The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

The Dark Side of Deficits
August 27, 2010
By John Mauldin
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Secular Bull and Bear Markets
It’s Not the (Stupid) Economy
The Consequences of a Credit Crisis
The Dark Side of Deficits
LA, Europe, Kansas City, and Houston

In the pre-crisis days, I used to write about things like P/E ratios, secular bull and bear markets, valuations, and all of the things we used to think about in the Old Normal. But what about those topics as we begin our trip through the New Normal? It’s time to reconvene class and think through what might change and what will remain the same. I think this will be a fun read – and let me tip my hand. I come out on the side of a new secular bull that gets us back to trend – but not just yet. The New Normal has to have its turn first. (Note: this will print out longer than usual, as there are a lot of charts.)

And speaking of first, I once again need some help from readers. I will be in “jail” next week for the Muscular Dystrophy Society. I need you to help bail me out. You can go to https://www.joinmda.org/downtowndallas2010/johnm and make a donation to help kids and families who really need help in these difficult times, and also help sponsor research that will eventually cure this disease. If you follow the link, you can see a cute video – and then make your donation!

I thank you and I am sure Jerry’s kids thank you too!

Secular Bull and Bear Markets

Market analysts (of which I am a minor variety) talk all the time about secular bull and bear cycles. I argued in this column in 2002 (and later in Bull’s Eye Investing) that most market analysts use the wrong metric for analyzing bull and bear cycles.

(For the record, even though I am talking about the US stock market, the principles apply to most markets everywhere. We are all human.)

“Cycles” are defined as events that repeat in a sequence. For there to be a cycle, some condition or situation must recur over a period of time. We are able to observe a wide variety of cycles in our lives: patterns in the weather, the moon, radio waves, etc. Some of the patterns are the result of fundamental factors, while others are more likely coincidence. The phases of the moon occur due to cycles among the moon, the earth, and the sun. In other situations, though, apparent patterns are no more than the alignment of random events into an observable sequence.

All cycles have several components in common. Cycles have a start and an end, they have characteristics that repeat from cycle to cycle, and they often have an explainable cause.

Stock market observers have identified what they believe to be scores of cycles, patterns, correlations, and relationships that have spawned a seemingly endless inventory of predictions and trading schemes. Every trader has his favorite system, well-fortified with back-tested “research” and “facts.” These systems all work fine until you begin to use them with real money.

The patterns are so numerous that some market experts discount all theories and acquiesce to a philosophy of randomness (that would be you, Burt!). However, just because we don’t understand it, doesn’t mean there’s not useful information contained within a pattern.

I argue that we should use valuations and not prices as the criterion for determining secular bull and bear cycles. If you use valuations, the cycles jump off the page at you. Using prices, it is very difficult. Let’s look at a table prepared by my good friend Ed Easterling of Crestmont Research. Ed co-authored the two chapters in Bull’s Eye Investing on stock market cycles and has a treasure trove of charts and tables on a wide variety of investment topics at www.crestmontresearch.com. And his book Unexpected Returns is a must-read for anyone who manages money, whether their own or someone else’s.

OK, the following chart shows secular bears in terms of valuations. There have been four bulls and five bears (we are in one now) since 1900. (You can see a larger chart at Ed’s site, under secular cycles.)

Secular bulls begin with low valuations and continue until valuations get “too high” in terms of P/E ratios. The opposite for secular bears. The average cycle over the last 110 years lasted about 13 years. These are not short-term phenomena.

Within those longer-term secular cycles you can have so-called cyclical swings based on price, and some of those counter-trend cycles can be quite large!

The first cycle of the twentieth century was a bear. It started in 1901 with the market P/E ratio cresting at 23. Twenty years later, with the P/E ratio firmly in single digits at 5, the bear went into hibernation. Over the twenty years of that secular bear, the Dow Jones Industrial Average (DJIA) had managed to tick up from 71 at year-end 1900 to 72 at year-end 1920.

But, during those two decades, the market moves were far from calm. Annual returns from New Years’ Eve to New Years’ Eve ranged from -38% to +82%! The best-performing three years were +82%, +47%, and +42%. After each of those years I am sure the pundits proclaimed the death of the bear. Yet the three worst years were -38%, -33%, and -31%. As we’ll see with most secular bear cycles, the period was as violent and choppy as the high seas in a monsoon. Across the 20 years in this bear cycle, 45% were positive-return years – but never more than two in a row! The 11 down years were generally singles or pairs, with only one three-year stretch at the start of the cycle. Although the average gain was +30% and the average loss was 17%, the change from beginning to end was a paltry +2% in total.

Yet during that secular bear cycle, the economy grew and earnings rose. However, P/E valuations declined and offset virtually all of the economic growth. The market’s price (P) was essentially unchanged from start to finish, and E (earnings per share) rose sharply. So with the market price (P) virtually unchanged, it is clear that the decline in the P/E ratio offset the gains in earnings (E). Earnings growth is often strong in bear markets – and that growth is eroded by declining P/E ratios.

