Sunday, December 13, 2009

And I’m back…and the investment world is still nutty

Being away from the financial markets for a few weeks can provide a person with a surprising amount of clarity and perspective. Day to day it is hard to extract oneself from all of the noise, especially given the recent marriage between Washington and Wall Street. These days, whether the news comes from D.C. or New York, just about all of it has the potential to influence both the equity and credit markets. Political commentators and Congressmen are now financial experts, as they suddenly have become knowledgeable about high frequency trading, systemic risk and credit default swaps. Hedge fund managers now spend more time suggesting government policy and regulation reforms than chatting with company management teams. Gold is now seen as a barometer for the credibility of the US government and the Fed, along with being a newfound financial asset. What communist China does or does not do with all of its US dollar holdings could make or break any number of investment theses being put forth by financial pundits. Jim Rogers, a professional investor, and Nouriel Roubini, an economist, are at war. Instead of admitting that just about everyone failed to foresee the financial crisis, neoclassical and Keyensian economists continue to blame each other while the proponents of the Austrian school look on in disbelief.

I could go on and on regarding this new world we are living in but my guess is that you get the point. Whether this is going to be the status quo in the “New Normal” or not, I think we all can admit that we aren’t in Kansas anymore. Or maybe, it is that Kansas now looks more like Wonderland (of Lewis Carroll fame) than anything else. It is within this context and in the spirit of making holiday lists that I thought I would make a list of things that just don’t make sense to me. I learned very early on in my career that when asset prices, economic trends, and other fads don’t make sense, circumstances often arise that cause a swift reversal in sentiment. These are the kinds of things that ultimately make you scratch your head and wonder what everyone was thinking. Of course, betting on mean reversion can be life threatening for an investor as the market can stay irrational longer than investors can stay solvent. But, I thought it would be useful to point out some current truths and beliefs that we all should not be surprised if they eventually do a 180 in the coming months or years. Not one for making prognostications, I am not crazy enough to think that I can predict when and how a correction will come. The goal is just to make sure that everyone who has a stake in the outcome of certain events is at least aware that there is another side of every argument and investment rationale.

