Where we are at now, US Economy

With the massive amount of data available it can be hard to get a grasp on what is going on.  I tend to look more at the big picture and trends, as opposed to the data points.  So here it goes:

• GDP growth is slow – 2% for Q1 and 1.70% for Q2 (revised up today).  Year end estimates are in the 2% range.
• Employment isn’t good.  But hey, doesn’t look like mass layoffs are coming up soon either.
• Housing starts have bottomed and are in an uptrend.  Maybe even prices (?) have bottomed.  Just don’t expect a massive V recovery in either.  
• Real income growth is weak and still below the 2008 peak.
• Retail sales were up, but that was after a decline.  It’s not clear whether the trend will move down, sideways, or reverse back to up. 
• Industrial production continues to expand and is in an uptrend.   The ISM Index indicates a slight contraction. 

So the bad news is I wouldn’t expect a massive jump in GDP.  None of the above metrics (or any others) seems to indicate that.  This is because employment is terrible and income growth is weak.  Without higher incomes, there is less demand; less demand equals lower revenues, which in turn leads to lower employment.  This is why I am opposed to deficit reduction now.

On the plus side, nothing appears to be rolling over.  Retail sales were close, but the most recent jump at the very least gave pause to its recent moves down.  Hopefully this actually reverses the trend going forward.  Housing is now a tailwind as opposed to a headwind.  And manufacturing, while not roaring, is chugging along.

Ultimately, this is indicative of a slow growth economy, but not one that is cratering or in recession; although, the latter is more semantics at this point than anything.    

What to Do About a Higher CAPE?

In my last post I pointed out that from a longer term valuation standpoint the market isn’t a screaming long-term buy.  Before we get into how investors can navigate the secular bear market trend, here are some caveats with CAPE:

• Not very reliable over the short term.
• Given the above, low CAPE can go lower and high CAPE higher (i.e. can’t time the market with it).
• It’s only one measure.
• Innovation could alter the secular trend.

I am still under the assumption that the secular trend we are in is bearish.  That doesn’t mean ditch your stocks now; however, there are things you can do:

• Temper your expectations:  an annualized return of roughly 10% to 15% is going to be tough to achieve.
• Linear is dead:  the relative linear movement of equities from 1982 to 1999 is probably not coming back for awhile.   It is likely to return, but not until the secular bear cycle runs its course.  So expect the choppiness to continue.
• Risk On, Risk Off:   this isn’t to say go from 100% cash to 100% stocks at the drop of a hat, but take profits when you can and rebalance when needed.  Further, it wouldn’t hurt to dial risk back when markets get frothy.
• Have a plan on the downside: be aware of the trend: this seems obvious, but today it can be easy to get caught up in the news and confuse noise with signals.
• Preserve capital:  this one is the key.  Don’t suffer catastrophic losses.
• Stay up the quality chain:  similar to the above, but this way when the market moves down you don’t catch all of the downside.
• Diversify PROPERLY:  realize that asset class correlations tend to be closer to 1 and -1 right now and can change quickly.  Further, past correlations don’t mean that future correlations will hold.

  

Stocks for the Long Run…

If valuation levels are correct.  This isn’t anything new or complicated, investing in stocks when they are overvalued will likely yield a lower return over the long-run then when stocks are undervalued.  

There are various levels to measure this.  For this post I will look at Dr. Shiller’s Cyclically Adjusted Price to Earnings ratio (CAPE).  This widely utilized methodology calculates the inflation adjusted price of the S&P 500 divided by the prior 10-year mean of inflation-adjusted earnings.  In short, it is a measure of long-term valuation.

So where are we now?  These CAPE charts indicate: 

• We have a ways to go before we launch our next secular bull market (i.e. we are still in a secular bear market).
• CAPE moves in downtrends and uptrends, we are in a downtrend.
• Thus, CAPE should contract further (higher earnings combined with lower or stagnant equity price levels) before the next great long term buying opportunity presents itself.

Recently I read a study, which highlights the strong correlation between CAPE and forward equity returns – the longer the time horizon, the greater the correlation.  This is true not only in our market, but other markets (developed and emerging, though less tight in emerging).

