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.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

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

The other part of their business is already pretty much dead. As long as the number of defaults doesn’t increase they will probably have enough money to pay off the claims for expected losses on their credit default swaps. The problem? Expected losses are rising. Most prominently on various mortgage backed securities.

Likely outcome- These two go under eventually, a number of mortgage backed securities and other fixed income securities will eventually go under without MBIA and Ambac being able to pay the claims, those who purchased the insurance will be pressured and some may default themselves down the road. This is not cataclysmic. This is a big issue and will make things worse.

Suggested readings:The end of MBIA and Ambac?, Downgrades Come Easy, Upgrades Come Hard, Upgrades to AAA? — Forget It., On the MBIA, Ambac Downgrades; Regulatory Comments on MBIA, MBIA Downgrade Increases Collateral Requirements; Clarification on CDS Acceleration in Insolvency/Custodianship, MBIA: Moody’s Twists the Knife

Technorati Tags AMBAC, MBIA, monoline insurers

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.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

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

NYS Commissioner of Insurance has suggested splitting the Muni bond business from the rest of the insurers. FGIC seems to now think that isn’t a bad idea. Of course, since Elliot Spitzer has told them all to find sufficient capital in the next three to five days, they may have little choice.

Barry Ritholtz thinks this pretty much will lead to ending them as viable organizations:

What’s left is can best be described as a poorly run, derivative hedge fund led by people who have no business running a hedge fund of any sort, much less one of the poorly run derivative variety. But the fact that the NYS insurance commissioner is suggesting this should tell you that this has reached a level of government involvement that cannot bode well for our friends at ABK, MBIA and FGIC

Those vaunted rate cuts which Risk and Return was skeptical would be the driving force behind our economic path?

The Federal Reserve’s interest-rate cuts last month have failed to lower borrowing costs for many companies and households, increasing the chance of further reductions from the central bank.

Companies are paying more to borrow now than before the Fed reduced its benchmark rate by 1.25 percentage point over nine days in January, based on data compiled by Merrill Lynch & Co. Rates on so-called jumbo mortgages, those above $417,000, have increased in the past month, making it tougher to sell properties and risking further price declines.

Barry again:

Bill King noted a similar story on ABC News:

[Monday] night, the lead story on ABC evening news (World News) was ‘though the Fed has cut interest rates sharply in recent weeks, banks and credit card companies are hiking rates on consumers.’

Chase, Bank One and Bank of American were cited. The ABC News reporter said banks are hiking consumer interest rates and fees to cover losses on their crappy paper.

Yes, it’s that blatant and transparent.

Lovely. We get all of the wonderful inflationary effects of rate cuts — but none of the economic benefits.

Can you say “The Fed is pushing on a string?”
(Very good children. I knew you could)

True, though my own opinion is the Fed never has as much strength to push as we think they do. Way too much time is spent on what the Fed is doing. Granted, even though I know better, I do it as well.

While I keep sending you to Barry today, you might as well let him educate you on why the retail sales number that cheered some for a moment on Wall Street are actually looking pretty disastrous. Start here, finish there.

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

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags Economics, economy, Federal Reserve, Inflation, monetary policy, monoline insurers, retail sales

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.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

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

China turned in yet another double digit year:

China’s economy grew by 11.4 per cent in 2007, the highest pace in 13 years, but the trend of decelerating exports to a slowing US recorded in the final two quarters is expected to be carried into moderating growth this year.

China’s economy has now grown at double-digit rates for five straight years, an achievement hailed by the government as a “hard won gain” of difficult policy decisions.

New York Insurance officials are pressuring banks to bail out the insurers:

Leading US banks are under pressure from New York state’s insurance regulator to provide as much as $15bn to support struggling bond insurers, people familiar with the matter said on Wednesday night.

I am not sure if that is the right move for the banks, but you have to think they are saying to themselves, “How lovely, we pay these guys to insure bonds, when they cannot pay us they want us to provide the money they need to pay us back. Just lovely.”

The Congress has passed a stimulus bill. Of course, when are the checks supposed to arrive? In June. Haven’t I spoken about the time issue before? I think I have. Yes.

Steven Dubner has a similar observation, and some support. Bruce Bartlett throws in this chart to illustrate history supports we skeptics (click image to enlarge)

Which goes to prove that recessions end and stimulus rarely appears until after they are over.

Are we in recession? Calculated Risk looks at a little covered set of data from the Philadelphia Federal Reserve Bank.

