Wednesday, February 3, 2010

What They Are Not Telling Us

"A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy..."

Alexander Fraser Tytler, Scottish lawyer and writer, 1770

And now that we've been told solemnly that "AIG Bonuses Outrageous but Legal," it all comes home to roost. At least the execs who brought us to the brink of destruction (and the loss of our futures based on (disappeared) savings for retirement) won't be penalized for theirs.

Niels Jensen, John Mauldin's London partner enables us to see what has happened graphically with a little empathy from someone who owns a business called Absolute Return Partners. Wonder how they made out from the crash. If you follow his logic about the "recovered" stock market, it won't be hard to figure out - thanks to the taxpayer bailout of the rich. And some hints lurk within about why Obama is already trying the patience of his supporters with talk of benefit cuts only for them. (And you get a really good idea why the bailout was an excellent idea for them as their part of the economy is B-A-C-K!!!) As a matter of fact, refer to the New York Times of two weeks ago Sunday, January 24, 2010, for the article Ready to Spend, But Not to Boast. Yeah, they know better than boasting this time. (Selected paragraphs of Jensen's fine essay appear below (emphasis marks added - Ed.).)

The world of Minority Report is here, 40 years ahead of schedule. All I could do was just say "Wow!" It's young men like this that should make us all optimists that somehow we will figure out how to get through all this.

Travelling with John Mauldin

It was always naïve to believe that a crisis so deep and profound was going to go away with a whimper; however, an increase of more than 50% in global equity prices can be very seductive, and nine months of virtually uninterrupted gains have led many to believe that the problems of 2008-09 are now largely behind us.

Well, not quite everybody. Friend and business partner John Mauldin remains a sceptic. I have had the pleasure of travelling across Europe with John over the past week or so and, as the week progressed, my mood swung decisively towards a state where Prozac would probably be the most appropriate remedy.

Now, John and I do not agree on absolutely everything. For example, I believe – and have believed for a while – that he is too bearish on equities. But, before we go there, allow me to share with you the essence of John's views which can be summed up quite nicely by two charts, courtesy of BCA Research.


In John's opinion – and I do not disagree – we are still only in the second or third innings of the de-leveraging process (chart 1). Years of excessive debt accumulation cannot be reversed in 18 months, and it will take at least another 5-6 years to play out, possibly longer.


The other part of John's argument – and again it is hard to disagree – is that it remains an open question how much de-leveraging has in fact taken place. As you can see from chart 2, US sovereign debt has risen as fast as private debt has declined (and the picture is similar in many other countries), providing support for the argument that all we have achieved so far is to move liabilities from private to public balance sheets, effectively burdening tomorrow's taxpayer.

And take a look at this chart.


The outlook is very grim

The outlook goes from murky to unbelievably grim, if one includes off-balance sheet items such as social security, pension and health liabilities

. . . The bond market will ultimately determine when enough is enough. As President Clinton's campaign strategist James Carville once put it:

"I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone."

It can play out in a couple of different ways. Either bond investors will go on strike until they feel that they are being sufficiently rewarded for the higher risk associated with sovereign debt following the credit crunch or governments will implement budget curtailments designed to bring the debt escalation under control again, but that will be detrimental to economic growth.

My bet is that the latter outcome will ultimately prevail but not until the bond market forces the hand of our governments.


Why stock markets go up

Despite the grim outlook, the world's stock markets have produced brilliant returns over the past nine months. This has provoked some of the best and brightest in our industry (most recently Mohamed El-Erian, CEO of Pimco) to declare that there is a disconnect between the economic reality and the picture painted by Wall Street.

I am not convinced. Firstly, global equities reached extremely depressed levels back in February 2009, and the recovery, however muted it may ultimately turn out to be, has stopped the bleeding in most large companies, giving investors an excuse to accumulate stocks again (smaller companies is a different story altogether, but that is a story for another day). What matters to the likes of Coca Cola, Rolls Royce and Volkswagen is not so much how the domestic economy performs, because the leading lights of industry today are becoming increasingly detached from the domestic economy. Ever more important to those companies is the global stage, and the global outlook is considerably more upbeat than, say, the US, UK or German growth prospects.

Secondly, equities usually do very well in the very late stages of recession and early stages of recovery. I refer to our July 2006 Absolute Return Letter for an in-depth analysis of this, which you can find here.

Thirdly, valuations are not prohibitively high. Many bears refer to the stock market (whether European or US) as being very expensive at current levels, but that is plainly untrue. Based on 2010 projected earnings, most OECD markets are either in line with or 10-20% below historical averages (see table 3). Only in emerging markets can you reasonably argue that current P/E levels are not cheap relative to the long term average.


In 2009 there have been massive flows of capital towards emerging markets – and towards Asia in particular – and valuations have been driven up as a result. It is hard to argue that those markets are yet in bubble territory, if one uses the valuations in table 3 as a benchmark; however, by pegging their currencies to the US dollar, Asian countries have effectively adopted a monetary policy which is entirely unsuitable for economies growing as fast as they do. That is how bubbles have been created in the past and why Asian equity markets should be monitored closely for signs of overheating in the months to come.


Summing it all up, the fate of global equity markets is very much in the hands of bond investors. Under normal circumstances, this is the best time to be in equities. But these times are not normal, so do not expect that the outstanding performance of 2009 will be repeated in 2010. If international bond markets calm down again – and that may happen, at least temporarily – equities can probably post further (but modest) gains in 2010; however, the end game is approaching. If bond investors do not revolt in 2010, they probably will in 2011, so playing the economic recovery through equities is a dangerous game.

