Quotable Quotes: Richard Koo and Martin Wolf

Today, I am reinstating a popular blog service that I provided several years ago: Quotable Quotes.

In the past, I would seek out interesting and often humorous quotes from the very well known to those of lesser fame. In this updated version, I will include comments and other relevant data that are appropriate to the current economic, political, and market times.

The first installment (below) begins with a letter sent to and published in The Economist from noted economist Richard Koo. The emphasis (bold and italics) is added by me to accentuate key points that struck me as especially useful in understanding key elements in the investment decision-making process.

The second is an excerpt from Martin Wolf's most recent economic commentary. I encourage all to read his complete commentary (link provided, FT subscription required).

I trust you will find this reading well worth your time.

August 20, 2011

A different kind of crisis

SIR – The title of your leader on the debt crisis was well chosen (“Turning Japanese”, July 30th), but you missed the point. The Japanese problem of the past 20 years, together with the American and European problems of today, boils down to one fact: the economics profession has never considered a recession that could be caused by the private sector minimizing debt in order to repair balance sheets after a debt-financed bubble in asset prices. As a result, the profession has no clue as to what is the right thing to do.

In this rare type of recession, monetary policy is useless because people with negative equity will not borrow, no matter what the interest rate. Nor will there be many lenders when banks have such huge problems with their balance sheets.

In this environment, therefore, government must borrow and spend the savings generated by the deleveraging in the private sector in order to keep the economy from entering a deflationary spiral. But as John Maynard Keynes noted, it is almost impossible to maintain fiscal stimulus in a democracy during peacetime. It is this difficulty that prolongs this type of recession; it took Japan ten years to climb out of the policy mistake of premature fiscal consolidation in 1997.

The drama in Washington and other capitals is almost the exact replay of that confused policy debate in Japan. And the drama will continue until the public realizes that this is a different disease requiring different treatment.

Richard Koo

Chief economist

Nomura Research Institute

Tokyo

August 30, 2011

Struggling with a great contraction

Mr Obama wishes to be president of a country that does not exist. In his fantasy US, politicians bury differences in bipartisan harmony. In fact, he faces an opposition that would prefer their country to fail than their president to succeed. Ms Merkel, similarly, seeks a non-existent middle way between the German desire for its partners to abide by its disciplines and their inability to do any such thing.

Martin Wolf
Chief economics commentator
Financial Times

Life After QE2

“…it’s far from clear that the recovery will prove self-sustaining.”
Paul Krugman
NY Times, April 4, 2011

In his “The Transmission Mechanism for Quantitative Easing” commentary, Dr. Krugman delves into the how, why, and to what extent QE2 has worked thus far. He points to the sources of growth in US GDP (see accompanying chart) and highlights the fact that consumption and exports account for nearly 90% of the increase. Going a step further, Mr. Krugman then explores how a weaker US dollar and a higher stock market are likely significant factors to the results noting, “…casual observation suggests that a lot of the growth in consumer spending has been at the high end, which suggests in turn that a higher stock market might be driving it. And the lower dollar has clearly helped US exporters and import-competing firms.”

One conclusion from his analysis has to be the Fed’s intention of lifting the value of risky assets (stocks, specifically) and, thereby, triggering the “wealth effect” which then produces greater consumption which in turn helps the overall economy. However, as Mr. Krugman also notes, “…a lot of the growth in consumer spending has been at the high end…”, which helps bring him to a conclusion that is the crux of yesterday’s blog commentary: will the end of QE2 usher in an era of private sector led sustainable economic expansion?

If yes, then the US economy will (at best) continue to improve and maybe create the virtuous circle that enables the Fed and the government avoid, but more likely forestall, the day of economic reckoning.

If not, then what? Just a few points investors should contemplate as the stock market continues its Alfred E. Neuman (oh, excuse me, its climbing a wall of worry) rally.

This Time IS Different

The bulls (not the bears) would have you believe that this time is different.

The root of this view in anchored in the dogma that the cyclical recovery cures all ills as follows:

The cyclical recovery evolves as increased corporate spending on wages and new hires which, along with an increase in emerging economies’ consumer spending, result in a consumer led demand driven sustainable cyclical expansion. Corporate profits rise further enabling the virtuous circle to become engaged.

The sustainable cyclical expansion then helps to alleviate the structural risks to the global economy – e.g. current account imbalances – thereby enabling the financial sector to recover further and move the global economy off government life support.

The financial markets respond with a move more toward normality as rates rise, the dollar stabilizes, gold loses its luster, and equity valuation levels return to above average (>15 times). The combination of higher corporate profits and above average P/E levels drives stock prices back to record highs, which for the S&P 500 means 1548 (18 x $86).

An era of growth and prosperity returns thereby proving that this time is not different; that there will be no new normal (i.e. below average growth and profitability).

