Battling the Doomsday Machine

by: J.D. Steinhilber November 24, 2008    
J.D. Steinhilber

J.D. Steinhilber

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Last week presented another formidable test to the patience and fortitude of long-term investors in risk assets. The S&P 500 breached its lows from the 2001-2002 bear market and fell back to levels not seen since 1997. Citigroup's stock declined 60% in one week to under $4 a share. The Treasury bond market priced in five years (!) of deflation by driving the yield on five-year traditional Treasury notes to a level nearly half a percentage point below the yield level of 5-year TIPs (inflation- protected) notes. Pricing on corporate debt fell to lower levels than even in the Great Depression. Three-month Treasury bill rates ended the week at a stunning 0.01%, implying that owners of such securities agreed to be paid essentially no return.

Clearly, we are in a defining moment in investment and economic history. Markets are in a mode of risk aversion unlike anything we have ever seen in our lifetimes. In the midst of all the gloom and doom emanating from Wall Street, which is undergoing a radical and necessary transformation, people are paralyzed in fear. Investors have priced economic catastrophe into various asset markets. We have not had a deflationary depression since the 1930s, but that seems to be what the market is pricing in. No one knows what the future will bring, but that seems to be a very low odds bet. Recessions are useful in that they cleanse excesses. The worst excesses in this cycle were in the financial sector, and they are being rapidly purged. This can happen without plunging the broader economy into depression, providing we break the fear-based negative feedback loop currently at work in the markets and the economy. Recessions and bear markets of this scope inevitably breed a certain amount of pessimism, but the apocalyptic forebodings in the collective consciousness today seem overdone and unnecessary.

In the spirit of identifying positives to offset the prevailing gloom, let me offer the following observations:

Stocks are Historically Cheap Relative to GDP

In addition to the typical measures of price to earnings, price to book value, and dividend yield, a good measure of where stock valuations stand at a point in time is to compare the market value of all publicly traded stocks to the GDP of the country. As a result of their 50% decline over the past 13 months, U.S. stocks have fallen to 60% of GDP, which is well below the 80-year average of 79%. To get back to just the 80-year average would imply a 36% rise from current levels. But the bears say that GDP is unsustainable because consumer spending needs to come down. OK, fine. From 1950 to 1982, consumer spending consistently accounted for between 61% and 63% of GDP. It never moved outside of that range. Starting in 1980, consumer spending began its two decade climb to 70% of GDP, where it currently stands. I personally don't think consumer spending has to adjust all the way back to 62% of GDP (we are a wealthier country than 40 years ago), but let's assume we do. Based on current GDP of around $14 trillion, if we subtracted 8 percentage points, GDP might contract by a little over a trillion to just under $13 trillion. The current value of the stock market, measured in relation to GDP, would then be 65% rather than 60%, and it would still be cheap relative to its historical average of 79%.

A Protracted Japanese-style Debt Deflation is Unlikely

Many analysts draw a comparison between the current environment and Japan's debt deflation in the 1990s. In my opinion, these comparisons are overblown. Japan's assets, principally its commercial real estate prices and its equity prices, were substantially more overvalued and leveraged than U.S. assets at the onset of our respective "balance sheet recessions". In the 1980s, Japanese companies were five times more leveraged than their U.S. counterparts, and the overvaluation in Japanese real estate was legendary. At the market's peak in 1991, all the land in Japan, a country the size of California, was worth almost four times the value of all property in the United States at the time.

Nationally, House Prices Appear Reasonably Valued Again

There's a simple measure of sanity in housing prices: the ratio of median home price to median family income. Historically, it runs around 3 to 1; by late 2005, it had risen nationally to over 4 to 1. In some markets (e.g. California, Florida), the ratio got much higher. As we all know now, this overvaluation, enabled by astonishing excesses in the mortgage backed securities markets, is the single greatest reason for the mess we are now in and the collapse of Wall Street. However, as a result of the 20% decline that has taken place over the past two and a half years, the national median home price has dropped from $230,000 to $192,000 and is back down to 3.14x national median income. This implies that if some basic confidence returns, housing prices in most markets should stabilize.

