“Brinkmanship (or brinksmanship) is the practice of pushing dangerous events to the verge of disaster in order to achieve the most advantageous outcome. It occurs in international politics, foreign policy, labour relations, and (in contemporary settings) military strategy involving the threatened use of nuclear weapons. This manoeuvre of pushing a situation with the opponent to the brink succeeds by forcing the opponent to back down and make concessions. This might be achieved through diplomatic maneuvers by creating the impression that one is willing to use extreme methods rather than concede. During the Cold War, the threat of nuclear force was often used as such an escalating measure. Adolf Hitler also used brinkmanship conspicuously during his rise to power.

The dangers of brinkmanship as a political or diplomatic tool can be understood as a slippery slope: In order for brinkmanship to be effective, the threats used are continuously escalated. However, a  threat is not worth anything unless it is credible; at some point, the aggressive party may have to back up its claim to prove its commitment to action. The chance of things sliding out of control is often used in itself as a tool of brinkmanship, because it can provide credibility to an otherwise incredible threat.

The Cuban Missile Crisis presents an example in which opposing leaders, namely John F. Kennedy and Nikita Khrushchev, continually issued warnings, with increasing force, about impending nuclear exchanges, without necessarily validating their statements. Pioneering game theorist Thomas Schelling called this “the threat that leaves something to chance.” The British intellectual Bertrand Russell compared nuclear brinkmanship to the game of chicken. The principle between the two is the same, to create immense pressure in a situation until one person or party backs down, or both are annihilated.”

So what does this mean for investors?  In a nutshell, it is a step in the right direction.  But is it enough?

First, we would note that Chinese policy needs to be relaxed.  But odds are the initial move out of the gate will be tentative given the extent of the credit excesses lingering in the system, and as such, are unlikely to reverse slowing economic growth. Historically, policymakers response will be proportionate to the deterioration in the economy which means risk assets will likely be down substantially before policymakers respond in force. If and when, the party undertakes substantial fiscal and credit stimulus, we would turn more bullish on China-related assets.  We are not there yet.

It is important to remember that massive reflation and market intervention does not occur in healthy bull markets. Such policies can mark a bottom in price, but these “bottoms” are usually preceded by major crisis.  For example, the Fed began easing policy in January 2001 after the tech bubble burst but equities sold off through March 2003.  More recently, the Fed began liquidity injections and easing in August 2007 but market only hit bottom in March 2009.  The point is that an initial shift in policy is more likely confirmation of a bear market in risk assets and in this case, may indicate an economic acceleration to the downside before policymakers get ahead of the curve. 

Regarding the “coordinated action” announced today, investors might be reminded of similar central bank policies that saved us from Financial Armageddon a few years ago, and sparked a massive rally in risk assets which launched in March 2009.  Unfortunately, the first coordinated policy response was announced as early as 2007 so investors had a long ride ahead of them before the bottom!  For perspective, we compiled a timeline of central bank policy below using excerpts from a St Louis Fed report titled Lessons Learned?  Caution – this is somewhat exhausting!

