1/1/11 –
On 12/31/10 the S&P 500 closed at 1258, resulting in a total return of 15.1% for the year. We have not increased our allocation to equities. The market started its recent rally from a level of 1011. In August, it began to anticipate a second program of Fed quantitative easing to lower interest rates and spur the economy; but the expected monetary stimulus will not happen. Anticipating inflation, bond investors began to increase long-term interest rates.
The stock market is now focused on the fiscal stimulus of an $856 billion tax deal between the Democrats and the Republicans. This budget package will result in around $150 billion of new money for each of the next two years; that’s 1.1% of GDP. Economists have increased their average 2011 forecast of real GDP growth by about that amount to 3.6%. Almost all the articles in the 12/20/10 Barron’s are bullish. What to make of this?
We consider long-term value and risk when investing. The following analysis suggests that the stock market’s current price exceeds its value, especially after considering the medium-term risks.
Value of the Stock Market
Investment quality corporate bond yields are now around 5.5%. Requiring a reasonable 7% long-term return for the S&P 500, we assume a dividend payout ratio of 40% on adjusted operating earnings, or $27.26, versus the $23.02 now paid. The present value of dividends growing at a new normal rate of 4% (2% real + 2% inflation) per year is 945.
Even with the assumption of a generous dividend payout ratio, the S&P 500 is very overpriced.
Risk
The continuing crisis of the financial system has been caused by too much debt that has not yet been dealt with. The following table shows what has been happening to U.S. federal government and private sector debt:
|
U.S. Federal and Private Sector Debt
(billions of dollars, Federal
Reserve Report D.3) | ||||
|
Year |
Federal Government Debt (a), excl. intergov. |
Domestic Financial Debt (b) |
Total (a + b) |
Household and Business Debt |
|
2007 |
5,122 |
16,208 |
21,330 |
24,386 |
|
2008 |
6,362 |
17,113 |
23,475 |
25,002 |
|
2009 |
7,805 |
15,594 |
23,399 |
24,479 |
|
2010 (3rd q) |
9,056 |
14,445 |
23,501 |
24,387 |
|
Change (2007-10) |
+76.8% |
|
|
0% |
This table shows that increased federal government debt (a) has almost perfectly substituted for decreased financial sector debt (b), resulting in a minimal increase in the total since 2008. Therefore, the financial sector’s credit has improved; the government’s credit has decreased; and the real economy, that needs a real restructuring plan, has not been affected. *
A 4/08 IMF report considered an annual 1% U.S. private credit growth stringent, similar to that experienced in the severe 1990-1991 recession. Compare the 0% household and business credit growth in the table above with a nearly 9% annual average growth during the postwar years. The hope is that all this added government debt will cause the economy to reach a “takeoff point.” The problem is, the economy may stall upon takeoff because needed structural reforms in the U.S. have not occurred in the real economy to reduce the weight of debt. ** The political system and the U.S.’s ability to issue foreign debt in its own currency have allowed Congress to kick the can down the road, avoiding financial disaster and the necessary restructuring and austerity seen on the European continent. But the can may hit a boulder.
To use current jargon, the government has provided for the economy’s liquidity needs; but has not yet facilitated its solvency (net worth). In the December 13th Business Week, Greenlight Capital’s David Einhorn said:
|
The global economy, as I see it, is sort of in a period between two crises. We had a crisis in 2007-2008. Call it the private-sector banking crisis or the real estate bubble popping. But I think it’s sort of laid the seeds for what will eventually turn out to be another crisis. There is a lot of unfinished business. …what we did in the last crisis in resolving it was – rather than go to the root of the crisis, tally up the damage, allot the losses, clean up, fix things, and move on – I feel a lot of what we did was sort of sweep things under the rug and put short-term bandage fixes on things. And I think we managed to transfer a lot of the problems from the private sector to the public sector. I’m concerned that will eventually threaten the public sector as well. …There were a lot of bad loans made and we had the opportunity to recognize those losses, clean up the mess, and set a base for future growth. Instead what we decided to do was paper over the problems. We bailed out a lot of institutions…It’s created a very, very large budget deficit. And it’s created a monetary policy that is extremely easy, and it seems to be perpetuating itself in a way that I think is going to come to a tough spot. |
Specifically, private debt has become sovereign debt, creating the following market risks:
1) Congress might not be able to reach a consensus to reduce the U.S. budget deficit. U.S. government debt held by the public will reach 100% of GDP by 2022. Many elements of the Bowles-Simpson debt reduction plan should be on the table in the next two years. We hope the loyal opposition do not again confront the electorate with the mantra, “No new taxes,” leaving proposed expense cuts minimal or unspecified, letting magic balance the books.
2) There are now warnings of a crisis in the U.S. municipal bond market. More optimistic observers point to the abilities of the states to kick the can down the road.
3) Unable to issue more debt, the peripheral nations of the EU are beginning to undergo their own sovereign debt crises. Their fundamental problem is that currency union is nearly impossible without political and therefore budgetary union. As in the U.S., these nations have too much debt, high deficits, and low economic growth.
4) To add one more risk: We have earlier shown the error-correcting ratio: Bond Yields/Stock Earnings Yield was a significant stock market descriptor between 1968-1999. Now consider the qualitative impact of this ratio. Bond yields *** could increase because the bond vigilantes might start focusing upon the credit quality of U.S. sovereign debt, add: imported inflation, or the economy may start to grow. Bond yields have been at historic lows. We do not think the U.S. stock market could remain uncorrected if long-term bond yields increased, say by 20%.
As the above indicates, there is a likely risk of stock market problems. Markets do not usually consider sovereign debt a problem; but in such a crisis, a banker said, “nothing else matters.” The world economic system continues to be very unbalanced – both in the U.S. and abroad. The risks are very high and could have a major portfolio impact if they turn into events.
*Business failure is capitalism’s way of starting anew. It roots out abuses and obsolete practices. But consider what would have happened if the federal government had let Morgan Stanley fail in 2008; Goldman Sachs would have quickly followed. View that firm’s interconnections to the world financial system. Would anyone have wanted the world’s financial system to fail and begin anew? That would have melted down the entire world’s economy.
But democratic societies also require a general sense of fairness. Our table obviously shows that the government bailed out the financial sector without bailing out the real economy. We think both Washington and the financial industry should not forget this bailout. Both the financial and the real economies still need to be restructured, to lend or to produce appropriately.
** The economic rise of the Far East is due to both the export focus of its centralized governments and its cost structure. America has to think seriously about how to deal with this and about its comparative advantages in the world economy (probably the abilities to execute large and complex projects and to start new businesses), beginning with trade policy and the education system. A purely laissez-faire attitude has resulted in the currently unbalanced consumer economy.
add: This NYT article,
describing describes the relocation of a solar panel factory from
Massachusetts, essentially says that the U.S. has problems in social
organization at least in the short-run. to China.
The specific reason for the company’s move was the plunge in world-wide solar
panel prices, by two-thirds in the last three years. – due partly to the
government subsidies available there. But Evergreen Solar also generated large
cash flow deficits every year since 2000. The company probably had numerous
problems with its technology, its management, and then with subsidized foreign
competition.
Markets are freedom; yet there is also the saying, “Be
careful what you wish for…”
*** add: U.S. fiscal policy is getting caught between the Scylla of very large government deficits and the Charybdis of low structural growth. That is why we think the Fed should not try to “create” economic growth, but only ensure financial system stability while the real economy is reformed and restructured.
__
We met a venture capitalist; the conversation was starting to
get boring so just to see how he would answer, we asked what his ideas were to
put millions of Americans back to work. He was utterly taken aback by the
question, not knowing how to answer, and implied we were some kind of socialist.
This
article in the January-February 2011 Harvard Business Review suggests a less
abstract social reality of markets. It’s by strategist Michael Porter and Mark
Kramer called, “Creating Shared Value.”
Here is an excerpt:
|
In neoclassical thinking, a requirement for social improvement – such as safety or hiring the disabled – imposes a constraint on the corporation. Adding a constraint to a firm that is already maximizing profits, says the theory, will inevitably raise costs and reduce those profits. A related concept, with the same conclusion, is the notion of externalities. Externalities arise when firms create social costs that they do not have to bear, such as pollution. Thus, society must impose taxes, regulations, and penalties so that firms “internalize” these externalities – a belief influencing many government policy decisions…. The concept of shared value, in contrast, recognizes that societal needs, not just conventional economic needs, define markets. It also recognizes that social harms or weaknesses frequently create internal costs for the firm – such as wasted energy or raw materials, costly accidents, and the need for remedial training to compensate for inadequacies in education. And addressing societal harms and constraints does not necessary raise costs for firms because they can innovate through using new technologies, operating methods, and management approaches – and as a result, increase their productivity and expand their markets. (our emphasis) |
__
How to understand the current rally in the U.S. stock market? Peter Lynch said that if things at a company are getting better, you want to own its stock. The market obviously assumes that the economy will get better; analysts are looking for signs (bird entrails?) to confirm that expectation. The present situation, unfortunately, is not so simple. In the absence of what Hayek called “spontaneous order,” the U.S. economy is being supported in a static state by unsustainable trillion dollar (sic) government deficits. The increasing weight of debt, rather than the dead hand of regulation, is preventing the economy from growing. It will be crucial for government to convince investors, that over the medium term, the U.S. is getting its finances under control by enhancing revenues (if you must, raise taxes), cutting spending, and enacting structural economic reforms. Current proposals before the House of Representatives to cut government spending between $50 billion to $100 billion next year are merely symbolic posturing and will not affect the fiscal situation.
This leads to a finding by Reinhart and Rogoff (2010). In a column titled “Debt and growth revisited” they write, “…the relationship between federal government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above the threshold of 90 percent, median growth rates fall by 1% (our note: to a “new normal” rate of perhaps 2% real), and average growth falls considerably more.”
Reinhart and Rogoff’s analysis does not include U.S. government debt also owed to the social security system. Their figures of debt/GDP compare “real” debt against, presumably, real GDP. Their conclusion that debt/GDP above 90% results in reduced growth is, however, valid because they compare the 2009 U.S. debt/GDP level of 84% (guess how 2010 figures will look) against that of other countries with debt/GDP similarly calculated.
To our readers, this discussion also illustrates that that there is a lot of judgment in financial analysis. That’s why analyses (and especially quantitative investment models) should never just present the numbers, but also state the assumptions and situations that these numbers refer to.
Our investment in Citigroup has appreciated well both absolutely and relative to other bank stocks. Its price, however, fluctuates in the short-term with the general assessment of economic growth; we think that the company benefits in the short-term mainly from the spread between low-cost funds and lending revenues. Although its price would certainly be adversely affected in the medium-term by a sovereign debt crisis, we think its long-term potential outweighs what might happen because it is well situated for growth in the emerging markets. Since we have maintained portfolio diversification among assets, we aren’t going to change the weighting of the stock.
2/1/11 –
It would be much simpler if all an investor had to do was to identify undervalued companies.
Sovereign debt, as described in our previous posting, is excessive in the developed world; and that makes the economic system vulnerable to shocks, particularly oil shocks emanating from the problematic Mideast.
The use of a long-term valuation model implicitly assumes that stocks are a store of value. By valuing stocks with a present value of dividends model we assume a long-term analysis horizon, considering all cash flows from a company stock the same way as those from a bond or project investment. The alternate total return model considers only dividends received during the holding period (t) and the ending price of the stock, Pt . This model assumes that stocks are not long-term company investments but short-term speculative vehicles to be sold at time (t).
