I agree we should always question our assumptions and
have someone play devils advocate.
But I don't agree that, having done that, it is elitist
to think it possible to come to the correct conclusion ahead of the market - as
investment mgrs that's always our goal, right? (Altho I guess its possible to
be way too ahead of the mkt)
The article below offers some insight on our dilemma (ie.
Is the stock market telling us we're wrong or missing something crucial)
But first my own summary:
US stocks are up nearly double digits this YTD in a year
when we've witnessed:
- Payrolls job growth, despite being hugely boosted by
inane B/D assumptions, slowing to under population growth
- Household employment stats worse yet
- Monetary policy, previously too long easy, became
restrictive, now impacting with a lag
- Inverted yield curve for most of past year, historically
a reliable leading indicator
- Huge consumer debt burdens increasing even worse as
credit card debt escalating in recent mths
- $100 oil - almost
- Sinking home prices - conservatively estimated down 5%
YoY so far
- Housing recession ongoing a year after many were calling
its bottom
- Glut of housing on market likely to take years to digest
- Homeowners affected by rate shock of resetting mortgages
- but worst not til 08
- Tightening lending standards - and seemingly borrowing
appetites
- Delinquencies and foreclosures rising quickly
- Nonres construction finally showing signs of slowing,
following res constr with a lag
- Confidence surveys sliding
- Same store sales less than stellar
- Ongoing twin deficits
- Imminent fiscal crisis due to entitlements and
demographics with front edge of baby boom now retiring
- State and local govt budgets getting pinched from
declining corporate and property tax revenues
- Fiscal ease therefore less likely as countercyclical
option as with 2002 bush tax cuts particularly with Dems controlling house
- Falling greenback
- Opaque balance sheets
- Unknown exposure to off balance sheet risks in SIVs
- Massive writedowns of alphabet soup related assets
- Fasb 157 requirement to soon start disclosing level 1, 2
and 3 assets at time of market suspicion of what's on the books
- Credit crunch with TED spreads and the like blowing out
- Shutdown of the LBO and CDO markets at least for now
- CP drying up as mmkt investors flee to safety
- Structured finance and debt repackaging which served as
staple of markets for last few years losing credibility
- Ratings agencies downgrading in what could possibly turn
into a vicious spiral particularly if monoline insurers get affected
- Corporate profits (at least domestic sourced if not yet
multinatl) regressing to the mean from unsustainable record levels
- Stocks expensive relative to normalized earnings (see
Hussman's articles)
- Food prices rising
- Reduced foreign fund infusions into US as Asian and
MidEast govts break $pegs and diversify reserves means reduced financing for
private capital investment
- Japan reentering recessionary conditions and euro area
growth faltering - even without yet seeing much slowdown in US PCE
So have we really been too pessimistic about stocks or
have stocks remained too optimistic for too long on the basis of, best as I can
tell, just the following:
- Corporate profits still doing well (for now - and why
shouldn't they keep it up)
- Fed will reflate
- Weak $ will help exporters
- Fed will reflate
- Income growth seems okay
- Fed will reflate
- China's booming
- Fed will reflate
- Housing is the only weak spot in the economy (its
contained)
- Fed will reflate
Anyhow...
--------------------------
The Catastrophist View
What would it take to send the U.S. economy—and New
York’s—into free fall? A doomsday primer.
By Duff McDonald
Published Oct 28, 2007
New York Mag
Peter Schiff is laughing at me. I’ve just asked him to
entertain the following notion: that we dodged a bullet during August’s
financial-market turmoil and, with the stock market bouncing right back from
every dip, things might be okay. So why worry?
He stops laughing. “Why worry?” he asks. “Because we
dodged a bullet but are about to step on a hand grenade.”
Sitting in a corner office of a nondescript building just
off I-95 in Darien, Connecticut, Schiff, the president of brokerage Euro
Pacific Capital, and author of Crash Proof: How to Profit From the Coming
Economic Collapse, will spend the next hour spelling out a singularly
pessimistic view of the American economy. And he will do so while exhibiting a
curious juxtaposition unique to the bearish prognosticator: He speaks of
disaster with a smile on his face. No, he’s not happy about our impending doom.
