Higher.

Let’s start with a historical look at ten year stock market cycles.  The chart below starts (see 1) in December 1937 when the US stock market (excluding dividends) was down 40% over a full 10 year period.  Though the stock market was extremely volatile (a 20% decline followed the 40% ten year collapse, then a 50% rally, and a subsequent 40% decline – see Note).

A massive post WWII boom was experienced in America in the 1950s and 1960s, but the major stock market gains were investors who “entered the market” in the late 40s, and enjoyed the cumulative 10 year return of 300% (see 2). Markets moved gradually higher during the 1960s, and in the 70s suffered a major inflationary headwind and in real terms were down over 70%.  In nominal terms, by the late 70s stock investors had suffered a 10 year cumulative return of roughly 0% (similar to today?, see 3).

Thus began the glory days of corporate America and the global financial system.  Stock investors were handsomely rewarded for entering the stock market in the early 80s.  To give you an idea, the S&P was trading at 111 in March 1982, and by March 2000 was trading at 1,500.  The bulk of this gain was concentrated in the tech bubble of the late 90s, but still this was an amazing period for equity investors, with only one negative calendar year in 17 years on a total return basis! As such investors were handsomely rewarded with a cumulative 10 year return of nearly 350% through the end of the decade (see 4).

Now begins the dreary 2000s which had its own boom- bust cycle.  The current 10 year return (through October 2010) is currently -17%.

What is most interesting is that the historical average of  a 10 year investment in US stocks (excluding dividends) is capital appreciation of 107%.

This reminds us  of some important lessons of investment management:

1. That no matter how euphoric or demoralizing financial price trends may seem, at some point, conditions change and the markets establish a new trend.
2. It is extremely difficult to time a market top or bottom
3. Markets often correct through the mean (as you can see by the average 10 year return)

Our take from the above is that it is easy to project that the upcoming years will have very low returns: there is a historical precedent (negative annualized returns for the past decade), fundamental reasons (risk free rate near 0%, difficult earnings environment, etc), demographic reasons (the huge portion of Americans set to retire in the upcoming 10 years that will not stomach the volatility of Equities and prefer to have stable Fixed Income investments), etc.  But looking at the historical cycle tells us that experience would beg to differ.  What is clear is that after abnormally high (low) returns, one should never lose sight that stock market assets in a healthy economy will likely produce returns far below (above) the mean. What’s more, taking a lesson from Prospect Theory, we should note that humans are fallible.  As markets move for an extended period in one direction, investors will overestimate the likelihood that markets will continue in the same direction.

So, what would be a new direction? Above average returns. Let’s hope.

Note that in June 1937 Roosevelt’s administration took drastic steps in an ill fated attempt to balance the federal budget. The S&P fell 20% through March 1938.  It rallied 50% through the end of 1938, and then fell again another 40% through 1942. This was of course due to the effects of America’s war time economy subsequent to the Pearl Harbor attack and Eisenhower beginning a massive front in Europe.

1. tax increases by state / local governments
2. collapse in the EUR to below parity
3. aggressive tightening in China or Europe (for different reasons!)
4. policy mistake in the US

It is clear that the economy is chugging along, and that some of the biggest risks are how the markets will punish policy mistakes.  It reminds us of a quote from Schumpeter:

“As a doctor is unable to predict whether his patient will be run down by a motor car, so the economist is unable to predict in a situation in which so many political motor cars run about …”

- “Depressions, Can We Learn from Past Experience?”, Schumpeter, 1934

 

The past few weeks showed an amazing resurgence in seemingly black-swan type risks. First an Icelandic ash volcano that paralyzed European travel, a massive oil spill in the Gulf of Mexico, the “smartest guys in the room” aka Goldman Sachs getting hit with civil fraud charges by the S.E.C. and now out of nowhere a -9% selloff intraday on the US stock market. It was the biggest intraday selloff in percentage points since 1987.

