Free Markets, Free People

Lance Paddock


Half Solutions Will Not Work

Brett Arends is skeptical about Europe’s current direction:

Their proposal is preposterous. Anything can happen in this life, but it would be remarkable indeed if this idea got off the ground. Anyone pinning their hopes that this will solve the crisis needs to think it through.

Why would the Portuguese accept the right of Germany to impose budget cuts on their country? Why would the Greeks?

Would we accept that role for the Chinese and the Japanese, the biggest holders of Treasury debt? How would you feel if you opened the paper to be told that the new Sino-Japanese “Fiscal Stability Commission” in Washington had just slashed your grandma’s Social Security checks by one-third, scaled back federal highway repairs, and that it would impose a 10% national sales tax?

That is, after all, effectively what is being offered to the people of Greece, Italy, Spain, Portugal and Ireland.

It’s absurd. There is no reason why these countries should have to surrender sovereignty. They can simply, where necessary, default. A default by, say, Louisiana would not destroy the dollar. Neither did the bankruptcy of Enron or Lehman.

What happens when after signing the new treaty (if it ever actually comes to be) the Greeks or Italians decide to thumb their noses at the EU and default anyway? Kick them out? Isn’t that right where we are now? Isn’t the fear that countries are kicked out or leave leading to financial chaos and defaults? Will these countries truly continue to pay their bills and accept austerity in the face of a severe recession/depression?

If that is the concern, just as I have been pointing out for some time, anything short of true fiscal and political union will fail. The right of existing states to refuse to honor the treaty (remember the last one was treated as inconsequential by violators, including Germany and France) cannot exist which means the right of states to secede or be expelled from the union cannot exist. If that option is not off the table then Eurozone bonds cannot be treated as risk free. If they are not seen as risk free then they will be rated accordingly and the Eurozone will be unstable as Louis-Vincent Gave points out:

Basically, we have to remember that the average sovereign debt buyer is not a hazardous investor. The guy who buys a government bond is looking for a very specific outcome: he gives the government 100 only so he can get back 102.5 a year later. That’s all the typical sovereign debt investor is looking for. Nothing more, nothing less.

But now, the problem for all EMU debt is that the range of possible outcomes is growing daily: possible restructurings, possible changes in currencies, possible assumption of other people’s debt, possible mass monetization by the central bank etc. Given this wider range of possible outcomes, and the consequent surge of uncertainty, the natural buyer of EMU debt disappears. Again, the typical sovereign investor is not in the game of handicapping possible outcomes; he is in the game of getting capital back!

This is very problematic because once uncertainty creeps in, bonds will tend to gradually drift towards what I have come to call the bonds “no-man’s-land”. Basically, once sovereign bonds reach 90c to par, they tend to have a much higher volatility and much greater uncertainty. As a result, they are no longer attractive to the typical bond manager or asset allocator looking to buy bonds to diversify equity risk (think how Italian bond yields are now correlated to European equities. If you want to be bullish Italian bonds, you may now just as well spend a fifth of the money and buy European banks for the same portfolio impact…). And once a bond enters into no-man’s-land, it has to fall a lot before attracting the attention of distressed debt and vulture investors (usually yields of 15%+). So the first obvious problem is that more and more European debt markets are entering this “no man’s land” bereft of “normal” investors.

Do these countries need the Euro over the long term to be prosperous? More Brett:

The British look smarter and smarter for staying out of the euro area in the first place. Prime Minister John Major, and then, later, Chancellor of the Exchequer Gordon Brown, each took the decision to keep the British pound free. At the time fashionable opinion predicted disaster for the Brits. So much for that.

(Predictably, fashionable opinion now says the Brits look “isolated” for staying out. Really, you couldn’t make it up).

My guess is Brett is correct that we are no where close to a real resolution, which is a path to political unification or breakup.

It has long been clear the Franco-German duo wanted to use their shared currency to bludgeon the continent into something closer to a federal system.

Any investor pinning their hopes on this bird flying needs to be aware it looks a lot more like a turkey than an eagle.

This week’s meeting of European leaders already marks the fifth “summit” to solve the region’s debt crisis since early 2009.

My favorite comment this time: “After a series of ‘final’ summits, it would be nice this time to have a real ‘final’ summit.” That was from Standard & Poor’s chief European economist, appropriately-enough named Jean-Michel Six. What’s the betting Mr. Six will be attending Summit No. Six in the new year?

Which is not to say that the ECB or some other entity couldn’t stem the immediate crisis and kick the can further down the road. Maybe, but if so the question is how far? A week, a year, five years? That I cannot answer now.


The North South Divide

Fundamentally currency unions without fiscal union are flawed. Shoehorning the northern and southern countries of Europe into one (with our without fiscal union) made no sense at all (The Economist)

The economies of southern and northern Europe make strange bedfellows

SINCE bond investors began to discriminate between the euro-zone economies, pushing yields on Spanish, Irish, Greek, Italian and Portuguese government debt soaring, much of the talk in northern Europe has been of profligate governments in the south. As these indicators show, the euro zone’s problems go rather deeper than that. A large chunk of the single-currency area has a chronic competitiveness problem, with a horrible mixture of high unemployment, low productivity and low investment. One unsolved mystery is why all this ought to have some correlation with latitude. Answers to the Bundesbank, please.


