Tuesday, August 18, 2009

Links, links and more links

Taleb’s open letter to British Conservative leader Cameron: I found the link to the piece from Taleb in the Guardian on Zero Hedge. Stating his usual concerns about Black Swans, excessive debt and systemic fragility in letter form, Taleb warns David Cameron (who apparently may come to power if there is a political shift in Britain in the upcoming elections) not to follow the path the people in charge of the US have taken. He also cautions Cameron about putting too much faith in expert economists because he feels that they are the ones who allowed (or directly caused) us to get into this mess. While I happen to believe that Taleb is right about a lot of things, I fear that his drastic solution to the problem is unrealistic and therefore is not particularly useful:

The solution is obvious: build an economy that increases the role of well-tested traditions. Ban financial derivatives that require advanced mathematics rather than trial and error. Look at mother nature. There is a complex system built around sound principles that has insured both evolution and survival. It does not let anything get too big to fail. It breaks things early. I don't understand why people who stand against tampering with nature accept tampering with the economy that would have organically grown too. Work on building a "robust" society, capable of withstanding errors, in which the role of finance (hence debt) would be minimal. We want a society in which people can make mistakes without risk of total collapse. Silicon Valley offers a good example, where people have the chance to fail fast (and repeatedly).

In a perfect world that sounds great. But we have an existing system that many very wealthy and influential people have a huge stake in. Maybe it is time for Taleb to be more practical in his suggestions about what needs to change for a better future.


Why tempered optimism may be the best outlook: I got the link to this article in BusinessWeek from The Pragmatic Capitalist. While the title (Why It’s Smart to be Optimistic) sounds like the title of a segment on CNBC about stocks, the author is not peddling blind bullishness. Instead, he wants us to remember that recessions often bring out impressive human ingenuity and that creative destruction can have many long term benefits. As a result, he suggests that we be rationally optimistic about the future of America:

In other words, you owe it to yourself at least to consider the case for optimism. No, not starry-eyed, Panglossian optimism. We're simply arguing that practical people should open their minds to the opportunities to be seized just as much as to the dangers to be dodged. As futurist Esther Dyson of EDventure Holdings put it in one of the many interviews we conducted for this Special Issue: "Part of being optimistic means you really need to understand the problem and be cynical enough that you're not foolishly optimistic. Then you're not disappointed when things don't work out. A lot of people just think truth and beauty will win out and it's easy. It isn't."

His views go along with my stance that you should always look at all sides of an issue. As many of you know I have a lot of short term and long term concerns about the US economy and stock market. However, I accept the fact that there is no way to know for sure what the next growth industry will be or where the next technological revolution will come from. Therefore, I am cautiously optimistic that we will use our ingenuity and perseverance to come up with solutions to at least some of our myriad problems.


Now for some more immediate concerns: I also found this link on The Pragmatic Capitalist’s site. This chart-focused posting aggregates a lot of information that suggests that this is not a normal recession and therefore we cannot expect a V-shaped recovery. What strikes me about the data the author presents is the magnitude of the declines. All of his charts look the same. No matter what is being captured the output literally falls off a cliff. Exports, inventories, capacity utilization; you name it and the chart looks identical to the previous one. So it is no surprise that the cumulative effect of this data leads the author to conclude:

The pundits of green shoots will say that the economy is getting better and that the leading indicators are pointing to a dramatic recovery. THEY ARE WRONG. They were wrong in 2007 and they are wrong now. The one and only TRUE LEADING ECONOMIC INDICATOR in a debt riddled society is DEBT to INCOME. That ratio has not improved, it is worse than ever, especially at the governmental level.

Specifically, his main concern is about deflation. He shows a number of charts that capture the flow of money, but the most striking one is of monetary velocity growth, a metric that is down 75%. Now I am not an economist but I do understand that it is very hard to experience inflation when the velocity of money is so low. On a similar note, the author makes the case that you can throw as much money as you want into the system, but if the current income cannot service the existing debt then deflation is a more likely outcome.

That’s a pretty clear picture to me, one of DEFLATION at work. It is accelerating, not decelerating. That is a HUGE divergence from what’s occurring in the equity markets and from what you hear on television from the supposed experts.

I think we are on the precipice of a self-reinforcing deflationary spiral. The data is historic. The disconnect between the data and perception is historic. The Fed is attempting to do a magic trick by printing their way out of debt – it’s a trick that has NEVER worked throughout the history of mankind and will not work to create real growth now.


Mark Hanson continues to pound the table about the ongoing housing crisis: In his latest piece (which I found on Mish’s Economic Blog) Whitney Tilson’s favorite housing analyst explains why the foreclosure wave is turning into a tsunami. By looking at the early stages of foreclosure that include notice of defaults and notice of trustee sales, Hanson makes that case that the foreclosure-eligible property pipeline is about as robust as it has ever been. As you can imagine, this is not good news for housing prices.

As long as foreclosure and foreclosure pipeline housing supply makes up such a large percentage of total sales the housing market will never be on the mend because supply is effectively infinite.

Infinite? Now that sure isn’t comforting. It is easy to dismiss the conclusions made by Hanson because he has been knee deep in this for so long that he may have become somewhat biased. But I would argue that it is the bottom’s up analysts who are crunching local data as opposed to the top down strategists sitting in their offices on Wall Street who have the most valuable perspective on the housing market.