• The crisis first appeared in interbank lending markets in early August 2007, when the London Interbank Offered Rate (LIBOR) and other funding rates spiked after the French bank BNP Paribas announced that it was halting redemptions for three of its investment funds.
• The Federal Reserve sought to calm markets by announcing on August 10 that “the Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets” and noting that, “as always, the discount window is available as a source of funding.”
• Subsequently, on August 17, the Board of Governors voted to reduce the primary credit rate by 50 basis points and to extend the maximum term of discount window loans to 30 days.
• Then, in September, the Federal Open Market Committee (FOMC) lowered its target for the federal funds rate in the first of many cuts that took the rate essentially to zero by December 2008.
• Financial strains eased somewhat in September and October 2007 but reappeared in November. On December 12 2007, the Federal Reserve announced the establishment of reciprocal currency agreements (“swap lines”) with the European Central Bank and Swiss National Bank to provide a source of dollar funding in European financial markets. Over the next 10 months, the Fed established swap lines with a total of 14 central banks.
• On December 12, the Fed also announced the creation of the Term Auction Facility (TAF) to lend funds directly to banks for a fixed term.
• Financial markets remained unusually strained in early 2008. In March, the Federal Reserve established the Term Securities Lending Facility (TSLF) to provide secured loans of Treasury securities to primary dealers for 28-day terms.
• Later in March, the Fed established the Primary Dealer Credit Facility (PDCF) to provide fully secured overnight loans to primary dealers.
• Shortly after the creation of the PDCF, the Federal Reserve Board authorized the Federal Reserve Bank of New York to lend $29 billion to a newly created limited liability corporation (Maiden Lane, LLC) to facilitate the acquisition of the distressed investment bank Bear Stearns by JPMorgan Chase. The PDCF—and especially the Maiden Lane loan—marked significant departures from the Fed’s usual practice of lending only to financially sound depository institutions against good collateral.
• In July 2008, the Federal Reserve Board once again authorized loans to non-bank financial firms when it granted the Federal Reserve Bank of New York authority to lend to the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) if necessary to supplement attempts by the U.S. Department of the Treasury to stabilize those firms. The Fed was not called on to lend to either firm, however, and the Treasury Department placed both Fannie Mae and Freddie Mac under conservatorship in September 2008.
• The financial crisis intensified during the final four months of 2008. Lehman Brothers, a major investment bank, filed for bankruptcy on September 15 after the failure of efforts coordinated by the Fed and Treasury Department to find a buyer for the firm. 
• Within hours of the Lehman bankruptcy, the Fed was forced to confront the possible failure of American International Group (AIG). Hence, on September 16 the Fed again invoked Section 13(3) of the Federal Reserve Act and made an $85 billion loan to AIG, secured by the assets of AIG and its subsidiaries. 
• The Lehman bankruptcy produced immediate fallout. On September 16, the Reserve Primary Money Fund announced that the net asset value of its shares had fallen below $1 because of losses incurred on the fund’s holdings of Lehman commercial paper and medium-term notes. The Federal Reserve responded to the runs on money funds by establishing the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) to extend non-recourse loans to U.S. depository institutions and bank holding companies to finance purchases of asset-backed commercial paper from money market mutual funds.
• To help stabilize the financial system, on September 21, the Fed approved the applications of Goldman Sachs and Morgan Stanley to become bank holding companies and authorized the Federal Reserve Bank of New York to extend credit to the U.S. broker-dealer subsidiaries of both firms, as well as to Merrill Lynch. A few days later, the Fed increased its existing swap lines with the European Central Bank and several other central banks to supply additional dollar liquidity in international money markets.
• Financial markets remained in turmoil over the ensuing weeks. To help alleviate financial strains in the commercial paper market, the Fed established the Commercial Paper Funding Facility (CPFF) on October 7.
• The Fed’s next rescue operation came in November, when it participated with the Treasury Department and Federal Deposit Insurance Corporation in a financial assistance package for Citigroup. The Federal Reserve agreed, if necessary, to provide a non-recourse loan to support a federal government guarantee of some $300 billion of real estate loans and securities held by Citigroup.
• Two days later, on November 25, the Federal Reserve announced the creation of the Term Asset-Backed Securities Lending Facility (TALF). Under this facility, the Federal Reserve Bank of New York provides loans on a nonrecourse basis to holders of AAA-rated asset-backed securities and recently originated consumer and small business loans. The TALF was launched on March 3, 2009, and the types of eligible collateral for TALF loans were subsequently expanded on March 19 and May 19, 2009.

“Throughout the fall of 2008, the Federal Reserve Board approved the applications of several large financial firms to become bank holding companies; these firms included Goldman Sachs, Morgan Stanley, American Express, CIT, and GMAC. The Board cited “unusual and exigent circumstances affecting the financial markets” for expeditious action on several of these applications. 

“In addition to the Fed’s rescue operations and programs to stabilize specific financial markets, the FOMC reduced its target for the federal funds rate in a series of moves that lowered the target rate from 5.25 percent in August 2007 to a range of 0 to 0.25 percent in December 2008. On November 25, 2008, the FOMC announced its intention to purchase large amounts of U.S. Treasury securities and mortgage-backed securities issued by Fannie Mae, Freddie Mac, and the Government National Mortgage Association (Ginnie Mae). The FOMC increased the amount of its purchases in 2009. The stated purpose of the purchases of mortgage-backed securities was to reduce the cost and increase the availability of credit for the purchase of houses. The move to support a particular market through open market purchases is highly unusual for the Federal Reserve and unprecedented on this scale since before World War II.”

A friend sent me this updated look at the S&P yesterday, which provides some perspective on where we are in this cycle using “the last time around” as a guideline.  The chart aligns the bail out of Bear Stearns in March 2008 with the bail out of Dexia this year.  The conclusion appears obvious if you are able to step away from the day-to-day noise, rumors, plans, and announcements.  This will take some time to fully play out.  Until it does, we’d recommend reducing exposure to risk assets on policy-induced rallies.  We have not yet learned the most obvious lesson of this ongoing financial crisis.  You cannot solve a solvency problem with liquidity.

]]> http://www.viewfromtheblueridge.com/2011/11/30/is-it-enough/feed/ 0 http://www.viewfromtheblueridge.com/2011/11/11/easy-money/ http://www.viewfromtheblueridge.com/2011/11/11/easy-money/#comments Fri, 11 Nov 2011 16:27:45 +0000 Christopher Pavese http://www.viewfromtheblueridge.com/?p=1577 With all eyes on European bond markets, few investors are paying attention to growing risks to the Chinese growth miracle.  Concerns are growing, but most of the work we’ve seen boils down to, “Yes, we know it is unsustainable, but we don’t think we need to worry for a few more years because . . . . blah, blah, blah.”  We think this is a mistake. The lesson learned from prior manias is simply that if something can’t go on forever, it probably won’t.  And if it seems too good to be true, it probably is.  More often than not, investors are rightly focused on the odds that circumstances turn negative.  But every so often, it is much more important to consider the consequences of these low probability events.  With so many believers in the Chinese growth miracle and so many economies, investment strategies, and corporate managements almost solely dependent on the Chinese for growth, we spent some time last week exploring the growing cracks emanating from Beijing.  Slides from our investor call are available for download below.

