October 1, 2007
Recession Risks - Increasing but not Decisive
A postscript from last week's comment: On Thursday, September 27th, the Federal Reserve entered into $6 billion in 14 day repos and $20 billion in 7 day repos. It also rolled over two small, shorter-term repos from earlier in the week that will roll over again on Monday – probably at least $10 billion, with a weekly total of about $30 billion by Thursday October 4th, to extend other repos that come due at that time. As of last week, the total amount of Fed repurchases outstanding is $44.75 billion. This is close to the total quantity of reserves in the U.S. banking system (which includes these repo proceeds). Meanwhile, total borrowings of depository institutions from the Fed – the much vaunted “liquidity” lent by the Fed at the Discount Rate – dropped from $2.4 billion to just $306 million last week, which is about the norm of recent years.
In short, next to nothing is actually lent through the discount window. Meanwhile, the Fed's open market operations are not injections of new liquidity, but a continuous rollover that finances a stable level of reserves, at a level that is negligible in relation to $6.3 trillion in total bank loans. If investors want to believe the superstition that Fed actions have anything but psychological effect, they should at least be prepared to demonstrate a specific mechanism by which observable FOMC operations exert that effect. It certainly is not through meaningful “injections of liquidity” into the banking system.
In recent weeks, a relative quiet has emerged both in stocks and in the credit markets. In stocks, the major indices have recovered to levels close to their prior highs. As yet, however, market internals have been fairly sluggish, trading volume has been fairly dull, and we've observed continued dispersion across industry groups and leadership (e.g. new highs vs. new lows) rather than the sort of uniformity that is normally associated with a robust willingness of investors to accept risk.
The other difficulty is that we've now reestablished the overvalued, overbought, overbullish combination of conditions that has historically been associated with average returns below Treasury bill yields, even when market action has been otherwise favorable on the basis of price trends. Importantly, these instances are not usually associated with immediate and persistent losses. Rather, they tend to be associated with further incremental gains and marginal new highs, followed by sudden losses that abruptly erase weeks or months of upside progress within a handful of trading sessions.
One might argue that the view of stocks as richly valued must certainly be incorrect, with the S&P 500 at a price to forward operating earnings ratio of “only” about 15. However, even if we take current record profit margins as given, and assume they will persist indefinitely at levels about 50% above their historical norms, a multiple of 15 times forward operating earnings is still only low relative to levels of the late 1990's. Those levels, by the way, have been associated with total returns on the S&P 500 that have lagged Treasury bills for more than 8 years now, despite the rebound of recent years. The current price to forward operating earnings multiple is as high as it was at the 1987 peak, higher than it was before the 1990 bear market, and is in fact at the highest level that would have been observed in history except for the late 1990's. Most of the points prior to 1965 featured interest rates that were lower than they are presently. Again, current multiples also implicitly assume that profit margins will permanently remain at the highest levels in history. Current stock prices are at far higher multiples to normalized earnings.
With regard to the broader economy, we've also observed a relative quiet in mortgage-related and economic concerns. The mortgage issue is likely to resurface, since a large volume of adjustable-rate mortgages are due to reset in October from the low “teaser” rates at which they were initiated. It might have made sense to speculators to purchase homes at these low rates, with little money down. It was not necessary to “afford” these homes, because the expectation was to sell them at higher prices and achieve an enormous percentage gain on that small down payment. With home prices dropping, speculators are learning – as speculators repeatedly do – that their short-term speculation has turned into a long-term investment. For a good number of buyers, these will also turn into a foreclosure problem. However, that risk is still at least 90 days out, so the next major spike in foreclosures is actually not likely until about February of next year.
What about recession risk? At present, we still don't have enough evidence to anticipate an imminent recession. The risks are clearly rising, and a number of the measures we monitor are weakening considerably, but in terms of evidence, a clear determination would emerge from some combination of weakening in the ISM indices - say, a PMI below 50, a sharp drop in consumer confidence – say, 20 points below its 12 month average, or an abrupt drop in payroll employment of about 100,000 jobs or more, sustained over a two month period – say, two consecutive 50,000 losses, or a 100,000 loss with zero growth the next month.
