In a January 7, 2009 article, 2009: Major Post Asset Deflation Themes, we outlined the major investment themes for 2009. This article will expand on the primary drivers of asset prices and secular investment trends. These topics can help investors successfully manage their portfolio during the transition from current concerns about deflation to future concerns about inflation.
Recapping 2009 Themes
- Expansion of the money supply / fiat currency concerns / inflation
- Commodities, clean energy, and water
- Economic shift from United States to Asia
- Infrastructure & government programs
- Baby boomer's transition from consumers to savers / consumer deleveraging
Other Important Themes and Concepts
The big picture fundamentals remain concerning. Below we outline some other possible drivers for asset prices in the coming years. It is important to understand, long-term rallies can take place in asset prices even in the face of poor fundamentals.
Leveraging and Deleveraging
In order to better understand where we are today and what the future may hold, it is important to review how we got into the current economic mess. Access to and the use of credit were key drivers of financial market gains in both the 1982-2000 and 2003-2007 bull cycles. Structured investment products, which bundled everything from student loans to commercial loans, helped fuel a rapid expansion in the availability of credit. Federal Reserve policy also contributed to an increasing dependence on more and more credit. Easy access to credit led to the widespread use of leverage. Leverage is the process of borrowing money (levering up) to purchase all types of assets, ranging from securities to commercial real estate. All types of assets, from stocks to residential housing, were used as collateral for more and more loans. More money, via access to credit, created more demand for all assets. As demand for the assets increased so did their value. When the assets increased in value, so did the value of collateral to borrow against. Money managers used rising stock prices as a source of new collateral to borrow against. They borrowed more and bought more stocks, which created even more demand. Real estate investors borrowed against existing properties so they could buy additional real estate assets. It all worked very well as long as the value of the assets used as collateral continued to increase or at least stayed relatively stable. Leverage ratios expanded as the prices of all assets, from classic cars to vintage violins, kept going up.
When asset prices began to fall in value, the "leveraging" process across the entire economy shifted to a "deleveraging" process. Leveraging involves borrowing more and buying more assets. Deleveraging involves paying back loans, often with money raised from the sale of assets. As the value of assets fall, collateral falls. When collateral drops, capital calls are soon to follow. Just as leveraging created demand for assets, deleveraging drives the need to sell assets. You have probably heard the terms "forced selling" or "forced liquidation". When everyone is leveraging, it creates buying pressure. When everyone is deleveraging it creates selling pressure. Increased buying pressure leads to higher prices of assets. Increased selling pressure leads to lower asset prices. Lower asset prices lead to more collateral calls, which lead to even more selling. And around and around we go until equilibrium is reached between the need to sell and the desire to buy. The process of selling to meet collateral calls, which in turns puts even more pressure on asset prices, is often referred to as a "deflationary spiral".
We mentioned above that structured investment products greatly increased the availability of credit. The structured investment products pooled loans and sold the loans to numerous investors in the form of securities. As you might imagine when default rates pick up on loans, the value of the securities backed by the loans drops. After the downward spiral in assets prices started, investors in securitized loans lost a lot of money. When investors lose money, they are less inclined to line up for the new offerings of securitized loans. Thus, a giant source of capital for the credit markets has dried up. If you cannot borrow, you cannot use leverage in the same way you once did. The deleveraging process has negatively impacted the prices of almost all asset classes from oil to corporate bonds.
Financial Firms Forever Changed
Selling securitized loans was big business on Wall Street. The use of leverage in "proprietary trading" at all the major investment firms enabled them to lever up their investment gains in good markets. In declining markets, the use of leverage magnifies losses and can take down a firm the size of Bear Stearns or Lehman Brothers. Securitized loans and proprietary trading were a major source of revenue for financial firms. These cash cows are not coming back anytime soon, which means earnings expectations for all financial companies will have to come down significantly. Lending institutions wrote numerous bad loans during the bubble years. Now that loans are defaulting at increasing rates, regulators are calling for higher loan loss reserves (a little late). Higher reserves mean less money to lend. Less money to lend means fewer loans and lower profits for banks. Financial stocks were a major driver of investment gains in recent bull markets. It is doubtful at best financial stocks will lead us into the next bull market.
