As one of the few who saw this crisis coming and how it might play out across the board, not just in particular areas, he deserves a listen. As one of the most successful investors of the last 30 years he would warrant a listen anyway.

Watch the whole thing.

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Technorati Tags Asset Allocation, credit crisis, Emerging Markets, equities, Housing Market, investing, Jeremy Grantham, Risk, value investing

Instead let us look at what expectations for them are now. From Citigroup (pdf.)

What we see here is that expectations for profits and loan growth are far higher than past crises show are likely. The question we have to ask is whether it is as bad as those past events? I don;t know, but if it is as bad as it appears expectations are still too high.

Key points:

Earnings (of course) collapse, driven in part by soaring bad debts. However, these periods also suffer massive shrinkage in loan books and (more modest) shrinkage in deposits and total balance sheets. Pre provision operating profit also tumbles, in part reflecting this balance sheet shrinkage. Applying even the least damaging of these episodes (Hong Kong 1997-2002) to the current sector would see loan books halve and earnings, equity and operating profit all fall c40% from current forecasts.

[...]

To be clear, none of our economists forecast depression or deflation in Europe, but as recent IMF analysis demonstrates, recessions preceded by financial crisis tend to be long and deep. We might find ourselves rereading this report in a few years time and thinking that we were way too bearish to even raise this spectre. Or we might not.

My suspicion is that the specific problems mentioned earlier make these outcomes far more likely than many people wish to admit.

Hat Tip: Alphaville

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Technorati Tags banks, Citigroup, debt, deflation, European banks, Financial crisis, loan growth

The resentment, irritation, condescension and, at times, outright hostility to my Cassandra act makes me wish I had a video of my own. Sigh…

Oh well, it pays to remember that Cassandra was right. I was never as sure of myself as Peter, but risk management isn’t about knowing you are right, but knowing what could go wrong and whether it is likely enough to act upon.

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Technorati Tags credit crisis, financials, investing, Peter Schiff, Risk

What does it mean? I think it ultimately depends on factors unrelated to the move itself. Econompic provides us with some context:

Obviously large one day moves in and of themselves tell us little about what is to come. So, let us at least look at what the market is priced to deliver longer term.

Stocks are not cheap, they just seem so because they have been extremely expensive for a very long time (and thus we have had a decade of poor returns.)

Nevertheless, they are around fair value, which is somewhere around 1000 on the S&P 500 depending how you figure it. That should result, without any expansion in P/E ratios (adjusted for the business cycle) in returns of about 3-6% above inflation (referred to as real returns) over the next ten years. This assumes approximately a 50% earnings payout as dividends (3.3% dividend yield) plus earnings growth of between 0- 3% above inflation. For an example of this calculation I suggest this short piece from Ed Easterling (pdf.)

Assume an inflation rate of 3% and nominal returns would be 6.3%-9.3%. Not bad.

Of course a lower valuation (about 677 on the S&P 500) would result in about a 4.5% dividend yield. That means real returns of about 4.5% to 7.5% and once again assuming inflation of 3% nominal returns of 7.5% to 10.5%.That would represent an adjusted P/E of about 11. That is certainly characteristic of bear market bottoms, but that may be a few years off, or not. Either way, if we are about at the bottom then returns are reasonably attractive from here.

Of course returns could be higher if P/E ratios increase. That would reduce the contribution of dividends but increased appreciation would more than make up for it. Of course, that sets us up for lower returns once that process reverses or stalls, thus leaving us without increased appreciation and lower yields (once again, the pdf explains that very well.) They could be lower if they decrease.

Earnings are likely to decrease dramatically over the next few quarters. So further downside is very possible, but not a given.

According to Morningstar Jeremy Grantham thinks the markets is cheap and is buying in earnest. Reading the piece I don’t see him saying that. In fact this statement is completely at odds with what he actually says in the piece:

So, add Grantham to the list of sage investors who see this as a huge buying opportunity. The list includes Marty Whitman and Dan Fuss

I was actually going to do a piece comparing the views of Grantham and Whitman, both men I respect very much. Controlled Greed already noted the divergence, how did Russ Kinnel miss this? Oh, and I like Russ Kinnel, I just disagree with this characterization. I side with Grantham (and my explanation above is a simplified version of Grantham’s own method of establishing return estimates) whose views are better represented at Barron’s.

Henry Blodget likes the plan to inject capital into the banks. While not exactly how I would have designed it, it is close enough for government work. He does ask a key question, why doesn’t the plan include forced writedowns? As investors this is important for several reasons:

It removes the fear that banks and bank investors will be hammered by future writedowns

It turns the banks’ attention 100% to putting the new equity to work

It attracts private capital (because investors won’t worry about getting sandbagged)

It eliminates the death-by-a-thousand-cuts scenario that killed Japan.

To put some numbers on this: So far, US financial institutions have taken about $650 billion in asset writedowns. Nouriel Roubini and others have put the total expected writedowns at $1-$2 trillion.  This suggests that banks still have $350 billion-$1.350 trillion in losses to take.  Losses in this range could wipe out common shareholders, the government, and the financial institutions….unless the banks can easily raise additional equity to offset the losses.

The government may be hoping that 1) the writedowns are done, or 2) the banks can just slowly write off the rest of their crap assets against earnings over the next several years (thanks to the elimination of mark-to-market accounting). Given the magnitude of the projected losses, this seems like wishful thinking.

Alternatively, the government may plan to just keep injecting more and more capital until the writedowns are finally done.  If this is the plan, however, other private-market investors are unlikely to follow suit.

So we have one remaining and important question for Messrs. Paulson and Bernanke: What about the future writedowns?

Exactly.

Doug Kass is worried about Muni Bonds. I am worried about everything, but there is an answer, get a discount which reflects that. Where? Maybe this is the answer.

Yves Smith notices Charlie Munger is in a foul mood when it comes to Wall Street. I have to agree that the financial sector needs to shrink. I have long argued that financial intermediaries should not be such a large part of the economy, and is merely a product of leverage, not a dollar for dollar addition to our nations productive capacity and wealth. By in essence increasing the money supply over and over again our financial sector increases the share of wealth they get to collect a toll from. Note, the fantastic increases in leverage has not resulted in increase in economic growth, it has resullted in the financial sector appropriating a larger and larger proportion of that wealth.

Paul Farrell’s Lazy Portfolio’s have done better than the market:

The Kirk Report observes:

At a minimum, these passive lazy portfolios will provide a benchmark for you to compare your own returns to. Also, if you’ve not already proven that you can time the market effectively and consistently beat these passive strategies, then you have no excuse but to implement them until you do.

Good advice, though our clients have done a whole lot better than that, so obviously there are better options.

Have you suffered large losses? Sometimes misery enjoys company, especially when the other guy is in much worse shape than you. Imagine an icelander-Iceland Plunges 77% On Re-Open

Of course you could have been advised by Nicholas Taleb, who has done even better than we have, up massively I like this quote:

We refused to touch credit default swaps. It would be like buying insurance on the Titanic from someone on the Titanic.

Of course his strategy is intended as a hedge, not an entire portfolio, but I am impressed.

Paul Kedrosky gives his view on where this is all leading. I agree with much of it, and find the rest reasonably likely:

We are going through a credit crisis sparked by the subprime meltdown. It is broader than that, however, really the tail end of an orgy of leverage and credit creation dating back at least 15 years

The unwinding of all this credit bubble will take longer than most people expect, and the damage will continue to be broader than most expect. Beyond banks and financial institutions, it will include many municipalities, some large-cap tech names reliant on major debt-financed network buildouts, a host of debt-financed non-financial companies, and some sovereign nations. Total cost: Bridgewater’s $2.7-trillion looks close enough to me .

S&P forward-year earnings forecasts will come down faster than at any time in recent history. We will see 20% average estimate reductions across the board, leading to a further revaluation of the markets. After all, at S&P 1010 we are trading at 19x trailing earnings, and 18x forward, neither of which are inexpensive historically speaking. Admittedly, the above is not the non-financial S&P P/E — ex- financial and consumer stocks we are more like 14x — but it is a distinction that will get blurred as we go into this recession.

We are already in a recession that will last well into the the fourth quarter of next year.

Unemployment may touch 9% in the U.S. at trough.

Obama will win the U.S. presidency.

Housing will fall 10-15% further in U.S., and we are only beginning major declines in Canada, U.K., Australia, and elsewhere.