Will Eurobonds Work?

(Originally posted at Risk and Return)

I have been skeptical and so is James Bianco:

The problem in Europe is simple – they created a common currency – the euro. For years, the market erred. It thought that meant that every sovereign debt had the same rating as Germany. I was buying Greek bonds. I was buying Irish bonds. I was buying Italian bonds. But I thought I was buying German bonds. Then, a couple of years ago, I had an epiphany – no, I was not buying German bonds; I was buying Greece, Italy, and Ireland, or whatever, not Germany.

Those countries, recognizing that they could borrow into infinity because everybody thought they were lending to Germany, pretty much did that and expanded their welfare states to the point where they cannot pay their debts.

Germany has disappointed everybody with its intransigence, its unwillingness to “get with the program,” and endorse massive ECB bond buying and Eurobonds. Their reason? They believe they will be stuck with the bill. Of course, they are right, they will be:

If a Eurobond market comes with with strict discipline/rules on borrowing and paying debt back, it might work.  Unfortunately no one will agree to a Eurobond market with strict discipline/rules.

If a Eurobond market comes with no discipline/rules, then it is just another way to trick the market into thinking they are buying German Bunds.   It will “work” for a while as the crisis will ease until everyone borrows too much money and then comes back much worse.

I am not even sure it will work more than a few days at this point, but maybe. Either way it is not a solution, but a stop gap at best. It is also a stop gap that should not be attempted unless an actual endgame is in sight:

So how do you fix the Euro crisis?  Unfortunately there are only three solutions and all are distasteful:

  • Call off the union and go back to legacy currencies.  This destroys the banking system who will be paid back with devalued/nearly worthless currencies.
  • Massive austerity.  This option is very unpopular among the electorates and will cause a bad recession/depression.
  • Fiscal union.  This is a nice way of saying Germany finally wins WW2.  Is the rest of Europe now ready to take orders from Berlin?  Didn’t they fight two wars to prevent this?

The only reason ECB printing keeps being mentioned is because the three options above are untenable and money printing is the only other thing they can think of.  Money printing does NOT fix anything, it just makes the problem better for a while until it comes back worse than before.

This dovetails with my analysis in The German Dilemma that their are no good options from the German perspective, and in fact fiscal union is far more problematic than commonly realized:

Full Fiscal Integration: Since all other solutions put in place circumstances that are unstable and merely kick the can down the road, the fundamental flaw in the Euro needs to be addressed. That is the lack of a unified fiscal policy. The answer then is the end of sovereignty, the creation of a US of Europe. An obvious objection is that Germany wants to be a sovereign nation. We’ll skip this niggling little detail, but even if they didn’t want to remain sovereign do they want to harmonize laws and economic policy with Greece and some of the other PIIGS? West Germany just  integrated with East Germany and the experience was traumatic featuring massive transfers to East Germans. The PIIGS will still not be competitive with Germany. That means internal adjustments (internal devaluation or austerity) to allow them to become more competitive for the PIIGS’ or massive transfers. Thus unifying the Eurozone under a single fiscal policy means massive transfers from Germany to the PIIGS to harmonize the welfare states and unify the debt and avoid austerity throwing the entire Eurozone into depression. Germans will pay for the debt in one fashion or another.

Cullen Roche points out that in the US we don’t worry much about the need for internal transfers between states to keep the system sound.  Today that is true, though it has led to large conflicts in our past, playing a role in civil unrest, uprisings, the conquest of a continent and near destruction of its former inhabitants and the Civil War. Our unity was easier to envision and still born of blood and tragedy.

I am not saying unification of Europe would lead to such tragedies and conflicts. However, we need to ask if Germany (or really all the countries) want to make the internal transfers that make such a system work? Germans would pay a great deal, Greece and the other PIIGS would suffer internal austerity to the extent that they contribute to the economic re-balancing. Do Europeans, or most importantly the Germans, view themselves as a people who will be responsible for paying all the bills to integrate the Greeks and others?

Are Europeans ready to think about their home countries in the same way Texans think of Texas? Their state, but completely subordinate to the US? Will they be able to secede? We answered that question in the US with a war of incredible savagery and destruction. My guess is a unified Europe would be far less stable. They will not choose a civil war comparable to the US, but instead countries leaving over time as well as never entering the union. That leaves us with all the problems we have now still being there. Without a European populace overwhelmingly in favor of a true union this will not work. We would be faced with a PIIGS like crisis with every election and the possibility of secession in each of the former countries.

The necessity of creating a union where there is no possibility of secession, where citizens are more loyal to the European sovereign entity than their own countries is incredibly unappreciated. Half measures will not work. If Texas were to get upset about staying in our own Union it would not matter how overwhelmingly popular the idea of leaving was in the Texas legislature, the US military will ensure that Texas stays a subordinate state. We decided that issue in 1865 at the cost of well over 600k casualties.