Sounds good, doesn’t it? Even plausible, provided one thing – conventional thinking in unconventional times requires a belief that this time IS different.

The Burden of Proof

The bulls would have everyone believe that the burden of proof that this time is different falls on those who say what was no longer works (the old normal) and that the future is a place of great uncertainty (the new normal) with the road ahead a most bumpy one. There’s one problem with this thinking – evolutionary processes to new normals are normal. A purging of the old always occurs and it always leads to a new normal, whatever that new normal may be.

Extrapolating the recent past into the future often becomes a substitute for first order thinking. Be it fighting the last war or blindly accepting corporate earnings guidance, embedded interests conspire to preserve the status quo, which facilitates a blindness to change. And it is change that is normal, not what-worked-before-will-work-again-indefinitely thinking, made all the more illogical given the highly dynamic complex global macro environment the world finds itself in.

In evolution, those that are about to become extinct are the last to notice. The same is true in the social sciences of economics and the markets, where old rules in changed times demand the view that this time is different.

Doing the Valuation Math

Now that my market forecast events have begun (with NYSSA's event last Thursday), it's time to do a little valuation math for the year ahead. So, based on the initial comments heard at last week's event and elsewhere, here you go:

18 times $80 (S&P 500 operating earnings for 2010) = 1440.
1440 minus a present value discount (12%) = 1267

This is the bulls’ case for why stocks should go higher this year – an above historical average P/E times a robust earnings growth for 2010 minus an historical average discount rate (bringing the future value back to the present*) equals a most profitable year.

The valuation debate is a paradox – simple yet complicated. Simple in that the formula is rather easy to compute. Complicated in that the social science known as investing involves numerous variables, many of which are highly subjective. For example, the P/E used in a valuation model is based on the views of the investor for the economic and market times of the moment and the near future. In the current case, the bulls would argue that an above average P/E is appropriate for the current and near future because history says so – low inflation + robust economic growth + strong corporate balance sheets = above average P/Es. Exactly what level above the historical average P/E (which happens to be 15) is the subjective wiggle room and a key area of the valuation debate. Then there is the earnings number.

$80 operating earnings for the S&P 500 for 2010 is the best case number I am hearing of late. Of course, this number is open for debate. The final two components that investors might want to ponder doing the valuation math involve the discount rate and the time period.

In the above illustration, I used the historical average return for large cap stocks, which has often (but not always) been 12%. Some would argue that 10% (or lower) is a more appropriate going forward expected return for stocks given the slow growth environment envisioned for the next several years for advanced developed economies. Then there is the time period one discounts the future value. In the above case, I use 12 months. Some might argue things are far to dynamic and a 6 month discounting time period is more appropriate.

Investment Strategy Implications

Wherever you fix the fair value of today’s market, the valuation math always needs to be done as it provides the return context for an asset. For what it’s worth, I think these times are extraordinary and do not warrant an above average P/E (which signifies a below average risk climate). Rather, I would argue the uncertainty factor for 2010 is considerably higher than the bulls believe, despite the prospects of a robust earnings period for the large cap, multinational companies that populate the S&P 500. Risks in areas broad (e.g. geo political, US domestic political, developed economies’ internally generated growth) and specific (e.g. sector specific issues such as those facing the financial services and healthcare industries, sustainability of Chinese growth, regulatory change) are abundant and should be ignored at one's financial peril.

All of this leads to the more prudent conclusion that an average P/E times a moderately higher earnings growth rate is appropriate. In other words,

15 times $74 = 1110
1080 minus 12% = 977

Therefore, at today’s price of 1140 the market is currently 14% overvalued.

Liquidity driven markets have a funny way of producing overvalued markets. And an even funnier way of producing justifications for just about any fantasy valuation levels one wants to concoct. At least for a while.

*Note: It is important to remember that on any given day stocks sell at a discount to their expected future value. Therefore, today’s price is always a discount to where stocks should be in the near future.

We Have Nothing To Fear But Uncle Sam Himself

No, this won’t be a Limbaugh/Beck/Cato Institute inspired rant against the evils of big government. Rather, today’s commentary focuses on the FUD factor - fear, uncertainty, and doubt – that many small businesses harbor toward where the US economy (and the regulatory side of our government) is headed.

Investors know the adage that the markets abhor uncertainty. In the current economic climate, what should be appreciated equally as much is how uncertainty is playing into a diminished US economic recovery: global multinational big earnings notwithstanding.

When I started focusing on the potential of a bifurcated earnings season several months ago, I noted the risks to the US economy and the need for a sustainable, organic economic recovery. As the primary engine of jobs growth, small businesses are key to a sustainable economic recovery – a point highlighted in my September 22nd David Malpass podcast interview and recently emphasized again in a Bloomberg Surveillance radio interview with the National Federation of Independent Businesses (NFIB) chairman, Bill Dunkelberg.

