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Economic Depression: A Value Trap
By Paul Lamont
October 6, 2011
“Early last week, ECRI notified clients that the U.S. economy is indeed tipping into a new recession. And there’s nothing that policy makers can do to head it off.“ - ECRI
We follow the Economic Cycle Research Institute. As they explain:
“...the key is that cyclical weakness is spreading widely from economic indicator to indicator in a telltale recessionary fashion. Why should ECRI’s recession call be heeded? Perhaps because, as The Economist has noted, we’ve correctly called three recessions without any false alarms in-between.”
“We are in a double-dip recession already.” - George Soros on CNBC.
Sell ‘Em All, Paul!
What is an investor to do? In 2008, everything financial fell in value except for U.S. Treasuries, the Japanese Yen (Cash is King but the Yen is Emperor), the Swiss Franc (marginally), gold (up 6% in 2008 having run up so far before the panic hit) and bear market inverse funds. With the stock market registering the worst quarter since the financial crisis (S&P500 down 14%), and all 500 of the S&P500 stocks down on plunge days like August 8, 2008, investors should clearly not be holding any stocks. (or bonds either!)
In August, we debunked the idea that companies holding cash was somehow bullish for their stock price. Later in the month, we discussed how value investors fell into a value trap in the early 1930s. Just as a reminder, a value trap is when companies that are cheap keep getting cheaper (and some go out of business!).
If we are indeed falling into a value trap and the mass of investors always place themselves in the most danger possible, we should expect the Wall Street selling machine (which caters to the masses) to pump out headlines describing companies as cheap all the way down.
Well they have started. As a recent Bloomberg report describes: S&P500 valuations are 25% below the previous last 9 recession - all the way back to 1957. Very compelling! But as usual, when it comes to the Wall Street sales machine one only has to dig into the details to figure out that what seems like a buy of a lifetime is really not. Fortunately, we only have to make it to the second sentence: “Companies in the benchmark gauge for American equities trade at 10.2 times 2012 forecast earnings...” The problem here is obviously ‘forecast earnings.’ This isn’t real money. These are earnings estimates cooked up by the same Wall Street firms who are trying to sell the stocks. And as reported by Ned Davis Research (and noted by other independent analysts across the web), Wall Street stock analysts this summer were estimating the largest growth in earnings in 30 years - which is as far back as we can track. A price will look small if you can make earnings look really big. “As Ned Davis has noted, stock returns are usually considerably weaker beginning from periods with high earnings expectations.” Disappointment = expectation - reality.
Analysis used to be based on actual earnings in the good ol’ days. However the industry switched to estimates when stocks continued higher in the 1990s past all historical precedent. (Wall Street had to keep the hype machine going in the bull market of the late 90’s - they couldn’t spoil the party by using real earnings). For investors who would prefer to use historically reliable methods for measuring stock valuations, we continue to suggest the Q-Ratio and the Shiller PE. After all, there will be a time (eventually) to buy stocks, the only asset class that outperforms inflation in the long run.
As for investors who fall for the ‘cheap’ sales trick, their buying creates the multi-week dead cat bounces like we had in 2008 and which we expect to have many times over the next few years.
A Dead Horse
We first used the chart below in June of 2009 (The Great Comparison) to show the similarity of the S&P500 to the market collapse of the Great Depression in 1929-32. Yes, there are timing differences. And while we got ahead of ourselves in revealing the plot last year, we present the updated chart without commentary to prevent ourselves from spoiling the ending. We promise not to flog this dead horse anymore.
“There is a big difference between a depression and recession. In a recession, people don’t have as much money to spend as they had in past years, so they cut down on purchases and products decline in price. But business and farming still go on with lower prices. The people have money to spend, just not as much. In a depression, nobody has any money. The farmers still produce crops and cattle but nobody has any money to pay for anything.” - Thoughts and Advice from An Old Cattleman. Gordon Hazard, D.V.M. 2002.
Nothing They Can Do
In February 2010, we noted Ben Bernanke was failing his two lessons learned from the Great Depression. Those two lessons were “keep monetary policy supportive” and “do not let the financial system break down.”
Since that time, Bernanke has indeed tried to be supportive with money implementing QE2. Unfortunately, QE2 has boosted bank reserves, but measures of broader money are still stuck in neutral while other forms of lending are still falling. So after a short sugar high in the stock market, monetary policy is just not working. We are still in a liquidity trap.
As for his second lesson, he described the situation in 1931: “Globally there were massive bank failures. I think perhaps the most critical, in May of 1931 the Creditanstalt, which was one of the largest banks in Europe, failed which generated a wave of financial crisis around the world. Up until early 1931, arguably the 1929 downturn was just an ordinary, severe but ordinary downturn, it was the financial crisis and the collapse of banks and other institutions in late 1930 and early 1931 that made the Great Depression ‘Great’.”
You would think that with the turmoil in Europe, for instance the bank run going on at Dexia, Bernanke would be on pins and needles. Not so. As the Telegraph reports, Bernanke said last Tuesday, “the U.S. is an innocent bystander.” He does however admit “the current situation – which is ongoing uncertainty – has been a negative for our economy.” But what can he do? The interconnectedness of the global financial system is just too complex. For instance, some are suggesting the reason Morgan Stanley’s default risk is so high is because of their exposure to French banks. But others see the Chinese hard landing as more of a problem. So what should Ben do? What can he do?
As Jim Rogers explains, not much:
“The market puts pressure on them then they step back. Eventually, Rhonda, the market’s not going to put up with it anymore...The market is going to say no more. And then we are going to have an uncontrolled disaster. The governments will not be able be able to control the chaos in the market and then we are going to have something much worse than 2008 and 2009. The market is not going to put up with this for forever.” - Jim Rogers
Kyle Bass, a hedge fund manager from Texas, (and who you will no doubt hear much more about in the future because he’s the subject of the new Michael Lewis book) had quite a good discussion on the European situation on CNBC. Good, in that he and I completely agree. It can be found here.
“I don’t think a default can be orderly.” - Kyle Bass. Hayman Capital Management.
Last month, we expected stocks to fall until the Fed announced QE3, which we incorrectly assumed to be announced on Sept 21st. We suspect that means investors should continue to hold on to the cash in their wallets as the market forces the issue. Dr. Marc Faber suspects the Fed will announce QE3 when the S&P500 hits 950. And as we said last month, “if at any time the Fed fails to meet the expectations of the market, we should be prepared for another full blown financial crisis.”
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