Deflation is Reversible under a Paper Based Money System

As Chairman Bernanke articulated in his famous 2002 speech on the subject, deflation is reversible under a fiat money system. It is puzzling that so many seem to doubt that premise and are pricing assets as though the economy were headed into a protracted (i.e. multi-year) deflation. The Fed is already expanding its balance sheet like never before. Moreover, a large fiscal stimulus package, which will either be deficit financed or monetized by the Fed, is coming in January. Before long, I suspect that more market participants will conclude that the inflationary actions of the central bank and the government will outweigh the deflationary forces that stem from wealth destruction and credit contraction. The gold market appears to be on the leading edge of figuring this out: gold prices are up nearly $100/ounce in the past three days.

The "Smart Money" is Buying Aggressively

According to InsiderScore.com, which tracks the buying and selling activity of insiders (i.e. executives and board members) at S&P 500 companies, insider buying is at its most bullish levels since the two weeks following the Black Monday market crash of October 1987. Something tells me that in the not too distant future, we will be reading about corporate buyback announcements. If corporate debt markets were at all functional, no doubt such buybacks would already be underway.

A Big Three Restructuring, Done the Right Way, Would be a Positive Development

A restructuring of the big three, even in a "pre-packaged" bankruptcy, is not an end; it is the beginning of a healthier U.S. automotive industry. Bankruptcy and restructuring can be a great catalyst for companies to undertake the right kind of reforms and undertake a thorough house cleaning and reform of contractual obligations that render the big three uncompetitive. Washington could administer the restructuring and conditional taxpayer assistance on fundamental reform that could finally make the U.S. automakers competitive. That is something all Americans would like to see.

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This article has 13 comments:

  •  
    Nov 24 10:48 AM
    excellent article!
    Reply | Link to Comment
  •  
    Nov 24 10:53 AM
    Interesting commentary, Comrad.

    The rich will always be rich, the poor will only grow larger in number.

    Nothing on earth compares to democracy destruction, which is really the price being paid for all this "fiscal debauchery" no matter whom contributed to it's demise.

    The system might be saved, but democracy is nothing but smoke and ashes. I hope the rich are finally happy.
    Reply | Link to Comment
  •  
    Nov 24 11:23 AM
    If I may, this article can be summed up as follows: we'll inflate our way out of this recession (depression?); assets appear cheap, but historical valuation criteria, assumptions and models are busted, and; don't fear low odds events.

    It would be helpful to know how the "low odds" of a depression were calculated. What criteria and distribution were used?

    How does the expansion of the Fed balance sheet "cleanse excesses" of the system when the Fed is part of the system? The various actors who engaged in risky behavior (from the government down to individuals) are now passing the payment of the price of the consequences to the innocent. Remember, there is no free lunch--someone has to pay eventually. The bubble is simply being shifted and when this one bursts the results could be catastrophic. This realization could be why the markets are pricing in a doomsday scenario. It doesn't mean that such a scenario will come to pass, just that it is a possibility and perhaps more likely than many realize.
    Reply | Link to Comment
  •  
    Nov 24 11:27 AM
    Yet more nonsense from the pump and dump crowd!
    Reply | Link to Comment
  •  
    Nov 24 12:50 PM
    While your GDP analysis and argument is well thought out, I think it fails to take into account the growth in corporate, government and consumer debt that has been used to leverage the growth of the last thirty years. Ultimately, I think there is a great deal of deleveraging that needs to take place and we've only just begun the process. While I'd love to believe that we're at the bottom, I think you're like the bargain hunters of 1931 buying in when the Dow was at 180. It took them until 1945 to break even and until 1954 before they actually doubled their money.

    How Wall Street can ignore the failure of Citigroup and rally is beyond me. There's a serious desire to believe this is the 1980's or even the 1970's and not the 1930's.

