What Possibilities Lie Ahead?
In investing, knowing when to be in the game and when not to be is more important than what play to call.
I quote trading commandments often when I write as I truly do live by them (when I don't live by them I have this nasty habit of being wrong). One of those commandments is simply 'The ability not to trade may be more powerful than the ability to trade.' In fact, taped to the top of my Bloomberg terminal is the phrase 'Never trade just to trade.'
I bring this commandment up because I have been asked by many in the press lately for my take on 2008 and the first question of the interview is usually "What are your price targets for the S&P 500 and Dow Jones Industrials Average at mid-year 2008 and year-end 2008?"
My generic response is usually "I don't give price forecasts because, after all, if I knew where the S&P 500 were going to be at certain dates in the future, I would not need to manage money and would likely have a 125 foot yacht in the Mediterranean." All kidding aside, making those sorts of predictions is foolhardy, in my humble opinion. Even if you were to give me every data point six months ahead of time, I still would not be at all comfortable providing anyone with a price target.
There are just too many exogenous factors at play. I have no problem answering the question "Do you think the market has a good or bad risk/reward ratio at present?"
Investing is an art, not a science, and knowing when to be in the game and when not to be in the game is more important than what play to call. So I will say this, which could possibly be a new trading commandment-'The ability not to make a forecast is more powerful than the ability to guess at a forecast'. And when we are facing times that are truly unprecedented in the financial markets, the ability to not make a specific forecast, I believe, is more important than ever. Below, I will detail what I think could happen, and why I am positioned cautiously. I will also detail what I would do if I were lucky enough to get the macro picture right. In other words, what would turn a mess into opportunity?
I have been saying for a long time that I am neither a bull nor bear, just a cautious observer with the responsibility of managing other people's money, plus my own. I am admittedly cautious, but not just to be cautious, rather to be able to have capital available at the other side of the financial situation that I believe we are in.
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I will do this in the following three sections-'Where We Are,' 'Where We Could Be Headed,' and 'How Can We Profit from the Mistakes of Others?' I will brief, but to the point and hope you find it to be interesting and of use.
Where We Are
The U.S., and other countries, have spent the last 20 years or so building up both sides of the balance sheet. Back in 2004-2005, newspapers were peppered with the fact that "household net worths were at a record high." And indeed, the newspapers were correct. The one important point left out by the press and one that I have focused on for years is that the net worth was induced by debt growth. At the consumer level, debts as a percentage of GDP are off the charts and growing parabolically-see the chart below, courtesy of Ned Davis Research.
Household Debt as a Percentage of GDP
Click here to enlarge.
I then read a lot about how liquid households were and how they would forever buy stocks and that liquidity wasn't an issue. Again, I can't argue with the part about loads of cash; what I do argue with is the amount of net cash. Think of the consumer as one big balance sheet with two bloated sides: increasing asset prices (real estate bubble) and increasing debt. When the assets decline, the debt remains.
This is how margin calls develop. So I will bring out a chart I haven't used since 2001 that shows how much cash is available at the household level adjusted for debt. And there are only a few resolutions to large amounts of debt. You must service the debt, re-finance the debt, or default on the debt. Since re-financing, for now, is out of the question, this leaves servicing the debt and defaulting and I will highlight the consumer's ability to service debt in the chart below.
Consumer Debt Ratio
Click here to enlarge.
According to Ned Davis Research, "the household debt service ratio is an estimate of required debt payments to disposable income. The higher the burden, the less money consumers have left over to spend on goods and services and the more likely they will default." No wonder the Christmas season was so weak.
Imagine that the stock market is a car moving down the road that needs fuel to keep accelerating. If the tank, in this case liquidity (or better yet net liquidity) is on 'E', the market will stop accelerating or possibly stall out. The chart below, while slightly confusing, simply takes all of the 'non-equity liquid assets,' which includes checking accounts, CDs, money funds, savings accounts, corporate, foreign, municipal and U.S. Government Bonds and subtracts debt from that. As of September 30, 2007 that number stood at $10.451 trln dollars. The problem, of course, is that household liabilities stood at $14.157 trln, leaving net liquidity at minus $3.706 trln. Why is this important? Net liquidity is what drives secular bull markets.
To see how much liquidity there is relative to market values you simply divide assets (in this case the Wilshire 5000 Equity Index: a very broad equity index valued at $15.362 trln) and one finds that there is minus 24.1% liquidity to market value. That tank isn't only on 'E,' it is below 'E.' Also of note is that in 1953, 1974, 1980, and 1984, the gas in the tank was near 70%. Now that is a full tank. Does this mean the market can't go higher? Of course not. It simply suggests that the marginal dollar isn't going to be able to move it as fast. The chart below says it all.
Household Free Liquidity as a Percentage of Wilshire 5000 Equity Index
Click here to enlarge.
In sum, the consumer is highly leveraged and fairly fully invested in stocks, which the chart below with data from AAII (American Association of Individual Investors) shows, and does have a lot of cash, with which if debt levels increase could eventually be a source of fuel for stocks. But the most glaring part of the pie chart to me is the 9% position in bonds, while Treasury yields fall, but as corporate bond yield rise (credit spreads are rising dramatically). So one has to wonder if that cash will go to pay off/service debt or into the capital markets. My guess is to pay down debt and consume less.
AAII Allocation Survey
Click here to enlarge.
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