There’s an editorial in the NY Times published by David Stockman, a former budget director to Ronald Reagan. He writes a scathing diatribe condemning the irresponsible practices of legislators and central bankers. He anticipates a bad economic outcome that will be made worse because central bankers have already used their ammo and will therefore be less effective in any subsequent crisis.
Mr Stockman’s piece is interesting. However, his is not my point of view, nor my reason for writing this post. Indeed, I was largely spurred to think more about Mr Stockman’s editorial after I saw that it was listed as #3 of Bloomberg’s top ten stories. Admittedly it is probably a slow news day, making it easy for this news to be in the top ten (for perspective, the #10 story on Bloomberg was that the new “GI Joe” movie was the top box office seller over the weekend).
The purpose of this post is larger than a reaction to this editorial; it’s for me to step back and reflect on my own thoughts on the market, something I try to do regularly during quiet moments. Mr Stockman’s editorial turned my thoughts to the task, and his point of view was definitely worth considering.
As for Mr Stockman’s piece, he correctly observes that there has been irresponsible government spending and policies that spur moral hazard by bailing out banks that have gotten themselves in trouble. Having said this, in terms of looking to the future, I felt the editorial lacked substance, data, or a historical framework opining on why the outlook is grim. Mr Stockton simply asserts that calamity is at hand. The feel of the editorial is, in my humble opinion, evangelical rather than an analytical evaluation of what the future is likely hold.
So onto my thoughts . . . .
Predicting the future is hard. It’s challenging enough to predict a single company. The number of factors to consider (spending patterns, debt levels, employment, government actions, central bank interventions, and market sentiment – to name just a few) are each too complex to predict in isolation let alone to forecast all together in an intertwined system. So with that, I don’t try to predict the future. Instead, I try to predict several possible futures. I try to assess what is possible, or even likely. (As far as my job goes, I endeavor to invest so that I am protected from the worst of any of the possible outcomes while still being exposed to upside no matter what the outcome.)
For the purposes of this post, my goal is only to mention what some of the possible factors are that could drive the potential futures that could unfold. I’ll simplistically look at two scenarios: healthy economy vs. market unrest.
The healthy economy scenario (bull markets continue):
The economic data, especially in the US, supports the presence and continuation of the healthy economic scenario. Unemployment claims and the unemployment rate are steadily declining. Regional Federal Reserve surveys show generally positive outlooks and expanding business conditions.
Further, central banks are committed to raising asset prices. This last observation seems to be the most powerful, in part because it has been successful in the recent past, and in part because it is continuing full force and even arguably increasing (Japan is entering the fray and I think it is reasonable to anticipate the ECB may cut interest rates at some point in the near future). Even if monetary easing is only successful at boosting price levels without impacting the economy (inflation in a flat GDP environment), this should raise confidence as people feel wealthier (their homes and stock portfolios are worth more). On that last point, higher asset prices means higher stock prices. As an investor, nominal growth is almost as important for me as real growth. (I seek to generate returns on a real, inflation-adjusted basis, but that starts with being cognizant of nominal returns that are driven by inflation.)
In essence, this healthy scenario is a virtuous economic cycle (currently unfolding) with stock markets further turbo-boosted by cheap cash that results in increased M&A activity, accelerated stock buyback programs, and investors concomitantly bidding up stock prices as they ‘reach for yield.’
The ‘unrest’ scenario:
I think back to the Asian currency crisis of 1997. At the time, Thailand was overextended and had to devalue its currency (see Wikipedia here for a more detailed account). The country was viewed as small, isolated, and irrelevant. Once Thailand was in distress, the market at large started looking for the next vulnerable entity and the worldwide financial system was affected. The point is that there is tremendous interconnectedness of all economies. Central bankers have been remarkably adept at patching over crises. Further, they have learned from their recent experiences and, as a result, should be even more capable in facing future issues. However, there remain quite a lot of potential imminent and future shocks. It is possible that the mishandling of just one crisis could be highly impactful. Some of these potential crises that could be problematic include:
- Cyprus: The acute crisis has been dealt with, but the story is not over. Cyprus is likely to face a severe depression as the banking system collapses. This will put other Cypriot banks at risk along with the deposits therein. Further, after seeing Cyprus, there must be some people in Portugal, Greece, Spain, Italy, etc who will sleep better withdrawing their money and moving it to German banks. A bank run in any number of regions is a risk.
- Deepening recession in France: France’s bonds have been remarkably resilient, with 10-year yields at 2%. What happens if the market begins to doubt the financial health of France?
- Italy – No government at present. Grillo has talked about exiting the Euro. Political pundits say it is just talk, but still a concern.
- I could go on about dangers in the Euro-zone, but they have been written about at length. Just mentioning a few more items: — Luxembourg’s banking system is even bigger than Cyprus’ relative to GDP. Not that this fact itself presents a danger, but it could become an investor/market concern and bears watching. — Slovenia is facing a banking crisis much like Cyprus endured. How will that be handled? — Greece remains in recession/depression and needs further debt restructuring.
- There are increasing stories of asset bubbles in China. Perhaps fast growth can absorb this. If not, bursting of a bubble with a resultant banking crisis in the world’s second largest economy would undoubtedly have ramifications.
- Egypt is in the midst of its own financial crisis (see NY Times) and is increasingly struggling to buy food and fuel. Interestingly, the NY Times asserts that Egypt is resisting implementing necessary economic reforms and is instead betting that it is too big for the international community to let the country fail financially.
- North Korea is threatening to escalate aggressions against South Korea and the West.
- As much as central banking interventions have been successful at boosting markets to date, food and fuel price inflation are possible side effects that could be counterproductive and destabilizing.
- Argentina is fighting (losing) a court battle that will mandate the country repay long-standing written-down bonds, which could force the country to default on its obligations.
My list of worries is longer than the simple status quo/good scenario, but that does not make a market downturn any more likely. However, my concerns are all tangible, such that a continuing bull market is not a foregone conclusion. All the pitfalls might be circumvented, but this is not a foregone conclusion. My job is to not just identify sources of return, it is to recognize risks. In that vein, I like having protection. Seeing the potential for both good and bad outcomes (directions for the market), I have chosen to keep a generally neutral posture across my holdings in total. In terms of my individual investments, my bets reside in the individual stocks themselves.
I’d be remiss to not at least mention the markets themselves when I think about positioning my investments. While the market overall is not expensive, (the S&P 500 index is now trading at about 14x 2013 estimated earnings), I am seeing an increasing number of companies trading well in excess of 20x or even 25x 2013 earnings. Many of these are companies with market-like growth and peak profit margins. Admittedly, part of my low net exposure derives from an investment landscape where it is challenging to find attractive valuations. I like wide safety margins and healthy returns. I am more than comfortable passing on an investment that, in my esteem, is priced to perfection. This characterizes much of the current landscape as I see it.