This doesn’t mean you should avoid stocks altogether, in fact in the short-term CAPE isn’t reliable at all.  I just think it’s important to highlight the secular bear cycle we are in and that future will probably present better long term buying opportunities for equities than right now.

TARP “An Abysmal Failure”

Those were the words of Neil Barofsky (appointed by Bush, registered Democrat), former special inspector general for TARP, in a recent interview with Yahoo! Finance.  Here is the video:

And here are some key takeaways:

• Banks could dictate terms of their own bailout
• No difference between the Bush administration and the Obama administration
• Most of blame goes to executive branch, and thus Treasury (again both parties)
•  Program was intended to restore lending, help homeowners, but nothing in program to compel the banks to do so 
• Geithner essentially acknowledged that the program was to allow banks to soften the blow and extend the foreclosure process
• Government just looked the other way in the face of misconduct
• Accounting tricks and spin have essentially showed TARP is a gain, but losses were still less than expected
• Further, the above “gain” doesn’t take into account all other bailouts
• It did help prevent financial Armageddon, but did little in the way of helping the broader economy and households, which is the reason why Congress passed TARP in the first place

In hindsight without the world on the brink of returning to a hunter-gatherer society it’s much easier to criticize the program.  It was really scary in the Fall of 2008.  I admit that.  Further, I will concede I don’t think Paulson, Bernanke, Geithner, etc. created this massive wealth transfer out of malice.

Having said that, I think Barofsky is correct – consumers are still over leveraged, unemployment is high, consumption is weak, growth is slow, etc.  While all are improving, none are indicative of a robust economy.  There could have been a better way to handle TARP (e.g. controlled bankruptcy, greater controls) and if there wasn’t, why wasn’t there?

Ultimately I think TARP is another example of treating the symptoms and not the disease.  The banks were in trouble because they made excessive loans to consumers who were leveraged to the gills.  The economy won’t feel any better until the consumers repair their balance sheets.  TARP, monetary easing, and other policies have done little to address that.

HT to Big Picture for alerting me to the video.

Here is Barofsky’s book.

Takes From “Fooling Some People All of the Time”

A friend pointed me to the book Fooling Some People All of the Time by David Einhorn, president of the hedge fund Greenlight Capital.  The book details Einhorn’s short position in Allied Capital. At first I was hesitant to read it because most of my reading is more macro than micro (as you could probably tell from this blog).  However, it turned out to be a great read and even read more like fiction.

Einhorn goes into detail why he took the position (egregious accounting, loan fraud, ponzi scheme), how the position played out (longer than he anticipated, same Allied practices continued), his struggles along the way (SEC accusations, phone records stolen, ad hominem attacks), and what ultimately happened (he was right, made a lot of money).  Rather than write a book report, I figured I would highlight some of my key takeaways:

1. Trust Yourself.  Executives, analysts, journalists, regulators all failed shareholders.
2. Short Selling is Good.  I always thought this, but if you have beef with it this book is worth the read to see why it's good.  Essentially short sellers help uncover what everyone else (again, executives, analysts, journalists, regulators) fail to see.  There are other reasons why short selling is good for markets, but won’t get into detail.  Just know Spain banning short selling won’t work.
3. When a Company Attacks Short Sellers, Bet on the Latter.  Again, this is something I have thought for awhile.  First, why would a company who has nothing to hide attack shorts?  Ultimately they know the market price will reflect the value, if anything it gives executives a chance to load up on cheaper shares.  Shorts don’t bankrupt a company or lead it to have bad business practices, the company does.  It’d be like blaming the doctor for the diagnosis.
4. Trading Stocks is Hard.  The amount of research Einhorn did on this one company is astounding.  Just know when you buy an individual stock, the person selling it you is probably very astute. 
5. Markets Aren’t Efficient.  This is obvious.  If markets were efficient Einhorn couldn’t have made any money as Allied would have been priced under $5.

Those were just the first five that came to mind.  I have some more, but will leave it at that.  Anyway, it’s an entertaining, although at times frustrating given the lack of concern against Allied’s practices, story.

