Wednesday, November 05, 2008

The Big Y

A great book for those who really want to delve into secular market cycles is "Unexpected Returns" by Ed Easterling. The book offers a graphical representation of the current confusion over where stocks should be priced. One can get much of the information in the book at the web site, including a picture of his right pointing Y.

Stocks are always priced at a multiple of their earnings. We call this multiple the price to earnings ratio or the PE. During normal times, the PE ratio tends to be pretty much a function of long term interest rates. Some folk use AAA corporate bond rates and some make relatively minor adjustments to the 10-year treasury rate and others use an average of 10-year and longer dated treasuries as guides to what PE ratios should be. The PE constantly moves toward 1 over the average yield of the 10 and 30 year treasury bonds, until some event temporarily jerks the PE off coarse. The average treasury yield today is about 4% implying that the correct PE for the S&P 500 should be around 25! By this measure the S&P is currently offering a half price sale.

From the theory of rational expectations, the current PE of around 12 might be the result of the market discounting a long drawn-out recession. Indeed, the spread between the 5-year treasury note and the 5-year TIP note indicates that inflation over the next 5 years will be slightly negative, not on the order of a "great recession" but slightly negative. In the USA, inflation was slightly negative for just a month or two after hurricane Hazel tore up the NC coast in 1954 and for a month or two right at the end of WWII. Inflation reached negative annual rates of 10% during the early and late 1930's!

The difference between then and now is that the government did exactly the wrong things prior to, during and after the market crash. The crash got started when the Herbert Hoover administration and two misguided senators promoted and passed restrictive trade policies. It is always remarkable when misguides souls add tariffs to the price of goods because they are too cheap! Obviously, the wants of politically powerful few often trump the wants of the many, those who enjoy buying goods at low prices. The fact that republicans from the days of Lincoln to Hoover supported restrictive trade for the benefit of fat cat businessmen and that democrats have since supported restrictive trade for the benefit of fat cat union leaders makes no difference to the poor guy that just wants to buy goods at a fair price.

Of course, if one nation restricts the purchase of the others goods, the second nation is likely to compound the mistake by taxing the first nations goods. This is exactly what happened during the 1930's. Had Europe ignored the high taxes, the currency markets would have gradually reconciled the accounts. Even when a nation refuses to counter punch with equal tax increases, the benefits of free trade continue to be felt by many. Free trade is one of those rare free lunches. The more free the trade, the more free the people. Free trade gives producers bigger markets in which to sell and it gives consumers lower priced goods. Everybody ultimately wins.

After restrictive trade policies got the depression ball rolling, central bankers made matters worse by failing to supply the markets with off setting liquidity. The responsibility of the FOMC is to lean against booms and busts. The old saw is that the FOMC's job is to spike the punch bowl to get the party started but to remove the punch bowl before the party gets out of hand.

None of the above events have occurred in the current slow down. Indeed, Chuck Schummer and the Silly Senator from SC (not Jim Demint) only jaw boned China's policies a year or so ago and Obama has helped hold up only a relatively small trade deal, the one
with Columbia. Democrats managed to raise huge campaign war chest from the unions without doing much to "earn" the money.

Indeed, the primary reason our dramatic housing slump, auto slump and commodity price inflation did not send our economy into a deep ditch was because exports and imports have been super strong. In regard to monetary policy, I don't believe there has ever been such an increase in the adjusted monetary base as reported by the St. Louis Fed last week.

It has been the surge in fiscal and monetary stimulus that has spooked "the other half" of the market. Those who are not worried about the coming great deflation are worried about the coming great inflation. Thus we have arrived back at Easterling's Big Y. During times of great anxiety, markets often become schizophrenic and the tight relationship between expected inflation and long bond rates is broken or at least in obscure territory. Estimates for next years S&P earnings are all over the map.

Both negative inflation rates and high inflation rates can produce low PE ratios, causing the split in Easterling's Y. This is nothing more than the "fear factor". When two men are scared of the future, one will sell his stocks to buy "safe" treasury bills, even when they pay only .4% interest and the other will sell stocks to buy gold at $730 per ounce even when he knows that commodity prices are falling. Gold is a store of value. The value of gold rises when inflation rates are higher than interest rates but one cannot use zero as a denominator. When no one is willing or able to borrow money, the interest rate is zero and our methods of measuring values goes berserk. Japan has suffered from zero real demand for borrowed money for a number of years.

The good news is that the dramatic growth in the monetary base is the cure for the projected negative inflation. The child who is hurting from constipation is not happy to have Castor Oil forced down his gullet, the resulting cramping of intestinal muscles is no fun but the ultimate relief is marvelous. For you young timers out there, Grannies across our land once used Castor Oil as a miracle cure for what ever ailed you. It was even used to induce labor in pregnant women. Contrary to legend, it was not the taste or the odor that was objectionable, it had neither, but the experience was similar to drinking cooking oil and it did make ones hurting belly hurt in new places before it made ones belly feel better.