Bulls claim that current weakness in the property market has been largely driven by government tightening.  We would agree, but they also contend that as policy reverses and addresses weakening fundamentals, markets will respond accordingly.  Fed tightening ultimately busted the US housing bubble, but subsequent easing hasn’t had much of an impact.  The oversight in this argument is sentiment.  Once Chinese buyers awaken to the reality that house prices can move in two directions, we believe the genie is out of the bottle.  This article from Caijing suggests the genie might be a little upset about falling prices, as investors storm the offices of property developers after 25% price cuts.  Optimists also point to varying regional dynamics to support the notion that national market is holding up well.  Entirely possible, but California, Florida and the rest of the sunshine states were more than enough to wreak havoc on our banking system.  We doubt the Chinese capital cities (or Australian “regionals” for that matter) will avoid similar repercussions.

While many agree that a property-led hard landing is likely “in the next few years,” few are willing to acknowledge that it could happen sooner rather than later.  We wonder how long a country can go on building ghost towns and empty housing projects, before the bill comes due.  I suppose they need to create demand for all their Expressways of Excess.  Signs of misallocation are everywhere, but the most unsettling is the affect unregulated mining is having on one of the world’s great wonders.  Apparently, part of the Great Wall is now collapsing according to China Daily. Investors are also aware of the issues that the Chinese banks are facing, but point to declining NPLs as “proof” that the banks are well capitalized or that the deterioration will remain manageable.  History is not on their side. Didn’t American banks boast miniscule NPLs prior to the collapse of US housing?  It would seem the street is confusing cause and effect.

Finally, even those willing to admit that the banking system may be insolvent (trust us . . . it is), argue that an insolvent banking system is not an issue for China’s command economy as the problem is ultimately a fiscal issue and will inspire a fiscal solution.  This is perhaps the most misunderstood and ridiculous claim by consensus today. China’s reserves do not make its economy bullet proof by any means.  They simply represent assets on the PBOCs balance sheet for which there are offsetting liabilities.  The dangerous assumption underlying a bullish China thesis today is that these capital inflows will continue.  In an economic slowdown, particularly one driven by a credit freeze, capital flight is a significant risk.  Importantly, we have begun to see this already in the third quarter as outflows were more intense than even those experienced in 2008.  Increasing this risk, is shifting sentiment within China as 60% of the rich are already looking to take their money elsewhere, according to the FT.  Victor Shih has highlighted The Fragile State of China’s FX Reserves repeatedly.  But perhaps the most disturbing development we’ve recently heard, is this quote from a Chinese banker with close ties to powerful political parties: “There is a sense that we are approaching an inevitable breaking point, when the pressures in society will boil over and consume the rulers . . Almost all the elements are in place for an uprising like we saw in 1989. Corruption is worse today than it was then, people feel they can’t get ahead without political connections, the wealth gap is much bigger and growing , and  there has been virtually no political reform at all. The only missing ingredient now is a domestic economic crisis.”

We have written extensively about the link between China and Australia over the past year.  We think now is a good time to revisit these Predictable Surprises we outlined in June 2011, and the potential for an abrupt reversal in Australia’s terms of trade.  On November 2^nd, Governor Stevens explained the following after cutting Australian interest rates: “The terms of trade have now peaked and will decline somewhat in the near term, but they remain very high.”  What he means by “very high” is illustrated below.  The rise in Australia’s terms of trade over the past decade is the biggest in a very long time.  In the five major mining booms in Australia’s history since 1850, the exchange rate has played an important role in each of them.  In the current episode, the only period with a floating rate, it has risen by a large amount.  If the terms of trade has now peaked, as the RBA (and Chinese growth) suggests, the implications for AUD are massive

But don’t take it from us.  This recent interview with Jim Chanos touches on all the main points of our thesis.  Here’s a quick summary of his points along with a link to the video well worth a few moments of your weekend:

