June 2010
June 25, 2010 11:00 a.m.
Always Interesting Investments
There always are interesting investments, said Rob Arnott, manager of the PIMCO All Asset fund, a component of our hedge fund mutual fund portfolio. Arnott forecasts that inflation hedges will be a very interesting investment over the next year or two as a deflationary trend takes hold and people flee inflation hedges.
Arnott spoke this week at the Morningstar Investment Conference, an annual event in Chicago. A number of my favorite investment managers speak at the conference, including this year Jeffrey Gundlach of DoubleLine Total Return, Steve Romick, of FPA Crescent, as well as Arnott and others. The conference is directed at investment professionals, but you can benefit from it. Articles on the major presentations are available here.
The economic news the last few weeks surprised many investors and analysts by being worse than expected. We haven’t been very surprised by this trend. The boom since March 2009 was artificially induced, and that stimulation is being withdrawn or leveling out. The deleveraging of the economy continues, and increasing levels of federal stimulus will be needed to sustain economic growth. For example, mortgage rates are at historic low levels, but housing sales continue to decline. Financial services company analyst Meredith Whitney gives a good summary of the current and near-term outlook.
Congress is about to approve the new financial reform law. It will take a while to digest it, but a few things seem clear. It wouldn’t have prevented the last financial crisis and won’t do anything to prevent another crisis. It will increase your costs and reduce your choices. But don’t take my word for it. Listen to a guy who’s been through a few financial crises.
June 21, 2010 02:30 p.m.
A Road Map for the Crisis
A great many books already have been published about the financial crisis. Few are worth reading in detail. One that is worth reading is The Holy Grail of Macro Economics by Richard C. Koo. For some time I’ve been warning investors that this economic and business cycle is different from what they’ve been used to since 1982. We are in a period when individuals and businesses try to clean up their balance sheets by reducing debt. Instead of borrowing and buying, people are saving and repaying. It is a long-term deleveraging cycle, which follows a long-term credit boom.
Most economists and analysts aren’t familiar with this type of cycle or even acknowledge its existence. Koo already lived through one like it, because he is Chief Economist of Nomura Research Institute, a division of Nomura Securities of Japan.
While I’ve been referring to the crisis as a deleveraging cycle following a credit boom and PIMCO calls it the “new normal”, Koo calls it a balance sheet recession. We’re all talking about the same thing, and Koo believes the situation in the U.S. and most of the developed world mirrors what Japan went through starting in the late 1980s. He hopes that if policymakers acknowledge this, they won’t make some of the policy mistakes that were made in Japan.
A major difference is that in Japan businesses took in too much debt and were overleveraged. In the U.S. individuals and households were the primary borrowers. Businesses, at least large businesses, have very solid balance sheets. This makes the cycle a little different, but doesn’t change most of the key factors.
Koo believes that government needs to keep the economy growing while consumers rebuild their balance sheets. While households cut back, government needs to step in and borrow. The U.S. government has been doing that so far, but concerns about deficits could bring that to a halt. Koo’s recommendation is that the government borrow and spend, but only until private sector balance sheets are restored. Then, the government needs to gradually rebuild its balance sheet.
Koo is free with criticisms of U.S. policymakers by name, as well as their Japanese counterparts over the years. He believes if his prescriptions are followed the U.S. economy will slug along for about five years. He also explains why Germany is responsible for the current problems in Greece and the other PIIGS countries. A new bubble is growing in China, he believes, and could pop in the not-too-distant future. The advantage for China is the government doesn’t have to build a consensus before acting. China, Japan, and other Asian nations need to shift from export-oriented economic policies to boost domestic demand and growth. The book is worth your time.
June 15, 2010 10:45 a.m.
Some Fresh Warning Signs
You know one of my concerns for a while is that much of the economic and market growth of the last year appears to be artificially stimulated. With the developed countries continuing to delever their balance sheets and flirting with deflation, the economy doesn’t look to be able to sustain the growth without the stimulus.