  1. New York City residential real estate prices: Yes, yes, I know New York is an island. There are only so many apartment buildings that can be built and the fact that a lot of City apartments are rent controlled limits supply even more (because people never move). Plus, insane Wall Street bonuses are back in 2009 and there are always wealthy foreigners who would love to have a pad in Soho. The consensus is that all of these facts put a floor under apartment prices and anyone who wants to live in NYC should buy any and every dip. Well, you know what else is an island? Japan is an island. They can’t build much more real estate there either and values are still substantially below the early 1990s (pre-crash) levels. I’m not insinuating that NYC real estate prices are going to crash like Japan’s did but think about the following before you immediately dismiss the comparison: to be able to live in an apartment big enough for three people to live comfortably, the going monthly rental rate is somewhere in between $6000 and $6500. Really, $72,000-$78,000 a year in rent? I’m not even talking about expensive neighborhoods like TriBeCa or Chelsea. This is the rate on the Upper West Side, a nice but certainly not shiny, luxurious part of the City. New York has always been an expensive place to live but now that rental and housing prices have dropped significantly everywhere else the spread between NYC and the rest of America has gotten extremely wide. If you take a step back and compare what it costs to live in NYC with what it costs just about anywhere else in the US it is hard to imagine such price discrepancies are sustainable on a real, inflation adjusted basis.
  2. The US dollar carry trade: This is a topic that seems to elicit a lot of disagreement. Nouriel Roubini is sounding the alarm about how devastating an unwind of the carry trade could end up being. On the other hand I have read numerous arguments that there is not any evidence of a large US dollar carry trade. The thesis of these people is that banks are holding massive amounts of capital in reserve at the Fed so they are not engaged in the carry trade. Further, if hedge funds are borrowing in US dollars to invest in higher yielding assets it is not a huge concern because aside from LTCM, hedge funds have failed without bringing down the financial system or the economy. Honestly, I have no idea how prevalent the dollar carry trade is. But, if people are levering up to buy risky assets with the hope that the dollar will continue to depreciate against other currencies and that US interest rates will stay low for a long while, it shows that people have learned nothing about the risks of leverage. After the painful unwinding of the Yen carry trade and the subsequent forced selling that occurred in late 2008 and early 2009, you would think people would be more cautious. But, based on how quickly the Wall Street banks have decided that the financial crisis was only a small speed bump, it would not surprise me if certain investors and institutions were taking part in a really crowded US dollar short. All I can say is watch out if it is forced to unwind because the keyhole is definitely not big enough for everyone.
  3. The US deficit: Clearly, I don’t have to say a whole lot about this. Everyone and their dog realizes that the fiscal path that the US has embarked upon is not sustainable. But a $1.4 trillion deficit for fiscal year 2009? How did trillion become such a common word in our lexicon? I guess my concern is about the magnitude of the deficit. It’s not like the deficit slowly grew and kind of snuck up on us. The deficit for fiscal year 2007 was only $162 billion. For FY 2010 the projected deficit is in the $1.5-$1.7 trillion range. That’s between 9 and 10.5 times the deficit in 2007!!! I am not making an argument about the merits of stimulus and Keynesian reactions to recessions. All I am saying is that the size of the increase on a percentage basis is just ludicrous and it is hard to believe that there will not be some lasting negative impacts from the fiscal choices made in the last few years.
  4. The Fed’s balance sheet: If I had asked you two short years ago what you would worry about if I told you that by the end of 2009 the Fed would have doubled its balance sheet, you would have immediately said “inflation.” The Fed is desperately trying to fight deflation by increasing the money supply. The banks sure aren’t helping the cause by leaving so much money with the Fed and not lending it out. As a result the velocity of money is way down, a fact that limits the impact of the increased liquidity. In addition, the so-called output gap also serves to dampen inflation as it is very unlikely that wages will rise in an environment with such a large production shortfall and severe unemployment. So yes, the deflationary pressures are daunting and the Fed is only trying to keep the economy from drowning. But, how do we know that the percentage increase in the balance sheet has not put the Fed in the position that it cannot possibly reduce its asset holdings fast enough or efficiently enough to prevent inflation? Again, we are in uncharted territory. I am unaware of any monetary policy that has been so accommodative in such a short period of time. Unless the rules regarding printing money have changed and the US economy is not subject to the inflationary pressures that crippled Argentina and Zimbabwe, it is hard for me to imagine this grand experiment working flawlessly.
  5. The rise in the S&P 500: Let me make a couple of things clear. First, the S&P trading at 666 in March 2009 probably undervalued the 500 companies in that index by a decent margin. When I look at some of the 52 week lows on companies with great franchises, substantial free cash flow generation and real growth prospects overseas, I realize that I was foolish not to back up the truck and purchase calls on the S&P. Along with many other young and old investors I was paralyzed by the substantial volatility in share prices and had no idea how to handicap the government’s involvement in seemingly every facet of the US economy. Lesson learned. Thankfully, I am not yet at the point where anyone else’s money is on the line but my own.

Having said all that, just because the S&P was undervalued at 666 does not mean it is fairly or undervalued at 1106. At 666 the market was discounting a very draconian reality. And now? Well, if you ask David Rosenberg of Gluskin Sheff he would say that the market is pricing in 5% GDP growth in 2010. If you ask John Hussman he would say that at the current price the market is assuming companies will go back to the levered profit margins they enjoyed during the housing bubble. In fact, in his latest missive he suggests that over the next decade the market return from today’s level is unlikely to be more than 6%. I have just started reading Alice Schroeder’s biography of Warren Buffett titled “The Snowball” and coincidentally 6% is the same return Buffett expected for this decade based on the prices in 1999. In any case, 5% GDP growth next year seems unlikely and 6% returns for the next decade are certainly not that attractive. The implication, of course, is that the market has gotten well ahead of company-specific and economic fundamentals. Plenty of people are cheering the end of the technical recession but I am not going be jumping up and down until the real, Main Street recession starts to turn around. Until then, I am going to look at any further gains in the S&P 500 as speculative advances that are bound to reverse until US leaders take meaningful steps to reduce the multitude of structural imbalances facing the economy.

  1. Dubai: Don’t tell me it never crossed your mind that man-made islands and underwater hotels were a bad idea or at very least a sign of unwarranted excess. I mean, come on…

This is certainly not a comprehensive list but it does incorporate of lot of topics that will inevitably impact the returns on a number of asset classes over the next few years. Again, you are free to disagree with me about any or all of them. However, I believe that any rational investor who takes a step back from his or her portfolio should be at least a little concerned that prevailing valuations, trends and monetary/fiscal experiments may eventually be short circuited by the simple rules of supply and demand. In other words, if you are making investments with the underlying premise that this time it is different, I suggest that you re-think your strategy and/or make sure that success or failure is not solely a function of market timing.

(Picture courtesy of