I have been reminded with great frequency over the past few months of the accuracy of that old Chinese curse, “may you live in interesting times”. Those old Chinese, and presumably the younger Chinese, knew a thing or two. Well, at least from the perspective of the poor writer, there is no shortage of subject matter!
As I sit here in late March, it is now generally acknowledged that we are in the worst bear market/economic crisis since at least the 1930s. Some people are starting to say the worst ever, which remains to be seen but is less hyperbolic than it once seemed. Whether we are at the beginning, middle, or towards the end of this crisis is a matter of debate, although only the most blithely optimistic would say that we are anywhere near the end of it.
The big problem is that it’s, well, a big problem. No one has ever tackled a problem of this magnitude before. The closest would be the Japanese economic crisis of the late 1990s triggered by a collapse in real estate prices which caused widespread bank failures (sound familiar?) and their solution didn’t work so well, taking over 10 years before any real recovery. We may learn from their example, although it’s not clear that our solution will be any easier or any quicker, as our economic problems are even more profound.
Our current focus is on fixing the banks. This is both necessary and appropriate. Without a working banking system, we have no credit and without credit, we have no economy. Fixing it will not be easy, and it will not be cheap. Even if it happens quickly (and it may not), there will remain a number of other problems which will have to be fixed before the American, or world, economy, can return to any semblance of normal. These problems include the housing market (remember…where this all started), commercial real estate, credit card defaults, the federal budget deficit (accumulated and ongoing), and dealing with the enormous increase in our money supply.
Any one of these problems is potentially as serious as the savings and loan “crisis” of the early 1990s. At the time, that was viewed at the time as the worst financial crisis since the Depression…oh, how life would be easy if that were the extent of our problems now!
Let’s not fool ourselves. There is no guarantee that anything the government is doing right now is going to “work”, if by work one means restoring the economy to its previous health. Remember that the reason that we’re in this mess is because a bubble in real estate values collapsed, causing enormous losses to both owners and lenders. Unless real estate prices return to 2006 levels – which is, in the short term, out of the question – the problem does not go away. The best anyone can do is hope that (1) it doesn’t get a lot worse (through some sort of foreclosure mitigation program) and (2) the spillover to the rest of the economy is limited…which requires recapitalizing the banks.
Everyone needs to recognize that the scope and size of these problems is beyond anything that has ever been experienced before – and recognize that solutions are not easy, not quick, and not obvious. There is a tremendous push from public and press to “do something”. The people in the administration are smart and hard working and trying to do what they believe to be the right thing. That does not mean that they will always do the right thing. Since no one really knows right now what the “right thing” is, that should not come as a surprise. Some things they try may not work or even make things worse.
If Congress continues to be focused more on posturing and sound bites than on actually fixing the problems in a bipartisan, intelligent, and cooperative way – not, unfortunately, its usual modus operandi -- it can ensure that whatever the administration is trying to do will fail.
There are going to be unattractive consequences of whatever the government undertakes. Rescuing a bank, or an industrial corporation like GM, means that its executives fail to suffer the consequences of their poor judgment. Rescuing overcommitted home buyers rewards them at the expense of people who bought within their means, or didn’t buy at all. It is distasteful, even maddening, to contemplate rewards to the undeserving at taxpayer expense. However, the alternative…punishing every corporate executive and every borrower and every lender that exhibited poor judgment …means that the virtuous among us wrap themselves in self-congratulation while the economy goes down the drain. Cutting off your nose to spite your face, my mother used to call it.
Even if and when the banking sector gets back to business, the economic landscape of America will change in a profound way. For too long, America’s economy has been fueled by a manic orgy of buying fueled by borrowings against home equity and credit cards. Those days are over. The new American economy will be more sober, more restrained, and more sustainable. It will also be less profitable for manufacturers and (one hopes!) more profitable, in the long term for lenders since loans will be based on realistic views of income and asset values. What this means for long-term profitability of banking and industry is impossible to say at present.
I do not know how long it will take to fix these problems, or what it will require, or what America’s economy will look like at the end of it. I do know, with a great deal of certainty, that whenever and wherever we end up, the American economy is not going to look the same as it looked in 2005. This may not be a bad thing, as there were lots of unhealthy activities going on then (as we now recognize).
No matter how it ends up, there will be a great deal of uncertainty about the investment and economic outlook for months, and perhaps years, to come. Uncertainty means volatility and volatility means risk. Because of our view that the uncertainty in the market will be lasting and significant, we have taken a very conservative position with respect to US equities. This does not mean that we doubt that there will ultimately be a recovery, but that we recognize that we are in a very long and very dark tunnel. While there will inevitably be some light at the end, it may take us a very long time to emerge from this tunnel and we are not exactly sure where we will be when we come out. Until we have more certainty, we would prefer to err on the side of caution.