• The Chinese were supposed to get involved a year ago, that didn’t happen.  They were supposed to save Greece months ago, but that didn’t happen.  China will do what’s in China’s interest.
• Big misconception regarding Chinese reserves.  FX reserves have liabilities against them. They arise when exporters earn income in other currencies and turn them in for RMB. Like any central bank liability, there are RMB liabilities against their dollar reserves.
• China is on a bigger and faster treadmill to hell than ever.
• Chinese are beginning to realize that property prices can go down.  Numerous reports of investors thrashing property development offices.
• Take Chinese bank profits with a grain of salt.  American banks recorded record profits prior to 2007. It’s all about credit.
• In the last two banking crisis in 1999 and 2004, Chinese banks had 40% non performing loans without recession.
• Real estate transactions are down 60% year over year.  The property slow down has started.
• Chanos is short Ag Bank of China.  They are holding onto restructuring receivables from previous bailouts at 100 cents on the dollar.  Those receivables account for more than 100% of their tangible book value.  They are probably worth 10 or 20 cents on the dollar.
• Most China observers weren’t talking about any “landing” three months ago.  The fact that they are not admitting that the plane is not staying aloft says something in itself.
• Chinese consumers are shrinking as a percent of the economy. Fixed asset investment is driving everything – up 24% versus 9% economic growth in the year.
• The inherent problem China has it two governments. Central government is hitting the breaks, but local governments who are in bed with developers have every incentive to keep building.
• There were 30-40% rallies in credit-sensitive sectors for three years in the west.  Chanos didn’t cover his shorts until things stopped deteriorating in 2008. We are not anywhere close to that in China as things have just begun to unravel.  The property slow down started in the third quarter of this year. The fundamentals have just started to deteriorate.
• No numbers of visas in your passport will substitute for lack of judgement.  Plenty of people who lived in Miami all of their lives lost everything.

Easy Money (Nov-11)

“At the point our nation recognizes that the pattern of repeated bubbles, crashes, and misallocation of capital is not solved by the Fed but is instead caused by the Fed, it will become clearer that the best path to economic recovery is to shift attention toward debt restructuring, real investment, useful infrastructure, and the creativity and work ethic of real human beings. Until then, we will have an economy built on speculation and paper, stacked into a flimsy house of cards.”

-  John Hussman, Weekly Market Comment

Dr. Hussman’s full comments are definitely worth a read this week as he puts to rest a number of questions regarding an imminent downturn, the Greek race toward default, the probability of recession and those “sticky” profit margins.  You can access his weekly comments here.  After reading them this morning, I opened a package on my desk which contained additional reading material for the week – our friend Francois Trahan’s new book, The Era of Uncertainty.    The dedication alone assures it will be a practical resource rather than Wall Street gurgle.  It reads, “To Ben Bernanke . . . thanks for the material.”

I’m sure we’ll have more to share on this one as I make my way through it.

High yield bonds and many other investment media have once again gone from being weeds to flowers – from pariahs to market darlings – and it happened in a startlingly short period of time. As is so often the case, things that investors wouldn’t touch in the depths of the crisis in late 2008 now strike them as good buys at twice the price. The swing of this pendulum recurs regularly and creates some of the greatest opportunities to lose or gain. Thus we must always be mindful.

One of the most important things we can do is take note of other investors’ attitudes and behavior regarding risk. Fear, worry, skepticism and risk aversion are the things that keep the market at equilibrium and prospective returns fair. When investors fear loss appropriately, too-risky deals can’t get done, and risky investments are required to offer high prospective returns and generous risk premiums. (And when fear reaches extreme levels during crises, the capital markets turn too stingy, asset prices sink too low, and potential returns become excessive.)

But when investors don’t fear sufficiently – when they’re risk tolerant rather than risk averse – they let down their guard, surrender their discipline, accept rosy projections, enter into unwise deals, and settle for too little in the way of prospective returns and risk premiums.

There’s nothing more risky than a widespread belief that there’s no risk . . . and, as Alan Greenspan said, “. . . history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

I recite all of this because I have no doubt that investors are making substantial movement back in the same direction . . . In other words, in most regards the capital markets – and investors’ tolerance of risk – are retracing their steps back in the direction of the bubble-ish pre-crisis years. Low yields, declining yield spreads, rising leverage ratios, payment-in-kind bonds, covenant-lite debt, increasing levels of LBO activity and the beginnings of the return of levered, structured vehicles . . . all of these are available for the eye to see.

There may be corners of the market where elevated popularity and enthusiastic buying have caused prices to move beyond reason . . . But for the most part, I think investors are taking the least risk they can while assembling portfolios that they think can achieve their needed returns or actuarial assumptions.

In general, I would describe most security prices as falling somewhere between fair and full. Not necessarily bubbly, but also not cheap.

If I had to identify a single key to consistently successful investing, I’d say it’s “cheapness.” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity. When investors are serene or even euphoric, rather than discomforted, prices rise and we become less likely to find the bargains we want.

I try to get away from it, but I can’t. The quote I return to most often in these memos, even 17 years after the first time, is another from Warren Buffett: “The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.” When others are paralyzed by fear, we can be aggressive. But when others are unafraid, we should tread with the utmost caution. Other people’s fearlessness invariably translates into inflated prices, depressed potential returns and elevated risk.

Today, pension funds and endowments simply can’t achieve their goal of nominal returns in the vicinity of eight percent if they keep much money in Treasuries or high grade bonds, and they may not even expect public equities to be much help. They’ve moved into high yield bonds, private equity and hedge funds . . . not because they want to, but because they feel they have to. They just can’t settle for the returns available on more traditional investments. Thus their risk taking is in large part involuntary and perhaps unenthusiastic.

