Breaking Down the Bull Argument from David Dreman

This Month in Forbes by David Dreman :

Is Recession Normal? No
David Dreman, 11.16.09, 12:00 AM ET

Let's look more closely at the bear case. While it's true the market has had an enormous rally since early March, it is important to remember that it had fallen more precipitously than at any time since the Great Depression. The financial sector of the S&P 500, for example, fell 83% between June 1, 2007 and Mar. 6, 2009. This sector's decline was steeper than the overall market's decline between September 1929 and the 1932 low. So yes, this rally is strong and sharp, but remember that it comes off the worst stock market drop since the 1930s. It still hasn't really come close to recovering the ground it has lost. The Financial Select Sector SPDR Fund (XLF) is trading at 60% below its 2007 high.
So please don't judge the current rally in the context of typical market cycles. Remember, about a year ago our global financial markets were in a state of panic. If you check market history, you will see that the rallies following such panic attacks tend to be sharper and swifter.

As I point out in one of my previous posts, we agree that rallies are sharp and vicious off severe selloffs.  No arguments there.  But neither has the case for a new bull market been made yet by Mr. Dreman.

And please don't fixate on trailing price/earnings ratios. Multiples are inflated because earnings are depressed. It's that simple. We are in a severe recession, and hundreds of companies have ailing income statements.

Stock market investors aim to see around corners, and they should be doing that now. Corporate earnings will be down sharply this year (particularly if you include writeoffs), but they will rebound over the next three years. I can't tell you how quickly the recovery in earnings will come, but I am sure it will come. Go back to that market of 1932, when the Dow Jones industrial average bottomed out at 41.22. The Dow almost tripled within the next three years, even though it took earnings almost five years to catch up to where they were before the crash. In short, it's normal for stocks to rebound ahead of earnings.

Mr. Dreman is comparing the current cycle against the Depression.  Fine.  It took the market three years to bottom and during that time there was in fact a 50% rally.  But the market fell another 80% after that.  Further, the market did not get back to the levels of that initial 50% rally of roughly 300 on the Dow until 1954!  That is 22 years later Mr. Dreman.  Not a convincing argument that we are to look blindly into the abyss and trust that earnings will recover, debts will be repaid, valuations will catch up to the market.

I'd be more inclined to be receptive if the market exhibited characteristics of a bottom.  The market was overvalued compared to historical metrics at bottoms on Price / Sales, Price / Earnings, Dividend Yield.  Bottoms are also usually accompanied by hatred, revulsion.  Markets tend to die a slow death and then are born anew when no one is watching.  Granted we got revulsion from a section of the market, but market participants were frothing at the bottom. That by definition is not a true bottom.  I am not convinced by a long short.

The bears have a different view. They think the economic malaise will last for years or even decades, as in post-1989 Japan. Get used to a new normal in our economy, they say, one in which growth is sluggish or nonexistent for a whole generation. I say rubbish.

The great global investor John Templeton (1912--2008) said that the four most dangerous words in investing are "This time it's different." In more than 30 years of managing money I have witnessed many a shift in market sentiment. It lurches from irrational exuberance (as with tech stocks a decade ago) to irrational gloom (bank stocks in March). I just don't accept today's gloomy view.

In fact Mr. Dreman you're the one asking for blind faith and telling us this time is different, that the market can avoid historical characteristics of stock market bottoms, that we can issue mountains of debt to work off a debt crisis, that there is a fundamental loss of moral hazard, that the consumer is tapped, that Japan is in a debt and demographic crisis and will not assist in this recovery, ditto U.K.

Finally you Mr. Dreman are another child of the bubble in U.S. prosperity of the past 30 years and your automatic assumption, similar to Washington Politicians, is that the U.S. will revive because it has always done so in the past 30 years.

I would point you to this weeks Barrons article on the Depression.  Everyone underestimated the depth of the correction because there hadn't been a severe correction in over 20 years.  Ignore history at your own peril, Mr. Dreman.

History Lesson From the 'Twenties

Courtesy Barrons

 

Most of the article blames the government for policy mistakes.  Fair enough, policy mistakes were made.  But at a fundamental level, it was the misguided, misinformed opinion of the politicians - probably in connection with big corporations - that they are more potent than the business cycle and possess the tools to create immediate, ongoing prosperity. 

In many ways, the approach we are taking today reminds me of the same sort of thinking, that QE, bailing out the banks, creating huge amounts of debt will leave us better off.  Somehow, history suggests that this time will not be any different.  My core principle "you cannot fight your way out of a debt crisis by issuing more debt".

