Welsh Letter Investment letter – January 2010


Investment letter – January 21, 2010


The National Association of Business Economics has declared that the 2008-2009 recession should be called the “Great Recession.” This is understandable since it has been deeper and more protracted than any prior recession since the Great Depression. Of course, the 7.2 million workers who have lost their job, or the 17.3% of the workforce who are underemployed, and the millions of homeowners who have or will lose their homes to foreclosure, this recession has been anything but great. Although, the phrase ‘Great Recession’ differentiates this recession from all the other recessions since World War II, it falls short in describing the nature of this recession. The depth and longevity of the recession was the result of a credit crisis, which punctured a credit bubble that had been at least 25 years in the making. A more descriptive phrase would be ‘The Great Exhale.’

The collapse in the availability of credit forced the Federal Reserve to create an alphabet soup of programs with the sole intention of replacing one form of credit or another that had previously been provided by banks, securitization markets, or credit market participants. The Federal Reserve is engaged in an epic struggle to prevent the credit bubble from shrinking further, since that could ignite another round of asset deflation. The majority of economists have already concluded that the Fed has not only succeeded in reversing the contraction in credit, but that the Fed will be too successful, leading to a bout of inflation. Some suggest that the rally in gold is already pricing in this outcome. The consensus view is that the economy will strengthen as job creation begins to boost demand, causing production to increase and inventories to be replenished. The potential for a double dip recession has been dismissed as unlikely. If there is any hand wringing, it’s whether the Fed has the capacity to design an effective ‘exit strategy’, and whether they will have the political independence and foresight to execute their exit strategy, neither too early nor too late. Much of the same crowd, who did not see the credit crisis coming, and totally misjudged its impact, are now expecting a relatively smooth transition from the largest global financial crisis in history to a self sustaining recovery in 2010. I’d feel better if the evidence for this rosy outcome was a bit more supportive.

Table 1. Personal Consumption as a Percentage of GDP, 1951-2008

Period Average Beginning End

1951-1960 62.3 61.5 63

1961-1970 61.8 62.8 62.4

1971-1980 62.5 62.3 63

1981-1990 64.6 62 66.1

1990-2000 67.3 66.4 68.6

2001-2008 69.8 69.5 70.1

Between 1980 and 2008, personal consumption as a percent of GDP grew from 63.0% to 70.1%. (Table 1) This increase occurred because consumption was growing faster than GDP, giving the economy an extra boost.

A number of factors made this possible. In 1980, the savings rate was near 10%. As consumers spent more of their income, the savings rate fell to under 1% by 2007. Although it has rebounded to above 3%, the long term chart suggests it could climb back to the 8% to 9% levels of the 1950’s and 1960’s.

Between 1980 and 2007, the net worth of Americans increased from $10 trillion to $64 trillion. In 1980, interest rates were between 15% and 20%. As the cost of money fell between 1980 and 2007, real estate values and stock prices rose significantly. The combination of lower interest rates and higher asset prices made it possible for consumers to borrow a lot of money. In 1980, home equity was 70% of home prices. By the end of 2006, home equity had fallen below 50%. The net result is that household debt soared from 46.5% of GDP in 1982 to 98% in 2007.

Just as gasoline powers a car, job and income growth fuels economic growth. Although job growth in the 1980’s and 1990’s was a bit less than in prior decades, it was still healthy. However, job growth in the 2000’s was far weaker, even before the Great Exhale wiped out 7.2 million jobs. The decade that ended in 2009, is the first decade since the 1930’s without job growth.

These long term factors, all goosed GDP growth between 1982 and 2007, beyond what it otherwise would have been. As we begin a new decade in 2010, each of these factors is likely to be more of a drag on growth than a booster. Between 1950 and 1980, personal consumption as a percent of GDP was remarkably stable, holding near 63%. It is likely that consumption will gradually slip back toward 63% to 65% of GDP during this decade, as consumers increase their savings and reduce debt. Household debt as a percent of GDP will also drop from 97% toward 85% to 90%. This downshift will take a number of years to unfold. The decline in household debt will be both voluntary, as some consumers choose to take on less debt, and involuntary, as banks maintain higher lending standards for years. Since interest rates are already at generational lows, consumers will be forced to pay off their debts from income, which is going to take some time. Hopefully, job growth will be better than during the last decade, which would be helpful. From the high in 2007, net worth plunged from $65 trillion to $48 trillion in early 2009. It has since rebounded by $5 trillion. While that is good news, the stark reality is that the mountain of consumer debt is being supported by a net worth foundation that is 20% smaller.

As discussed in my November letter, the ratio of total debt to GDP has soared since 1980. The increase looks very much like other parabolic curves that have appeared in various market averages over the last 300 years, i.e., the Nasdaq Composite in 2000, and the Nikkei in Japan in 1989. The key point is that after a parabolic increase stalls, the price has collapsed, whether it was oil, stocks, silver, soybeans, real estate, or even the South Sea Company in 1720. The Federal Reserve is doing everything it can to prevent a collapse in debt, after its parabolic rise. However, consumer spending will be weaker in coming years, which means economic growth will be slower than in previous decades. That will likely retard job and income growth, which won’t make it any easier for consumers to pay down debt and increase savings. The majority of economists expect a self sustaining recovery to develop in 2010. I think that’s a bit optimistic.