Those of us who calibrate our behavior based on what others are doing should increase watchfulness and, as Buffett suggests, apply rising amounts of prudence.

Prudent Behavior in a Low-Return World

• Go to cash – not a real alternative for most investors.
• Ignore the lowness of absolute returns and pursue the best relative returns.
• Forget that elevated prices might imply a correction, and buy for the long run.
• Reach for return, going out further on the risk curve in pursuit of returns that used to be available with greater safety.
• Concentrate investments in “special niches and special people”; by this I meant emphasizing strategies offering exceptional bargains and managers with enough skill to wring value-added returns from assets of moderate riskiness.

Of all of these, I consider reaching for return to be the most flawed, especially if it’s done without being fully conscious (which is often the case when return becomes hard to come by). I’ve described this approach as “insisting on achieving high returns in a low-return world” and reminded people of Peter Bernstein’s admonition: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”

In short, when the market is defaulting on its job of being a disciplinarian, discernment becomes our individual responsibility. I think we’re back to needing the cautious attributes, not the aggressive. An unusually large number of thorny macro issues are outstanding, including:

• the so-so U.S. recovery;
• the U.S.’s deficit, debt ceiling impasse and dysfunctional political process;
• the economic impact of deleveraging and austerity;
• the over-indebtedness of peripheral eurozone countries;
• the possibility of rekindled inflation and rising interest rates;
• the uncertain outlook for the dollar, euro and sterling; and
• the instability in the Middle East and resulting uncertainty over the price of oil.

With all of these, plus prices that are fair to full and investor behavior that has increased in aggressiveness, I would rather gird for the things that can go wrong than ensure maximum participation if things go right.

We have a hard time finding anything to disagree with in Mark’s most recent letter and look forward to reading his most recent book.

How Quickly They Forget 05-25-11

Cracks in the Rally

Our friends at Ned Davis have identified 10 rallies of 5% of more since the bull market began in March 2009.  In each, leadership has been text-book, with cyclicals and commodities leading the market.  At least until now.  The current rally has seen a decisive change in character with health care, telecom, and staples among the market’s outperformers.  Also, worth noting is the picture below from Francois Trahan which clearly shows that $4 gasoline is starting to take a toll on the consumer.  The rally in early cyclicals relative to late stage cyclicals provided investors accurately identified the pending market rally in late 2008.  The relative decline in these groups pointed to “double dip” fears in early 2010 and also confirmed the market’s excitement for QE2 later in the year.  Again, this has changed.  And rather abruptly at that.  The sever underperformance of early cyclicals today was warning of weak economic data ahead months ago and continues to warn of a decline in economic growth later this year.

Source: Wolfe Trahan

Inflation is all the Rage

Inflation is everywhere.  Every investor we talk to is terrified about a declining dollar.  Every company we speak with is worried about spiking input costs.  Even friends who run local restaurants here in town have asked us how best to buy silver to hedge against a dollar collapse.  Yet this chart, from KimbleChartingSolutions highlights a massive negative divergence.  Charts don’t lie.  Politicians do.  And the charts are telling us exactly what we’ve been saying for years.  In a highly indebted global economy, the immediate forces of an extended deleveraging process are deflationary.  Take a look at recent comments from the world’s largest retailer.  American’s don’t have money to spend on anything else, as long as they are paying $4 gallon to fill up their SUVs.

It’s worth noting that the last time we saw a spike in inflation expectations of this magnitude was H1-08, right before commodities collapsed.  I’ve been saying for almost a year now, that higher commodity prices are ultimately deflationary within the context of a long term deleveraging process.  The data support our thesis.  When inflation expectations have spiked to levels this high, CPI has actually fallen at a 4.6% annual rate.  Markets often move in a manner to prove the majority wrong.  Consensus today is betting big on shorting dollars and shorting treasuries.  We are setting up for another monster rally in both.  The only question is the level from which it starts.

Source: Kimble Charting Solutions

Faster Than a Speeding Bullet

Speaking of spikes in inflation expectations, we think the excerpt below from Bill Hester, CFA is worth a close look:

The topic of inflation tends to be a tool used by both sides of the debate about stock market performance. It’s argued that because corporations can pass on rising prices of raw goods to consumers, earnings will keep pace with inflation, so equities are a good hedge against inflation. It’s also argued that because the 1970′s was a terrible decade to own stocks, very high rates of inflation must be bad for equities. As in many discussions surrounding financial market topics, there is some truth in each of these arguments. But the full story tends not to lend itself to such broad generalizations.

Maybe one of the most underrated risks regarding inflation is the speed at which it is rising, even if that increase is off of a low base. It’s not high levels of inflation that precede important stock market declines, but instead how rapidly inflation is rising relative to its recent trend. And when you mix an overvalued market with rapidly rising inflation, bad outcomes tend to follow.

