Pushing on a String…or a Spring?
Second Quarter 2009
It is springtime here in the upper Midwest although on most days it still doesn’t seem like it. Similarly for the economy and the financial markets, “better weather” may not seem remotely possible anytime soon, but it’s on the way.
The 4th quarter of 2008 and the 1st quarter of this year should prove to be the low point in terms of economic disruption and investor risk aversion. Our rationale for better weather continues to rest on the resiliency of our economy as well as the extraordinary countermeasures taken by policymakers around the world to push back against the prevailing economic disruption and financial panic.
We don’t think it necessary to look much beyond the actions of our monetary authority-the Federal Reserve-to gauge the importance of the countermeasures. With their actions, the “Fed” has taken a Great Depression rerun off the table for our economy (see Chart 1).
We know this chart may indeed look familiar for we’ve referred to it for the past several months. Months, we painfully acknowledge, during which both the economy and stock prices have proceeded to go in almost a straight line in one direction-down!
Against this backdrop, it’s easy to wonder whether policymakers are merely “pushing on a string” and their actions are either insufficient or ineffective. You don’t have to look very hard to find elegant and articulate arguments that project skepticism about improvement anytime in an “investable” time horizon.
the current Federal Reserve is making sure the Great Depression doesn’t happen again
In a panic, confusion reigns. This panic has triggered erosion in confidence unlike anything witnessed since the Great Depression. It’s not just a lack of confidence in the policymakers (and their policies) but also erosion in confidence about the economic system itself. Even the Wall Street Journal-historically a champion of capitalism-published a letter on its editorial page recently making the case for socialism as the way out of the pickle we’re in!1
But it’s important to note that extrapolation of gloom (and doom) into the future has likely become the consensus outlook. With expectations for persistent economic winter so rampant, surprises – of the favorable kind for a change – are likely.
Here’s why this is much more than just wishful thinking. Consider that as oil started to flow into the Alaskan Pipeline for the first time after its construction in the 1970s, there was a significant time lag before oil flowed out of the pipeline at its ultimate destinations. Fed actions likewise work with a considerable lag within the context of a very long, winding, and complex “pipeline”.
Observing various points along the financial and economic pipeline provide signs that the Fed’s actions are slowly but surely gaining traction. A later section entitled, The Pipeline is Filling, examines some of the signs for those interested.
If we are correct that “pushing on a string” is an overrated risk, is it possible that policymakers have overdone things and are instead “pushing on a spring“? Are the massive countermeasures pulling us from the ice of deflation and delivering us into the fire of inflation?
The potential for the Fed to “overstay” current policy is a risk, as we detail in a later section, Another Look at the Great Depression. We don’t think rising inflation however, is much of a threat at this point as the de-leveraging forces within the economy remain more powerful than the re-inflation dynamic.2
To see what’s meant by this, let’s return to our weather analogy one last time. Our better weather forecast is for something resembling 50 or 60 degree days. Those types of days feel great after winter. But they won’t be confused with economic good times.
Consumer balance sheet de-leveraging, persisting unemployment challenges, rising bankruptcies, and anti-business/capitalism sentiment will likely constrain the pace of economic growth. But accompanying better weather has the potential to unleash significant investment opportunities within investments that are priced for economic winter, as we explain in still other sections that follow.
The Pipeline is Filling
Fed actions work with a lag and within the context of a very long, winding, and complex “pipeline”.
Near the “source” end of the pipeline is Fed activity. The adjective, “aggressive” understates recent Fed policy. The Fed’s balance sheet has undergone an unprecedented expansion as they’ve engineered a record growth in the money supply.
Their policy is not occurring within a vacuum. Moving a bit further down the pipeline is the Treasury bond market. Fed actions have awoken the “big kahuna” of leading economic indicators-the shape of the so-called “yield curve”-and it is sending a strong signal as Chart 2 indicates.
Chart 2: Yield curve shape sending an economic recovery signal
The “shape” of the yield curve (the relationship between the yields on short- and longer-term Treasury securities) may be the single best leading indicator of future economic momentum. The current super “steep” curve (whereby yields on long Treasury bonds are well above those on short Treasury securities) signals increasing economic momentum is ahead. And, it’s also important to note that a steep yield curve helps bank profitability by augmenting their profit margins.