Today showed us that financial markets are fickle. Sentiment and risk perception often swing abruptly. Greece’s economy is small, at EUR 254 billion, particularly in an economic bloc that is nearly EUR 9 trillion or 35x its size. The Greek problem has the potential to develop into a full blown epidemic, threatening the entire European economy.

The political tension is rising: elections in the UK today with a change in leadership from Labour to Conservatives, Germany’s elections in North Rhine – Westphalia, etc. A Greece bailout is very unpopular, but so is preempting a global financial crisis. Whereas some rumors have indicated that Greece has consulted with Lazard to examine a restructuring, other rumors have hinted at G-7 coordination today (May 7) to contain the crisis.

A simple punchline is that a Greek debt default or restructuring is inevitable. Even in the event of restructuring the result is the same.  Looking back to the 1930s the Creditanstalt bank default occurred in 1931, sparking a global banking crisis, but the great crash of the Great Depression occurred 2 years before in 1929.

Regardless on the view of whether Greece will be bailed out it is difficult to envision an environment where this will be beneficial for the Euro. This is not to say that a breakup of the EUR is in order. But, countries now including the ECB will be inclined to transition into quantitative easing, ie print their currencies.

Own gold as a hedge. Stocks are a good buy given that this event will definitely leave in place accommodative monetary policy. We dont think an all out default of Greece or a disintegration of the Euro bloc will occur. If we are right, stocks will rocket from current levels with renewed stimuli and a refocusing on economic fundamentals.

The fragility of the financial system
Given that Greece’s GDP is approximately US$ 356 billion (compared with Germany’s US$ 3,652 billion economy), the Greek debt crisis is not an insurmountable task for the EU.  In fact, current talk is to help Greece meet its immediate obligations (20 billion EUR of its debt falls due in April and May) only. What the Greek crisis has shown the market is the fragility of the global financial system (much like the Dubai scare did in November of last year).  Also clear are the deflationary pressures still circling through the global economy.

Further profligacy is feared
Clearly, either Germany or the EU can gather enough financial resources to bail out Greece. Most likely it will be  a joint effort led by France and Germany, the country with the deepest pockets.  But as the Economist said: “Berlin frets that a rescue will only encourage further profligacy”.

Why the markets got spooked
What is most at question now is the “common currency regime” of the Euro bloc.  Combine the moral hazard problem of bailing Greece out, with bleak finances in the peripheral euro area, the small chance that the Euro bloc countries can maintain their fiscal responsibilities, along with the continuing economic contraction in Europe and you will understand why markets got spooked.

Where do we go from here?
After vague promises, markets want European finance ministers to come up with concrete measures.  The issue at hand is whether the EU will finalize the details of support extended to Greece to prevent a default.  Since January 22, markets have been seized by the ongoing concerns regarding Greek public finances though the S&P rallied back to 1,100 from a low of 1,040.  Let’s put this in a global context:

• As we discussed on our blog post on January 26 ( click here to read ), Greece’s problems relate not only to an extraordinarily high debt load but a really ugly deficit problem as well: the debt to GDP ratio in Greece is near 125% and the fiscal deficit as a percent of GDP is near 12.5%.
• The ECB has not done as much as the Fed in reflating its economy: since 2008 M2 has expanded about 13% in the US, whereas in Europe M3 has expanded only 6%.  Additionally the Federal Reserve’s balance sheet has grown by a multiple of 2.6x in the same time frame, compared with 1.4x in the Eurozone.
• Euro area authorities will find a way to bail out Greece and avoid the markets forcing the PIGS into a default scenario. PIGS refers to Portugal, Ireland, Greece and Spain.  Note that since last week Greek rates have dropped from 7% to 6%.

In summary
We think evaluating the EUR move over the past two months has been fundamentally logical (the EUR is overvalued on a purchasing parity basis, combined with the Greek drama) as well as on a technical basis (DXY seemed to make a major market bottom this year).  We think the EUR will drift lower versus the US$.