Fixing the problems that lie ahead of us will represent a marathon effort. To those who have become addicted to the quick fix and the easy answer, there is bound to be much disappointment ahead. To conquer all of these obstacles will take more time, more resolution, more strength, more will, and more cooperation than anything this country has undertaken since World War II. Be prepared.
Sunday, March 22, 2009
Tuesday, March 10, 2009
Economists gone wild
My friend Bill, who is himself an economist and a good one (and who does not try to predict stock market movements) sent me the following link to something put out by a couple of Stanford economists which is one of the more ridiculous things I have seen in this cycle.
http://www.voxeu.org/index.php?q=node/2785
Basically, these two guys postulate that "uncertainty is now falling" and use as evidence of that the fall in the VIX from its spectacular heights of October/November to a much lower number. There are, however, a number of serious flaws in their argument.
First, while they are correct that the VIX is down by 50% (or was when they wrote the piece in late January...it has now gone up again) it is still very high by historical standards. It is presently at a level that is roughly equal to the worst of any previous economic crisis in living memory. While it is an improvement, true, it can hardly be heralded as the end of uncertainty.
There is no demonstrated correlation between the level of VIX and the direction of stock market movements. If everyone (correctly or incorrectly) believes the stock market will move down, then the VIX will be quite low. Where there is consensus, the VIX is low. The VIX rises to high levels only when the consensus proves to be terribly wrong (as in October 2008 or October 1987 -- AFTER the crash).
The VIX says nothing about the economy, only about implied stock market volatility. There is nothing to suggest that consumer spending or corporate earnings is going to improve meaningfully or that the unemployment news is going to show any improvement. With no major improvements in employment, earnings, or consumer confidence, there is not going to be much improvement in stock market levels, VIX or no VIX.
http://www.voxeu.org/index.php?q=node/2785
Basically, these two guys postulate that "uncertainty is now falling" and use as evidence of that the fall in the VIX from its spectacular heights of October/November to a much lower number. There are, however, a number of serious flaws in their argument.
First, while they are correct that the VIX is down by 50% (or was when they wrote the piece in late January...it has now gone up again) it is still very high by historical standards. It is presently at a level that is roughly equal to the worst of any previous economic crisis in living memory. While it is an improvement, true, it can hardly be heralded as the end of uncertainty.
There is no demonstrated correlation between the level of VIX and the direction of stock market movements. If everyone (correctly or incorrectly) believes the stock market will move down, then the VIX will be quite low. Where there is consensus, the VIX is low. The VIX rises to high levels only when the consensus proves to be terribly wrong (as in October 2008 or October 1987 -- AFTER the crash).
The VIX says nothing about the economy, only about implied stock market volatility. There is nothing to suggest that consumer spending or corporate earnings is going to improve meaningfully or that the unemployment news is going to show any improvement. With no major improvements in employment, earnings, or consumer confidence, there is not going to be much improvement in stock market levels, VIX or no VIX.
Wednesday, February 25, 2009
Outlook for 2009
There is, of course, tremendous uncertainty about what is going to happen to the economy and the market over the next 3, 6, 12, 24 months. How far things will fall is unknowable. I believe it is generally recognized that the economy will get worse, perhaps much worse, before it gets better. How that gets reflected in the market is an open question and one that I am not going to attempt to answer here.
The point I am trying to address is not how far things might fall, but how far they might rise if and when they do. My belief is that because of profound structural, psychological, and behavioral changes, we are not going to return to the profit levels of 2005-06 in the foreseeable future. I think that when earnings and the economy return to “normal”, earnings will look much more like the late 1990s than like 2004-2005. This has fairly profound implications for what one can expect in terms of a stock market recovery.
Let me put out a series of observations which have led me to this rather unappetizing conclusion.
(1) There will be no good news in housing for a while. Prices continue to drop precipitously despite ample financing available for qualified buyers, at least at conforming levels. Current price declines have not been enough to attract new buyers into the market in any quantity. Buyers are still likely to hold back given the uncertain employment outlook. Government policy, if effective (a big if) is targeted at reducing the rate of foreclosure, which might reduce the rate and amount of further declines but will not bring prices up from current levels. At best we can hope for a bit of stability at current levels. Given employment trends, however, the supply of distressed housing coming on the market is likely to exceed or approach absorption.
