The Bulls are Full of Beans
Yet another warning.
October 22, 2009
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The Bulls are "Full of Beans"
Authored by Bob Andres
"Risk varies inversely with knowledge"
Titles of books and articles are designed to grab the potential reader and bring him/her along for the ride. In this respect, titles can be as important as what is actually expressed or written. The effort of coming up with interesting titles allows the writer to have some fun while providing him/herself with some unverified evidence regarding his/her own creativity or cleverness. This week’s title is a classic "double entendre" which suggests a negative regarding our bullish friends, but in reality the title translates to "The Bulls are Energetic and Full of Enthusiasm." A title more in sync with my actual views would be "The Bulls are Full of Prunes." This title suggests that the bulls are full of hot air and are talking nonsense. Hopefully, the interrelation between markets, economics and fruits and vegetables is now more clearly defined. Before moving on to the important stuff, let me nominate Dr. Hannibal Lecter (Silence of the Lambs) for the best "double entendre" when he said to Clarice, "I do wish we could chat longer but I am having an old friend for dinner."
Investing and uncertainty are inseparable. However, the degree or magnitude of uncertainty redefines the risk that investors confront in the decision making process. The Homeland Security Advisory System recognizes 5 levels of risk. These include severe, high, elevated, guarded and low. Adopting these measurement standards to the current economic and market environment suggests that investors remain at a "high risk" of economic and market disruptions. While progress has
About Bob Andres
Bob is a third party consultant. He regularly communicates economic viewpoints and investment strategies to the marketplace. Bob serves as a source of insight and perspective to advisors and their clients. He regularly engages with advisors in support of their client meetings, presentations and conference calls.
His business pedigree includes:
• President of Merrill Lynch Mortgage Capital Corporation
• Vice President and Manager of Merrill’s secondary corporate bond trading division
• President and Co-Founder of Martindale Andres & Company, a firm that managed in excess of $2 billion in assets
Bob has been featured in Barron’s, Institutional Investor and a broad array of financial publications throughout his career.
This Perspective discusses general developments, financial events in the news and broad investment principles. It is provided for information purposes only. It does not provide investment advice and is not an offer to sell a security or a solicitation of an offer, or a recommendation, to buy a security. Investors should consult with an investment advisor to determine the appropriate investment vehicle. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon and risk tolerance. The statements and opinions contained herein are solely those of Bob Andres, a third party consultant who is the author of Andres Perspective. While the statements and opinions of Mr. Andres are provided in good faith, PMC does not warrant their completeness or accuracy and they should not be relied upon as such. Past performance is not a guarantee of future results. October 22, 2009 www.EnvestnetAdvisor.com Question or comments? Call (212) 642-7425 For Advisor Use Only - Not for Public Use subscribe by emailing email@example.com p 2
been made, it is clear to me that these high levels of risk and uncertainty will be with us for an extended period of time. Historical precedents support my view. In addition, the broad set of domestic and global economic issues confronting policy makers paired with the current difficult geo-political environment only serves to exacerbate the problems relating to investor uncertainty.
Debt as a Weapon
Fighting fire with fire may work in controlling forest fires but the concept of fighting record indebtedness with massive amounts of additional debt has little, if any, empirical data to suggest it may bring about sustainable economic growth. U.S. debt (not including off balance sheet debt) totaled $52.8 trillion on June 30th of this year. GDP is currently running around $14.2 trillion. This translates to approximately $4.00 in debt for every dollar of economic output. This is truly historic and is not in itself sustainable.
Managing Investment Uncertainty
My often expressed investing theme designed to mitigate high levels of uncertainty is that "you win by not losing." This remains my preferred strategy. In such periods my focus is on "RIP or Rest in Peace."
• Risk-adjusted returns with attention paid to matching the level of risk taken with the level of return derived.
• Income flow
• Preservation of capital
Consensus GDP growth for the Q3 is in the 3.0% to 3.5% range. Q4 is expected to come in around 2.4% while the consensus for all of 2010 is now about 3.0% (though I am very skeptical). If these numbers come in as expected, they are a
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direct result of our "Booster Shot" economy. The cash subsidies for both corporations and consumers are the equivalent to shots of HGH (human growth hormone). They work when administered, but provide little long-term benefit to the recipient. To paraphrase the words of the economist Lacy Hunt, these policies merely indenture citizens further without providing any income for debt repayment. "Debt levels are expected to rise as a percentage of GDP from the current 35.7% to 76.5% over the next decade according to the Office of Management and Budget. Dr. Hunt suggests that the U.S. is on a parallel course with the Japanese experience. Japanese debt ratios, as a percentage of GDP, have risen from 50% in 1988 to approximately 178% currently, and yet their nominal GDP is no higher than it was 17 years ago, and their employment stands at levels registered twenty years ago." The fact that U.S. employment today (131 million) is identical to data levels first attained in 2000 gives credence to Dr. Hunt’s contentions. We need to ask ourselves how economic sustainability will occur in the absence of:
• Consumer spending growth
• Employment growth
• Lower taxes
• Banks functioning in their traditional role of lending
• A growing money multiplier
The cash subsidies for both corporations and consumers are the equivalent to shots of HGH (human growth hormone). They work when administered, but provide little long-term benefit to the recipient.
