Saturday, February 21, 2009
Is it any wonder entrepreneurs and investors are worried about an Atlas Shrugged scenario and holding off on action and investment while the rules keep changing? I defy anyone to find one truly stimulative action in his plan, one action that communicates to someone ready to put time and money at risk that in some measurable way incentivizes the kind of entrepreneurial risk taking that powered us through the 80s and 90s after the last economic disaster brought on by government fiddling in the 70s.
True leaders look forward and enroll the country's collective imagination not on a vague concept of hope, but a concrete vision of the future. Kennedy had the space program. Reagan had the unabashed embrace of the virtues of capitalism that he shared with the world like a man on a mission (something we haven't truly seen since the Clinton years, despite the rhetoric). Yet Obama seems to want to define himself by what he's not going to be, not going to do. I'm not going to claim McCain would have done a better job at this point - his best days of leadership were clearly behind him and while I think he would have and should have been where W was, he blew his opportunities; his time has passed. But if we're never going to define what "Hope" really is, what's the point?
A true leader identifies the core problem and then looks for the fastest way to fix it. Once that's identified, the problems with that approach appear and mechanisms to address fairly the side-effects of the fast fix are considered. If reasonable mechanisms are available, then he rolls out the full plan. In this case, housing prices need to bottom to a level that attracts investment and the healthy kind of speculation--and the fastest way to get there will pile a lot of extra stress on the financial system in the short term. Those who can afford their payments can stay. Those who can't need to be able to go through a bankruptcy process (perhaps under another name) very quickly so they can buy again as soon as they're able. In the mean time, we need to allow banks and their equity and debt holders (who are generally citizens as well) to preserve their long-term interests while accelerating the short-term declines in housing values.
If we go straight to bankruptcy we risk unraveling the whole system, so the hardest part may be the conversion of equity and debt in failing institutions to equity in reconstituted institutions at a level proportional to the prior stakes they held. Forcing any one stakeholder to lose their share entirely for the greater good is a recipe for chasing private capital out of these institutions permanently so we must find an alternative at all costs lest we find the blood of the death of capitalism on our hands.
Is this a hard thing to do? Absolutely. But the alternatives are all much worse and until now it seems this belief among the political class that their actions are not jeopardizing capitalism (because their ends are well intentioned) won't be challenged until it's too late. So when folks like Rick Santelli on CNBC make an understandable rant about the mortgage plan that clearly hit a nerve, you get responses like this that paint a picture of a condescending and tone-deaf Obama administration claiming we are just don't understand their program because the ends justify their means. Bollocks. He's administering painkillers in a way that will arbitrarily create winners and losers, rewrite the rules midway through the game, and curtail any healthy economic speculation that creates jobs and entire industries to the sidelines while we figure out how to play the new game.
Like everyone else, I'll adjust my behavior to account for the new rules but in the mean time I'm going to be even more cautious about spending and new investment even while I consider extreme actions with my own obligations that might have been unthinkable when credit was so easy to get. The more likely the rules will change, the more comfortable the players get with pushing the envelope in ways that further stress the system. Instead of letting patience and time do their work, we add more perturbation until no stakeholder is left with hope. Eventually, desperation for stability in waters made more choppy by bad leadership enables the crowd to consider sacrifice the very essence of capitalism they used to hold sacred for the false hope of government mandated stability that has ended poorly in every society that has tried it.
Saturday, February 7, 2009
What's amazing to me is how viable this model looks as a predictor. If the SPX bottom continues to hold, we would exit the offical recession about halfway through the year when unemployment peaks at 10% but from here we eventually rally to 1100 on the SPX and end the year up slightly with a pullback to 1000. During 2010, we would reach a short term peak at around 1200 that will stick for the latter half of next year but begin a slow slide back to 1000 by 2011, kicking off a tumultuous trading range during the next 5 years that sees the market swing down toward 850 up to 1050 in several waves until finally bottoming at 800 in the latter half of 2014 when we enter another brief recession as the Fed is forced to raise rates amid early signs of inflation. We get a false start in 2015 with what at first appears to be a rapid recovery as we briefly break 1000 again only to kick up the massive inflation we had expected all along.
Stagflation takes hold as we're forced to use high interest rates to keep inflation in check, sacrificing growth in the process and putting us into a final 24-month recession in which we finally breach 800 and continue further downward, ultimately bottoming in the 700s and reaching 12.4% unemployment before exiting even more dramatically than we did in 2009 as the 2017 bull market takes hold. After an uncertain 2018, the bull market resumes with force in 2019 when we retake 1400 for the first time since 2008 and during 2020 we finally celebrate new highs and reach SPX 1600 amidst enormous economic expansion.
If we successfully make the turn Monday, successfully stave off the temptation to nationalize banks and increase trade barriers, then I think this is this is about as close a predictor of what comes next as we could hope to assemble right now. If we fail on Monday and revisit 800, then I'll put the 30s re-run together (shudder). Let's hope it doesn't come to that.
- "You Reap What You Sow"
- "What Goes Around Comes Around"
- "To every action there is an equal and opposite reaction."
