift from this change to fears of a double dip recession that will lead to the next leg down in the equity markets.
Illusion #3: The Emerging Market Mirage
The biggest smoke screen that I have seen recently, however, is the emerging market mirage. Many strategists believe that the Asian growth economies are going to lead the global economy out of this recession. As a result, many firms and individuals have emerged advocating full investment in foreign markets in order to shield investors from the low growth developed economies.
Chinese, South Korean, and Indian equities have sharply outperformed their American and European counterparts during the most recent bear market rally. The prevailing thought by money managers blindly throwing money into these markets is that this is where the growth lies during a potential economic rebound. This school of thought is flawed for several reasons:
1) Contrary to popular belief, these economies benefited from much of the fake growth that took place over the past decade fueled by cheap credit. As a result, the deleveraging process that still needs to unwind will impact these markets significantly.
2) These economies remain heavily dependent on exports. Thus, the decoupling theory, or belief that their domestic economies can more than offset the reduced demand in developed economies is ludicrous. Many U.S. equity bears continue to shift funds into emerging markets thinking that those economies have or will soon decouple from the U.S. economy. They point to the outperformance of the Chinese Composite, the Hang Seng index in Hong Kong and the Indian Sensex as these indices have outperformed U.S. equities during the most recent bear market rally. They conveniently exclude the fact that these indices had fallen much more sharply than U.S. indices as of November 2008. These strategists have concluded that China and India, sporting populations well in excess of 1B people each (or roughly 37% of the global population) will easily step in and replace the purchasing power of the U.S. I agree with this school of thought over the long term, however, it took decades for this relationship to develop, and it will not unwind over the course of several months.
At first glance, it is difficult to argue against the potential purchasing power of over 2B people in China and India, but of China’s 1.3B people, 130M live on less than $1 a day. Additionally, 8% of the Chinese population lives below the poverty line. Although Chinese GDP for 2008 amounted to $7.8T, 40% of its GDP was based on exports to the U.S., Japan, South Korea, and Germany. Unlike U.S consumption, which accounts for 67% of the economy, only 36% of the Chinese economy is based on consumption. This does not even begin to address the huge gap between the rich and poor in both China and India as their respective middle classes attempt to establish themselves. People also cannot ignore the practical environmental limitations of having over 2B people try to live an American lifestyle.
Those clamoring to gain emerging market exposure will see their portfolios decimated during the next wave down in the late summer and early fall. Expecting these economies to replace American consumption is akin to asking a high school student to support a family with their part-time mall job after both parents have been laid off. China and India will grow, but not until they have been weaned off the Western economies.
Given my thoughts above, I will highlight several key concepts underlying my current investment strategy:
1) I do not expect equity markets to pull back meaningfully until this fall, but I believe that certain names within the consumer cyclical, technology and financial sectors in the U.S. are now attractive shorts. For example, Goldman Sachs, Amazon, Google, and Apple all have rich valuations and have significant downside risk once investors realize that the economic recovery will not take place nearly as soon as expected.
2) If yields in the treasury market continue to rise, this will have an immediate and sharp impact on stocks. The yield on the 10-year note has already risen to over 3.6%, and that is with the Fed in the market purchasing treasuries. Investors (mainly China) continue to reallocate funds from longer dated notes to short term bills because of inflation concerns. This has resulted in widening spreads between bills and notes although mortgage rates remain artificially suppressed because of government controls and subsidies.
3) Starting in August, I will begin shorting basic materials and related stocks such as Rio Tinto. I decided to delay this strategy because commodities still have room to run as people continue to rotate out of the dollar and into hard assets.
4) I will short emerging markets in late August because they are not the safe haven that everyone assumes.
Sunday, May 3, 2009
The Top Is Near
The equity market has continued its impressive rally with the S&P rising nearly 32% off of its March 6th low. About half of the S&P 500 companies have reported earnings, with over 65% beating sharply reduced estimates. On average, operating profits have fallen 30% over the prior year. I stated back in my March 29th post (after the S&P had already rebounded 23%) that the rally could last another 10%. We have almost reached that target as the S&P rose an additional 9% in April. I'm revising my prior projection upward by about 5% from current levels, which will result in a short term S&P target of around 920. Let me reiterate my stance; this rally is completely unjustified from a fundamental perspective and the result of technical oversold conditions. Many stocks that I follow are trading at multiples that are unsustainable given the current and future economic climate.
