One of the most interesting debates in economic and investing circles today concerns the mental state of investors. Are they overly optimistic about the state of the economy, buying stocks with no regard for the risks? Or are they still so shell shocked that they’re willing to pay Uncle Sam to hold their money in T Bills? Stocks seem to be sending one signal, bonds another and the dollar….well the dollar is in some kind of bi-polar, inversely correlated universe all it’s own. Gold is rising when stocks are falling – and when they aren’t. Investors are asking, “What the heck is going on?”
When I talk to individual and professional investors alike, the most commonly held opinion about markets is one of overwhelming, impending doom. Individuals have mostly missed the rally since March; some of them are angry about it and others just don’t seem to care. Professionals have mostly participated – or at least that’s what they claim – but they’ve had one foot inching toward the door since about May. The issues facing the economy are well known and some recite them like some kind of economic catechism:
Q: What is thy next shoe to drop?
A: And the next shoe shall be commercial real estate and it shall fail as its residential brethren hath failed before it. Verily, all the banks shall suffer.
Q: Whither thy dollar?
A: And the dollar shall fall until such time as the plagues hath befallen the financial sector. Then the dollar shall rise as the phoenix, as it did after the failure of the Lehman in the time of Bush the Younger, and slay all those who worship at the altar of the carry trade.
Q: Is Goldman Sachs wholly incapable of doing any good and inclined to all wickedness?
A: Indeed, Goldman hath corrupted the temple of Bernanke and worships only mammon. Their wickedness will be revealed and their manipulations unveiled. Blankfein does not do God’s work for he is a deceiver who sprang from the loins of Lucifer. When the scales are lifted from mortal traders’ eyes, markets shall crash.
Q: Do not the heathens of the East manipulate their coin?
A: Yea, the Yuan is held fast to the dollar and the imbalances do grow. The money doth run hot and bloat the coffers of the communists. Their covetous ways hath inflated the price of commodities and built skyscrapers that their people shun. Their charade canst last and is doomed to collapse upon the heads of all who believe in the myth of the rising emerging market consumer.
The negative case is an easy one to make. To my imaginary catechism could be added quite a few other potential pitfalls that are widely known:
- State and local governments are broke and will have to reduce their spending next year when the federal stimulus spending runs out.
- Health care reform will raise taxes and further reduce the incentive to hire.
- Cap and trade will raise the cost of energy for individuals and corporations.
- Taxes will rise when the Bush rates expire at the end of 2010. Or they’ll be repealed before then by a Congress desperate to show they are serious about deficit reduction ahead of the mid term elections.
- More foreclosures will swamp the banks as resets hit the Option ARM market.
- There is a huge shadow inventory of foreclosures that the banks are holding off the market. When it hits, residential real estate prices will take another leg down.
- The rise in third quarter GDP was due to one time programs (cash for clunkers, etc.) and won’t be repeated.
- Consumer spending will never return to its previous levels.
- Corporations won’t spend if consumers don’t.
There are grains of truth in all these things but the key point is that they are all well known and therefore already factored into the markets. Or at least that’s what the efficient market hypothesis tells us. That theory has taken a bit of a beating over the last year though so maybe one of these well known things will be what starts the next leg down to the lows of last March – or even lower if you believe the most pessimistic among us. I have my doubts.
Many of these negatives are conditional. The negative aspects of health care reform assume that the Senate passes legislation, a compromise bill can be forged and that Democratic leaders can find enough votes in both houses to pass it. Talk about passing a camel through the eye of a needle…Cap and trade will indeed raise energy costs – assuming something passes that resembles the House bill passed earlier this year. With the recent revelations about data manipulation by global warming scientists, that just got a little harder. State and local governments will indeed have to tighten their belts, but those who are negative assume that reduced government spending is a bad thing. Is it? On taxes, it is certainly true that tax rates will rise if the Bush tax cuts are allowed to expire, but that assumes a positive outcome for the Democrats in the mid term elections. With generic ballots currently favoring Republicans that may be a big assumption. A big problem from Option ARM resets assumes that these mortgages haven’t already been refinanced or foreclosed. I can’t find any evidence that they have, but neither have I seen evidence that they haven’t. Investors should be very careful about the assumptions they make when forming their investment opinions.
One of the most damaging of our psychological biases when it comes to investing is what is known as recency bias. Simply put, what it means is that we place the most emphasis on recent events when forming our opinions about the future. Those who spend their days worrying about conditions similar to those that precipitated last year’s crisis are likely wasting their time and energy. Just to take one example, a real estate led banking crisis is, in my opinion, highly unlikely. Why? Well, consider:
- The Fed has just spent $1.75 trillion buying mortgage securities on the open market, most of them likely from banks.
- Banks borrowing costs, thanks to the Fed, are basically zero. Even with long term rates historically low, this is a very profitable environment for banks.
- The change in accounting rules means the banks will be allowed to let bad loans cure without writing them down. This is basically what was done in the early 80s with bad Latin American loans.
