Peter Boockvar Debunks Deflationistas

Good Tech Ticker clip featuring Peter Boockvar explaining why any deflation/disinflation will inevitably lead to more easing and ultimately inflation. I discussed this at length last year in Flaws in the Deflation Case.

Goldman and Global Debt Jenga

Jesse gives us this hilarious depiction of Goldman Sachs’ role in the Greek debt crisis. According to Bloomberg, Goldman played a significant role in helping Greece hide its debt from the EU.

Here’s an excerpt from Jesse’s accompanying piece, Simon Johnson: Goldman Faces Special Audit and Possible Ban in Europe:

Regular readers will be aware of our thesis that the American Wall Street banks have become dominated by a culture of compulsive sociopaths who are incapable of reforming or restraining their greed. Like all addicts, they push the envelope looking for a new high, emboldened by each successful scam, the weakness of regulators, and the craven support of politicians, going further and further until at long last they go one step too far, with spectacularly destructive results.

Goldman Sachs may have reached that point. And as also suggested here, the rebuke may be coming from European and Asian nations who become weary of the extra-legal antics of the rogue American banks.

In the interests of harmony, the Europeans may once again bow to US pressure and continue to permit the Money Center privateers to roam through the interational financial system wreaking havoc, as they have been doing through the domestic US economy. It will be too bad if they do.

This is in no way an excuse for the Greek government. But what Simon Johnson is saying in this essay below is that Goldman is not only not blameless, but is enabling, complicit and perhaps even presenting the opportunity for market manipulation and fraud to other parties. Typically they like to ‘package’ these scams and take them from one customer to another, so that greed meets need, as a corrupting influence. It is no different than a bank engaging in money laundering in support of the criminal activity of another organization.

As always, Jesse’s latest is well worth the read. As is the Simon Johnson piece he references.

It’ll be interesting to see how Goldman stock reacts tomorrow when markets reopen after a long weekend. It should be an ugly day for GS, which in this bizarro stock-world means it will probably close up 5%. As Tyler of ZH says, good news is good, but bad news is better.

Sorry for the light posting lately, been on vacation and occupied with some other things. Should be back to normal soon.

Race To Ruin: PIIGS vs. U.S.

An analyst at Deutsche Bank created some buzz the other day when he said that the PIIGS’ (Portugal, Ireland, Italy, Greece, Spain) debt crisis could be a “dress rehearsal” for a U.S. one.

It makes for a catchy headline, but the funding crisis in America will play out differently than the PIIGS’ bloc does. The key difference is our ability to print money and devalue the dollar. QE is off-limits for EU members, at least. Bernanke would probably call that an advantage, but I’m not so sure.

Either way, it is nice to see some light shined on America’s debt problem. It’s not pretty, and the sooner we deal with it the better. From BusinessWeek:

The cost of insuring against U.S. and U.K. debt defaults may rise in the same way as it has for so- called European peripheral nations including Greece and Portugal, Deutsche Bank AG said.

‘The problems currently faced by peripheral Europe could be a dress rehearsal for what the U.S. and U.K. may face further down the road,’ Jim Reid, a strategist at Deutsche Bank in London, wrote in a research note today.

The cost of insuring against U.S. and U.K. debt defaults may rise in the same way as it has for so- called European peripheral nations including Greece and Portugal, Deutsche Bank AG said.

‘The problems currently faced by peripheral Europe could be a dress rehearsal for what the U.S. and U.K. may face further down the road,’ Jim Reid, a strategist at Deutsche Bank in London, wrote in a research note today.

I  heard the “dress rehearsal” line on Bloomberg yesterday, during a Niall Ferguson segment. Scroll down for the clip, it’s among the better mainstream coverage of the global-debt-crisis coverage.

Worse than Greece?

The fundamental outlook for PIIGS is bad. Greece has gotten the lion’s share of attention lately lately. But you could argue the same or worse for the United States or U.K.

Zero Hedge recently escalated the acronym-hoopla by adding the U.K., Turkey, and Dubai to create STUPID. Regular readers objected to the absence of the U.S., expanding it to STUUPID.

America’s situation isn’t pretty, and may be worse than PIIGS’ or STUPID’s long-term. In the Bloomberg clip I mentioned earlier, Niall Ferguson points out that in 2009 America’s deficit-to-GDP was 10.2%,.compared to Greece’s 8.7%. Spain and Ireland were both slightly worse, with deficit-GDPs of around 11%. I included the Ferguson clip at the bottom of this post, there are some interesting charts comparing the health of various economies.