(2) Even if housing stabilizes at current levels, that means that the effects on lending institutions and personal wealth is permanent. Many large lenders are technically bankrupt and being supported by the US (and UK) government. How this affects future lending is unclear but can hardly be positive.
(3) The effect of defaults on consumer debt have not yet been fully felt. The consumer debt market is twice the size of the subprime mortgage market. Even if defaults are much less than the 20% on subprime mortgages, that is a large additional hit to bank balance sheets. Also, expect much more careful underwriting of both mortgage and consumer debt with more appropriate risk premiums (read: higher interest rates for many borrowers).
(4) Unemployment is sure to rise. The latest figure was 7.6% or about 11.6mm people out of work. As of January 09, this included 3.7 mm people who had been unemployed for 5 weeks or less, so the number is rising rapidly. Generally economists are suggesting that the number will peak at 9% or 10%…today Goldman said that its previous prediction of 9% in the 4th quarter could be realized much more rapidly than it had expected. Unemployment of 9% would represent another 2.2mm people out of work, 10% would be another 3.8mm.
However, those statistics do not count 7.8 mm people who are involuntarily working part time because their hours have been cut back and 2.1mm people who are no longer counted because they have given up looking so the statistic is much worse than it looks. If you counted 50% of the underemployed and all of the discouraged workers, the unemployment rate is likely to peak at about 14% or 21 million people out of work. This does not take into account the effects of the bankruptcy of one or two of the large auto makers, which seems more likely than not.
At the very least, it is now expected that another 2-3mm people will be out of work at the peak. Much of what I have read does not anticipate any significant improvement in this until 2010 at best. Job losses are quite likely to send the personal finances of the affected people over the edge and cause another wave of loan defaults and restructurings if not personal bankruptcies. Again while I do not know whether this drives house prices down further, it certainly puts a damper on their ability to rise.
(5) The US is a largely consumer driven economy and consumer behavior is likely to be massively affected by (a) losses of home equity wealth (b) losses in stock market wealth and (c) potential fears about job losses. There are few consumers who are not affected by at least one of these three. As I have mentioned in the past, I believe the most obvious effect will be that consumers will generally postpone non-discretionary large ticket purchases (cars, electronics, consumer durables, travel, home remodeling, and so forth) and reduce spending on items that cannot be deferred. How much is unknown. Certainly spending fell off a cliff in December and there is no obvious reason why it should revive any time soon.
(6) The decline in discretionary spending means that those people who do have jobs will dramatically increase their savings rate (including savings of whatever they get through the planned government stimulus bill). Long term this will have a positive impact on the economy but we are not concerned with the long term at the moment. It will be interesting to see whether short term reductions in spending on discretionary items translates into a changed mindset on the part of the US consumer toward more long term savings, which would be helpful to individuals and probably to the health of the economy over the next 30 years, but is not going to speed up this recovery.
(7) I have no reason to believe that the current administration programs will have much of an effect on the above. At best the spending will reduce the rate at which unemployment increases. The tax cuts, which amount to nearly 40% of the program, will go straight into savings given people’s lack of propensity to spend.
(8) To summarize my expectations, they include: no recovery in housing prices, less readily available consumer credit, and no recovery in bank capital all leading to lower – probably much lower – consumer spending. Lower consumer spending leads to lower corporate profits.
How low? Of course it’s hard to say but let’s look to history for some realistic numbers. Things have fallen so fast that it’s hard to annualize from where we are now. For the full year 2008, SPX earnings were $65.39. Of course things weren’t so bad at the beginning of 2008, compared to now. In 2006, they were $87.72. Data can be found here.
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/spearn.htm
Again, my point is not to predict a low point but to come up with a “normal” number once the recovery actually happens. My thesis is that the “good times” of 2006 are not coming back any time soon. We are going to have tighter credit, high unemployment and underemployment, cautious spending from those consumer who still have jobs, and a lot of government regulation. I don’t see any of those things getting better until at least 2010 and possibly not until well after that. To get away from the effects of the housing bubble and excessive consumption, I looked back to 1995-2000, when I remember things actually being pretty good. SPX earnings were $56.13 in 2000 and averaged $45.75 for that six year period. I think those are reasonable starting numbers. They may be too high.
Note that in 2001, which represented the breaking of the stock market bubble but was an extremely mild recession by historical standard (GDP down only 0.6% from peak), S&P earnings fell 31% to $38.85. Applying the same percentage to 2008 as a way of guessing 2009, you get $45. Now, of course 2008 already represented a recession, but on the other hand this recession has already been far worse than 2001 and is only getting worse so I don’t think $45 is at all pessimistic. In fact I think 2009 may be far worse – who knows, maybe $30-35 -- and it takes the market until 2010 or 2011 to get back to $45.