But he is happy that people are finally taking him seriously.
Some people, anyway. The recessionary fears that were
sparked by the global liquidity crisis in August have eased, largely because of
a resilient stock market and a belief that the Federal Reserve’s interest-rate
cut in September curtailed deeper losses. When Goldman Sachs invested in its
own imploding Global Equity Opportunities hedge fund in August, calling it an
“opportunity” and not a “rescue,” people laughed. Guess who laughed last? Goldman,
which had reportedly enjoyed a $370 million gain on its $2 billion rescue by
October. The optimists stay focused on stories like Steve Jobs’s next stroke of
genius.
But Schiff, whom CNBC calls “Dr. Doom,” has not, as bears
do when winter approaches, gone off to hide in a cave. Why not? Because every
single one of the underlying economic factors that he has identified as cause
for concern has worsened. And his is no longer a lone voice in the woods. If
you don’t care to listen to a man nicknamed Dr. Doom, you can listen to people
like former Federal Reserve chairman Alan Greenspan, esteemed bond-fund manager
Bill Gross, or famed money manager Jeremy Grantham. They’re part of a growing
chorus of voices that are saying many of the same things as Schiff.
Their bearish arguments come in many shapes and sizes,
but here’s the basic one: The past five or six years have been deceptively
fortunate ones for the U.S. economy. That’s because any troublesome
developments—the surge in oil prices from $28 per barrel in 2003 to about $87
today, for example—have been papered over by rising home prices. Home equity
has been used to buy flat-screen TVs, SUVs, and more homes. Wall Street bought
up all this debt from lenders, thereby allowing them to lend more.
The softening of real-estate prices in most parts of the
United States put a crimp in this system, but it hasn’t stopped it. The
question is, what, if anything, will? What will bring on the apocalypse that
Schiff and others believe is inevitable? They see it like this:
THREAT NO. 1
The Bottom Continues to Fall Out of the Housing Market
Manhattan’s gravity-defying real estate aside, it’s quite
clear the nation is experiencing a genuine housing crisis. In August, pending
home sales dropped 6.5 percent, and they currently sit at their lowest level
since 2001. The National Association of Realtors conducted a recent survey that
showed more than 10 percent of sales contracts fell through at the last moment
in August, primarily owing to disappearing loan commitments from banks. The
crisis will only deepen, when more borrowers see their adjustable-rate
mortgages adjusted upward. There was a foreclosure filing for one of every 510
households in the country in August, the highest figure ever issued, and by one
estimate, more than 1.7 million foreclosures will occur in the country by the
end of 2008. That’s not just subprime borrowers: According to the Federal
Housing Finance Board, while nearly 35 percent of conventional mortgages in
2004 used ARMs, some 70.7 percent of jumbo loans—those above $333,700 (the
jumbo threshold in 2004; it’s now higher)—did too.
Historically, bond-market investors have been the boring
counterparts to their equity-market brethren. But in his October Investment
Outlook, famed bond investor Bill Gross was anything but. The managing director
of money management firm pimco pointed out that the Federal Reserve is caught
in a bind: It must continue to lower interest rates to ameliorate this
burgeoning housing crisis, but in doing so, it “risks reigniting speculative
equity market behavior, and … a run on the dollar.” (More on the dollar later.)
Gross doesn’t have the answers but observes that the Fed is “in a pickle, and a
sour one at that.” Worse yet, concerns that a rate cut might be inflationary
actually caused bond yields to rise in the wake of the rate cut, something that
doesn’t normally happen. The Fed’s influence, always overstated, might turn out
to be nonexistent in a credit market that remains on edge.