If a similarly firm enforcement of Eurozone union is not agreed to (and setting aside a war to force union) then why should the market assume the system will remain intact? Why consider the bonds issued by the various states, or the Eurozone as a whole, deserve a AAA rating?  My belief is that eventually the Eurozone will suffer other crises as states face local elections that wish to leave for one reason or another. Critically Eurobonds and fiscal Union make it easier for countries to leave, since the debt will be the Eurozone’s, not theirs. They can leave and stick the remaining members with the bill. That is an incentive which virtually ensures instability.

Treaties don’t matter if there is no enforcement mechanism, and all enforcement mechanisms at the end of the day have to have a credible belief in military force behind them to matter. Otherwise those who wish to exit can just thumb their noses at whoever stays behind. Has there ever been a successful union where the underlying members could leave? Not that I am aware of.

There are no good options, only more or less realistic ones.



There are certainly more comprehensive tributes, but this is my favorite so far. From Steven Horwitz:

Unlike many, I am not an Apple-phile. I honestly don’t get the emotional relationship people have with their products. HOWEVER… there is absolutely no doubt that Steve Jobs is a symbol of all that is right with markets and capitalism. This is a man who became very, very rich by making many people’s lives (including my own) very much better. He was a master at creating value and persuading people that they wanted things they didn’t know they wanted. He should be part of the pantheon of human heroes.

Unlike the political and military heroes of war we too often celebrate, Jobs is a hero of peace. He made his money through persuasion not at the point of a gun, and through mutual benefit not oppression and exploitation. Those of us who really desire a peaceful society should not celebrate those who were victorious in war, but those who created value through peaceful, voluntary, mutually beneficial exchange – exchanges that happen billions of times every single day. And we should do it no matter whether what was exchanged was electronic bits of magic, food for us to eat, or financial instruments that improve the movement of capital. They all create value and improve our lives, and all of their benefits are deserved.

Thanks for everything Steve and thanks for making the world a better place one peaceful, cooperative exchange at a time.


Further Reading: The Devil’s Dictionary Edition

The story of professional curmudgeon and cynic Ambrose Bierce and The Devil’s Dictionary. Bierce’s astringent satire and observations made Twain seem treacly sweet:

POLITICIAN, n. An eel in the fundamental mud upon which the superstructure of organized society is reared. When he wriggles he mistakes the agitation of his tail for the trembling of the edifice. As compared with the statesman, he suffers the disadvantage of being alive.

HISTORY, n. An account mostly false, of events mostly unimportant, which are brought about by rulers mostly knaves, and soldiers mostly fools.

MAN, n. An animal so lost in rapturous contemplation of what he thinks he is as to overlook what he indubitably ought to be. His chief occupation is extermination of other animals and his own species, which, however, multiplies with such insistent rapidity as to infest the whole habitable earth and Canada.

SATAN, n. One of the Creator’s lamentable mistakes, repented in sashcloth and axes. Being instated as an archangel, Satan made himself multifariously objectionable and was finally expelled from Heaven. Halfway in his descent he paused, bent his head in thought a moment and at last went back. “There is one favor that I should like to ask,” said he.

“Name it.”

“Man, I understand, is about to be created. He will need laws.”

“What, wretch! you his appointed adversary, charged from the dawn of eternity with hatred of his soul — you ask for the right to make his laws?”

“Pardon; what I have to ask is that he be permitted to make them himself.”

It was so ordered.

HEAVEN, n. A place where the wicked cease from
troubling you with talk of their personal affairs, and the good listen with
attention while you expound your own.

For several years now we have been trying to explain repeatedly that buybacks are in general a bad deal. Jason Zweig looks at the question. That being said, the The PowerShares Buyback Achievers Portfolio has done very well over the last three years. We’ll let that hang there and discuss in more detail later.

Economics proceeds on the assumption of ‘given data’ and produces a beautiful, aesthetically satisfying theory to show how these data determine a resulting order, but [economists] forgot that these data are purely fictitious: the data are not given to anybody. — F. A. Hayek

Ben Bernanke and the Costanza Effect

Yesterday I wrote The Bear Arrives. Then it left in the space of less than an hour. Supposedly it is because a new plan is coming to save the Eurozone. This one seems to require lenders to take more losses. Unsurprisingly some banks are not happy with that idea. Still, we may be getting somewhere. Somebody will need to take a loss. I suggest this interview from Kyle Bass to put this in perspective:

there’s only one way out in my opinion of this debt mess and it’s through restructuring and that means default. It’s not the end of the world. It just means a lot of people are going to lose a lot of money and then we’ll get up the next day and go back to work.

Researchers believe they have found the written form of the ancient Pict language.

UCLA has restored Robert J. Flaherty’s LOUSIANA STORY (1948), a portrayal of Cajun life and the disruption an oil company causes when it enters the bayou.

The Robin Hood Tax is a bad idea, at least as described.

While a recession may be coming, Mark Perry reviews the reasons we are “not experiencing any of the significant, persistent and widespread declines that would lead the NBER to declare sometime next year that the U.S. economy entered a recession in any of the recent months.”

Auto Sales strength should help lead to a weak, but improved, GDP number for the third quarter.