As Mr. Dunkelberg noted in the November 20th Bloomberg radio interview, normally in an economic recovery one of the first groups out of the box to embrace the prospective better times ahead are small, independent businesses. Optimistic by nature, this group wants to find ways to make payroll and grow their businesses. However, as Mr. Dunkelberg also noted, such is not the case in the current recovery as the normal optimism is absent. In its place is a still very high degree of FUD - much of it anchored in concerns over regulatory and legislative change.

There are two implications to this small business tale of woe – one economic, the other market.

As the recent 3Q09 earnings results demonstrate, the global growth story along with the weak US dollar is benefiting the large, multinational while masking what could be the start of a hollowing out of the US economy. The longer term economic implications are obvious – weakened domestic growth impacting the key jobs engine of the economy, small businesses, limits hiring and wage increases, which further inhibits the US consumer’s spending habits and feeds into the new frugality, which then diminishes the US economy’s economic vigor. When you add to this mix the angst over change noted above, the cocktail you end up with is not a very pleasant tasting concoction.

As for the market dynamic to all this, it is a fruitful exercise to compare the price action of the large and mega cap sector of the market to the mid, small, and micro groups for signs of price performance divergences. If a divergence begins to develop (a point I first noted on September 29th), then a market recognition of the real economy risks noted above will very likely set the stage for a more meaningful market pullback, most likely in the first quarter of next year.

As the above chart* shows, such divergences have begun to occur - the recent highs by the large and mega cap sectors (SPX and OEF) are thus far not being confirmed by the Smids and micro cap groups (MDY, IJR, and IWC). Moreover, the late October/early November pullback made lower lows in the Smids and micro caps but not in the large and mega cap areas. Both market developments are facts that have not occurred since the bull rally got started in early March.

Crying Uncle

Maybe all will be well as the rising tide of big business eventually lifts the smaller boats. Then again, a scenario similar to Japan in the 1990s make occur in which big business exploits their competitive advantage at the expense of their smaller, more domestic brethren via pricing pressures to gain market share. And we all know how that story turned out.

*click image to enlarge

At the Intersection of Fundamental and Technical Analysis

This evening I have the privilege of moderating a panel discussion for the Market Technicians Association Educational Foundation. My goal is to gain insight into the economy and markets at the intersection of fundamental and technical analysis with my esteemed panel: Robert Barbera, John Mendelson, Jason DeSena Trennert, Louise Yamada, CMT, and Edward Yardeni. Some of the likely questions that I will pose in the Q&A portion of the program that I control as moderator are:

• Will the US economy evolve into a growth period with less reliance on government stimulus programs and more of a self-sustaining, organic nature?

• How will the US jobless rate decline in an environment where the job creation machine of the US economy – small and mid sized businesses – are credit constrained and have limited access to the benefits of a weak US dollar and the global growth story?

• Will the globally oriented companies in the US follow the example of their Japanese counterparts of the lost decade of the 1990s and take advantage of their stronger economic position vis-à-vis the more domestically oriented companies and engage in pricing pressures to gain market share thereby further depressing the economic recovery ability of the smaller, more US centric companies (which thereby further inhibits their ability and willingness to hire)?

• Is the third question noted above the reason why small and micro cap sector have been lagging the market rally of late (thereby producing a price divergence and the prospects of a market correction)?

Tomorrow, I will share with you the answers I receive to these and other questions along with several thoughts and observations.

Until then, if you have any questions you think I should pose to the panel, feel free to send them to me at vinny@bluemarbleresearch.com.

V Shaped Rally ≠ V Shaped Recovery

Yesterday’s posted interview with David Malpass brings into sharp focus a key aspect of the US economic recovery that far too few investors are tuned into. Specifically, the underappreciated dynamic that second, third, and lower tier companies (the backbone of employment growth in the US) may not deliver the much anticipated above consensus earnings results this and future quarters ahead. Moreover, as the backbone of employment growth, weakness in second, third, and lower tier companies act as a depressant on wages, hours worked, and consumer sentiment. Therefore, how the US (and global economy) will reach a sustainable recovery without the US consumer is a riddle wrapped in an enigma.

Lacking a large exposure to global markets (where the growth is and where the weak US dollar helps deliver strong short term results), the SMIDS (small and mid cap companies) on down are vulnerable to disappointing investors with at or below consensus earnings results next month. In this regard, David points out in the interview that above consensus earnings results this coming 3Q09 for large and mega cap multi nationals may come to pass via pricing power pressures on all companies offset by volume growth courtesy a cannibalization of the units growth to lower tier companies.

(As a reminder, 2Q09 bottom line results surprised to the upside thanks to cost cutting, as top line growth was largely in line with expectations. In the current quarter ending next week, expectations are for above consensus earnings results produced by top line growth that surprises to the upside (with cost cutting is largely done). With the US economy still on its knees, it is hard to see how US domestic top line growth (revenues = price x units sold) can surprise to the upside. How this happens for companies that will not benefit from global markets (and a weak dollar) is a mystery soon to be revealed.)

