Finance in Wonderland

We're in a surreal phase. As Denninger points out, there is no legal authority for the Federal Reserve to accept stocks and shares as collateral, which it is now doing ("was that a wooden horse that came in through the gates?"). There is an air of unreality - huge firms suddenly going down, one by one, while we're trying to make ourselves believe that it's all still normal, somehow.

And now that Lehman has bitten the dust, we shall see whether London Banker was right - whether Lehman was calling in foreign investments in order to give US domestic creditors an unfair share in the asset recovery scramble.

Intermission

The FTSE has just closed at 5,414.40, about 1,150 points down from a recent high (10 December 2007) of 6,565.40.

But the gyrations have gone on for much longer. The FTSE bust UPwards through 5,438 on 29 October 1998, heading for nearly 7,000 by the end of 1999; popped and went through 5,417.60 in a DOWNwards direction on 29 August 2001; hit bottom (3,287) on 12 March 2003; rose back UP through 5,358.60 on 2 November 2005 - and here we are again.

Except we haven't factored-in inflation, so each later revisiting of the 5,400 level represents a further loss in real terms.

Meanwhile, let's take a look at what we might do to preserve what little wealth we have.

Residential property: costs about double its long term trend (3x income). But Mrs S isn't keen on a caravan, not even, as I suggested, "if we get a nice horse".

Stocks: the S&P's long-term trend p/e ratio is a little under 15, so to get back to that it should fall by 25 - 30%. Looks like we're partway there. Emerging markets have boomed, but as that sage Christopher Fildes said many years ago, the definition of an emerging market is that is is a market from which it may be difficult to emerge.

Bonds: a painful subject, with CDOs and the like. Hard to tell quality from rubbish at the moment, and if the credit contraction forces interest rates up, the capital value of bonds will have to fall to match the yield available on other kinds of loaned money.

Commodities: some markets such as gold are small enough to be manipulated by speculators (and sales from stock) - and much of the investment in them may be leveraged, which brings in extra uncertainty because the credit crunch could force sales to cover cash calls. Others, such as oil, may be affected by reduced demand in a recession. So commodities are not a no-brainer for the amateur investor. How many will know when they've reached the top of the price spike? Agriculture might be interesting, though, as I reported a while ago and as Jimmy Rogers says now, according to Contrarian Investor.

No wonder Marc Faber said last year that he saw bubbles everywhere. He has since gotten into gold, among other things, but he is a very smart, quick-moving trader. If I had any serious money, I'd rather use him (and others like him) than try to compete with him.

What else?

Some governments offer their own instruments for matching inflation - Index Linked Savings Certificates in the UK, TIPS in the USA, for example.

I suppose that if you expect food and fuel to rise in price, you might stock up - though a John Denver-type petrol store is probably unwise, if not illegal. And even tinned food, rice and dried pasta will only stay in good condition for so long.

And not everything is likely to go up. We look as though we're in for an odd combination of inflation and deflation. Houses, stocks, maybe bonds, maybe some commodities, may present buying opportunities sometime. And how about those consumer durables - the cars, computers etc you may want to renew or upgrade sometime? So cash really doesn't seem that bad to me, so long as you make sure you're maximising your rights under local depositor protection laws.

And then there's the bigger picture. Douglas Adams, author of The Hitchhiker's Guide To The Galaxy, observed of unhappiness: "Many solutions were suggested for this problem, but most of these were largely concerned with the movement of small green pieces of paper, which is odd because on the whole it wasn't the small green pieces of paper which were unhappy." My point is not that money is unimportant, but that it won't be enough to see ourselves all right - we still have to live with our neighbours. It's important to get the economy straightened-out, because when others are unhappy and insecure, we shan't be safe, either. Perhaps there's a selfish element in altruism.

It's pretty clear how things are now, and there's no need to keep the sirens going when you can see the fire. All I hope is that concerted, imaginative action will minimise the damage. A wilder hope is that we might reform the system - especially our rotten currencies and remote, self-centred politicians. I've learned much from joining in the debate, but don't think I have much more to contribute at this stage, so I think I'll be better off giving my ego a rest and reading you, instead.

My final guess, for now: it'll be time to get back into the swim in the Spring of 2010.

A secular bear market in housing?

It's now generally accepted that houses are overpriced. I think valuations will not only go down, but (notwithstanding bear market rallies) stay down for at least a generation.