The short-term total return model dominates investment thinking, thus it is possible for the 1/17/11 Barron’s to write:
|
America’s structural problems, including a gargantuan deficit, and the policies that perpetuate them, just might bring the country to ruin – but not before the stock market rallies another 5% or 10% or 20%, our panelists predict. That’s because constructive cyclical or short-term forces, …and rising corporate profits, could influence the direction of stocks for at least the next year or so. |
Obviously, if you believe this, you are going to dance by the door. We think long-term investors should be very cautious; because of high stock market valuation, a system that has not cleared itself of the excessive debt that retards sustainable economic activity, and now turmoil in the Mideast.
__
It’s assumed that the stocks simply reflect what’s going on in a company or economy. The markets, however, play another role. At times, and we emphasize that qualification, they can create their own reality. This reflexivity is the basis for the Fed’s monetary policy. If economic demand is lacking, the Fed can lower short-term interest rates, raise asset prices and thus stimulate demand and employment. But due to structural problems in the U.S. economy, there is too much debt and a dearth of production ability (manufacturing is now only about 11% of GDP); lowering interest rates is unlikely to increase employment. QE2 and government deficits will only make the economy appear to grow for a while.
The supply-side rhetoric of limited government hobbled financial system regulation, thus greatly contributing to the current crisis. But government now needs to enact supply-side measures to encourage (to be quaint) trade and commerce.
__
Could anyone have predicted that demonstrations for democracy in Egypt would erupt on January 25, 2011? How did U.S intelligence miss this? According to Senator Kerry, the U.S. could only report that the preconditions of revolution already existed. The specific date of that social phenomenon resulted from the complex interaction of people on the social media and the example of the popular Tunisian Revolution.
Could the Tunisian Revolution have been identified as an Egyptian catalyst beforehand by foreign policy experts? We think that would have been playing it too smart, trying to predict the behavior of a large-scale and not too stable system. We would stay with preconditions in those cases.
__
A regime is a systematic way of doing things. Whether a regime is political or monetary, transitions are likely to increase uncertainties.
The popular Egyptian revolution is resulting in a major change in social assumption. The Enlightenment assumed that society exists for the benefit of its people, rather than for the benefit of a narrow elite. From the French Revolution of 1789 on, that transition can cause societies to be very fraught; and there is the greatest danger of things going wrong.
In the political case of Mubarak’s Egypt, the regime and economic interests were military; and the same military is now being asked to usher in a transition to democracy. Whether the military regime can do that depends upon a variety of complex factors: the successful formation of political parties that can channel demands, the acceptance of a legitimate political bargaining process, and the effectiveness of suasion by the United States with the officer corp. When societies are highly polarized and partisan, Iraq is an example, social agreements are impossible. It is therefore crucial that Egypt avoid irreconcilable political polarization. South Africa is an example of a peaceful transition to democracy, where the message was – above all – reconciliation.
If Egypt manages to establish a liberal democracy, it will be a model for governance for the rest of the Mideast, a model that the neo-conservatives had expected Iraq to provide. To be clear, the social media can produce a popular demand for democracy at the barricades. Whether it can produce the institutions and habits of democracy remains to be seen.
In the United States, a monetary regime transition from QE2 would result in a tightening of monetary policy. Ben Bernanke, chairman of Fed, was recently asked whether the Fed’s program of quantitative easing was justified. He said it was, and then said that purchase of U.S. debt on the Fed’s balance sheet could be easily reversed (all you have to do is change the sign). What if the Fed, in June, merely ceases to purchase government bonds? Would the markets, now used to monetary ease and the carry trade with free money, stage a fit? That also remains to be seen.
3/1/11
-
The momentum of massive monetary creation has driven recent economic growth. Both have driven the upward momentum of the stock market, so far. That leads us to a very simple conclusion. The stock market, as all markets do, discounts the future only slightly, especially when it is murky; assuming simply a continuation of the historical trend *. In the short term, the stock market values most the past momentum of reported company earnings and ignores almost totally (until its too late) less visible long-term macroeconomic risk, for instance the risk that the U.S. housing market might collapse. Maybe market participants (and computers) choose to ignore politics and macroeconomics because they are too complex, the timing of actual events in both being difficult to determine. But conditions, more generally context, ultimately matter in social behavior.
The IBM supercomputer, Watson, recently trounced human contestants in Jeopardy ® with some very clever machine learning programs. A writer noted that the system is totally unaware of context and of what matters in a context.
We recently attended a value investor conference. A hedge fund manager, who predicted the housing crisis, spoke. He said, “You’re right because your reasons are right, not because of what the crowd says.” What he meant was what Mr. Market says don’t matter (if you aren’t leveraged), but your reasoning does. To shed some more light on this observation from financial economics. What logical information set you use depends upon your investment time horizon. Short-term investors consider the momentum of the good or bad news. This value investor considers the sustainability of a company’s long term growth, the purchase price, and the condition of the macroeconomy.
Those who have been reading our articles know what we think about the present macroeconomy. Consider this 2/24/11 WSJ article by James K. Glassman, who wrote, “Dow 36,000.” Here is an excerpt of that article:
|
In 1999, I co-authored a book called “Dow 36,000”…I told readers to tilt their retirement portfolios strongly toward stocks-but with an extra large dollop of optimism because stocks at the time seemed undervalued. 1 I was wrong…. Even with dividends, annual returns over the past 11 years have been a few piddling percentage points. What happened? The world changed. While history is usually the best guide for the future, it is far from perfect 2…. The first major change is that the relative economic standing of the U.S. is declining. The Congressional Budget office estimates that U.S. growth will average a little more than 2% over the next 70 years compared to about 3.5% during the second half of the 20th century. This is a stunning decline 3…. The second big change involves risk. Along with most investment analysts, I used to consider only one kind of risk: the volatility of an asset’s price…. But there is a second kind risk, the kind we can’t really measure or expect… These discontinuous risks 4 – or “uncertainties,” as the famous University of Chicago economist Frank Knight called them – are multiplying in a world in which technology provides instantaneous connections among markets and allows just about anyone to do just about anything, anywhere.... Perhaps I’m wrong about the world being a riskier place. But even if I am, this is still a time for investors to proceed with caution. They can protect themselves against the worst by ratcheting down the proportion stocks they own compared with bonds… 1 They weren’t. At the end of 1999 the ratio: Bond Yields/Stock Earnings Yields peaked at 2.7; it should have been around 1.6. 2 Maybe it only rhymes. 3 Unless something is done. 4 This is a usefully precise term, that depends upon perspective. Knight (1921) considered economics a social science, rather than an exercise in graduate level mathematics. He wrote, “Economic theory based on utilitarian premises, which is to say all “economic” theory in the proper sense of the word, is purely abstract and formal, without content (our note: context)….Any question as to what resources, technology, etc., are met with at a given time and place, must be answered in terms of institutional history…” |
Value investors are usually told to hold their noses and buy. We will do so when the U.S. stock market is priced for better value; even though we smell smoke, provided we think the floorboards aren’t about collapse. But we agree with Mr. Glassman’s suggestion that investors should favor (short to medium-term) bonds.
* Market momentum also works in reverse, until value investors start purchasing stocks.
__
The economic future very much depends upon the political dramas being played out in Washington and the states. Liberalism is a reasoned form of government; a policy is rational if its consequences are as intended. Consider two policy slogans, aimed at limiting the role of government:
“No new taxes.” The tax cuts of 2001 were supposed to enhance economic growth. In fact, between 2001-2008, real annual economic growth was 1.8% v.s. 3.4% in the previous eight years.
“Cut discretionary spending.” Indiscriminate budget slashing, the economist Jeffrey Sachs points out, will remove government’s ability to plan for the future - for economic growth, education, and energy. This will result in a poorer society that does not invest well.
Markets are freedom; but, as Keynes (1935) noted, they are short-term. They are furthermore not self-regulating, and have invested very badly for the future, as this truly disturbing picture of housing baking in the Nevada desert shows *. Profitable investment opportunities in the United States, rather than budget slashing **, should be what really concerns people. To provide for the future, all societies require at least some degree of rational management.
* The ideological response has been to blame the government; in particular the Community Reinvestment Act (1977) for this real estate mess. In fact, the role of the CRA in this crisis was very minor. The Financial Crisis Inquiry Commission Report (2011, p. 221) quotes banker Lewis Ranieri about the CRA. “You know, CRA could be a pain in the neck…But you know what? It always, in my view, it always did much more good than it did anything….You were really putting money in the communities in ways that really stabilized (them) and made a difference.’ But (private) lenders including Countrywide used pro-homeownership policies as a ‘smokescreen’ to do away with underwriting standards such as requiring down payments, he said. ‘The danger is that it gives air cover to all of this kind of madness that had nothing to do with the housing goal.’” Some in Washington should get real.
** The 2011 budget proposal passed by the House slashes non-security government discretionary programs by $61 billion (approximately $104 billion annualized) from an administration proposed $530 billion. This table (expand text to 100%) shows where the real problem lies. The House seems to be fixated on one summary line item this year; maybe they should discuss a few more add: for future years. Deficits may have peaked in 2010, but the succeeding ones are still cumulative.
__
The table below shows the changes in U.S. debt between Q3 and Q4 of 2010. Federal government debt greatly increased, and domestic financial debt continued to decrease.
|
U.S. Federal and Private Sector Debt (billions
of dollars, Federal
Reserve Report D.3), 2007-2009 data unchanged from previous report) | ||||
|
Year |
Federal Government Debt (a), excl. intergov. |
Domestic Financial Debt (b) |
Total (a + b) |
Household and Business Debt |
|
2007 |
5,122 |
16,208 |
21,330 |
24,386 |
|
2008 |
6,362 |
17,113 |
23,475 |
25,002 |
|
2009 |
7,805 |
15,594 |
23,399 |
24,479 |
|
2010 |
9,386 |
14,236 |
23,622 |
24,445 |
|
2010 Δ (Q3-Q4 ) |
3.6% |
-1.5% |
.49% |
.33% |
Nobel laureate and former IMF chief economist, Joseph Stiglitz (2010) , in effect, writes that this
financial crisis has resulted in a lack of private credit. This problem, as the
table above shows, continues. The economy is starting to depend on large
government deficits, domestic financial debt continues to decrease, and the
private non-financial economy lacks the means to grow.
A further analysis of “Household and Business Debt” shows, between Q3 and Q4, total household debt decreased by -.15% (-.6% annualized). Household debt remains too high, and a lack of real estate collateral is forcing a deleveraging. Business debt grew by .90% (3.6% annualized), but business cannot grow in the long-term without an increase in household expenditures. According to a 4/08 IMF report, U.S. private credit growth averaged 9% per year in the postwar period.
These questions are fundamental to international economic competition, the wealth of the nation, and a reduced trade deficit:
1) What can the U.S. manufacture better than the rest of the world?
2) Is large-scale manufacturing still viable in the United States, as a source of economic wealth?
The problem is less that the U.S. is declining, but that the rest of the world is catching up while the U.S. wastes its time on symbolic struggles that do not have an effect on economic growth. It’s time to deal with the real issues of taxes (revenues), entitlements, the fiscal deficit, and the economic future.
