"The dogmas of the quiet past are inadequate to the stormy present. The occasion is piled high with difficulty, and we must rise with the occasion. As our case is new, so we must think anew, and act anew. We must disenthrall ourselves, and then we shall save our country.” - Abraham Lincoln, address to Congress, 1862
I found this quote to be fitting, as the recent downgrade of the US credit rating certainly presents a challenge to our global stature. The question de jure is: Will the current environment and aftershocks circulating around the downgrade be a capitulatory event to equity market selling, or is this potentially the beginning to something much bigger? The dividend yield on the S&P 500
now sports a higher yield than the 10-year treasury, suggesting the herd will accelerate their move out of bonds and into stocks.
Further adding to a potential capitulation bottom, during the week ending August 10, investors removed $30 billion from stock funds that invest in US equities, the most since May 2010, when investors pulled money following a one-day market crash that briefly erased $862 billion. From a global equity perspective, it was the highest yank since October 2008, and the argument that this was a move that shook out loose hands is certainly relevant. The trailing P/E multiple on the S&P 500 is 12.9x, 3.5% less than the average multiple during the 10 contractions since 1949. Borrowed money in accounts at 61 New York Stock Exchange firms has fallen 4.6 percent, the biggest drop since June 2010, according to a July 22 statement from New York-based NYSE Euronext. Leverage slipped to the lowest level of 2011, according to Morgan Stanley’s prime brokerage.
Accommodative monetary policies have done little to support a deflationary environment. The Federal Reserve has chosen to print “our” way out of this and has tabled the attention on inflation for another day. Ben Bernanke expects inflation to remain at 2% or below, a key component to further exceptional easing. Except that day may be sooner than the Fed intends. Deflation remains the more worrisome risk and likely downside leader, but recent inflation (August PPI and CPI) data came in rather hot. Low rates into 2013 will support dollar devaluation, a not-so-blatant way to cheaply finance our debt.
Using historical GDP data as a reference point; when annualized GDP growth falls below 2%, the economy steers towards a recession. Current 2011 GDP stands at 1.6%, following accommodative polices and monetary easing. Taking a look at the most recent ISM number, we are walking on a tightrope of contraction. Eurozone GDP growth fell more than expected to 0.2% on a quarterly basis from 0.8% in Q1 - the slowest since the end of the recession in 2009. Of particular concern is that the German economy almost stalled at 0.1%, down from 1.3% in Q1. Further on the topic of stalling second-quarter GDP, France reported an eye-popping zero Q2 GDP growth. This past week the Brazilian central bank lowered interest rates by a quarter percent; this is after it had already raised rates five times this year to combat rising inflation. Why the sudden change of mind? Central bankers fear slowing global growth, citing deterioration in the outlook for the global economy.
Up next to change course will most likely be the European Central Bank. It has raised rates twice this year but, according to Bloomberg, growth in the 17-nation eurozone slowed to 0.2% in the second quarter from 0.8% in the first quarter. The footnote to this data point, here at home, is that although we are walking alongside an economic-data-driven cliff, corporate balance sheets are in pristine condition. It will most likely require a swan-type event to tip the scale.
From economist John Mauldin:
Highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked. There are no good endings once you start down a deleveraging path. Much of the entire developed world is now faced with choosing from among several bad choices, some being worse than others.
Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang
-- confidence collapses, lenders disappear, and a crisis hits.
On the surface, the four largest banks in the US -- Wells Fargo
(C), Bank of America
(BAC), and JP Morgan
(JPM) -- appear to be in healthy shape with $471 billion of tangible common equity among them, nearly double their total in June 2007. Deutsche Bank CEO Joseph Ackermann said over the weekend, “All this reminds one of the fall of 2008, even though the European banking sector is significantly better capitalized and less dependent on short-term liquidity.” Germany’s DAX index responded with a 5% decline, while yields on two- and 10-year bonds dropped to record lows. Yields will continue to be depressed as confidence in the real economy and financial sector shift. The swan event will likely emerge from a global confrontation through contagion regarding debt destruction and the impact on bank balance sheets. Investors should be focused on monitoring the TED spread, Libor rates and bank credit spreads closely for signs of a repeat credit event. According to analysis by the IMF, marking sovereign bonds to market would reduce European banks' tangible common equity -- the core measure of their capital base -- by about 200 billion euros ($287 billion), a drop of 10% to 12%. Ackermann further articulated that if haircut provisions were applied to sovereign debt holdings held at major European banks, a large majority would be insolvent: “It’s stating the obvious that many European banks would not survive having to revalue sovereign debt held on the banking book at market levels.” This should come as no surprise; in April 2009 a FASB 157 allowed major US banks to take their mark to market and apply interesting math in order to appear solvent.