Treasury yields have soared despite the Fed's treasury purchase program as the 10-year note has risen to 3.15%. Money has flowed from treasuries to equities and corporate bonds as risk appetite and inflation fears return. Foreigners have also scaled back on treasury purchases as China remains a vocal critic of the government's recent policies. On March 25th, I recommended that investors consider TBT, (a double inverse ETF that increases with yields) which has risen 9% in the past five weeks. The equity market has gone from properly pricing in risk to underpricing risk over the past six weeks. Treasury yields will decline as risk aversion re-enters the market and deflation concerns return.
Commodities (and related stocks) have risen sharply on hopes of an economic recovery in the second half this year. Oil settled above $53/barrel on Friday while wholesale gasoline climbed to over $1.51/gallon. This represents nearly a 70% increase over the December gasoline lows of around $.90 as refiners cut back on production to boost profit margins. As a result, retail gasoline prices have risen back to $2.20/gallon throughout most of the nation despite the fact that the economy remains mired in the midst of the worst post-war recession. I would hate to see what happens to oil prices if the dollar actually weakens as the recent run-up has been driven entirely by speculation that the economy will improve within the next six months.
The problems plaguing this economy are structural, not cyclical, so the conventional wisdom applied by money managers in prior downturns will not apply this time around. I am therefore providing a 12-18 month S&P price target of approximately 500, representing a 43% decline from Friday's close. As illustrated by the excel table below (obtained directly from Standard & Poor's), the S&P is currently trading at 15X full year 2009 operating earnings estimates of 58. Valuations even look attractive once 2010 is considered with a forward PE of "only" 11.60 based upon Friday's close. But hold on a second, analysts are forecasting a sharp recovery in 2010 with operating earnings expected to jump 30% over the current year. Even if the pace of economic decline slows over the next 12 months, these projections border on the absurd. With a real unemployment rate of just over 15% and rising, the consumer is only now beginning to feel the impact of the upcoming depression.
Source: http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,0,0,0,0,0,0,6,0,0,0,0,0.html
The figures above represent operating results, not reported GAAP earnings that are often lower because of write-downs and other one time adjustments. Over the past several decades, the spread between GAAP and operating earnings have increased, artificially lowering PE ratios. In any event, 2010 earnings estimates will prove overly optimistic and should decline over the next four quarters. S&P operating earnings will not surpass $50 in 2010, well below the current $75 estimate. Accordingly, the PE ratio will contract to below 10 as investors price in a severe multi-year contraction. Historically, bear markets trough in the 6-10 P/E range, well below the current levels. Once we apply a 10 P/E on $50 of earnings, we arrive at an S&P of 500. I will most likely revise this preliminary estimate downwards as I review additional data.
This argument really comes down to one simple question. Do you believe that the worst is over? The bulls will say that the economy is near a bottom while the bears believe that the worst is yet to come. There is one important distinction, however. If you buy the bear's argument, you are buying the facts and prescribing to common sense while the bulls are trying to sell a mystery tonic that promises way more than it could ever deliver. There will be the buying opportunity of a lifetime....just not yet!
Treasury yields have soared despite the Fed's treasury purchase program as the 10-year note has risen to 3.15%. Money has flowed from treasuries to equities and corporate bonds as risk appetite and inflation fears return. Foreigners have also scaled back on treasury purchases as China remains a vocal critic of the government's recent policies. On March 25th, I recommended that investors consider TBT, (a double inverse ETF that increases with yields) which has risen 9% in the past five weeks. The equity market has gone from properly pricing in risk to underpricing risk over the past six weeks. Treasury yields will decline as risk aversion re-enters the market and deflation concerns return.