Investment Strategy Implications

In a liquidity driven stock market, all logic goes out the window – for a while. Justifications for over valued markets abound. And buy high to sell higher becomes the music that all performance based investors must dance to. Phrases like “melt up”, thanks to expectations that the $3.5 trillion sitting in near zero percent money market funds will be forced into equities, is the support rendered for P/E ratios that warrant above average (i.e. 15 times) levels. Sound familiar?

In such times, a prudent investor is a contrarian investor. Momentum driven/fast money “investors” awaiting sideline money to sell to on the basis of melt ups and a sustainable global economic recovery rooted in a deleveraging US consumer may turn out to be a fantasy bubble about to burst.

The End User Dilemma

Back on August 3rd subscribers to my weekly newsletter - Sectors and Styles Strategy Report - read the following:

"China may become the bigger fly in the bullish ointment. Unlike the US, China has spent all of its stimulus package money not on consumer demand related areas (where it is most needed) but on more infrastructure projects. Since the US consumer is and will remain in balance sheet repair mode for a while and developed economy consumers (Europe and Japan) reluctant and/or unable to pick up the slack, end user (consumer) demand must materialize from emerging economies. With savings rates very high in China and other developing economies, expectations of V-shaped global economy recovery of a sustainable nature (meaning balanced and asset bubble free) seem fairly unlikely.

Therefore, a close eye should be kept on China and the very real prospect that a bubble burst may occur in that country. Should such an event occur, the global growth story becomes highly suspect, and equity values based on a global V-shaped recovery and expansion very problematic."

At the end of the day, somebody has got to buy something from someone else. The government may be the lender of last resort but it is not the buyer of last resort. That title belongs you and me - the consumer. And, despite its best Keynesian wishes, the prospect of demand being a guaranteed result of fiscal stimuli remains an unresolved mystery. Therefore, as helpful as next year's conveniently politically-timed US stimulus package will be, it cannot be, nor should be, counted on as lifting the world economy out of its end user dilemma. Moreover, government schemes like "cash for clunkers" get you only so far. They're like a life preserver keeping one's economic head just above the water, and nothing more.

Investment Strategy Implications

When stocks moved away from the abyss a certain sense of relief was taken to a modestly enthusiastic extreme. The more optimistic drank the valuation kool-aid of born again bullish investment strategists. "The more things change, the more they remain the same" became the mantra as business as usual replaced the panic-driven mindset - business most unusual.

With the past few days of market decline, perhaps reality will begin to sink into the valuation equation. Hopefully (but not likely), the vital focus on what is necessary for a sustainable global economic recovery will take center stage. And with it a concentrated effort to appreciate the end user dilemma.

Less Bad = Some Good

Equities are ending the first quarter on a more optimistic note. This pertains not just because stocks are rallying today but to the fact that many investors stared into the abyss of the Great Depression II and came to the conclusion that a couple trillion dollars thrown at the world economy along with an era of better regulatory management and a most appropriate change/modification to mark to market will generate 2008 operating earnings for the S&P 500 at something north of $50.

Moreover, recent economic data suggest that the debt constrained US consumer will find ways to maintain some level of spending while apportioning a larger but not overwhelming portion of earnings to savings. Lastly, emerging economies are well positioned to assist in the global economy averting a worldwide recession, despite the pain emanating out of developed economies.

Perhaps this is the economic justification for the improving technical analysis readings of late.

Investment Strategy Implications

Perception is reality. And the perception that the end of world may not occur this year has led many investors to conclude that an appropriate P/E between 12.5 (bad times) and 15 (average times) applied to a $60 operating earnings number is where equities belong. And that gets to almost exactly where the market is today: P/E of 13.75 (average of 12.5 and 15) times $60 = 825.

Helicopter Hank

“It is like if you are in an airplane and the oxygen mask comes down,” said Stefanie Kimball, (Independent Bank’s) chief lending officer. “First thing you do is put your own mask on, stabilize yourself.”

"In Michigan, Bank Lends Little of Its Bailout Funds"
NY Times, January 14, 2009

The above quote and article captures the essence of the TARP money dump by Helicopter Hank in 2008. This is, no doubt, a large part of the dynamic that has investors worried, but not in the way that may seem apparent.

Under Obama and the Democrats, TARP funds will be allocated in a striking different manner. And this fact justifiably has many investors concerned that a significant increase in bank failures will be a part of the economic landscape this year: something that the accompanying chart from the Economist strongly suggests. Moreover, with no political dynamic at work this year, it is hard envision any scenario in which the second wave of TARP money would find its way to undeserving banks and with such poor transparency and regard for the terms under which such money is made available. As a result, investors should expect that banks with shaky balance sheets are headed for the operational dustbin. And with them, the economic consequences of the deleveraging process will continue unabated.