Beware of Market Rallies Ahead

More doubts about leveraging the EFSF

Capital goods orders and shipments remain strong according to Ed Yardeni:

It’s hard to put a negative spin on such strong numbers, other than to note that they looked this strong during the previous two cycles when they peaked and then took a dive. On a more fundamental basis, capital spending is driven by corporate profits and cash flow, which have been very strong. They should remain strong, though both are likely to grow at slower paces through next year.

On the other hand he sees issues for earnings overall going forward, especially in the materials sector.

Odds are that there will be lots of disappointments in the earnings season ahead, most likely led by the Financials and Materials sectors. Of course, the bad news for the quarter may have been discounted already. However, there could also be lots of cautious guidance about Q4 and 2012. Industry analysts are already trimming some of their earnings estimates for next year, particularly in the Financials sector.

Goldman is getting more and more bearish.

The derivatives nightmare:

“What is the gross number and what’s the difference between the gross and the net?” Citi CFO John Gerspach replied: “I don’t think that the gross number is relevant.”

It isn’t? So, we are all supposed to trust that as an industry (really, five US banks) you have a handle on a total derivatives book of 332 Trillion! Seriously? This reminds me of one of my favorite posts from back in 2008, JP Morgan, Lehman and Nightmares:

Personally there are better ways to make money than hoping a company with 90 trillion in derivatives exposure has a handle on it in my book, but then again, I am admitting that I have no idea what I am talking about, and cannot find anyone else who does either.

Warren Buffet often speaks of defining a circle of competency when investing and staying inside it. It doesn’t matter how big the circle is, just knowing when you are inside it. Well, 90 trillion in derivatives exposure is outside of my circle of competency to assess.

The nightmare is what if it is outside of JP Morgans circle?

Personally the idea that Trillions, netted or not, are within anyone’s circle of competency is ridiculous.

Lesson’s from 1930

We are often told that we cannot be about to have a recession because they are always preceded by an inverted yield curve, to which we reply:

  1. Glad to know the Fed can therefore outlaw recessions.
  2. Funny, when we pointed out a few years ago the yield curve was inverted and flashing recession the yield curve wasn’t considered such a great barometer.

Ruslan Bikbov at BofA Merrill Lynch found that a weak argument and decided to adjust for that fact and then tested his method. What do you know, the yield curve is flashing recession.

HSBC says there will be no hard landing in China.

Deutsche Bank agrees forecasting a slowdown to 7% and a drop of 10% in housing prices. However, this interests me:

Readers may ask why we are not projecting a 30% drop in property prices. Those who understand China’s political economy should know that a 15% decline in average property prices in 35 cities within a few months must be accompanied by a range of economic and social consequences. These will include a sharp decline in real estate transactions, a visible deceleration in real estate investments, rising unemployment in the property construction and agency sectors, a further decline in construction material prices, demand destruction due to inventory destocking, and finally a worrying decline in GDP growth and the resulting concern of social stability. In other words, the government will most likely not tolerate a 30% drop, and probably not even 15% in our view. We expect real estate policies will likely be relaxed way before a 30% price decline is observed.

I see, the old “the government won’t allow it” explanation. Maybe, but the idea that we can assume government policy can control the economy is awfully presumptuous. Now that we know that can be done, market and economic realities be damned, we should all just merrily bid stocks up because governments have eliminated business cycles, haven’t you noticed?

Sam Harris on the Future of the Book and how writers need to adapt.

 

 


Further Reading: Monkeys Writing Shakespeare on Flying Carpets Edition

(Cross Posted at Risk and Return)

Bring Out Your Dead-carnage on Wall Street

Dividend cash outs are EEEEVVVVIIILLLL!!!!!

“In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” – Rudiger Dornbusch

Free Markets Work: Bailout Riven Caricatures Don’t- John Hussman conducts a beat down on certain memes.

In an absolutely shocking announcement Greece will not meet its deficit targets. Similarly we are astounded to find out that Madonna is not a virgin.

Via Michael Kitces exactly what do you do to shut down a deceased person’s social media accounts when they die? In Has Your Client Asked: What Happens To My “Tweets” When I Die? we walk through the basic policies for Twitter, Facebook, and LinkedIn to close the accounts out. It even covers how to memorialize a facebook page, so friends can leave remembrances.

Next time you are in New Orleans, I suggest you consider a tour of star bartender Chris Hannah’s favorite places. Oh, and definitely stop by the French 75 and ask for something old, classic and hardly served so he can show his stuff. Maybe a Martinez. Oh, and invite me! Just don’t tell him I called him a star, he would hate that.

The Death of Equities II: Historical Fact Should Inform Our Opinions

Is that bullish? Or is the ‘dumb money” right this time? I can believe either way for now, but longer term I believe we will see this continue until the secular bear ends in a whimper at very low valuations because nobody cares anymore. The stock market won’t be relevant to most people’s lives because they won’t be in it. See 1982.

On the coming war between investment bankers and traders as our banks shed thousands of workers. Footnote three might be missed so we quote it here:

It is also no matter of indifference in today’s environment that when an M&A banker screws up or fails to close a deal, he loses only time and a potential fee. When a prop trader or structured products banker screws up, he can blow a hole in the side of his bank larger than all the revenues earned by all of his compatriots all year. And when a whole industry of capital markets bankers screw up, it can blow a trillion dollar hole in the side of the global economy. Or so I hear.