- TARP will likely be extended so more capital is available if needed.
- Does anyone really believe the Fed or Treasury would allow a large bank to fail?
Investor sentiment is a tricky thing to figure out right now. A lot of “professional” investors – mutual fund managers, Wall Street strategists, etc. – seem a bit too bullish right now, but this is a group that will be bullish – long term – on Judgment Day. Individuals, or at least the ones I talk to, are so confused that most of them can’t even form an opinion. Those who sold in the first quarter are so mad – at themselves mostly – that they may never get back in; they are deathly afraid of buying another top. Those who stayed the course seem just as nervous; they are so relieved to have gotten a reprieve that they are getting out while the getting is good, negative rates on T Bills be damned. And everyone seems to believe that the US is on the decline and the best investments are ABTUS – Anywhere But The United States.
There is a current of negativity about the US running through society right now. It is easy to believe, especially after President Obama’s Mandarin mendication tour, that America’s best days are behind her. If our leaders assume that is true, then certainly it might be, but I remember another time in my life when we heard similar sentiments. It wasn’t true then and it doesn’t have to be true now. Our problems may seem daunting, but they aren’t any worse than the set we faced when Jimmy Carter was delivering his malaise speech. We recovered quickly back then and we can again, but the solutions to these problems will not be found at a Whitehouse Jobs Summit or on Sino supplication tours.
Predicting the future is a notoriously difficult business. The next bull market rarely looks like the last one and the next crisis will only vaguely resemble the one just past. I don’t know what the future holds and I don’t know what the next crisis will involve. I suspect though that it won’t be caused by any of the things everyone is so worried about today. That would be way too easy.
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I will be traveling to San Francisco next week to visit my daughter over the holiday and therefore won’t be publishing a commentary next weekend. I’ll still be blogging though so please check there for updates. Have a nice – and safe – holiday. Happy Thanksgiving!
Weekly Economic and Market Review
Economic data last week – with the exception of those housing related – were generally favorable. Retail sales were up 1.4% in October and a big part of that was a rise in auto sales. After the post clunkers plunge last month, it is safe to say this was a bit of surprise for most people. Not for me though; I still expect sales to slowly ramp back up to the long term average of around 12 million annual units. As for non auto sales, the last three months show a gain over last year and a lot of the drop earlier in the year was due to a drop in gas station sales which is a function of a drop in price. No one ever got rich betting against the US consumer. The NY and Philly Fed surveys both showed growth with the Philly version improving slightly and the Empire state version falling slightly. Inventories fell again but the inventory to sales ratio is still a little too high. Higher production to replenish inventories is still a bit in the future. Producer and Consumer prices both showed increasing inflation. Cash for clunkers pushed up used car prices which was partially responsible for the rise in the CPI. It just keeps on giving….Inflation comparisons with last year will start to look even worse next month. Prices fell pretty drastically at the end of last year so the year over year numbers will start to look pretty bad next month. I wonder how the deflationist will spin that.
Industrial production was up only marginally. As I said above, inventories still need to come down a little more. Housing starts were just plain ugly – down 10.6% from September. The drop was blamed by some on the confusion over whether the tax credit would be extended but that doesn’t make sense to me. It was also a rainy month so that might have had some impact. If starts don’t pick up next month, that would be a very bad sign. Residential investment is usually an early cycle indicator. Economic recoveries start at home. Jobless claims were unchanged in the week and are just above 500,000. I suspect that job growth will start in the first quarter unless something changes.
Stocks around the world were pretty mixed on the week. The Dow managed to rise a bit but the other US indices were down fractionally. International markets were also mixed with China, Singapore, Israel and Korea on the upside and Tokyo leading the losers. The US dollar rallied a bit, but gold continued to make new highs. The commodity indices were basically flat while the Real estate indices continued to struggle. Bonds, especially the short end of the curve, continued to rally for some inexplicable reason. There are a lot of crosscurrents at the end of the year so I suspect a lot of this means exactly nothing. The rush to the short end of the curve is a bit unnerving though. Why would anyone buy Treasuries with a negative real yield? Beats me…..
The S&P struggled at the end of the week but no technical damage was done.
The volatility index may have made a higher low last week
Taiwan is still a favorite. The market jumped on the cross border investment agreement with China but a lack of details forced a pullback:
Brazil is another favorite although I have to say, I’m increasingly uncomfortable with two things. First is that everyone seems to be bullish on this market and second is that the government imposed another transaction tax last week, this time on ADRs. The governemnt needs to be careful not to send too strong a signal on how welcome foreign investment really is.
Here’s a new market to look at. I haven’t looked into the fundamentals yet, but cotton is forming a nice chart formation. A breakout above the 37 – 37.5 level should be bullish.
Is livestock ready to join the commodity rally?
Natural gas appears to have made a bottom:
Gold just keeps going and going and going…..