 

EIGHTY YEARS AGO THIS WEEK, THE U.S. economy took its first step into the abyss. Variety magazine headlined it as "Wall Street Lays an Egg." Barron's headlined with "Severe Liquidation on Thursday Stemmed by Banking Support; Subsequent Rally Followed by Orderly Decline at End of Week."

The severe liquidation of Black Thursday, Oct. 24, 1929, continued into the next week. By the issue of Monday, Nov. 4, Barron's was reporting "one of the most cyclonic breaks in the history of Wall Street." From the peak of Sept. 3, when the Dow Jones Industrial Average reached 381.17, the decline totaled 151.1 points on Nov. 4. "In barely seven weeks, the price gains of more than a year were swept away."

In neither Variety nor Barron's was there any apprehension that the Great Depression would follow the stock market.

In November 1929, Hoover took an active role in protecting the economy. He met with industrialists and union leaders and pushed them into a deal: Industry would not cut wages. Unions would not strike. If there wasn't enough work, jobs would be shared rather than prompting layoffs.

Hoover believed high wages were the key to prosperity. For employers, he created policies that allowed firms to cooperate in order to avoid "cut-throat competition" for labor.

On the labor side, Hoover signed the Davis-Bacon Act forcing local governments to pay union wages on public works and the Norris-LaGuardia Act outlawing injunctions against strikes and picketing.

Hoover's policies did what they were supposed to do: By late 1931, real hourly earnings in manufacturing had increased by more than 10% (adjusted for deflation of prices). Yet manufacturing hours worked had declined by more than 40%, even more than total output, which fell about 20%. By the end of 1931, the general unemployment rate was 15.9%, and it would get still worse for two more years.

Ohanian calculates that under Hoover's wage-support program, which trickled down from large businesses to small, the prevailing industrial wage rate was as much as 40% higher than the wages job-seekers would accept. Too many workers chased too few jobs that paid too much, and the result was men lined up around city blocks to apply for jobs.

The Hoover policy was more cooperative and voluntary than the mandates of the New Deal's National Industrial Recovery Act, but they were the same anticompetitive, price-fixing policies.

While generations of Americans have blamed Hoover for relying on the free market instead of government intervention, some of the workers' misery in the Great Depression should be attributed to Hoover's mistaken high-wage policy.

Japanese Demand for U.S. Debt Is Bound to Weaken Dramatically

By way of the always dramatic and usually accurate Ambrose Evans comes this piece that ties in with my view that markets are not recognizing the severity of the Japanese situation and how this will impact future purchases of U.S. Treasury securities.

It is Japan we should be worrying about, not America

Japan is drifting helplessly towards a dramatic fiscal crisis. For 20 years the world's second-largest economy has been able to borrow cheaply from a captive bond market, feeding its addiction to Keynesian deficit spending – and allowing it to push public debt beyond the point of no return. 

The rocketing cost of insuring against the bankruptcy of the Japanese state is telling us that the model has smashed into the buffers. Credit default swaps (CDS) on five-year Japanese debt have risen from 35 to 63 basis points since early September. Japan has suddenly decoupled from Germany (21), France (22), the US (22), and even Britain (47). 

Implications: The Japanese carry trade is likely to continue losing favor, leading to a strengthening impact on the Yen and weakness for the Dollar.

Secondly, the rapidly deteriorating situation makes it increasingly a fait accompli that the Japanese will not be able to continue their Treasury purchases at a time the U.S. desperately needs their support in the wake of the Fed's completion of their $330 billion purchase program.

Simon Johnson, former chief economist of the International Monetary Fund (IMF), told the US Congress last week that the debt path was out of control and raised "a real risk that Japan could end up in a major default".

The IMF expects Japan's gross public debt to reach 218pc of gross domestic product (GDP) this year, 227pc next year, and 246pc by 2014. This has been manageable so far only because Japanese savers have been willing – or coerced – into lending for almost nothing. The yield on 10-year government bonds has been around 1.30pc this year, though they jumped to 1.42pc last week. 

"Can these benign conditions be expected to continue in the face of even-larger increases in public debt? Going forward, the markets capacity to absorb debt is likely to diminish as population ageing reduces saving," said the IMF. 

The savings rate has crashed from 15pc in 1990 to near 2pc today, half America's rate. Japan's $1.5 trillion state pension fund (the world's biggest) has become a net seller of government bonds this year, as it must to meet pay-out obligations. The demographic crunch has hit. The workforce been contracting since 2005.
The pillars of the government debt market are crumbling. If Japan's bond rates rise to global levels of 3pc to 4pc, interest costs will shatter state finances. 