Hedge-fund veteran Rick Bookstaber, the author of A Demon
of Our Own Design, spells out a potentially disastrous scenario that could
unfold regardless of what the Fed does: Continued foreclosures result in a
further drop in housing prices, which results in further foreclosures, which
result in a further drop in housing prices. Even for those of us not selling,
reduced home values result in a reduced sense of security, which results in
reduced consumption, which results in a slowing economy, which … you get the
point.
THREAT NO. 2
The Derivatives-Related Meltdown, Part II
Anybody who glances occasionally at the financial pages
these days knows that mortgages issued to home buyers are packaged together (in
a process called securitization) into a collateralized-debt obligation, or CDO.
That’s what’s known as a derivative, a security whose value depends on the
value of other securities. The price of the CDO, you see, is “derived” from the
prices of the underlying mortgages. (It works with credit cards, too, or bank
loans—any kind of debt will do.)
In principle, the idea of a CDO makes perfect sense. In
buying $5 million worth of a CDO, an investor has essentially lent money to an
entire portfolio of homeowners, instead of placing all his eggs in one basket,
say, by funding a single $5 million mortgage. In the real-estate-crazy
environment of the past decade, the CDO market took off like a rocket. But the
buyers of these derivatives made a critical error—they confused the spreading
of risk with the elimination of risk. A booming economy made this confusion not
just possible but irresistible. With relatively few defaults in the first half
of the decade, investment firms, including many hedge funds, came to see CDO
returns as a sure thing and loaded up on them, often borrowing money to do so,
taking on debt to buy debt and thereby setting up a potentially deadly chain
reaction. The readiness of the secondary market to buy all these mortgages
encouraged the lenders to run wild and lend to anyone who walked through the
door, leading—inevitably, in retrospect—to a decline in loan quality. Analyst
Christopher Wood of Asia-Pacific investment house CLSA succinctly defines the
problem in his highly readable newsletter Greed & Fear: “[Securitization]
has one fatal flaw, which will ultimately prove to be its undoing … it removes
the incentive of those making the loan to worry about whether the loan is a
good credit.”
Still, it all held together until mortgage defaults began
to cut into the yields of these CDOs and holders looked to sell them, only to
realize their value had slipped. Forced liquidations as a result of that “price
discovery” were a primary factor in Bear Stearns’ hedge-fund calamity in
August. And it’s not over yet: The aftershocks of the mortgage meltdown are
still being felt, as banks such as Citigroup and Deutsche Bank announce
multibillion-dollar write-downs.
Each time one of these write-downs has been announced,
the market has had a curiously positive response, taking the news as a sign
that the worst was over and the banks were cleaning up their books. But because
these derivatives are linked to other debt, there’s no reason to be certain
that trouble won’t bleed into other markets. Among other things, the liquidity
crisis froze the market in structured investment vehicles (SIVs), a nifty bit
of financial engineering that banks use to profit from the spread between
short-term debt and long-term debt. No one yet knows how nasty these losses
could turn out to be because SIVs are stashed, Enron style, off the books.
THREAT NO. 3
Consumers Run Out of Steam (and Take the Economy Down
With Them)
The U.S. economy, for all its worldly sophistication, is
driven by mall shoppers and late-night Amazon addicts—70 percent of the gross
domestic product is accounted for by consumer spending, which is buttressed by
debt. According to the Federal Reserve, total U.S. household debt was, as of
August, $2.5 trillion—a 24 percent increase in the past five years. Total
credit-card debt, including gas cards and the like, was $915 billion.
The willingness of consumers to keep spending and piling
on debt in the midst of a slowing real-estate market is hailed on Wall Street
as an act of patriotism, which Schiff considers perverse. Imagine, he suggests,
that you ran into a good friend and asked him how he was doing. His reply: “I
took out a third mortgage, maxed out my credit cards, and emptied out my kids’
college savings account so I could buy a bigger TV and a new car, and we’re
going to Greece on vacation over the holidays. Things are great!” Schiff lets
the idea sink in and then finishes the thought: “And we’re celebrating the fact
that we’re doing this as a nation?”