Commodities (and related stocks) have risen sharply on hopes of an economic recovery in the second half this year. Oil settled above $53/barrel on Friday while wholesale gasoline climbed to over $1.51/gallon. This represents nearly a 70% increase over the December gasoline lows of around $.90 as refiners cut back on production to boost profit margins. As a result, retail gasoline prices have risen back to $2.20/gallon throughout most of the nation despite the fact that the economy remains mired in the midst of the worst post-war recession. I would hate to see what happens to oil prices if the dollar actually weakens as the recent run-up has been driven entirely by speculation that the economy will improve within the next six months.
The problems plaguing this economy are structural, not cyclical, so the conventional wisdom applied by money managers in prior downturns will not apply this time around. I am therefore providing a 12-18 month S&P price target of approximately 500, representing a 43% decline from Friday's close. As illustrated by the excel table below (obtained directly from Standard & Poor's), the S&P is currently trading at 15X full year 2009 operating earnings estimates of 58. Valuations even look attractive once 2010 is considered with a forward PE of "only" 11.60 based upon Friday's close. But hold on a second, analysts are forecasting a sharp recovery in 2010 with operating earnings expected to jump 30% over the current year. Even if the pace of economic decline slows over the next 12 months, these projections border on the absurd. With a real unemployment rate of just over 15% and rising, the consumer is only now beginning to feel the impact of the upcoming depression.
Source: http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,0,0,0,0,0,0,6,0,0,0,0,0.html
The figures above represent operating results, not reported GAAP earnings that are often lower because of write-downs and other one time adjustments. Over the past several decades, the spread between GAAP and operating earnings have increased, artificially lowering PE ratios. In any event, 2010 earnings estimates will prove overly optimistic and should decline over the next four quarters. S&P operating earnings will not surpass $50 in 2010, well below the current $75 estimate. Accordingly, the PE ratio will contract to below 10 as investors price in a severe multi-year contraction. Historically, bear markets trough in the 6-10 P/E range, well below the current levels. Once we apply a 10 P/E on $50 of earnings, we arrive at an S&P of 500. I will most likely revise this preliminary estimate downwards as I review additional data.
This argument really comes down to one simple question. Do you believe that the worst is over? The bulls will say that the economy is near a bottom while the bears believe that the worst is yet to come. There is one important distinction, however. If you buy the bear's argument, you are buying the facts and prescribing to common sense while the bulls are trying to sell a mystery tonic that promises way more than it could ever deliver. There will be the buying opportunity of a lifetime....just not yet!
Thursday, April 16, 2009
US Prices Drop For First Time Since 1955
This was the title for an April 15th Financial Times article following the March Consumer Price Index (CPI) report showing a .4% year-over-year decline. Think about the significance of this statement for a moment. Prices have risen for 53 consecutive years.....53! And you probably thought that Joe DiMaggio's 56 game hitting streak was impressive. However, anyone that has taken an introductory economics course learned that cyclical patterns will lead to either rising or falling prices as the economy expands and contracts. Every basic textbook reminds us that rapidly expanding economies lead to full capacity utilization driving prices upward. The opposite should also hold true as economies slow and these pressures ebb, theoretically pushing prices down. Oddly, this basic free market principle does not seem to apply given inflation's impressive 53-year winning streak.
How is it that prices have continually risen despite the recessions and economic shocks of the past half century? Enter the Central Bank, affectionately dubbed the Federal Reserve, although it is neither Federal nor does it maintain any significant reserves. The Fed, run by a consortium of private bankers, has designed a debt-based system that requires ever-expanding prices to fuel the repayment of all outstanding loans. Although this may sound confusing, bare with me for a moment. If you could call a timeout and pause all economic activity while simultaneously requiring the immediate repayment of any outstanding debt, the global economic system would collapse. More simply, the amount of debt in circulation far exceeds the amount of cash currently in the system, and the ability of debtors to repay their obligations. This makes complete sense when examined from the perspective of an average middle class household. It may have modest savings, but a huge mortgage and credit card debt, which is reliant upon future income to repay, eclipses whatever savings accumulated. These future earnings will not exist without a continuously expanding money supply. Inflation represents the Fed's best and only tool to ensure that enough money is circulating through the system to repay these future obligations.