U.S. consumers will become much more aggressive savers, both through debt reduction and direct saving. Similarly, future fiscal stimulus will largely be saved in service of this overdue need to fix domestic balance sheets.

U.S. long yields have to rise, making curve steepener trades feel appropriate.

Commodities will stay under pressure for the next two years,and then reverse savagely as developed countries emerge from recession at very similar times. We have newly resynchronized the global economies, which will have immense consequences.

Coming out the other side, we will see a barbell economy, with growth and investor interest at the mega-cap consolidator end, and at the entrepreneurial smaller end. The latter will be driven by major developments in clean technology, in particular, which was just given a two-year window to gestate before the major economies worldwide turn higher and begin driving energy prices straight up.

David Merkel is hopeful, but skeptical. He feels that not only do we need to delever, we will. That means a lot more difficulty. This plan shuffles the issues, and maybe that is an improvement, but the issues remain. If you don’t read David regularly, start.

Treasuries got clobbered. Many bonds seem attractive right now, except treasuries. Kind of the opposite of returns in recent weeks. Yields are low and the world is likely to be awash in them (as if it already wasn’t) in the future.

Lastly, surprise, surprise, Nouriel Roubini is still very pessimistic. I have been with him all the way, I hope it isn’t quite as bad as he thinks:

Nouriel Roubini, the professor who predicted the financial crisis in 2006, said the U.S. will suffer its worst recession in 40 years, driving the stock market lower after it rallied the most in seven decades yesterday.

“There are significant downside risks still to the market and the economy,” Roubini, 50, a New York University professor of economics, said in an interview with Bloomberg Television. “We’re going to be surprised by the severity of the recession and the severity of the financial losses.”

The economist said the recession will last 18 to 24 months, pushing unemployment to 9 percent, and already depressed home prices will fall another 15 percent. The U.S. government will need to double its purchase of bank stakes and force lenders to eliminate dividends to save them from bankruptcy, Roubini added. Treasury Secretary Henry Paulson said today he plans to use $250 billion of taxpayer funds to purchase equity in thousands of financial firms to halt a credit freeze that threatened to drive companies into bankruptcy and eliminate jobs.

“This will be the first round of recapitalization of the banks,” Roubini said. “The government has to decide to intervene much more directly in the provision of credit and the management of these companies.”

[...]

“The stock market is going to stop rallying soon enough when they see the economy is really tanking,” Roubini added.

The U.S. unemployment rate stood at a five-year high of 6.1 percent last month. Home prices in 20 U.S. metropolitan areas fell 16 percent in July from a year earlier, the most since records began in 2001, according to the S&P/Case-Shiller home- price index. Bank seizures may push home prices down further, scaring away buyers in coming months, after U.S. foreclosures rose at the fastest rate in almost three decades in the second quarter, according to the Mortgage Bankers Association.

Roubini said total credit losses resulting from the meltdown of the subprime mortgage market will be “closer to $3 trillion,” up from his previous estimate of $1 trillion to $2 trillion. The International Monetary Fund estimated $1.4 trillion on Oct. 7. Financial firms have so far reported $637 billion in losses, according to data compiled by Bloomberg.

Summary:

Stocks are not cheap, but long term investors finally have a market priced to deliver reasonable returns. Neverthess, stocks not only could become cheap, the market is facing many risks, including the possibility of much lower earnings than are now expected. Some exposure to the market may be warranted, but scaling back in over time makes more sense than going all in at this time.

Hat tip: as always, some of this is from Abnormal Returns. Even if not, go there.

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Technorati Tags bear market, bond market, bull market, Charlie Munger, closed end funds, Commodities, credit crisis, David Merkel, dividends, Doug Kass, economy, Ed Easterling, Henry Blodget, housing, Iceland, Jeremy Grantham, lazy portfolio's, leverage, markets, Marty Whitman, municipal bonds, Nouriel Roubini, p/e ratio, Paul Kedrosky, recession, Russ Kinnel, stocks, subprime, tresuries, Valuation, Yves Smith

Money tends to go where it is best treated, as measured by an asset class, hedge fund or by a traditional investment adviser. As a result, a lot of money will be shifting by year-end, and it is bound to have a disruptive market effect as well as likely to feed continued volatility.

If you delegate investing to an adviser, here are several questions that you may consider asking during a 2008 year-end review of your investment performance:

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Briefly, I think I will answer for those of you who do invest with us, how I would answer the questions. Feel free to question us more closely in person. Note: While this discussion applies broadly to all of our clients, it is specifically addressed to the vast majority of our assets under management, accredited and qualified investors (those with a net worth of 1 million and up) in our model portfolio’s.

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

In our case this discussion really should not be constrained to 2008. We believe we are in the midst of a long term bear market that began with the bursting of the tech bubble in 2000, especially for US financial assets. We participated in the cyclical bull that began in 2003, with significant allocations to international, emerging market, real estate and other high flying assets. Starting in 2006 we began to become more defensive as valuations became more and more unreasonable, allowing our portfolio to move forward based on those areas we felt were most attractive. That allocation allowed us to post strong results through the third quarter of 2007, but the portfolio was dominated more and more by assets not dependent on the general direction of the market. By 2007 we felt returns were likely to turn negative, the economy would struggle and a defensive portfolio was the most prudent path. We had by February of 2007 scrubbed nearly all exposure to financial stocks from our portfolio.

In general our expectations have been met. The markets, especially financial stocks have struggled. Following our strong showing through the first three quarters of 2007 we had a strong burst in the fourth quarter as the markets in the US fell. We weathered the storm in January with a small gain and when all was said and done had a solid first half of the year, with positive returns in each quarter, with solid gains in June to finish off the second quarter.

We began to have concerns short term with our exposure to commodity stocks, especially energy, and hedged that exposure somewhat. We assumed that some of the relationships in our hedged positions might have a short term reverse as well. Unfortunately all of our main performance drivers reversed from the middle of July to the middle of August. It was unusual that all would reverse at the same time, as opposed to being spread out. Unfortunately most, if not all, of our gains during 2008 were lost, though we were still positive since the downturn in the broader equity markets began in October. We feel that most of what we are doing now is still well positioned, with the most likely trouble spot being our unhedged positions, specifically commodity stocks and Asia. Depending on their relative performance we will have a flat to positive end to the year. Our expectation is we will finish the year with returns in the high single digits, which is what we expected at the beginning of the year.

What about surprises? The relative strength of small cap and real estate stocks stick out. We feel they will resume their under performance going forward. Commercial real estate is starting to roll over and we expect that to weigh on REITs. Small cap stocks are still very overvalued, and earnings likely to continue to disappoint. As credit markets and the economy become even more strained access to credit will hit them hard. If they struggle greatly relative to larger, higher quality stocks we could see our expected return numbers increase markedly.

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

We have outperformed broad market indices handily year to date, since the downturn began, and for trailing one, three and five year periods. Heck, we are positive for the year! Accomplishment enough, if unspectacular. Compared to the indices the various areas of our portfolio have performed from okay to fantastic. No major underperforming areas.

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

We felt the US faced a high probability of a recession coupled with a worldwide slowdown. We felt the credit markets were the most vulnerable, due to a severe housing downturn, and inflation would be an concern. Interest rates were a bit uncertain since, with inflation an issue and growth vulnerable, the fed would be pushed in both directions. More importantly, due to the difficulties in the credit markets we felt interest rates would be relatively insensitive to the federal reserves efforts and interest rates would remain stubbornly high, with credit spreads likely to widen dramatically. Thus we felt diversifying credit exposure internationally would be prudent and bonds would not be as positive a counter to equity risk as they were in the last downturn.

That has all come true, but our moves to diversify in fixed income have not proven of much benefit. However, our emphasis on other strategies to reduce risk versus fixed income has added value, demonstrating that an over reliance on traditional fixed income to protect in a downturn would not be optimal. In fact, fixed income has been a drag on performance on both the upside and downside of the market over the last two years for us.

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

Yes, though our change occurred before the downturn. We have made some small tactical changes as the year has progressed, though our fundamental approach we feel is still sound. We are preparing for some significant changes in the near future, especially if the equity markets weaken substantially from here and we position the portfolio for a more positive market environment.

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

This question really doesn’t apply to us since we don’t trade individual securities, though we have hedged positions where one side or the other have struggled. That of course is the expectation for a hedged pair of positions targeting an absolute return. Nevertheless we wish some had been more successful, even if as a pair they outperformed the indices.