We can use the Producer Price Index to highlight this characteristic. The graph below shows each occurrence where inflation in the PPI Index was above 3 percent, the most recent PPI value was at least 60 percent above its 18-month moving average, and the cyclically-adjusted P/E ratio was above 16. For clarity, I’ve only displayed the first occurrence in any 12-month period. This set of conditions highlights periods where valuations were high (and therefore risk premiums are low) and producer inflation was rising at a fast pace relative to its recent trend.

It’s clear from the chart that periods following high P/E multiples and quickly rising rates of inflation haven’t worked out well for investors, on average. The worst instances came in December of 1965, three months prior to a 23 percent decline, in February 1973, a few weeks into a decline which would take stock markets down by half, in September 1987, and in September 1999 and October 2007, just prior to last decade’s two 50 percent-plus declines. The May 1989 instance was early, as the economy didn’t enter into a recession until the summer of 1990. But the market was mostly unchanged during this period, and would eventually fall by 20 percent. The one instance that was followed by gains came in July of 2003.

Source: Hussman Funds

Extreme Conditions and Typical Outcomes

Bottom Line: Inflation is bad for stocks, at least until the market has fully discounted it.  At 24x normalized earnings, this is a stretch.  What’s worse than inflation, is the present set of conditions in the market today which are among the most extreme in history.  According to John Hussman, the current set of conditions isn’t observed often, but the historical instances satisfying in post-war data are instructive.  Here’s an exhaustive list of them:

• August 1972, November-December 1972: The S&P 500 quickly retreated about 5% from its August peak, then advanced again into to its bull market peak near year-end (about 6% above the August peak). The Dow then toppled -12.3% over the next 50 trading days, and collapsed to half its value over the following 22 months.

• August 1987: The market advanced about 6% from its initial signal into late August. The S&P 500 then lost a third of its value within 8 weeks.

• June 1997: The only mixed outcome, during the strongest segment of the late 1990′s tech bubble. The S&P 500 advanced another 10% over the following 8 weeks, surrendered 4%, followed with a strong advance for several months, surrendered it during the 1998 Asian crisis, and then reasserted the bubble advance. Over a 5-year period, the overvaluation ultimately took its toll, as the S&P 500 would eventually trade 10% below its June 1997 level by the end of the 2000-2002 bear market. Still, the emergence of the internet, booming capital spending, strong economic growth and job creation, rapidly falling inflation, and dot-com enthusiasm evidently combined to overwhelm the negative short- and intermediate-term implications of this signal.

• July 1999: The S&P 500 advanced by 3% over the next two weeks, then declined by about 12% through mid-October, and after a recovery to the March 2000 bull market high, the S&P 500 fell far below its July 1999 level by 2002.

• March 2000: The peak of the bubble – the S&P 500 lost 11% over the following three weeks, recovered much of that initial loss by September, and then lost half its value by October 2002.

• May/June 2007, July 2007: The S&P 500 gained 1% from the late-May/early-June signal to the July signal, then lost about 10% through August 2007, recovered to a marginal new high of 1565.15 by October (about 1% beyond the August peak), and then lost well over half of its value into the March 2009 low.

• February 2011, April 2011: A cluster of signals in the 2-week period between February 8-22 immediately followed by a decline of about 7% over the next 3 weeks. As of Friday, the market has recovered to a marginal new high about 1.5% above the February peak.

So not including the cluster of signals we’ve observed in recent months, we’ve seen 6 clusters of instances in post-war data (we’re taking the 1997, 1999 and 2000 cases as separate events since they were more than a few months apart). Four of them closely preceded the four worst market losses in post-war data, one was quickly followed by a 12% market decline, and one was a false signal over the short- and intermediate-term, yet the S&P 500 was still trading at a lower level 5 years later. The red bars indicate instances of this syndrome since 1970, plotted over the S&P 500 (log-scale).

Source: Hussman Funds

Piling Debt Upon Debt

What’s wrong with this picture?  While stated Debt to GDP ratios rank at the top of investor concerns today, they do not even scratch the surface of developed world solvency issues.  As shown by JPM, unfunded entitled obligations dwarf existing public debt at home and in Europe.  We need leaders to “get real” and stop making empty promises at home.  The good news is, we only have to fight amongst ourselves to reach an appropriate long term solution.  What are the chances that the various egos and political constituencies across the EU can coordinate a comprehensive solution that appeases all of the individual sovereigns involved?  Wolfgang Munchau of the FT provided the clearest response to our question.  “A monetary union is at a natural disadvantage when it comes to the handling of crises. There is no central government that takes decisions, which makes communications hard to control. What is less forgivable is the serial incompetence of the Eurozone’s decision-makers, as exemplified by the perpetual eagerness to declare the crisis over the very second financial market pressure subsides. Not only do they know little about financial markets, they have surrounded themselves with policy advisers who know little too.”

