The Past as a Portal to the Future - Part 2

In my continuing quest for "Truth" where the economy and markets are concerned, I have been reading up on some of the more pessemistic points of view. I have never been a very good pessemist, even though I can talk a good game. By definition, the pessemistic perspective is extreme, and therefore less likely than some middle-of-the-bell-curve scenario. I am inherently a pragmatist and live in the middle of that bell curve. But even if I have a hard time following with actions the completely negative point of view, knowing it helps harden me against the possibility of it coming true. So, it is worth knowing and understanding.

I have read books by super-Bears, Robert Prechter and articles by David Tice. I am even willing to listen to or read Marc Faber, Bill Fleckenstein, Doug Kass and Jeremy Grantham, all of whom have been right to this point in time about the depth and severity of the financial crisis. But most of these guys have been calling for the 2008 market since the mid-1990s or earlier. Had I gone to cash when they first recommended it back then, I would still be down today from where I am. I find timing the market to be very difficult because of my optimism about the future. The only time I can bring myself to sell is when stocks or funds are obviously overvalued as the Techs were in 2000 at 50 or 100 PEs, or when gold was at $1000 earlier this year.

But after weighting my portfolio to large cap, low P/E, high dividend payers, I have mostly held on through this firestorm knowing that even in the deepest depressions (1930s) a consistent program of reinvesting to average down cost will eventually get one back to even. But being out of the market and getting left behind leaves almost no chance of ever catching up. As they say, "there is no bell ringing at the bottom". If the market were to rebound 25% to 11,000 in February, how many people would then invest. How many more would consider that to be a "dead cat bounce" and continue staying on the side line, perhaps as the market went higher? This is the danger of getting in and out of the market. (for readers in retirement without the requisite 10-15 year time frame to absorb the worst possible scenarios and rebuild a portfolio, cash and Treasuries should already be the game plan and hopefully is).

Here is an article that makes the case for "the worst is yet to come". The comparison, which I respect very much and might end up being true, is that we are at 1937 but with the 1930-32 plunge of 90% from top to bottom to come. The author makes the case that since so far a complete crash has been forestalled by government intervention, it must still be in our future. Of course, in the 1930-32 period, Hoover did try hard to stop the market and economic plunge, but his advisors had little historical insight to work with and none of the Federal and State social safety nets we have today. History has shown us the Hoover administration did much too little, too late to stop the plunge. Because the market and economy fell so far and so hard, it took 10 years to rebuild.

I take on faith (we don't really know if it will work) that the Feds can backstop the economic decline. It is one grand experiment we are all living. But the naysayers don't know any better that the decline can't be stopped. They are no more believable in their claims. And haven't most of the people that should go to cash already done so? The rest of us should wait it out, if we can afford to do so. Pulling out enmasse will just make problems worse as it would further collapse the capital base in the economic system. This is one of the logical fallacies of the Bears. They make the case everyone should get out because the market is about to fall. But it is the panic selling that drives the markets lower. If everyone stays put, becomes more optimistic and holds on, the market CAN'T fall. We will see if Obama and his team can change mass psychology and eliminate the panic impulse that creates Depressions. My bet is they can. But if they can't, I will wait patiently for the fever to run its course.

Here is the article with its accompanying charts.

http://www.howestreet.com/articles/index.php?article_id=8243

Paul McCullough Proclaims the Fed on the Right Track

Check out this morning's CNBC appearance by Paul McCullough. He is one of PIMCO's three leaders, that includes Bill Gross and Mohamed El-Erian (who left PIMCO to be Harvard Trust Fund's manager of $38B, but came back to PIMCO and is highly respected). The three of these guys don't get it wrong too often.

http://www.cnbc.com/id/15840232?video=938759900

So, if we are in for a period of stabilization due to the pouring on of liquidity into our financial system, and then due for some significant inflation to pay for all that stimulation needed to save the financial system and home values, we should be positioned accordingly with our portfolios. And because this has been our thesis for the past year or more, we are.

But I never thought we would go through this severe a deflationary recession to get to the expansionary inflation; only talked about it as a remote possibility since I thought the Fed / Treasury knew enough history to avoid it. Bernanke undoubtedly does. But don't underestimate the ability of the Congress to get in the way of solving our national problems. They have no trouble getting us in (way too loose regulation on lending / banking and way too socialist in home lending policy), but want to find someone else to blame when the stuff hits the fan (I am thinking of a certain Sen. Barney (Fife) Frank).

