The Japan Syndrome

Before taking a multi-week break with family in which I intend to post only for major market action, it’s time for some review.  The macro theme in the U.S. economy and financial markets strikes me as just what I stated in one of my first blogs.  This is what I wrote on January 9, 2009 in Land of the Setting Sun:

We are Japan.

(Though with nukes and military bases in about 92 countries)

Barack Obama made it more or less official today: trillion dollar deficits are here to stay.

“Potentially we’ve got trillion-dollar deficits for years to come, even with the economic recovery we are working on.”

The dead hand of government will provide tax cuts, either by printing money or borrowing from the savers of the US and the globe, to “stimulate” something by someone…

I had concluded that the superpower was “going Japanese”.  Meaning, deficit spending with large deficits yet low and dropping interest rates.  Post-bubble semi-deflationary trends despite inflationary central bank action.  What “everyone knew” were “temporary” zero-ish short-term interest rates now look to continue indefinitely, as in Japan; no doubt the Japanese were as surprised by the persistence of ZIRP as Americans have been and may continue to be.

In the going-Japanese theme, in which the stock market averages are at levels seen in the early 1980′s (though dividend payouts increase the total return), Japan has not had an unusual number of recessions since its twin real estate and stock market bubbles began bursting after peaking in 1989.  The stock market and economic activity have spent much or most of the time rising.  The stock market has however been subject to a few crashes.  Short periods of downside action have negated years of rising stock prices. 

While the crash of 1987 left me unfazed, as it merely represented a reversion back to a rising trend line and most stocks clearly represented real value relative their prices, the crash of 2001-2 left me more concerned about stocks given how much chicanery in business and Wall Street was revealed in the aftermath of the bursting tech bubble and recession and given record high overvaluation in 2000.  Exactly five years ago, I began exiting the stock market given that I believed that the domestic economy was already in recession.  After all, housing was in a deep depression by then and autos were in a significant recession.  My timing was off.  I exited stocks around Dow 13,000, and two month later, the Dow peaked around 14,300.  Yet I was unconvinced and was not sucked into the momentum trade, because economic fundamentals appeared to be deteriorating.  Bonds yielding 5%, though risky, appeared the better bet along with cash.  I was out of the market because I saw a recession along with investor insouciance.  As 2008 moved along, and the insolvencies in the financial companies became more apparent, I grew yet more bearish.  Something like the market actions of late summer and fall 2008 eventually came to look inevitable.

Events now, unfortunately, remind me of the 2007/8 scenario, and I would emphasize that the world did not end then and will not end going forward, so this is not a deep doom and gloom post such as are common in the blogosphere. 

Instead of the banking system’s insolvencies centered in the U.S. and the U.K., this time we have entire countries and their associated banks.  Of course, the bulls argue that specifically because countries cannot be allowed to fail in a disorderly way, there will be no “Lehman moment” this time.  We shall see.  I argue for extra caution without needing to predict whether the downside risk comes to pass concentrated in a short time (“crash”) or is spread out over a long period of time.

The U.K., which is not a eurozone member, is in recession.  China is in a growth slowdown at best.  Little Ireland is “recovering” from a depression.  Greece is in a depression.  Portugal is under the control of the troika.  Larger Spain is in a functional depression.  Yet larger Italy is said to be in its fourth recession since 2000.  This was the pattern seen in the U.S.  A tiny sector of the stock market, housing stocks, peaked in the summer of 2005.  Larger problems were coming, and the real news kept getting worse.  The national housing market peaked in or around early 2006.  Mortgage servicers and the like began going belly up in late 2006.  A Bear Stearns housing mortage-related fund or two had severe difficulties in the first half of 2007.  In August 2007, the Fed announced a surprise discount rate cut.  As 2008 moved along, larger and larger firms with greater and greater systemic importance began faltering.  This pattern of larger and larger insolvencies is similar to what we see in Europe. 

Market action has also some eerie parallels.  Consider the action of the stocks of the prior bubble sector.  The tech stocks peaked in 2000.  Seven years later, “everyone knew” that they had washed out the excesses and were on a roll again.  The NAZ surged to post-crash highs.  Nokia and Oracle were hot again.  Ha!  Wrong time to buy and hold.  The same thing is happening now in housing stocks.  They peaked in 2005.  It is seven years later.  Received wisdom again is that since everyone’s got to live somewhere, and much builder capacity has been removed from the market, the public home-building companies are good investments again, even if the stocks are a bit ahead of the fundamentals.  In addition to this action in the housing stocks, the prior bubble sector of Internet stocks bubbled again.  This began last year with what I began calling Internet bubble 2.0 IPOs.  I am on record as having predicted that the Facebook IPO would mark the top for the tech sector, just as the Glencore IPO marked the top of the commodities sector last spring. 