"You’re traveling through another dimension, a dimension not only of sight and sound but of mind; a journey into a wondrous land whose boundaries are that of the imagination. That’s the signpost up ahead."
– Rod Sterling
Your next stop…the "Equity Zone"
The equity market has lapped the fundamentals and is suggesting by valuation that we are about to enter the "wondrous land of VR (V-shaped recovery)" – where imaginations rule. Markets have moved at warp speed with little resistance to the point that the Twilight Zone might be seen today as a reality show. Markets are clearly suggesting the recession is over and we are in a robust recovery stage. They point to what has occurred in other post-war recession periods in support of their position. I believe this to be truly misguided because it gives little credence to the fact that the causes of this recession, or the recession itself, bares little resemOctober 22, 2009 www.EnvestnetAdvisor.com Question or comments? Call (212) 642-7425 For Advisor Use Only - Not for Public Use subscribe by emailing firstname.lastname@example.org p 4
blance to post-war recessions. John Hussman of the Hussman Funds reinforces this point with clarity when he states, "Valuations here are far different than they have been at the beginning of the typical economic expansion. Moreover, economic expansions have historically always been paced by rapid expansion in debt-financed classes of expenditure such as housing, capital spending, and sustained (not just one-off cash for clunkers) demand for automobiles. In prior recoveries, debt financed expenditures have turned up quickly and have typically led other classes of expenditures by nearly a year." We have outlined in previous Perspectives
what Dr. Hussman refers to as "the profound differences between those instances and the current environment." A quick review is maybe helpful: The housing debacle, which was generated by poor underwriting practices, benign neglect by the regulators, old fashion greed, lenders accepting a disproportionately low return for risks incurred and of course, excesses in financial engineering, played a pivotal role. Simultaneously, the recession, as the economist David Rosenberg makes clear, was an outgrowth of "excessive debt accumulation and a central bank’s and government’s willingness to tolerate years of excessive risk-taking and parabolic asset inflation, together with a view that bubbles can only be identified after the fact." The "after the fact" viewpoint came from former Fed Chairman Alan Greenspan. Does the comment sound a tad defensive? In reality, either inflationary pressures or uncontrolled inventory growth triggered most post-war recessions. And finally, what post-war recession led to sustainable economic growth where the credit contraction was this severe, where unemployment was this severe, where debt accumulation was this severe and where the consumer deleveraging process was this severe? Did I mention the real threat of rising taxes?
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Real GDP vs US Housing Starts
source: Hussman Funds October 22, 2009 www.EnvestnetAdvisor.com Question or comments? Call (212) 642-7425 For Advisor Use Only - Not for Public Use subscribe by emailing firstname.lastname@example.org p 5
The March 3rd, 2009 Perspective was entitled "The Coming Head-Fake of Economic Growth." I made the case for an economic respite sometime in the third or fourth quarter of 2009. The rationale for this viewpoint centered on reduced volatility in inventory management and some nominal impact from the stimulus package. I said then and I repeat again: the key for advisors and their clients is determining whether such growth is a "head-fake or the beginning of sustainable organic growth." I continue to find myself on the head-fake side of this argument. In the interim, equity market valuations may well be sustained through positive Q3 GDP numbers to be announced soon, with some buying by long only managers looking to avoid being shutout, and finally by the fact that year-over year earnings numbers will turn very positive in Q4. I mentioned earlier that equity valuations have lapped fundamentals. They appear overbought and overvalued from virtually all measurement standards. Some equilibrium will eventually return either by lower valuations or stronger fundamentals. However, I believe investor risk is increasing rapidly and is associated with growing expectations that earnings and the economy are about to reverse the missteps of the last two years. My assessment of current data undermines these optimistic expectations. Extreme movements in either direction usually do not have a long shelf life and we all know that the ride up is more fun than the ride down. Good fortune.
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