Here's some reasons, some having a longer-term effect than others:

• house prices are now a very high multiple of earnings, choking the first-time buyer market.
• presently, there is increasing economic pessimism, which will further inhibit buyers.
• the mortgage burden now lies in the amount of capital to be repaid, rather than the interest rate; that's much harder to get out of, and will prolong the coming economic depression, either through the enduring impact on disposable income, or through the destruction of money by mortgage defaults on negative-equity property - and as valuations fall, there will be more and more of the latter.
• fairly low current interest rates allow little room to drop rates further to support affordability - and at worst, rate drops could sucker even more people into taking on monster mortgage debt. But interest rate reductions are unlikely to benefit borrowers anyway. The banks have survived for centuries on the fact that while valuations are variable, debt is fixed. They got silly with sub-prime, but by George they will remain determined to get all they can of their capital back, and preserve its value. The people who create money literally out of nothing - a mere account-ledger entry - are now tightening lending criteria and will continue to press for high interest rates; for now, they will content themselves with not fully passing on central bank rate cuts, so improving the differential for themselves, as compensation for their risk.
• food and fuel costs are rising, and given declining resources (including less quality arable land annually), a growing world population and the relative enrichment of developing countries, demand will continue to soar, cutting into what's left of disposable income.
• our economy is losing manufacturing capacity and steadily turning towards the service sector, where wages are generally lower.
• the demographics of an ageing population mean that there will be proportionately fewer in employment, and taxation in its broadest sense will increase, even if benefits are marginally reduced.
• the growing financial burden on workers will further depress the birth rate, which in turn will exacerbate the demographic problem.

In short, there will be less money available to chase house prices; and in my view, less to chase investments, too. It may be very similar in the USA - as Jim from San Marcos says now (repeating himself from last May):

A market goes up when more people want to buy, than those that want to sell. Well, all of these first time home buyers have no spare cash for the Stock Market. The Baby Boomers, sometime in the future are going to want to sell. The question arises, "Sell to Whom?"

Returning to houses, there are still those who think valuations will continue to be supported by the tacit encouragement of economic migration to the UK.

Now, although this helps keep down wage rates at the lower end (where is the Socialist compassion in that?), the government is pledging the future for a benefit which is merely temporary, if it exists at all. Once an incoming worker has a spouse and several children, how much does he/she need to earn to pay for the social benefits consumed now and to come later? State education alone runs at around £6,000 ($12,000) per annum per child.

And then there's the cost of all the benefits for the indiginous worker on low pay, or simply unemployed and becoming steadily less employable as time passes. And his/her children, learning their world-view in a family where there is no apparent connection between money and work. The government makes get-tough noises, but in a recessionary economy, I don't think victimising such people for the benefit of newspaper headlines will be any use. I seem to recall (unless it was an Alan Coren spoof) that in the 70s, Idi Amin made unemployment illegal in Uganda; not a model to follow.

So to me, allowing open-door economic migration to benefit the GDP and hold up house prices doesn't work in theory, let alone in practice.

Besides, I maintain that in the UK, we don't have a housing shortage: we have a housing misallocation. There must be very many elderly rattling around alone in houses too large and expensive for them to maintain properly. This book says that as long ago as 1981, some 600,000 single elderly in owner-occupied UK property had five or more rooms; the ONS says that in 2004, some 7 million people were living alone in Great Britain. Then there's what must be the much larger number of people who live in twos and threes in houses intended for fours and fives. Before we build another million houses on flood-plains, let's re-visit the concept of need.

Maybe we'll see the return of Roger the lodger - if he's had a CRB check, of course.

Would I buy a second home now? No. Would I sell the one I live in? I'd certainly think about it - in fact, have been considering that for some years.

Here we go

Two from Karl Denninger in the last two days:

Monday, he reasserted his belief in DE-flation; but as I've been saying for some time, maybe the real issue is the divide between haves and have-nots, and he deals with that, too. No point being rich if you daren't go out.

Yesterday, he sounded the bells for a possible crash today. Maybe this is when Robert McHugh's prediction is fulfilled.

Dead Cat Splat

Some expect the market to drop, but bounce quickly as in 2000. Vince Foster says not, since this boomlet has been credit-fuelled.