Have you ever wondered which NFL team is most attractive? No, I haven’t either.

The Danish decide to tax fat. McQ is not amused…okay, in a way I think he is.

Further evidence that risk factors, equity risk premiums and the whole idea that volatility and beta are positively related to return doesn’t work is an anomaly that we have been pointing out for some time. Lower beta and lower volatility and high quality all outperform riskier fare. More special cases for Fama and French to explain away.

We have explained that dividends are the key to understanding stock returns for the market as a whole. Yes, even for growth stocks and other low dividend players. For reasons not unrelated to the discussion above, we will also enjoy pointing out that dividend payers have crushed the market since 2000 and the gap is continuing to grow.

Finally, progress on that whole flying carpet issue.

Can you eat decently at an indecent restaurant?

We see that the global economy is decelerating rapidly, but maybe we will avoid an out an out recession. Gavyn Davies looks at the difference between the hard (slow but positive) and soft data (heading into recession.) The question is how will the gap close?

Doug Kass’ recent bullishness has been fading. To help himself think things through has 10 Questions for the Bulls and Bears. He starts today with the Bulls.

The story of Coca Cola’s stock price in pictures. Key takeaways: Dividends made a big difference. The price went up way faster than profits, and then sat there for 13 years.

Lesson for us? It was too expensive (Buffet has admitted he should have sold) and now after 13 years we believe it is attractive as are many high quality stocks. The rest of the US market? Not so much.

The legendary value investor Jean-Marie Evillard agrees with us that the US is still not cheap, despite claims I heard on CNBC repeatedly throughout the day that stocks were “incredibly cheap.” The kool-aid is obviously still flowing. You can hear his views in this excellent TV interview.

Steve Leuthold is likewise loaded for bear. Lots of good thinking:

For me, one of the long-term tragedies is that the stock market is trading today at a level that we first crossed on the upside back in 1998. I was so bearish then, that had you told me that prices would be unchanged 13 years later, I would not have been surprised. But I certainly would have expected better value would have been re-established in the U.S. stock market by virtue of 13 years of flat action and improving fundamentals. It shows how extreme those late 1990s valuations were.

{…}

Stunningly, Europe trades at 10 times normalized earnings. The U.S. is trading at a 65% P/E premium to Europe. The historical average has been more like 15%. You could argue maybe there should be some additional premium in this environment, given what Europe is going through, but the odds are that this is going to narrow here in the next 12 to 24 months.

{…}

We need to get through this bear market before we start planning for the next bull, but we would expect something fairly similar to what we have just gone through. This was a 26-month run, which isn’t too far off the historical median. We need to disabuse ourselves of this recently adopted notion that bull markets and economic expansion tend to last six to eight years. The historical norms are much shorter than that.

Bill Gross is sounding gloomy:

There are no double-digit investment returns anywhere in sight for owners of financial assets. Bonds, stocks and real estate are in fact overvalued because of near zero percent interest rates and a developed world growth rate closer to 0 than the 3 – 4% historical norms. There is only a New Normal economy at best and a global recession at worst to look forward to in future years.

Bob Janjuah sounds the gloomy tune as well. He sees a lower bottom in October and then a strong rally to 1200 on the S&P with hope in effective government policy driving things upward. Then:

In or within a year from now I expect global equities to be 25% to 30% lower. My S&P500 target for the low in 2012 remains 800/900, and I think an ‘undershoot’ into the 700s is entirely possible. For the valuation-focused, assume S&P 500 EPS in 2012 of $90/$100, and P/Es in the 8 to 9 area – I see this kind of P/E as the new norm in the kind of world we are in. In this bearish outcome I would expect 10-year bund yields at 1% to 1.25%, 10 year UST yields at 1.25% to 1.5%, and 10-year gilts below 2%. The USD should do well, credit and commodities should not.

Via Tyler Cowen: Virtual monkeys write Shakespeare

In the everybody knows the truth whatever it is department, we have this from Frank Stephenson:

Today’s prize goes to John Judis who writes in The New Republic (gated),

“You know, when Herbert Hoover had to face a financial crisis and then unemployment, his strategy was to balance the budget and cut spending …”A question for Mr. Judis: In what world, sir, does spending going from $3.1 billion to $4.6 billion (during a time of deflation no less) constitute a CUT in spending?

This is also a good time to plug Steve Horwitz’s new Cato piece, “Herbert Hoover: Father of the New Deal.”

Finally I cannot recommend highly enough Ken Burns Prohibition.


ECRI Changes Outlook From Slowdown to Recession: Updated with Official Statement at 11:25 AM CST

(Cross posted at Risk and Return)

Okay, I have been sitting on this since Monday, but last week ECRI changed their call from a severe global slowdown to an actual recession here in the US. It was just announced on Bloomberg radio:

He told Tom Keene that a recession is the “overwhelming message coming out of our forward-looking indicators.”

And more ominously: “It is not reversible.”

“The U.S. economy is tipping into a new recession,” he said, adding, “We don’t make these calls lightly.”

He cites “dozens of leading indexes for the U.S.” and “contagion in what is going on among those leading indicators. It’s wildfire, it’s recessionary, it is not reversible.”