Investment Strategy Implications

Were it not for the fact that the stock market is deeply oversold, this morning’s 10 to 1 down ratio (both the advance/decline and advance/decline volume) might lead some to conclude that a return to the really bad old days of last year (with 5% + down days, rising VIX levels, banking crisis du jour, and more pain to follow) is underway rather than a second selling climax based on fears well known, defined, and, yes, manageable.

On the assumption that the plethora of money already doled out and what’s in the monetary and fiscal pipeline (including the Fed’s acquisition of selected “toxic assets” and the prospects for bank “write ups”) will have the desired effect of injecting into the US economic body enough juice to trigger the badly needed multiplier effect on corporations and households beginning in the second half of the year, a cautiously optimistic view of equities does seem warranted - at least for the next several months.

Helicopter Hank did what he did and in a manner that only he fully appreciates*. In short order, his actions will be perceived as they should be – a prelude to the real work of restoring the US and global economy to a more balanced era of growth and stability.

*A more conspiratorial mind might suspect there was a political dimension to his largess as 2008 was a presidential and congressional year. Providing “walking around money” to banks who did not qualify under the agreement that healthy banks should receive TARP funds does make one wonder just what was Helicopter Hank thinking?

A Most Dangerous Inflection Point

“If we don’t act swiftly and boldly, we could see a much deeper economic downturn that could lead to double-digit unemployment.”
President-elect Barack Obama
January 3, 2009

There is a major economic battle underway pitting the resurgent Keynesian forces of President-elect Franklin Delano Obama against the monetarists and the remnants of the laissez faire/supply side crowd. To exemplify this policy struggle, consider the following two recent quotes from Paul Krugman:

“The biggest problem facing the Obama plan, however, is likely to be the demand of many politicians for proof that the benefits of the proposed public spending justify its costs — a burden of proof never imposed on proposals for tax cuts.”

“(Milton) Friedman’s claim that monetary policy could have prevented the Great Depression was an attempt to refute the analysis of John Maynard Keynes, who argued that monetary policy is ineffective under depression conditions and that fiscal policy — large-scale deficit spending by the government — is needed to fight mass unemployment. The failure of monetary policy in the current crisis shows that Keynes had it right the first time.”

To help complete the picture of this economic/political battle royal we have the factions of the newly empowered Democratic Party and its liberal wing seeking to spend the political capital they think they have earned courtesy the recent election results. Then, on top of all this is the stickiness of Washington business as usual and the reality that entrenched power is rarely ceded without a fight.

Needless to say, the task before Mr. Obama is daunting. And we will all learn if his campaigning skills can be translated into effective policy decisions and leadership.

Investment Strategy Implications

The central question is not whether all the money being thrown at the global economy (both fiscal and monetary) will produce positive results. It will. Rather, the key question is whether the policy actions under vigorous (and potentially divisive) debate involving trillions of dollars ends up stabilizing and then turning things around or merely mutes the decline to an era of lessened living standards and a lower quality of life. If the former, a new era of growth ensues. If the latter, get ready for the Great Depression II and a highly dangerous future.

The US is not Japan

ZIRP (Zero Interest Rate Policy) has arrived in the US. And with it comes the inevitable comparisons with the last major country to employ the policy – Japan.

The low hanging intellectual fruit is to conclude that what happened in Japan will happen in the US. Japan employed ZIRP for years with little affect ergo the US will have the same experience. Japan struggled unsuccessfully to fend off deflation so the US will struggle unsuccessfully to fend deflation. But if we go beyond the sound bite and dig a little deeper we just might see that the US is not Japan therefore to assume an identical outcome is just too, well, sound-bitey.

For example, from a central bank perspective consider what Martin Wolf points out in his commentary today re deflation, Japan, and the US: “At this point, one might wonder why Japan has struggled with deflation for so long. I have little idea. But the explanation seems to be that the Bank of Japan did not wish to take such drastic measures (as the Fed has done) and the Ministry of Finance did not dare to force the point. Such self-restraint will not deter the US authorities.”

No doubt that the US consumer will need to drift closer to his/her Japanese counterpart as the deleveraging process continues to push Americans toward a more frugal future. But old habits are hard to shake, and with so much money being pumped into all facets of the US economy one should assume that the cutbacks in US consumer spending will never approach the levels in Japan.

While some fret over deflation, others worry that the flood of money will inevitably produce inflation. This is a justifiable concern. But that is a problem for another day. For today’s problem, the analogy that best fits is the one describing the firefighter and a house on fire – you don’t worry about water damage when the house is ablaze. Besides, once the credit crisis/deflation blaze is extinguished the Fed has ample policy options to address the more familiar risks of inflation.

