Tuesday, November 3, 2009

Real Nobels Awarded (How We (Yes!) Get Our "Just Desserts")

Don't turn green as you make your way through this humorous (NOT!) take on why your financial world vanished right before your eyes.

It's not too late to fix it, but it is too late to do it easily. (Emphasis marks have been added - Ed.)

Just Desserts

Jeremy Grantham

I can't tell you how surprised, even embarrassed I was to get the Nobel Prize in chemistry. Yes, I had passed the dreaded chemistry A-level for 18-year-olds back in England in 1958. But did they realize it was my third attempt? And, yes, I will take this honor as encouragement to do some serious thinking on the topic. I will also invest the award to help save the planet. Perhaps that was really the Nobel Committee's sneaky motive, since there are regrettably no green awards yet. Still, all in all, it didn't seem deserved. And then it occurred to me. Isn't that the point these days: that rewards do not at all reflect our just desserts? Let's review some of the more obvious examples.

1. For Missing the Unmissable

Bernanke, the most passionate cheerleader of Greenspan's follies, is picked as his replacement, partly, it seems, for his belief that U.S. house prices would never decline and that at their peak in late 2005 they largely just reflected the unusual strength of the U.S. economy. As well as missing on his very own this 3-sigma (100-year) event in housing, he was completely clueless as to the potential disastrous interactions among lower house prices, new opaque financial instruments, heroically increased mortgages, lower lending standards, and internationally networked distribution. For these accumulated benefits to society, he was reappointed! So, yes, after the fashion of his mentor, he was lavish with help as the bubble burst. And how can we so quickly forget the very painful consequences of the previous lavishing after the 2000 bubble? Rewarding Bernanke is like reappointing the Titanic's captain for facilitating an orderly disembarkation of the sinking ship (let's pretend that happened) while ignoring the fact that he had charged recklessly through dark and dangerous waters.

2. The Other Teflon Men

Larry Summers, with a Financial Times bully pulpit, had done little bullying and blown no warning whistles of impending doom back in 2006 and 2007. And, famously, in earlier years as Treasury Secretary he had encouraged (I hope inadvertently) wild and reckless financial behavior by helping to beat back attempts to regulate some of the new and most dangerous instruments. Timothy Geithner, in turn, sat in the very engine room of the USS Disaster and helped steer her onto the rocks. And there are several others (discussed in the 4Q 2008 Letter). You know who you are. All promoted!

3. Misguided, Sometimes Idiotic Mortgage Borrowers

The more misguided or reckless the borrowers, the more determined the efforts to help them out, it appears, although it must be admitted these efforts had limited effect. In comparison, those who showed restraint and either underhoused themselves or rented received not even a hint of help. Quite the reverse: the money the more prudent potential buyers held back from housing received an artificially low rate. In effect, the prudent are subsidizing the very same banks that insisted on dancing off the cliff into Uncle Sam's arms or, rather, the arms of the taxpayers - many of whom rent.

4. Reckless Homebuilders

Having magnificently overbuilt for several years by any normal relationship to the population, we have decided to encourage even more homebuilding by giving new house buyers $8,000 each. This cash comes partly from the pockets of prudent renters once again. This gift is soon, perhaps, to be extended beyond first-time buyers (for whom everyone with a heart has a slight sympathy) to any buyers, which would be blatant vote-buying by Congress. So what else is new?

5. Over-Spenders and Under-Savers

To celebrate the overwhelming consensus among economists that U.S. individuals have been dangerously overconsuming for the last 15 years, we have decided to encourage consumption and penalize savers by maintaining the aforementioned artificially low rates, which beg everyone and sundry to borrow even more. The total debt to GDP ratio, which under our heroes Greenspan and Bernanke rose from 1.25x GDP to 3.25x (without even counting our Social Security and Medicare commitments), has continued to climb as growing government debt more than offsets falling consumer debt. Where, one wonders, does this end, and with how much grief?

6. Banks Too Big to Fail

Here we have adopted a particularly simple and comprehensible policy: make them bigger! Indeed, force them to be bigger. And whatever you do, don't have any serious Congressional conversation about breaking them up. (Leave that to a few journalists and commentators. Only pinkos read pink newspapers anyway!) This is not the first time that a cliché has triumphed. This one is: "You can't roll back the clock." (See this quarter's Special Topic: Lesson Not Learned: On Redesigning Our Current Financial System.)

7. Over-bonused Financial Types

Just look at Goldman's recent huge "profits," two-thirds of which went for bonuses. It is now estimated that this year's bonus pool will be plus or minus $23 billion, the largest ever. Less than a year ago, these same guys were on the edge of a run on the bank. They were saved only by "government" - the taxpayers' supposed agents - who decided to interfere with the formerly infallible workings of capitalism. Just as remarkably, it is now reported that remuneration for the entire banking industry may be approaching a new peak. "Well, we got rid of some of those pesky competitors, so now we can really make hay," you can almost hear Goldman and the others say. And as for the industry's concern about the widespread public dismay, even disgust, about excessive remuneration (and, I would add, plundering of the shareholders' rightful profits)? Fuhgeddaboudit! In the thin book of "lessons learned," this one, like most of our other examples, will not appear.