The ECRI has been saying since June that a lasting and persistent global slowdown was inevitable and the view has been turning more and more negative. You can see video of Lakshman Achuthan discuss their conclusion in June here, and at the end of August here.

Last Wednesday, the Economic Cycle Research Institute issued its U.S. cyclical outlook, summarized with “Economy on Recession Track – The jury is in, and the verdict is recession.” We look at a lot of things in setting our own expectations, but we’ve found the ECRI to be very useful in confirming or questioning our own conclusions. While the ECRI’s weekly leading index went through a worrisome deterioration in 2010 and concerned us a great deal, ECRI itself never issued a recession warning. Last week, they did.

“Today, we must sound the alarm bells loud and clear. ECRI’s leading indices of U.S. economic activity have turned down in a textbook sequence – first the U.S. Long Leading Index, then the Weekly Leading Index, and finally the U.S. Short Leading Index. Their growth rates are also in cyclical downswings, as are the growth rates of every one of ECRI’s sector-specific leading indexes. Under the circumstances, there is no indication that a reacceleration in economic growth is near at hand.

“In the process of scrutinizing the evidence, we examined every one of these leading indexes to check whether they are in pronounced, pervasive and persistent (three P’s) downturns consistent with a ‘hard landing,’ namely, a recession, rather than a non-recessionary slowdown. After examining the three P’s for all of these leading indexes, we found that the overwhelming majority of their trajectories are currently in recessionary configurations. In practice, such a finding is sufficient to justify a recession call.

“A useful way to summarize the evidence we see pointing to recession is to examine the spread of weakness among the components of ECRI’s U.S. leading indexes of economic activity… In that context, the recessionary decline in a summary measure of numerous reliable leading indicators, coupled with an ominous drop in a broad measure of current economic activity representing facts, not forecasts, constitutes a compelling recession signal.”

We have felt that the chances of a recession were much higher than most not only for now, but as a general feature of the post 2008 crisis US and global economy. At this point we are scratching our heads as to why anyone would assume a recession will not occur in the US and in much of the world economy. While nothing is certain, we believe investors should at minimum consider carefully how much they are willing to see their portfolio decline and make sure their portfolio can stay above that mark should a recession occur.

Update: You can hear the entire interview on Bloomberg Radio here.

Update II: Here is the discussion on CNBC


Abnormal Returns has more thoughts on the call and what it might mean for markets. I think the downside is much further than the average of past recessions due to how far off earnings estimates will be given how stretched profit margins have been.

Here is the official statement from ECRI:

U.S. Economy Tipping into Recession

Continue reading


Further Reading: Cocktails in New Orleans Edition

An introduction to the linguistic peculiarities of the professional kitchen.

Should Larry Ellison and Oracle be running scared?

Can I be replaced by a blogging robot?

We are seeing that fewer and fewer companies are deciding to go public. Professor Bainbridge looks into why.

We keep hearing that Bank Of America can get past its legal troubles over mortgages, and it may well. However, shareholders are still pushing a $50 billion lawsuit over the purchase of Merrill Lynch.

Tales of the Cocktail has a great new site. Yes, I’ll be there again next Summer. I say we arrange a meeting at the French 75.

Albert McMurry gives us the last part of his series on his frist trip to New Orleans for Tales:

It’s said that if you look at New Orleans’ history — founded by the French, occupied briefly by the Spanish and sold to the Americans— that there’s a real sense that we’re simply the latest landlord to sit in the chair, and well after we’re gone, this city will remain New Orleans. JT rightly stated that it is the type of city where you rest when you’re tired, eat when you’re hungry and drink when you’re sober.

That was one of the things I enjoyed about Tales, all the people who had never been to New Orleans, which for some reason surprised me. Thanks for coming Albert. Hope to see you come back soon.

If Japan is a “safe haven” what does that say about the rest of the world? Via Abnormal Returns

The bubbles in China are showing the classic signs of a top. If “Ghost Cities” are not enough, Ponzi schemes associated with investment in them should be. Even more so in that it bubbled up in the shadow banking system.

Is Doctor Copper signaling a global slowdown? What does it say about US stocks? Maybe not much. What about other metals and BRIC’s? I think we are seeing a major slowdown in China developing.

Of course, that doesn’t mean we can’t get excited at opportunities popping up. Russia is getting very cheap!

Willem De Kooning appreciated as an artist and a cultural phenomena

Calpers wonders if it can hit their return target of 7.75% long term. I am dubious without more inflation they can do so.

China may be slowing, but our economy has hit stall speed. Our economy has never slowed to this level and not gone into recession within a year:

Doug Short explains:

As the chart illustrates, the latest YoY real GDP, at 1.6% (revised upward from 1.5% in last month’s GDP estimate), is below the level at the onset of all the recessions since the first quarterly GDP was calculated — with one exception: The six-month recession in 1980 started in a quarter with lower YoY GDP (1.4% versus today’s 1.6%). And only on one occasion (Q1 2007) has YoY GDP dropped below 1.6% without a recession starting in same quarter. In that case the recession began three quarters later in December 2007.