Bespoke compiles some data to help us understand how a Bear Market behaves. That is part of my next post, I have some thoughts on that as well.

I stand by the claim that as investors we should pretty much discount fiscal stimulus as a plus any time soon. Greg Mankiw doesn’t think things are bad enough for this to do much good in any case, and potentially is a long run negative.

Tyler Cowen discusses the law of unintended consequences:

Dubner and Levitt have an article in the NYTimes with three examples of the law of unintended consequences, the Americans with Disabilities Act made it more costly to hire people with disabilities and reduced their employment, ancient Jewish sabbatical law intended to help the poor has made them worse off, and the endangered species act has resulted in habitat destruction.

If it isn’t a law it is certainly a key risk factor.

Oh, and about that fraud, 7.1 Billion dollars worth by a single trader.

Which leads Barry Ritholtz to feel the Fed intervened for the wrong reasons. I lean his way on this. In fact, this kind of makes the point that he is right.

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

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags bond insurers, China, Federal Reserve, fiscal policy, fiscal stimulus, Links, recession

Stock markets around the world plummeted Monday, prompted by pessimism about U.S. President George W. Bush’s plans to boost the U.S. economy.

Share prices in Asia, Europe and the Americas all plunged by significant amounts; Wall Street only avoided joining the tumble because U.S. markets were closed Monday for Martin Luther King Day.

Markets in Europe reacted with London’s FTSE 100 Index down 5.5 percent at 5,578.20; the CAC-40 in Paris down 6.8 percent to 4,744.15; and Frankfurt’s DAX dropping 7.2 percent to 6,790.19.

In Japan, the benchmark Nikkei 225 index closed on 13,325.954 points, a slide of 3.9 percent and its biggest dip in two years. Shanghai’s Composite index fell 5.1 percent.

Read the rest if you want to feel depressed.

This is probably a mix of the need for stimulus being a bad sign for the world economy, and a realization that the stimulus is also not going to be sufficient. I agree on both conclusions. My concerns over the economy have been expressed in no uncertain terms for some time, and I have given my reasons for doubting the efficacy of fiscal stimulus packages. Fiscal stimulus that relies on increasing spending is an especially false hope, except in rare circumstances. Tax packages that make the adjustments businesses and investors need to make less expensive can help, but to do so they would have to be substantial, and politically I doubt they will amount to much.

Interestingly, Paul Krugman has historically felt similarly. Unlike Paul, I doubt monetary policy can do much either.

An important thing to remember when we discuss the government stimulating the economy, is that the numbers involved are completely out of whack. Let us pretend that the government spending $145 billion actually subtracted not a whit from other people’s spending or investment. That it was all added spending in our economy that would not exist otherwise. This is frankly ridiculous, but let us for the sake of argument pretend it were true. Folks, when we are talking about a 13 trillion dollar economy, that seemingly large $145 billion seems awfully puny. Around 1%. That one percent is supposed to make a difference?

Of course, that is a completely unrealistic scenario, because in fact the government will borrow the money from somewhere, money that would largely have been spent or saved in another fashion anyway. Academic studies show large amounts of the stimulus will be used to pay down credit cards and other debt. Some will be saved. Whatever that is, it isn’t a stimulus.

Similarly, the Federal reserve, for all the sturm and drang in the papers over the massive liquidity injections, is similarly poorly positioned. They control approximately $30 to $40 billion in reserves. That is it. The amount of liquidity “injected” has been essentially nil. Almost all of it was just the federal reserve rolling over existing repurchase agreements with banks. They can attempt to lower interest rates, but that will have a long delayed impact. Politically the Fed and the government need to be seen doing something, but what they can do is vastly overrated.

I bring this up not to scold our politicians, or the Fed, but to emphasize that we as investors should not be fooled about such policies rescuing us if we are not appropriately positioned. Certainly we should be mindful of the last time investors were urged not to “fight the Fed.” Huge losses followed as many investors walked hand in hand with the Fed to interest rates as low as 1%. I chose to fight and I am glad I did.

The economy and markets may recover, but policy will not be the major determinant.

Other views:

Tyler Cowen points out that rebates don’t always accomplish what they are supposed to do.

Menzie Chen looks at business incentives.

James Hamilton makes his case against fiscal policy, and echoing my own thoughts thinks Bernanke was not giving the green light to it that many believe.

Paul Krugman has his own thoughts about what to do now.

Mark Thoma questions the efficacy of making tax cuts permanent.