Thinking about how to lever up at these depressed stock price levels leads me to two of the Proshares ETFs: DIG and UYM. Both use leverage to get 150% of the Dow Sector index. Here is a sampling of their holdings and performance (naturally, miserable the past few months):

UYM

http://profunds.com/ProFundsProfiles/FundID_402/Basic_Materials/Profile.fs

DIG

http://profunds.com/ProFundsProfiles/FundID_413/Oil_and_Gas/Profile.fs

Off the Charts Bad

The past week has brought the stock market, actually all investing markets, to the worst place they have been, by many measures, in recorded history. This is actually encouraging. If it is this bad, how much worse can it get? And we are all still standing, so we should congratulate ourselves for that not-so-minor accomplishment.

How bad has it been? From today's Barrons, here are some quotes from Michael Santoli:

"The virtually unwitnessed level of damage in a short period almost defies hyperbole. After Thursday's drop to an 11-year low on the S&P 500, the index was farther below its all-time high than at any time since 1949. The year 2008, had it ended then, would rank as the worst since 1872 at least. The S&P hadn't been as far below its 200-day average since 1932. Nearly 40% of S&P 500 stocks were below $4 billion in market capitalization, the minimum new stocks must meet to be added to the index. More than 40% of the stocks in the Russell 3000 were trading below $10."

"Investment-grade corporate bonds have outperformed stocks since 1980. The S&P 500's indicated dividend yield rose above the 10-year Treasury yield for the first time since around the time the Giants and Colts faced off in their classic 1958 championship game."

Yesterday, I blogged the opinions of super-Bear Marc Faber who is finally calling for an end to the crash. Other long-time bears, even perma-bears like Jim Rogers, David Tice and Peter Schiff, are calling for more of the same. Technician Louise Yamada is calling for a low around 400 to 600 on the S&P500, which is another 50% drop from where we are today. All of these are forecasts are possible, but are they likely? It seems that even if market cycles are never the same, at least they rhyme. The two major historical references are the twin 1930s declines and the twin late 60s and early 70s declines. The path from here is likely to be similar to the aftermath of both periods.

And from another article, an interview with Robert Fetch, are similar sentiments:

"...the market is clearly discounting a fairly severe recession. There's a good chance that before this is done, the S&P will make a new low. When the S&P went below 804 last week, the percentage decline off the highs marked the greatest bear market in history since the Great Depression." "You have the capacity right now, as a value manager, to find good, solid low-valued stocks of good companies without having to pay a premium for them for the first time, really, since the early 1980s".

What marked both the 1932 and the 1974 market bottoms and resulting economic declines, was a government led effort to restimulate the economy which eventually led to a dynamic market environment. The two periods had different political settings. 1932 marked a three year period under President Hoover where the government did nothing while the markets and economy declined. Hoover and the Congress were following "Laissez Faire" (hands off) economic policies under the theory that market economies would heal themselves without government assistance. It proved to be a painfully incorrect theory.

It wasn't until FDR took office in early 1933 (March back in that time), that the New Deal was born and the government poured money into the economy with the goal of re-employing people to alleviate the very high 25% unemployment of the period. In hindsight, economists, led by Milton Friedman, have shown that had the initial response to the 1929 market crash and resultant asset deflation been more aggressively reflationary (aka stimulation through low interest rates and work programs), the worst of the Great Depression might have been avoided. In any case, investing in the market in early 1933 would have proved very beneficial, even given the 1937 correction, severe in its own right.

The 1968 and 1974 twin crashes were a little different, politically. 1968 was brought on by the uncertainty around civil upheaval caused primarily by the Vietnam war and two major political assinations (Martin Luther King, Jr. and Robert Kennedy) coinciding with a blowoff top of the 60s tech bubble. Thereafter were several years of economic gyrations and failed government policy as indicated by the collapse of the gold standard and the 1972 wage-price freeze to contain inflation. Then in 1973 came the OPEC oil crisis and gasoline rationing accompanied by a 400% spike in oil and gas prices. The proverbial straw came with the Nixon Watergate scandal and his subsequent impeachment.

But unlike 1932-33, the market collapse in 1973-74 did not coincide with a Presidential election. Instead, we had Gerald Ford serving essentially two years of a lame duck Presidency, during which nothing significant could be accomplished in Congress or the Administration to repair the economy. Under Jimmy Carter, there were efforts to stimulate the economy which worked to some degree. But the stimulation in the vicinity of high oil prices, caused massive inflation by 1978. Then came round two of OPEC's assault on the Western world's economies. High oil and gas prices in 1978-79 caused another significant recession and 20% market decline which was eventually resolved by Paul Volcker's attack on inflation and then the Great Bull Market of 1982-2000.