Here is a link to the book.  Also note, Einhorn and Greenlight donated $7m to charity from trading profits on Allied.

A Note on Unemployment

The employment picture is a huge economic headwind.  That is why each report gets so much attention.  Lack of employment = continued weak demand.  If the employment situation improves, consumption should pick, balance sheets will heal faster, the economy will improve, and then you get a positive feedback loop.  With that in mind, let’s take a look at the most recent report…

The Good:

• We added 163k jobs
• Better than consensus (100k forecast)
• The stock market appeared to like the number
• Indicates we aren't in a recession

The Bad:

• Other aspects of the report were more negative
• Unemployment actually rose to 8.30%
• U6, a broader range of unemployment rose to 15%
• Revisions in prior months and seasonality 

What it Means:

Nothing.  While I just said the report gets attention, it’s one report.  The trends remain not good and the employment picture is still poor.  Calculated Risk has some fantastic graphs that illustrate this:

• Deepest job loss and slowest job recovery in Post WWII recessions (here)
• Long-term unemployment, while decreasing, is still elevated (here)
• Note, if this doesn’t decrease it could indicate a more secular employment problem
• People ages 25 to 54 are underemployed relative to prior levels (here)
• People still aren’t participating in the labor force as they have in the past (here)

So to conclude, it’s good we are moving in a positive direction, continuing to heal, and seemingly not in a recession as of now.  Still, the report is not a game changer and does not augment the underlying key theme – the employment situation as a whole is weak.

Focus on the trends, not one reading.

Investors Mistakes – Part III - My Additions

My last few posts outlined Barry Ritholtz’s 10 investor mistakes and Robert Seawright’s 10 Most Common Behavioral Biases.  I gave a brief description and then provided a solution to avoiding such errors.  Today I cover some errors not mentioned by the last two authors.

1. Political Trades – an investor makes an investment or trade based on his or her own political views or that of a commentator.  Solution:  Avoid these investments all together.  An easy way to spot one is the association of a political party or politician to reason why investment ABC will move up or down.  That isn’t to say geopolitical events don’t move markets, they do.  But look for analysis with data, not vague political diatribes.
2. All or None – this is similar to Rithotlz’s #3 (being your own worst enemy), but often times investors will get bullish and want to move all into stocks and/or bearish and move all into cash.  Such large moves can drastically increase the chances of being right or wrong and alter the longer-term risk/reward profile of the portfolio.  Solution:  Have a game plan.  Make moves in ranges, particularly on the downside.  If you get nervous, take a % away from equities and move into bonds, but try not to alter your whole portfolio.  Even better, have a plan on the way down with different sell points, hedged investments, moving up in quality, stop losses, etc.
3. Ignoring Liquidity – not realizing the importance of having your capital locked up in investments that don’t trade daily.  Solution:  Not all illiquid investments are bad, but make sure you realize that your assets will be tied up and for how long.  A hedge fund probably has greater liquidity than CRE, but both will have capital tie ups, for example.  Further, make sure you know the underlying investments, as this has bearing on the nature of the liquidity.  In the last downturn, some of these investments, which were supposed to provide quarterly liquidity couldn’t perform due to the nature of their holdings.   
4. Investing in What You Don’t Understand – deploying capital to investments (now investments with a higher yield are all the rage) that are confusing and/or complicated to the investors.   Solution:  Don’t get it?  Don’t buy it.  If you can’t answer the questions how much risk am I taking for the return and what the investment does to produce said returns, then chances are the investment isn’t for you.  It doesn’t make the investment bad, but it just increases your risk that it won’t perform as expected in any number of economic scenarios.  A rule of thumb - the more complicated the higher the seller compensation, so watch the soft costs, they dig deeply into return.
5. Ambiguous to Time Horizon – investing in inappropriate asset classes based on time horizon.  Need money in a year?  Don’t invest in stocks.  Solution:  Figure out what you need from your savings and investments over the next few years and earmark assets for those purchases.  A lack of liquidity can also be measured by selling your assets at a loss when you need the cash. Making sure your time horizon matches your asset mix can help alleviate that issue.

I have 5 more, which I will get to at some point down the road.