As far as the bond market is concerned, as often pointed out by Martin Barnes at BCA Research, if you want to know where the next crisis will be, then look at where the leverage is being created today. And nowhere is there more leverage being created at the moment than on sovereign balance sheets. What is happening is an experiment never undertaken before. As John Mauldin puts it, we are operating on the patient without anaesthesia.

The big challenge will be to get the timing right. These situations can run for longer than most people imagine. Japan's crisis has been widely predicted for almost a decade now, and the ship appears to be as steady as ever. As I suggested earlier, the key to predicting the timing of Japan's demise – because there will be one – may very well be embedded in the savings rate, which could quite possibly turn negative in the next few years.

The Dubai crisis taught us that markets are in a forgiving mode at the moment and, before long, Greece could very well find some respite from its current problems. But then again, ultimately, governments will find – just like millions of households have found over the years – that you cannot spend more then you earn in perpetuity. The enormous debt levels being created at the moment will haunt us for many years to come . . . .






rjs said...

american thinking is still dominated by euro-centricity, but there's a good reason we call it the "old world"...whether this current crisis is the straw that breaks the old camel's back or not i cant say (latest is that although germany seems satisfied with greece's austerity program, greek unions are very unhappy and there will be strikes and or riots), but as mauldin lays out, there's just too much debt out there that wont be paid back for the union to survive... demographics argue against europe and japan as well, as both have aging and declining populations...

there have been allegations of manipultion in our stock markets, propping up the price, but i dont even think such an effort would really be necessary, with all that funny QE money sloshing around out there from the world's central banks; its all got to go somewhere, so despite insider selling, a lot of it continues to leak into stocks and commodities...

Suzan said...

I'm kinda of with you on this one, but there again . . . they are still manipulating the energy and green markets . . . so who knows how much and where?

The bubble(s) can be anywhere as we've already learned to our great chagrin - even in markets where lots of investment is needed to actually make a difference.

with all that funny QE money sloshing around out there from the world's central banks; its all got to go somewhere


rjs said...

well, im not saying there's not somethings fishy going on...

Where Did They Get The Money? (BlackRock) - We counted over 1,800 13Gs that Blackrock dumped on Friday. For those less familiar with the 13G, since we don’t often write about these filings, it’s a requirement when ownership exceeds 5% of the outstanding shares. With few rare exceptions, these filings represented new positions for Blackrock since we only counted 11 amended 13Gs, Where did Blackrock get the money? Blackrock has just $3.96 billion in cash on hand according to the most currently numbers on Yahoo Finance. The S&P 500 alone has a market cap of some $13 trillion dollars. Something "funny" is going on here folks, and it demands an inquiry - and answer. The underlying question remains - if and when something goes wrong, what does Blackrock have available to them to deal with it when they're managing an asset base larger than that of The Federal Reserve?

Suzan said...


I was just reading about Blackrock's latest moves.

Need better research.

Let me know what you find and thanks for pointing out the latest Mauldin.


Where did Blackrock get the money?

rjs said...

suzan, you now know as much as i do...i had seen the same story with less detail at zero hedge, but since i dont really cover the market, i skipped by it until financial times linked back to this one at market ticker...

Jolly Roger said...

Our situation is so close to the Soviet situation of the late 1980s (including a guy who increasingly looks like our version of Gorbachev) that I really don't see how we avoid the same fate. I actually think that some of the folks of the right wing know this, and that their extremism is calculated so that when the time comes, they can set up their longed-for third world theocracy down in Dixie.

Given that this country is not going to survive (and I don't think you can argue with a straight face that it will, if you take everything about to hit us into consideration and then add the obstructionists who are keeping things from being fixed,) then the questions become (1.) How will the debt of the former US be divvied up, if it even can be, and (2.) how hard a hit are places like China and Saudi Arabia going to take?

An interesting time is coming. It's just around the corner. You can almost see the headlights now.

Suzan said...

I hate to say it, Jolly Roger, but you've mentioned something that has crossed my mind (and that I've written about) several times: that we are lunging down a tortuous, rocky, danger-filled path laden with the type of "shocks" documented by Naomi Klein that usually just happen to 3rd world countries (or the USSR).

Most people never put two and two together when the USSR collapsed, seeing the sellout from within and the takeover of the resources by the Tom Delayites (to put a too fine point on it prolly). It was chaos over there as they entered into 3rd or 4th world status for about a decade, and their assets, built by the heart-rending poverty of the people on the bottom were divvied up by foreigners and connected insiders - thus the trials of those infamous Russian businessmen.

We already are hearing that the rich are starting to recover their self esteem by picking up the cheap assets left by that financial earthquake and that their brilliance for everything else makes them eligible for bonuses even when the taxpayers had to bail them out (which according to the proposed "cleanup" legislation will become the "correct" way to deal with future bubble blowouts). The serfs will pick up the final tab - just like the USSR's did. And people wonder why the KGB has reemerged so strongly? Ha! If it wasn't in the plan, it should have been.

And our new wealthy owners have got some pretty "good" arguments, don't they?

After all, it's still a country rich in assets, although the citizens have "burdened themselves with heavy debts and must learn to live with less."

Interesting idea about that "longed-for third world theocracy" being prepared by the Rethug/Tea Partyers now.

Yeah. It's just like the American Revolution, ain't it?

And, trust me, according to my international sources, China and India and Russia (not to mention our benevolent rulers like SA's Ali Busha) know exactly how they are going to deal with the devalued US $$$.

And Obama's role in this? I quit expecting anything good from him after the appointment the first week of Geithner and Summers. Obviously, they were all in it together: Goldman Sachs and Morgan Stanley forever, huh?

Thanks for commenting.


Our situation is so close to the Soviet situation of the late 1980s (including a guy who increasingly looks like our version of Gorbachev) that I really don't see how we avoid the same fate.