__
The horribly tragic tsunami that hit Japan also overtopped a 13 foot seawall protecting the nuclear reactors at Fukushima, flooding the emergency diesel generators that were to provide power. As a result, three reactors and a spent fuel cooling pond above one more are overheating, all in a precarious state. With 20/20 hindsight, it seems that a common technological thread links the Financial Crisis of 2008, the oil spill in the Gulf of Mexico, and Fukushima. Derivatives at interrelated financial institutions concentrated, rather than spread, risk; the blowout preventer at B.P.’s Macondo well did not prevent a blowout due to a design flaw; and crucial emergency diesel generators at Fukushima were located, not on the roofs, but on low-lying land.
Gaussian probabilities sometimes mislead because they assume
a highly controlled or very balanced world, for instance one where markets
function perfectly. Also, studies performed years ago at Fukushima
undoubtedly showed that there was a very low probability of seawall
overtopping utilized only
the historical earthquake record around the site. This shows that If you
are going to use technology to meddle with Mother Nature, you had better
identify the crucial system failure points and make sure they simply don’t fail
– period.
The lesson of this for the financial system is that TBF institutions simply cannot fail, so adequate regulation has to ensure they do not take large risks 1. The analogy of this for investors is the asset allocation decision. A goal of asset allocation is not to prevent short-term loss, but to enable you to withstand those losses and have a decent chance at long-term profits.
1 In the 3/21/11 Barron’s, Professor Leven hit the nail on the head. “Sophisticated financial systems disconnected from economic fundamentals can destroy more than they create…adherence to basic risk models matter and can serve a national economy well.”
4/1/11
–
The 3/28/11 Business Week quotes a portfolio manager, “If someone had told me that the U.S. was invading Libya, you have uprisings throughout the Middle East, the price of oil itself was over $102 a barrel, there was major devastation in Japan…there is no way I would have said the S&P would be up for the year…” Add to that: 1) Eurozone debt problems 2) Continued high U.S. unemployment 3) Continued problems in the housing market and therefore consumer net worth 4) Budget problems at the federal and state levels 5) Fed tightening at the end of QE2 6) A financial system that continues to be seized up – the U.S. stock market has climbed a wall of worry.1
Or has it. We think that the stock market has climbed the wall of money that the Fed has unleashed upon the economy through low short-term interest rates, bond purchases for its own portfolio, and guarantees. 2011 nominal economic growth is estimated to be around 4%. The Federal budget deficit will be around 7.5% of 2011 GDP. That means that 2011’s projected economic growth will be due to the budget deficit.
Furthermore trends in bank lending (see page 2, line 9, “Loans and leases on bank credit”) and securitizations (Excel file download, requires patience) signal no increase in autonomous economic growth. The increasing trade deficit indicates an excess of domestic demand for imports over foreign demand for U.S. exports.
There are two reactions to low economic growth:
Economists generally make the Keynesian assumption that the present problem is essentially one of demand management; therefore if the U.S. economy is operating way below capacity the role of government is to provide massive monetary and (now) fiscal stimulus to increase demand and therefore economic growth. The problem with that prescription lies at the heart of economics. The efficacy of monetary and fiscal policies rests upon having a balanced economy that can be at least somewhat fine-tuned. But the discipline is so mathematical and abstract that it basically assumes away the behaviors of collectives, institutions and the organization of production. The crisis of 2008 was a crisis of financial institutions and of trade policy. Simply throwing money at a problem won’t solve it.
The second reaction is more natural. In response to bad real estate investments, it makes common sense for both homeowners and the nation to cut back. That will be increasingly necessary if the U.S. fails to invest in education and new opportunities.
Neither reaction, however, addresses the real problems: Globalization has placed U.S. workers in direct competition with 2.4 billion more abroad, directly affecting American growth and incomes.2 The financial industry, having less to productively finance, in search of new profit sources began to write and sponsor exotic derivatives and securitizations that crashed the financial system. The budget deficit fuels the trade deficit. These are the three large problems facing the U.S. economy that require government to address.
Since people live in nations and the multinational economy does not, the U.S. has to restructure for new sources of economic growth, get that budget deficit down, and insist on generalized trade reciprocity. Throwing money at the complex problem won’t solve it. Targeting policy at various points in the system probably will, but there has to be a theme. Is U.S. politics capable of reform? We hope so.
1 Markets, and of course ultimately people, can live with potentially cataclysmic events provided they are remote. During the 1950s, U.S. economic growth was very high even though nuclear war threatened annihilation for everyone. The problem with the event risks we mention is that they are not remote, and the markets will react adversely if only one or two of them become acute fact.
2 An article by Xing and Detert, “How the iPhone Widens the United States Trade Deficit with the People’s Republic of China” for the Asian Development Bank Institute pinpoints exactly the problem with manufacturing in the United States. The following discusses business and not politics.
In 2009, the Apple iPhone, although designed and mainly marketed in the U.S., contributed $1.9 billion to the U.S. trade deficit. The more iPhones Americans bought, the larger that deficit. The authors write, “Unprecedented globalization, well organized global production networks…and low transportation costs all contributed to rational (our emphasis) firms such as Apple making business decisions that contributed directly to the US trade deficit…”
In manufacturing, a bill of materials is a recipe for producing a product. The article analyzes the iPhone’s bill by major supplier:
|
Manufacturer |
Component Example |
Total Cost ($US) |
|
Toshiba |
Flash Memory, Touch Screen |
59.25 |
|
Samsung |
Processor, Memory |
22.96 |
|
Infineon (Germany) |
Camera, GPS Receiver |
28.85 |
|
Broadcom, Cirrus (US) |
Bluetooth, Audio Codec |
10.75 |
|
Rest of Bill of Materials |
|
50.65 |
|
Total Bill of Materials |
|
172.46 |
|
Labor Costs |
|
6.50 |
|
Total Direct Costs |
|
178.96 |
U.S. manufacturers accounted for only $10.75, or 6.2% of all parts costs. Due to the lack of domestic product development, the electronics component industry is now essentially abroad.
Assembly labor in China was only 3.6% of total costs. However, an additional portion of the “Rest of Bill of Materials” might have been sourced there.
The value-added, or profit from each iPhone sold accruing to Apple was $500 sales price - $178.96 or $321.04
This $321.04 value added then went to pay the indirect costs of engineers, marketers, executives, office and retail space, and the remainder was profit before taxes. Management followed the rules of the capitalist system. Their corporate objective function is then: Max (Present Profits).
The authors then go on to ask a very interesting question, “Could the iPhone Be Assembled in the US?” The iPhone’s gross value added profit was $321.04 in 2009. What if it were totally assembled in the US? “Assuming that the wages of US workers are ten times as high as those of their PRC counterparts and their productivity would be in equal in 2009…the total assembly cost would rise to US $68 and total manufacturing cost would be pushed to approximately US$240.” Apple’s value added profit would decrease to around $260. Thus “…the hypothesis that competition drives iPhones’ assembly to the PRC does not hold. It is the profit maximization behavior of Apple rather than competition that pushes Apple to have all iPhones assembled in the PRC.” There is nothing wrong with this, but “…corporate social responsibility (CSR) has been adopted as a part of corporate values by many multinational companies, including Apple. It may be an effective policy option to practice CSR by creating jobs for low skilled workers, such as using US workers to assemble iPhones.” This assumes a corporate objective function: Satisfy (Present Profits, Employment).
Now consider the German model that manufactures, at a high price, incrementally improved and sophisticated industrial products. Take a look at this Deutsches Museum link (the U.S. science museums have been turned into aquariums). This type of industrial production requires investments in the future and the education and retention of a skilled workforce. The corporate objective function is then: Max (Future Profits). This model is the most consistent with the first.
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The above illustrates why manufacturing matters so much for economic prosperity. Apple can sell the iPod for $500, at 2.8X actual direct costs. After the allocation of overheads, the realized profits would be somewhat less.
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In bucolic England, manufacturing’s share of GDP is 11%, about the same as in the U.S. On 4/7/11 a WSJ article noted:
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British lawmakers look with envy at Germany, where manufacturing is responsible for 24% of a currently booming economy. German experts typically put the difference with the U.K. down to better German vocational training and the direct involvement of business in German education. German youths can take apprenticeships with combine practical work training in a business with weekly attendance of vocational schools called Berufsschulen*. Courses at the Berufsschulen are designed in part by entrepreneurs. (our emphasis) The U.K. has no close equivalent. Germany has also been more successful in exporting to the world’s fastest-growing markets. Almost 6% of German exports go to China, 1% to India, 2.6% to Russia, and 1.1% to Brazil. All four of those countries combined accounted for just 5.7% of U.K. exports. British manufacturers say their problems begin with schools, and with a lack of interest in engineering and technology. * We don’t speak German, but remember this word. A berufung is a calling, and therefore a serious matter. |
The article goes to note, “Manufacturers complain that
universities are too focused on developing and selling patents rather than
developing the actual technologies, which soon vanish abroad (our
emphasis)….The U.K. government has said that it plans to set up a network of
technology and innovation centers in which companies can get access to equipment
and expertise and conduct research and development, and that it will provide
funding for an extra 75,000 apprenticeships over the next four years.”
In the late 19th century, the U.S. originated the industrial mass production system, a system that resulted in a U.S. skill of supplying democratic mass markets; but not requiring a great deal of expertise from individual workers. As the example above clearly illustrates, the industrial mass production system has been exported; leaving the U.S. with the necessity of developing and exporting more sophisticated products to close the trade gap.
5/1/11 -
Great societal difficulties are not generally conducive to an atmosphere of rational and considered discussion. The current budget debate in Washington is an example of this. Globally unfettered financial markets transferred the surplus savings of Asia and the Mideast to the subprime mortgage and derivative markets of the United States. After the Financial Crash of 2008, the call in the U.S. is now for a smaller and less regulatory government. We’re for individual freedom and rights, but at another logical level think that the government should do for people what they can’t do for themselves. The following discusses the U.S. stock market and then the international economic system.
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In the 4/17/11 NYT, there is an article on the present stock market titled, “The Wall of Worry Has Never Looked So High.” This article summarizes the views of two former Merrill Lynch managers, Richard Bernstein who was its chief investment strategist until 2009 and David Rosenberg, who was its chief economist; both are accomplished but emphasize different information. We agree with Mr. Rosenberg, who considers the behavior of whole system. Summarizing the two:
Mr. Bernstein: “This cycle is the biggest wall of worry I have ever seen or will ever see in my entire career….People don’t accept that the American economy may be actually be strengthening.” …Mr. Bernstein readily concedes that on an “absolute” basis, the picture is hardly perfect, but he says the critical question for the market is whether the trend is positive of negative. He is convinced that prospects for American companies are quite bright, and expects that investors will grudgingly climb that wall of worry, moving the markets higher. He advises embracing risk in the American market in a big way.
Mr. Rosenberg: “I think that people who are still bullish right now will be in for a very big surprise.”…Mr. Rosenberg said that the boom in the American stock market was largely caused by the “radically” expansionary monetary policy of the Federal Reserve. The Fed’s current program of ‘quantitative easing” – its second bout of purchases of Treasuries and other securities, known as QE2 – is scheduled to end in June. “There is no political support for an extension,”…but if the Fed ends its asset purchases, “it will be a very big deal – a bad one – for the equity markets.” …Mr. Rosenberg ticks off other “pernicious headwinds,” including geopolitical risk...