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Not only do we, it is a core value at our firm, and that is exactly how we put it. “We eat our own cooking.”

Hat Tip: Barry Ritholtz

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Technorati Tags absolute returns, advisors, assessing performance, bonds, investment performance, markets, stocks

Buried around a truism, the New York Times has produced a misleading and rather silly piece on the value of “predictions.”

The thrust of the piece is that predicting the markets and the economy, especially in the short term, is fraught with peril. True enough. That is why whenever giving our view of the future it is in terms of the risks one takes relative to the returns one might get. Hence the name of this site.

However, some things can be said, and often with a great deal of confidence. Timing is an issue, the magnitude can cover quite a bit of ground, but things can still be said. The problem for investors is that in a world filled with conflicts of interest and myopia how to tell which views on those tradeoffs to which one should pay attention? It is not that “predictions” (which is a term they use loosely) are to be ignored.

Anyway, that is the stated context for the article. The subtext however is the denigration of “outlandish” predictions, by which they mean those emanating from us negative nellies. Thus, the somewhat cautious claim of Bill Gross of a trillion dollars in losses related to the credit crisis is trivialized:

But despite this decidedly mixed track record, forecasters still enjoy a rapt audience, particularly at a moment when so much in the markets depends on the uncertain course of the housing market and the broader economy.

At investment and commercial banks, losses tied to bad mortgage investments, which now exceed $450 billion, are certain to rise further if home prices continue to decline and more
people default on their mortgages. Last week, Bill Gross, a prominent bond fund manager, offered another forecast for the final bill: $1trillion. Some market watchers say the figure could be even higher.

Obviously we will not know for sure until some time down the road, but it is interesting that Gross, as well as a number of others who have been hooted down for their alarmism, have consistently been proven to be too optimistic. The 450 billion dollar figure which everyone recognizes will go dramatically higher (that is math, not opinion) is already dramatically higher than we have been repeatedly told would be the most the losses would be.

Our firm, as well as a number of others, are not band wagoning here. We “predicted” that we would be fortunate if the losses didn’t reach a trillion or more. No precision, no claim to knowledge we didn’t have, just a little simple math which showed it would be “bigger than a breadbox.”

Despite that obvious track record which shows that some people saw at least the general outline, if not the exact shape of things, we get this kind of piffle:

Ideally, predictions on companies and stocks would be “thoughtful, nontheatrical forecasts that take a look at long-term fundamentals,” said Abby Joseph Cohen, a longtime strategist at Goldman Sachs.

But, Ms. Cohen added, less dramatic forecasts rarely make headlines. “If what is being provided to viewers and readers are these theatrical forecasts, that is what many people will pay attention to because that’s what they have available.”

Abby may be a wonderful person to have over to dinner, and a dear friend to have, but she is also someone who has led more investors over a cliff than any major strategist of the last ten years. Abby has been the outlandish one, as anyone who was unfortunate enough to listen to her in 1999 and 2000. I am sure she views the thoughts of those who have consistently stressed the risk levels and overvaluation of stocks over the last 10-12 years as being outlandish in their claims. However, look at the returns of the market over the last 10+ years (10 year return for the S&P500: 2.55%.) Pitiful.

“We have gone from an abnormally calm period, and we’ve blown right through normal volatility,” Ms. Cohen said. “We are in an exceptionally volatile period.”

Does anyone fact check at the Times? That is an outlandish claim. It is most decidedly not true. For those who wish to get a more accurate description of volatility today versus history, the essential Ed Easterling of Crestmont Research will bring you up to speed (pdf.) Listen to Abby at your peril.

This however tales the cake. First, the truth:

Another source of investment guidance used to come from research analysts, who try to predict quarterly earnings at companies. But there is a great deal of guesswork involved here, too. Analysts correctly predict earnings only a fifth of the time. Nearly two-thirds of quarterly earnings beat estimates, and the rest come in too low, according to data from Thomson Reuters. Many companies, of course, try to defuse overly optimistic forecasts to manage investors’ expectations and deliver “better-than-expected” results.

Then this nonsense:

This year, Wall Street’s crystal balls have performed even worse than in the past. As earnings season for the second quarter winds down, 67 percent of companies reported earnings higher than what analysts had predicted, and 22 percent reported earnings that were worse. Only 10 percent of companies matched analysts’ expectations.

We go from a decent point about how wrong analysts are to this misleading………

Okay, I will attempt not to get steamed. The problem with analysts is they are consistently too bullish, and by huge amounts. Exactly the opposite of what that statement implies. Yes, companies consistently beat the estimates when they are finally reported, but only after analysts slash those estimates almost down to the day the reports are made. This year companies have consistently failed to make estimates that were made just weeks earlier. Compared to what was “predicted” 3, 6 or twelve months ago the earnings have been dramatically lower. There is a problem with analyst predictions, and investors should be warned. However, this just muddies the issue of what those problems are. Conflicts of interest, behavioral biases, being too optimistic about the particular industries they cover (even when not conflicted) etc. It is not that they are too cautious about earnings prospects.

Then, to add insult to injury, we get this:

Poor predictions are nothing new in the financial world: in 1999, a pair of prognosticators — James K. Glassman and Kevin A. Hassett —published a book titled “Dow 36,000”; the blue-chip index closed last week at 11,370.

But investors seeking light in a dark period may just have to stick with no one’s predictions but their own.

That helps investors. We get evidence that some of the silliest predictions of the past were wrong; a false implication that analysts are often wrong, but too bearish; a plea from one of the most disastrously bullish strategists of our era not to listen to outlandish claims from people who have been proven correct; and people who make valid points (such as Taleb) are placed in a context with which I am sure they are uncomfortable; all in the service of a message that no one’s advice is worth taking. Never mind that most of the greatest investors of the past half century warned repeatedly that returns were likely to be unsatisfactory, regardless of this present crisis. Never mind that many, if not most, of those same voices warned repeatedly that the housing market was set for a fall, that a credit crisis was likely imminent, and on and on.

No, we shouldn’t listen to anybody.

Since the Times doesn’t want to tell you this, or examine it, I’ll jot down a few things to keep in mind.

• Analysts are almost always too bullish.
• As one of her sources, Taleb, would likely agree, economic models based on assumptions of equilibrium (essentially all of them) unsurprisingly almost always (until the horse is out of the barn) predict some sort of equilibrium, or at least a tendency to move back towards it. Thus economic activity is often well outside of their predictions. More importantly, “fat tail,” or extreme, events occur at rates far more frequent than their models assume. There are literally dozens of market and economic events which have occurred over the last century, when statistically (according to the assumptions of modern finance and economics) it was unlikely even one would happen.
• The real returns from stocks are much lower than most market commenters and professionals realize.
• You can with a fair degree of confidence predict most asset class returns over 5-10 years of time. I said with a fair degree, not certainty. Unfortunately most attempts to do so use unrealistic assumptions or historic returns. The first problem is obvious, but requires knowledge of what is reasonable. Most people use the latter, historic returns, as their guide. Big mistake.
• Also, somewhat off topic, though important nonetheless, stocks are not cheap yet, but they may still go up.
• I think it is unlikely they will not go lower from here.
• For Clients: If stocks do go up smartly and we don’t do as well as we could have, we have had a pretty darn good 12 months (or five years for that matter.) Trailing a bit now would hardly be a crisis, and as last year proved, we may not trail even then.

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Technorati Tags forecasts, media, New York Times, Risk

Using far more “off the cuff” methods than Nouriel Roubini, the IMF, Jeremy Grantham, John Hussman, UBS, John Paulson or Goldman Sachs, I have been expecting the starting point for discussion should be something around 1.2 trillion, with significant risk to the upside on that number. That was across the system.

Now, in addition to that rather prominent band of bears comes Bridgewater, one of my favorite reads, who estimate that financial institutions alone will see losses of 1.6 Trillion. This comes courtesy of Paul Kedrosky who translated the leaked report:

Explosive Study: The banking crisis will be much worse

Westport (USA) – The expected losses from the financial crisis will reach $1600 billion. To-date financial institutions have so far announced only $400 billion. The pessimistic forecast comes from a confidential study by Bridgewater Associates, the second largest hedge fund in the world.

“We are facing an avalanche of bad assets,” says the study. The biggest losses were the U.S. credit banks before. “We have big doubts that the financial institutions will be able to have enough new capital in order to cover the losses,” the authors write.