Historically the stock market has averaged a 12x P/E. More recently the average has been more like 15-16 except in the 1999-2000 bubble. I think given everything that will be going on in housing, unemployment, and government deficits, not to mention the shell-shocked consumer we are unlikely to experience above average P/Es. I would point out that recent years have been characterized by a mispricing of risk and I believe the tendency to underprice risk has been pretty well shaken out of the market for a while.
However, if you take an optimistic estimate of a 16 P/E applied to 2000’s EPS figure of $56, you get an S&P level of 898. That would be an increase of 7.7% from today’s level. That to me seems to be about the maximum upside that the most optimistic forecaster could expect. Using $45 a share, which is both 31% less than 2008 and also the average from 1995-2000 and applying a 15 multiple would generate an S&P level of 686 or a decline of 16% from today. A 12 P/E on $56 gives the same figure. A less optimistic – perhaps more realistic -- view of a 12 P/E on earnings of 45 gives a level of 552 or a decline of 33% from today. And of course there is no reason that P/Es cannot dip below 12.
I would guess the “new normal” – that is AFTER unemployment peaks and AFTER housing prices stop declining and after the government stops pouring money into banks and automobile companies and God knows what else – to be S&P earnings in the $40-50 range. Put whatever multiple you want on that, but it isn’t going to be 20X.
As we all know, anything can happen. However, when I look at what is likely, the numbers say to me that stock market appreciation is relatively unlikely over the next year and if it does happen, the appreciation is likely to be small – single digits. I estimate a market decline to be considerably more probable than an advance and the magnitude of such a decline to be considerably larger as well. Thus, the risks of equity ownership at the moment appear to be asymmetrical and unfavorable.
The point I am trying to address is not how far things might fall, but how far they might rise if and when they do. My belief is that because of profound structural, psychological, and behavioral changes, we are not going to return to the profit levels of 2005-06 in the foreseeable future. I think that when earnings and the economy return to “normal”, earnings will look much more like the late 1990s than like 2004-2005. This has fairly profound implications for what one can expect in terms of a stock market recovery.
Let me put out a series of observations which have led me to this rather unappetizing conclusion.
(1) There will be no good news in housing for a while. Prices continue to drop precipitously despite ample financing available for qualified buyers, at least at conforming levels. Current price declines have not been enough to attract new buyers into the market in any quantity. Buyers are still likely to hold back given the uncertain employment outlook. Government policy, if effective (a big if) is targeted at reducing the rate of foreclosure, which might reduce the rate and amount of further declines but will not bring prices up from current levels. At best we can hope for a bit of stability at current levels. Given employment trends, however, the supply of distressed housing coming on the market is likely to exceed or approach absorption.
(2) Even if housing stabilizes at current levels, that means that the effects on lending institutions and personal wealth is permanent. Many large lenders are technically bankrupt and being supported by the US (and UK) government. How this affects future lending is unclear but can hardly be positive.
(3) The effect of defaults on consumer debt have not yet been fully felt. The consumer debt market is twice the size of the subprime mortgage market. Even if defaults are much less than the 20% on subprime mortgages, that is a large additional hit to bank balance sheets. Also, expect much more careful underwriting of both mortgage and consumer debt with more appropriate risk premiums (read: higher interest rates for many borrowers).
(4) Unemployment is sure to rise. The latest figure was 7.6% or about 11.6mm people out of work. As of January 09, this included 3.7 mm people who had been unemployed for 5 weeks or less, so the number is rising rapidly. Generally economists are suggesting that the number will peak at 9% or 10%…today Goldman said that its previous prediction of 9% in the 4th quarter could be realized much more rapidly than it had expected. Unemployment of 9% would represent another 2.2mm people out of work, 10% would be another 3.8mm.
However, those statistics do not count 7.8 mm people who are involuntarily working part time because their hours have been cut back and 2.1mm people who are no longer counted because they have given up looking so the statistic is much worse than it looks. If you counted 50% of the underemployed and all of the discouraged workers, the unemployment rate is likely to peak at about 14% or 21 million people out of work. This does not take into account the effects of the bankruptcy of one or two of the large auto makers, which seems more likely than not.
At the very least, it is now expected that another 2-3mm people will be out of work at the peak. Much of what I have read does not anticipate any significant improvement in this until 2010 at best. Job losses are quite likely to send the personal finances of the affected people over the edge and cause another wave of loan defaults and restructurings if not personal bankruptcies. Again while I do not know whether this drives house prices down further, it certainly puts a damper on their ability to rise.