Read the rest of this entry »

Your weekend home work assignment is Chris Whalen’s invective, I am Superman: The Federal Reserve Board and the Neverending Crisis:

This article asserts that, in dealing with the 2007-2009 financial crisis, the Federal Reserve Bank (Fed) has placed its role as monetary agency and de facto steward of the market for U.S. Treasury debt ahead of its statutory responsibility for ensuring the soundness of the private banks.  This is not to say that the Fed supplies whatever credit the government wants — at least not yet — but in terms of both the provision of credit to the private financial system and the price of this credit, the growing fiscal imbalances of the U.S. government seem to be playing an increasing role in Fed policy decisions.  This paper explores some of the issues involved in recent Fed policy decisions and draws some preliminary conclusions as to the conflicts between the Fed’s role as central bank and also as prudential supervisor.

Its must reading . . .

Jonathan Miller and I have been kicking around an idea for a “Home ownership is a good thing” OpEd.

Apparently, we aren’t the only ones:

• Five Reasons to Stop Worrying About Your Home’s Value (Moneywatch)

• In Defense of Home Ownership (NYT)

None of these hit the issues and topics that we want to cover — but it is interesting that other folks are thinking along the same lines.

Now, if only I could figure out whether these articles are 1) Contrarian pushback against the dominant RE meme; or b) proof that the bottom is not yet here, as people cling to the hope of a RE recovery.

Matthew Taylor explores the meaning of 21st century enlightenment, how the idea might help us meet the challenges we face today, and the role that can be played by organisations such as the RSA.

This is perfect for a Friday afternoon: An amusing romp thru Wall Street:

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click for ginormous graphic

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Via William Banzai7

Succinct summation of week’s events

Positives

1)Initial Jobless Claims 17k less than expected at 473k and down from 504k last week
2)ABC confidence at 6 week high, UoM confidence slightly weaker than expected but up a touch from July
3)Q2 GDP better than feared but still weak
4)Bernanke elaborates, doesn’t lower ’11 GDP forecast and stops for now at QE1.5
5)Refi’s rise to most since May ’09
6)Ireland has good bill auctions, albeit very short term maturities
7)German IFO highest since June ’07, consumer confidence highest since Oct ’09
8)UK retail index strong
9)Housing stocks and INTC shrug off bad news and AAII has bulls at lowest since Mar ’09.

Negatives

1)CDS and yields in PIIGS moving higher again
2)Italian consumer confidence lowest since Mar ’09
3)Existing and New home sales awful
4)Durable Goods weak with non defense cap goods ex aircraft down 8%
5)PC sales slowing.

This chart of 10yr Treasury yields since 1790 is from Doug Kass at Real Money.

Dougie notes “The only time that yields have consistently been below current levels was WWII — 1941-44 — and and immediately after, to 1951, when the U.S. enforced a ceiling on yields. Even during the 1930s when the great Depression contracted the economy 25%, deflation drove yields to 2.5-4.0%.”

10’s are currently 2.436% after the durable goods number yesterday.

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10 yr Treasury yields since 1790

click for ginormous graph

hat tip via David W

Staying with the belief that the Fed can still do more, Bernanke said they are prepared for more accommodation if needed but he finally publicly acknowledges that “central bankers alone cannot solve the world’s economic problems.” He gives color on what left the Fed can do if circumstances warrant but acknowledges drawbacks to each perceived benefit. On the economy, “although private final demand, output, and employment have indeed been growing for more than a year, the pace of that growth recently appears somewhat less vigorous than we expected…Much of the unexpected slowing is attributable to the household sector, where consumer spending and the demand for housing have both grown less quickly than was anticipated.” He still expects a modest recovery. On inflation he says, “the risk of either an undesirable rise in inflation or of significant further disinflation seems low.”

Bottom line, the speech is as one should have expected it to be, an elaboration of the Aug 10th FOMC meeting but with an uncertain game plan going forward, but game plan on their part nonetheless, if the economy turns down again. Yes the Fed has bullets left as long as they have the printing press but we can only hope that they carefully analyze whether the law of diminishing returns is here with monetary policy and thus the costs of further moves outweigh the hoped for benefits. Turn the screens off now, enjoy the weekend and join the rest of the country that wasn’t paying attention to what Bernanke thinks they can and may do next.

If you try to place an order at Amazon.com today, get ready for some trouble.

The checkout system will not let you make a purchase unless you agreed to do a free 30 day trial of Amazon Prime delivery service. There was simply no way the order could be placed without this occurring. So I placed the order, and called their support line (800 ) to cancel Amazon Prime($79 year)

You may wonder why this is, but according to Amazon support, its a glitch. ( I am suspicious of this).

If it is a glitch, announce it and apologize — if not, if its a new policy, then Amazon should not only expect to lose customers, they should also brace for an FTC investigation.

I am surprised and disappointed. Very UNAmazon like behavior . . .