    Good luck to you. Personally, I'm long on wheat and rice... in my pantry!
    Reply | Link to Comment
  •  
    Nov 24 02:14 PM
    Good article. Thanks. One nit on a personal pet peeve.

    The author wrote:
    "providing we break the fear-based negative feedback loop currently at work in the markets"

    This is not a negative feedback loop, it is a positive feedback loop.

    Negative feedback loops maintain equilibrium in a system.
    Positive feedback loops amplify results away from equilibrium in a system.


    It is a common error to use "negative feedback" loop to describe a positive feedback loop that has unpleasant, or negative, consequences, as is the case here.

    Thanks.
    Reply | Link to Comment
  •  
    Nov 24 04:00 PM
    Figuring in a little overshoot, a median income of 45k and the 3X formula being 2.8X, gives a median house value of 126k. That is where things should be. It will take awhile longer.
    Reply | Link to Comment
  •  
    Nov 24 05:30 PM
    let's party like it's 1931!
    Reply | Link to Comment
  •  
    Nov 24 05:51 PM
    I agree. The constant swings everyday of 5-6% up, then 5-6% down for the whole market are symptomatic of panic, fear, and being irrational. The situation is bad, but I don't think people understand that the government controls the printing press, and they have repeatedly said they will do anything to avoid the worst case scenario. It isn't the just and right thing to do, but that is the state of the world we live in.
    Reply | Link to Comment
  •  
    Nov 25 01:20 AM
    just to point out each of your points has a fairly strong counter argument. as you are an investor trapper - each person needs to understand the risks of investing in this environment. no pain, no gain.
    Reply | Link to Comment
  •  
    Nov 25 02:48 AM
    Judging by the title, I was expecting cool, shiny robots with Austrian accents. A bit disappointed. Solid post otherwise.
    Reply | Link to Comment
  •  
    Dec 15 11:52 AM
    "Clearly, we are in a defining moment in investment and economic history. Markets are in a mode of risk aversion unlike anything we have ever seen in our lifetimes."

    Yes. Generational shifts like these don't come around every day and they don't go away until the new generation has learned its lesson.

    The drop will be defined by the rise and excess that created it and we had decades of excess and wealth generated out of thin air using otrher people's money. Expect at least a few more years of significant downward moves in stocks and the economy in general until society has been taught a much needed lesson: saving is good, spending what you don't have is bad.

    --Fred
    Reply | Link to Comment
  •  
    Dec 15 12:07 PM
    "According to InsiderScore.com, which tracks the buying and selling activity of insiders (i.e. executives and board members) at S&P 500 companies, insider buying is at its most bullish levels since the two weeks following the Black Monday market crash of October 1987. Something tells me that in the not too distant future, we will be reading about corporate buyback announcements. If corporate debt markets were at all functional, no doubt such buybacks would already be underway."

    While researching the market crash of 1929-1932 I found an endless number of statements like these. The problem is that they are not based on facts and data and anyone using them will get what they have already received over the past year.

    Here are some facts:

    The stock market was and still is overpriced based on almost every historical measure using data going back into and past the 1930's. P/E ratios are still over 19; book value is 50% higher than historical averages; the stock market itself is still above its "fair value" or mean.

    Consumers are in terrible shape with high debt and their credit lines being cut.

    Home prices are expected to drop a total of 40% or more from the highs, which has greatly reduced the spending power of consumers.

    Deflation is a fact and deflation tends to keep consumers and businesses from spending.

    Housing has yet to bottom.

    Financials have yet to bottom.

    Job loss is still accelerating.

    Government debt is growing at a staggering rate.

    Need I go on?

    I am very bullish on America and the stock market over time but by being realisting in the past year I have more than TWICE as much in my retirement fund than I would have if I had ignored the facts and data.

    Knowledge is what makes man what he his; ignoring facts makes you just one of the fools who ends up a loser. Sorry for the tough words but it is time to wake up and smell the coffe

    --Fred
    Reply | Link to Comment
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