When the NBER business cycle dating committee puts a date on the start of a recession (note that they don't forecast these – they only date them in hindsight), the start of a recession usually just precedes 1-2 month period where payroll employment abruptly falls by 150,000 to 200,000. You'll generally observe expanding employment in the 6 months or so prior to the official start-date of a recession. That 6-month growth will generally be less than a 1% increase in total employment (the latest 6-month growth is just under 0.5%). In general, by the official start-date, the unemployment rate has notched up an average of about 0.3%, mostly because growth in the labor force has slightly exceeded growth in employment in the prior few months.
While recessions are often viewed as if there is some "representative consumer" that just backs off for a while, that sort of chararacterization doesn't fit the facts at all. Though consumption represents about 70% of GDP, it is also the smoothest component of the economy (Friedman and Modigliani were right on this). Indeed, nominal consumption has never declined on a year-over-year basis, even in recessions.
Recessions are not caused by a general shortfall in spending, but instead by a mismatch between the mix of goods and services supplied by the economy and the mix of goods and services demanded. Though demand shifts away from some kinds of output that the economy produced in the prior expansion (as we saw with tech and telecom in 2000-2002 and are seeing in housing today), we often see continued demand in other sectors, but the mismatch takes time to correct, and output and employment suffer as a result. Most job losses during a recession are typically concentrated in a small number of industries, while other industries experience growth and even growing backlogs and rising employment. So the next recession, whenever it occurs, will probably feature a good amount of dispersion. Most likely, we'll observe particular weakness in housing-related industries (and associated finance sectors), while a variety of sectors including technology, oil services, broadband telecommunications, and consumer staples may be better situated (though such stability still may not prevent stock price weakness).
As a sidenote, the Keynesian view of recessions being caused by a sudden desire to save is terribly simplistic. Even in the Keynesian model, a greater desire to save only has negative effects because investment is assumed to be fixed (because of the savings-investment identity, this forces savings to be fixed, and algebraically, the only way people can save a larger fraction of their income but still end up with a constant amount of savings is for income to decline). So even if one believes the Keynesian model, the most efficient response to a recession is to encourage investment - actual physical investment - through policies like temporary investment tax credits, R&D credits, and the like.
As for the stock market, it's important to keep in mind that if you look at the 6-month periods before and after the start of a recession, you'll observe that the S&P 500 has almost invariably dropped by about 20% from the high within 6 months before a recession starts to its low within 6 months after the recession starts. The eventual market decline is often far worse, but it's very typical to observe a 20% plunge within that 6-month band around a recession's start-date.
Conversely, the strongest portion of a new bull market often occurs while the economy is still in late-recession. Severe market declines don't neatly overlap recessions - rather, they start before a recession starts and end before a recession ends. For that reason, as Mark Hulbert recently noted, if you measure only between the official start and end dates of a recession, the market's performance is actually fairly flat, on average.
The bottom line is that we don't yet have the evidence of immediate recession risk, but that evidence is increasing, and unless one expects the downturn in housing to blow over, investors should not be too glib about the recent calm. For our part, we don't have sufficient evidence to of investment merit (favorable valuation) or speculative merit (favorable market action) to accept market risk here. Speculators who wait until there is convincing evidence of recession typically discover that any reasonable selling opportunity is long gone.
Averages, not instances
That said, I should emphasize that we are currently hedged not because I view a recession or market decline as imminent, but rather because under similar conditions, stocks have underperformed Treasury bill yields, on average. Our hedging is not an attempt to align ourselves with any near-term forecast of upcoming market action. Rather, we attempt to align ourselves with the average return/risk profile of the market, given prevailing conditions.