House Prices: Not Even Close To A Bottom
The number of previously owned homes for sale at the end of November 2008 would require 11.2 months to sell at the current pace. Healthy markets have roughly 6.0 months of unsold inventory. Home prices will continue to be under pressure. Home values are tied to all sorts of collateral for loans. As prices decline, it adds more fuel to the deflationary spiral. Be careful to differentiate between projections of prices paid, sales, and housing starts. Until prices paid can stabilize, we cannot see the light at the end of the tunnel. Although it moves us in the right direction, increased sales at lower prices is not what we need.
Wall Street Killed the Golden Goose
Wall Street compromised their integrity by selling many "safe" investments to institutions and individuals. The rating agencies told them it was all "AAA-rated". When the leveraged house of cards came crashing down, investors were left with illiquid and sharply devalued securities. It will take years, if not a generation, before investors forget about Wall Street's greed and incompetence in the area of risk management.
We Borrow and Consume - They Lend and Produce
The times of borrowing our way to prosperity may be coming to an end. The U.S. government and consumer have been borrowing almost at will in recent years. Foreigners have been happy to lend us money so we in turn could purchase their relatively cheap manufactured goods and oil. As America's ability to repay is no longer as certain as it once was perceived to be, foreigners have already begun to question the wisdom of making loans denominated in U.S. dollars. The combination of the bursting of the global credit bubble and graying boomer population have changed the risk parameters of blindly funding America's consumption habits. As the risks increase, lenders will at some point begin to demand higher rates of return on their loans, which means higher interest rates in the United States. Higher interest rates in an economy built on debt is not a reason for optimism. At some point in the future, shorting U.S. Treasury bonds may be a trade with strong fundamental support (we just need to wait for technical alignment). Unsustainable imbalances are also present in the Medicare and Social Security systems. Something has to change. Many Americans are unaware that similar demographic problems are present in numerous developed countries.
A Glut of Strip Malls and Golf Courses
Access to credit enabled developers to build a little slice of "Generica" in every corner of our cities and towns. Riding down the road in Dallas looks much the same as in Atlanta. We can use our gift cards at Starbuck's, Best Buy, or Chili's. The weak state of the economy and rapidly deteriorating consumer spending have put fear into the hearts of Generica's retailers, many of whom are saddled with high debt. Expect to see less construction and more vacancy signs as retailers disappear or choose to exit certain markets. The depressed economy is already hurting many of the thousands of golf clubs built since 1990. While the deals on golf memberships are certain to be appealing, the default rates on club loans will not be.
Stock Valuations: A Bottom Is Possible, But So Are More Losses
Many talking heads point to "once in a lifetime opportunities" based on current stock valuations. While we agree with the positive case that can be made based on the November 2008 lows, we also understand historical valuations also could point toward the S&P 500 hitting bottom around 600 (35% lower than the 01/02/2009 close). Valuations have fallen to a point where keeping an open mind about further gains is prudent, but not to a point where it is time to blindly become fully invested. Current valuations can be termed as moderately attractive based on history and normalized earnings. When the charts point toward an improved environment, we can then argue we have some reasonable fundamental and technical alignment.
Obama Effect - Don't Assume It Can Only Be Positive (or Negative)
Regardless of your political inclinations, it is apparent President-elect Obama possesses remarkable political skill. Keynesians are going to have their day in the sun as President Obama plans to stimulate (spend) like you have never seen before. Popular opinion says the new administration can reverse the current negative spiral and get everyone to start spending again. We certainly understand this theory and it may indeed work, at least for a while. However, a prudent investor should examine both sides of any argument.
The other possible outcome after the administration's initial honeymoon is one of great disappointment. All politicians are skilled at making campaign promises. Mr. Obama has talked about "changing the world", which is an admirable goal. With the current secular trends firmly in place, "changing the world" and spending our way to prosperity may be a tall order. The same comments would apply if John McCain were moving to Pennsylvania Avenue. If you think Americans are down now, consider how their fragile psyche will react to the possible realization the new administration cannot pull a miracle out of their policy hat. This is neither a prediction, nor a forecast, just one of many possible outcomes.
France Does Not Inspire Confidence
While we respect there are many significant differences between France and the United States, there are some troublesome parallels between French policy in the 1980's and those being implemented and proposed in Washington today. Francois Mitterrand promised to create full employment and prosperity by:
- Nationalizing major segments of industry, including the banking system
- Taxing the rich
- Implementing massive social welfare programs
- Stimulating the economy by inflating the currency (a.k.a. printing money)
It didn't work. The results were double digit inflation, budget and trade deficits, and a general decline in the standard of living. Unemployment hit 10%. The franc declined in value relative to other currencies. (Source: Trader Vic by Victor Sperandeo).
