Will the Next Recession Look Different from the Last One? (Assuming the Last One Has Ended)

Mish has a post up involving a discussion with a Cerdian economist named Ed Leamer. I am going to comment on one point:

Leamer: Dips come from collective postponement of the postponeable purchases: homes, cars and equipment. But all three of these are at record lows relative to GDP after all the postponement that has already occurred. (After having falling to the floor, the economy has to at least get back to its knees before it can fall again.)

The dip Dr. Leamer is referring to is a new recession.

I wonder if his thinking reflects conventional thinking. I also wonder if when the next recession occurs, it will again fool the experts who are thinking as Dr. Leamer things and thus will not foresee it because it occurs on the less cyclical consumer spending side of the economy.

Meanwhile, we had a turnaround Tuesday today. Gold and silver reversed, and perhaps the record or near-record spreads on the yield curve out to 30 years have peaked. In the meantime, given the collapse in the fraction of the potential labor force that is actually working, we may simply see a combination of a continued retrenchment in consumer spending (especially that which is not due to government transfers/money-printing) and a government in financial straits pulling back on its support of housing. Plus, oil prices have been known to spike unpredictably. What would that event due to auto sales, travel and the like.

In the meantime, BofA ("BAC" symbol) fell 2 1/2% today, sadly once again hitting resistance at its declining 50 day moving average. The nearby chart tells the tale. It is one thing when gold or AAPL, in confirmed structural bull markets with prices that have been bid up fast and high, sell off. It is another thing when a laggard in a lagging industry helps lead the market down following a surge to overbought and over bullish levels. Informed people such as Chris Whalen of Institutional Risk Analytics have been stating that BofA is insolvent and needs to be taken under government protection with its bondholders taking haircuts. The government presumably would make great efforts to avoid this, given the effect on confidence such an action would have at this stage of the so-called recovery.

If Mr. Whalen is more or less correct, then the "Japanification" of the United States continues with seriously impaired major financial instutions existing as zombies ("too big to fail"). The 5-7 year notes are at or near all-time record low yields except for the past week or two. Who knows, but as the banker to the world, all the U. S. has to do is stop importing all elective things and the world will run short of new dollars. Thus I suspect that for all the moaning elsewhere about QE2, overall most of the rest of the world is happy to see America poorer and getting ready to ship its products to them rather than taking the fruits of their labor in return for our depreciating paper. Barack Obama predicted that the world would not let us live in our big homes wasting carbon-based fuels during his campaign. Meanwhile, though, there simply is no other currency ready to take the dollar's place as a reserve currency. (Gold will have to wait. The world is not ready for it yet.)

If he was correct on that in one way or another, please don't be surprised if the U. S. joins Japan and suffers a new recession despite zero interest rates.

Copyright (C) Long Lake LLC 2010

Distortions Galore

I was going to write a post about one data point or another that came out today, but Calculated Risk plus Bloomberg cover them all. The bottom line is that in past years, when one economic datum after another comes out weak--ranging from ECRI's WLI growth rate dropping below 10% (a level not even reached in the severe 1981-2 recession) or the various weak reports out of new home sales (record low sales), the Dallas Fed Manufacturing Index and the like, and the widespread skepticism that the European bank stress tests are useful, the stock market usually drops and Treasuries rally in price.

Not now. Perhaps the prospect of zero interest rates forever has gladdened the hearts of valuation algorithms amongst owners of capital.

The VIX has dropped to around 23. In turbulent economic times I have noticed that it averages roughly 25. In good, stable times it is in the teens. Thus the VIX hit a record low late in the last decade's bubble period.

It appears to me that when record low governmental interest rates are widespread and are dropping, this could only fail to be a bubble in government debt if price deflation were present--and this would be "good" deflation, associated with greater supply of goods and lower real costs of production.

This is how living standards improve rapidly.

The last time the U. S. had this sort of "good" price deflation was in the latter part of the 1800s.
But guess what: there was virtually no Federal debt then. There was no central bank. There was no involuntary unemployment. Gold was not an investment; it was money. Financial paper took the place of money but was recognized as not being money. Living standards soared and immigrants flowed without restriction into this country, the only requirement being passing a medical test for public health reasons.

Now, any deflation we have is the "bad" kind: price-cutting, such as of homes, due to overproduction. But we have "underproduction" of iPads due to component shortages (presumed temporary).

An example of "good" deflation that theoretically might occur would be the simultaneous discovery near New York City and Los Angeles of massive amounts of easily accessible fields of natural gas, sufficient to displace huge amounts of imported oil.

I'm not holding my breath for any such game-changing event, however.