Source: JPMorgan

Italy is headed for a double dip on our estimates.  So is Spain.  Although markets are pricing in a roughly 100% probability of a Greek default, while crises in Ireland and Portugal have intensified, credit pressures in Italy and Spain have stabilized relative to the three little pigs.  With a hawkish ECB likely to choke off any hope of growth in the periphery, and additional downside risk coming from fiscal austerity, seems that the market’s current complacency is ill advised.  Spain’s total Debt to GDP is at record highs and well above the EU average.  Even beyond the obvious bubble in credit-fueled housing markets, Spanish companies are swimming in debt and barely breaking even, despite the current “recovery.”

Words Fail Me

Great chart below from Soc Gen’s Albert Edwards, which mirrors what we are seeing in various Economic Surprise Indices.  Similar to the first chart we shared above, the change in analyst optimism has led turns in the economy and in stock markets since the beginning of the current (?) bull market in March 2009.  As Albert says, “Post-bubble volatility will continue to surprise. This patch of stronger-than-expected economic data will inevitably subside with the demise of QE2. This is how it was in Japan after their bubble burst. Our most preferred leading indicators are already suggesting the turn is here.”  Markets may have begun to sniff out the economic weakness ahead, as they have done over and over again throughout history.  Or perhaps they are beginning to question whether or not risk assets will continue to levitate without the Fed’s daily bid, which is scheduled to conclude over the next few weeks.  Coincidentally, this would coincide nicely with most of the cycle work we monitor.  The Presidential Cycle should begin to run out of steam in the next few months.  We are also entering a six-month period of negative seasonality from May through October, which has historically been even more troubling with leading indicators declining.  Shorter term cycles point to a near-term top which would most likely be followed by a rally back to trend

to suck in the last of those on the sidelines, right before we kick off a fresh cyclical bear market.

Source: Societe Generale

And to top it all off, probably as good a sign of “capitulation” as any, is the fact that we’ve closed out nearly 20 short positions year-to-date and substantially reduced the gross exposure of the portfolio, at least until we see signs that the market is reconnecting with economic reality.  Pending that reality check, we’ll just stick with our highest conviction ideas for now.  We think David Einhorn – who apparently agrees with our Best Buy investment thesis (although we’ll agree to disagree on a certain Florida land company) – said it best in his recent quarterly letter, so I’ll make no attempt to edit his comments and will simply plagiarize instead – “Much like Charlie Sheen, who seems to believe that all publicity is good publicity, recent market behavior suggests that we are in the part of the cycle where ‘all news is good news’ . . . We expect to take some lumps when our shorts release strong earnings and their stock prices rise accordingly.  Yet this quarter we were repeatedly confuzzled when we read company news announcements that we expect to cause falling stock prices, only to see them rise instead – and sometimes sharply at that . . . Nevertheless, we believe that this environment is cyclical, and that it will continue this way . . . until it doesn’t.”

Is “confuzzled” even a word?  Perhaps my CFA colleagues in Scotland can tell me.  Until then . . . .

Great post from Distressed Debt Investing today.  This is yet another sign of wide-spread complacency as investors truly believe that Bernanke has eliminated all downside risk in asset prices.  Please see the link below and engrain this picture in your head while navigating this “blow off” rally in risk assets.  In recent weeks, we’ve begun to wonder when investors stepped into Mr. Market’s Time Machine back to 1999 (note CRM trading at 244x trailing earnings and the recent $50 Billion valuation on a social networking fad) . . . but it would now seem that we have jumped forward a few more years to 2006-2007 to combine the best of both worlds – a return to the momentum investing of the go-go tech days combined with the more recent free-money bubble in credit.  The speed at which investors have jumped back on the risk bandwagon after being burned twice in the last decade by inflated asset prices, is nothing short of amazing.  Fool me once, shame on you.  Fool me twice, shame on me.  Fool me three times?

In a sense, the financial crises marked a critical inflection point: either the world would rebalance to more sustainable sources of growth, or, on the back of stimulus, continue to pursue the logically flawed policies of asset and credit-driven growth—the very same policies which led to the crisis in the first place. It is now clear that the path of political least resistance was chosen. As a result, the global economy has become more imbalanced with 45% of growth derived from countries running fiscal deficits of greater than 10%. Additionally, central bankers around the globe are now targeting asset prices in order to drive consumption while the emerging economies in Asia have fallen back into the illusory comfort of export-led growth. With China, Japan and Germany—the world’s 2nd, 3rd and 4th largest economies—running perennial trade surpluses, the burden of global demand is placed squarely on the already over-indebted countries of the west, specifically, the US and Britain.

Although the world today remains highly imbalanced, we are also careful not to underestimate the will of policymakers, or ignore the adept management and profitability of many high-quality companies over the near term. We would not at all be surprised by a further increase in equity prices.

Nonetheless, similar to banks in 2007, governments today rely more on access to capital markets to fund themselves than any time in history. Many countries in Europe are effectively insolvent, yet have avoided default as a result of recent liquidity (either provided by markets or from bailout vehicles and supranational entities). Liquidity, however, largely results from confidence. As confidence erodes, sovereign defaults will become more likely.