Finally, via Abnormal Returns, Greg Mankiw asks great questions:

If some journalist out there talks to a member of the Federal Open Market Committee, here is the question I would ask:

If the economy now gets the fiscal stimulus being proposed (about 1 percent of GDP), does that mean that the Federal Reserve will cut interest rates less than it otherwise would?

My follow-up questions:

If the answer to the first question is No, then ask, Why the heck not? Monetary and fiscal policy are two tools available to increase the aggregate demand for goods and services. The goal here is to prop up demand sufficiently to maintain full employment without causing inflation. If the U.S. government is using fiscal policy more, it should use monetary policy less.

If the answer to the first question is Yes, then ask, How much higher will interest rates be kept as a result of the fiscal stimulus? And is it really better to have a fiscal stimulus and higher interest rates than a smaller deficit and lower interest rates?

More from Greg here, and here.

Update: Megan McCardle echoes my concerns:

As talk of stimulus plans grows, readers are asking for my thoughts. Which are: stimulus rarely works unless it is massive and very rapidly applied, and if it is massive and very rapid, it usually has much larger problems.

The difference between tax cuts and spending is irrelevant in theory. In practice, because so few people pay significant income tax, it has distributional effects. Since rich people seem to save more money than poor people, this blunts the effect of the stimulus. On the other hand, spending is generally much more distortionary than tax cuts, because the government picks what the money is spent on. One more reason not to like fiscal stimulus packages.

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Technorati Tags federal government, Federal Reserve, fiscal stimulus, monetary policy

I have to agree with Frederic Mishkin of the Fed:

I think there is too much focus on what decision will be made about the federal funds rate target at the next FOMC meeting. What is important for pricing most financial assets is the path of monetary policy, not the particular action taken at a single meeting.

One of the great myths of the market is the over-agency of the Federal Reserve. In reality, the Fed is much less powerful than is commonly believed.

I think some people have to believe that there’s some mysterious group that’s in charge and running things. Ron Paul even blames the Fed for higher oil prices.

Nobel Laureate, Edward Prescott, wrote in the Wall Street Journal:

I am not saying that there are no real costs to inflation — there certainly are. And if we get too much inflation we can exact high costs on an economy (witness Argentina as an example). However, I am talking here of the vast majority of industrialized countries who live in a low-inflation regime and who are in no danger of slipping into hyperinflation. It is simply impossible to make a grave mistake when we’re talking about movements of 25 basis points.

I would add that even if they do not make a mistake it is unlikely to change the outcome for investors in any dramatic fashion. The Fed is just not the main determinant of asset prices, nor is the yield level of treasuries.

That doesn’t mean the Fed hasn’t made mistakes which have contributed to our present woes. Milton Friedman’s old partner, Anna Schwartz, brings out the wood (via Greg Mankiw)

As rebukes go in the close-knit world of central banking, few hurt as much as the scathing indictment of US Federal Reserve policy by Professor Anna Schwartz.

The high priestess of US monetarism – a revered figure at the Fed – says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. “The new group at the Fed is not equal to the problem that faces it,” she says, daring to utter a thought that fellow critics mostly utter sotto voce.

“They need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence,” she told The Sunday Telegraph. “There never would have been a sub-prime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for,” she says.

[...]

Her fame comes from a joint opus with Nobel laureate Milton Friedman: A Monetary History of the United States. It revolutionised thinking on the causes of the Great Depression when published in 1965. The book blamed the Fed for causing the slump. The bank failed to use its full bag of tricks to stop the implosion of the money stock, and turned a bust into calamity by raising rates.

“The book was a bombshell,” says British monetarist Tim Congdon. “Until then almost everybody thought the free-market system itself had failed in the 1930s. What Friedman-Schwartz say was that incompetent government bureaucrats at the Fed had caused the Depression.”

I guess restoring confidence that they won’t make things worse is better than nothing, but monetary policy in the range within which they operate will not be the answer, or the cause, for regulatory problems, investor and homeowner myopia and irresponsibility that has already occurred, or overvaluation.

“Steve Jobs is one powerful dude.” (Silicon Alley Insider) (From Abnormal Returns)

Mark Hulbert asks if we really want to assume that the bond market is wrong in betting that inflation will be below 2.5%?

Retail sales in December fell. Barry Ritholz points out:

Credit card debt turned up, the home ATM turned down, inflation was rampant, real income gains non-existent, the job market mediocre. On top of that, we had much higher prices for daily requirements like Food and Energy — and still, there was total denial about how healthy retail is.