Bridgewater Associates in financial circles enjoy a first-class reputation, several central banks are among its customers. “Bridgewater are on the pessimistic side,” says George Magnus, Senior Economic Adviser at UBS in London, “but they have absolutely right.”

I don’t know if this hitting the blog world explains the sickening reversal in the market today, but if it doesn’t it probably should.

Off the cuff ? What do I mean?

Simple, sometimes when you start adding up something that is really huge it doesn’t really matter or help to know exactly how much risk there is, or where all the damage will come from, it is bigger than a breadbox, or in this instance, bigger than a piano falling from 10 stories up. At some point it pays to just get out of the way. I remember telling clients who kept asking me when would be a good time to invest in the Nasdaq (especially QQQ’s) during the last bear market that I had no idea, and frankly didn’t see the point in trying to figure it out. I wasn’t even going to look at it until it was below 1500. The usual response was a blank stare and incredulous statements about how it “couldn’t go that low!”

Same here. Once the losses start going past the trillion point get back to me, I may bother to put a more precise estimate on it, though by then you probably will not care.

Or, to put it the way I put it in response to a discussion of what we were going to do based on our outlook for the market and how bad that outlook should really be:

It seems to me that debating whether a building you are about to fall off of is 30 or 60 stories high is a bit irrelevant, the answer is still “step away from the ledge.” I don’t think it changes what we should be doing now to know exactly how bad it is going to get.

Is this priced into the market? No, a thousand times no. On a related note, Barry Ritholtz looks at what happens after big one month sell-offs. In the past a rebound, but he asks good questions for those tempted to trade this for a bounce.

Technorati Tags banks, credit markets, economy

A robber in a ski mask blamed the bank for what he was about to do, The Associated Press reported Feb. 22.

“You took my house, now I’m going to take your money!” the assailant hollered. Talk about a reverse mortgage!

The FBI plans to review the bank’s foreclosure records for clues.

The suspect is presumed to be ARM’ed and dangerous.

The New York Times reports that bailing out homeowners is becoming increasingly talked about. This graphic explains why:

Alan Blinder wants the Feds to enter the mortgage business as they did in the great depression. Hat tip: Greg Mankiw

Edmund Andrews worries that Mortgage bailouts could create moral hazard issues. Uh, you think?

Tanta is pretty unimpressed, though she does give us some thoughts on the issues around making mortgage securitization less of a disaster than it has been this time around.

Dean Baker points out that plans to buy up the mortgages does carry some risk. Throw in his lack of conviction that raising the ceilings for the mortgages that Fannie Mae and Freddie Mac can purchase in areas with high-priced homes will help.

This post on worries about the credit worthiness of Fannie and Freddie shows the markets are pretty unsure about them as well.

Mark Thoma gives his thoughts here and here.

Yves Smith has the most realistic reaction to all these proposals for solving these issues. They probably will not work, expose us to moral hazard, and would be far more expensive than Alan Blinder believes. Many of the solutions look at this as a temporary problem of credit markets and people who couldn’t afford their homes. That is true, but more fundamentally homes need to come down in price. Plans that assume the need to stabilize home prices, or help out borrowers who are over extended, are building in failure. Prices will likely not stabilize, and probably shouldn’t. James Hamilton seems to agree as well:

To the extent that analysis is correct, a “pause” in the foreclosure process will be helpful only if house prices are finished falling. But house prices decline sluggishly in response to market pressure, given the unwillingness of many sellers to acknowledge the magnitude of their capital loss. Even if the number of homes sold were to rebound tomorrow, there would remain a large inventory of unsold homes that will continue to push prices down.

Calculated Risk looks at the merits of the various home price indexes. James Hamilton weighs in on the topic as well.

The National Association of Home Builders remains cautious about the market going forward despite a slight up tick in activity. The fact that permits fell, starts were flat, and for single families at the lowest level since 1991 might have something to do with it (pdf.).

As abandoned homes pile up neighbors in Minneapolis are being urged to “adopt” their neighbors homes .

Barry Ritholtz lets us know about Rotten Neighbor.com .

Some believe this whole mess is part of a fundamental shift in the American landscape, with cites doing better, suburbia declining and taking on some of the characteristics of decaying inner cities. Extreme, but some of it has a ring of truth as urban living becomes more desirable and desired.

But we could be Britain!

Britain’s housing market is a “house of cards” that is set to implode after years of reckless mortgage lending, chronic oversupply of new flats and widespread fraud, a leading analyst said yesterday. (The Times) (via Barry Ritholtz )

Now for a Little discussion of the past

One of the ongoing debates over the last few years has been the economic impact of home equity withdrawal through home equity lines of credit and loans, cash out refinances, etc. How important was it? Was it sustainable?

I think those of us who worried about it can claim that it is now fairly clear it wasn’t sustainable. So let us go down memory lane and look at what was of such concern by the end of 2005:

Notice the two previous big drops came with pretty large economic downturns. The drops worsened the downturns and the downturns worsened the drops. That seemed pretty obviously something to be concerned about, but we negative Nellie’s were told to pipe down time and again. By this Summer that trend was reversing :

The problem for the market:

One would expect to see profit margins coming under pressure, even without the mortgage meltdown. Historically a housing downturn has been bad for the economy, despite claims by some that it would be “contained” and is a small part of the overall economy. Once again, that is without the mortgage and credit market meltdown we are now experiencing:

Nevertheless people still argued that Mortgage Equity withdrawal was somehow different than other debt because it was being used on improvements. Well that economic engine has gone into reverse:

ORLANDO, Fla. – Those fancy home fix-ups touted in cable TV shows and home magazines are losing their luster with consumers.

With the shakeout in the housing market, homeowners are worried they won’t get their money back from high-dollar redos.

And lenders are less willing to finance pricey home improvements.

That has caused a decline in nationwide remodeling.

“We saw a downturn in 2007, and 2008 looks every bit as tough for the industry,” said Kermit Baker, a researcher with Harvard University’s Joint Center for Housing Studies. “After some almost record-breaking growth, the market has stalled.”

Per capita home remodeling expenses in the region that includes Texas jumped almost 50 percent between 1996 and 2006. But since then, spending for home upgrades has fallen.

In a quarterly comparison, nationwide home remodeling expenditures have fallen about 10 percent since their high in 2006.

Researchers blame the downturn in the overall housing market for dampening the desire for home redos.

“Homeowners have been scaling back on their remodeling plans as the overall market has weakened,” Mr. Baker said.

“Homeowners are concerned that they may be overimproving their homes relative to their neighborhood and prices in the market.”

Studies back up those concerns. Average returns on a home remodeling project have fallen from 82.5 percent in 2003 to 70 percent last year.

With home prices depressed in many neighborhoods, homeowners are especially worried that they won’t get the bucks back they spend on luxury features such as saunas, European cabinetry and imported tile floors.

“There are some signs that the emerging weakness may be greater at the upper end of the market,” Mr. Baker said. “We are seeing more of a return to basics.”

That means less costly improvements and standard maintenance, he said, rather than “some of the sexier kitchen and bath projects.”

Tanta goes back over the argument at length at Calculated Risk, but obviously it has not been sustained. Nor was any where near all the equity withdrawn going to improvements on homes, so we can expect declines across a range of goods and services.

Tellingly, banks and lenders now agree on that fact:

Last year, 34 percent of borrowers said they used their home equity lines to pay off other debt and 29 percent used them for home renovation, according to a survey of lenders by BenchMark Consulting International. Another 31 percent used them to pay for other things, such as medical bills, weddings or vacations.

Paying off other debt in many cases only meant freeing up the ability to run those credit accounts up again. The assumption being that home appreciation would continue so they could do it again, or just plain didn’t have any plan at all. So the banks are now freezing people’s Home Equity Lines of Credit :

Larry F. Pratt, chief executive of First Savings Mortgage in McLean, said most mortgage documents he has seen give lenders wide latitude to suspend or freeze credit lines.

“A layperson would not recognize the language because it’s not that blatant,” Pratt said. “It talks about deterioration of the value of the asset or the value of the collateral. . . . It’s not boilerplate language by any means.”

Across the nation many borrowers are upset. This will put a crimp in consumer spending moving forward.

Hat tip: as always some of this is from Abnormal Returns. Even if not, go there.

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Technorati Tags bailout, credit crisis, Economics, economy, home equity, home equity loans, housing, subprime

The indicator in question focuses on corporate money-raising. Considerable research has shown that when companies turn aggressively to the equity market for their financing needs, through new issues or secondary offerings, it is a sign that the stock market is overvalued. Though there is no easy way to interpret the data, current trends in corporate finance appear no worse than neutral for the stock market’s intermediate-term prospects. And the data may actually be painting a bullish picture.