In a recent interview, John Santer, a district director
of NeighborWorks America, a community-based nonprofit, pointed out that 43
percent of American households spend more than they earn each year, and fewer
than six in ten have enough savings to last them three months if they were
suddenly out of a job. So where’s the money coming from? From 1991 to 2005,
Americans borrowed $530 billion against the value of their homes each year.
James Glassman, a senior economist at JPMorgan Chase,
told a Tulsa, Oklahoma, luncheon crowd in early October that before 1985,
consumer spending grew in line with income, but since that time, it’s grown
half a percent faster on an annual basis. As a result, household savings, which
once reached 10 percent of income, is now literally negative. “My guess is that
in five years we’ll look back and realize … that the consumer we knew for
twenty years is coming to an end,” he said.
Roger Ehrenberg, an ex–Wall Streeter and author of the
financial blog Information Arbitrage, forecasts extreme financial pain. “You’ve
got a weaker dollar, declining economic fundamentals, and a debt-strapped
consumer—I’d call that a bad fact set,” he says. “Lay on top of that the
mortgage problem and declining home values, and you can paint a pretty ugly
picture.”
THREAT NO. 4
That the Rest of the World Decides They Don’t Need Us and
the Dollar Tumbles Hard
The dollar is falling, possibly collapsing, depending on
whom you talk to. The greenback has sunk close to its lowest point in the
post-1973 floating-exchange-rate era, so low that it’s been overtaken by the
Canadian dollar—affectionately known as the loonie—for the first time since
1976. How low will it go? When Alan Greenspan was asked by Lesley Stahl of 60
Minutes last month what currency he’d like to be paid in, his response was
telling: “[The] key question … is, ‘In what currency do you wish to hold your
assets?’ And what I’ve done is I diversify.” Translation: He isn’t betting on
the dollar. And neither is the majority of Wall Street.
Here’s why catastrophists see that as a major problem:
About 25 percent of our government debt is held by foreign governments, with
the major holders being Japan ($610.9 billion), China ($407.8 billion), the
U.K. ($210.1 billion), and our friends in the Middle East, the oil-exporting
countries ($123.8 billion). When the current Fed chairman, Ben Bernanke, cuts
rates to soften the housing blow for Americans, he also weakens the dollar by
making dollar-based investments less attractive. And when the dollar weakens,
so, too, does the value of these gigantic positions held by the foreign
governments. At some point, they’re no longer going to tolerate the losses we
inflict on them by lowering rates, and if that happens and they start dumping
dollars, watch out for the peso.
The bulls will tell you that foreign governments
understand the American economy is the key to global economic health, and that
they’ll suck it up and take it when we devalue their debt. To which Schiff
offers another analogy. Imagine if five people were washed up on a desert
island: four Asians and an American. In splitting up their duties, one Asian
says he’ll fish; another will hunt, another will look for firewood, and another
will cook. The American assigns himself the job of eating.
“The modern economist looks at this situation and says
the American is key to the whole thing,” says Schiff. “Because without him to
eat, the four Asians would be unemployed.” The alternative: Without the
American, the Asians might eat a little more themselves and even spend some
time building a boat. This is happening as we speak: With the rise of the
Chinese consumer class, the local citizenry is now spending, and the country is
no longer totally dependent on exports. Which means they’re no longer totally
dependent on us.
Readers of the financial press are surely familiar with
the buzzword of the moment, decoupling. It’s used to describe how U.S.-Europe
and U.S.-Asian trade relationships are becoming less dependent at the same time
as European-Asian ties are growing. Most Asian nations, including China, are
seeing more rapid growth in exports to Europe than to the U.S. And the U.S. now
accounts for a declining share of European exports. The bearish interpretation:
that the longtime global embrace of the dollar is loosening.