The last point to make re the Fed and its announcement yesterday is their intention to purchase longer-dated assets to force rates lower, specifically in the mortgage arena. In this regard, it is worth noting that such action may have a powerful side effect – the pricing of illiquid, hard to value assets tied to mortgages. This aspect was part of the original TARP proposal (price discovery) and may result in write-ups of assets held on the banks' books written down to 20 cents on the dollar.

Investment Strategy Implications

With the TED spread sitting at 1.57% this morning, all due to LIBOR, the flood of money from the Fed coupled with anything resembling $70 or better in operating earnings for the S&P 500 in 2009 (current bottom up estimates sit at over $80) may be more than enough to draw investment funds out from under the mattress (3 month Treasury rates at 0.01% today) and into financial assets.

The past is prologue. The US is not Japan.

Krugman and El-Erian in the Valley of FUD

In his excellent book, “When Markets Collide”, PIMCO chief Mohammed El-Erian writes about the journey and the destination that the global economy and markets are undergoing and puts in context and helps clarifies much of the current economic and financial chaos. Mr. El-Erian describes a world that will be but is clear to note that the process of getting there may be “bumpy”.

Nobel laureate Paul Krugman points to the same concept in his blog posting yesterday (“After the Stimulus”) in which he lists the components of the US economy for 2007 and their averages from 1979 to 2007. As the accompanying table from his blog shows, the economic mix of the US economy got to be quite imbalanced primarily due to credit inspired high consumption levels by the US consumer. In the process, net exports became the counterbalancing force*.

As El-Erian declares in his book, a transformational world (economic and financial) is inevitable and has been underway for some time (long before the current credit and now economic crisis). And Krugman states, “Consumption probably isn’t going back to a 2007 share of GDP — savings are back. So what will fill the gap, once the stimulus is gone? Housing? Not for a long time. Business investment? Hard to see why. The natural thing would be to trade lower consumption for a smaller trade deficit.”

It is logical to assume that the US economy will experience two mega trends in the coming years:

• US consumer spending will fall while US consumer savings rise (aided by the baby boomers’ need to provide for their retirement years now that the wealth effect has gone kaput)
• Net exports will improve as global growth, particularly in emerging markets, continues to expand (certainly relative to developed economies)

It is also likely that non-residential investments (capex) will move closer to their average as corporations retool to meet the global export opportunities while government spending will increase as the US government seeks to stabilize the US economy (large fiscal deficits and other government programs like TARP).

Investment Strategy Implications

The bottom line for those investors willing to look beyond the valley of FUD (fear, uncertainty, and doubt) that we are currently wallowing in is to position their portfolios (what’s left of them) to exploit these mega trends. To follow this direction, however, requires context, perspective, and perseverance – something sorely lacking in a panic stricken financial climate.

*table contents
C = Consumer
N = Non residential investment (capex)
R = Residential investment (housing)
G = Government expenditures
NX = Net exports (exports minus imports)

Out With The Old, In With The New

On the surface China’s actions re stimulating their economy may look to some as a modestly positive development. However, such thinking misses the larger point.

Emerging economies are beginning to show a willingness to take the global growth lead. By seeking to generate domestic demand (which is what their stimulus package is designed to target), China is showing the way for other well capitalized emerging economies to take control of their own economic destiny: Depend less on exports to the developed countries and their overburdened consumers and more on their own emergent middle class for growth and stability. In the process, emerging economies will be a central part to a world economic transformation that will usher in a new, more sustained era of global growth that is difficult to impossible for many to see through the current haze of the credit crisis.

It is, of course, reasonable to be skeptical that such a transformation will succeed, certainly to the extent that it replaces in large part what has been the engine of global growth – the US consumer. Moreover, the process of transformation will not be smooth. The disruptions to the world economy and financial markets have been profound. And the policy responses have been both disjointed and evolutionary. But progress is being made as evidenced by the TED spread.

Of course, in a world dominated by conventional thinking and simplifying assumptions re trends, it is not hard to find many doubters that the progression to a new multi-polar world order underway will result in growth and stability that far exceeds the credit juiced era just ended. Moreover, it is equally hard for many to believe that such a world will include better managed financial instruments to satisfy the emergent global appetite for financial innovation. But that is precisely where the surprise may lie.

Investment Strategy Implications

While it won’t happen overnight, the global growth handoff is underway. Coupled with a rebalanced developed economies, global growth driven by emerging economies appears to be poised to lead the way for a more sustainable and balanced era. More work needs to be done and things must go right on a whole range of levels (economic and financial). However, yesterday’s news re China is a big step in the right direction.

Beyond the Sound Bite: An Interview with Liz Ann Sonders

My conversation with Charles Schwab's Chief Investment Strategist includes a recession call, thoughts on the lasting consequences of the credit crisis (most notably deleveraging), and sector weightings.

The length of the interview is 12 minutes 45 seconds.