What I do see is rampant overpricing of financial assets all over the place, this being a sign that too much "money" has been "printed". Yet the real economy is far less buoyant. Not only is this disconnect unhealthy, but since the money is circulating in New York and its printing supports the establishment in Washington, the result is that people look around themselves in their localities and see a distorted view of the real economy.

It's sort of like trying to see what the temperature is out on the farm by putting your thermometer inside a hothouse.

But the Federal Government is locked into a Japanese-style model in that its fiscal health waxes and wanes with the economy. When the economy is weak, Federal finances weaken. Normally, the "market" would make the increasingly leveraged borrower--the Feds-- pay an increasingly higher price to borrow. Inexplicably, as default chances rise, prices have been falling on said debt. Is this due to "crowding out", manipulation, or no other good investments being perceived available to typical bond investors?

If, for one reason or another, the U. S. is going Japanese (before perhaps defaulting), then the pattern in Japan provides a good template. That template includes huge undervaluation in stocks; and, gold has moved to a record high in yen terms over the years. If one lives in Japan and thus has had roughly stable consumer prices for years, then gold has quadrupled in yen terms.

Anyone who thinks that money printing/massive deficit spending associated with a zero interest rate policy exempts the pricing of tiny minority fractional ownership of corporations (aka stocks) from traditional valuation measures may want to study the Japanese financial experience.

Of course, the U. S. is not Japan, past need not be prologue, etc. Nonetheless, isn't there a saying or two about learning from history?

Copyright (C) Long Lake LLC 2010

The New Bubble: Feds May Need a Stock Crash to Keep Deficit Spending Affordable

We are moving into government bailout bubble territory in the U. S. The state of California had to (could) increase the size of its bond offering. What's up with that? The Feds are helping.

A potentially vast new FHA rejiggering of mortgages to help bail out borrowers and lenders alike with taxpayer funds has just been announced. The money is said to be coming from some prior bailout funds.

The surprising thing is that with the flood of issuance, the 10-year is not back above its peak of last year in yield. Certainly sentiment on the Treasury bond is as bad as can be imagined. Meanwhile "liquidity" is running wild. The "smart money" "knows" that the party will continue until the Fed tightens, thus stocks and junk bonds are buys.

When I look at my Value Line charts, I can find almost no stocks below their "value lines". Some such as Oracle and Mickey D are at their lines, but one is left with TJX and DLTR, Chubb and Everest Re (insurers highlighted by Barron's today), and scattered others. Mostly the chart patterns look long-term weak, short term overbought. You never know with bubbles and can't try to pick the top.

Holding this bubble together is a rickety edifice.

If Treasury yields surge, look out. Since Obamanomics requires low borrowing rates, watch out for the opposite happening. Obamanomics requires Treasuries to have low rates more than companies to have high stock prices. The more people and businesses suffer, the more the Feds can step in and save them. The question is whether the government can keep long rates low or even for them to move much lower. The Japan scenario, in other words. 1-2% inflation would be fine to allow 3% 10-yar treasury yields. Remember that long rates were much lower than today's all through the 1940s and well into the 1950s even as some years of war and post-war high inflation came and went. In other words, sometimes rates can be well below inflation. It just depends on psychology and on relative opportunities. And right now cash is trash and stocks are fundamentally overpriced.

There is no good general investing solution right now other than trading profits, which most people living normal sane lives cannot hope to achieve. I still think that one of these months, we are likely to see a recrudescence of a Treasury buying surge/panic. No idea when, though. But unlike with stocks as a whole, the 10-year pays you to wait.

Gold continues to act as suggested here. It is frustrating traders, short sellers and long-term investors. The more the financial markets inflate in price and gold does not, the more it is likely that gold prices are set to surge.

Copyright (C) Long Lake LLC 2010

Financial Markets and Health Care "Reform"

Whether an investor considers the just-passed reshaping of the health insurance system in the U. S. as beneficial reform or "deform", your thoughts quickly turn to that which you can control: your money.

I confess that I have not kept up on the amount of tax increases that are now scheduled to take effect over the next few years before the real costs (benefits to recipients) are felt by taxpayers. For now, this legislation withdraws spending power from the public and taxes interest income and capital gains, I believe with a new 3.8% "Medicare tax" (a misnomer, as revenues go to the general fund).

This is occurring while two fundamental measures of stock market valuation each show at least 50% overvaluation: cyclically-adjusted price-earnings ratio (CAPE) and "q" (valuation of non-financial stocks based on replacement cost). Please click HERE for a link to Smithers & Co.'s chart and commentary on this.