Mr. Bernstein is looking at the income statement; and Mr. Rosenberg is looking at the balance sheet. Their philosophies and life experiences (training) lead them to different conclusions. More generally, if you can assume the health of the world’s economic system, the U.S. multinationals will make money on a sound enough world balance sheet. If this continues to be a crisis of the system, this is a lull between still unresolved debt and structural problems. We think this is the time to be very careful.
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Large-scale markets and international trade require regulatory institutions and social safety nets to improve social predictability. The choices are to reform that system, or ditch it for an even more radical market fundamentalism that produced the present troubles. If you consider revolution, the consequences will most likely not be predictable. Whether you vote Republican, Democrat, or Independent; this is really the time to think things through, to the practical consequences of the policy you support. An extreme position on social matters, no matter what, will most likely lead to bad consequences. The history of successful liberalism has been the experience of incremental reform. The following book is an excellent discussion about the necessary role of government in the international economic system. 1
1 Dani Rodrik, The Globalization Paradox, W.W. Norton, New York (2011). “People demand compensation against risk when their economies are more exposed to international economic forces; and governments respond by erecting broader safety nets, either through social programs or through public employment…modern industrial societies have erected a wide array of social protections-unemployment compensation, adjustment assistance…,” (p.p. 18-19).
Furthermore, government has crucial role in helping a society to upgrade its production. “Japan had many of the features of the economies of the periphery. It exported primarily raw materials (our note: its static comparative advantage) - raw silk, yarn, tea, fish – in exchange for manufactures...But Japan had an indigenous group of well-educated and patriotic businessmen and merchants, and even more important, a government, following the Meiji Restoration of 1868, that was single-mindedly focused on economic (and political) modernization. The government was little moved with the laissez-faire ideas prevailing among Western policy elites at the time,” (p.p. 142-143).
“Markets are not very good at providing signals beyond short-term private profitability.* Left to their own devices, they undersupply the incentives needed for productive upgrading. That is why in the words of the Harvard Business School innovation expert Josh Lerner, ‘virtually every hub of cutting-edge entrepreneurial activity in the world today has its origins in proactive government intervention.’ The benefits of globalization come to those who invest in domestic social capabilities….By restricting in the name of freer trade the scope for industrial policies needed to restructure and diversify national economies, it undercuts globalization as a positive force for development,” (p. 157).
Rodrik writes that the current laissez-faire World Trade Organization is problematic. The current system of market fundamentalism, now in the name of reducing transaction costs, does not meet specific domestic social goals or economic needs. “Replacing our economic world on a safer footing requires a better understanding of the fragile balance between markets and governance…markets and governments are complements, not substitutes. If you want more and better markets, you have to have more (and better) governance,” (p. xviii).
* This adds specifics to Keynes’ observation in chapter 12 of The General Theory:
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…most of (the experts, our note: now also computers) are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behavior is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment organized along the lines (our note: for short-term liquidity). For it is not sensible to pay 25 for an investment which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence (our note: value investors would simply purchase more if the stock hit 20 for no good reason).
J.M. Keynes, The General Theory of Employment, Interest, and Money, Harcourt Brace (ed) 1964, p. p. 154-155. |
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We analyze the expected returns of the U.S. stock market on a long-term present value basis:
Key Assumption: Economic growth
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Our S&P 500 Estimate 2% real * + 2% inflation =4% growth in earnings
Value Line Industrial Composite 3/11/11 estimate to 2016 = 4% growth in earnings |
We prefer to use two different models to appraise the S&P 500. But since there has been a substantial economic growth change, our historically based, error-correcting model of the S&P 500 (that conveniently did not include growth) is likely not to be useful. As a second best measure, we run the present value model against two separate datasets, assuming a constant 4% growth rate, and compare their results:
Case I: Value Line 3/11/11 Survey of 941 industrial, retail, and transportation companies. Excludes financial and utilities companies.
Growth = 4%, Dividends = .68, Price = 41, Calculated Rate of Return = 5.72%
Case II: S&P 500 3/11/11. Includes financial and utilities companies.
Growth = 4%, Dividends = 23.46, Price = 1304, Calculated Rate of Return = 5.87%
Using a single model, the two estimates of stock market return are within 15 basis points (.15%) of each other. We therefore have confidence that it accurately capitalizes assumed U.S. economic growth.
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Case III: S&P 500 5/6/11 Growth = 4%, Dividends = 23.46, Price = 1340, Calculated Rate of Return = 5.82% |
We compare this 5.82% projected rate of return against the average of 5.03% for best grade bonds. There is a 79 basis point (.79%) expected return premium for stocks ** given the following risks:
Continued Eurozone problems.
End of QE2 in June.
Continued decline in U.S. house prices.
Congressional debt ceiling and budget disagreements.
Consider the following:
A positive net national savings (personal, corporate, government savings – depreciations) is necessary for the economy to grow. It is most unusual for a country to have a negative net national savings rate.
2008 Net National Savings
(billions of dollars, World Bank Data)
|
Country |
Net National Savings |
|
China |
1,957 |
|
Germany |
375 |
|
Portugal |
-14 |
|
Greece |
-23 |
|
United States |
-138 |
The evaluation of risk and return is fundamental to any investment analysis. Modern Portfolio Theory made the unrealistic assumption that all market risks (that is the reaction of investors to events) are Gaussian. The effects of the above risks cannot be quantitatively measured, but they can be qualitatively determined. The present risks of the U.S. stock market exceed its return premium.
Carefulness is probably a matter of temperament. But when is it logical to be careful? According to Rodrik (2011) it is logical to be careful “…in cases where adverse effects can be large and irreversible.” This is a useful principle.
* Between 2001 and 2005 the real growth of the U.S. economy was 2.7% per year; biased, of course, to real estate.
** We would look for a 1.50% return premium over bonds and think this is reasonable. That would place the S&P 500 at 964.
6/1/11 -
The U.S. stock market was embedded in error-correcting political and financial systems. Repairing these systems requires what Isaiah Berlin called, “The Sense of Reality.” The objection we have to the formulas of ideologically driven politics is that they are not at all empirical, taking into account the real situation and learning from experience. The consequence is mistakes. Consider these slogans:
“We will be greeted with flowers,” helped justify the Iraq war. What decisionmakers neglected was the reality of deep sectarian and tribal fissures in Iraqi society, between Sunnis and Shia, making liberal democracy there impossible. The cost of that war is presently 4,454 American military casualties, more than 100,000 Iraqi casualties; a further cost to Iraq of a decimated society, and a total estimated cost to the U.S. of more than $3 trillion (Stiglitz).
“Government is the problem, not the solution,” justifies market fundamentalism. The short-term profit maximizing private sector then took full advantage of government inattention: creating a mania in residential real estate financing, that resulted in a panic, and then a crash. Using an average of Goldman Sachs and IMF figures, estimated total loan losses will be $1.775 trillion. Assuming a 50% market share, U.S. public financial institutions will write off around $887 billion in loans; about 52% of their net worths in 2007.
The result of this binge was a huge misallocation of resources and the present price, continued low economic growth.
add: According to Bob Lutz, former vice-chairman of General Motors, the company would not have survived its bankruptcy without the government’s debtor-in-possession financing, enabling it to pay its bills. This financing was simply not available from the private sector in 2009. A collapse of GM and Chrysler would have destroyed a large part of the U.S. auto industry and its suppliers.
“No new taxes,” neglects entirely the revenue side of the budget, to reach a goal of minimal government. The tax cuts of 2001 were supposed to enhance economic growth. In fact, between 2001-2008, real annual economic growth was 1.8% v.s. 3.4% in the previous eight years, A more nuanced approach, requiring thinking, would ask when and how government can be effective.
The very far right, although conservative in claim - is sweepingly revolutionary in intent, waving ideological slogans and barricading the legislative process. Democracy is a system of shared power. For there to be the necessary trust, all must at least acknowledge that they live in a common reality. Refusing to acknowledge that reality prevents the whole system from learning by experience, which better adapts the U.S. to the world and encourages economic growth.
We recently attended a talk by a former government official. He characterized his job in the Washington:
Stressful, akin to working in a fishbowl.
Every news item is used to torture the opposition.
There is a loss of long-term horizon. Short-termism in rampant.
The parties don’t think anymore. They have their scripts and stick to them.
A 5/23/11 NYT article by David Brooks describes the workings of British democracy:
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In 1920….Each party took different whacks at pieces of the great national problem, depending on its interests. Opposing parties, when it was their turn in power, quietly consolidated the best of what the other had achieved. Gradually, through constructive competition, the country quarreled its way forward. The United Kingdom seems to be in the middle of that sort of constructive quarrel now…. If the quintessential American pol is standing in his sandbox screaming affirmations to members of his own tribe, the quintessential British pol is standing across a table arguing face to face with his opponents. British leaders and pundits know their counterparts better. They are less likely to get away with distortions and factual howlers. 1 They are less likely to believe the other party is homogenously evil. They are more likely to learn from a wide range of people. |
The ancient Greeks developed their precise reasoning to deal with politics. Aristotle made a distinction between Sophia, thinking well about the universal truths of the world, and Phronesis, “…the capability to consider the mode of action in order to deliver change, especially to enhance the quality of life…Phronesis is concerned with particulars, because it is concerned with how to act in particular situations.” 2
1 This report attempts to link “Rising Energy Costs” to “An Intentional Result of Government Action.” Even OPEC barely influences the daily price of oil traded in the world markets. This report is really a complaint about domestic tax policy, permits, and regulations. It’s disturbing, and we certainly hope not typical.
2 Wikipedia, 5/25/11. How are principles
relevant? In the modern world, that depends upon the degree of system
complexity. Geoffrey Moore (2005) writes that simple systems are designed around
rules. More complex systems require insight and alignment around essential
principles, because each customer’s situation is unique.
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As an example of the above reasoning, consider the case of modern Greece and its relevance to the U.S. budget debate. As the 5/30/11 Barron’s relates, Greece is at the verge of sovereign default. Like the U.S., the country is saddled with too much debt amassed during a binge. In shorthand, the country’s sovereign Debt/GDP ratio is around 160%; by comparison, the U.S.’s ratio is around 90%. Both Greece’s and the U.S.’s debt ratios are too high. However, there are differences. The U.S.’s level is lower; and it can issue debt in its own currency, a large proportion to be funded abroad. Greece’s finances have to be restructured according to one of the three C’s of lending, its capacity to pay.
There is an advantage to looking at a foreign case. The U.S. budget debate involves complications of political philosophy, fairness, and an emotional reaction to economic difficulties. Consider how the level-headed article in Barron’s considers handling Greece’s financial problems:
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Europe should make Greece restructure its debt-swiftly….Failure to restructure will also bring further societal and economic ruin. With Greece’s unemployment rate at 15%, biding time until an eventual default could throw the country into depression, incite more unrest and drag all of Europe into deep recession, It could even cause Europe’s common currency, the euro, to unravel, and shake the foundations of the European Union itself…. Delaying a debt restructuring by even one or two years would mean that the amount to be recovered by bondholders could shrink from 50% to 30%, according to Citigroup. Delay a few more years, and the amount recovered could be next to nothing. Meanwhile, Greece’s economy would keep shrinking. That would bring dire human cost, says David Goldman, formerly Bank of America’s head to fixed-income research. Unemployment could approach Spain’s levels: 20% overall, with youth unemployment near 40%. Emigration would rise, Goldman says. Some public services could be halted, and protests could grow deadly again. |
Unlike Greece, the U.S. need not (note this word) involuntarily default. But the basic problem is the same, too much debt. The first reaction, cut everything, is not the useful reaction because there are social limits to extreme austerity. “A wise lender would have to conclude that the Greeks have given just about all they can. The only choice left is restructuring…” The U.S. still has a limited time to get its house in order. It makes sense to continue a level of deficit spending, in spite of our visceral dislike of that, to avoid an economic collapse and really use the time to restructure the economy and reform the government’s finances over the next three and more years. Squabbling and gridlock in Washington is a waste. Economic growth requires a stable social consensus.