It is clear to me that we can rely on one of these two precedents to forecast the next 5-10 years in the markets. As pointed out before, even if history does not repeat, it rhymes. Here is a chart comparing the three periods in question that makes that point:

If we are at the end of 1932, just prior to the inauguration of a new Democratic President with a mandate to fix the economy and get people back to work, we can look at a market run 0f over 400% between February 1933 and February 1937. If instead, we are at May 1938, we can look at a 50% run over the next 16 months. After the market peaked in October 1939, the fear over WW2 stopped the market ascent and it went sideways until February 1945, near the end of the war.

If, as I think we are, at the market bottom of September 1974, on the heals of Nixon's impeachment in August, we can have at least a 70% run over the next two years as we did until the uncertainty over the 1976 election stopped the run up that summer. But because the market crash has coincided with the Presidential election, we may have a much more robust recovery in the market and economy than in 1974-76. Barak Obama has already promised to rebuild the national infrastructure to put people to work. This will be his New New Deal. The resulting spending will pump a lot of money into the economy, will lower unemployment and eventually improve the consumer spending outlook.

If the last scenario is correct, what will benefit? Infrastructure, materials and energy companies. The improving consumer will also benefit the developing export-driven economies in Asia and restart the Chinese economy (further increasing demand for infrastructure materials and services). Some names that look interesting, all down 60-80% from their peaks, are engineering companies: JEC, FLR and URS; Materials stocks: CX, BHP, FCX, NUE; Energy stocks: PWE, MRO, PVX, SU; and Asia stocks: FXI, IFN and TDF.

I already own most of the above, and have held them through this decline for better or worse (mostly worse as of late). But the case for infrastructure is better than ever. Now the above stocks are dirt cheap by every fundamental metric. Even if the timing of the recovery of the market is off by 6 months or a year and there is more decline to come in the immediate future, held over a 5 to 10 year time frame, the above will reward.

Good investing!

"Dr. Doom" Marc Faber calls for a Huge Market Rally

There is a certain Marc Faber, who is an anti-American Swiss national, living in Hong Kong, who has long called for the demise of the American stock market and the US dollar. He is interviewed in Barrons's regularly, and is a member of that journal's elite "Investor Roundtable".

Last night (Friday morning Europe time), he gave an interview where he is calling for a huge rebound in the stock market, and a collapse of the US Treasury bond market and US dollar, in response to the current market decline and the monetary expansion to prop up the economy. This is the scenario that I am positioned for, with big holdings in Canadian energy (non-US denominated) and material stocks and funds.

He did end his interview with an ominous warning that if the monetary expansion / reflation does not work, then we will experience a tremendous depression, worse than the 1930s. But this is how he got his title: "Dr. Doom"

Here are some of his quotes. You can see his interview on the right hand bar of this webpage.

"The sheer amount of money governments are pumping into the financial system will eventually lead to a very strong rally in beaten-down assets (aka energy), investor Marc Faber said on CNBC Friday.

But Faber also warned that if the markets remain depressed as liquidity increases the result could be a depression worse than in 1929. (don't know how this could happen...they seem mutually exclusive...either you have an asset deflation-based depression, or inflation. If it turns to hyper-inflation and worthless currency, ala Germany in the 20s or Argentina in the 70s, it would destabilize the economy, but would not be called "a depression").

By and large asset markets are "terribly oversold" now, while investors are going overboard into the U.S. dollar and U.S. Treasurys, Faber, editor of the Gloom, Boom & Doom Report, told "Squawk Box Europe."

"What you could see in the next three months is a very strong rebound in asset markets, in equities, followed by a selloff in bonds and eventually a selloff in the dollar," he said.
Governments and central banks around the world are providing liquidity and that will eventually have an impact, Faber said.

And once the buying starts the rally is likely to be "stronger than people expect" given that financial institutions are sitting on so much cash, he added.

'Colossal Deflation'

"I think the intervention by the government in the past and at the present time has created more volatility, not less, and so right now we have deflation, we have colossal deflation in asset prices," he said, noting that equities alone have lost $30 trillion globally.

But "I assure you if you throw enough money at the system, eventually you can reflate, especially in the United States," Faber added.

Statistically a rebound should happen, but if it doesn't "the air is out" and the world faces an economy "worse than the depression of '29 to '32," he said.

Dialogue on Housing Deflation - from ArizonaRealEstateNotebook.com

Cbass // Apr 27, 2008 at 7:12 pm

Brian,

So you mean to tell me that prices for goods and services can not increase while our economy stops growing or goes into a recession just becuase there is supply?

en.wikipedia.org/wiki/Stagflation

“Demand-pull stagflation theory explores the idea that stagflation can result exclusively from monetary shocks without any concurrent supply shocks or negative shifts in economic output potential. Demand-pull theory describes a scenario where stagflation can occur following a period of monetary policy implementations that cause inflation. This theory was first proposed in 1999 by Eduardo Loyo of Havard University’s John F. Kennedy School of Government.”