Cutting Back vs. Ramping Up

Greece is currently implementing “draconian” budget cuts, while America continues to spend like mad, focusing exclusively on the immediate future. It’ll be interesting to look back in 5-10 years, and see how the contrasting strategies played out.

It’s The Total Debt

America’s official public debt-GDP number may not be at nauseating levels yet (around 85% of GDP), as pundits like Krugman and Delong are fond of reminding us. But even the official US numbers are ugly, particularly the recent spike as shown by this chart:

While the U.S. isn’t the worst offender on the chart, there are a number of problems with these official numbers. First, these comparisons don’t factor in some very real liabilities, including trillions of potentially-worthless Fannie and Freddie assets. Jonathan Weil of Bloomberg explains:

Excluding Fannie and Freddie, the national debt held by the public is about $7.9 trillion. With them, it exceeds last year’s $13.2 trillion gross domestic product. Even the geniuses at Moody’s Investors Service are warning that the country’s AAA rating might not last. No country can owe more than its yearly productive output for long without giving up its accustomed lifestyle and influence.

Those numbers also only include federal debt. America’s local governments, companies, and citizens are all leveraged to the hilt. This chart is at least a year old, but it’s telling:

Liabilities Ignored, Baby Boomer Crunch Looms

Cooked government books also ignore entitlement program shortfalls and unfunded future liabilities. Take a look at Social security, which,  for the first time in 25 years, is collecting less in taxes than it brings in. That wasn’t supposed to happen until 2016. Bruce Krasting has a good writeup here.

The outlook for social security, and all other entitlement programs, will only get worse as Baby Boomers retire. When Boomers, an outsized age-demographic, were in their earnings prime, social security and other programs had large surpluses. But instead of putting that money aside to pay for the inevitable trend reversal, we padded our deficits with it. It’s gone.

Depending on which numbers you look at, and what timeline you use, America has unfunded liabilities of anywhere from $30 trillion to $99 trillion. The higher number comes, surprisingly, from the head of the Dallas Federal Reserve, Richard Fischer (from a 2008 speech):

For the existing unfunded liabilities to be covered in the end, someone must pay $99.2 trillion more or receive $99.2 trillion less than they have been currently promised. This is a cold, hard fact

It’s inevitable, and borderline cliche, but America’s years of gluttony will inevitably lead to a day of reckoning. Somebody’s bound to get screwed, and most people will have to adjust to a lower-quality of life for a while.

Holders of U.S. debt will likely take hits if/when QE 2.0 begins. Baby boomers themselves are getting crushed by low interest rates. How is a retiree supposed to live off 1% CDs? Bernanke will keep rates down as long as he can, because it’s incredibly profitable for banks. But it’s going to be brutal for those who rely on fixed income.

The system can eventually fix itself, but only if we let it. Eternal monetary easing and govt support is a recipe for a subpar economy, indefinitely. Analysts are also seeing an increased risk of a prolonged period of stagflation.

I’ll end with this quote from Jesse,who has a way with words:

The banks must be restrained, the financial system reformed, and balance restored to the economy before there can be any sustained recovery

Here’s that Niall Ferguson segment from Bloomberg. Skip to 4:35 for the Deutsche Bank “dress rehearsal” quote and some nice graphs.

Anyone Who Isn’t Really Confused Doesn’t Understand The Situation

Guest Post: Grey Owl Capital Management’s Q4 2009 investment letter. A good read, especially the sections on market valuations.

“Anyone who isn’t really confused doesn’t understand the situation”
-Edward R. Morrow

Reports concerning unemployment and housing show economic conditions continued to worsen in the fourth quarter. While corporate profits (as measured by the S&P 500) have improved from the significant losses of -$23.25/share reported in the fourth quarter of 2008, they are nowhere near their peak annual rate of $85/share experienced between the third quarter of 2006 and the second quarter of 2007. Importantly, much of this improvement can be attributed to financial firms which, while repaying TARP funds, are at the same time receiving another (lightly-disguised) subsidy as they borrow from the government at a Fed Funds rate under 25bps and lend that money right back to the government at close to 4%. Yet, “the market” (the S&P 500 is at 1140 as we write) is up over 70% from its 666 March low.

