Sunday, May 22, 2011

Exited, Pursued by a Bear

We may be on the verge of learning more about how much capital has been wasted by the malinvestments of the past decade. I believe that the single most important stock group is the financial group. It is the financials that reflect whether the "marks" that are assigned to assets are accurate, and if they are inaccurate, in which direction the inaccuracy is. As Shakespeare might have said, leverage is all (unfortunately), and the financial stocks reflect this modern reality.

When economic activity is increasing and especially when it is accelerating, financial institutions have strong capital bases and compete with each other to lend funds. When there is a sound base for economic expansion, as in the 1980s and 1990s, the lenders have lots of good credits to consider, and in return, the good credits are able to provide substantial collateral and/or down payments to the lender. So the loans tend to be net profitable to the lender.

Internet 2.0 and weak dollar matters aside, and government spending (i.e. Fed "money") notwithstanding, there are no signs of that happier situation in the country as a whole as we approach two full years since the trough of economic activity. The top tier "Too Big to Fails", namely JPM and WFC, have uninspiring stock charts and have continued to underperform a rising stock market. This is just what happened in 2006 and 2007. On the other end of the quality scale among the TBTFs, here is a 5-year stock chart of BofA. A renewed bear market in the stock is threatened. (Please be aware there is no prediction here of what the stock price will do, especially in the short term.) But I will disclose that I have sold the stock short, creating my own micro-mini hedge fund considering I own a considerable amount of offsetting but not very liquid long positions in a similar place but with, I feel, better value for the price.

To a somewhat lessened degree, Goldman Sachs and Morgan Stanley have stock charts that look like BofA's.

There has also been no sustained sign of life in the truly moribund giant financials, Citigroup/AIG/Fannie/Freddie, all of whom were saved from some form of bankruptcy by direct support from the central authorities.

I take this as a bad fundamental sign. If matters go well in the economy, one will look for sustained outperformance in these companies. Right now, I prefer not to fight the tape. And since the Fed is scheduled to end QE 2.0 imminently, a cautious or bearish stance toward stocks is no longer fighting the Fed. If the Economic Cycle Research Institute (ECRI) is correct in their prediction of a significant global industrial downturn beginning this summer, these global financial companies should see their own business both diminish overall and switch more toward less profitable segments, such as fixed-income trading rather than M&A and stock trading.

There are also valuation metrics which resemble those extant at the 2007 peak. To wit, here is a chart from the Andrew Smithers website. Please note that the S&P 500 is up from where it was when this chart was created. Click HERE for an explanation of both independent valuation measures this graph utilizes.

The averages are at similar degrees of overvaluation as have rarely been seen in the past 11 decades.

People protest that current values are "OK", because interest rates are so low. My response is a "Yes, but" type of response. Interest rates are low because organic credit demand is lacking. This is the problem of our current biflation.

The nominal price of homes is flat to down. Housing grew to be such an important source of non-revolving credit that it became the animal that could sit wherever it wants. When housing went down and continues to stay down, significant percentage upticks in credit demand in much smaller sectors (smaller from a credit standpoint) fail to replace housing's importance. Thus, capital was credited to savers such as myself, but there is a surfeit of capital relative to users of capital. So, the weak credit environment explains the low interest scenario (without justifying the extremism of the zero interest rate policy of the Fed), and that goes hand in hand with weak economic growth prospects. These weak prospects are, in my view, enough to be consistent with much lower stock prices.

It is my view that all the money-printing, bailouts, happy talk from the media, and the like, have lulled investors to sleep. However, how many investors realize that from their respective bottoms in fall 2008 and winter 2009, gold has has a somewhat greater appreciation than the Dow Jones Industrial Average, dividends included? In other words, since the stock market bottomed in nominal terms in March 2009, it has actually declined further in terms that I prefer, namely gold.

Meanwhile, not only is housing double dipping, but autos are dipping as well, and at a much lower annual rate than was the case at the peak in the aughties. From J. D. Power and Associates:

High Gas Prices and Lower Incentive Levels Contributing to Dismal Start for May New-Vehicle Retail Sales

" . . .Retail sales in May are being hit by several negative variables—specifically, high gas prices, lower incentive levels and some inventory shortages," said Jeff Schuster, executive director of global forecasting at J.D. Power and Associates. "As a result, the industry will likely be dealing with a lower sales pace at least through the summer selling season, putting pressure on the 2011 outlook.'"

It is clear from the title, the above excerpt, and the whole text of the press release (which makes clear that most U. S. and global auto manufacturers have no exposure to Japanese parts and thus can make all the cars the market can afford), that the automakers' main problem is that when they tried to raise prices (by removing or decreasing incentives), buyers could no longer afford their merchandise, in view of the economy in general and gas prices in specific.

Because homebuilding and the industries that feed off of new home sales and home resales are so depressed, the ongoing depression in those industries will not be enough to cause a new recession. It will however be enough to eventually cause the accountants to lose patience with unrealistic valuations of real estate owned by banks (REO) and the value of mortgages, especially second liens. This is why I highlighted BofA above.

Finally, real people are feeling just like the stock market when the stock averages are adjusted for gold's price. They are seeing and feeling no improvement in their lives. Here are two examples. runs a daily crawl on its website that tracks a measure of employment levels and discretionary spending. Currently, the average respondent is spending $62/day. My recollection is that 3 years ago, when I started following the same website, spending was about double that. And this is not adjusted for the general increase in prices. Thus, people are truly squeezed. On the same site, the hiring/not hiring differential is only +12 today. It was +25-30 3+ years ago, when unemployment was rising, so this level is at best consistent with employment growing in line with population growth (in my very humble opinion).

The second example is Bloomberg's Consumer Comfort Index. This has sunk to 9-month lows:

So when I think of the intersection of markets and the economy, I think that the American people have it right. They know what's happening in their jobs, communities and bank accounts. For the first time in memory, a technical recovery in the economy and a surge in the stock market has left almost all people behind. There is no magic to this. It simply reflects an amazing amount of money printing. It is my supposition that all this new base money has been created by the Fed because the amount of capital that was destroyed (misallocated/malinvested) was massive. The weakness in the dollar, which commentators usually wrongly describe as strength in gold, simply reflects that the country was never really as rich as it was measured as being in the late 1990s till the Great Recession finally brought the reality home. One of these days, the stock market will resume being a weighing machine rather than a voting machine. What the nominal pricing will be is unpredictable, but one of these days, a look at the 110 years of the Smithers chart suggests that the stock market will be depressed as far below its average as it is now above.

That's why, for what may be a summer of negative economic news, I have fled growth-oriented investing and weak-dollar investing and have circled the wagons around the basic investments of gold, cash, and Treasuries. Barring general systemic collapse, the worst that can happen to me in this posture is that I do not participate in some up-moves. But I can sleep a lot better that way than if capital is destroyed by what I view as the stock market reverting to normal pricing of pre-owned securities.

Copyright (C) Long Lake LLC 2011

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