Can the anti-stimulus measures of upcoming revenue enhancements and the real and psychological effects of increasing taxes on income derived from savings (which savings derive from income that has already been taxed) provide the impetus for declining stock prices and rising prices of Federal debt?

In other words, the Japan scenario, in which imposition of a national sales tax was associated with the above results in the 1990s?

Yes.

Copyright (C) Long Lake LLC 2010

China Banking Crisis Coming?

Bloomberg.com is reporting that China May Face ‘Massive’ Bank Bailouts After Stimulus Program.

One year ago the L. A. Times reported on a raft of empty, "see-through" office buildings in Beijing, built for political reasons. This article suggests that just as the academic and Big Finance economists who warned that the U. S. housing market had levitated into a bubble were proven correct, foreigners who have no first-hand knowledge of what's going on in China are wise to be cautious about its real prospects. From the article:

China may be forced to bail out banks that made loans for local-government projects under the unprecedented stimulus program unleashed in 2008, according to Citigroup Inc. and Northwestern University’s Victor Shih.

In a “worst-case scenario,” the non-performing loans of local-government investment vehicles could climb to 2.4 trillion yuan ($350 billion) by 2011, Shen Minggao, Citigroup’s Hong Kong-based chief economist for greater China, said yesterday.

“The most likely case is that the Chinese government will engineer a massive financial bailout of the financial sector,” said Shih, a professor who spent months researching borrowing by about 8,000 local government entities. . .

Shih was more pessimistic than Shen in an interview on Bloomberg Television in Hong Kong yesterday. He said that if the central government stops lending to the entities now, the cost of a bailout may already be “in the neighborhood” of 3 trillion yuan. . .

The article more briefly presents some other viewpoints and is worth reading by many investors, given China's role in the commodities market. If China cools off, all commodities price will tend to follow. If China actually experiences a bursting bubble, it's a look-out-below scenario at least for a while for a great many markets with the possible exception of gold, which one of these days may stop tracking the stock market.

The larger context of the above issues is that it is a fact that China went on a credit binge in the aftermath of the fall 2008 global financial crisis. The U. S. government has done the same with the collaboration of the Washington-based Federal Reserve Board (which for all practical purposes is a public-private entity with the emphasis on public and thus is currently best thought of as an arm of the Federal government and the privately-owned New York Federal Reserve Bank). Certainly Britain has moved almost in policy lockstep with America. The countries with better banking regulations such as Canada and Australia actually may have their own housing bubbles or at least significant booms. Japan has continued to print money.

In other words, major governments all over the world have responded to a crisis caused by too much debt by socializing the losses at the cost of new government borrowings. This means that the return of corporate profits is largely due to money-printing rather than corporate brilliance, the sudden implementation of major cost-saving measures (other than such examples as IBM slashing R&D expense), or organic growth.

Gallup.com's near-real time polling data show that hiring/not hiring remains mired where it was 16 months ago. The same % of people think the economy is poor as thought so 20 months ago.

The stock market has bounced and hiring has lagged, just as predicted by Reinhard and Rogoff's research into banking crises ("This Time Is Different" is their ironically-titled book on the subject).

Almost every economist, investor and day trader "knows" that we are in a sweet spot of the investing cycle, with the economy due to turn up while the Fed remains easy, valuations are (allegedly) cheap to reasonable, and that happy days will be here again so that there will be gullible investors to sell overpriced stock to. Even hard-headed Andrew Smithers has sounded a softer tone, despite his own research showing that historically, this is a miserable time to be in the general stock market.

While Bloomberg is reporting that only now has American investor optimism replaced pessimism, my own review of Value Line's stock charts shows no bargains. Whether or not they have been optimistic, stock prices are "too high" or at least too high for current profits, asset value and dividends in my view for most individual issues, with the "junk" the worst buys.

MCD is my current favorite of the quality stuff, based on various chart patterns, recent operational news, and other criteria. Of greatest importance is that while it has not quite traded above its all-time high of mid-2008, its 50-day and 200-day moving averages are both at all-time highs. So this recent move to $65 and above is well-supported. This thinking worked out well for gold last summer. Even if MCD doesn't go up in price, its yield beats cash and is close to that of a 10-year Treasury and is likely to rise steadiliy in the future.

A few working days ago, I spoke favorably of long Treasuries for a trade (TLT). I closed that trade out with a small profit Friday. TLT went up a little more after I sold it. Any government as powerful as the U. S. government can keep supplying enough bonds to the market to overwhelm the possibility of meaningful price appreciation. It appears as though this administration, with the support of Congress, means to do just that. Perhaps by November, China will be seen to have a bursting bubble, a Perot-like zeal to shrink our Federal deficit will have gained real power in the elections, and Treasuries can surge up in price (down in yield) as David Rosenberg has been forecasting for some time.