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add: It’s necessary to get the economy growing again. But individual tax cuts are not the solution because, depending upon the period studied, there has been either a positive or no correlation between marginal tax rates and economic growth, the former within a range of 91% to 28% in recent times. Economic growth is the product of a balance among government policies and basic research, private development initiatives, and education – not lower tax rates. This 6/7/11 NYT article discusses Germany as an example and what the United States needs to do.
What’s wrong with this picture? The issue isn’t whether these investments are ultimately profitable. The first thing that strikes us is the lack of variety in the large internet companies that might go public in 2011. Biologists say that a healthy ecosystem is diverse and less prone to shocks.
Our portfolio is only about 16% net invested in equities. Why not 0%? This is because we are basically a long-term investor and like our companies.
7/1/11 -
The purpose of the law is to establish agreement and therefore social order. Current news headlines discuss the impending financial implosion of Greece, the spread of financial contagion to other countries and the banks of the Eurozone, and then possibly to the United States.
In the private sector, an orderly bankruptcy process usually occurs when a company’s creditors come to the conclusion that it no longer makes sense to throw good money after bad. In the United States, companies then file for Chapter 11 court protection from their creditors. According to the 6/17/11 Wikipedia, “The principle focus of modern…business debt restructuring practices no longer rests on the liquidation and elimination of insolvent entities, but on the remodeling of the financial and organization structure of debtors experiencing financial distress so as to permit the rehabilitation and continuation of the businesses.” The benefits of an orderly restructuring of obligations can be seen in the rehabilitation of both GM and Chrysler as going concerns.
The international environment is much more anarchistic, suffering from coordination problems. The Eurodollar is not just a pretty coin. In the 5/31/11 FT, Martin Wolf described the eurozone as, “…an updated version of the classical gold standard. Countries in external deficit receive private financing from abroad. If such financing dries up (like an outflow of gold), economic activity shrinks. Unemployment then drives down wages and prices …” But this problematic design did not take into account the fact that a refusal to lend can precipitate a crisis and much of the borrowing in Europe occurs via the banking system. The national financial authorities. notably in France and Germany, are now not willing to accept the required bank writedowns that reduce capital. They kick the can down the road by providing just enough funds to keep the game going, while Greece suffers from social strife (stasis). The alternative to enabling an orderly writedown of debt, is a disorderly writedown.
Dealing with the financial system’s excessive debt in an orderly manner will restore general confidence, so both debtors and creditors can begin anew. Greece’s $330 billion GDP is slightly less than Philadelphia’s; the first step might be to ring-fence its $504 billion debt. The banks will then have to agree to write off $200-$300 billion of that debt and recapitalize themselves, requiring an European political consensus. Otherwise, as Alan Greenspan and Mohamed El-Erian say, it’s only a matter of time.
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8/1/11
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The Catalyst
S&P has downgraded U.S. long-term debt from AAA to AA+. The S&P 500 closed at 1119, down 6.66% in a single day. Here is our analysis of the catalyst. The world’s financial system was built upon the bedrock of U.S. treasuries. Calling that bedrock more risky created a re-pricing of all the world’s financial assets, particularly risk assets like stocks, resulting in market drops. The resulting flight to safety (paradoxically) has resulted in an increased investment of treasuries, except managers are now also trying to reduce risk by diversifying their bond portfolios to the extent they can. This illustrates that there is really nowhere to hide when the directors of the world’s bank start squabbling.
We will eventually purchase more value stocks.
The Consequences
The short-term stock market rarely does things for one reason. In a complex and often uncertain world, the short-term stock market acts in a certain way because events (planets) line up in a configuration that outlines a plausible crowd-interpreted reality; Keynes * was more acerbic about this. The particular events that are driving the stock market lower are a series of reports that finally convinced people that the economy is not growing due to structural reasons (we said that earlier, see our 10/1/09 comment). Very recent negative reports and risks are: 1) The June Consumer Spending report, 2) The July Manufacturing Report, 3) The GDP growth report cited below, 4) The possibility of an U.S. credit downgrade (The U.S. having nearly defaulted), and 5) The irresolution of the Eurocrisis, now beginning to involve the large economies of Spain and Italy.
As we demonstrated in “How the U.S. Stock Market Works” the short-term stock market error-corrects to a degree, if the Fed’s monetary policy is efficacious; or else it will simply fluctuate with volatile opinion.
We think that stocks might sell at better realizable values later. U.S. financial institutions are in better shape than they were in 2008.
* Chapter 12 of Keynes’ The General Theory (1933) is about markets and investments. We suggest this chapter to our readers. It led us to eventually read Keynes’ entire writings on investments that are very practical and contrarian in philosophy.
The Situation ↑
From a broad perspective, the Financial Crisis of 2008 was caused by social changes in both the developing and developed worlds which opened up low-cost labor markets to the profit-seeking multinationals. A future article will discuss both economic and other social processes, but here we concentrate only upon the investment implications.
The investment environment in the U.S. is now very different from that which pertained before. Before, investors had to consider only one factor, the Fed’s loosening of monetary policy that would inevitably result in a stock market rally and eventual economic growth. It was then possible to give a signal to invest in the stock market (that was the secret). Now, this is a crisis of the system, with interest rates at the zero bound. Investors have to navigate many cross-currents.
On 7/21/11 a WSJ article cited the main effect of this systems crisis upon the U.S. economy, low growth.
U.S. 2011 Real Growth (Annualized)
1st Quarter 2nd Quarter 3rd Quarter
|
Economist Estimated (2/11) |
3.6% |
3.4% |
3.5% |
|
Actual (7/29/11) |
0.4% (r) |
1.3% |
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The legacy of the Financial Crisis of 2008 is low growth in the U.S. and systems instability in general. Michael Spence, economist and Nobel Prize winner, has published a very thought-provoking book titled, The Next Convergence (2011). His chapter on investment behavior is especially well-written. For some reason, we agree with it. On the topic of risk, Spence writes, “Investors have a renewed or heightened sense that risk is dynamic and far from (Gaussian) stationary as the conventional framework held…the models that we use to assess risk are incomplete and not sufficiently dynamic.” Expected returns from investing in the stock market, on the other hand, are low because, “The advanced–country markets appeared to be valuing assets on the basis of a sharp recovery. Many observers, including this writer, view the valuations as excessive. Government support, both financial and fiscal, is still in place; unemployment is very high; deleveraging and household balance-sheet restoration is far from complete....”
With the black swans of systematic risk fluttering around: the U.S. budget deficit, the Euro crisis, and the unremedied real estate market still declining, what is an investor to do? Spence helpfully, but not optimistically, provides a table that shows the stock market’s realized annual return over a ten year period, if the realization of systematic risk in the ninth year were to cause the stock market to decline, say by 20%. If such a decline were to be earlier, the realized annual returns would be worse.
Realized Annual Returns over Ten Years
Normal Returns Decline 0% Decline 10% Decline 20%
|
6% |
6% |
4.28% |
3.06% |
|
8% |
8% |
6.05% |
4.81% |
The table above illustrates that realized systematic risk drastically reduces long-term investment returns. That is why our discussions value rationality and stabilizing institutions. But predicting systematic events is like trying to predict an earthquake, “Major systemic disruptions do not occur every year. Rather, instability builds up and then the system is shocked and resets, the exact timing being still quite unpredictable. As a result, wrestling with systematic risk requires a reasonably long time frame…”
What are value investors supposed to do since, “Fair valuations and undervaluations are not exempt from the downward pressures of a crisis (when all correlations go to one) or from the resetting of asset values after a buildup of systematic risk.” The author generally suggests:
1) Purchasing tail-insurance against specific extreme events.
2) Dynamic asset allocation, requiring fairly liquid portfolios. “It…seems to me that investment and portfolio strategy should include a careful monitoring and evaluation of…inputs. (…warnings from those with a track record of focusing on the stability of the macroenviroments). Action can be taken when the weight of the arguments is persuasive, if not definitive.”
The measures above are really for investors managing institutional portfolios, not for those handling their own. The alternative is the original Golden Rule. If you are going to treat the market well by investing your hard-earned funds in systematically volatile * stocks, you should expect the market to treat you well by giving you something in return (besides simply going up in price over the short-term). That something is current dividends. In fact, over a very long time period (1825-2009, Ibbotson) 61 % of long-term market returns were from dividends. **
We will favor value stocks that also pay decent dividends, when institutions are somewhat more stable. There is a theoretical justification for this. In chapter 12 of The General Theory (1933) Keynes wrote, “ The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future….(But) there are…certain important factors which somewhat mitigate in practice the effects of our ignorance of the future. Owing to the operation of compound interest… there are many individual investments of which the prospective yield is legitimately dominated by the returns of the comparatively near future (like the returns of dividend-paying stocks).”
The combination of a laddered bond portfolio and dividend-paying stocks, purchased at the right price, will provide investors with long-term income, hedged against inflation. If they don’t need the current income, they can simply re-invest it. This was the conventional investment wisdom from the 1930s to the mid 1950s, before the advent of the growth stock era.
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* If you consider the Latin American debt crisis, the Asian debt crisis, the internet bubble, the housing bubble, and now the market’s overvaluation of stocks, why these mistakes? Macro mistakes occur because of macro uncertainties. Consider the more tractable corporate case. A company shows continuing earnings growth (good) but its markets are evaporating, there is no revenue growth (bad). The market will quickly sniff out this situation and accord the company a low P/E for its future prospects. In contrast, sovereign states are larger than companies and therefore have many more options to kick the can down the road. As is happening in Europe, they can rely on opaque accounting, commercial banks, central banks, and multilateral organizations. There are many political players in the international finance system, and therefore many uncertainties. One way of dealing with this complex situation is to have a single comforting idea, that countries do not go out of business. You get inertia (resisting a change in motion), until (to mix a metaphor) an earthquake strikes. |
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** This conclusion, of course, depends upon the time period considered. Since in the future the U.S. will have to deal with both lower economic growth and increased entitlements, this is a reasonable assumption. |
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According to the new government debt limit agreement, discretionary spending reductions next year will be $21 billion, or around .13% of GDP *. There will also be $1.5 trillion in deficit reductions over ten years, against a baseline that can change and will probably involve a mixture of tax increases and spending reductions, to be determined by a joint committee. The net effect of this legislation will likely be slightly contractionary next year, at a time when economic growth is decreasing (see the above). This legislation therefore places a somewhat greater task on the private sector, to grow the economy.
This legislation is better than the default that was threatened. Government will now facilitate the creation of new opportunities for the domestic economy.