(Newton's Third Law of Mechanics)
- "Energy can neither be created nor destroyed. It can only change forms." (The First Law of Thermodynamics)
- National Debt and Treasury Yields: The full effect of Reagan-era tax cuts wasn't felt until the wave of investments that followed turned profitable during the Clinton era, but the few short years of budgetary surplus that followed were followed immediately by profligate government spending that is only going to increase sharply in the near term so long as it can be repackaged as "economic stimulus" by the legislative and executive branches. For nearly all of 2008 as the credit crisis deepened, fear drove a flight to quality in the form of US Treasury Bonds, pushing yields down to historic lows and effectively granting us a limited-time opportunity to borrow at near-zero rates. While the Fed has been talking up the notion of "buying Treasuries at the long-end of the curve" the reality is that the best they can hope for is a smooth rise in yields as risk appetite returns and Asian investors demand higher returns for T-Bill investments. ETFs like TBT and PST are the most convenient ways for retail investors to capitalize on rising yields (but keep in mind that because they are 2x levered instruments they should be looked at as a short term trade rather than a long-term holding), and a strategy of buying on pullbacks and selling on yield spikes has rewarded patient buyers nicely each time so far this year. With tax revenues likely to be down substantially in the near term even as government spending spikes, there's so much inevitability to this trade that your timing doesn't have to be perfect to exploit it. Unfortunately, the flip side to this inevitability is that eventually tax revenues, inflation, or both will need to increase sharply by the end of the decade to reach equilibrium again.
- Deflation and Inflation: Apart from the commodity bubbles that mostly popped last year (Gold is the stubborn exception but as I've discussed before that collapse in the near term is inevitable as it can't avoid at least a partial failure to live up to all the supernatural qualities ascribed to it--assuming governmental response is at least minimally comprehensible), we've seen significant deflationary pressure pop up in the global economy since at least the tech collapse in 2000 (and some would argue since the early 90s when Japan's asset bubble popped and the first large fed funds rate drop helped create the overheated tech bubble in the first place, but the exact timing isn't as important as recognizing the broader trend here). At this point, it's entirely rational to believe that the aggressive Fed response that lowers its fund rate to effectively zero will inevitably result in some inflation down the road. Absent any extreme shock treatment that would chase out all foreign investment in T-Bills and drive the yield above 20%, the soonest we would see signs of that inflation is 2010 and if history is our guide it will be more like 2012 or 2013 before real worries set up. Because of this lag time, any investor looking for an inflation hedge right now should consider investing directly in Treasury Inflation Protected Securities (TIPS) or in related ETFs like TIP which both offer long-term inflation protection. Most 401(k) plans offer access to TIPS auctions and secondary markets as well. Although there are no guarantees we've reached the bottom for commodities like oil and natural gas, those with more risk appetite may want to consider scaling into ETFs with exposure to the oil and natural gas stocks that have been beaten down to historic lows. I've been playing to the inevitable recovery in this sector via the United States Natural Gas Fund (UNG) and ProShares Ultra Oil and Gas (DIG) which is 2x levered so it's more of a trading vehicle than UNG, but there are lots of other ways to play the "reflation trade" that are much less risky than gold. Eventually, inflation will set in and these commodities are nearly always among the first to reflect it - accumulating exposure to them as they hit new historic lows is a great way to exploit the deflation/inflation cycles that are playing out now.
- Government interventions with large financials: As we've seen with the TARP program and its offspring, including the new program to be unveiled on Monday by Treasury Secretary Tim Geithner, the temptation for government to change the rules of the game with little warning has proven impossible to resist thus far--and the resulting uncertainty has sent so many investors to the exits that even the most healthy financial institutions have taken a huge hit in stock price and private investment that might have stepped in has been sidelined. If Monday's news is followed up with reinforcing actions that let investors of all means feel confident in what boundaries will be respected by future government action, it may finally be possible to rally from here as all the sidelined cash gets finds solid reasons to get back in the game. So much damage has already been done via backtracking and rules-changing that it will take an enormously focused effort with a strong spokesperson and a track-record of action that passes more than a few public tests before snakebitten investors will return. That's led to some historic if highly speculative buying opportunities and while I'm willing to incur fairly heavy losses along the way, I'm not going to make specific recommendations right now except to say that buying a few shares of beaten-down stocks in a few financials could be immensely profitable over time. Spend only what you're willing to completely lose, and don't bet it all on one name. My most speculative bet right now is on Citigroup (C) and my biggest return so far is on Barclays (BCS) where I'm currently sitting on a gain of well over 100% from a small purchase on 1/23 at the height of British bank nationalization fears. I'm nowhere near breakeven at this point, but I'm well positioned to exploit the coming move over the next year from capitulation/despondency/depression to hope/optimism as we swing back upwards again on the wave action that results from the psychology of asset cycles (I like Jeff Bernstein's model the most, but there are lots of others that are similar). It's quite possible that Friday was the final turning point out of the bottom, but we won't know for sure until bank stocks have already risen 5x from their lows and will take may more years before handing out the next 500%. The fact that so many financial CEOs last week have talked about how quickly they want to get out of TARP is a good sign that we may be nearing the end of the intervention - let's hope Monday's plan is the last news on the subject for rest of the year. If it isn't, the 1930's cascading crashes scenario will be all but inevitable. I'm rooting for a response that bears more resemblance to the 70s - ugly but more sideways than up or down. It's more tradeable, and eventually a combination of high interest rates and inflation signals its exit to begin the next real bull market that by about 2020 or so will finally take out (on an inflation-adjusted basis) all the highs set in 2007-2008 regardless of whether we have a 30s scenario or a 70s scenario in the interim)
