THE ROAD NOT TAKEN
Investment letter – September 16, 2010
In the two years since Lehman Brothers was allowed to fail, there have been numerous books on the causes of the financial crisis. The housing boom and subsequent collapse is understandably at the epicenter of most of the books. Depending on the political persuasion of the author, the emphasis is that conservatives or liberals deserve more blame for the following reasons. What typically follows is a narrative of political bias. The fact is that both views have it partially right. However, at the end of the day, what is more important is that a number of contributing factors are worse now, than before the crisis.
Consider the following, which are presented in no order of significance, or intended to be inclusive of all the contributing factors. A number of institutions were so large and integral to the global financial system, central banks and governments around the world had no choice but to intervene and bail them out, since they were too big to fail. The solution applied to this problem by policy makers has been to make them even bigger. And there are no plans to break them up in the future. Instead, banks will be required to increase their reserves until 2019. This will work until the next batch of financial wise guys figure out a way to circumvent the rules. This is a bit like adding more bandages to the wound, rather than stitching up the wound. If a bank is poorly managed, it should be allowed to fail. Period.
Some have said the Federal Reserve held rates too low for too long in 2002 and 2003. Others point to a lack of oversight exercised by the Fed, as ads touting loans of 125% of a home’s value in 2004 failed to sound any alarm bells inside the FOMC. Now we have the Fed holding rates under .25% for an extended period because, in reality, they don’t have a choice. I have no idea how the Federal Reserve is going to delicately extricate itself from keeping rates so low. As the Fed does eventually raise short term rates, the debt burden of an already debt burdened consumer and federal government will increase. This will make balancing the Federal budget more difficult, and surely lead to politics playing a role in the Fed’s decision making. The scary thought is that I don’t think the Fed knows how they will accomplish this daunting task.
Owning a home is part of the American ‘dream’, especially since home prices have over time increased in value. The rating agencies were so convinced that home prices would never decline nationwide their risk models didn’t even include the possibility of a decline. Even as the ratio of median home prices to median incomes rose from 3 to 1 (between 1965 and 2000), to 4.6 to 1 in 2006, the rating agencies chose to ignore the obvious in lieu of collecting billions in fees. They continued to rubber stamp pools of mortgage backed securities AAA well into 2007, after the cracks in housing emerged. No surprise then that politicians would want to exert their influence on the GSE’s (Fannie Mae, Freddie Mac, and FHA) to make it possible for more lower income families to own a piece of the American dream. Prior to 2007, the GSE’s represented 45% of the home mortgage market. Now the GSE’s are behind 95% of all mortgage originations.
Although there had been banking panics in 1873, 1884, 1890, and 1893, the Panic of 1907 was the most severe, since it was centered in New York City. On October 24, 1907, the New York Stock Exchange would have closed had it not been for J.P. Morgan’s effort to raise $25 million from fellow bankers to provide much needed liquidity. This brush with disaster culminated in the establishment of the Federal Reserve in 1913. The common denominator in all of these panics was a run on banks, with depositors demanding their money. As simply explained by George Bailey in “It’s A Wonderful Life”, the banks didn’t have enough cash on hand, since they had lent the money so homes could be purchased and businesses could run. The primary purpose of the Federal Reserve was to inspire confidence so bank runs wouldn’t happen in the first place, and then, serve as the lender of last resort when they did occur. The Federal Reserve failed to provide enough liquidity in the early stages of the Great Depression and allowed the money supply to contract. This certainly deepened the 1930’s downturn, and ultimately led to the establishment of the Federal Deposit Insurance Corporation (FDIC) in 1933 with the passage of the Glass-Steagall Act.
Theoretically, the Federal Reserve is an independent central bank. However, since the Constitution gives Congress the power to coin money and set its value, the Federal Reserve must act in accordance with objectives set by Congress. In 1978, Congress passed the “Full Employment and Balanced Growth Act”, which mandated that the Fed establish a monetary policy that strives for full employment, growth in production, price stability, balance of trade, and balancing of the Federal Budget. The Act, which also known as the Humphrey-Hawkins bill, also explicitly states that the Federal government would rely primarily on private enterprise to achieve those goals. However, the Act expressly allows the government to create a ‘reservoir of public employment’, if private enterprises fall short.