[...]

Professor Lamont, who is also a portfolio manager at DKR Capital, a hedge fund in Stamford, Conn., has calculated the new-list percentage back to 1929. Its all-time high was nearly 15 percent, at the beginning of the Depression. Its second-highest level, almost 11 percent, was in March 2000, just before the Internet bubble burst. (He published these results in 2002 in an academic working paper.)

This result doesn’t surprise me, and is intuitively reasonable. There is also this:

Two researchers who have studied these patterns are Malcolm P. Baker, a finance professor at Harvard Business School, and Jeffrey Wurgler, a finance professor at New York University. For each year from 1927 through 1996, the professors calculated the share of total capital raised by publicly traded corporations that came from issuing stock — what they call the equity share.

Over the 12 months after the quartile of years with the lowest equity shares (when this proportion was no higher than 14 percent) the stock market returned an average of 14 percent, according to the professors. In contrast, the market had an average net loss of 6 percent following the quartile of years with the highest equity shares (when this proportion was no lower than 27 percent). Their results were published in the October 2000 issue of the Journal of Finance.

This likewise makes sense that you would generally observe those conditions.

Where does the equity share stand now? In an e-mail message, Professor Wurgler said it was 6.1 percent for 2007 through September, the latest date for which data are available. Because this puts the current market solidly in the quartile of past years that were followed by above-average returns, he says the data are sending “a bullish stock market signal.”

So maybe I should be trading in my bearish hat over the next few years? I don’t think so:

In separate interviews, he and Professor Baker hastened to add that this bullish signal by no means justifies throwing caution to the wind. They pointed out that companies have had far easier access to cheap debt financing in recent years than they did in earlier decades. As a result, they argued, the current low equity share may not be strictly comparable with similarly low previous readings — and thus may not be as bullish as it otherwise would appear.

Throw in large cash reserves, record profit margins (which are reliably mean reverting) and companies hardly needed to issue equity. They already did that in extremes earlier. Much financial activity was diverted to private equity and M&A as well.

But judging from how companies have been raising new money, Professor Baker said, there was little evidence of extreme levels of speculation at the recent stock market high. At least to this extent, he said, this means that “there is less downside risk in the market today than there was in March 2000.”

Maybe so, though it seems a big risk one must account for in any decision on how to allocate assets. The problem, like with much finance theory, is that these are coincident indicators of the real problem, excessive speculation driving assets far above a reasonable estimate of their long term value. When stocks are overvalued companies do tend to issue equity, we see more companies going public, etc. However, they are not the actual driver of returns, and thus can give us a hint to check on whether the market is overvalued, but not whether it is.

Simply put, any reasonable assumption about growth in earnings, payout ratios and profit margins predicts low returns. Whether those low returns are fairly valued or not, there they are. If valuations decline to boot, we have a major decline in store.

I don’t believe investors realize how low the embedded returns in stocks are. Since I believe investors think that the US stock market can give them higher returns at these levels than is likely, when they are disappointed by declining profit margins and growth rates below their assumptions (combined with looking at their pathetic returns over the last 10 years) they will likely adjust the price. That adjustment could come fairly quickly (It would take a 30% or more drop from here just to get back to equities being priced to deliver real returns close to 5%) or by a combination of smaller declines and rallies going on for years, such as we have seen since 2002. That of course assumes inflation doesn’t become a larger issue (very much in doubt) and/or the pessimism doesn’t cause a large over shoot to the downside. When investors have been disappointed for a period of 10 years or more they have had a habit in the past of getting in very dark moods.

Hat tip: Abnormal Returns

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Technorati Tags equity, IPO's, returns, Risk, stock market indicators, Valuation

If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. The recessions that began in 1991 and 2001 lasted only eight months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.

But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.

In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy.

The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.

But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.

The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment.

Read the whole thing, but it mirrors much of what we have been saying. Here is Martin on the Charlie Rose show where he stresses that it is not just a subprime issue, that all kinds of assets were not priced appropriately, and frankly still are not:

Hat Tip: Barry Ritholtz

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Technorati Tags Charlie Rose, credit markets, Economics, fiscal policy, Martin Feldstein, monetary policy, NBER, Risk, the economy

The whole world of economics is enormously more complex than the world of physics. And therefore the teaching of business schools, including Yale’s, is unrealistic. Even though economics is a very old subject, it has not truly come to grips with the main difficulty, which is the inordinate practical importance of a few extreme events.
-Benoit Mandelbrot

The largest determinant of investment success is how you perform during these extreme events. While a well diversified portfolio may give you incremental performance gains during normal times, one which performs well during extreme events can lead to compounding returns of enormous consequence to your long term wealth.

Technorati Tags Benoit Mandelbrot, compounding, extreme events, quotes, Risk, Wealth

In the insurance business, there is no statute of limitation on stupidity.

-Warren Buffett

If only the monolines (that survive) credit default swap investors, and others could keep this in mind going forward. Risk has to be priced not on the basis of the current environment, but on what that environment might be down the road. In a mean reverting world, good times are not a reason to accept lower premiums for risk.

Technorati Tags insurance, monolines, Risk, risk premium, swaps, Warren Buffett

As I wrote in April 2000, bear market psychology typically evolves something like this:

“This is my retirement money. I can’t afford to be out of the market anymore!”

“I don’t care about the price, just get me in!!”

“It’s a healthy correction”

“See, it’s already coming back, better buy more before the new highs”

“Alright, a retest. Add to the position – buy the dip”

“What a great move! Am I a genius or what?”

“Uh oh, another selloff. Well, we’re probably close to a bottom”

“New low? What’s going on?!!”

“Alright, it’s too late to sell here, I’ll get out on the next rally”

“Hey!! It’s coming back. Glad that’s over!”

“Another new low. But how much lower can it go?”

“No, really, how much lower can it go?”

“Good Grief! How much lower can it go?!?”

“There’s no way I’ll ever make this back!”

“This is my retirement money. I can’t afford to be in the market anymore!”

“I don’t care about the price, just get me out!!”

Heh, well I don’t think I see that kind of attitude yet. He makes some other points which I have discussed before, but bear repeating:

But as I’ve frequently noted, most bear markets are not simply one-way movements. Bear markets typically comprise two, three or more separate 10-20% declines, punctuated by fast, furious rallies. It’s easy to forget that the 2000-2002 bear included three bear market advances of 20% from intra-day low to intra-day high, as well as numerous smaller advances, all of which were surrendered in subsequent plunges to new lows.

What about earnings growth? I don’t think we will see much this year, but even if I am wrong I would suggest not getting too comfortable:

At the January 1973 market peak, earnings had hit a new high, and stock prices were selling at a P/E multiple of 20, which is extreme on the basis of record earnings. Over the next 2 years, corporate earnings grew by 56%, yet the market fell by half. The 73-74 bear market teaches that stock prices can decline from rich valuations even if earnings grow dramatically:

How that worked out is gone into in detail and with a bit of sass. As I said, well worth reading. Market history does not prove what will happen in the future, but it does prove that some beliefs cannot be counted upon.

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Technorati Tags Bear markets, history, Valuation

Secondly, this occurred at a time of what I believe is the first global bubble in pretty well all asset prices, so there is a much greater degree of broad-based vulnerability.

This is why traditional, long only diversification is likely to be less effective than in the last downturn, and even tactical, long only measures will be difficult to implement. What do you over weight if everything is expensive? In 2000 it was real estate, value, especially small cap value (like home builders) emerging markets, bonds, etc. Does anyone see those as a place to hide now?

People think the Federal Reserve can stop a bear market because they can throw money at it and lower interest rates. It is even more certain we can collectively stop a bear market if some fiscal stimulus is thrown in. To which I say, ‘Oh, you mean like 2000 and 2002?’ — when they threw what I call the greatest stimulus in American history, an unparalleled series of interest-rate cuts, cumulating in two, almost three, years of negative real returns, real interest rates coupled with a really substantial tax cut, which would never have happened without 9/11.

The combination would have gotten the dead to walk, and it stopped the bear market eventually. But the Standard & Poor’s 500 was down 50% and the Nasdaq — which was all anyone talked about back then — went down 78%. And a puny five to six years later, people are saying there is not going to be a bear market because the Fed is going to lower rates and because the government is going to have a stimulus package. But we have just been there, done that, and we had a nice bear market.