* Assuming 4% nominal GDP growth, 2% inflation and 2% real.
9/1/11
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On 8/29/11 the WSJ noted that the short-term correlation of stock movements in the S&P 500 had risen to 80%, up from 73% during the peak of Financial Crisis of 2008. This results from a trading strategy, “risk on” or “risk off,” depending upon the market’s current evaluation of macro circumstances. (Will the U.S. fall into another recession? Will the Euro implode?)
Usually such macro considerations can be catalysts that drive the prices of individual stocks down to where they become value. Investors, however, might not have the luxury of simply letting the situation stabilize first, as we suggested above. The markets (that now include high-frequency trading computers) might simply say “risk on” and drive prices up again. Probably the best strategy will be simply to wait until the stock market is priced to yield a desired return, in this case the rate on best-grade corporate bonds + 1.5%.
Another strategy to reduce risk is to diversify by averaging across time. We are going to do something like initially purchasing around 40% of a stock’s position according to the above, and then averaging in the remainder. We are trying to disabuse some of our readers of the notion that it is possible in the present market to avoid all downside and to gain only the upside. Mr. Madoff promised something like that. A more realistic goal is simply to lose less in down markets and to get invested in dividend-paying value stocks, to take advantage of their returns exceeding that of bonds.
10/1/11 –
The S&P 500 has been tumbling because the Fed announced "significant downside risks to the economic outlook;" furthermore no permanent solution for the Eurozone’s financial problems is in sight. The short-term correlation of stock movements in the S&P 500 has risen to 80% (WSJ, 8/29/11) because this is a crisis of the system.
We are starting to be very glad that we partly hedged our investments. The S&P 500 is getting somewhat closer to our purchase point, where we will gradually increase our allocation to stocks, also trimming our hedges. How this financial crisis will develop no one really knows; but when we gradually increase our exposure to stocks, we will minimize risk by diversifying over time. We will discuss the reasons for what we are doing.
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In a 9/28/11 NYT article, former chancellor of the Exchequer and prime minister, Gordon Brown, writes that the €440 billion European Finance and Stability Facility that the Germans recently approved is, “…far too small…Two trillion Euros (sic) are needed just to recapitalize the banks and finance the borrowing needs of Greece, Spain, Portugal, Ireland and Italy until 2014.” The financial problems now facing Europe vastly exceed those now facing the U.S. Since credit in Europe tends to be allocated administratively, by the banks, “…the liabilities of Europe’s banks are 350 percent of G.D.P. (five times more than the American banks), and German banks, which are leveraged at 31 times the size of their assets, are themselves in trouble and in need of recapitalization.” Brown proposes, given the magnitude of this problem, both the European Central Bank and the I.M.F. need to be involved without delay.
A flap of a butterfly’s wing in Berlin or Athens could cause an earthquake in the U.S. financial markets. This is a time to be very careful. Anyone for a two year treasury at a .24% annualized yield? Clearly this is a time to be concerned with a return of capital, rather than a return on capital.
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The Financial Crisis that began in 2007 now involves larger collectivities than just companies. Thus, we discuss political economics. In the United States, excesses in the private sector required a bailout by the public sector. The public sector is now increasingly burdened by debt and the private economy is burdened by the ills of, “stagnant growth, increasing unemployment and banks that will not lend” (NYT, 9/17/11). In the Eurozone, Greece’s impending default (1.9% of Eurozone GDP) has called into question the public debt of the larger economies that now include Spain, Italy, and maybe beyond.
In both cases, the demands placed upon the public sector exceed the present ability of politics to adjust. Europe has achieved monetary union, but not a fiscal union that requires extensive political agreement. In the United States, public frustration with economic conditions resulted in a 2010 election that placed in the House a conservative blocking majority that accords to the public sector a diminishing role, when more collective action is needed to ensure the United States a better future. Private corporations with their higher labor costs compete internationally with state-backed corporations, and diminished resources are available for education. Fareed Zakaria says either wages will adjust downwards or education must adjust upwards.
All societies respond to the flux events according to their traditions. But any general tradition contains within itself various themes. The themes that people choose determine how well their societies adapt to change. Very relevant to U.S. politics in 2011-2012 is a resurgent theme that ties together guns, unregulated markets, and “no new taxes.” This anarchical strand fueled the feisty colonists in the Revolution of 1776, tamed the frontier, and resulted in a larger role for the United States to spread the ideal of freedom around the world. It is very much a part of the American character. But making a good, the only good leads to problems. The political scientist, Benjamin Barber, writes:
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…in America anarchism has been a disposition of the system itself, a tendency that has in fact guided statesmen and citizens more compulsively than it has motivated dissidents and revolutionaries. It has been incorporated into popular political process and has become an integral feature of the political heritage. Wherever privacy, freedom, and the absolute rights of the individual are championed, there the anarchist disposition is at work. Wherever free markets are regarded as promoting equality and statist regulations is decried as coercive and illegitimate, there the anarchist disposition can be felt… The political philosophy that issues from such quasi-anarchist ideals as liberty, independence, individual self-sufficiency, and the free market, and privacy is encapsulated in the slogan “that government is best which governs least.” …Liberal (our note: conservative) democrats…are wedded to natural or negative freedom; they can conceive of no solution other than to limit or eliminate all government. Because for them freedom and state power are mutually exclusive… …This stance helps to explain why liberal (conservative) democrats often seem obtuse about power and conflict in the “natural market.” Having stipulated that “nature” means “free” and that “community” means “coercion” they can hardly entertain the possibility that community may support certain kinds of freedom or that nature may nourish forms of coercion and conflict more insidious than those known in democratic politics. …Thus it is the anarchist disposition more than any other that leaves liberal democracy so incomplete, so polarized, so thin as political theory and so vulnerable as political practice. * (We think the major problem of the George W. Bush administration was that it started with this theory of non-government and ended with the practice of blotched governance. Consider Katrina, the war in Iraq, the fiscal deficit, and the Financial Crisis of 2008.)
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Reconstructing an idealized past, the
ideologues of the Right happen to neglect facts. We don’t see how any form of
successful governance can neglect facts. Recall that the federal government was
created in 1787, when the Confederation of thirteen separate colonies was unable
to solve problems of civil order, public debts, and trade. Since the
Constitutional Convention, the federal government, among other things:
1) Purchased a large part of the United States from the France. (1803)
2) Purchased Alaska from Russia. (1867)
3) Granted federal lands for state colleges. (1862)
4) Financed the transcontinental railroad. (1862)
5) Built dams, schools and airports during the New Deal. (1935)
6) Built the interstate highway system. (1956)
7) Funded very large-scale basic scientific research at the national laboratories and through the Defense Department (including of course Darpa’s Internet).
8) add: Catalyzed the development of the venture capital industry in the 1960s by co-funding Small Business Investment Companies. The SBICs supported Apple Computer, Compaq, and Intel before they went public.
The ideological far Right should complain about all of the above. To compete in a globalized economy, the U.S. needs a growth plan for the economy’s future and to increase collaboration among business, government, and the universities. The laissez faire assumption that everything will optimally adjust has lead to the hollowing out of the U.S. economy. An even more significant theme within American culture is that of partnership and teamwork.
Where to start? Note this graph showing how industry (energy capture) dramatically increased wealth, starting in the 1850s. Manufacturing and trade policy really matter. The American multinationals should try very hard to keep jobs in the United States. The government could be a facilitator, particularly of new businesses with the potentials for export and the development of new products. The U.S. should expect a generalized reciprocity from our trading partners. It might be noted that since 6/09, when the recession officially ended, the cumulative merchandise trade deficit has reduced the growth of the U.S. economy by more than 14% (Tonelson).
* Benjamin Barber; Strong Democracy; University of California Press, Berkeley; 1984, 2003; p.p. 9,10.
11/1/11 –
In October 2008, after Congress passed TARP, Secretary of the Treasury, Henry Paulson, summoned the CEOs of the nine largest U.S. banks to Washington. He strongly suggested that they recapitalize by selling the government preferred stock, carrying some restrictions. They signed. The $250 billion bank recapitalization program was part of an effort by the U.S. government to avert the collapse of the world financial system. The 10/14/08 NYT estimates that recapitalization and bank guarantees amounted to $2.25 trillion. This was an example of the central banking rule, “(in a panic)…lend freely at a penalty rate. ‘Freely’ means…only to solvent borrowers and with good collateral, subject to the inevitable exceptions.” (Kindleberger, 2000 ed.)
It is now October 2011. The seventeen nations of the Eurozone are in the throes of financial crisis because many governments are not able to bring their deficits under control, turning their sovereign debt from risk-free assets into assets carrying considerable credit risk. This was certainly not what investors, including the highly leveraged European banks, their regulators and creditors, had expected. The result has been a seizure of inter-bank lending on the continent, that if continued, will result in a major sovereign debt crisis and a major recession in Europe, with the U.S. inevitably affected. On October 26, the ministers of the Eurozone met for the fourteenth time on this crisis to arrive at a “definitive” solution. Their agreement contains three main provisions:
Writedown of the 60% private portion of Greece’s €350 billion debt by 50%, reducing Greece’s debt load to a still high 120% of GDP by 2020.
Requiring recapitalization of the European banks by around €106 billion ($150 billion).These banks will recapitalize themselves by first going to the public equity markets (which are now closed to them), second to their respective national authorities and third to the Eurozone’s rescue fund. The amount of new bank capital required is less than the book value of a single large U.S. bank.
Leveraging the effect of Europe’s €250 billion available rescue funds and starting a SIV (special investment vehicle) to insure the new debts of Italy, Spain, and other countries, with no specific agreement reached at that meeting.
The Eurozone ministers’ meeting reflects the fact that that they have achieved a monetary, but not a fiscal union – with enforced balanced budgets. The European Central Bank cannot guarantee Eurozone debt. The proposed arrangements, intensely negotiated, will require only an additional €30 billion contribution from the governments, not satisfying the central banking rule. *
What does this mean for U.S. investors? Recently, the S&P 500 has rallied to more than 1270. ** Why didn’t we try to chase it? Due to short-term distortions caused by the Fed’s zero interest rate policy, we think the stock market remains overpriced on the fundamentals. In particular, given the above risks, stocks do not possess an adequate margin of safety below their intrinsic values. In spite of our partiality towards equities, we have not invested in them heavily.
This is also due to opportunity cost. The opportunity cost of investing in equities is not cash, carrying a zero percent rate of interest. The opportunity cost is corporate bonds. A laddered intermediate-term bond portfolio bought within the last year, will return 5-6%. Particularly, given the above, we want the S&P 500 to return at least 6.5% long-term. We think we are being rather partial to equities at that low required rate of return.
* Britain’s Gordon Brown has estimated that about €2 trillion will be required to recapitalize the banks and deal with Eurozone debt problems until 2014, more than any single country can handle. More involvement by the European Central Bank will be required. Greece and the euro can no longer be separated without ruining both. The Eurozone economy is slightly smaller than the United States.
This leads to another major point. Any kind of long-term investing assumes the viability of the system, which at this time means reaching the political agreements necessary to restore stability. To cite but two examples:
TARP didn’t pass the House the first time on September 29, 2008. The S&P 500 promptly dropped by 8.5%. The Bush Administration finally got the bill through the second time on October 3rd. Recalling this episode, Henry Paulson said, “The Republicans in the Senate were overwhelmingly favorable to doing what we had to do….The Republicans in the House had the hardest time. I had the most difficult time working with them.” Congressional obstruction could have sunk the U.S. financial system and economy.