The cover of last week’s Economist read “Bubble warning” and we could not agree more. By our estimation, the S&P 500 is now 20-30% overvalued. However, with a no-end-in-sight loose monetary policy this rally could continue for quite some time. We will spend the rest of this letter discussing our process for investing in this climate. First, a review of our performance compared to investable options for the major market indices:

Our overall investment process is quite simple . We spend most of our time looking at individual investment ideas trying to find five to seven ideas each year that meet very specific criteria. For us to invest your capital (and ours), we need to believe that the idea has a very low probability of losing money and multiple ways (depending on how the uncertain future evolves) of providing a better-than-market return over a several-year time period. Given our generalist approach (we do not focus on a single sector or market cap), we are able to be very meticulous and look at lots and lots of ideas before committing to one. In other words, we can wait for the “fat pitch” Warren Buffet so frequently discusses. We then try to build a portfolio that diversifies factor risks. That is, we try to build a portfolio that diversifies exposure to changes in inflation or consumer behavior or global trade, etc.

In a “normal” environment, our approach works fine. Today, there are two (somewhat related) forces, exogenous to the above process, that create complications. The first concerns the structure of the overall economy. It is unclear how the significant national debt, increased government involvement in the economy, and unorthodox monetary policy will broadly affect corporate profits and real (after subtracting inflation) returns. Second, most valuation approaches conclude that equities are overvalued. Additionally, we have yet to experience a real “revulsion” bottom in the current market cycle – investors have yet to “give up” on equities, a behavior that typically marks market troughs. Therefore, we are concerned that even if we make investments that we believe are undervalued, they may be subject to a broad re-pricing lower along with the rest of the market. While their intrinsic value may remain sound (or even grow), these investments could get cheaper during a broad market correction. Our last two letters addressed point one – the economic issues – in depth. Please refer to these letters for more on that topic . In this letter, we will briefly touch on valuation and then describe a thought exercise that helps us frame the key issue we now face: how much capital do we invest in opportunities we believe are cheap today and how much dry powder do we keep available for potentially cheaper opportunities that the market may afford us in the future?

Current Market Valuation

Valuing a broad market index like the S&P 500 is actually straightforward. One way to approach the process is to work backwards from the return investors expect. The return from owning equities can only come from three places: 1) earnings growth, 2) dividends, and 3) re-pricing (i.e. a change in the earnings multiple – price-to-earnings or PE ratio) .

Since 1900, earnings growth has averaged 6% nominal (i.e. including inflation). If we expect a return greater than 6%, we will need either a dividend yield that makes up the difference or a re-pricing higher. Over this same period from 1900, the forward PE ratio on the S&P 500 has averaged 14. With a 50% dividend payout , this has allowed for the close-to-10% average returns most investors equate with equities. The return from 1982 through the end of 2009 was higher than 10% because the market started from a PE ratio of 86. The return since 1999 was well worse than 10% (actually negative) because the market started from a PE ratio of 30.5 .

As of this writing, Standard & Poor’s lists expected “as reported” (i.e. GAAP) earnings for 2010 at $58.71. This equates to a forward PE ratio of 19.4. The dividend yield on the S&P 500 is currently just under 2%. We believe “fair value” is closer to the historic average PE ratio of 14 and a dividend yield closer to 4% as this is the only way a broad market index can provide investors with the return they have consistently required for holding risky equities.

There are only two strong arguments for higher valuations. The first argument is that we are experiencing an economic shift to sustainably higher corporate profit margins and/or profit growth. Profit margins have been mean reverting over long periods. Basic economics provides the rationale. Excessively high profit margins engender competition, which eventually drives profit margins down. The second argument for higher valuations is that investors have permanently changed their expected return for holding risky equities. Like the mean reverting profit margins, the mean reverting earnings multiple over very long periods tells us this is unlikely. Those two arguments notwithstanding, we believe the stock market is 20-30% overvalued.

Three well-regarded investors, who (like us) warned of pending doom well before the recent credit crisis and market correction, agree with us again. John Hussman of the Hussman Funds says the S&P 500 is currently priced to deliver total returns averaging just 6.1% over the coming decade. Jeremy Grantham of GMO believes fair value on the S&P 500 is 860. David Rosenberg of Gluskin Sheff says the market is 25% overvalued. So what is a value investor to do?

Buy 80-cent dollars or wait for 50-cent dollars?