So the Fed's 1%-2% targeted annual inflation rate is beginning to make a little more sense. The bankers have convinced the general public that our economy cannot achieve sustainable growth without modest inflation, which is a complete a lie. Deflation, per the Fed's mandate, should be fought with all the tools available at its disposal. In a true deflationary environment, income streams will contract, inhibiting businesses and individuals alike from repaying their respective debts. This results in skyrocketing defaults and the failure of every major bank that is reliant on future inflationary earnings for their debtors to repay current obligations.
Deflation is best compared to a forest fire, painful and destructive in the near-term, but instrumental for building a solid foundation for future growth. Other than serving as a pricing mechanism, it encourages saving (through increased purchasing power) and proper capital formation supported by these savings, rather than debt. However, given the current system's complete over reliance on debt, any prolonged period of deflation will also lead to a complete collapse of the system. To further simplify, the current monetary system is structurally flawed and bound to collapse because it violates the most basic economic covenant; that prices must rise and fall with the cycles.
This brings me to my final question. Is the foundation of modern finance built on a flawed theory "that a dollar today is always going to be worth more than a dollar tomorrow?" After all, in a true free market, shouldn't bank lending models at least factor in for the possibility of a deflationary environment? Economic principles and common sense tell us that nothing happens 100% of the time, not even inflation. The most recent monthly CPI report proves this fact.
I realize that this post may seem overly theoretical, but I believe that these questions are essential to understanding the issues that plague our economy and declining standard of living. Make no mistake about the future of this topic, however, as people begin questioning the viability of the current monetary system.
How is it that prices have continually risen despite the recessions and economic shocks of the past half century? Enter the Central Bank, affectionately dubbed the Federal Reserve, although it is neither Federal nor does it maintain any significant reserves. The Fed, run by a consortium of private bankers, has designed a debt-based system that requires ever-expanding prices to fuel the repayment of all outstanding loans. Although this may sound confusing, bare with me for a moment. If you could call a timeout and pause all economic activity while simultaneously requiring the immediate repayment of any outstanding debt, the global economic system would collapse. More simply, the amount of debt in circulation far exceeds the amount of cash currently in the system, and the ability of debtors to repay their obligations. This makes complete sense when examined from the perspective of an average middle class household. It may have modest savings, but a huge mortgage and credit card debt, which is reliant upon future income to repay, eclipses whatever savings accumulated. These future earnings will not exist without a continuously expanding money supply. Inflation represents the Fed's best and only tool to ensure that enough money is circulating through the system to repay these future obligations.
So the Fed's 1%-2% targeted annual inflation rate is beginning to make a little more sense. The bankers have convinced the general public that our economy cannot achieve sustainable growth without modest inflation, which is a complete a lie. Deflation, per the Fed's mandate, should be fought with all the tools available at its disposal. In a true deflationary environment, income streams will contract, inhibiting businesses and individuals alike from repaying their respective debts. This results in skyrocketing defaults and the failure of every major bank that is reliant on future inflationary earnings for their debtors to repay current obligations.
Deflation is best compared to a forest fire, painful and destructive in the near-term, but instrumental for building a solid foundation for future growth. Other than serving as a pricing mechanism, it encourages saving (through increased purchasing power) and proper capital formation supported by these savings, rather than debt. However, given the current system's complete over reliance on debt, any prolonged period of deflation will also lead to a complete collapse of the system. To further simplify, the current monetary system is structurally flawed and bound to collapse because it violates the most basic economic covenant; that prices must rise and fall with the cycles.
This brings me to my final question. Is the foundation of modern finance built on a flawed theory "that a dollar today is always going to be worth more than a dollar tomorrow?" After all, in a true free market, shouldn't bank lending models at least factor in for the possibility of a deflationary environment? Economic principles and common sense tell us that nothing happens 100% of the time, not even inflation. The most recent monthly CPI report proves this fact.
I realize that this post may seem overly theoretical, but I believe that these questions are essential to understanding the issues that plague our economy and declining standard of living. Make no mistake about the future of this topic, however, as people begin questioning the viability of the current monetary system.