In the above negotiations, German Chancellor Angela Merkel had to face down European bankers that were refusing to take a 50% writedown on Greek debt. An 11/27/11 NYT article wrote, “…Mrs. Merkel called the bankers’ bluff, said officials present at the discussions. Accept the 50 percent write-down, she told the bankers, or bear the consequences of default. In effect, she was willing to risk a credit event, and to place the blame for any fallout on them.”
These two examples show that preserving financial system stability is now a political, rather than an economic matter. It is dependent upon someone doing the right thing, by blinking in the face of catastrophe. This is why we are being very careful and would like to see at least a decent margin of safety in our stock investments.
** This is instructive; the market can deal only with broad generalities. By rallying, the market is saying that this is change in the right direction. We, however, are concerned with the specific fundamentals.
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The eurocrisis has too many complicated moving parts, among them the electorates and legislatures of seventeen separate nations that have veto power. The “definitive” deal that the ministers arrived at lasted four days. Greek Prime Minister George Papandreou sought to relegitimize his government by calling for a risky popular referendum to approve that deal, backed down when all political parties protested and then offered to resign to get a legislative vote of confidence.
All permutations of the Eurozone crisis ultimately involve two policy options. The crisis can be handled either by an European Central Bank guarantee of all Eurozone debt, in spite of spotty national fiscal controls, or by a national recapitalization of the commercial banks after writedowns, affecting sovereign credit quality. There will be problems ahead, probably to be solved by some form of limited ECB guarantee and IMF oversight, snatching victory from the jaws of defeat during a major turmoil.
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The 11/9/11 CNN wrote, “The cost of Italian debt is soaring, the euro is plummeting and the debt crisis that we have all been fearing appears upon us.” We thought the catalyst for the next financial crisis would be a flap of a butterfly’s wing in Athens or Rome. It turned out that Phase II of the Financial Crisis of 2008 has been triggered by crises in both Athens and Rome. That is why when the financial environment is fraught, it is difficult to judge the effect of a single event.
We assume our readers have reduced the risks of their portfolios so they are fairly indifferent to what happens (within limits) in Europe. The evolution of this crisis will be interesting, an illustration of Kindleberger’s Manias, Panics, and Crashes (2000 ed.), a classic that ought to be re-read every five years or so. The conventional wisdom generally holds that stocks are a store of value, to be held for the long-run. Yet, an analysis of the financial record in Kindleberger (Appendix B) reveals that in the 380 years between 1618-1998 there have been 38 major financial crises, or an average of one every ten years. This means that stocks are really not for the long-run, but that investors have to always think in terms of valuations and risk control, giving leeway to specific facts and circumstances. We think an emphasis of valuation is important (particularly in a low-growth environment) because when valuations hit their peaks, the economy is likely going through some kind to unsustainable excess that markets will eventually correct, often violently.
The U.S. Financial Crisis of 2008 has morphed into the Eurocrisis of 2011. Like all financial crises, this one has proceeded from the stage of “…financial distress…where…a firm…must contemplate the possibility, perhaps only a remote one, that it will not be able to meet its liabilities.” to “…a race out of real or long-term financial assets and into money…”
Kindleberger goes on to write, ”Revulsion against commodities or securities leads banks to cease lending on the collateral of such assets.…Revulsion and discredit may go so far as to lead to panic (or as the Germans put it, Torschlusspanik, “door-shut-panic”), with people crowding to get through the door before it slams shut. The panic feed on itself, as did the speculation, until one or more three things happen: (1) prices fall so low that people are again tempted to move back into less liquid assets; (2) trade is cut off by setting limits on price declines, shutting down exchanges, or otherwise closing trading; or (3) a lender of last resort succeeds in convincing the market that money will be made available in sufficient volume to meet the demand for cash.”
The political economics of the Eurozone is very
complicated. But the Eurozone simply lacks a lender of last resort, to act
clearly and decisively when required. By the way, we surely hope that Congress’
Joint Select Committee on Deficit Reduction can reach an agreement by 11/11
/11 11/21/11; their proposal has to be sent to the CBO for scoring. We don’t
think the market consequences will be pleasant if they can’t agree. Congress had
better connect the dots between what they do and Europe.
11/12/11 and
following comments in blog form:
11/12/11 - What are the prospects for financial reform in Italy and Greece? Both have appointed technocrats to carry out reforms demanded by the EU. A columnist of the Athenian paper, Kathimerini (The Daily), writes, “Maybe this time will be different...maybe…reliability, correct negotiation with our partners and dignity will for now act as a strong antidote to the madness, hysteria and violence that made us stand out so much more than any other country experiencing a debt crisis.”
But there is another perspective. Consider the immense difficulty of fiscal reform in the U.S.; now consider this 11/10/11 NYT article. “The question now, in both Italy and Greece, is whether the technocrats can succeed where elected leaders failed – whether pressure from the European Union backed by the whip of the financial markets will be enough to dislodge the entrenched culture of political patronage that experts largely blame for the slow growth and financial crises that plague both countries.” What might happen in both countries is, the more things change….
By rallying, the markets are assuming that events are moving in the right direction. Investors’ faith might be better placed in the ECB and IMF, the former for guarantees and the latter with experience in country reform that could lead to greater fiscal discipline.
11/14/11 – Faced with the possibility of sequestration, word is leaking out that the Congress’ Supercommittee might agree on budget revenues, a single line item, punting the tough decisions to the congressional tax-writing committees during an election year. There is the possibility of extreme ideological rancor next year, while concrete tax proposals disappear until after the elections in 2012.
This suggests a problem for investors. Developing societies may have fragile property rights, the rule of law is inconstant, and the accounting entity can at best be unrepresentative of the entire company; but they have what many investors want, growth. The developed world is facing low growth and increased political uncertainties. The markets will eventually adjust to these as event catalysts unfold.
What the U.S. stock market will adjust to is the new normal era of low growth. Our next book review will discuss the authors’ remedy for this condition.
11/21/11 –
After more than two months of wrangling, the Supercommittee announced they did not reach agreement, triggering an automatic sequestration, a ten-year $1.2 trillion cut in expenses starting in 2013. A lot has been written on how to establish democracies. Not much has been written on how they fail. Democracies fail when a significant and recalcitrant minority simply refuses to compromise, for instance on taxes, throwing sand into the gears of government. That is why, whether in Washington, Brussels, or Iraq, it is so important to have a consensus on the nature of the state to make governance possible. If there is no governance, there is no center that will hold – a fact that markets around the world are beginning to be aware of.
U.S. investors now face two systems crises: one in Europe and the other in Washington. We see no reason to change our fixed income investment strategy. Pimco’s Mohamed El-Erian said that investing in stocks is like buying a good house in a declining neighborhood. Before doing so, make sure that the neighborhood has stabilized and make sure of your ability to hold on.
12/1/11 –
Government action, or the lack thereof, has a strong influence on the
financial markets.
add: The S&P 500 opened at a level of 1247.
The following article discusses appropriate monetary policy during a time of financial crisis. It will explain the reasons for what the U.S. has done and the main thing to look for in Europe, before it’s safer for stock investors to go back into the water.
Both Paul Samuelson and James Tobin called Irving Fisher, “the greatest economist the United States has ever produced.” His reputation as a celebrity economist was permanently harmed when just prior to the Wall Street Crash of 1929, he said the stock market had reached, “a permanently high plateau.” His contributions, however, included monetarism, utility theory, and general equilibrium. Monetary economics is very simple:
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GDP = v x M where: v = velocity, or the number of times that money turns over M = the money supply |
This equation is always right if you allow (v) to vary all over the place, as it does. If you assume (v) to be a constant, as the formula actually requires, it will be very inaccurate.
This equation is, however, useful in extremis, when the arguments are qualitative. First, imagine that (M) is zero. There would clearly be no economic activity beyond barter, and measurable GDP would be zero. Now imagine both (v) and (M) to be very large numbers, as in Germany during the frantic 1920s. The economy would immediately be driven beyond capacity, with too much money chasing too few goods; extreme inflation will result. Now imagine (v) is a very small number; the money created is bottled up in the banking system. This is the current U.S. situation.
Possibly after thinking over his stock market observation, Irving Fisher published, “The Debt-Deflation Theory of Great Depressions” in 1933. This paper stated 49 tentative conclusions, of which we include fifteen. These conclusions start with general economic assumptions and end with recommended economic policies. The Fed and Ben Bernanke, who studied the Great Depression, are certainly aware of this paper. If you’re just interested in the conclusions, skip this section:
1) We may tentatively assume that, ordinarily and without wide limits, all, or almost all, economic variables tend, in a general way towards a stable equilibrium. (This is Econ I.)
2) There may be equilibrium which, though stable, is so delicately poised that, after departure from it beyond certain limits…is like a ship which, after being tipped beyond a certain angle, has no longer this tendency to equilibrium, but, instead, a tendency to depart further from it.
3) Any variable is almost always above or below the ideal equilibrium. (Like stock market prices)
4) It is absurd to assume that, for any long period of time, the variables in the economic organization…will “stay put” in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave. (Now, he’s getting real-world.)
5) While any deviation from equilibrium of any economic variable theoretically may, and doubtless in practice does, set up some sort of oscillations, the important question is: Which of them have been sufficiently great disturbers to afford any substantial explanation of the great booms and depressions of history?
6) In particular, as explanations of the so-called business cycle, or cycles, when these are really serious, I doubt the adequacy of over-production, under-consumption, over-capacity, price-dislocation, maladjustment…over-confidence, over-investment, over-saving, over-spending and the discrepancy between saving and investment.
7) …in the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after…In short, the big bad actors are debt disturbances and price-level disturbances. (This is what Reinhart and Rogoff write about.)
8) Disturbances in these two factors-debt and the purchasing power of the monetary unit-will set up serious disturbances in all, or nearly all, other economic variables. On the other hand, if debt and deflation are absent, other disturbances are powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929-33.
9) No exhaustive list can be given of the secondary variables affected by the two primary ones, debt and deflation; but they include especially seven, making in all at least nine variables as follows: debts, circulating media (M), their velocity of circulation, price levels, net worths, profits, trade, business confidence, interest rates.
10) …we deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling, and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation…precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor…lead(ing)…to pessimism and a loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause (9) Complicated disturbances in the rate of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest. (In social matters, long chains of reasoning often violate common sense; but this one seems to be sound.)
11)
When over-indebtedness stands alone, that is, does not lead to a fall of prices, in other
words, when its tendency to do so is counteracted by inflationary forces
(whether by accident or design), the resulting “cycle” will be milder and far
more regular.
12) Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. *
13) …it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged. **
14) Had no “artificial respiration” been applied, we would soon have seen general bankruptcies in the mortgage guarantee companies, savings banks, life insurance, railways, municipalities, and states.
