Tuesday, April 21, 2009

Narratives in Investing - Alpha

Have we hit an equity markets bottom? Recent narratives by the press (planted in the press?) suggest we have. A well-documented bias of investors is the availability bias. That is, news or data widely available (typically blared through the press) is over-weighted, while patchwork and non-interconnected, less-available news is underweighted (page 13 news in 4 places). When combined with the narrative effect, which is investors' ability to form a coherent story, whether or not it is true, these biases can lead to silly market herding movements. See a fuller overview here: Fuller and Thaler (2003) and Mullainathan and Shleifer (2005). So here are two stories to chew on, the well-trumpeted bull story, and the lurking quietly bear story.

BULL STORY
The recent run-up in the S&P500 and other equities (and the fall of Treasuries as people leave safety) suggests many investors think we have reached and passed the bottom, for these reasons:
-"Green shoots" in the news, and expectations of economic growth have risen. 214 fund managers, ever the optimists, think so, according to a survey of fund managers by Bank of America-Merrill Lynch. The bank’s monthly survey showed the number of respondents expecting the world economy to improve over the next 12 months swung sharply upwards to a net 26 per cent from minus 24 per cent in March – the highest reading since early 2004. The survey, which polls 214 fund managers with a total of $561bn of assets under management, also showed that investor risk appetite had returned to levels last seen before the demise of Lehman Brothers.
-Large positive earnings from money center banks (C, GS, MS, etc.) suggest they are healthy again, and the financial system is recovering.
-The second derivative on growth may be slowing - that is, the rate at which unemployment rises and GDP falls may be slowing. Really, no one has a clue as to Q1 2009 GDP (WSJ economists poll have ranges from -0.7 to -8.0).
-Consumer confidence is up, tech companies are posting decent profits, IPOs are up (3 this quarter, the highest since Q2 2007), and M&A juices have returned.
-Not as many foreclosures as reported, many people are refinancing with low rates.

BEAR STORY
No bottom yet - we will likely see new S&P500 lows by year end - the only question is at what level - 400, 500, or 650? With lookforward 2010 earnings at 40 to 50 for the index, and a bear multiple of 8x to 12x, the range for the S&P 500 is 320 to 600.
-We are only halfway or so through global deleveraging, per numerous measures (total debt over GDP, household debt over GDP, etc.), and further delevering will be painful. "McKinsey estimates that if the US savings rate had remained steady at the level seen in 1980, a trillion dollars less would have been spent in 2007 alone. Already since its peak in 2007, household net worth has fallen by $13,000bn, almost equivalent to one year of US output. McKinsey reckons that could be worth about $650bn of consumption. Pretty hefty, but it pales next to the risk to spending from household deleveraging. Assuming no income growth, each 5 percentage point fall in the debt-to-income ratio equates to about $500bn less consumption. With debt-to-incomes currently at 130 per cent, even getting back to 100 per cent will be very painful indeed." (FT, below)
-No financial recovery. The bank's are fraudulently making up earnings, with the consent of accountants and US regulators. The idea is to allow them to mark-to-make-believe, book profits, and hope an economic recovery will actually make them solvent (this is the 1990-92 solution when many US money center banks, like C, were insolvent). Abe Lincoln had a saying: "How many legs does a dog have if you count its tail as a leg? Four - because calling a tail a leg doesn't make it one". Unfortunately, the Japanese zombie dead banks of 1990-97 offer another, more likely possibility (banks were only taken over and restructured in 1997, with a semblance of real accounting. Global financial regulators should heed that. Until there are massive restructurings and nationalizations (US govt. takes over C and BAC and other to break them up, same for the UK and its banks and Europe), the financial system will be stuck in rot. From its credit bubble in 1989, the peak to trough drop in Japanese equities was about 80%.
-Housing is still in the dumps. Nationally, prices have only fallen 30%, and Shiller expects the natl. average will be 45% (with 50-60% total drops in some areas). Rogoff's quantitative work suggests it takes 3-5 years for housing to work out. Also, foreclosures were low in Feb./Mar. since many lenders were "waiting and watching" to see what Obama would do. I expect massive foreclosures and corporate defaults in Q2-Q4 2009, higher than anything since 1930. We shall see.
-Massive govt. debt buildup yet to effect markets - at some point, we will see currency devaluations and higher interest rates, which will put more pressure on economic growth - the lesson from 1933 to 1937 was that the best way to reignite growth was to inflate the currency (devalue it), and that fiscal spending and debt had little impact (see Frieden's "Global Capitalism," pp. 187-193 - he asserts that deficit spending did nothing to end the Depression, but it was rather the large monetary increase coupled with bank restructurings - so when FDR pulled back the money supply in 1936, the US returned to a mini-Depression in 1937).
-Unemployment will top 11%, possibly even 12% in 2010. And this is a key economic statistic, because the % of people working clearly affects economic output and growth (CA and 7 other states are already above 10% - compare this to the WSJ consensus of 7.3% to 10.5% for Dec. 2009). While statistically unemployment peaks after growth, I don't see healthy positive GDP growth (above 1%) returning till late 2010 or so.
-Financial losses in the low trillions and a negative wealth effect will keep growth weak or negative well into 2010, according to the IMF's April 2009 Global Financial Stability Report. US consumers are doing what they should, which is saving and investing.

Catalysts: Another run on GE due to the insolvency of GE Capital - further large bankruptcies, done in a disorderly way (GM, Chrysler, MGM, etc.) - monoline blowup (risk or ratings downgrades and cascades still exists) - CA blowup (the state is still insolvent!) - national blowup, such as a run on PIGS' (Portugual-Ireland-Greece-Spain) national bonds as they can't backstop their financial system - Spain is the safest of them, but will have near 20% employment by early 2010.

Alpha's subjective estimate: 80% chance on S&P500 falling further to new lows, 20% that we've hit bottom and will recover. A great time to short into a bear market rally - Spring seems to bring out the foolishness in investors. Personally, I wish this analysis were wrong and that the US will leave this nuclear winter of our own making sooner. But neutrally and rationally, I see more pain ahead.

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