Beyond the Sound Bite interviews can be found at beyondthesoundbite.blogspot.com
To listen to this week's podcast interview, click here

Finally On The Right Track But...

...not out of the woods.

The way out of the credit crisis has been paved. Coordinated actions taken by European countries following the lead of the UK now points toward a recapitalization of the banks (injecting money into the banks in return for an equity stake) as the first right step, according to most economists and informed market strategists. Additionally, a shift in the US toward a similar plan is underway.

With a plan of action that appears to address most of the problem head on, investor attention can and should begin to turn to the aftermath of the crisis. In that regard, there appears to be two dimensions to our brave new world:

1. What will be the global financial model?
2. What will be the global economic model?

While this will become the primary area of analysis going forward, there is one conclusion that can be reached immediately – the US consumer is on the long deleveraging path toward more savings and less spending. The consequences to the global economy and where growth oriented investors should place their bets will be part of the investment equation of the future. But that is then and this is now.

For the moment, with the TED spread still at elevated levels and the technicals only supporting an oversold rally, all market advances should be viewed as just that – oversold rallies. For while the equity markets may be at an internal low, a sustainable advance is most certainly months away.

Investment Strategy Implications

While it is debatable whether yesterday's record stock market advance is a product of the belief that the light at the end of the credit crisis tunnel is not a train headed our way but the daylight out of the darkness, the path toward a resolution of the financial crisis appears to have its best hope yet. To get there, however, it must be forgotten that equities are not the thermometer of the credit freeze - the TED spread is.

So when bond traders return today and bankers have another day to digest the European and American government actions, we will all get a better read on where things stand.

There They Go Again

commentary from this week's "Sector and Styles Strategy Report*:

Back on February 11th I wrote a report titled “What are the Sell Side Analysts Smoking?” The commentary and report focused on the excessively optimistic outlook earnings forecasts for 2008 by bottom-up analysts. Excessively optimistic in that top-down forecasts were substantially below the bottom-up numbers.

At the time, the bottom-up crew projected operating earnings for the S&P 500 for 2008 was an astounding +24% over 2007’s numbers ($102 versus $82.54). Whereas, the top-down forecasts had operating earnings for 2008 in mid $80s on down to the mid $70s.

Since then, particularly over the past two months, the bottom-up forecasts have gradually ground down to reality so much so that they have now reached the slightly negative territory of -2.4% (see Earnings Outlook on page 3 of the report*). One might therefore conclude that for 2009 the bottom-up boys and girls would factor in more of the data and analysis from the top down crowd but that is just not the case. For 2009, the numbers are equally, if not more, astounding.

According to the recent consensus forecasts, bottom-up earnings growth expectations for 2009 is a whopping +26%! Even after you exclude Financials you still end up with a +13.3% number. Excluding Financials and Energy gets you to 13.8%. And, lest you think that this dream state is restricted to the US, think again. The global numbers are a cool +18.7%, up from 2.8% currently projected for 2008.

Where does this thinking come from? How do you get such optimistic numbers when most top-down forecasts (from economists and investment strategists, often in the very same firms!) are much like this year – closer to 0%.

I believe a major part of the problem lies in the process by which bottom-up analysts go about making their forecasts. Specifically, when it comes to making earnings forecasts, many if not most bottom up analysts have a “silo” mentality, often acting as though there were no interconnections between their defined industries and companies and the broader macro climate. To be more specific on this point, I am not talking about your basic, tradition GDP starting point but rather the thematic and trend issues that are often hard to quantify such as the credit crisis and the risk of contagion therefrom.

Investment Strategy Implications

There is no news in stating that there are many risks facing investors as the last leg of 2008 unfolds and 2009 comes closer into view. Yet, what seems to be news to many bottom-up analysts is the interconnectedness and impacts from thematic and global macro trend issues.

Therefore, for the benefit of those who insist on using bottom-up forecasts exclusively, let me offer that the great risk for 2009 is the one I have written about time and again – credit related losses that move UP and OUT: UP the quality spectrum (within an asset group) and OUT to other asset groups, such as credit cards, student loans, auto loans, and corporate debt.

This danger is tied to the economic pain that results from deleveraging, with deleveraging not restricted to the banking industry but to the US consumer as he/she comes to terms with the consequences of a negative wealth effect and the need to repair their seriously overleveraged balance sheet. The result would be more savings, less spending, an extended period of subpar growth, and a transformation of the US and world economy away from its high dependency on US consumption.

Reliance on the traditional and the standard methodologies during times of economic transformation and change can and almost certainly will lead to faulty projections that can be very expensive.

*Published Aug. 25, 2008. Subscription required. For more information, click here

A Scramble for Alpha in an Alpha Starved Environment

commentary from this week’s “Sectors and Styles Strategy Report”*:

Unless one buys into the idea implied by the recent price action of US consumer related sectors (see pages 4 and 8*) that economic matters in the US are about to get much better, the only reasonable conclusion one can reach re the recent market action is the hedge fund dominated action of rotational trading. A scramble for alpha in alpha starved environment (for most hedge funds, specifically) appears to be clearly underway.