His view: housing is woeful, emerging markets look as though they may be topping-out, the Ted Spread is signalling insolvency fears, the 10-year bond rate augurs slowing growth; so cash is king.

Bad news: we depend on the banks

The long-experienced team at Contrary Investor thinks the credit market needs watching, not the equity market. Outlook: oh, dear.

When things turn vengeful, let's take a careful look at the banks, and those who give them their orders. Not for the first time, they've lifted us up, and are making ready to drop us from a great height.

As the song from Mary Poppins has it:

If you invest your tuppence
Wisely in the bank
Safe and sound
Soon that tuppence,
Safely invested in the bank,
Will compound

And you'll achieve that sense of conquest
As your affluence expands
In the hands of the directors
Who invest as propriety demands

[...]

You can purchase first and second trust deeds
Think of the foreclosures!Bonds! Chattels! Dividends! Shares!
Bankruptcies! Debtor sales!

... for the whole lyric see here.

The scene ends, happily enough, with a run on the bank as young Michael loudly demands the return of his twopence.

Contradicting the contrarians

Cash is king for now, but later next year it'll be equities up, dollar up, bonds down, according to the round table on Safe Haven.

UPDATE

But Tim Wood expects the market to hit a low - "The straw that finally breaks the camel’s back may be closer than you think."

Some interesting correlations

Greg Silberman reveals the results of some interesting research:

1. Since 2003, if the dollar falls, all other asset classes rise; and conversely, if the dollar rises, the rest drops.

2. The "real" (adjusted for the price of gold) interest rate on 3-month Treasury bills predicts movements in the exchange rate of the dollar a year later.

Since the "real" interest rate has fallen sharply, he therefore expects a strengthening in other assets next year.

Modestly, Silberman adds, "Correlations are never perfect and tend to fail just when you need them most."

I think he's right there. To me, there seems to be a lot of jiggery-pokery in the gold market (speculators vs. central banks), and the predominance of "fiduciary money" (credit) in the economy means that we're measuring sizes with elastic bands.

In times of stress, the normal predictors don't hold, so currently I view all investments as speculative. My first priority is to reduce my vulnerability with respect to creditors, and my second is building cash to take advantage of emerging opportunities.

Defensive investing

Michael Panzner's latest is lucidly entitled "Today's Lesson: Bad Economy = Bad Stock Market". At last, financial analysis I can understand.

I've never understood why the stockmarket seems serenely unrelated to the dire state of the economy. Supposedly the market "looks ahead" around a year, but it can't be seeing what I'm looking at.

Anyhow, Panzner reproduces Dan Dorfman's article in the New York Sun, which reviews what's happened to the market in past recessions and gives tips on strong defensive areas - booze, cigs and "household products". I can understand that, too - or the first two, at least.

Visions of 2008

Following Dearieme's comment on the previous post*, I'm going to try to visualise a chain of events over the next year - guesswork, of course, with plenty of obvious ones:

USA

a marked deflation in property prices
a reduced demand for luxury goods and services
reduced imports of the above
consequent recession abroad
further interest rate cuts
higher unemployment
higher taxes
higher State and Federal budget deficits
a sell-off in equities
increased demand for bonds
a weakening currency
higher prices for food, fuel and clothing

increase in the price of good-quality agricultural land
consumer price inflation indices will not be able to continue to mask the real increases in costs of living, and this will have further consequences for public finances
public enquiries, leading eventually to a thorough reform of the financial system

UK

much the same as above, except I don't think our house prices will fall so far - the US subprime mess will hit investments, but we will drop our interest rates to devalue the pound to maintain stability against the dollar

Gold

will continue to fluctuate interestingly, but although some smart money is after it, there will be less spare money around generally, and other commodities will offer interesting opportunities for inflation-beaters. It's already above its inflation-adjusted long-term trend, and lenders will make sure that the real value of their loans is not destroyed by hyperinflation

... in short, slumpflation.

UPDATE

*and, by way of comparison, here is Karl Denninger's outlook in his Dec 24 post.
... plus a more sanguine assessment by Nadeem Walayat.

A Merry Christmas to all, and thanks for your visits and comments.

Credit default swaps - a line of dominoes, one falls

Karl Denninger reports on the savage downgrading of a credit default insurer from "A" to "CCC" (junk) in one move - essentially a collapse in creditworthiness - and explains the implications for credit and investment markets. His conclusion is crystal clear:

If you're long stocks, bail now.