8. Overpaid Large Company CEOs

Even outside the financial system, there are many painfully obvious unjust desserts in the form of top management rewards. And most of the excessive rewards come out of the pockets of our clients and other stockholders, which is particularly galling. When I arrived in the States in 1964, the ratio of CEO pay to the average worker was variously reported to be between 20/1 and 40/1. This seemed perfectly respectable and had held for the previous 30 years. By 2006, this ratio had exploded to between 400/1 and 600/1, which can only be described as obscene. The results certainly don't suggest such high rewards: a) 10-year stock market returns are close to zero in real terms; and b) U.S. GDP growth has finally slipped below its 100-year trend of 3.5%. After deducting the effect of the rampant increase in the financial system, the growth in GDP ex-finance has fallen to 3.1% since 1982 and well below 3% since 2000, all measured to the end of 2007 to avoid the recent crisis. The corporate system, to be frank, seemed to run faster and more efficiently back in the 1960s before CEOs and financial types began to gobble up other people's lunches. I suppose I have done my share of gobbling. But, it still ain't right!

9. Holders of the Stocks of Ridiculously Overleveraged and Wounded Corporations

Yes, I admit this is part envy and part hindsight investment regret. But, really, our financial leaders so overstimulated the risk-taking environment that junky, weak, marginal companies and zombie banks produced a record outperformance (the best since 1933) of junk over the great blue chips. (Ouch!) In a world with less moral hazard, which would be a world of just, although painful desserts, scores of these should-be-dead companies would be. As it is, they live to compete against the companies that actually deserve to be survivors. Excessive bailouts are just not healthy for the long-term well-being of the economy.

10. The Well-managed U.S. Auto Industry

While firms in other industries fail and their workers look for new jobs, the auto industry is rewarded by direct subsidized loans, governmental arm-twisting of creditors forced to settle far below their legal rights, and direct subsidies for their products. All of this for their well-deserved ranking as the most short-sighted industry of the last 20 (40?) years, and one of the worst managed.

11. The World's Most Over-Vehicled Country

We chew up a dangerously large amount of Middle Eastern oil (and oil desperately squeezed from Canadian tar sands), which is ruinous for our globalpolitical well-being (and ability to avoid war) and also not so good for an overheating world. So the answer must be to subsidize more car purchases, and when the subsidies run out, you can have all the fun again. Good long-term thinking!

12. Stock Options

This, of course, is the crème de la crème of unjust desserts. Recent practices have basically been a legalized way to abscond with the stockholders' equity. So if the stock price crashes, perhaps with considerable help from management, that's all right - just rewrite the options at the new low prices. There has been no serious attempt to match stock option rewards (or total financial rewards for that matter) to the building of long-term franchise value. Instead, the motto is: grab it now and run! You can fill in your own favorite anecdotes here - there are so many of them!

13. Finally, Just in Case You've Forgotten, We Have My Old Nemesis, Greenspan

Alan Greenspan receives the title of Maestro in the U.S. and is knighted by the Queen for thoroughly demolishing the integrity of the U.S. financial system. He overtly ignored the great threat of bubbles in asset classes and, in fact, encouraged them. He Ayn Rand-ishly facilitated the progressive dismantling of governmental restrictions on financial behavior, he deliberately kept real interest rates at zero for years, etc., etc., etc. You have heard it before. Now, remarkably, in his very old age he has become imbued with the spirit of Hyman Minsky: "Unless somebody can find a way to change human nature, we will have more crises." Now he finally gets it. Too late! In his merely old age, he ignored or abhorred Minsky, and consistently behaved as though markets were efficient and the players were honest and sensible at all times. But for all of the egg on his face, the Maestro continues to consult with the rich and famous, considerably to his financial advantage. In the good old days, he would have been set in the village stocks, and not the kind you buy and sell. And I would have been right there, Alan, with very ripe tomatoes.

The Last Hurrah and Markets Being Silly Again

The idea behind my forecast six months ago was that regardless of the fundamentals, there would be a sharp rally.

After a very large decline and a period of somewhat blind panic, it is simply the nature of the beast. Exhibit 1 shows my favorite example of a last hurrah after the first leg of the 1929 crash.

After the sharp decline in the fall of 1929, the S&P 500 rallied 46% from its low in November to the rally high of April 12, 1930. It then, of course, fell by over 80%. But on April 12 it was once again overpriced; it was down only 18% from its peak and was back to the level of June 1929. But what a difference there was in the outlook between June 1929 and April 1930! In June, the economic outlook was a candidate for the brightest in history with effectively no unemployment, 5% productivity, and over 16% year-over-year gain in industrial output. By April 1930, unemployment had doubled and industrial production had dropped from +16% to -9% in 5 months, which may be the world record in economic deterioration. Worse, in 1930 there was no extra liquidity flowing around and absolutely no moral hazard. “Liquidate the labor, liquidate the stocks, liquidate the farmers” was their version. Yet the market rose 46%.

How could it do this in the face of a world going to hell?My theory is that the market always displayed a belief in a type of primitive market effi ciency decades before the academics took it up. It is a belief that if the market once sold much higher, it must mean something. And in the case of 1930, hadn’t Irving Fisher, arguably the greatest American economist of the century, said that the 1929 highs were completely justified and that it was the decline that was hysterical pessimism?

Read the rest of this fascinating financial exposé here. Oh, and don't look at that graph! It's a killer.

And weep anew.

(And pack.)

Suzan ____________________

3 comments:

TomCat said...

Suzan, this is excellent! I'm pleased you got going!

Suzan said...

Thank you, friend!

And I'm glad that you are pleased.

Welcome aboard.

S

TomCat said...

Thank you muchly!