January 11, 2006
Our misgivings about toying with Milton’s contrast notwithstanding, you cannot help but wonder what has gone wrong since the US stock market mania hit its final note in 2000. No, we are not talking about what has gone wrong for the average ticker chaser, but for steadfast value investors and those individuals, like deer caught in headlights, that seem locked into the profession of doomsday. Put simply, how have the US economy and financial markets been able to cope so well following one of the largest stock market busts in history?
Not surprisingly former Fed boss, Paul Volcker, succinctly answered this question more than 20-years ago. The following quote will suffice:
“I overstate it, but the traditional method of making small moves has in some sense, though not completely, run out of psychological gas. Every time the interest rate goes up by a small amount [bankers] say okay, we'll raise the prime rate. Whatever you do is inadequate -- you, the Federal Reserve -- and we'll go along. We have access to liquidity at a fairly fixed federal funds rate -- the rate isn't going to change all that abruptly -- and you're not having much impact on market thinking or on market confidence in your ability to keep the money supply under control.” Volcker. October 6, 1979
In other words, by adopting a ‘measured’ plan of tightening Greenspan proved that he did not learn the lesson Volcker taught: that being ‘the traditional method of making small moves can run out of psychological gas.’ We would further this point and argue that what Greenspan also overlooked is that the increasingly ‘flexible’ financial marketplace – which has come to realization thanks in part to Greenspan’s unwillingness to regulate the OTC derivatives albatross and slow ballooning hedge fund power – can readily adapt to telegraphed shifts in monetary policy. What a telegraphed approach to monetary policy unwittingly does, in effect, is place growth in the money supply in the hands of Wall Street dealers and debt starved US consumers. Ever wonder how the US housing mania could continue to boil even as the Fed continually raises its Federal Funds rate? Greenspan calls it a conundrum (that long-term rates remained low as short term rates rose), but the Volcker lesson says this happens because of ‘inadequate’ monetary policy choices.
Understanding how the markets compensated to the Fed’s ‘measured’ campaign is, in many circles, as simple as observing that real, or inflation-adjusted, interest rates remained near historic low levels during the Fed’s tightening campaign. We have talked about the dangers of the ‘carry trade’/’asset dependent’ US economy before, and have no issue with ‘real interest’ rate theories. Nevertheless, the basic point that the Fed has not learned to control the money supply is paramount. For example, last year the Fed talked about the increase in risky mortgage loans and held a secret meeting to discuss as much. No firm action came to pass. When it comes to trying to avert asset bubbles from growing to dangerous proportions, talk from the Fed is cheap…cheap money that is.
Something indeed happened on the way to hell; the Fed forgot Volcker’s important lesson and this allowed investors and consumers to commit every financial sin imaginable to keep the good times rolling. And while the optimist could counter that the economy is growing, jobs are being created, and stocks are up, we can not help but fear that the recovery has come at a grave long-term cost. Volcker, talking about ‘monetary and fiscal discipline’ in ‘An Economy On Thin Ice’, expressed similar concerns last year:
“The U.S. expansion appears on track…Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks -- call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it.” Volcker. April 10, 2005
But will longer-term imbalances come home to roost in 2006? Although ‘forecasting’ is itself a mugs game, in the spirit of the season we have mapped out some of our opinions below.
Amidst the continuance of strong ‘as reported’ corporate earnings, US stocks broadly went nowhere in 2005. Against the backdrop of raging energy prices, the financial markets and US economy generally behaved in a placid manner. Yes, there were moments, including GM/Ford’s debt downgrade(s), Delphi and Refco bankruptcies, and China’s denial of being behind a huge copper position seemingly ready for default, when the financial markets exhibited a seeming anxiety. But shortly after the arrival of any agitation, the antidote of overwhelming liquidity, market flexibility, and investor confidence soon restored financial calm.
“If the dollar doesn’t collapse, U.S. interest rates do not rise all that much, and more greater fools can be corralled by cowboy analysts, the optimists may be right about 2005.”
With the US dollar rallying, US interest rates rising a mere 13 bp (10-Year Treasury), stocks holding their own, and the US the consumer, remarkably, showing little sign of tightening their purse strings, 2005 did little to resolve the concerns of value investors and market bears. We do not envision these trends continuing much longer.
Before getting to the meat, it is important to note that the problem with making predictions to start a year is that you never know which variables investors are going to focus on, and in a desperate search to flush out those variables you can fall into the trap of trying to determine the future state of investor psychology, not the fundamental state of corporate health. Be it energy prices, the US dollar, gold, corporate defaults (or lack thereof), we do not know what investors will hone in on in 2006. What we do have is an opinion on what some of the major events might be; events that may or may not deeply impact investor psychology.
First and foremost, the US consumer, currently not saving a dime, is unlikely to find their housing ATM machines as hospitable in 2006 as in 2003-2005 and, baring any serious real estate meltdown, this should have a dampening effect on spending. This topic is so widely covered and agreed upon that it warrants mention but no further elaboration. Incidentally, with housing prices starting to fall, let us be the first to say that part of the government’s take on inflation (which focuses on rent prices not home prices) is probably going to start overstating actual year-over-year inflation sometime in 2006.