(5) The US is a largely consumer driven economy and consumer behavior is likely to be massively affected by (a) losses of home equity wealth (b) losses in stock market wealth and (c) potential fears about job losses. There are few consumers who are not affected by at least one of these three. As I have mentioned in the past, I believe the most obvious effect will be that consumers will generally postpone non-discretionary large ticket purchases (cars, electronics, consumer durables, travel, home remodeling, and so forth) and reduce spending on items that cannot be deferred. How much is unknown. Certainly spending fell off a cliff in December and there is no obvious reason why it should revive any time soon.
(6) The decline in discretionary spending means that those people who do have jobs will dramatically increase their savings rate (including savings of whatever they get through the planned government stimulus bill). Long term this will have a positive impact on the economy but we are not concerned with the long term at the moment. It will be interesting to see whether short term reductions in spending on discretionary items translates into a changed mindset on the part of the US consumer toward more long term savings, which would be helpful to individuals and probably to the health of the economy over the next 30 years, but is not going to speed up this recovery.
(7) I have no reason to believe that the current administration programs will have much of an effect on the above. At best the spending will reduce the rate at which unemployment increases. The tax cuts, which amount to nearly 40% of the program, will go straight into savings given people’s lack of propensity to spend.
(8) To summarize my expectations, they include: no recovery in housing prices, less readily available consumer credit, and no recovery in bank capital all leading to lower – probably much lower – consumer spending. Lower consumer spending leads to lower corporate profits.
How low? Of course it’s hard to say but let’s look to history for some realistic numbers. Things have fallen so fast that it’s hard to annualize from where we are now. For the full year 2008, SPX earnings were $65.39. Of course things weren’t so bad at the beginning of 2008, compared to now. In 2006, they were $87.72. Data can be found here.
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/spearn.htm
Again, my point is not to predict a low point but to come up with a “normal” number once the recovery actually happens. My thesis is that the “good times” of 2006 are not coming back any time soon. We are going to have tighter credit, high unemployment and underemployment, cautious spending from those consumer who still have jobs, and a lot of government regulation. I don’t see any of those things getting better until at least 2010 and possibly not until well after that. To get away from the effects of the housing bubble and excessive consumption, I looked back to 1995-2000, when I remember things actually being pretty good. SPX earnings were $56.13 in 2000 and averaged $45.75 for that six year period. I think those are reasonable starting numbers. They may be too high.
Note that in 2001, which represented the breaking of the stock market bubble but was an extremely mild recession by historical standard (GDP down only 0.6% from peak), S&P earnings fell 31% to $38.85. Applying the same percentage to 2008 as a way of guessing 2009, you get $45. Now, of course 2008 already represented a recession, but on the other hand this recession has already been far worse than 2001 and is only getting worse so I don’t think $45 is at all pessimistic. In fact I think 2009 may be far worse – who knows, maybe $30-35 -- and it takes the market until 2010 or 2011 to get back to $45.
Historically the stock market has averaged a 12x P/E. More recently the average has been more like 15-16 except in the 1999-2000 bubble. I think given everything that will be going on in housing, unemployment, and government deficits, not to mention the shell-shocked consumer we are unlikely to experience above average P/Es. I would point out that recent years have been characterized by a mispricing of risk and I believe the tendency to underprice risk has been pretty well shaken out of the market for a while.
However, if you take an optimistic estimate of a 16 P/E applied to 2000’s EPS figure of $56, you get an S&P level of 898. That would be an increase of 7.7% from today’s level. That to me seems to be about the maximum upside that the most optimistic forecaster could expect. Using $45 a share, which is both 31% less than 2008 and also the average from 1995-2000 and applying a 15 multiple would generate an S&P level of 686 or a decline of 16% from today. A 12 P/E on $56 gives the same figure. A less optimistic – perhaps more realistic -- view of a 12 P/E on earnings of 45 gives a level of 552 or a decline of 33% from today. And of course there is no reason that P/Es cannot dip below 12.
I would guess the “new normal” – that is AFTER unemployment peaks and AFTER housing prices stop declining and after the government stops pouring money into banks and automobile companies and God knows what else – to be S&P earnings in the $40-50 range. Put whatever multiple you want on that, but it isn’t going to be 20X.
As we all know, anything can happen. However, when I look at what is likely, the numbers say to me that stock market appreciation is relatively unlikely over the next year and if it does happen, the appreciation is likely to be small – single digits. I estimate a market decline to be considerably more probable than an advance and the magnitude of such a decline to be considerably larger as well. Thus, the risks of equity ownership at the moment appear to be asymmetrical and unfavorable.
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