Good trading,

The Covert Analytics Team

How does this resource help?
At Covert Analytics we adopt a market forecasting and asset allocation approach which is based on simple, easy to understand principles. One of our principles is that an expanding liquidity base and credit creation usually leads to a favorable environment for economic expansion, and in turn a healthy climate for stocks and bonds.  “The rising tide lifts all boats” is an apt metaphor. As most of our readers know, our entire approach to investing is buy when the climate is ripe for appreciation, and sell when the climate is risky. many of the indicators we analyze to evaluate the monetary conditions are distributed by the St Louis Fed. (click here to open publication)

$473 billion in loans set to hit the market?
We were intrigued by a research piece put out by Standard and Poors.  Thanks to Barry Ritholtz at The Big Picture for distributing such an interesting piece.  The most important conclusion of this piece was that approximately $473 billion in loans will eventually need to be liquidated, which amounts to an estimated 1.75 million properties (or about 50% of all the houses available for sale as of December 2009). In other words, it is ugly! The dollar amount is estimated based on their categorization of the loans under analysis into four categories: performing, recently cured, seriously delinquent and REO.  Finally, the tally of $473 billion comprised of seriously delinquent, REO and likely to redefault loans, will need to be liquidated unless met with a substantial pick up in demand.

Why is this important?
This is important because it will likely hang on house prices for a very long time.  No matter how you slice it, Real Estate (technically a component of “tangible assets”) is the most important component of Household Net Worth.

So lets make the assumption that due to the foreclosure estimates from the S&P study, there is a 10% decline in housing prices coming.  This would result in a household contraction of $2.3 trillion. The National Bureau of Economics Research says there is a 10% pass through effect to consumer spending as a result of declines in household net worth. This would be an economic contraction of $230 billion (which represents 1.6% of GDP).

Can excess liquidity help offset this contraction?
The Monetary Trends publication shows some disappointing trends: the velocity of money is sluggish …

And bank credit growth is actually contracting!

In other words, it is unlikely that we will see a pickup in demand to offset the foreclosure crunch.  The data definitely does not suggest it, and given still high loan requirement standards, lower credit scores due to inability to meet payments, and deleveraging by banks and consumers, common sense confirms it!

Here is Barry’s post:   http://www.ritholtz.com/blog/2010/02/shadow-inventory-of-troubled-mortgages/

Federal Reserve balance sheet data:  http://www.federalreserve.gov/Releases/Z1/current/z1r-5.pdf 

Thanks for reading!

The Covert Analytics Team

Market commentators are often referencing how the US will face a Japanese style deflationary bust given the over indebtedness of the economy (government and individuals) and the deleveraging that will occur. A credit fueled bubble propelled Japanese assets to dizzying heights in the 80s. A similar, primarily-US, credit fueled bubble propelled assets across the world to new highs.  The retrenchment that occurred in Japan led to two decades of lethargic performance, in both the markets and economy.  The Nikkei is still 75% below its 1980s peak.

We often hear comparisons to how the US is in the unfamiliar process of deleveraging.  That after excessive credit growth for decades a retrenchment is uncomfortable, but 100% necessary.  Nomura here describes this as a “balance sheet recession” and is what happened in Japan :

“According to Mr Koo of Nomura, an economy in which the overindebted devote their efforts to paying down debt has the following three characteristics: the supply of credit and bank money stops growing, not because banks do not wish to lend, but because companies and households do not want to borrow; conventional monetary policy is largely ineffective; and the desire of the private sector to improve balance sheets makes the government emerge as borrower of last resort. As a result, all efforts at “normalising” monetary and fiscal policy fails, until the private sector’s balance-sheet adjustment is over.”