Finally, the fiscal deflation necessary to cover both the on-and-off-balance sheet liabilities around the world is politically impossible, which, combined with a hyper-expansionary Federal Reserve, provides a positive backdrop for gold, as well as other sound currencies. Although we may tactically alter our position size given the wild swings in sentiment that accompany it, gold is likely to remain a core position for the medium term.

Shorting Congress – Commentary & Strategy (January 2011)

Investors and economists either understand this or ignore it at their peril.  Excessive asset prices (in tech stocks, then in housing, then in . . . ) got us into this mess in the first place.  Our “solution” – more excessive asset prices and more debt.  Witness Bernanke’s response to recent questions on QE’s effectiveness.  Our Fed Chairman actually points to the performance of the Russell 2000 – a proxy for small cap speculative stocks!!  Never mind that US small cap equities are now priced to deliver negative returns over the next decade and are as expensive as they were in December 2007, before the market collapsed!!

Great article from one of the few economists who “get it” in The Times.  Emphasis added.

We cannot support ever-rising debt.

Andrew Smithers
The Times – Economic Opinion, 29th December 2010

Most macro-economic theories had egg all over them when the financial crisis broke. Only a few economists, among whom I am naturally proud to be included, warned of the looming problems. The signs of trouble lay in excessive asset prices and too much debt. But most economists saw nothing to worry about because asset prices and debt have no place in their theories.

In the immediate aftermath of the crisis there were some signs of contrition. Dr Bernanke, the Chairman of the Federal Reserve, who had previously insisted that asset prices did not matter, appeared willing to reconsider the question. Such doubts seem now, however, to have been forgotten. Few of those who give recommendations on economic policy have changed their views to reflect our sad and dramatic experience. They forget that those who refuse to acknowledge past errors are likely to repeat them. It has been said with more wit and truth than charity that “Science advances obituary by obituary.”

The traditional and unreformed schools of economists, such as Monetarists and Keynesians, want further stimulus to the economy by increasing debt. Keynesians want faster growth in national debt and Monetarists in bank debt. The major division today is between those who see more debt as the way out of our current difficulties and those few iconoclasts who saw debt as the cause of our troubles and now fear that more debt will add to them. 

Since World War II the world economy has grown well, but growth in output has been dwarfed by growth in debt. In the US debt has tripled as a percentage of GDP, with private sector debt growing five times as fast as output. This raises two major questions. Why has it occurred and how long can it continue? The first is quite easy to answer. It has paid! Despite the dramatic increase in private sector debt, there has been no comparable long-term rise in the losses suffered by lenders and thus nothing to discourage them from even more lending. Economic policy has been responsible for this. When an economy slows, bankruptcies rise and the losses suffered by lenders make them cautious about new lending. To stop such caution causing the economy to contract, governments and central banks have stepped in. Debtors, and thus of course lenders, have been bailed out by increased budget deficits, lower interest rates and, on occasion, by direct support for failing companies.

Until recently these policies appeared to be successful. Recessions and periods of rising defaults have been mild and short-lived. Governments and central banks have combined to ensure that there has been no increase in the overall risks run by lenders. The specific risks run by bankers and other lenders, which are that individual borrowers will default, have remained in place. But lenders have been insured by official action against the risk of a general rise in the level of defaults. Had this been allowed, it would have discouraged lenders and stopped the growth in debt relative to output. This would have had the short-term disadvantage of making recessions sharper and more frequent. But it would have had the huge advantage of avoiding our recent asset bubbles and the major recession which has followed. We suffer today not only from a severe loss of jobs and output, but also from the dramatic rise in budget deficits which has weakened our ability to cope with another debt crisis.

A clear sign of the limits to our ability to support ever rising debt has been given by the Irish crisis. Before the trouble broke, Ireland had a very low national debt and was running budget and current account surpluses. Its problem was the huge level of debt in the private sector. When borrowers ran scared that they wouldn’t be repaid, the government was forced to make its implicit promise to bail out lenders into an explicit one. Excessive private sector debt suddenly became an excess level of national debt. 

For the past 60 years output has grown far more slowly than debt. It has been rightly said that what can’t go on forever, will stop. Keynesians tend to respond by saying that this is a long-term problem and, quoting the master “In the long run we are all dead.” The Irish crisis suggests, however, that we are all now living in the long-term.

Excessive worries about the short-term outlook for the economy were the fundamental cause of the current crisis and radical short-term measures were, I think, needed to deal with the result of past errors. But it is surely time to turn our attention to the long-term issues of debt and excessive asset prices. There are obvious steps that should be taken and equally obvious steps that should be avoided. One positive step would be stop subsidizing debt as we do today, by making interest an allowable expense for corporation tax. One thing we should not do is push up asset prices through central bank buying, known as quantitative easing. We have an asset bubble in bonds and, although US share prices are nothing like as overvalued as they were in 1929 and 1999, they are at levels equal to the other peaks of 1906, 1937 and 1968. Although this does not mean that the bubble will burst next year or even in 2012, we are running large and unnecessary risks. The Federal Reserve’s policy of asset buying, known as QE 2, seems to me to be most ill-advised.