Saturday, April 11, 2009
Financial Earnings Do Not Equal Solvency
Wells Fargo reported record profits, nearly doubling analyst estimates despite the worst recession in the post-war era. The Fed designed its aggressive policy to slash interest rates over the past year to yield the maximum benefit for banks just as the economy fell of a cliff. The major banks are sitting on a pile of free cash as depositors earn less than 1% on their savings. This steepening of the yield curve has made it impossible for even bankers to lose money. So the Fed's actions have punished savers yet again and transferred a significant amount of wealth from the saving public to the banks. These actions continue to discourage saving while simultaneously encouraging excessive risk taking by lenders and debtors. However, an economy needs a solid savings base in order to encourage sustainable capital investment that is not based purely on debt. This begs the question; why do oil companies reporting record profits infuriate the general public while banks are applauded for producing record quarters? After all, don't both these industries generate their profits at the expense of the general public?
This upcoming week will see financial heavyweights Goldman Sachs, JP Morgan Chase, Bank of America and Citibank all report first quarter results. These companies are all expected to post solid numbers as they will benefit from the same operating environment that Wells Fargo exploited during the quarter. However, the market has priced in a solid earnings season for these banks following the Wells Fargo pre-announcement on Thursday and significant run-up in bank shares over the past four weeks. Do not expect the banks reporting this week to "blow out" the numbers because Wells Fargo achieved its results by under-reserving for future losses. I advised investors to avoid shorting financial stocks ahead of the mark-to-market rule change several weeks ago, and they have rallied sharply since that point.
Let me be as clear as possible. Although the financial sector will produce positive operating cash flow aided by free money, it remains insolvent, sitting atop a pile of bad assets. While bank share prices no longer reflect this reality, it is only a matter of time before the market prices these bank stocks accordingly. With additional capital raises looming and loan defaults accelerating, some excellent long term shorting opportunities are emerging within the sector following this earnings season. No other industry employs the amount of leverage that financials utilize. Even at a 10:1 leverage ratio, banks use $1 in equity to fund $10 in lending. So a small change in the value of the underlying assets can wipe out a large amount of equity. This is exactly what has plagued the sector for the past 18 months. The banks' tangible equity pales in comparison to the size of their actual balance sheets. After all, what is a couple billion dollars in quarterly profit when banks maintain balance sheets in the hundreds of billions? Further, these balance sheets will continue to deteriorate as the economy contracts.
This upcoming week will see financial heavyweights Goldman Sachs, JP Morgan Chase, Bank of America and Citibank all report first quarter results. These companies are all expected to post solid numbers as they will benefit from the same operating environment that Wells Fargo exploited during the quarter. However, the market has priced in a solid earnings season for these banks following the Wells Fargo pre-announcement on Thursday and significant run-up in bank shares over the past four weeks. Do not expect the banks reporting this week to "blow out" the numbers because Wells Fargo achieved its results by under-reserving for future losses. I advised investors to avoid shorting financial stocks ahead of the mark-to-market rule change several weeks ago, and they have rallied sharply since that point.
Let me be as clear as possible. Although the financial sector will produce positive operating cash flow aided by free money, it remains insolvent, sitting atop a pile of bad assets. While bank share prices no longer reflect this reality, it is only a matter of time before the market prices these bank stocks accordingly. With additional capital raises looming and loan defaults accelerating, some excellent long term shorting opportunities are emerging within the sector following this earnings season. No other industry employs the amount of leverage that financials utilize. Even at a 10:1 leverage ratio, banks use $1 in equity to fund $10 in lending. So a small change in the value of the underlying assets can wipe out a large amount of equity. This is exactly what has plagued the sector for the past 18 months. The banks' tangible equity pales in comparison to the size of their actual balance sheets. After all, what is a couple billion dollars in quarterly profit when banks maintain balance sheets in the hundreds of billions? Further, these balance sheets will continue to deteriorate as the economy contracts.