At a minimum, there will be a dip, raising concerns about the potential of a double dip. That should be enough to cause the stock market some consternation. As discussed in the December letter, if there is to be a second phase to the financial crisis, it is likely to be triggered by European banks or a hiccup in China, after their lending binge in 2009.


Hardly a day goes by without some market analyst proclaiming that markets are a discounting mechanism, and that much can be learned by listening to the ‘message of the markets’. This belief is so accepted on Wall Street that I heard Rosetta Stone will soon be offering a course for those wanting to learn the “Language of the Markets”. Before you place your order for “Language of the Markets”, please consider that markets are wrong at every top and bottom. And it holds, whether the market in question is stocks, housing, oil, gold, or Cabbage Patch dolls. I know that this statement amounts to heresy.

However, history is full of examples, and if one reviews them, the veil is easily lifted. For instance, what did the 1987 stock market crash signify, since the economy continued to grow for another three years? When gold zoomed over $800 in 1980, was it forecasting that inflation would decline for the next 20 years? When the stock market made a new all-time high in October 2007, was it telling investors that the credit crisis was over? If it is so obvious that markets are often spectacularly wrong in telegraphing the future, why do so many experienced market strategists continue to believe that markets are harbingers of the future? The answer is actually fairly straight forward. Most of the time the perceptions held by the majority of market participants are properly aligned with economic reality. It is only at turning points, when a Gap develops between perceptions and reality, that the market fools the majority. For instance, between 2003 and 2007, market participants expected the economy and earnings to continue to grow, and they were neither disappointed nor surprised. The net result is that the stock market continued to forge ahead. As the credit crisis unfolded during 2008, institutional money managers were repeatedly given economic reasons to sell. Perceptions of the economy’s unraveling were supported by economic reality, as each month brought forth a litany of depressing statistics. The downtrend in the stock market continued, even as it became increasingly oversold and bearish market sentiment soared, because economic reality matched perceptions. As long as perceptions and economic reality are aligned, the existing trend in the stock market will remain intact, no matter how excessively bullish or bearish market participants get. If the perception is that the economy is going to improve or worsen, and it does, hasn’t the market discounted and anticipated the actuality? It certainly appears so, and that is why market participants believe that markets are prescient. Since markets spend far more time trending up or down, the link between perception and reality is reinforced most of the time. This leads market participants to assume perception always leads reality. This is why this premise is rarely questioned, even though markets are wrong at every top and bottom.

The contradiction between markets being wrong at every major turning point, and the belief that markets tell us what is going to happen next is explained by the Gap. Perceptions of the future are largely shaped by what is experienced in the present. Time is experienced in a linear sequence, which influences our expectations of what is likely to follow. If the economy is improving or in good shape today, our perception of the future is likely to be positive. As the market approaches an important top, a Gap develops between our perception of the present and expectations for the future, and economic reality. In 2007, the consensus expectation was that the Federal Reserve had addressed the credit crisis after cutting rates in September 2007. Although the economy might slow down in 2008, a recession was not forecast. Market strategists also expected the global economy to ‘decouple’ from the U.S., so they recommended increasing international exposure.

There were two problems with this analysis. As I discussed in my November and December 2007 letters, the Federal Reserve was not going to be able to handle the credit crisis, as they had handled previous crisis’, since the credit creation process was broken. Banks were bogged down with $350 to $400 billion of private equity loans they couldn’t move off their balance sheets. The securitization markets provided more credit than banks (40% to 35%), and those markets were beyond the Fed’s reach. As I said then, “It really is different this time.”

Secondly, the notion that the rest of the world was going to decouple was built on sand. In October 2007, the European Central Bank released its third quarter survey of European bank lending standards, and it showed that a record 31% of banks had tighter standards. This meant that Europe was going to slow by the spring of 2008. In addition, the central banks in China and India had both raised rates and reserve requirements during 2007, which meant China and India’s were going to weaken more than expected.

As the U.S. market was making its all-time high in October 2007, technical indicators like the advance/decline line were lower than they had been in July 2007, as were other measures of market momentum. This divergence was a sign of internal market weakness, and suggested that the market would be vulnerable, if selling pressure increased. The odds that selling pressure was going to increase were high, given the Gap between what most market participants expected, and how the economy was going to perform. The stock market experiences its largest moves when participants are surprised, and that always happens after a Gap. In 2008, the Gap was maintained, even after Bear Stearns had failed and the market established a trading low in March. By May, the consensus was that the economy would recover in the second half of 2008. Most analysts didn’t notice that in April, the Fed had taken the unprecedented step of moving $400 billion of Treasury paper off its balance sheet, in exchange for bank holdings of mortgage, auto, and credit card backed securities. This suggested to me that the credit crisis was far more serious than most economists realized, and cast doubt on whether a second half recovery was possible. The rest, as they say, is history.