The primary objective of the “Full Employment and Balanced Growth Act” has been to use a combination of fiscal and monetary policy to mitigate the natural ebb and flow of the business cycle. In the 25 years between 1957 and 1982 (300 months), there were 64 months that the economy was in recession. In the 25 years between 1982 and 2007 there were only two shallow recessions, which each lasted 8 months. On the surface, it certainly appears that the manipulation of fiscal and monetary policy had succeeded in taming the business cycle. In reality, the attempt to defeat the business cycle only succeeded in allowing far larger imbalances to develop. During the window of apparent success, between 1982 and 2007, total debt relative to GDP, mushroomed from $1.65 for each $1.00 of GDP in 1982, to $3.70 of debt for $1.00 of GDP in 2007.
Household debt as a percent of GDP rose from 44% in 1982 to 98% in 2007. Rather than allowing a recession to remove excesses and recalibrate the level of credit and debt relative to asset prices and GDP, the manipulation of fiscal and monetary policy only allowed the economy to inhale. As a result, we are now experiencing the Great Exhale. Although the Great Recession has ended, the Great Exhale has years to run. Unfortunately, policy makers are still using the same playbook that created so many imbalances. I have no idea whether the Great Exhale will end with a whimper or a bang. Neither outcome looks appealing. The one thing I am not doing is holding my breath in the expectation that policymakers will realize that all things oscillate in cycles, including the business cycle.
Since their peak in 2006, home prices are down almost 30%, and mortgage rates are at multi-generational lows. Despite the increase in affordability, new home sales fell to their lowest level in July since 1963, when the Commerce Department began records. Sales of existing homes plunged in July to their lowest level since 1995. Some of this weakness can be attributed to the expiration of the first-time home buyers’ tax credit at the end of April, which clearly pulled sales forward. This is another example of policy makers attempting to affect the natural ebb and flow of supply and demand. New home sales and existing homes sales will likely rebound in coming months, as a sense of equilibrium is restored to the housing market. That said, housing will remain weak, as long as unemployment growth remains elusive, income growth is feeble, and lending standards require home buyers to make a down payment and prove their income.
I continue to believe that home prices will fall further, since the imbalance between demand and supply remains intact. According to the Mortgage Bankers Association, 14.4% of borrowers had missed at least one payment, or were in foreclosure at the end of June. Between 4.5 million and 6.0 million homes will work their way through the foreclosure process in the next two to three years. This suggests the percent of distressed sales will remain a significant portion of total sales. After dropping from 41% of total sales in January 2010 to 22% in June, distressed sales were 30% of total sales in July. In June, 11 million homes were worth less than the mortgage, representing 23% of homeowners, according to Core Logic. It is estimated that 10% to 12% of homeowners, who could afford to make their mortgage payment, have voluntarily chosen to stop making payments, since they are so under water. As prices fall further in early 2011, more homeowners will be pushed over the edge. There is a good chance that year over year median home prices will be negative in the first half of 2011. This will damage bank balance sheets and consumer confidence.
The outlook for home prices will not improve until the labor market strengthens materially. Although 67,000 private-sector jobs were created in August, monthly job growth remains under the 113,000 jobs needed each month just to absorb new workers. Since 1973, real improvement in the labor market didn’t take hold until weekly jobless claims fell to under 400,000. Though down from 500,000, the most recent tally is still above 450,000. In the last 27 years, the only time weekly jobless claims were at the current level was while the economy was in recession. The Conference Board’s Index of Consumer Confidence rose to 53.5 in August. However, anytime it has been below 80, the economy has been in a recession. Ironically, the recent dip in jobless claims and modest uptick in consumer confidence encouraged investors who were worried about a double dip. Talk about low expectations!
A recent poll by Strategy One, found that 65% of Americans say a double dip is now likely to happen. Of those expecting a double dip, 44% fear it will be worse than the first recession.
Strategy One’s survey, which was based on A U.S. Census Bureau statistics, also revealed the following:
• 87% say they do not plan on buying a car or house in the next 4 months.
• 79% say they will spend less on Christmas this year.
• 41% plan to cut back on spending over the next 4 months, while 8% plan to increase it.
The ‘Less Is More’ philosophy, first discussed in January 2009, is taking hold for more American consumers. Each 1% that consumers choose not to spend, shaves almost .7% off of annual GDP, since consumer spending represents 70% of GDP.
In 1950, the average corporate CEO earned 30 times as much as the ordinary worker. Today, it’s 300 times as much. No one is worth 300 times the average worker. In 1978, the average per capita income for men was $45,879. Adjusted for inflation, the same figure in 2007 was $45,113. As incomes were soaring for a few CEO’s, the average worker has not come close to keeping up. Income inequality in the United States is greater now than at any time since 1929.