As Ben Graham once said, “I recall to those of you who are bridge players the emphasis that bridge experts place on playing a hand right rather than on playing it successfully. Because, as you know, if you play it right you are going to make money and if you play it wrong you lose money – in the long run. There is a beautiful little story about the man who was the weaker bridge player of the husband-and-wife team. It seems he bid a grand slam, and at the end he said very triumphantly to his wife ‘I saw you making faces at me all the time, but you notice I not only bid this grand slam but I made it. What can you say about that?' And his wife replied very dourly, ‘If you had played it right you would have lost it.'”
I've been to Vegas a couple of times, and probably gambled a cumulative $100. I don't enjoy it, because I know who has the edge, and it's not me (you would have found me over by somebody's grandmother playing the nickel slots). There's no point in gambling serious money, because the odds are against winning in repeated games. Playing the hand right in that context means not playing at all. The same holds true for accepting market risk in an unfavorable Market Climate. There will certainly be individual hands that win, and the wins might even come in “streaks” from time to time, but the correct strategy is not to play. We remain fully hedged for now.
Forecasts are not particularly useful because the Market Climate we observe several weeks from now may be different than what we observe today, and because the “predictable” amount of return over the next few weeks will be small in relation to the probable random noise. It's only over repeated instances, averaged over the full market cycle, that the predictable returns overwhelm the noise.
Even if specific market outcomes can't be “timed” or “predicted” with any consistency, it is enough that the average return/risk profile of the market differs across various market conditions. This fact may not appear helpful, since it doesn't help to accurately forecast individual outcomes, and that's what people think they need. But consider it this way. Knowing that a coin is slightly biased toward heads won't help much in forecasting an individual throw either. Still, that sort of knowledge can provide an enormous edge when you average the outcomes of a large number of throws.
So our approach is to refrain from forecasting individual outcomes. Our approach is instead to align ourselves with the average return/risk profile associated with prevailing market conditions, again and again, through bull and bear markets. Taken over the complete market cycle, this approach has been more than enough to achieve strong performance at modest risk.
The overall intent of our investment approach is to outperform the S&P 500 over the complete market cycle (including bull and bear markets combined), with smaller periodic losses than a passive investment strategy would experience. It may be helpful that we have low correlation with other investment strategies, which can be a diversification benefit. But our primary objective (and my continued expectation in the current market cycle) is to outperform the S&P 500, with smaller periodic losses, over the combined course of bull and bear markets.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. In addition, the market has reestablished an overvalued, overbought, overbullish set of conditions that has historically been associated with average returns below Treasury bills, even when other aspects of market action have been favorable. As noted above, the general tendency in such conditions is not for the market to experience relentless losses. Rather, the market tends to drift marginally higher for some period of time (typically 1-2% over a period of a few weeks) and then to abruptly lose weeks or months of upside progress in a matter of days.
In bonds, the Market Climate last week was characterized by unfavorable yield levels but favorable market action. Bond prices dropped briefly last week, and we used that to slightly increase the duration of the Strategic Total Return Fund to about 3 years, still mostly in TIPS, but with a modest position in straight coupons as well. Precious metals were also hit mid-week, and we took that opportunity to boost our exposure to precious metals shares to about 15% of assets in the Strategic Total Return Fund. Again, I don't view any particular level of bond yields or the XAU as a “buy,” but we have room to expand our exposure in these on any substantial weakness, while also having enough of a “core” position to be comfortable with further strength without any need to “chase” the markets.
Overall, our investment positions are moderate but constructive in both bonds and precious metals, but conditions are not presently strong enough to warrant aggressive exposures in either market. The primary wild card in the bond market is persistent dollar weakness and surging oil prices, which may feed into inflation surprises that we could otherwise rule out because of widening credit spreads. Given the low level of bond yields at present, we have to manage any increase in duration carefully. Bond yields have an unruly tendency to “pop” sharply from depressed levels unless there is ongoing evidence of economic softening. That said, we're still inclined to use any substantial weakness in bonds and gold as an opportunity to build our exposures, which is another way of saying that I don't currently expect any sustained upward pressure on bond yields, or downward pressure on precious metals shares.
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