Still further down the pipeline are other signs of policy getting important traction. It was the freeze in the credit market plumbing (bond and money markets that underlie the economy) in the wake of the collapse of investment bank Lehman Brothers last autumn that unleashed the worst of the financial panic. The Fed’s pump priming has caused credit market stress to abate (Chart 3), which is a necessary condition for better economic weather.
Chart 3: Ice in the credit market “pipes”continues to melt
The Bloomberg Financial Conditions Index pictured below – comprised of various credit market yield “spreads” – indicates whether stress in the credit markets is intensifying (Index is falling) or stress is abating (Index rising).
Closer still to the “real economy” end of the pipeline are indications of a “turn” in new manufacturing orders (Chart 4) and – believe it or not – positive developments in housing (Chart 5).
Chart 4: New Orders are the “lifeblood” of manufacturing
It’s no secret that auto sales have collapsed. After averaging something close to 16 million unit sales of cars and light trucks for years, recent sales have been in the 8 to 9 million range – roughly a 50% decline. However, production of new vehicles has been around 4 to 5 million (annualized) units – or a rate nearly 50% below the terrible sales rate itself – an unsustainably low level. It’s been estimated that each year about 5% of the outstanding vehicle stock are junked. This means that new vehicle production must be around 7 to 8 million (annualized) to simply replace the no longer usable ‘junkers”.
In some housing markets it has become cheaper to buy than rent. In some cases, market prices of homes are below what it would cost to build the home. Recent home sales in some of the hardest hit California markets are staging an upturn as falling prices increase demand (showing “markets” still do work).
The Stock Market: Priced for Economic Winter
Extreme risk aversion has stocks priced for more gloom and doom. Even modestly better economic weather may unleash the significant investment potential that exists.
1.) Value Line’s Appreciation Potential statistic: Readings at the current 5-year +17% annual appreciation potential (over and above inflation) are at or near record levels
2.) A lessening of risk aversion could bring money on the sidelines back into the risk assets
3.) Sub-par 10-year return episodes (like we have now endured) have been followed by extremely rewarding multi-year periods
4.) Note: Are the past 10 years the worst period ever? Are recent conditions really worse than those prevailing during the Great Depression, WWI, WWII, etc.?
For a little more perspective on just how deep gloom has become with respect to stocks as investments, consider the following:*
“The 40 years ending February 2009 were the second worst 40-year period for equities since 1900, with only the 40 years ending December 1941 doing worse!
Let’s put this into some context. The 40 years ending in 1941 included:
- the stock market panic of 1907
- the World War I Era (1910-19 was a rotten period for stocks)
- the Great Depression
- and the icing on the 40-year cake, the Japanese bombed Pearl Harbor on December 7, 1941
How could these last 40 years even begin to match that? Alas, in stock market terms, they did.”
More on the Great Depression
The Great Depression dissected:**
- It was marked by 2 severe economic contractions-the deflationary disaster of 1929-33 and the “double dip” recession of 1937-38.
- Both of these downturns were preceded by declines in the money supply – courtesy of inappropriate Federal Reserve policies.
- However, despite anti-trade tariffs, tax increases, and a collapse of the financial system, the first downturn within the Depression ended in 1933-once the Fed abandoned its deflationary monetary policies and money growth resumed.
- FDR was inaugurated in March 1933.
- The business cycle trough of the 1929-32 contraction occurred before the New Deal was implemented.
- Economic growth (real GDP) grew sharply (9+% per year) over the 1933-37 period.
- The unemployment rate fell from 26% (May 1933) to 11% (July 1937).
- The double-dip downturn in the economy late in the decade was again triggered by a sharp contraction in the money supply. As the economy and the stock market recovered, the Fed feared that they had sown the seeds of inflation by easing policy too aggressively in 1933-37.3
Viewing these events through the lens of stock price “phases” (see following chart) is also informative.
The 1933-36 period (“phase 2″ in chart below) – smack dab in the middle of the Great Depression-and smack dab between two rotten stock market return periods – saw the stock market rocket higher as the economy merely survived.
The doom part of gloom and doom faded when the economy regained a pulse during 1933-36 and stock prices staged a 200% advance!
Experiences From Japan’s “Lost Decade”(1989-2002)
By 1989, Japan was nearing the top of the financial world. They were gobbling up expensive “trophy” properties around the globe and paying mega-record prices for art work. Their economy and stock market had been one-way propositions (up!) for decades, and many feared they would supplant the U.S. economic leadership position.