Returning to the real world, polls in the United States in the summer of 2007 indicated that a majority of people thought the country was in a recession.  This is the case now with today’s polls.  (More precisely, most people think the “Great Recession” never ended, I believe.)

Year-on-year profits of S&P 500 stocks has now turned flat for the first time since the recession’s ending period.  Eroding interest rates on “credit-worthy” borrowers across the globe suggest a diminution of private credit demands.  There is palpable trouble in America, no matter whether we’re the proverbial best house in the global neighborhood.  Amongst the troubles is that which I observed in 2000.  I always felt that the 2001 recession began in the aftermath of the Bush-Gore tied election.  Not that there were many policy differences between the two men, but the country was transfixed by the high drama of the challenge to the Bush victory in Florida.  Similarly and more directly relevant to economics, the kick-the-can non-decisions of Congress and the White House that has created the “fiscal cliff” has led to policy uncertainty which affects economic and financial decisions of innumerable businesspeople and investors.  The general rule in business and investing is that when you’re not sure, don’t do something.  That dynamic could be occurring here and now.

Meanwhile the media reassures investors not to worry, the Fed’s got you covered whether you are in stocks or bonds.  This is the case whether it’s Bloomberg News, the WSJ, or the hoary independent advisory Value Line, whose regression formula for stock prices now projects an easy and massive upside for stocks over the next few years in relation to “risk-free” Treasurys.  Finally, the mood amongst the most of the individual people I speak with is one of cautious optimism.  “Everyone knows” that the Great Recession was so horrible, and the Fed and the government so committed now to “stimulate” the economy, that another recession is out of the question. 

Yet basic economic theory that underlies capitalism’s appeal as the best engine to raise living standards, and which is not limited to “Austrian” theory, is that savings need to be invested in pursuits that more than exceed the value of the production that was not consumed and was then “saved”.  A productive “saving” is not simply a loan to a bank aka “deposit” which then is re-deposited at the central bank.  Neither is your loan to the bank that is then invested unwisely by the bank in a new asset (“loan”).  The savings that are invested badly are, in Austrian terms, malinvestments.   Given that the U.S. in 2007-9 was revealed to have an inadequate pool of real savings to support its then-current level of economic activity, and what is revealed out of Europe on an almost weekly basis, and given the slow economic growth in the U.S. despite all the “stimulus”, how much productive savings can be pointed to now in the United States since the recession year of 2009?  How many malinvestments have been made by the FHA with 3.5% down housing loans, or the Feds with their student loan programs?

For newbies to my posts, I would point you to the elevated level of Smithers’ parameters for stock market valuation, which are independent of prevailing interest rates.

You may wish to review the timely and only slightly early warning of last year’s meltdown that I provided in June. 

Stocks are high.  They have been kept aloft largely by the amazing total returns of Treasury bonds.  The zero-coupon 30-year Treasury bond had a total return of 50% last year alone.  It is up nicely this year as well, beating the stock market.  This is part of the flexible monetary/financial system of the U.S.  With no doubt, this is the least-pubicized massive bull market in an important asset class I have ever seen or even heard about.  In contrast, the headlines and chatter are all about stocks.  The Dow trades like a bond when weak economic data appears and trades like an inflation hedge when the Fed threatens to print.  To me, a more attractive set-up to go or remain long occurred in 1981-2 and in other periods that were recognized as challenged and in which stocks were viewed as risky rather than as safe havens.  In those periods, stronger economic/inflation data (nominal GDP growth) was viewed as negative for stocks, because then the Fed would tighten and make bonds more attractive.  And, weaker growth/recessionary data were bad for stocks, because we were then living in normal times, when bad news was actually recognized as bad news by stock investors.  LOL.  Now almost all news is good news for stock prices. 

Yet the zero-coupon long bond has appreciated more just in the past 17 months than the total return from the SPY since January 1, 2009 (43 months).  How many stock bulls know that?

Mr. Bond is, for now, in control.

Stocks are high.  They may go higher.  They may never fall.  Friday’s close may never be undercut.

But beware if and when they start to descend.

It’s then that gold, and Treasurys, may again be recognized by the media as an investor’s best friend.