Friday, April 3, 2009
The Service Based Economic Model Has Failed
The once popular rhetoric of the past decade has turned to a whisper as cracks in our service based economy continue to widen. The dinner bill is due and everyone is trying to pass the check off to the next person as they scramble for the exits. Unfortunately, the years of binging are much more expensive than anyone could have imagined as the sticker shock sets in.
The official March U-3 unemployment rate rose to 8.5% as the U.S. shed another 663,000 jobs in March, roughly in line with estimates. Even more concerning was the large January adjustment, pushing total job losses to 740,000 for the month. It's odd how the current month figures came in so close to estimates while there was such a significant adjustment to the January report. Originally, the BLS estimated that the U.S. "only" lost 598K jobs in its original January release. That's nearly a 24% margin of error from the most recent revision. Would the BLS ever consider transferring job losses to prior months in order to cushion the impact on the markets? I will let you decide for yourself, but I fail to see the point behind releasing a draft report that could include a 24% margin of error. The U-6 unemployment rate, which is far more reflective of reality, soared to 15.6%. As I previously stated, this figure factors in underemployed and marginally attached workers.
http://www.bls.gov/news.release/empsit.t12.htm
Treasury prices fell last week and yields rose to 2.9% on the 10-year note as the market anticipated the U.S. will sell an anticipated $59B in notes this week. Interest rates have climbed back to the levels prior to the Fed's announcement of its treasury purchase program in March. Yields would have risen to well over 3% had it not been for these note purchases. The Treasury has several auctions scheduled for next week, and investors will keep a close eye on the auction results, although the Fed will no doubt provide support in the face of waning foreign demand. Note that the CDS spreads on government issued debt has risen steadily over the past six months as risk is transferred from the private sector to the government with all the bailouts.
I want to take a step back and discuss where I think the general economy is headed over the next several years. Putting the recent equity market rally aside, I have long-term concerns on the U.S. economy. This stance is a matter of common sense and based on the following factors:
1) Slightly less than 70% of the U.S. economy is based on consumer spending. This debt-fueled spending has also supported 25% of the world economy, buoying export countries like China, Japan, and Taiwan. As American consumption increased, productive capacity declined, forcing the government and households to take on more debt to maintain their standard of living. There are more than $5T in outstanding credit lines and $500B was pulled in Q4. Prominent banking analyst, Meredith Whitney, believes that banks could pull more than $2.7T by the end of 2010. With rising unemployment and lower credit availability, it does not take a genius to see where consumer spending is headed over the next year....down.
2) The American standard of living has steadily declined over the past several decades. There are currently 32M people on food stamps in this country, representing over 10% of the population. This is an astonishing number for the largest economy in the world and indicative of a failed system. It was possible in the 1950’s and 1960’s for a factory worker to comfortably support his family on one income alone. Today, that quality manufacturing job has disappeared, while it often takes dual incomes to maintain a similar standard of living. In short, families have to work longer and harder for lower wages as the cost of living skyrockets. This often goes unreported in most media outlets because these fundamental shifts are easy to overlook.
3) Neither the government nor the private sector has come up with a long-term structural solution to resolve the growing trade deficit. The approach has been to throw more debt at the problem just as the economy tries to deleverage. There is a significant difference between this downturn and those in prior cycles. America had a stronger savings rate and manufacturing base to fall back on during the prior postwar recessions. Unfortunately, the spending programs outlined in the stimulus consists of too many one time handouts that add little long-term value to kick start the economy. In other words, this country must make a fundamental shift from over consumption to production, but no administration over the past 20 years has been willing to tackle these serious issues.
4) Putting the credit crisis aside for a moment, the economy was due for a significant correction based on the demographics of the U.S. population. The baby boomers have just surpassed their peak spending years at roughly 48 years of age. This will result in a severe spending slowdown that will dramatically reduce GDP growth for the better part of the next decade. It will not be until the echo boomers reach their peak spending years that you will see a meaningful rebound within the domestic economy.
The questions that bullish money managers and analysts cannot answer should also be the simplest. What will bring the quality jobs back? What catalyst will provide the foundation for a sustained economic recovery as consumers reign in their spending to reduce their debt levels? These are the fundamental questions that bullish analysts continue to dodge. Until these issues are resolved, the economic contraction will not see the bottom.