As stated here before, I watched a lot of people “not fight the fed” all the way to large losses last time around. Can we learn anything?

What about places to hide?

That isn’t something we can laugh off. Last time, there were plenty of opportunities: Bonds were cheap and TIPS (Treasury-inflation protective securities) were brilliant; real estate was cheap and REITs were brilliant. Even within equities, emerging markets were much cheaper than U.S. equities, and within U.S. equities, value stocks were only a little expensive and small-caps were only a little expensive and small-cap value was actually a little bit cheap. So you could really hide and could reasonably expect to make money, which we did in each of the three years of the bear market.

Uh, already addressed this, but let us look at another couple of themes of ours:

Profit margins, the great prop to the market, surprisingly defied the laws of gravity for three years in the developed world and, particularly, in the emerging world and even in Japan. That was because the global economy was stronger than any corporation counted on and, in the U.S., consumption was always higher and our savings rate was always lower than any corporate economist would have suggested, going into negative territory. But there are a few near certainties in this business — not many, but a few — and one of them is that abnormally high profit margins will go back to normal. The timing is unfortunately shrouded in fog. The other near certainty is that house prices will go back to a normal multiple of family income. In the end, we, the people, have to be able to afford the houses and they are affordable at something around 2.8 times family income. When they peak in Boston at 6 times and nationally at 3.9 times, you know you are in for tough times.

What about the magic elixir of lowering rates boosting economic growth?

It doesn’t have that much of a powerful effect on the economy. If it had any more profound effect, there would be a positive relationship between debt increasing and GDP growth, and there is none.

It doesn’t?

I have an exhibit that shows the 30 years prior to 1982 when the debt-to-gross domestic product ratio was completely flat at 1.2 times. Total debt is defined as government debt, personal debt, corporate debt and financial debt. Then in the 25 years after 1982, the flat line goes up at a 45 degrees angle from 1.2 times to 3.1 times GDP. Massive. In the first 30 years, when debt is flat, annual GDP growth is its usual battleship, growing at 3.5% and hardly twitching. After the massive increase in debt, GDP, far from accelerating, grew at 3%. So debt in the aggregate does not drive the economy. The economy is driven by education, man-hours worked, capital investment and technology. It is not driven by what I owe you and you owe me.

Of course it could have an effect elsewhere:

It drives down the dollar, which is inflationary, and, eventually, it could be seriously inflationary.

I think we have mentioned that we aren’t too hot on private equity as a diversifier for the moment, and we suspect it is in a bubble of its own. Jeremy nails down why:

I have yet to meet a private-equity firm that put into its spreadsheet the assumption that system-wide profit margins could decline by 20% to 30%. They have taken the current, abnormally high profit margins as a given and then determined to improve them by, let’s say, 15% and assume everything works out pretty well.

But if the base declines by 20%, even if they end up improving margins by 15%, they are going backwards. And if they pay the 25% premium up front, which was normal, and if they leverage 4-to-1, which was normal, then they almost precisely wipe out all of the clients’ money, all of the 20% in equity and if, perish the thought, they don’t add 15%, but add perhaps zero to 5%, then they do more than wipe out the equity, they leave the underlying debt in ragged disarray. That is the next shoe to drop on the credit side.

Jeremy was wise enough to avoid financials like the plague, and we took his advice last year. Thank goodness. Thank goodness we not only listened, but have a significant amount of assets invested with him. That, combined with our hedges, has turned out to be a profitable move.

His prediction, which seems about right given the numbers I have been watching, on the housing market:

It has a lot to go. It still has to drop 20% to 25% to reach more normal levels, or if you prefer, it could wait five years for income to catch up, barring no big recessions. With the housing market gone, people turned to credit cards and with economic times slowing down — whether there’s a recession or not — consumers are going to slow down a lot, are slowing down or have slowed down a lot.

Update: For those without a subscription, Seeking Alpha has the beginning of the interview.

Technorati Tags Barron's, bubbles, debt, Federal Reserve, Housing Market, Jeremy Grantham, profit margins, stimulus, stock market, Valuation

However, at some point in the future I expect that the S&P500 will not retain its gains beyond what was made in 2003. All the rest, if not more, will likely be given up at some point.

That is not a prediction about the near term, but it would not surprise me if it were to come true over the next year.

Our investment approach does not depend upon it, or even a downturn at all, but it is a risk we have actively accounted for in our approach. Doing so has been a profitable decision for those of you who are in our tactical asset allocation models, both before the recent swoon, and since. I hope that you are pleased and will reward us with your continued confidence.

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Technorati Tags expected returns

On the investment merits however, stocks in general are at extreme levels only exceeded significantly by the recent tech bubble. Only by comparison to the elevated levels of the last 15 years can the S&P 500 be considered even reasonable, much less inexpensive. Unlike 2000 when many asset classes were reasonable, and only cap weighted indexes and a few components were expensive, almost all asset classes are overvalued. In many ways, from a valuation standpoint, this is a far more tenuous situation than 2000 when you could easily select assets that had not taken part in the bubble. Now there are few places to hide.

So no, the market hasn’t “discounted” a recession. Even the idea that the U.S. economy is in recession is contentious. The S&P 500 is off only about 10% from its record highs, recession concerns and a weakening of profit margins are not reflected in market prices. At best, they are discounting a slowdown based on the assumption that recent earnings growth and profit margins can be extrapolated longer term once we get past it.

John Hussman put it well (my emphasis)

Similarly, in stocks, analyst estimates reflect a quick return to record profit margins about 50% above their historical norms. If those assumptions disappoint and it becomes clear that profit margins will not be forever sustained at record highs, it doesn’t only imply near-term earnings disappointments – it implies that the whole stream of future earnings impounded into stock prices is wrong.

Since I believe this has been a long term issue, how bad has the valuation penalty been so far? Since April of 1998 the return of the S&P 500 has been below that of Treasury bills. That is almost 10 years! Since 2000 the S&P 500 has trailed inflation. In fact, the S&P500 has trailed treasury bills since Nov. of 2005 as well.

Is the market significantly cheaper than in 1998? No. Should we expect better going forward? No. The likely path is we will get similar or worse returns in an interesting way.

So, who will make money with real returns that an investor might consider satisfactory? The lucky, savvy speculators, the hedgers (I put my money on L/S guys in the vein of Julian Robertson) tactical asset allocators who hedge and protect capital (using some of the above) etc. Indexers, closet indexers and other low tracking error portfolios will disappoint.

Vitaliy Katsenelson, author of Active Value Investing: Making Money in Range-Bound Markets (Wiley Finance)points out some of the reason’s markets aren’t as cheap as they seem (and even then we are talking about p/e ratios well above “average.”)

Unfortunately, the cheapness argument falls on its face once we realize that pretax profit margins are hovering at an all-time high of 11.9%, almost 40% above their average of 8.5% since 1980. Once profit margins revert to their historical mean, the “E” in the P/E equation will decline. If the market made no price change in response, its P/E would rise from 17 to 23.8 times trailing earnings.

Maybe profit margins will stay high?

Profit margins revert to the mean not because they pay tribute to mean-reversion gods, but because the free market works. As the economy expands, companies start earning above-average profits. The competition reacts to fat margins like bees sensing sugar water. They want some, too, so they fly in and start cutting into these above-average margins. This always has happened in the past, and it will happen again and again in the future.

Let us see a chart, we all love charts:

Vitaliy deals with the most common reason’s people believe “it will be different this time.” So read the whole thing.

Let us move on to the misuse of forward operating earnings. Comparing the historical PE ratio to forward earnings estimates fails the smell test in a number of ways. The proper comparison would be to historical forward PE’s, not trailing PE’s. On that basis we end up with a lot lower forward PE to call “average.” Throw in the elevated profit margins and we get some really scary numbers for the market to get to “average.” John Hussman:

Now, to the issue of P/E ratios based on forward operating earnings. As noted above, it’s clear that forward operating earnings are generally much higher than the record level for trailing net earnings to-date, and of course, record earnings are always equal to or higher than raw trailing earnings.

Investors are used to the idea that “normal” P/E ratios are typically in the range of 14 to 16. But as Cliff Asness of AQR has repeatedly stressed, those norms are based on raw trailing earnings. If you calculate P/E ratios based on earnings figures that are higher, you clearly obtain lower P/E ratios.

As it happens, the long-term historical norm for the P/E ratio based on forward operating earnings would be about 12.