For those that are willing to scale into and stick to bets on what we all know is inevitable eventually, the long-term reward for speculation on the date and price at which an asset class has reached at the height of market pessimism will will be huge but it will be commensurate with the risks that must be taken to make the investment and stick with it. Perfect timing is unlikely and patience will be sorely tested until the bearish traders working against you capitulate after the sentiment turn is finally identified. Wyckoff suggests the last stage of accumulation is a final drop that shakes out the weak longs and fatally traps the remaining short interest and Friday's action is the first time I've seen that king of pricing action sustain a full trading day since the start of the year. A confirmation of that action again on Monday might finally take us to the end of Phase B and into a clear "Creek" that stays confined within a much narrower trading range until the final plunge down and spring, which I think are likely to coincide with the next round of quarterly earnings reports in April. Buying that bottom will be hard to do until that final bear trap has sprung and pricing action has gone up from the massive short squeeze that follows, but as long as Obama's administration resists the temptation to change the rules again, the spring will work just as it did last week, with bearish pessimism driving double-down denial until the upward momentum is inevitable again just as the downward momentum became inevitable last spring to those who were paying attention.
Sunday, February 1, 2009
- Stable financial systems: do banks have the faith of depositors, is bank-to-bank lending taking place, and are solid creditors receiving loans? In general, the answer is yes, however there is a great deal of unrest among financial investors, who have pushed common stock to new lows amid concerns that underperforming "toxic" assets will fail at much higher rates than loss reserves could cover. The fear is that common stock holders would be wiped out if the government were to force issue through nationalization, although I have not yet heard a credible argument for why either the government or the struggling banks themselves would want to go there.
Note: I don't think it's good enough to say the market won't recover until we know the full scope of the losses - there's a kind of Heisenberg uncertainty principle here and the cost of getting a full accounting is that it can only be done by forcing the sale of those assets at the lowest possible price and thus guaranteeing the failure of the institutions that hold them, which will have massive systematic ripple effects throughout the system at the worst possible time -- forcing a bottom at any cost is a guarantee of failure at so many levels that we will have no choice than to follow the 1930s pattern (downward cascades eventually followed by upward cascades that get us back to the same starting point) when I think the 70s pattern (ugly and drawn out but range-bound) is still playable.
- Free-flowing global trade: at the moment, no major new trade barriers have been thrown up. We know from history that new trade barriers were a major factor in making the depression worse than it would have been in the 1930s. However, political pressure for "buy American" clauses in infrastructure spending and similar pressures abroad are laying the groundwork for new trade barriers that would almost certainly harm any recovery.
- Long-term incentives for investment, growth, and job creation: In addition to huge trade tariffs, the imposition of significant new taxes helped dry up business investment in the 1930s as the rewards for risk-taking became further limited by confiscatory taxation. Already we're seeing understandable anger at executive compensation starting to lead to new legislative proposals around compensation and taxation that if not carefully written may have the unanticipated side effect of discouraging new investment right when we need it the most. And other legislation aimed at preserving or creating new jobs may backfire if it ends up distorting investment decisions in the short term in ways that do not lead to long-term profitability that can be sustained over time.
- Clear and effective regulation with consistent enforcement: If everyone knows the rules of the game and they are enforced, long term investment decisions can be made and executed. If the rules are constantly changing and enforcement practices are constantly in flux, investors will avoid placing their capital at risk. Unfortunately for us, the rules of the game are not only changing but it's far from clear when and how they will eventually settle down. Obama appears to be willing to keep changing the rules until the game is going the way everyone wants, all but ignoring the fact that communicating that stance to investors is akin to telling investors he does not have their back if they are decide to take risks and make long-term commitments--and virtually guaranteeing the downturn will take longer to play out as a result.
Bottom line: the early successes in responding to the credit crisis and great disruption will mean nothing if Obama succumbs to the temptation to nationalize banks, add new trade barriers and taxes, and in general keep changing the rules month-by-month. Failure is still very much an option, and given the dysfunctional nature of American politics over the previous decade I would suggest that failure is the default option right now. If Obama steps up as a leader this month and stays consistent over time, we're looking at a 70s scenario - ugly but manageable. That's as good as it can get, folks. Otherwise, we're dealing with a 30s cascading crashes scenario that we won't be able to exit until we're united by a bigger cause -- and we can only hope that's not more war like it was for FDR.