In his 2011 Jackson Hole speech, Chairman Bernanke observed that “growth in the second half looks likely to improve.” Our look at YoY GDP percent change suggests that we must indeed see stronger second half growth to avoid the recession that now appears to be a definite risk. If Q3 real GDP shows a continuation of the current trend, the NBER will likely pick a month in Q2 as the beginning of a new recession.

While overseas stocks are looking cheap there is nothing to suggest that they are not risking going lower. Many countries, including the US, are at risk of recession or severe slowdowns. All are well below trend from a long and intermediate term trend following standpoint. Dow Theory says stay away and the behavior of leading stock indicators, is bad. The Shanghai is still leading on the way down and High Yield funds are breaking support.

The Dow Jones and the S&P 500 joining hands?

I am not sure how I missed it, but did you know there is a controversy at the University Wisconsin-Stout over a Firefly poster?

Albert Edwards is still maintaining his long held projected bottom of 400 on the S&P500. Now that is even lower than I have ultimately expected. But hear him out! He also has held since 1996 that ultimately the 10 year treasury would end up at 1 1/2%. That was, and until this year, had seemed even more outlandish, but here we are:

Jeremy Grantham of GMO says this is “no market for young men”. Maybe now I am over 50 it is my time! Yet my forecast of the S&P bottoming at 400 is still met with utter derision. I have been underweight global equities since the end of 1996 and overweight government bonds. Meanwhile US 10y bond yields have fallen from 7% to 1¾%, a hair’s breadth from our longstanding 1½% target. Similarly, in my very humble opinion, S&P at 400 is almost inevitable.

I suggest reading the rest (it is short) but there is good news. The long standing bear promises to be a bull when that happens.

On the other hand Cullen Roche is more optimistic:

  1. This is a household balance sheet recession in the USA and not a corporate balance sheet recession as was experienced in Japan. Because their corporations were so excessively indebted their equity market remained weak for many decades as companies paid down debts rather than focusing on profit maximization.
  2. US corporations remain incredibly diverse and their broad global footprint has allowed them to remain profitable even during this historic downturn.
  3. US corporations have cut costs massively and are already experiencing close to no growth in domestic revenues. Without a massive collapse in foreign revenues corporate profits are unlikely to experience a decline that would warren stock prices at the 600 level as the Japan comparison might imply.

In short, without some sort of unforeseen catastrophic event in China or Europe I find it hard to believe that stock prices in the USA will follow the Japan story down to the 600 levels…..

I tend to be in the middle of them on this, between 600 and 700 (or its inflation adjusted equivalent) sometime in the next five to seven years, but I’ll adjust my expectations as needed. Either way, the risks are high.

Rather than debating if there will be a recession in Europe, economists are now trying to figure what it will look like and how long it will last.

Josh Brown has a great interview with Jeffrey Gundlach. I especially like this:

On Stock Dividends Being “Higher than the Yield on a Ten-Year Treasury”: he says this is nonsense because there is no risk parity between a stock and a Treasury bond, he says you have to look at this comparison on a volatility-adjusted basis or not at all. For example, If the yield on the ten-year bond doubles overnight from 3 to 6%., you’ve lost about 20% of your principle – but if Microsoft’s yield doubles from 3 to 6% overnight, you’ve probably lost 50% of your principle. Apples and oranges.

We will just repeat ourselves, those using the yield versus treasury argument to tell you stocks are cheap are dangerous to your wealth.

They are still trying to ban shorting, and banks are still declining.

Tyler Cowen on leveraging the EFSF has some of the same issues as I do:

I’ll repeat this link for background. I would feel better about the idea if the context were: “We can always go back to the trough, but leveraging the fund is the easiest way for us to strike quickly and decisively.” Instead I see too much of: “We can’t get any more from our taxpayers, so we’d better stretch this one as far as we can.” That’s just inviting the speculators to set up camp against you.

Who will fund the leverage? BRICS? American investors? Ultimately other Europeans? All of those parties already can construct their own leveraged positions in Italian government debt, if they wish. So presumably the leverage will be a hidden subsidy to the financiers, one way or another, to get them to participate. Subsidizing the debt buyers, rather than guaranteeing the debt (admittedly that may be impossible and undesirable for Germany), hardly seems like the way to go. You bear the costs of the bailout without any assurance it will work.

This German-language video suggests many of the German representatives do not know what they just voted for.

You’ll find lots of good comments on Twitter, and here. How about this take?:

“Germany voted for the EFSF extension. Greece celebrated by going on strike.”

Of course, we don’t know if Slovakia will even approve the EFSF. Yep, the grand dreams of Euro stability hinge for the moment on Slovakia.

The Vienna Vegetable Orchestra?

 


Musings, Rants and Links over the 18th Fairway:03/16/2010

The French Finance Minister has noticed that the disparities within the European economy are causing a number of issues, and fingers the….Germans!

“Clearly Germany has done an awfully good job in the last 10 years or so, improving competitiveness, putting very high pressure on its labour costs. When you look at unit labour costs to Germany, they have done a tremendous job in that respect. I’m not sure it is a sustainable model for the long term and for the whole of the group. Clearly we need better convergence.”