15) If even then our rulers should still have insisted on “leaving recovery to nature” and should still have refused to inflate in any way, should vainly have tried to balance the budget and discharge more government employees, to raise taxes, to float or try to float, more loans ***, they would soon have ceased to be our rulers. For we would have insolvency of our national government itself, and probably some form of political revolution without waiting for the next election. (The Republican argument that the U.S. has to stop increasing or pay off its debt is valid only under two conditions: 1) The U.S. never grows again. 2) Can’t issue debt at acceptable interest rates. Neither condition currently pertains. To the contrary, current world market conditions favor the U.S. If you think we’re in trouble…)
Monetarism is generally taken to be a doctrine requiring minimal government involvement in the economy. Milton Friedman would have had the Fed simply increase the money supply at a constant rate, and then let the private sector grow. This article by Fisher shows that in extremis, even monetarists should turn to the government to prevent a spiral of rapid deflation. There is a role for government in both the Keynesian and Monetarist schools of economics, during severe economic crises in the latter. This explains why, since 2008, the Fed has done everything in its power to avoid deflation and embarked upon two rounds of quantitative easing. In simple terms, it has countered reductions in (v) with large increases in (M) to stabilize GDP.
By an expansive monetary policy, the U.S. has avoided a downward economic spiral; but needs real structural and fiscal reform to get its economy growing again. Europe might be entering such an economic spiral. European central bank policy is single-mindedly aimed at fighting inflation. A blanket ECB guarantee of Eurozone debt and fiscal unification will require a political will that may be absent because Germany had a calamitous experience with inflation in the 1920s, (not stated) encountered many difficulties when unifying the economies of West and East Germany and does not have a strong shared identity with other members of the Eurozone. The present situation of the euro, with no effective central bank, could lead to the consequences Dr. Fisher writes about. A limited ECB guarantee of eurodebt combined with a program of rigorous country restructuring will enable the euro to stay intact. We would wait for a sign of that kind of policy.
“Time is of the essence.”
* Dr. Fisher’s boat analogy is very apt; consider the detailed dynamics. An 11/7/11 BBC News article is titled, “Is the euro about to capsize? In seafaring, there is a concept called the ‘free-surface effect’. It happens when a surprisingly small amount of fluid can move freely inside a boat. It is an accident waiting to happen. As the boat tilts in the waves, the water starts to flood across the floor, pushing up against the boat’s lower side. Instead of righting itself again, the boat begins to list more and more as the water moves inside it, until the boat capsizes. Something is happening to the euro….” Because there is uncertainty as to whether the euro will survive, the bond markets will continue to raise the financing costs of the Eurozone countries until the boat capsizes.
** Relevant here are the channels by which monetary ease reaches the economy. Normally, fiscal deficits will reflate the economy, sometimes even to excess. In this case, the U.S. Congress will not let fiscal policy be effective; so all the burden is on the Fed to increase (M) through a banking system that, in total, barely increases lending.
*** In the more self-contained U.S. economy of the 1930s, increasing debt or taxes drained purchasing power.
11/27/11 -
The Eurozone ministers are now talking about adopting strict budgetary rules for each country, a medium-term solution that also describes what the U.S. should be doing. However markets, once affrighted, have their own logic. The lemmings are poised to run off the apocryphal cliff (They migrate in droves; they don’t really run off cliffs.). Their minds concentrated, the short-term markets don’t care about the medium-term. They are now looking for an up-front Eurozone guarantee. In the meantime, European banks are starting to shrink their balance sheets, which will reduce economic activity around the world. They will return more money to their bond investors than they will raise by new bond sales, a funding gap of $241 billion in 2011.
Kindleberger (2000 ed.) describes the relevant psychology. At issue is the investors’ confidence that they will be repaid. In the 19th century, an era of unregulated markets, large panics were common. In 1857, a financial panic swept from New York to Liverpool and then to the Continent. The Hamburg Senate (Germany had yet to be unified.) voted to borrow 10 million marks worth of silver bullion.
Appeals for this loan were made to the financial world. A Berlin firm wrote back, “Bruck and Kaiser are not financially ambitious.” By December, almost every financial and trading house in Hamburg was threatened with bankruptcy because ship captains were unwilling to unload their cargoes for fear that the transport would not be paid. Then, “…word came from Vienna that it would take the whole loan. A train bearing the silver (the Silberzug) arrived shortly. From an early account that I can no longer pinpoint, I gained the impression that the train had only to make a triumphal tour of the city to quiet the panic. The details are more pedestrian. The silver was removed from the train and loans in silver were made (to the banks)…The panic ceased on December 12, when it was known there was enough for all. Some firms…turned out not to need any when confidence was restored.” *
* Kindleberger, p. 183.
11/30/11 -
Angelica Schwall-Düren is a member of the opposition Social Democratic Party in Germany and heads a committee in the Bundestag that deals with European affairs. She writes in the 11/27/11 NYT about the political forces within Germany that affect Angela Merkel’s economic decisions:
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Angela Merkel risks a revolt within her own party should she agree to any measures that might impose costs on German taxpayers or diverge from German economic dogmatism, especially the mantra of central bank independence. From the beginning of this crisis, the involvement of the European Central Bank has been a sore point for Germany. It has become a question of principle rather than a question of economic reasoning (our note, the core issue is of course economic nationalism). To outsiders this may astonishing…To cling to economic principles that predate monetary union and the evident market failures of the past years seems naďve at best, when considering the possible fallout of a French downgrade. But to discuss alternatives to Germany’s central banking dogmatism is taboo for Germany’s right, regardless of advice from Nobel laureates and German economists. |
This passage illustrates that economic policy can be counterintuitive. During a crisis, it is necessary for the government to spend money to get economic activity going again. The major problem with the Eurozone is that the founders established a monetary union before a political union. They hoped a shared identity, enabling further political integration, would develop in time. That is happening, but not fast enough.
11/30/11 –
To avert the possibility of a world-wide financial collapse, the major central banks today announced coordinated action to provide liquidity support to the international financial system (the modern equivalent of the Silberzug). The Fed lowered the price of existing U.S. dollar liquidity swap arrangements, making dollars more easily available to the foreign central banks. This measure will reduce, but probably not eliminate, the contagion effect of the European financial crisis. However it won’t restore economic growth, in the U.S. or abroad, because the money will likely remain bottled up in the financial system. We have reduced our portfolio hedges so we are now at about 30% of our equity target.
Taking a cue from
2008, the financial authorities are not going to let the worst happen. The
financial system has at least some stability with this backstop. Financial
repression (i.e. low interest rates) will likely distort the overall
financial markets for a long time. We will invest in additional individual
dividend-paying value stocks when the market makes these available. The S&P
500 increased to 1247 on 11/30/11.
12/1/11 -
The logical sequence of solutions is top-down, as the Eurozone looks at it. First, get the financial control structure right and then, as a reward, the ECB will buy bonds, or more efficiently, issue some form of a limited guarantee. Concerning jittery markets, the practical sequence of solutions is bottom-up. First, get some limited form of guarantee in place, while the house is on fire, and talk about the financial control structure later. The Eurozone was moving too slowly with their processes. The central banks therefore stepped in to buy time and to limit the possible damage to the global financial system. Better the ECB had acted first; but again - as we know - economics can be very political.
12/5/11 -
No investment is without risk. The Eurocrisis had likely made investments in the stock market riskier than ever. But there is good news coming out of Germany. Chancellor Angela Merkel won't stand in the way of loans granted by the Bundesbank to the IMF. This means the way is becoming clearer for money to channeled, in a roundabout fashion, from the Bundesbank, to some kind of IMF trust and then to the individual countries. The IMF will also be able to help implement the budget controls necessary to make the Eurozone viable.
12/9/11 -
Twenty-six ministers of the European Union * concluded an agreement to solve a major architectural problem, establishing provisions for binding control over national debt levels - to be implemented over a twenty year period. DeGaulle once asked how you govern a nation with 246 kinds of cheeses. This may be a positive change for Europe; this is also the kind of reform that the U.S. will require in the long-run. In both cases, timing the addition of more sobriety will be very important.
The markets, however, ask, "What have you done for me lately?" By this measure, the new agreement offers only some improvement over the present situation where there is (only) 250 billion Euro available in the European Financial Stability Facility to solve a 2 trilllion Euro problem. The seventeen nations of the Eurozone have pledged to keep in place this fund, agreed to move up the establishment of an Euro bailout fund by one year - maintaining a combined effective lending capacity of 500 billion Euros - and will likely make an additional 200 billion Euro available to the IMF. In addition, the European Central Bank willl likely make more credit available.
Although an economic downturn in europe is pending, it is
less probable that the world-wide investment environment will be struck by the
whirlpool of economic catastrophe. At worst, Europe may muddle through.
We have increased our equity allocation to around 60
percent of target, and will maintain that level for a while.
* Britain was the only member of the European Union that did not sign this agreement. Democracies differ. British and American law is precedent-based. In contrast, continental law is rule-based. The following excerpt translates, literally, the letter from Sarkozy and Merkel to Herman Van Rompuy, President of the European Council. It should give the reader a sense of what we are talking about:
1) The present crisis has demonstrated clearly the gaps in the architecture of the Eurozone. We have to remedy these gaps...for the stability and durable growth which permit us to preserve our european model...we have to consolidate in a significant manner the foundations of the Eurozone.
2) We need more binding and ambitious rules and commitments for the Eurozone members. Because to have a single currency implies sharing responsibilities to the Eurozone as a whole....We propose these new rules and commitments to be included in the European treaty.
3) This framework should comprise in particular:
a) The adoption by each member state of the eurozone of...a balanced budget. The European Court of Justice, at the request of the European Commission or of a member state (our note) should have the possibility of verifying its transposition in national legislation.
b) To complement the preventive section of this Pact and in particular to attain the objective of a structural budget equilibrium, a new procedure ought to be established to correct all violations of the ceiling deficit of 3% of GDP....Exceptional circumstances ought to be taken into account:
c) We need a comprehensive framework on prevention....(There will be) a series of interventions, of increasing intensity in the rights of Member States...as a focused response to continued infringement. The proposed stages and sanctions proposed or recommended by the Commission, should be adopted by the Council, unless a qualified majority of the Euro area member states decides otherwise....
The 3% deficit provision reiterates, with consequences, the same provision contained in the founding Maastricht Treaty, drafted exactly twenty years ago. We think that Europe will be serious about reform, having experienced the consequences of inattention.
12/12/11 -
Could the southern economies of the Eurozone start growing again by resorting to their own currencies and then devaluing them? Could, to mention a country, Tajikistan industralize simply by manipulating its currency? We think not. Social organization in the real world matters. The NYT of the above date quotes a HBR contributing editor. "A globalized, networked economy requires a stable currency...Inside the euro or not...the real competitors for countries like Greece and Portugal are Poland, Hungary, and Romania, and to thrive they need to remain part of the European space and invest in education and high technology to attract more capital from abroad....The path to development is not devalued money in the hinterland, but intellectual capital from the metropole."
Many of the structural problems facing the southern countries of the Eurozone are the same as those facing the United States.The difference is that the U.S. still has more time to act.
12/13/11 -
We will reduce our equity investments from 60% of target to 40% of target. The 12/13/11 FT reports that the ECB has signalled that Eurozone country central bank contributions must go only to the IMF's "General Resources Account," rather than to a "Trust." This means that the Eurozone will not be able to dedicate more funds to backstop its economy, and that the U.S., as a general shareholder in the IMF and other nations would also have to be involved. Like a mortgage backed security, the Eurozone deal is getting evermore complex and even less credible.
This is not an argument for a stock-free portfolio. Some multinationals have high net free cash flows and dividends that exceed 3%.