By early 2009, the perception was that the economy was mired in a very deep recession. As the stock market was plunging to new lows, bearish sentiment was overwhelming, and it certainly felt ugly. However, another Gap between perception and reality was developing. As discussed in the February 2009 letter, economic statistics were about to turn less bad, which would come as a surprise, since most were still expecting further deterioration. Technically, numerous momentum measures were far less oversold in early March, when compared to October and November. This momentum divergence suggested that selling pressure was abating, setting the stage for an upward reversal. Technical analysis helped pinpoint the top in October 2007, and it also assisted in identifying the low in March 2009. After the stock market reversed, economic statistics gradually became less bad. As I have discussed since March, the rebound in GDP would make it look like a V-shaped recovery was beginning. I expected GDP would turn positive in the fourth quarter, if not the third quarter. The rebound in housing, industrial production, and the significant drop in the number of workers losing jobs, has reinforced investor’s perception that a recovery is on its way. Reality has aligned with perception. On the surface, it appears to most market observers that the market has again done a wonderful of discounting the recovery. This is why large institutional money managers have done very little selling. As I have discussed in prior letters, this lack of selling pressure has been a major force behind the market’s rally since July. It doesn’t take much buying to push the market higher, if there is no selling pressure.

This is likely to continue given that year over year comparisons will be using the first quarter of 2009, as the base (the weakest quarter, GDP-6.2%). Even a weakling looks good, compared to someone who’s just passed out cold, and is prone on the floor. If the recovery appears on track, as I suspect it will through the first quarter, large institutional money managers will have no reason to sell, and they won’t. The key to 2010 is whether another Gap develops, between perception and economic reality. In the September 2009 letter, I discussed that the transition to a self sustaining recovery was facing a number of secular and cyclical headwinds that would weigh on growth. I won’t review them again, since that letter went into a fair amount of detail on each secular and cyclical headwind. As discussed previously in this letter, the U.S. consumer is one of these headwinds. At a minimum, I expect a dip to develop, after the first quarter. I think it will be deep enough to raise concerns in the media that a double dip recession could occur. Since the consensus is that the economy will continue to improve as the second half of 2010 unfolds, any deviation from this script will create a Gap, and provide large institutional money managers with a reason to sell.

Since we won’t know for a number of months whether a self sustaining recovery is at hand, or not, combining technical analysis with fundamental analysis could prove valuable, as it did in October 2007 and March 2009. On January 11, 523 stocks made a new high, 810 stocks made a new high last week, the advance/decline line made a new recovery high, and various momentum measures exceeded their October peaks. The divergences that were in place at the October 2007 top and March 2009 low are not present. As long as measures of market momentum remain strong, corrections will likely be confined to a range of 4% to 7%. A close below 1,080 on the S&P would be negative. If a Gap is going to develop as I expect, I think technical analysis will provide us an advanced warning.


Last month, I wrote, “The technical pattern in the price of the S&P now suggests that the S&P will rally to 1,135 to 1,165. Since institutional money managers believe the economy is on its way to a sustainable recovery, the stock market is unlikely to experience a meaningful decline, until the confidence institutional money managers have in the sustainable recovery story is challenged. If they are right about the recovery, the market will follow the pattern of 2004, and only experience modest declines of 4% to 7%, and trend modestly higher by the end of 2010. This is the consensus view. I do not believe the economy will make a smooth transition to a self sustainable recovery. The road is likely to get a bit bumpy after the Fed removes its various support measures by the end of the first quarter.” The high so far has been 1,150. The S&P has peeled off a quick 35 points over the last two days, as China announced plans to scale back lending in 2010 after a binge in 2009, and President Obama presented plans to revamp large banks. When the dust settles, I suspect most large institutions will not believe either event will meaningfully disrupt the recovery they expect. As long as the S&P holds above 1,080, the market is likely to make another run at 1,150. The S&P rallied 85 points from November 2 to November 16. As discussed in the Special Updates in December, the low on December 18 finished a triangle pattern. If 85 points is added to the December 18 low of 1,094, a target of 1,179 becomes possible. The initial rally took the S&P from 1,094 to 1,150, or 56 points. If the S&P bottoms around 1,105-1,115, a rally of 56 points would target 1,161-1,171. If the S&P does rally above 1,150, any technical divergences will flash a caution sign.


There is a growing monetary and economic schism within the European Union, between economies which are very weak, Portugal, Italy, Ireland, Greece, Spain, and Germany and France, which are doing better. This tension is going to lead to more weakness in the Euro in coming months, which will benefit the dollar. We are long the dollar March futures from 76.75. We are also long the dollar ETF UUP from an average price of $22.40. Raise the stop from 75.50 to 76.26 for all positions.


We are short the gold ETF GLD from average price of $107.94, and long the gold short ETF DZZ from an average price of $14.88. Cover half of the GLD short if it drops below $101.00, and sell half of DZZ at the same time.


Treasury bonds are locked in a directionless trading pattern, which sounds better than saying I don’t have a clue. A close above 3.92% on the 10-year Treasury bond would be a negative short term, while a close above 4.02% would be an intermediate negative, and open the door for a move to 4.5%.

E. James Welsh

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