The official March U-3 unemployment rate rose to 8.5% as the U.S. shed another 663,000 jobs in March, roughly in line with estimates. Even more concerning was the large January adjustment, pushing total job losses to 740,000 for the month. It's odd how the current month figures came in so close to estimates while there was such a significant adjustment to the January report. Originally, the BLS estimated that the U.S. "only" lost 598K jobs in its original January release. That's nearly a 24% margin of error from the most recent revision. Would the BLS ever consider transferring job losses to prior months in order to cushion the impact on the markets? I will let you decide for yourself, but I fail to see the point behind releasing a draft report that could include a 24% margin of error. The U-6 unemployment rate, which is far more reflective of reality, soared to 15.6%. As I previously stated, this figure factors in underemployed and marginally attached workers.
http://www.bls.gov/news.release/empsit.t12.htm
Treasury prices fell last week and yields rose to 2.9% on the 10-year note as the market anticipated the U.S. will sell an anticipated $59B in notes this week. Interest rates have climbed back to the levels prior to the Fed's announcement of its treasury purchase program in March. Yields would have risen to well over 3% had it not been for these note purchases. The Treasury has several auctions scheduled for next week, and investors will keep a close eye on the auction results, although the Fed will no doubt provide support in the face of waning foreign demand. Note that the CDS spreads on government issued debt has risen steadily over the past six months as risk is transferred from the private sector to the government with all the bailouts.
I want to take a step back and discuss where I think the general economy is headed over the next several years. Putting the recent equity market rally aside, I have long-term concerns on the U.S. economy. This stance is a matter of common sense and based on the following factors:
1) Slightly less than 70% of the U.S. economy is based on consumer spending. This debt-fueled spending has also supported 25% of the world economy, buoying export countries like China, Japan, and Taiwan. As American consumption increased, productive capacity declined, forcing the government and households to take on more debt to maintain their standard of living. There are more than $5T in outstanding credit lines and $500B was pulled in Q4. Prominent banking analyst, Meredith Whitney, believes that banks could pull more than $2.7T by the end of 2010. With rising unemployment and lower credit availability, it does not take a genius to see where consumer spending is headed over the next year....down.
2) The American standard of living has steadily declined over the past several decades. There are currently 32M people on food stamps in this country, representing over 10% of the population. This is an astonishing number for the largest economy in the world and indicative of a failed system. It was possible in the 1950’s and 1960’s for a factory worker to comfortably support his family on one income alone. Today, that quality manufacturing job has disappeared, while it often takes dual incomes to maintain a similar standard of living. In short, families have to work longer and harder for lower wages as the cost of living skyrockets. This often goes unreported in most media outlets because these fundamental shifts are easy to overlook.
3) Neither the government nor the private sector has come up with a long-term structural solution to resolve the growing trade deficit. The approach has been to throw more debt at the problem just as the economy tries to deleverage. There is a significant difference between this downturn and those in prior cycles. America had a stronger savings rate and manufacturing base to fall back on during the prior postwar recessions. Unfortunately, the spending programs outlined in the stimulus consists of too many one time handouts that add little long-term value to kick start the economy. In other words, this country must make a fundamental shift from over consumption to production, but no administration over the past 20 years has been willing to tackle these serious issues.
4) Putting the credit crisis aside for a moment, the economy was due for a significant correction based on the demographics of the U.S. population. The baby boomers have just surpassed their peak spending years at roughly 48 years of age. This will result in a severe spending slowdown that will dramatically reduce GDP growth for the better part of the next decade. It will not be until the echo boomers reach their peak spending years that you will see a meaningful rebound within the domestic economy.
The questions that bullish money managers and analysts cannot answer should also be the simplest. What will bring the quality jobs back? What catalyst will provide the foundation for a sustained economic recovery as consumers reign in their spending to reduce their debt levels? These are the fundamental questions that bullish analysts continue to dodge. Until these issues are resolved, the economic contraction will not see the bottom.
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