Japan is descending into a debt situation where it is only a matter of when not if.

No one knows exactly when a country tips into a debt compound trap. But Japan must be close, even allowing for the fact that liabilities of the state Loan Programme (FILP) have fallen by 40pc of GDP since 2000. 


"The debt situation is irrecoverable," said Carl Weinberg from High Frequency Economics. "I don't see any orderly way out of this. They will not be able to fund their deficit. There will be a fiscal shutdown, a pension haircut, and bank failures that will rock the world. It is criminally negligent that rating agencies are not blowing the whistle on this." 


"This is incredibly dangerous," said Russell Jones from the RBC Capital Markets. "The rate of deflation is shocking. The debt dynamics are horrible and there is the risk of a downward spiral." 

And some particularly ominous conclusions that portend where we think U.S. strategy is headed:

It wasted its immense fiscal firepower, scattering money for 20 years on half-baked spending projects to keep the economy afloat. QE was too little, too late, and this is the lesson for the West. We must cut borrowing drastically over the next decade, and offset this with ultra-easy monetary policy. Does Downing Street understand this? Does the White House? Does the European Central Bank? Clearly not.

 

China : When the Driver of the World Economy Is A Speculative, Drunk, Riverboat Gambler

It is our opinion that China today is circa Japan in the late 1980s when it was a manufacturing powerhouse and seemed poise to continue its rise to superpower and world domination.

Jim Grant, Grants Interest Rate Observer: 

“China today is where Japan was in the late ’80s, except with the greater political instability that comes with a semi-controlled economy and the lack of a social safety net (read: jobless, hungry people don’t write angry letters, they riot)…Today China projects to the world a similar image as Japan did in the 1980s… “

Richard Bernstein, former chief investment strategist at Merrill Lynch, says China’s economy is overheating and that investors should avoid its stock market. “China is an immense credit bubble that's going on right now,” he tells CNBC.   "They have massive overcapacity and their solution to that problem was to build more capacity over that," says Bernstein, now CEO of Bernstein Capital Management.

 “A superb primer on the risks of China’s go-for-broke lending drive was published by Fitch Ratings on May 20. Is it not passing strange, the agency asks, that Chinese lending is accelerating even as Chinese corporate profits are shrinking? ‘Ordinarily, falling corporate earnings are met with tightened lending, but in China, precisely the reverse is evident. . . .’ You would expect—and Fitch does anticipate—that the borrowers of these trillions of renminbi are not so profitable as they were in the boom, and some will therefore struggle to service their debts.”


Lately, the Chinese economy has been impressing us with its growth…But Chinese economic structure is not is not superior to the West’s; the Chinese can just cook GDP numbers better and control their economy more effectively through forced lending and spending.
However, these short-term advantages come with long-term consequences – there will be a steep price to pay for them; there always is. 




“Examining, first, the track of Chinese bank lending and, second, the trend in Chinese nonperforming loans, the seasoned reader will remember … Drexel Burnham Lambert. In the mid-to-late 1980s, the American junk bond market combined breakneck growth with muted default rates. The secret, fully revealed during the subsequent bear market, was that the default rates were a direct product of the issuance rates. Borrowers didn’t default because of—to adapt the Fitch formulation to that earlier time—the ‘pervasive rolling over and maturity extension of bonds as they fell due.’ Drexel failed when the junk market did.

“Since 2005, China has generated 73% of the global growth in oil consumption and 77% of the global growth in coal consumption.”

Today, Chinese economic growth is the force pushing the global economy and stock markets. The quality of this growth, however, is low as it is predicated on massive (forced) lending and is unsustainable. As and when Chinese growth finally slows, the impact will be felt in many, often unsuspected places.

We believe that China’s pulling in the reins will impact commodity markets, commodity producers and commodity exporting nations. Combined with our expectation of deflation in the intermediate term, this will severely impact commodities.  Let’s take oil, for instance. As incremental demand from China slows, oil prices will suffer and impact the Russian economy in particular.  China accounts for 15% of Brazil’s exports (up from 1.5% a decade ago), significantly impacting the economy of that South American nation.


Finally, we are bearish on China because of the enormous amount of overcapacity that currently exists in the country.  China’s manufacturing capacity was structured for a leveraged U.S. consumer and a leveraged world.  As the world delevers, China as the exporting nation faces a difficult transition given it’s excess capacity.  Like the U.S., it is desperately attempting to reflate its economy and continue growth is because it sees the difficult adjustment that lies ahead.