How about a chart to back that up?

Obviously we don’t need to just worry about financials being rocked just by mortgages in the consumer space. Actually, I think corporate debt is going to be an issue as well, and of course the derivatives market, especially credit default swaps, are bound to become a major issue. Throw in all the insurers of this debt…I think we better move on.

Despite much wailing, the LBO loan market may not add much to Wall Street’s problems in the great scheme of things. See, I moved on. Million dollar losses seem so small now.

Meanwhile, in addition to the tens of billions evaporating from their earnings, banks such as Merrill and Citibank are busy diluting investor capital by selling huge chunks of ownership to overseas investors. Also read this followup. Probably the best their shareholders can ask for is to lose money and have future earnings sold to others. Better than bankruptcy I guess.

John Paulson bet against the housing market and cleaned up. Join the club John, though unfortunately our clients didn’t make quite the killing you did, but we are happy enough.

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Technorati Tags Alan Greenspan, Anna Schwartz, Barry Ritholtz, Ben Bernanke, Citibank, credit, debt, Economics, Edward Prescott, Federal Feserve, FOMC, Frederic Mishkin, Housing Market, Inflation, John Paulson, LBO, Merrill Lynch, Milton Friedman, monetary policy, mortgages, recession, Steve Jobs, subprime, Wall Street

Trying to get defensive? The Wall Street Journal notices some of the same things we have been talking about that make it difficult, while the New York Times picks up on another theme of ours, the relative attractiveness of growth stocks. I take issue with these statements:

defensive-minded value stocks

growth stocks, which are riskier and throw off less dividend income than value shares?

Value stocks are not necessarily less risky, nor a better value. Value investing may be less risky, value stocks however may or may not be a value. By most measures value stocks have never been so highly valued, especially relative to growth stocks. Nor can it be said value stocks are less volatile. Some are, some are not. I am a value investor, but growth stocks, especially high quality (low debt; high, stable profit margins) look like more of a value to me. The rest of the article supports that contention despite these clichés.

Barry Ritholtz looks at the markets and sees parallels with the “Five Stages of Grief.” I think he probably has that about right. He also points us to this interesting graphic on volatility (click on the image for a larger version.)

Source:
http://www.nytimes.com/imagepages/2008/01/05/business/20080106_soapbox_graphic.html

In looking this over one sees that despite the increase in volatility last year, it seemed much more volatile than it was because we were at historically low levels. I am a glass half empty guy on this. I think we will see volatility increase even more.

At Abnormal Returns the question is asked, how did you do last year?

If you can’t conduct this exercise, what are you doing? Surfing the investment blogosphere for stock tips or economic forecasts? Those will in all likelihood not make you a better investor in the coming year. Knowing how your mutual funds, ETFs, investment advisors, or your own individual stock picks did against a reasonable benchmark should tell you a great deal about your investment process.

Frankly, few people I meet have any idea how they did last year. Statements do not provide time weighted rates of return, and most investors I meet think they did better than they really did. James Picerno makes the point:

While such a goal [superior risk-adjusted returns] isn’t impossible, it’s devilishly difficult to achieve for the long run. Ironically, most investors probably have no clue just how difficult the task. Why? Because one can only recognize the depth of the challenge by routinely analyzing a living, breathing portfolio over the course of time. Daily analysis is ideal, although weekly or even monthly data will suffice over long periods. In any case, unless you’re crunching the numbers regularly, and comparing your results to a benchmark, it’s easy to overlook just how elusive successful investment strategy can be.

We make few changes in our portfolios once we set things in motion each year, but I dig into the details on a daily basis, and we discuss it at our weekly Investment Committee meeting in detail. The details of how and why performance is achieved are crucial in the decision about what comes next, and whether ones strategy is really properly aligned, or whether active risk management is really what one should be doing at all.

An area we will be discussing with great vigor at our yearly investment conference is the direction of the dollar. One of our more profitable themes has been the decline of the dollar. The New York Times finds many people have decided that theme may have run its course. I look forward to our own debate on this.

To finish up let us look at some suggested blog world reading. Steven at Value Blog Review lists his favorite investment blogs for the year, some of my favorites are included. The same goes for Steve Waldman’s list.

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Technorati Tags Dollar, Economics, exchange rate, finance, growth stocks, investing, returns, Risk, today's links, value stocks, volatility