Of course, that means we get a chart:

Look closely. Exactly when has the market been more expensive on the basis of forward earnings? The mid 60’s, which led to one of the worst periods for stock returns in market history. 1987 which corrected in a day and of course the entire late 90’s to now. All periods of severe under performance.

Uh, John gives us a caveat:

Of course, that average of 12 includes the heights of the late 1990’s bubble. The historical average was just 10.6 prior to that point.

I am inclined myself to throw out the late 1990’s (we do all agree now that the valuations of that period were insane, whatever we said at the time, right? So should insanity be used to justify anything?) Your mileage may vary. Back to those profit margins (my emphasis)

It gets worse. Currently, profit margins are at the highest level in history, which further reduces the P/E multiple we observe. If investors wish to use that observed P/E ratio as their standard of value without normalizing for profit margins, they should be aware that they are implicitly assuming that profit margins will remain at current levels indefinitely.

Okay, another chart:

The following chart presents the ratio of forward operating earnings to S&P 500 revenues (net profit margins are even more volatile).

Chart: Historical Profit Margins (Forward Operating Earnings / Revenues)

You’ll notice that prior to 1995, there were only a few instances when operating profit margins exceeded 8%. At those points, prior to the late-1990’s bubble, the forward operating P/E for the S&P 500 averaged just 8. That’s not a typo.

No, I am not predicting an 8 PE down the road. I am saying that in any historical sense the markets are not, and have not, been cheap. That is why returns have been low, below that of treasury bills for a very long time, and likely to be so over any reasonably long term interval going forward.

Go ahead and read John demolish the “Fed Model” of valuing the stock market while you are at it. In fact, Go ahead and read this from John on that very subject as well.

For further thoughts, check out Barry Ritholtz’s similar demolition. He gives us another chart on the ridiculousness of forward operating earnings from the Wall Street journal:

Look at that. How do we get from 3% and 4% for the first two quarters (which I find unlikely in and of themselves, but maybe) to 16% for the year? From Barry (my emphasis)

Analysts are unflaggingly inaccurate at turning points. Example: Q3 S&P500 earnings consensus were +8% — S&P500 earnings came in at -8%. Q4 has been similarly lowered, undercutting the earlier forecasts of undervaluation.

Now let’s look at 2008. S&P 500 forward earnings over the next 4 quarters are as follows: Q1 = 3%; Q2 = 4%; Q3 = 20%; Q4 = 50%, according to UBS.

Earnings explosions like the ones above generally only occur after earnings collapses. Earnings grow reliably at about a peak of 6% over the long term, and the average is lower. In fact, the average is only around 1% over inflation depending on your point of measuring (it looks a bit higher now, it was a good bit lower at the trough of the last earnings collapse.)

Since clients may read this I want to reiterate that seeing the challenges ahead are exactly what this site, and our investment policy, is all about. The reason we have done so well, especially over the last year, is that we have expected and accounted for these, and other, factors we have been covering. The danger is for those investors, or their advisors, who haven’t faced up to the implications of high valuations.

We’ll deal with the Fed Model in more depth here at Risk and Return in the near future. John and Barry hit some of the highlights, but there are fundamental issues which I think deserve more exploration.

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Technorati Tags Asset Allocation, Fed model, indexes, John Hussman, Julian Robertson, operating earnings, return, Risk, S&P500, Valuation, Vitaliy Katsenelson

These trades were profitable because a bond could pay out more in interest than it cost to buy the insurance available in the derivatives market to protect the holder against default. In the world of structured finance, a bank would buy a bond, get it guaranteed, or wrapped, by a monoline to support the bond’s AAA rating, but then also pay another monoline to write a default swap on the first monoline, to guard against it defaulting on its guarantee.

The difference between what the bank paid for the insurance and what it received in yield from the bond could be pocketed as “risk-free” profit – and in many cases banks took the entire value of that income over the life of the bond upfront.

[...]

Bob McKee, an analyst at Independent Strategy, a London research house, believes that up to $150bn worth of CDO business done by the monolines could be negative basis trades.

Standard & Poor’s, in a note on the potential impact of monolines on banks this week, said it believed some of the CDOs hedged by bond insurers were part of a strategy of “negative basis trades”.

The problem is that if monolines are downgraded and their protection becomes ineffective, profits booked up-front need to be reversed. Restating earnings is a very tricky area for investment banks – not least because the traders involved will have long ago pocketed their bonuses.

There is always more than one cockroach.

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Technorati Tags bonds, financials, investment banks, monolines, negative basis trades, Risk

A while back MBIA, AMBAC and other monoline insurers backed sleepy municipal bond portfolio’s. Having entered, and then become ensnared, in the broader credit markets, they face being downgraded. If they are downgraded, the bonds they guarantee are downgraded, even money market instruments:

What’s happening is that tax-free money funds are dumping billions worth of muni securities backed by shaky insurers, and these bonds aren’t attracting many buyers. Funds have the right to sell securities back to their brokers. On occasion, doing this is one way muni managers can meet customer redemptions. But now they’re using it as a convenient exit strategy to get out of troubled securities before they’re downgraded.

The problem with that solution:

The Fed worries that banks could wind up stuck with more of these bonds on their books. That would eat up valuable capital reserves. “The Fed wants banks to lend to corporations and personal borrowers, not to act as a holder of last resort,” says Robert Auwaerter, who oversees $440 billion in fixed-income assets, including $48 billion in muni money-market funds, at Vanguard Group. Retail muni money-market funds have assets of $289.5 billion; institutional versions of the funds hold $182.4 billion.

If muni money-market funds keep them they risk losing capital, if they don’t banks already struggling to stay afloat not only have to take on the liability but will have their capital absorbed by these bonds and unavailable to lend to others. The permutations of this crisis are stretching way past my point of imagination.

HT: Abnormal Returns

Technorati Tags banks, Federal Reserve, investing, monoline insurers, municipal money market

Reactions:

Barry Rithotlz- Q4 GDP: El Stinko!

• Consumption slowed to 2% from 2.8% in Q3; I suspect that only partly reflects real growth, meaning its partly inflated by price rises;

• U.S. exports continue to increase: Up 3.9% for the Q. Overseas trade added nearly half a point to Q4 GDP;

• Overall, the US economy grew 2.2% for the full year 2007 — the slowest since 2002 (1.6%)

• Inventory build, which drove the 4.9% Q3 data, was totally absent. It sliced 1.25% from GDP, after adding nearly a point in Q3.

• Inflation remains sticky: Price index for personal consumption expenditures rose by 3.9% in Q4 after a tepid 1.8% in Q3. This was the second highest PCE # since 2001

• Q4 business spending rose 7.5%. Investment in structures went 15.8% higher (which seems an awful lot to me); Equipment/software purchases rose by 3.8%.

• Biz spending decelerated in the fourth quarter from Q3’s hotter 9.3%.

Calculated Risk:

Since PCE came in at only 2.0%, clearly there was a sharp slowdown in December, and the growth from the last month of Q3 to last month of Q4 was probably negative – suggesting a recession might have started in December.

Edit: The ADP employment data is also available this morning, showing nonfarm private employment grew by 130,000 in January, and without a downward revision, those numbers are definitely not recessionary.

More on those ADP Numbers.

Bespoke delves into historical US GDP numbers.

Real Time Economics notes the weakness was highly influenced by inventory liquidation.

Manufacturers however are feeling pessimistic.

Calculated Risk breaks down the impact of non residential investment.

Dean Baker pretty much chalks up the consumer spending necessary to keep the GDP positive to spending on flat screen TV’s!

Stefan Karlsson says that trade adjusted real GDP turned negative, and thus the recession is underway.

Nouriel Roubini agrees.

The Fed Cuts!

Written before the cut was announced, Yves Smith of Naked Capitalism notes the Fed was already nearing negative real interest rates, and by some measures was already there.

James Hamilton gives us his research on when to expect the rate cuts to affect the housing and mortgage markets. Blog partner Menzie looks at how this is supposed to help and sees it as a positive, but a muted one.

Real Time Economics jumps in with several posts:

• Greenspan doesn’t think central banks have the power to prevent a recession:
  • “Global forces can now override most anything that monetary and fiscal policy can do,” he said in an interview with Germany’s Die Ziet, published today. “Central banks have increasingly lost their capacity to influence” long term interest rates, he said. He added that the solution to bank vulnerability to exotic investments is to have “far higher capital.”
• Personally I am on Greenspan’s side here. The Fed is just not as important or as powerful as people think.
• The Federal Reserve’s lone dissenter about today’s rate cut was Richard Fisher.
• Finally we have a roundup of reactions from various economists.
• Worries about those pesky inflation expectations.
  • The Federal Reserve’s aggressive rate cuts in the last 10 days are having one unpleasant side effect: they’re boosting bond investors’ concern about inflation.