Thus a core holding in Treasuries is reasonable, but it should be in direct ownership of bonds, not in a perpetual fund that in theory could provide zero nominal return indefinitely. The Japan scenario remains a realistic possibility for the U. S., which would surprise almost everyone, perhaps even the Japanese.

Copyright (C) Long Lake LLC 2010

Stocks Are not Cheap, No Matter how a Chart Is Drawn

As markets float upward following the path of least monetary resistance, the argument is made that the "market" is "cheap".

Today's Chart of the Day implies that P/E (price to earnings) ratios are comparable across the decades.

Unfortunately, that is not so. The greatest reason this is not so is the recent introduction of "non-recurring" earnings that are not presented according to Generally Accepted Accounting principles. In other words, today's earnings are often overstated relative to prior periods' earnings, thus falsely depressing the P/E.

This is one reason why dividend yields are so much lower than historical yields, despite alleged payout ratios that are much less different than before. (Another reason is the weaker financial strength of dividend-payers; decades ago there were numerous AAA-rated companies, now even though the economy can support more companies and they are bigger, there are hardly any.)

This blog recently pointed to Teva Pharmaceuticals, which is a litigious primarily generic products company, as a high-quality large-cap company that arbitrarily has decided that when it pays out hundreds of millions of dollars to brand companies for patent infringement or other patent-related costs such as out-of-court settlements, those dollars are not costs for purposes of earnings presentation.

It was not long ago that GAAP was the standard and only way earnings were presented. It was up to analysts to make the case that perhaps the stock price was too low due to GAAP peculiarities.

The problem now is that the financial community hardly ever goes beyond "earnings" in valuing stocks, unless it wants to highlight potential future earnings or earnings growth rate. Dividend yield and especially book value or asset value are forgotten. But the problem with pointing to non-GAAP "earnings" and excluding patent costs or the infamous "restructuring" costs (which pretend that closing obsolete factories is not a normal, recurring cost of doing business) is that the money is still not there.

A person can pretend that a sudden business or investment loss, or adverse IRS ruling is non-recurring. But a lender does care about income but also should care about net worth.

According to both the cyclically adjusted P/E and "q" (or Tobin's "q" ratio), stocks are about 50% overvalued. These two are favored by Andrew Smithers, a noted economist whose research has shown that these two measures are the two valid methods of measuring fair value in the stock market.

Because of the nature of those two measures, they cannot change quickly. A good year for earnings or real corporate wealth accumulation only changes them somewhat. Thus a 50% stock market fundamental overvaluation means that investors should be extra wary when a free chart purports to suggest that the "market" is historically "cheap".

Virtually all financial assets are expensive.

Choose your flavor. My flavors include financially strong companies that do not routinely present non-GAAP "earnings" with any prominence that have strong charts and strong real earnings trends, preferably with dividends, and with historically average or better than average fundamental valuations; gold for long-term safety; cash because everything appears too rich; and Treasuries because of the Japan scenario.

Copyright (C) Long Lake LLC 2010

Cross-Currents in the Treasury Market

The nearby charts nicely show the conflict between a short-to-intermediate term view of the 10 year Treasury note (bond) and the long-term view. (Click on each to enlarge.)

The 2-year view shows both lower highs in yield conflicting with a more rapid uptrend line that defines higher lows, with the panic December 2008 low the obvious starting point for the uptrend line. Conventionally, the likelihood would be that the more powerful trendline upward would tend to win out and that rates would push higher.

On the other hand, the post-1982 major downtrend in rates is clearly intact.

Very short-term, the 10-year is acting as though it wants to rise in price and thus for rates to move lower. Thus a speculative trade in IEF has chart support, but it is speculative because unlike ownership of an actual bond that pays off at par (presumably) at a date certain, ownership of an ETF is perpetual ownership and theoretically can decline in price indefinitely if yields on bonds continually rise.

The Big Finance companies' charts are of little help now in guessing the future.

Assuming that economists will judge that the economy bottomed last year, then if the current economic cycle follows the pattern of the past several, we can look forward to an irregularly-rising yield on the 10-year until the next economic downturn, when new lows in yields can be projected on the charts. This would be the Japan scenario. If this happens soon, before much real wealth can be created, then the Japan/Ice Age scenario would be a reasonable outcome. One of the straws in the wind in favor of this is diminishing foreign appetite for our debt. The Japanese government keeps selling more and more bonds to Japanese, and thus any default will be almost exclusively an adjustment of accounts within the family, perhaps consensual, perhaps contentious. That could certainly happen here.

Copyright (C) Long Lake LLC 2010