In investor parlance, we refer to a security that we believe trades at 80% of fair value as an “80-cent dollar.” Likewise, an investment that trades at 50% of fair value is a “50-cent dollar.” With the market 20-30% overvalued, through our research process we are able to identify a sufficient number of 80-cent dollars but few 50-cent dollars. This leads us to the question: do we buy the 80-cent dollars or wait for 50-cent dollars?

If we assume that an 80-cent dollar will accrete to fair value over a three-year period, we can expect an 80-cent dollar to provide us with a 7.7% annualized return . A 50-cent dollar that accretes to fair value over a three-year period would provide a 26% annualized return. The question then becomes, how long can we wait for the 50-cent dollar so that our average return over a longer period improves from waiting. It turns out that in this simple construct, we can wait six years making no investments, then buy 50-cent dollars that take three years to accrete to fair value and still achieve an annualized return over the full nine-year period of 8%. This modestly beats the alternative, which is three consecutive rounds of buying 80-cent dollars and allowing them to accrete to fair value over three years.

Unfortunately, the real world is more complicated than the above scenario. If we remove the simplifying assumption and include increases in intrinsic value, the 80-cent dollars look a lot better. After all, not only do we have two extra rounds of 80-cent dollars accreting to fair value, we also have six extra years of increases in intrinsic value. Additionally, we have no way to gauge if or when the overall market will correct and present us with 50-cent dollars.

Fortunately, we can again look to history for guidance.

Range-bound Markets

Two hundred years of US stock market history paints a remarkably consistent picture of (approximately) twenty-year bull markets followed by (approximately) twenty-year sideways or “range-bound” markets. We would contend that we are ten years into a sideways market.

Investment manager and author, Viataliy Katsenelson, describes range-bound markets this way, “range-bound markets are the bear markets of price-earnings (P/E) ratios (they decline), whereas bear markets are the bear markets of P/Es and earnings (they both decline). Range-bound markets are so-called payback markets – investors are paying back in declining P/Es for the excess returns of the preceding bull market.” Importantly for our above analysis, he demonstrates that range-bound markets have shown significant volatility and approximately as much downside volatility as upside volatility.

Thus, if history were any guide, we would expect the next several years to provide sufficient (downside) market volatility, which will allow us to increase our exposure to equities when more 50-cent dollars are available. As these securities recover to fair value, we will again tune our equity exposure based on the overall market’s level and the availability of new 50-cent dollars. Ideally, we will repeat this process until PEs decrease to well below their historic average of 14.

There is one caveat to the range-bound market theory. In past letters, we have discussed the potential for inflation (or at least a very unstable monetary unit of account) given the dramatic recent Federal Reserve actions, as well as the significant (and ongoing) increase(s) in the federal debt. We also described the historic correlation between inflation (documented by Crestmont Research) and inflation volatility (documented by William Hester of Hussman Funds) and shrinking earnings multiples (PEs). They show that multiples have expanded during periods of low and stable inflation and multiples have contracted during periods of high and volatile inflation. If inflation and/or inflation volatility is a necessary requirement for multiple contraction, we must consider the possibility that the Federal Reserve will be able to keep the value of the dollar stable, thus managing inflation and allowing the stock market to keep its elevated multiple for another cycle.

Katsenelson’s analysis makes a broader argument for multiple contraction based on human psychology: “They [range-bound markets] follow [bull markets] because excess optimism feeds on itself and drives stock market valuation to one extreme, and then unmet expectations turn into disappointment, driving stock valuations to the opposite extreme. Long excesses require lengthy corrections.” There just are not enough data points to provide us conviction that Katsenelson’s broader explanation is sufficient nor to show that inflation is necessary to create a range-bound market. Both explanations are possible.

Therefore, we choose to make decisions based on a range of outcomes. In other words, in today’s market we will buy some 80-cent dollars, but also leave some dry powder for the 50-cent dollars we expect (but are not certain) will appear. This will allow us to protect capital and provide the opportunity for satisfactory gains if we (and history) are wrong. It will also provide the opportunity for substantial gains if we (and history) are right. As the opening quote from Edward R. Murrow warns, there are no clear paths, only probabilities and ranges of outcomes. We aim to be prepared whatever future unfolds.

As always, if you have any thoughts regarding the above ideas or your specific portfolio that you would like to discuss, please feel free to call us at 1-888-GREY-OWL.

Visit Grey Owl Capital for more. Republished with permission. You can find their disclosure statement here.

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