The bubble then popped and Japan proceeded to undergo a slow motion depression of sorts. The economy struggled through 2002 until they finally mustered an economic recovery.
During their so-called “lost decade”:
- The Japanese “Dow” (Nikkei Index) lost 75% of its value
- Overall corporate earnings in Japan were crushed, also falling about 75% from their late 1980s peak
- Some businesses did, however, figure out a way to grow and produced superior business results
- Stock prices reflected differentiated underlying business results (see following chart)
The important point here is that, over time, investors did start to differentiate among businesses. The stock market proved itself a “market of stocks” comprised of companies with differentiated business characteristics and growth prospects. Business progress and stock price progress became (once again) “joined at the hip”.
As the financial panic kicked into high gear last October in the wake of the credit market freeze, stock price movements within markets around the world became almost perfectly correlated. That is, not only did virtually all stocks move in the same direction (down) but by unusually similar magnitudes.
As the Japanese experience suggests, investors will “correct” indiscriminate selling by differentiating among businesses and their stock prices.
Our investment strategy continues to be to maintain a portfolio of businesses that generate differentiated (superior) results. We have (as always) had individual constituents within the portfolio disappoint our expectations, but have continued to get it “right” in the overall portfolio sense. We expect superior business results to once again matter and help drive investment returns.
Bond Market, the Fed and Risk Aversion(1989-2002)
Our bond investment strategy is one of simultaneous positioning for both “offense” and “defense”. Segments of the bond market today possess unsustainable low yields (and unsustainably high prices) and other segments-abandoned in the “flight to quality” risk aversion during the panic-possess relatively high yields (and low prices).
We’ve been selling securities that are trading at the unsustainable low yields (Treasury bonds) and either moving towards the “next safest” areas of the bond market which possess more attractive risk/return prospects, or building cash to do so at a later date. These areas include: GNMA mortgage bonds, higher quality municipal bonds (where appropriate), some FDIC backed bank bonds, and, to a limited extent, investment grade corporate bonds.
As we have noted on previous occasions, high-quality bonds always lie at the heart of our strategies. The highest-quality sectors have been the only major “asset class” to benefit from the financial panic as investors rushed towards safety. As risk aversion lessens, we expect a reversal within the highest-quality area with yields rising and prices falling.
In addition, it’s important to consider the actions of another buyer within the market. The Fed recently announced stepped-up efforts to acquire bonds in the highest-quality market segments, as they execute monetary policy. Unlike most other investors, the Fed has a different objective in its bond purchase strategies. It does not want to lose money to be sure and it wants to earn a rewarding return, but these objectives are subordinate to their monetary policy aims.
In other words, the Fed will happily buy overpriced bonds if these actions restart the economic engine. As we’ve outlined throughout this report, we believe the Fed is well on its way of laying the groundwork for better economic weather. As a result, we say, if the Fed wants our bonds, let the Fed have them.
Risk/reward profile of the highest-quality segments of the bond market are extremely unfavorable, as the following chart suggests.
1 The Socialist Solution to the Crisis, Wall Street Journal, April 2, 2009
2 In technical terms using the Fischer quantity theory of money equation, where M x V = P x Q, the Fed has
engineered a rise in money (M) to offset the decline in the velocity of money (V) that’s occurred as credit stresses increased in 2008. This should stabilize economic activity (P x Q). However, for inflation (P) to increase, M, V and “real” economic output (Q) must all be experiencing a sustained rise. Not a likely situation over the short term.
* Jim O’Shaughnessy, A Generational Opportunity, Yahoo Finance March 17, 2009
** Sources: Paul Kasriel, The Great Depression – Just the Facts. Ma’am. The Econtrarian, February 9, 2009, A History of Interest Rates, Homer and Sylla, 3rd edition, Ibbotson & Associates, “On Milton Friedman’s 90th Birthday” Ben Bernanke speech, November, 2002
3 As a Great Depression scholar, Fed Chairman Ben Bernanke has made certain today’s Fed does not repeat the deflationary
mistakes of his 1929-33 Fed counterparts. Whether that causes today’s Fed to “overstay” their current easy money posture to avoid a 1937-38 like double dip remains to be seen.