Editor's Note: This article was written by Reid Holloway, a consultant who created The RLH Volatility Model.
When all else fails, try being calm and rational. Problem is, the calm and rational view these days doesn’t work.
Being calm and rational, you’d look at the S&P 500’s
trailing-12 P/E multiple of 24 and say, “That’s a bubble the air’s got to come out of.” But then it doesn’t. Or you’d look at an unemployment rate nearing 10%, or the maturity schedules of debt in the commercial real-estate sector, and have to conclude that financial crises of a magnitude larger than those surrounding the year-ago collapse of Lehman (see also One Year Later: What Have We Learned?
) must be imminent. You’d look at housing starts still limping along at half a million annually -- the lowest levels in a recorded history spanning five decades, or back to a time when the nation’s population was well under 200 million -- and wonder where the recovery so many are predicting is coming from.
This is apparently no time to be calm and rational, because every analysis by that orthodox angle leads you anywhere but explaining how the American stock market has risen more than 50% since its March bottom.
And yet, for the incessantly curious and even obsessed analytical mind, that just pours gasoline on the flames of desire to uncover and understand the hidden explanations that must be in there somewhere. The explanations that make sense. For me, it’s an intellectual translation of Chinese handcuffs. The harder you pull, the stucker you get.
Let’s try a longer-term view. Since early August 2007, the market is still declining at a rate of almost 13% annualized, the terrific recent advance notwithstanding. Don’t take my word for it; look up the most widely followed benchmarks and do the math. The Dow
was then just shy of 13,200 and the S&P 500 was above 1430. Just thinking about those numbers makes me feel like I’ve been punched in the gut, and they only go back a bit more than two years.
Still another view. Ten years ago the Dow was in the 11,000 range. The S&P 500 was around 1340-1350. That means the current market is trading at a 22% discount for your patience as a “buy and hold” investor over the past decade (an average annual compound rate of decline of about 2.5%). Additionally, 1999 opened the year with oil trading at $11-$12 a barrel and gold fluctuating around $275. Oil now goes for seven times what it was then (yet everyone talks about the massive selloff in oil over the past year or so), while gold has nearly quadrupled. Hmmm… doesn’t sound so much like a financial asset bubble as it does a commodity bubble anymore, does it?
With the US economy still contracting, albeit at a lesser rate some call evidence of an incipient turnaround, that oil-price number is cause for huge concern. Demand is virtually dead, so it’s difficult if not impossible to attribute a septupling of oil prices over a decade to industrial activity or budget-conscious consumer usage. That leaves two areas of concern to dwell on. One is a very troubling lack of attention to domestic energy development among traditional sources, and the other is the portent of monetary inflation and the degree of attention paid to the TARP, TALF and other bailouts that essentially point to Fed and Treasury money-printing.
The recently reported 1.7% rise for August producer prices would seem to be huge cause for concern; it’s not only a double-digit annualized rate -- which is very disconcerting -- it’s happening at a time when there’s no way to attribute it to rising incomes, burgeoning employment or industrial demand. But instead, most observations seem to emphasize the rear view mirror’s 12-month decline and not much speculation regarding its future importance, or the outsized energy portion of that report. Perhaps all this forms a backdrop for assessing the larger picture concerning East versus West, looked at as debtor versus creditor writ large. Most people assume without question that the danger for the United States is its vast debt to foreign nations, especially China. Does this make sense in terms of value contrasts and comparisons? I don’t think so. The US consumer’s balance sheet is already regarded as terrible; it’s one of the few things we don’t bother to argue about. But think what it would be if it were additionally burdened with the higher costs of embedded domestic labor in the absence of overseas alternatives. How much further would GDP be in the tank? How much higher would interest rates be? What would be the comparative rate of business failures and unemployment in the wake of entrepreneurship unable to handle those costs?
Indeed, the only reason the foreign debt issue even arises is the implicit worry regarding US debt quality deterioration and the specter of our not making good on borrower obligations, along with speculative implications for the already beleaguered dollar. But think about who’s really gotten the better trade. We’ve got the cheaper goods and they’ve got our paper. It doesn’t surprise me, therefore, that China is scurrying around on multiple continents to convert that paper into hard investments in mines, oil fields, other direct industrial investments, etc. But it’s a daunting chore for China considering today’s valuations for many of these assets over that ten-year time frame identified above in contrast to the shorter-term view currently relied upon more often than not.
History may have valuable lessons, but when in the past has there ever been today’s mix of such unusual and extraordinary circumstances? That’s a very hard call and, so far as I see it, about the only inference is uncertainty which markets generally don’t like. Nonetheless, it’s an uncertainty enshrouded in such vast complexity as to shield it from perceptibility, however colossal its eventual importance may turn out to be. So right now it may be just another brick in the “wall of worry” markets have been frequently known to climb.
Also hidden from statistical examination is what may be the largest factor of all -- the increasing political cultural and political chasm I like to call "buyers’ remorse" regarding President Obama and the policies he champions pertaining to public options in health care and the cap and trade initiatives. The implications -- which may not be clear to the marketplace until the 2010 off-year congressional election campaigns get underway in earnest -- are enormous and have a lot to do with activity in the bond markets now and interest rates to come.
The persistence of the 10-year rate in holding below 3.5% is therefore a stunning number to me in the context of unprecedented US government deficits -- federal, state and municipal, with taxes and fees rising meteorically nationwide and existing program spending increasing, huge new spending programs in contemplation and government payrolls still burgeoning relative to the private sector’s continued job-shedding. Keep your eye on that 10-year rate, and also keep your eye on the triple-tax-free muni market. The market fundamentals in those quarters have no historical guide whatsoever, and I find it difficult to envision “business as usual” if the pundits are right about near-term impending economic recovery, even if that recovery is confined to a corporate-earnings rebound and doesn’t extend to a major improvement in employment in the private sector (the “jobless recovery” scenario). An addition of 100 basis points to the 10-year benchmark could well unsettle a stock market seemingly comfortable trading at today’s lofty P/Es. But that scenario assumes an increase in credit demand that -- even with burgeoning government borrowing -- may not materialize if real estate activity and lending remains moribund, while the absence of any significant rise in capital-expansion spending seems likely to continue in the current context of capacity utilization.
No positions in stocks mentioned.
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