You see, having an economy so efficient that you can be more competitive than your neighbors with high wages and a high standard of living means you need to change so that the French, Greeks and other assorted PIIGS can continue down the path they have chosen. The Germans are just too darned efficient for the greater good.

In the interest of being helpful I have identified several important initiative’s that the Germans should adopt to align themselves more fully with their neighbors.

  1. Do not keep your debt levels below 3% of GDP…ever.
  2. Encourage massive strikes at the drop of a hat.
  3. Make public services far more attractive than working in the private sector, with massive  strikes and riots to keep it that way.
  4. Make it almost impossible to layoff anyone for any reason.
  5. Mandate at least six weeks paid vacation for every employee.

That should make sure your economy is not too efficient.

Is China’s economy about to rollover?

I won’t explain this, just let it sink in:

I don’t think it will be as bad as Japan, but the evidence isn’t giving me any great comfort either.

I love Apple, and I love my iPhone. Still, is Apple really worth more than Walmart? Or these various baskets:

  • 4x the global smartphone market
  • 5x the global music market
  • 100x the global smartphone app market
  • Enough to buy HP, Dell and Hitachi, with mad money left over for Xerox or Seagate

Yep, that whole efficient markets hypothesis may take a beating again.

Did any of you see Michael Lewis on 60 Minutes Sunday? If you didn’t, I highly recommend it.


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Watch CBS News Videos Online

Cross posted at The View From the Bluff


Musings, Rants and Links over the 18th Fairway: February Housing Edition

On the heels of last weeks delightfully mixed bag of employment data (job creation looks like it may be out of reverse and into neutral) we get some new housing data. There the signals are more disquieting, if expected (at least by me.) The housing market may now be heading back down.

The interesting aspect of this is that so many people see this as unlikely. So let us list some reasons why this is a real risk, if probably not as rapid a fall as we saw previously.

  • Prices are still above a long term stable level. This could be taken care of by stagnating prices and inflation, but there is little inflation right now.
  • The price to rent ratio is out of whack, and rents are still falling, in fact, accelerating. Little wonder, since there is an 11% vacancy rate.

Source: Gary Shilling

  • There are 231,000 newly built housing units sitting vacant.
  • There are 3.29 million vacant homes for sale.
  • Then there is the shadow inventory of homes that are off the market for various reasons (such as foreclosed homes banks are unwilling to sell yet to avoid realizing losses.)
  • Defaults are accelerating, with the largest source of pain now prime loans. As I have maintained for a long time this is not, and never has been, a subprime problem. Subprime was just what collapsed first being the weakest link in the housing market.

Source: Gary Shilling

  • That acceleration is unlikely to slow any time soon as not only are workers still losing jobs and few new potential owners getting jobs, but the length of unemployment is unprecedented in the post war era. The longer a worker is unemployed, the more likely they are to default.

Source: Gary Shilling

  • Lending is still tight for many mortgage seekers.
  • We are forming households at a reduced rate, thus lessening demand for new homes.

Source: Gary Shilling

  • More than 20% of homeowners are currently underwater. Nothing correlates more closely with default rates than negative equity.
  • Worst of all, we need to revisit an old topic of mine that is no longer a longer term risk, but right around the corner. The likely huge wave of defaults represented by Alt-A and Option Arm Loans about to reset. Defaults have followed with a lag each wave of resets, and the largest wave, from the era with the worst underwriting is about to hit. Notice, subprime is receding. With the system as fragile as it is now, what will this wave bring on?

I always am nervous about calling anything a prediction, but further housing deterioration is a very grave possibility.

Needless to say, this has led to further problems at Fannie, Freddie with more to come. Not that you should be concerned about that, the mission has changed. On their way to probably 400 billion in losses (I remember when I was an alarmist claiming that the losses would be far more than the 20-30 million the government was claiming, probably 200 billion. It turns out I was a cockeyed optimist) the government has officially eliminated any limit on their exposure. Why? It seems to be so that they can take losses!

Freddie’s federal overseers nevertheless have instructed Mr. Haldeman to focus on something that isn’t likely to make the bleak balance sheet look any better: carrying out the Obama administration plan to allow defaulted borrowers to hang onto their homes.

On a recent afternoon, employees at Freddie’s headquarters here peppered Mr. Haldeman with concerns about the company’s future. He responded that they were “fortunate” to have such a clear mission—the government’s foreclosure-prevention drive. “We’re doing what’s best for the country,” he told them.

Then there is the poor FHA:

FT Alphaville is certainly in the skeptical camp referred to by Ms Burns, and we were not reassured when the housing agency released its December monthly report on Tuesday.

According to the report, the default rate in the FHA’s single-family portfolio hit 9.12 per cent in the fourth quarter of 2009, compared with 6.82 per cent in the same period a year prior.

In absolute terms, that means the number single-family mortgages insured by the FHA and in default reached 531,671 in the fourth quarter of 2009. That’s a 66 per cent increase versus the same period in 2008.

The agency is being hit hardest by the 2007 and 2008 mortgage vintages; the performance of these loans is so dismal the FHA expects to have to pay claims on at least one out of every four loans made in those years.

Cross Posted at: The View from the Bluff

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