Investors reacted with enthusiasm, and then promptly collapsed. Actually, yesterdays charts were really bizarre. I expected the sell-off, but the market was strangely flat, then spikes up, then down.

Barry Ritholtz thought it was odd as well. Today was a different matter. A very strong day.

Errata

Credit default insurance has gotten much more expensive.

From Abnormal Returns I am copying this mini roundup on an issue that is finally getting substantial coverage these last few weeks:

More talk about the potential demise of the monoline bond insurers. (A Dash of Insight, Big Picture, FT Alphaville, naked capitalism)

Justin Wolfers has a question:

are those who are using the R-word suggesting that the “Great Moderation” is over, or simply that we are facing an especially unusual set of adverse business conditions? Or was there never any real change in the structure of the economy, and the last couple of decades have been simply a statistical fluke?

Who doesn’t own some of this stuff?

The company wrote off $275 million in investments in the quarter, which could rise to as much as $417 million, said Rebecca Goldsmith, a spokeswoman for the New York-based drugmaker …

“Some of the underlying collateral for the auction rate securities held by the company consists of sub-prime mortgages,” the company said today in a statement. If credit and capital markets continue to deteriorate, Bristol-Myers said, it “may incur additional impairments to its investment portfolio, which could negatively affect the company’s financial condition, cash flow and reported earnings.”

Fiscal Stimulus

Jason Furman vs Steven Landsburg on fiscal stimulus.

Alex Brill tells Greg Mankiw a secret behind the numbers.

Menzie Chinn gives her take.

Hat tip: As always, some of this is from Abnormal Returns. Even if not, go there.

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Technorati Tags credit, Data, Economics, Federal Reserve, fiscal policy, GDP, housing, monoline insurers, recession, stimulus

Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy . Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally
-John Maynard Keynes

Random Roger wants to know what his readers think of the strategy of trying to replicate the type of portfolio that David Swensen of Yale has created.

It is certainly a good question, as Yale’s returns are stunning. His interest is peaked by taking a look at this article in Registered Rep magazine.

So what do I think? I suspect regular readers, and our clients, know we are enthusiastic about the approach, though we do tackle it a bit differently. So Let’s take a look at what Yale does, and David Swensen recommends for retail investors:

YALE ENDOWMENT ASSET ALLOCATION TARGETS

Real Assets 27%
Absolute Return 25%
Private Equity 17%
Foreign Equity 15%
Domestic Equity 12%
Fixed Income 4%

Source: Yale Corporation

SWENSEN’S RETAIL ASSET ALLOCATION TARGETS

Domestic Equity 30%
Foreign Developed Market Equity 15%
Foreign Emerging Market Equity 5%
Real Estate 20%
Short-Term U.S. Treasuries 15%
Inflation-Protected U.S. Treasuries 15%

Source: David Swensen

Actually, not a bad strategic allocation on the retail side, and according to Registered Rep it did pretty well through last Summer. What it lacks is any direct hedging similar to the absolute return option, Real assets other than Real Estate, and Private Equity.

Real Assets can be replicated to some extent through ETF’s and some mutual funds. Absolute Return vehicles can include long/short funds, Managed Futures, and for some, actual hedge funds. In addition, direct hedges from mutual funds can be used where appropriate. You will not have access to the favorable cost structure that Yale gets.

A word about Private Equity.

David Swensen speaks to this in his book Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment but some of the lack of volatility is a statistical artifact present in some of his real assets and private equity. Since they are illiquid, the value of these investments often cannot be known, it is estimated or marked to model, rather than to the market. In reality Private Equity is both very volatile, and likely very correlated to the public equity market.

What Private Equity really provides to Yale, is higher returns. Swensen believes they can get top managers, but he admits that if you don’t have top managers that Private Equity does not even outperform once adjusted for risk. He feels though that the dispersion of skill is higher, and that with proper due diligence it can be identified. His results seem to confirm that.

Our twist upon this theme

So, whether we are talking about non accredited, or accredited, investors, how does our approach differ and can it be replicated? We add a tactical element. That goes for private equity as well. In our discussions we have been very wary of private equity, we didn’t think money being invested over the recent past was being invested in a way likely to generate much return, and possibly it would be disastrous. In essence we saw a Private Equity bubble about to pop.

The returns had been reasonably good mostly due to leverage built on easy access to credit. Leverage is fine if you know what you are buying, our suspicion is that most people didn’t realize the risk they were facing if the market turned south, credit dried up, recession, etc. To put it another way, the risk vs. return ratio was out of whack. I think our fear during that time of greed was as usual a good thing to have. We may get a bit greedier when there is a lot more fear in general.

Yale has a pure strategic asset allocation, in essence the managers in the Real Asset and Absolute Return spaces make the tactical decisions. We do the same, but we also tactically increase and decrease (within the constraints of the Investment Policy Statement of our clients) our net exposure to any given traditional benchmark, or beta. We are quite willing to hedge our exposure to US stocks for example, or to go short one part of the market, long another. That is, if we see the expected gap in performance over a two to three year time span as being quite large. We don’t want to be operating in the area where random noise can eliminate that potential return. “Fat pitches” only need apply when it comes to such strategies.

In addition, when upside returns look low, and the potential downside looks high, we increase our allocation to absolute return managers and strategies.

That goes to the problem I have with the strategic retail portfolios I see discussed by Roger and his links (including in the comments.) While over the long haul I believe a portfolio such as the ones examined might do better than more traditional allocations with consistent rebalancing (they have in the past) I don’t think it will get investors where they want to be over the nearer term, say the next five years, and it will take some awfully good years for them to ever catch up to the type of compounded rate of return investors expect.

Unlike 2000-2006, a period that started with a few over valued areas and many components of the market ranging from reasonably priced to under priced, nothing as an asset class is cheap right now. The reasons Real Estate (in the form of REIT’S) was such a fine diversifier are not as applicable now. Traditional asset class diversification may help (though adding huge slugs of Real Estate, something until recently we have always had, made little sense when the article Roger is discussing was written) but it will likely lead to very low returns relative to history. After eight years of low returns another five to seven more is likely to really alter people’s financial plans.

Rather, we suggest adding in diversification of strategies as well. That means portable alpha, or portable alpha inspired strategies, hedges and other strategies to emphasize absolute returns at the portfolio level until markets go through an extended cathartic sell off. Until that happens, whether over the next six months or three years, permanent returns are likely to be hard to get with a mix of diverse, but over valued securities. The eventual sell off will likely eliminate most of the returns gained during any upturns, leaving the investor with returns barely above, and quite possibly below, the rate of inflation. The most over valued areas should likely just be avoided or used as a hedge.

Of course, as Jeremy Grantham recently pointed out, cash isn’t such a bad thing either.

To put it another way, the publicly traded diversifiers of the past have been bid up in price and are now likely very correlated, at least on the downside.

What is the longer term problem with tactical approaches?

They are difficult to do. Both from a knowledge standpoint, and psychologically. Most investors, including professionals, have no idea what the historical valuation of the market is, or what return the market is priced to deliver in various asset classes. Essential information to adequately pursue this kind of strategy.

As the quote I began this post with states, the largest constraint is the psychological will to allow themselves returns that do not track the larger market. We say we want non correlation, but what we mean is we don’t want to go down with the market. The idea of not tracking the market on the upside is not what we want to hear. Even tremendously successful investors, like Jeremy Grantham, Rob Arnott and John Hussman suffer for the impatience of their clients, no matter their great track records and the logic of what they are doing.

Yet, unless one has the ability to time pretty closely the market, that is exactly what you have to do to carry off such a strategy. That will also be true of the type of replicated portfolios Swensen and others are proposing. The goal is performance over several years time. Hedges which over time turn out hugely profitable will not be received kindly during the upward marches which populate even extreme bear markets. Intelligent active asset allocation is therefore the province of the few and the thick skinned, thus the popularity of static strategic asset allocation.

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Technorati Tags Asset Allocation, bonds, Commodities, David Swensen, Hedge Funds, portfolio management, private equity, real assets, real estate, Risk, stocks, Yale