The current dose of stimulus into the banking system was handled poorly. The Bush administration first called in all the neighbors over a period of a few weeks to vote on whether the child really needs the dose of Castor Oil. After the vote was taken, the Bush administration took another 3 weeks to pass out the medicine. Under who knows what deal, it is evident that the administration made the process as bad as it could. The most likely reason was to give those "in the know" the opportunity to buy in at the bottom. To get the deal done, the administration apparently agreed to throw John McCain under the bus. How is that for a conspiracy theory? McCain ran a great campaign under terrible circumstances. It is the oft repeated opinion of pundits to the left and right of McCain that he ran a poor campaign. His window of opportunity was always a narrow path. He somehow managed to win over conservatives while trying to win over moderate democrats during the worst stock market since 1973-74.

The numbers tell the story best. The public sold billions of dollars worth of stocks at or near the bottom of the market, some very big investors lost billions to meet margin calls and as usual JP Morgan made out like a bandit during a time of economic crisis. JP picked up the largest savings and loan in America for less than the price of a song and a dance.

In any event, we have now been through about the "normal" amount of time for short interest rates to stay low before they stimulate the economy. The benefit of low interest rates will not be as great to the auto market as normal because the auto market is in the process of totally retooling to meet the CAFE standards that go into effect in 2011. The auto market is going to see a surge but it will not "catch fire" even though lower and lower gasoline prices will encourage the uninformed to take more of the big SUV's off the corner lots. Those who keep claiming that oil prices are going to go right back up, forget that the new low of our land is that auto mileage must go up dramatically in 2011 and year after year for the next 5? years. Demand destruction has once again been mandated by government. Had higher carbon taxes been used to lower taxes on labor, the markets would have made a smooth transition to better times. Again, the administration and the congress compromised on the most disruptive method of changing directions. Don't be surprised if bill that would trade carbon taxes for Obama's expanded earned income tax credit surfaces.

If interest rates are not going to cause a major boom in the auto business, where will they have the most effect? In the short run, the bankers are not using 1% short money to reduce the price of thirty year mortgages. Bankers have generally tried to avoid the classical risky but profitable strategy of borrowing short and lending long. To the extent they are willing, they now expect to be paid well. Thirty year mortgages are being issued at around 6.2% while bank deposit rates are as low as they have been. Banks can borrow at 1% and earn fees while making secured loans at 6.2%.

The discounted value of all future cash flows has been increasing as inflation rates and interest rates have declined. The Y question has been fear over the return of money rather than the fear of low return on money.

But, fear in the market place is subsiding. Libor spreads have declined for 17 days in a row. Furthermore, governments around the world are joining the US Fed in the correct action of lowering the cost of money. The pressure is on the UK to drop short rates at least 50 basis points. Market spreads are already better than those reached at the last jump off date, October 10, 2002. Real estate demand preceded the market jump off date.

FDR was one of the most popular presidents of all time. The many thousands of people who received direct payments from the government during his terms of office gave FDR credit for bringing the US out of its deep depression. Democrats labor under this false belief. The reality is that most of the FDR programs served to prolong the depression. Government programs such as the WPA, a public works program that built a lot of nice stuff, such as the Blue Ridge Parkway, was also known as the We Poke Around program. This program was the equivalent of the Henry Hazlitt broken shop window. Even those who are familiar with the broken shop window story are apt to forget that it was the tailor who got the worst of the economic ripple. It was the tailor who missed out on the sale of a suit while the baker spent his money to replace the broken window. In the case of the Blue Ridge Parkway, millions of dollars were spent to pay people to lean on shovels and to build a little used road though beautiful mountains during a time when productive capital was needed badly. No one will ever know what good projects could have been funded by the massive amount of capital spent on this mountain road. Please note that I am not attacking the Blue Ridge Parkway as much as the timing of its construction. Public works projects do not create jobs as quickly as productive industry. The net utility of parks and parkways will always be difficult to measure. However, getting the money out of the hands of government and into the hands of business would have created many more jobs and unemployment rates would not have remained above 20% for the many years that they did.

Again, the problems we have today are no where near the problems we had in the "good old days". The unemployment rate today is less than a third of the persistent rates of the 1930's and unemployment compensation today is not bad. Besides, millions of Americans are drawing unemployment while making money on side, including via the Internet. There are millions of short term jobs advertised on the Internet.

Obama was elected by making promises that will be impossible for him to keep. It will be left wing democrats, those whose hearts were broken by the failed promises of Nancy Pelosi, who will be most disappointed in Obama. That is OK, relative to the 40 million Chinese who died of starvation as a result of Mao's "Great Leap Forward" or the millions of families that were broken up by the LBJ welfare policies.

The Big Y is a sideways Y that meets at about 2.3% inflation and at a PE of about 17 times. Our economy will revert to this mean in due coarse. Dramatic growth in services, such as digital delivery of books, videos and newspapers will offset continued world wide reductions in manufacturing and agricultural jobs. A lot of hype and noise played out before the US took its dose of Castor oil but the dose has now been taken and it is working its way through the system. The ultra high earnings of the commodity based companies is going to meet the ultra low written down earnings of the financial sectors in the middle, at the intersection of the Y. Bush has not done as terrible an economic hatchet job as is commonly believed and the fear of Obamanomics is way over the top.