Just an example of some smart dude who agrees my thoughts are possible.

Brian McMorris // Apr 28, 2008 at 9:19 pm

CBass, I don’t think you and I are very far apart on this. I concede the idea of some level of stagflation at a time like this. Today we have “demand shocks” rather than supply shocks. That demand comes from the BRIC nations and is outside our Fed’s control.

I don’t know that residency at Harvard makes this guy smarter than you or me. But yes, anything is possible. But there is no real proof, yet, for this theory that was postulated in 1999 (stagflation that results from loose monetary policy).

The most often cited example of Stagflation came in the 1970s and was the result of supply shocks (in oil and base metals). The supply constraints, accompanied by rapid demand increases in Asia (as Japan and Korea underwent a huge expansion) did result in inflation. But monetary policy probably had little to do with it. A wage inflation spiral was a reaction to the “materials” inflation, but that was in a time of powerful unions that no longer exist. It took Volcker’s interest rate shock therapy in 1980 to break the cycle of wage increases gained by striking unions ending the phenomenon known as “inflationary expectations”.

The “stag” term suggests flattish growth that is behind the rate of inflation. If inflation is at 5% and nominal growth is at 4%, that is stagflation, and not really so bad. It is just important to be invested in hard assets during such a period so that investment earnings beat inflation.

But this scenario is a lot different than the Depression that many are predicting, which requires a Deflation. I say we already have a housing depression (deflation), as compared to the 30s for example. But the other elements of the 30s Great Depression, are not in place and very likely won’t be if the Fed keeps the economy from panicking by pouring on liquidity.

packerbacker // Apr 29, 2008 at 5:52 am

Brian-

I think you are smart. I like what you say, but someone should slap you for this. You say, “we are already in a housing depression-as compared to the 1930’s” A quick google would show you that during the Great Depression, around 25% of people were forclosed on, unemployement was over 20% and household income dropped 40%.

Brian McMorris // Apr 29, 2008 at 6:20 pm

Thank you for the compliment and comments. But see that I limited my statement to “housing depression” which I borrowed from Dr. Shiller himself. He is the greatest authority maybe in the world, on the history of housing pricing, and has lots of historic data to back up his comparisons. So I am comfortable with that statement.

Average national price is down about 15% from its peak now, and more or less in freefall. He concludes, and I have no reason to differ, that it could easily drop another 15% before it bottoms. That will be as big a drop as the 30s. I am not sure the source where 25% of homes were foreclosed in the 30s. I have not seen numbers that high. I don’t necessarily believe everything I read when I google.

As for unemployment and household income dropping, this time is different. I am not saying we are in another Great Depression, just the contrary.

What makes this time different, is we have the lesson of the 30s to teach us how to respond to the housing depression, so problems will not be magnified. We will probably not have 40% foreclosure, because this time, the banks started acting early to deal with their bad loans. The Fed also got into the act early because of Bernanke’s expertise on dealing with conditions that lead to broader economic depressions, including acting aggressively to cut interest rates and simultaneously supply liquidity (in numerous ways) to keep the banking system from imploding.

It did implode in the 30s and that is why foreclosures went so high, the banks could not afford to negotiate with the home owner, do short sales, or hold bad mortgage portfolios. The banks then were S&Ls with no where to go for help (there was a Fed, but it wasn’t ready for the problems it faced).

If you find economics interesting (you can probably tell that I do), I will share with you a very credible source on Depression era statistics, causes and effects: Mr. Ben Bernanke. Here is a speech of his from 2004 (so not colored by the current situation):

http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm

In it Bernanke quoted a study by economist Milton Friedman, published in 1963, that proves that monetary contraction was the proximate cause of the Great Depression. There are many examples given as evidence, but I will let you read it there rather than fill this space with quotes. This is why we see Bernanke’s Fed has been so dramatically increasing liquidity, much to the consternation of CBass and others. But Bernanke and others are on record saying it is much easier to fight easy-money induced inflation, than contraction-induced deflation. The housing crisis on its own contracts money supply (basically evaporating paper money in the form of mortgage liabilities). Bernanke’s Fed has responded by expanding it in other places, probably for a net zero effect. But we won’t know for a few years.

So, I stand by my earlier positions defending monetary expansion, but appreciate the opportunity to explain why.