As noted on numerous occasions and described at my recent NYSSA Market Forecast event, the current equity markets are overwhelmed by short term hedge fund traders with a near non existence from the more traditional investors. For what else can explain the surge and purge nature of the market action overall. Or the recent fascination with the second least attractive sector – Consumer Discretionary?

At the same time, the current US dollar rally (see chart on next page*) has encouraged fence sitters to take the plunge into US assets.

And while the dollar rally may have more strength left in it, the difficulties that the US will face in the coming years should give longer-term investors pause before completely buying into the strong dollar scenario.

Investment Strategy Implications

Just like cyclical corrections in secular bull markets, counter trend moves in bear markets are common. And can be quite productivity played if one is nimble. Combined with the recently oversold Financials sectors (which provides an alleviation of the pressure on the market overall) and strong undervaluation for equities (see next page for several thoughts on this matter*), the reasoning behind a fully invested position for the time being seems warranted.

Nevertheless, as noted in last Thursday’s Minyanville blog posting, this is a game of chicken with one of the signs to keep a watch out for is a return to form, especially in areas such as Consumer Discretionary and Financials.

*Published Aug. 18, 2008. Subscription required. For more information, click here

Sectors and Styles Strategy Report: August 11, 2008

excerpt from this week's report:
"No doubt, last week’s $14.3 billion surge in consumer credit will help the US economy in the near term, but eventually US consumers must begin to repair their debt laden balance sheets. At noted in my Thursday blog posting, until consumer expectations re their assets (real estate and financial) may not deliver their future needs (notably retirement), consumers live in denial and balance sheet repair (in the form of reduced borrowing and increased savings – from income) is deferred. This is a question of when not if..."


*To gain access to this week's report (and all reports), click on the newsletter subscription information link to your left.

Where’s John Maynard Keynes When You Need Him?

This morning’s testimony before Congress affords US Treasury Secretary Paulson and Fed Chairman Bernanke yet another opportunity to allay the fears of all parties interested in the health and wellbeing of the world’s economies and markets. Unfortunately, however, what is likely to be heard is more dogmatic drivel regarding the magic of the markets as the elixir that cures all ills.

Words such as “market discipline” will almost certainly be uttered by Messrs. Paulson and Bernanke today, as they cling to an ideology, “market fundamentalism” (laissez-faire or neo liberalism, if you prefer), whose time has passed. For with their adherence to “market discipline” comes the front line, the first wave of economic chaos in the form of a rolling destruction of major chunks of the financial services industry (not wholly undeserved) and the multi-dimensional feedback loop that the resulting deleveraging and radical shrinkage of the credit creation process will produce on the US (and ultimately world) economy.

Perhaps one might wonder if those on the other side of today's testimony table might provide some philosophical leadership in this highly charged political year. Guess again.

The Republicans find themselves locked in a defensive mode attempting to preserve their market fundamentalism ideology. (Supply side voodoo economics still rules this roost.) And where they are proactive is in areas that are tied to the ole timey magic of the “invisible hand” such as oil crisis = more land for drilling. No real solutions. No real comprehensive energy policy. More of the same animal spirits, magic-of-the-markets thinking.

As for the Democrats, their agenda is fairly obvious – look busy! As they appear to “fight” for the US consumer against the dark forces of cowboy capitalism and market fundamentalism their real end game is more power via a landslide victory this fall. Until then, why take more than band-aid economic action that will result in any form of a rebounding US economy when the more advantageous political objective is to pin the McCain tail on the Bush donkey?

Investment Strategy Implications

Cowboy capitalism expressed in the financial markets is market fundamentalism. They are rooted in the same philosophical thinking that has wrecked havoc on the world’s economies and markets via fat tail economic and financial crises that mega trends such as globalization, technological innovation, and financial innovation have only exacerbated.

What is needed, and getting more desperately so with each passing month, is new thinking and a new intellectual philosophy regarding government, the economy, and the markets. A good start would be a clear recognition that the philosophical underpinnings of the past two decades, the market ideology known as market fundamentalism and its economic counterpart, cowboy capitalism (replete with trickle down economics and ever resetting stock options for corporate executives), has produced radicalized results for the interconnected world economy and markets. What is needed is fresh thinking and a willingness to transform a broken system rooted in a defunct ideology. But that is not what you and I will hear today.

What you will hear is regulation and half measures. But neither is a real, sustainable solution. Therefore, the only remaining question is what will it take for transformative action that will produce less radical economic and financial results? The answer might lie in a global recession to rival the one some 70 years ago. Then we may see who emerges as this century’s John Maynard Keynes.