THREAT NO. 5
That We Don’t See It Happening Because It’s a Slow-Motion
Train Wreck
Last but not least, we can circle back to the Dow Jones
Industrial Average making new highs in October—14,087.55 on October 1—offering
hope that our equity portfolios will carry us through to the other side of
whatever it is we’re on the wrong side of. Before addressing the fact that the
equity market might just be clueless, there’s one last dollar-related point to
make. The true value of a stock portfolio isn’t really its quoted worth in
dollars—it’s what you could buy with that portfolio if you were to sell it.
Given that we as Americans don’t manufacture that much
anymore (we’re a service economy!), we are largely talking about foreign-made
goods, such as flat-screens from Korea or cars from Germany. Over time, if the
dollar continues to slump, foreign manufacturers will raise prices to
compensate for what they’re losing in the exchange rate. In that light, a Dow
at 14,000 with the euro at $1.42 is really no different from a Dow at 13,000
with the euro at $1.33. (One reason the price of oil has risen so high is that
it is quoted in dollars, and the sellers thereof have had to continually jack
up the per-barrel price to maintain their own purchasing power at home and
elsewhere.)
Still, a rising Dow is better than a falling Dow, and the
bulls are piling into every rally. Which still doesn’t impress Jeremy Grantham,
chairman of Boston-based money manager GMO, in the least. “The equity market is
always slow to pick up on someone else’s crisis,” he says, referring to the
turmoil in both the housing and fixed-income markets. “And so you’ve got a
slow-motion train wreck that has to work itself through the system.”
How will it work itself through? Grantham points to the
recent strength in profit margins, fueled by—you guessed it!—our plummeting savings
rate, and says there’s nowhere to go but down. “If you start with an overpriced
market and bring profit margins down, that’s more than enough to bring stock
prices down,” he says. “It is the most certain mean-reversion in all of
finance.” Grantham calculates that the U.S. stock market will have to fall by a
full third before it gets to its “fair value.” At which point we will likely be
in full-blown recession. And when that happens, Schiff says, we will see a
country in downsizing mode, “selling the consumer goods we’ve been buying back
to the Chinese. It will be one big, giant repossession.”
So assuming all this is true, that Schiff and his fellow
doomsayers are right about the rotten core of the U.S. economy, how will this
affect New York City? We’ve grown accustomed to the idea of our local economy,
particularly the real-estate market, being inherently stronger than the
nation’s and possibly immune to whatever woes strike the rest of America. Wall
Street, after all, makes money on downs as well as ups, and the stampede of
foreigners and foreign cash could, if anything, be aided by the weak dollar.
Last week, though, the argument against New York
invincibility was implicitly made when Merrill Lynch announced a
larger-than-expected write-down of $7.9 billion dollars in its third quarter
alone, primarily due to losses in the credit markets. Numbers as large as that
can paradoxically seem trivial due to the abstract nature of accounting—a
“write-down” involves no movement of real-life cash, just a readjustment of
some theoretical values—but here’s something nontrivial to consider: Merrill
Lynch is one of the largest employers in New York City. While so far only a few
Merrill bigwigs have been shown the door, it’s almost certain that a chunk of
the company’s rank and file will soon follow. All told, New York–based
financial companies had already announced more than 42,000 layoffs as of
October, according to one study, and the pace could pick up through the end of
the year. That’s people who won’t be bidding up new apartments, who won’t be
going out to dinner five times a week, who won’t be testing the outer limits of
their credit cards at Barneys. The downstream effects of this could be even
more severe, as every Wall Street job is estimated to account for another 1.3
to 2 jobs, meaning that additional job losses could push 100,000.
Meanwhile, the public sector is feeling it, too. A recent
report by Nicole Gelinas, published by the Manhattan Institute, forecast a
budget deficit for New York City next year and predicted that Mayor Bloomberg,
who enjoyed a string of budget surpluses until this year, will likely be forced
to leave his successor with a double whammy: a deficit and a projected 50
percent increase in outstanding debt. Of course, the catastrophists could be
dead wrong, as they have been for going on a decade now—but to them, it sure
smells like the seventies all over again.