The second topic worth discussing is the US interest rate situation. Soon to be guided by new Fed boss, Ben Bernanke, US interest rates are probably the most unpredictable variable around. On the one hand the Fed is probably nearing the end of their tightening cycle. This is the case because there is building evidence that the Fed has successfully punctured the housing (or loan) bubble, and the government’s ‘core’ numbers suggest that inflationary pressures are abating. But on the other hand little has transpired to suggest that the Fed should stop tightening immediately: global default rates are at an 8-year low (S&P), energy prices have the potential to bubble higher, and real interest rates are still below their historic norm. In our opinion the Fed stops tightening after a stressing financial market event rears its ugly head, more solid evidence of a weakening US housing market arrives, and/or once the US consumer shows signs of strain. Exactly when this takes place is anyone’s guess, but with the US yield curve inverting we would venture to say soon.
The third issue to contemplate is the US Dollar – the only variable that is potentially more volatile than US interest rates. We remain steadfast in our macro opinion that the US dollar is headed lower, and we fail to see how the inevitable adjustment in the burgeoning US current account deficit can transpire without, in part, a weaker greenback. With gold rallying by 18% spot in 2005, China freeing the Yuan on July 21, 2005, Russia diversifying away from US dollars, and other central banks chattering about diversification and/or an Asian-pegged currency basket, 2005 can be said to be a transition year away from US dollar hegemony. Whether or not this transition quickens during 2006 is difficult to say. What we will say is that we do not think that the old rules are going to repeat themselves: another Plaza Accord with China instead of Japan at the table is not imminent, a return to the gold standard is not going to happen overnight, and Asian central bankers are not going to simultaneously run for the exits out of the US dollar stadium. In short, we see a weaker dollar, but how we get there and what degree of devastation this causes is open for debate.
The fourth topic is gold. We are long-term gold bulls, but we believe that history could repeat itself and gold could suffer a massive sell off sometime in early 2006. We do not like the fact that the small spec net long interest is starting to increase in the COT data – every time the small specs arrive on the scene this has meant a bloody sell off. However, for the COT weeks ended November 11, December 13, December 27, 2005, and January 6, 2006, the commercials did something they had never done more than once in succession since the gold bull began: they reduced their net short position in gold (futures and options) as the price of gold rallied. We would sell some physical gold at current price levels but not all. Eventually, and as US dollar hegemony shows more signs of transitioning into something else, gold will benefit.
The fifth topic is stocks. There is very little on the surface to refute the bullish point of view when it comes to stocks. After all, corporate earnings are growing nicely, stock buybacks broke another record last year and are expected to be strong in 2006 (Trimtabs), and Moody’s says that corporations have the most cash on their balance sheets relative to debt since 1967. You can squabble about quality of earnings, the threat of upcoming accounting changes, and point to the fact that core earnings estimates for 2005 see the S&P 500 P/E multiple at an extremely high 19.85 if you want. Having pounded this drum before, and having lost confidence that any real change in reporting standards will soon come to pass, we will refrain from preaching to the converted. No, in our opinion if you care to focus solely on equities, the outlook for corporate profits and stock market liquidity leading into 2006 is bullish.
Unfortunately in a financial world deeply connected to currencies, interest rates, and economic reports, it would be akin to putting on blinders to focus solely on profits and liquidity. Thus, while our outlook for stock prices in the immediate term is positive, we see some looming clouds. The most ominous and obvious threat is that the asset dependent US economy can no longer produce a rising asset class for consumers to leverage. Wage increases, not offsetting inflation, have zero possibility of matching the stock market gains of the late 1990s and housing market gains since 2000. When the US consumer starts to feel asset poor the negative savings rate will become the negative that it is. Second, judging by extremely positive (contrarily negative) market sentiment reports and low volatility in the face of an inverting US yield curve – stock market participants are currently greedy rather than fearful. This alone gives us pause.
Conclusions - Let There Be Light!
Although the media made a special point of hyping Warren Buffett’s new position in Anheuser-Busch and overplaying his short term loss betting against the dollar (as opposed to discussing his longer term gains in this position), the world’s foremost value investor made very few changes to his portfolio in 2005. In fact, as of the third quarter of 2005 Berskshire was still sitting on more than $40 billion in cash and equivalents, or more than 35% of liquid assets. Back in 2000 when the markets offered more opportunities, this cash figure hit a low of $1.9 billion (or 2.6% of liquid assets).
With corporate earnings growing by double digits, the US economy performing well, and inflation supposedly in check, why did Buffett not dive into stocks in 2005? Notwithstanding the lie that is ‘as reported’ and the fact that companies have as many financial statement concerns as they did pre-Enron, the simple answer is that Buffett remained sidelined because the markets showed very few signs of fear in 2005. To be sure, just as the stock market correction in October 2005 threatened to throw a healthy dose of fear into investors, seasonal forces took over providing a base for the stock markets. In hindsight, the statement that the markets bent but did not break is applicable.
Buffett is probably right about carrying a cash heavy portfolio while waiting for better investment opportunities to emerge. And while we do not suggest that investors ignore stocks completely, until the gates of hell at least show a small sign of cracking open, cash – yielding nearly 4% on a CND GIC – seems so heavenly. It is difficult to be greedy when so few investors are displaying signs of fear.