Stockmarket crash on the way?

Clearly, The Contrarian Investor (2 Dec) thinks it's a possibility. So does Frank Barbera, who looks at the jaded market response to interest rate cuts and says:

All investors take heed, you are staring at a market that is NOT responding well to “Good News.” Markets that cannot rally on Good News tend to accelerate downward on any type of bad news, and that is the kind of market which appears to be taking shape.

What is long-term investment?

Jeff Prestridge, in today's UK "Mail on Sunday" finance section, reports that the Personal Assets trust, controlling £188 million, has changed its weighting from 60% cash earlier this year to 100% cash now. He's sniffy about their performance over the last 5 years, contrasting them with the likes of Baillie Gifford.

Well, I'm not a respected Fleet Street money journalist, merely a no-account bearish personal financial adviser, but I'd suggest that in the exciting investment world of today, maybe a five-year period is not a good basis for comparing long-term results, or conditioning expectations for the future.

I had a client ask my opinion about investments a couple of years ago, because his bank had been showing him their fund's marvellous growth over a three-year period. I took time to explain to my client that over the five years to date (then), the graph (as for the FTSE 100) described a kind of bowl shape, and the period chosen by his bank just happened to draw a line from the bottom of the bowl to the lip.

I then showed him the five-year line in all its loveliness:

I think it's fair to say that these are not ordinary times. There has been a steady build-up of electrical charge, so to speak, over something like a decade (some would say, much longer), and there may well be some powerful bolts unleashed as a result. Where will the lightning will strike next: a steeple, an oak tree, a cap badge - who can tell?

Massive debt; changes in the balance of international trade; demographic weakening of future public finances; sneaky currency devaluation; wild financial speculation; wars and the rumours of wars; imprecisely known ecological limits to growth; declining energy resources; the desperation of the world's poor to join our fantastic lifestyle; our fear that we may lose the comfortable living we used to imagine was our birthright; the corruption, abuse and neglect of the young; the selfishness of their parents and the middle-aged; the increasing burden and growing neglect and abuse of the old.

In all this turmoil, making five-year investment performance comparisons has an air of unreality, like planning tomorrow's menu on a mortally-wounded ocean liner.

I beg to differ

I seem to recall it was some Supreme Court decision, where one judge said he dissented from the view of his colleagues "for the reasons which they have given". Elegant.

Tony Allison, in Financial Sense yesterday, gives the above graph and reads it as an indication that we could be heading for a gold price spike like that in 1980; whereas I look at the inflation-adjusted trend since 1914 and think that, unless my timing in and out of that market is superbly prescient, I'm better off doing what I do now, which is trying to pay down debts and save cash.

Yes, when I've done the latter, I might well make precious metals and commodities part of my portfolio.

Michael Panzner on Michael Panzner

Michael Panzner quotes USA Today quoting him, and I'll quote Michael too, since the advice seems sensible...

Predicting tough times ahead, Michael Panzner, author of Financial Armageddon, recommends that investors buy shares of companies that sell stuff that people need to buy no matter what's going on with the economy. Companies that sell soft drinks, tobacco, prescription drugs and toilet paper, for example.

Investors, he says, should play it safe, loading up on defensive stocks, socking away more cash and moving toward the safety of U.S. Treasury notes and bonds.

Why the sea is salt, and why we are drowning in cash

We are said to be heading for a recession, so I had another look at Bank of England statistics for M4 - money supply as measured by private lending by financial institutions.

Since June 1963, there has NEVER been a quarterly period when M4 contracted. In fact, here are the only times in the last 44 years when UK quarterly monetary inflation ran at less than 5% p.a. equivalent:

As you see, mostly it was the nineties, with one instance in 1975 and three times in the sixties. The average rate for the whole series up to December 2006 is 13.47%. So the hand-mill never stops grinding.

But should it? Wikipedia gives an account of recession and the Great American Depression, and notes that during the latter period the money supply contracted by a third. Great for money-holders, bad for the economy and jobs.