One warning sign is from the Economic Cycles Research Institute. The ECRI groups some data into a weekly leading indicators index. Their index has a pretty good record and was particularly good in early 2009 to forecast the surge in the economy well ahead of most forecasters. Most recently the ECRI leading indicators began flashing a warning sign. The group isn’t forecasting a double-dip recession yet, but it says investors need to be cautious at this point.
The correction that began April 26 also packed a warning sign. A correction often is not a sign of a problem for either the stock markets or the economy. But when a correction dips too far below the standard 10% benchmark loss, it can be a sign of strong downward moment. Bespoke Investment Group says that in the 32 times since 1927 that a correction dropped 14.4% or more from the market’s peak, the decline usually gets worse. Only seven of those 32 declines stopped before falling at least 20%, and the other average decline the 25 times the market kept falling was 35.5%. The work by Bespoke and others indicates about 80% probability stocks will decline more than they already have.
Another sign that few of the problems that caused the financial crisis have been fixed is the latest news about Fannie Mae and Freddie Mac. These quasi-government entities continue to generate losses even as they take over the U.S. home mortgage market. Their bailout from taxpayers could grow to $1 trillion. As Bloomberg says:
“Fannie and Freddie, now 80 percent owned by U.S. taxpayers, already have drawn $145 billion from an unlimited line of government credit granted to ensure that home buyers can get loans while the private housing-finance industry is moribund. That surpasses the amount spent on rescues of American International Group Inc., General Motors Co. or Citigroup Inc., which have begun repaying their debts.”
Looking over all this information and more, David Rosenberg, formerly of Merrill Lynch and now with Gluskin Sheff of Canada, concludes we are nearing the end of a rally in a long-term bear market. Rosenberg thinks we are about 60% of the way through the secular bear market in stocks and gold is in a secular bull market that will end around $3,000.
In the last 15 months we’ve been among the few who believed in exercising caution during the rally that began March 2009, that it was a rally in a long-term bear market. While the risk of an economic collapse that was real in late 2008 and early 2009 now is low, there still are significant risks to your wealth. That’s why we’ve emphasized safety, income, and preservation of principal and will continue to do so for a while yet.
June 3, 2010 03:15 p.m.
Dealing with a Period of Rapid Changes
Many factors changed very quickly in the economy and markets. Not long ago people were convinced inflation would rise rapidly, the dollar would collapse, and the economy would grow. Since the Greece debt crisis became news, all that changed. The dollar is rising against the euro and British pound. This effectively is causing deflation in the U.S. We see that in falling treasury bond rates as well as the Consumer Price Index and wage reports. This is partly good news. Deflation means low interest rates for the government and probably a reduction in the debt-to-GDP ratio. On the other hand, deflation hurts households by increasing their real debt burden.
The real issue is whether the Greece debt crisis will spread to other countries and regions, including the U.S. Gold’s price rise shows many investors consider that possible, perhaps likely. Gold is the alternate currency for those concerned about the stability of paper currencies. One big worry is the number of European banks holding Greece debt. A default on that debt would lead to a widespread liquidity crisis similar to that experienced in the U.S. after the large number of subprime mortgage defaults and the Lehman Brothers bankruptcy. The Greece debt crisis does not have to spread the way the U.S. crisis did in 2008, but it could. Here’s a good, though high level, discussion and explanation of all the factors by John Makin of the American Enterprise Institute.
That’s why we’ve been conservative in our portfolios despite the market rise of 2009 and became more conservative recently. We’re in a long-term financial deleveraging, and that means a lot of market volatility and long-term trends in the financial markets that are flat to down.
Let’s step away from finances briefly. I know many of you are interested in your health. You seek knowledge about good food, vitamins, and supplements. Some food manufacturers try to combine these factors by claiming they add ingredients that increase the health benefits of their foods. Beware of these claims. Here’s a review of the major food promotions and the science, or lack of it, behind them.
Since you’re reading this journal, you are an Internet user. The World Wide Web changed our lives in many ways. Apparently it also changes our brains. Some of the change is good. But other changes aren’t so good. Regular Internet users are more prone to seek relatively superficial information about a lot of things rather than study anything in depth. Here’s a Wired magazine review of the research. Bottom line: Heavy web use rewires our brains, making us less focused.