According to the Kaiser Family Foundation, annual health care costs have risen from under $5,000 in 2000 to $13,770 this year. During the last 10 years, employee’s annual cost has jumped from less than $2,000 annually, to $3,997 in 2010. Although pushing more of the annual cost of health insurance onto employees has helped companies’ bottom line, the additional squeeze on disposable income has left consumers with less money to spend.
Over the next 10 years, 36 million baby boomers will turn 65. In the last few years, their retirement accounts invested in the stock market have lost 15% to 25% of their value. The interest rate of return on their CD’s and money market accounts has plunged by 60% or more. The value of their home, which many had counted on to fund a nice chunk of their retirement nest egg, has lost 20% to 40%. At the end of the first quarter of 2010, net household assets were $54.6 trillion, down 18% from the end of 2007. According to the Employee Benefit Research Institute, 59% of people between the age of 56 and 62 will be risk of not having enough money to cover basic living expenses and health care costs in retirement. All of these factors have made saving more and spending less now an imperative, which will crimp overall economic growth in coming years. However, the negative impact on the economy from this wave of retirees will likely last far longer. As of 2008, those between 65 and 74 spend 12.2% less than they did a decade earlier, based on Census Bureau data. This suggests that the drag on economy activity from a slowdown in baby boomer spending could last for 15 to 20 years.
Although the stock market may rally if Bush’s tax cuts are held in place for all but the top tax bracket, the economic reality is that it will only maintain the status quo. And the status quo is nothing better than a very weak recovery.
Although stock valuations have come down significantly from the absurd levels of 2000, they are not cheap based on the historical P/E ratio on the S&P 500. I believe a secular bear market began in 2000 that will last 14 to 16 years, and won’t end until the P/E ratio on the S&P 500 is at least below 10. Before the great secular bull market of 1982 to 2000, the P/E ratio dropped to 6, which is also where it was in the late 1940’s prior to the secular bull market that crested in 1966. As I have noted previously, the price low during the 1966-1982 secular bear market occurred in December 1974, when the DJIA touched 580. The market spent the next 7 plus years trading between 700 and 1,000 on the DJIA. I hope that the March 2009 low in the DJIA at 6,470 will mark the low of this secular bear market. However, the amount of money that the government has spent and the amount of monetary stimulus provided by the Federal Reserve has not generated a self sustaining recovery. A self sustaining recovery sustains itself through job creation, income growth, credit availability, and business investment. The lack of self sustaining recovery elevates the risk of a second dip in the economy. Any additional weakness in the global economy would have a very negative impact on the global banking system. Policy makers would likely respond with another round of fiscal stimulus. Let’s hope that is not required.
As I noted in the September 1 Special Update, “In the short run, the market has a few things going for it. Sentiment got a bit pessimistic, and seasonality is also supportive going into the Labor Day weekend. So the market could push higher, and potentially ‘breakout’ above 1,100. That would set the stage for a run to 1,130.” The S&P reached 1127.63 on September 13, and has held just below 1,130. The rally over the last 2 weeks has caused sentiment to swing from pessimism and concern about a double dip, to an expectation there will be no double dip. This shift in sentiment is surprising since it only took a few reports displaying less weakness than expected, rather than actual strength. Volume has been extraordinarily low. Technically, the market is now a bit overbought. As long as the S&P holds above 1,114, I think a pop above 1,130 is likely, with a run to 1,160 possible. I would recommend selling into any move above 1,130.
The GLD short at $120.50 was stopped on September 14 at $123.50. Based on the number of ads touting Gold, and the number of people who like Gold, it is fair to characterize sentiment as being very bullish. The S&P has been chopping sideways between 1,040 and 1,130 for all but a few weeks since last October. Traders are hungry to play anything that is trending, and Gold has been trending higher since February. In coming months, I expect GLD to drop below $113.00. I was willing to short GLD on the chance that it would make a double top. Although this is likely a fake out breakout, with it pushing above the prior high, respecting the trend in the short term is prudent.
The long Dollar ETF was bought, when it dipped below $23.80 on September 13. Keep the stop at $23.35.
THE FINANCIAL COMMENTATOR
A Guide to Federal Reserve Monetary Policy, the Economy, and Financial Markets
By James Welsh, Registered Investment Advisor