The recent run on Bank of America’s stock was not originated from a liquidity event, but deterioration of faith in the bank's future. Warren Buffett’s $5 billion capital investment shored up the bank from a further speculative run based on his belief the bank can meet its obligations. What it likely did not do is place a floor underneath the common equity. BAC’s CDS spread tightened by 120 basis points on the day of the Buffett backing; we know the common equity rallied as well. Interestingly, Goldman Sachs
(GS) witnessed a similar event on the announcement in 2008 of his investment. Its CDS tightened handsomely and the common equity rallied, but both went on to make new lows. Looking at Buffett’s prior preferred investments, Goldman Sachs fell 67% in three months and General Electric
(GE) fell 42% in two months after he infused them with his capital in 2008.
The red flag from “America’s bank” came days afterward when it announced the sale of half its investment in China Construction Bank; raising between $8.5 and $9 billion. That is roughly $14 billion raised. According to Bloomberg, BAC has $75 trillion in off balance sheet commitments. Nonperforming loans are $27.5 billion, and nonperforming assets $30 billion. Assets to cover these loans are roughly $37 billion. Liability and further litigation, now that the US government has announced its intention to file suit against BAC, will be concentrated to fraudulently originated mortgages, mostly from Countrywide. If Bank of America has $50 billion or more in additional losses to write down and the litigation extends for several years, it will only consume a nominal amount of the pretax earnings over that time. Again, unless another credit event manifests, the bank will likely not go under. If we are to witness a trickle effect from Europe, as we currently are, then all bets are off.
Let's characterize the state of the current US economy from the lens of 2007. At the time unemployment was relatively low and the Fed had the flexibility to be proactive, with the federal funds rate at 5.25%. Similarities can be extracted from the 2002 recession. Furthermore, the KBW Bank Index
(^BKX) to S&P ratio hit a new low in July; the two previous occasions this occurred was December 1999 and April 2007. We know that both markets peaked within four and six months respectively, setting the table for a significant crash in each market environment.
I have previously made the case that we are in a similar economic and trading environment to the 1934-1937 bear market rally. Bear markets do not last as long in duration as bull markets, but they cover the same amount of ground. It is during moments of panic and waning investor confidence that predicting financial stress and forecasting market reaction possess an inverse relationship.
The New York Times
published a piece last month
comparing our current economy and the 1937 recession, which reflected my previous written thoughts quite well. “Manufacturing output fell by 37 percent in 1937." Our output is at a twelve-month low. “Unemployment, which had been slowly declining, to 14 percent from 25 percent, surged to 19 percent.” In 2010 unemployment peaked at 10.2% and dropped to 8.1%; it now stands at 9.2%. “Price declines led to deflation.” The “good news” is that it was a quick dip, lasting until 1938. What this article fails to deliver on are the similarities in the moves the stock market made in 1937 and what the today’s market is doing. The bear market rally lasted from 1934-1937, 35 months, and the market gained 106%. Sadly the market dropped 49% thereafter. Our current cycle is at month 31 and toward its highs exceeded a 100% return.
We may not witness a recession by textbook terms, or it may be swift and short-lived. But what the data does not shed light on is how far markets will slide and the damage to investor confidence that will be left behind. Both of these circumstances are event-driven, and although we are seeing flashing signals to warn us, we do not know what the catalyst will be to tip us over. The retail investor is not participating in this market, but high-frequency trading and momentum hedge funds are. They have the ability, as witnessed during the flash crash and in August of this year, to move markets much more rapidly than even the most experienced investor can forecast.Twitter: @PeterPrudden