This would seem to be counter to what is occurring.  Companies are in better shape than ever and only in a doomsday scenario do you see the largest consumer market in the world, reverting to Japanese – style saving characteristics.  We for one think govermnent action to date has done one very important thing: restore Mr. Market’s confidence. Back to Japan for a second, Martin Wolf, whom we respect thoroughly describes the root problem of Japan’s weak economy for the past two decades on the corporate sector:

“My own view is that the underlying structural problem has been the combination of excessive corporate savings (retained earnings) and diminished investment opportunities, once catch-up growth was over.”

And here is where Mr. Wolf makes an interesting conclusion: could it be that China is facing a similar bubble risk like Japan was in the 80s?

“Yet Japan’s experience also has a lesson for quite a different economy. It indicates that when very fast growth begins to slow in a catch-up economy with very high corporate savings and comparably high fixed investment, demand may well prove extremely difficult to manage. This is particularly true if the deliberate promotion of credit growth and asset price bubbles has been part of the mechanism used to sustain demand. And who needs to learn this vital lesson now? The answer is: China.”

Please click here to read the full article.

Here they differentiate between a normal economic cycle downturn and one associated with a financial crisis.  Their conclusions indicate that they believe that this will not be a V shaped recovery.  One of our previous posts pointed to the fact that “bad news is good news” in that bad news (or news confirming a weak recovery) is good for asset markets because it implies that the governments will be there eager to provide liquidity and stimuli. 

BCA: Financial crisis recoveries (red) vs Normal

From BCA:

Economic cycles associated with financial traumas such as banking crises or asset price collapses tend to have deeper downturns and weaker upturns. The current uptrend in U.S. economic growth should be sustained, but the rebound will remain subdued compared to recent recoveries.

In the past, there has been a close correlation between the severity of downturns and the vigor of subsequent recoveries, arguing that a V-shaped expansion in the U.S.  may be in order. In this context, the consensus forecast of 3% growth in U.S. GDP in 2010 seems low relative to past cycles. For example, the economy grew at an average 7.7% annualized pace over the six quarters that followed the deep 1981-82 recession. Optimists also note that the slope of the yield curve historically has been a good indicator of the economic cycle. Thus, the current steep yield curve in the major economies would be another reason to expect a vigorous economic expansion. However, the lingering after-effect of the financial bust will remain a serious headwind to growth in much of the developed world for the next few years. Indeed, recoveries that follow financial recessions tend to be much weaker than what follows non-financial recessions. Significant damage was done to the financial infrastructure in the past year, consistent with a weaker-than-normal economic expansion. Bottom line: While the global economic recession has ended, growth in the major developed regions will be slower than would normally occur after such a deep recession. This should limit consumer price pressures and keep policy conditions constructive for risk assets.

 Hope you enjoy the read,

The Covert Analytics Team

Japan’ s problems are well known: major underperformance of the stock market, sluggish domestic economy, strong currency, aging population, high fiscal deficits, etc.  What is interesting is the uptick in performance of the Japanese stock market compared with the global benchmark.  Is this a sign of things turning around for Japan? Looking at the MSCI numbers for December (through Dec 24) we see that Japan is up 8.9%, compared with 2.9% for the S&P 500, and 4.8% for Europe.

Lets take a quick look at Japan.  First and foremost, it should matter to any investor. It is the second largest economy in the world. Second the stock market is down nearly 75% from its peak in 1989 and investors should be monitoring this economy closely to see if structural forces are in place to spark a rally. Note that this year there was an important shift of power in Japan: the Democratic Party of Japan (DPJ) took over after 54 years of rule by the Liberal Democratic Party (LDP). Could this serve as a catalyst for Japan to do what is necessary to ignite the economy?

Forget for a moment that Japan has the highest debt to GDP ratio in the world (near 200%).  They unveiled a 7.2 trillion yen stimulus package on Dec 8, a week after a 10 trillion yen credit program to support the economy. This is looking more and more like Japan is trying to play catch up and start quantitative easing in the British / American sense.