Hussman is on point as usual: John Hussman’s latest piece came out yesterday and has already been linked to across the blogosphere so I won’t spend too much time discussing it. However, what I like about his analysis is that he is ALWAYS FOCUSES ON VALUATION. He isn’t basing his investment strategy on green shoots or money market flows into stocks. He looks at the returns implied by the valuation and the dividend yields of stocks to determine his outlook for the equity markets.

Thus, when we look at the dividend yield of the S&P 500 at the end of U.S. recessions since 1940, we find that the average yield has been about 4.25% (the yield at the market's low was invariably even higher). Presently, the dividend yield on the S&P 500 is about half that, at 2.14%, placing the S&P 500 price/dividend ratio at about double the level that is normally seen at the end of U.S. recessions (even presuming the recession is in fact ending, of which I remain doubtful). At the March low, the yield on the S&P 500 didn't even crack 3.65%. Similarly, the price-to-revenue ratio on the S&P 500 at the end of recessions has been about 40% lower than it is today, and has been lower still at the actual bear market trough. The same is true of valuations in relation to normalized earnings, even though the market looked reasonably cheap in March based on the ratio of the S&P 500 to 2007 peak earnings (which were driven by profit margins about 50% above the historical norm).

As James Montier has pointed out numerous times, even at the low of 666 on the S&P it never looks like we got to the revulsion stage in the stock market. Hussman reiterates this sentiment by highlighting that the dividend yield on stocks never got up to the average yield from previous recessions. Does this mean we will re-test the previous lows? Of course not. But it is a good barometer of market valuation, which currently appears to be based on something much less tangible than price to earnings or dividend yield:

The primary element that is favorable at present is speculation – excitement over the prospect that the recession is over. Investors are presently anticipating the good things that have historically accompanied the end of recessions (strong investment returns and sustained economic growth), without having in hand the factors that have made those things possible (excellent valuations and a large output gap coupled with strong structural growth in potential GDP). (Emphasis mine)


The lasting effect of the indebted consumer: Hat tip to Zero Hedge for posting this well-written and comprehensive examination of the US consumer by Ed Harrison. His thesis is simple: unlike some of the other countries that are experiencing drop in export-induced recessions, the US is in the middle of a balance sheet recession that will keep inflation low and potentially lead to crippling deflation. That is unless the weakness in the dollar leads to commodity price appreciation at the same time wages are stagnant (or dropping in aggregate due to increased unemployment) and producers are forced to lower prices to clear inventory. This is not a good combination for consumers or businesses and indicates that the consumer may be very weak for an extended period of time.

One can only conclude that the asset-based economy of the last quarter century is over. It was based not just on a dubious productivity miracle but also on mountains of debt and over-consumption. The new normal is debt reduction and savings.

So, what are the long term implications of this debt reduction and savings? Here are two that I thought were pretty interesting:

Retailers are in a world of hurt, not just cyclically, but on a secular basis. Listen to the Patty Edwards interview. America has double the amount of retail space per capita that it did a generation ago. This is the definition of over-capacity. When a glut of supply meets a deficit of demand, you have the makings of a very bad outcome for the stocks in that sector.

Anyone who has listened to my rants knows that I am concerned that the US is over-retailed, over-drugstored, over-banked, and over-restauranted. Capacity was built for peak demand that was debt fueled and may not come back for years. This could lead to a supply overhang that is tough to overcome. Next:

Banks will be in a permanent state of crisis. If we learn anything from Japan, it’s that time does not heal all wounds. The Japanese tried to recapitalise their banking system by propping up zombie institutions. That didn’t work. It didn’t work in Japan in the 1990s and it didn’t work with Savings & Loans in the US in the 1980s. Why should we expect it is going to work now? But, team Obama has decided this is the way forward. If and when an economic relapse occurs, the fragility of the banking system will be made manifest.

The US policy makers have made the decision to let the banks try to earn their way through the cycle or as Karl Denninger likes to say, “extend and pretend.” Harrison argues that we are just setting ourselves up for a more dramatic fall in the future. I have to admit that I agree that this risk is far from off the table.


Alice Schroeder says don’t forget about the rating agencies: With much of the populist anger dying down as we all have been beaten into submission by the incessant bad news about the economy, some of the culprits of this crisis are no longer receiving as much attention. The author of The Snowball thinks this is a big mistake and can’t understand why the rating agencies may get off with only a slap on the wrist. Accordingly, she offers up much more dramatic reforms to the currently flawed and obviously ineffective system:

Plan A, therefore, is to pull the requirements for ratings out of loan covenants, investment guidelines, swap documentation, and collateral triggers. Allow lenders and insurers to demand from issuers the data they now give the ratings companies. Better yet, turn that data loose on the Internet and let the free market handle the rest.

Wiki-raters, bloggers, ratings boutiques would quickly emerge to analyze their way to fame and fortune. This is where the world is headed anyway -- a barbell. At one end, cheapie analysis done on the fly by strivers; at the other end, deep research purchased by the deep-pocketed few.

Wheeeeeee! Let’s let the blogosphere handle ratings. Now that would be awesome. I can just imagine the expletive laced rating of a REIT by Tyler Durden of Zero Hedge. In fact, I think I would even pay to read that even if I had no interest in the company.


(Picture of Alice Schroeder courtesy of Bloomberg.com)