This page points out that we tend (wrongly) to think of a period of economic slowdown as a recession, and says that technically, recession is defined as two successive quarters of negative economic growth. By that measure, we haven't had a recession in the UK (unlike Germany) for about 15 years - here's a graph of the last few years (source):

And then there's the stockmarket. It doesn't seem to reflect the real state of the economy - until you shift the lines, when for example the S&P 500 turns out to be a fair predictor of changes in GDP, as shown in a graph in a 2005 entry from this blog ("Capital Chronicle", by RJH Adams):

The same post also provides a brilliant graph of a measure of fair value for investors, known as Tobin's Q. Look at the wonderful opportunities presented by two world wars and the economic shock (blamed on oil prices, but maybe the causality is the wrong way round) of the 70s:

Mind you, looking at Wikipedia's Tobin's Q graph, the median market valuation since 1900 seems to be something like only 70% of the worth of a company's assets. Can that be right? Or should we take the short-sighted view of some accountants and sell off everything that might show a quick profit?

Nevertheless, it still feels to me (yes, "finance with feeling", I'm afraid) as though the markets are over-high, even after taking account of the effects of monetary inflation on the price of shares. And debt has mounted up so far that a cutback by consumers could be what finally makes the economy turn down. Not just American consumers: here is a Daily Telegraph article from August 24th, stating that for the first time, personal borrowing in the UK has exceeded GDP.

The big question, asked so often now, is whether determined grinding-out of money and credit can stave off a vicious contraction like that of the Great Depression. Many commentators point out that although interest rates are declining again, the actual interest charged to the public is not falling - lenders are using the difference to cover what they perceive as increased risk. Maybe further interest rate cuts will be used in the same way and keep the lenders willing to finance the status quo.

Some might say that this perpetuates the financial irresponsibility of governments and consumers, but sometimes it's better to defer the "proper sorting-out" demanded by economic purists and zealots. History suggests it: in the 16th century, if Elizabeth I had listened to one party or another in Parliament, we'd have thrown in our lot with either France or Spain - and been drawn into a major war with the other. We sidestepped the worst effects of the Thirty Years' War, and even benefited from an influx of skilled workers fleeing the chaos on the Continent. If only we could have prevented the clash of authoritarians and rebellious Puritans for long enough, maybe we'd have avoided the Civil War, too.

So perhaps we shouldn't be quite so unyielding in our criticisms of central bankers who try to fudge their - and our - way out of total disaster.

Investing for beginners

A useful - and free! - essay by Adam Hamilton in SafeHaven, called simply Stock Trading 101.

Hussman's view: white water

John Hussman is an American fund manager and takes pains to show that his judgments are carefully weighed; so his warnings are unlikely to be Chicken Little squawks:

In July, he looked at historical "awful times to invest", and found that July 2007 fits the same criteria. The 10-year outlook for the US investor is not attractive:

Presently, the probable total return on the S&P 500 over the coming decade ranges between -4% and 5% annually, with the most likely outcome in the low single digits.

More recently (November 12), he's considered many indicators and concluded:

I expect that a U.S. economic recession is immediately ahead.

(highlights mine)

This week (November 19), he remarks that much of the money apparently being pumped into the economic system is simply a rollover of earlier loans coming to maturity: the net increase is very small compared to the total oustanding, and so the rate of monetary inflation is slowing. He quotes Jan Hatzius of Goldman Sachs as saying (in effect) that if souring subprime debt hits financial institutions directly, they are likely to call in loans in order to preserve the ratio between their lending and their reserves, which in turn will slow the economy further.

What should investors do? He quotes the view of famous investment manager Jack Bogle:

"I would say do nothing – ride it out, if your asset allocation is right. The bonds in your portfolio and the long-term growth of businesses will bail you out. Unfortunately 80% of the market is speculators now, not investors. What would I say to the speculator? I would say I'm nervous and I might even say get out.”

So I guess it's the usual couple of points: are you in for the long term, or trying to make a quick killing? And where are you on the 25:75 Benjamin Graham bond-equity balance?

Baby boom, baby bust

Percentages of the population above age 65 in selected countries

Clif Droke (SafeHaven, yesterday) summarises Edward Cheung's work, which relates the Kondratieff cycle to demographics. The most spoiled generation in history is entering its retirement phase and starting to draw on its accumulated wealth, so creating a growing undertow in the financial tide.

Red screens

It all looked a bit woeful yesterday, but I stick with my prediction: the market will go up towards the end of the year, so that dealers can suck out a last-chance bonus. For perhaps slightly different reasons, Bloomberg reports a similar forecast.