Japan's Lost Decade
The 1990's are known as "the lost decade" in Japan. Fueled by credit expansion, Japan had bubbles in stocks and real estate (sound familiar?). After the bubbles burst, rather than come clean about bad debts, investments, and decisions, the Japanese tried to assist aligning companies with loans. Still saddled with problems many companies were referred to as "zombie firms" since they remained in business, but in a depressed and unhealthy state. Japan did not purge the bad debt and investments from the system.
U.S. policymakers have made similar mistakes by helping firms cover-up and hide bad debts and assets with bailouts, loans, and changes in accounting rules. If you are going to print money, provide loans, or intervene in the economy, it is better to do so sooner in the economic downturn rather than later. U.S. policymakers have done that starting with early interest rate cuts in 2007. This is in stark contrast to the almost non-existent initial reaction in Japan and cannot be ignored when making comparisons to the two periods.
Economic Woes Could Lead To Rising Tensions
While unlikely in 2009, in the coming years we may see a growing global resentment toward policymakers and business leaders who drove the economy and financial system into a ditch. A few more years out, tensions will surely be high as inevitable changes are made to Medicare and Social Security benefits. Higher taxes in a weak economy may add to the typical family's frustrations of trying to make ends meet.
Doing "The Easy and Self-Serving Thing"
Where were the whistleblowers on Wall Street? Who took a stand at the rating agencies and said, "This is wrong - these are not AAA-rated securities". Where was the conscience of the real estate appraisers, mortgage brokers, and loan officers who in many cases were involved with fraudulent loans in order to line their own pockets? Why didn't Congress have the political will to deal with the known problems at Fannie and Freddie before they helped bring down our financial system? Why didn't the Federal Reserve stop its bubble-blowing machine before it was too late? Where was the leadership in the corporate CEO's office and boardrooms on Wall Street? Why is a recession or company failure unacceptable? Why did policymakers pull out all the stops over the last decade to avoid a recession, which helps clear bad debt and bad decision makers from the system? Why is it acceptable to "walk away" from your mortgage even though you promised to pay? What ever happened to doing the right thing? What happened to working hard, saving your money, and buying things when you can afford them? The concern here is many of the political leaders, CEOs, boards, and market participants who should answer these questions remain employed or in power. We should be concerned about their ability to lead us out of this economic mess.
America Still Is The Best Place To Have An Idea
Money managers are risk managers, which necessitates being skeptical of all the financial cheerleaders and politicians that keep telling us everything is fine. The United States remains the best place on the planet to have a good idea. Our small investment firm is but one example of the great opportunities available to American citizens. Our freedom has always been and remains our greatest asset. My hope is that during these difficult times our leaders will "do the right thing" even if it means enduring a little political or economic pain.
As Investors, It Is All Relative
We have outlined numerous concerns about the economic outlook for the United States. Investors, especially currency investors, should keep in mind many of the problems in the United States are also present in other countries, developed and emerging. If you are down on the U.S. dollar, that means you have to be bullish on some other currency. Currency debasement (money printing) is taking place all over the globe. All major currencies are fiat currencies. High debt levels are not confined to the United States. Demographic and entitlement problems are common in other developed nations. Poor leadership and corruption are not unique to our country. In the long run, the best protection against inflation may be with "harder" assets, such as gold, oil, agriculture, etc. rather than taking stakes in other flawed paper currencies.
2003-2007 Bull Market Illustrates Possible Reflation
The recent synchronized global economic boom had never been seen before. Likewise, the synchronized intervention by global governments has never occurred before. Liquidity is being pumped into the global financial system from every corner of the globe. We must be open to and prepared for the possible reflation of asset prices, which includes stocks, bonds, and commodities. If you consider some of the "false gains" created by credit expansion in the 2002-2007 bull market, you become more open to the possibility of the successful reflation of asset prices via the printing press.
What We Know As Of January 16, 2009
Problems in the banking sector and government intervention into the "free" markets are far from over. Economic fundamentals remain weak. Valuations are moderately attractive. Despite endless calls for a bottom in asset prices, almost all major markets remain firmly in downtrends. On many fronts, we see what appears to be a gradual reduction in risk aversion. Money is being created out of thin air and pumped into the economy. Investors should pay attention, keep an open mind, and be prepared for bullish and bearish outcomes.