Time To Change Bias

At Tocqueville Asset Management, we claim to be contrarian investors. This implies two things:

 

First, we need to assess the consensus view, among market participants, of future economic and financial trends. The stronger the consensus, the more taking an investment stance contrary to it is likely to be profitable. This is not because the consensus is always wrong, but rather because of the way markets work. The more people share an opinion about stocks, bonds, real estate, commodities or art, say, the more that view is already reflected in “market” prices. Thus, there is less to be gained if the majority is right and more if the consensus turns out to be wrong. Market odds favor the contrarian.

 

Second, it is not so easy to be contrarian. The way the news is reported and disseminated has a tendency to make us think alike. We also tend to believe that if we understand (or think we understand) a problem, we can be confident of our conclusions. Unfortunately, old trends are usually much better explained, documented and reported than emerging ones, so that their causes and mechanisms are easier to understand. In contrast, emerging trends, often opposite to currently prevailing ones, come through as fuzzy: they are initially ill-understood and the case for them tentative at best.

 

To be effective, the contrarian must therefore adopt a bias. He or she must look at the news with an eye for “straws in the wind” that contradict the prevailing consensus. These usually do not appear on Page One or on prime-time news; they are often overlooked or misinterpreted; and they only acquire meaning cumulatively – straw upon straw.

 

The Wolf Scenario Has begun To Unfold

 

For more than a year, my own bias has been to look for trouble. Last May, I wrote:

 

“Why should this apparently virtuous cycle of rising liquidity, disinflation, low interest rates, resilient-to-booming economies and rising stock markets ever end? Because of (Herbert) Stein’s Law: ’That which cannot go on forever won’t’.

 

Today, liquidity is more a function of the widespread availability of credit than of traditional money creation. But credit availability, itself, is in good part a function of crowd psychology: in particular the optimism (or myopia) of lenders. It sort of appears out of nowhere and, sooner or later, it evaporates…

…Many investors whose judgment and long-term performance I respect have been warning for a while that some kind of serious trauma eventually will be the price to pay for the excesses and complacency of recent years. But, as in “The Boy Who Cried Wolf” tale, their warnings have become progressively discredited as economies and financial markets brushed off successive crises. Under pressure from public opinion, the number of boys crying “wolf” has been melting like ice under the sun.

 

But, as Victor Hugo wrote in a pamphlet against Napoleon III, ’If but one remains, I shall be that one‘.” (Please see The Boy Who Cried Wolf - May 14, 2007, in “Headlines and Bottom Line” on our website at www.Tocqueville.com.)

 

Since then, a major liquidity crisis has developed in the United States, with broad and global implications, leading to desperate efforts by economic and monetary authorities to stem the propagation of defaults and financial losses.

 

The United States Economy On The Edge

 

The definition of a recession, as officially measured by the National Bureau of Economic Research (NBER), is more complex than the popular one (two successive quarters of decline in Gross National Product). Unfortunately, the NBER usually makes its final determination after the recession is over, so that it is not of much use in looking forward.

 

In my view, the United States has entered a recession, however you define it. This is not yet an overwhelming consensus, but we are getting there. The U.S. economy has clearly slowed and is likely to continue to do so as households adapt to the rediscovered reality that, in the long term, they must learn to live within their incomes rather than on a growing mountain of credit. In fact, restoring savings may mean, for a while, spending less than we earn.

 

Corporate profits have begun to decline, although so far mostly in the financial sector and those related to real estate and construction. But most retailers are not doing that well either and it seems likely that, economy-wide and over time, corporate profit margins will decline from their recent record levels toward a more sustainable long term average. (Corporate profits recently were 8-9% of GDP, vs. a long-term average of less than 6%).

 

Historically, when profits have fallen, so has capital spending. There is no reason to expect that this time will be different. So, outside of a likely improvement in the trade balance and some help from the Federal government’s stimulus programs, few areas of the US economy look promising in the year or two ahead.

 

“Decoupling”: Not Yet

 

Internationally, the widely accepted “decoupling” theory is likely to become discredited – at least in part. This fashionable theory implies that emerging economies have evolved to the point where they are much less sensitive to the fortunes of developed ones and are thus able to continue growing in the face of a U.S. recession. But as the United States enters a recession, Europe, too, is markedly slowing and Japan’s economy looks vulnerable as well, in spite of a recent good GDP release that looks somewhat suspect in light of other statistics.

 

True, emerging economies have made spectacular strides in recent years. Their consumer sectors are promising fast future growth, based on the rapid emergence of middle classes and high saving rates. Most governments of emerging economies also have built large currency reserves that could be used to finance major infrastructure projects. These projects not only are needed, but could serve as a welcome anti-cyclical stimulus in case of a global slowdown in demand.

 

Nevertheless, with the possible exception of India, which remains a relatively closed and protected economy, most other emerging nations, whether natural resources producers or cheap manufacturers, still depend to a significant extent on their export sector.

 

China’s exports, for example, have grown from 20% of its fast-rising GDP in 2001 to 38% today. Exports to the United States have grown from a contribution of 4% to one of nearly 8%. Those to Europe have grown even faster, from 3% of GDP to over 7%.

 

Over the same six years, exports of all developing economies have increased from about 36% of GDP to 43%. It is hard to envision how these economies could not suffer significant slowdowns in the face of recessionary or near-recessionary conditions in the world’s largest economies that are their main customers.

 

The far-reaching tremors caused by the current financial crisis, originated in the U.S. domestic, sub-prime mortgage market, illustrate the truth that globalization has made the economies more interdependent, not less. As the “decoupling” myth is exposed, we can expect global economic growth to disappoint in the coming year or so.

 

Complacency Lingers On

 

In my view, and despite the spectacular unfolding of the current financial crisis, there remains a still-high level of complacency in the public.

 

On the economic side, this complacency rests on the recent experience of a long period of economic stability and the benefits of globalization (broader growth with subdued inflation).

 

On the financial side, there exists a perception that markets are protected by what has become known as the “Greenspan Put”. The idea behind this “put” is that, in today’s complex and somewhat inscrutable financial system, every time a speculative bubble bursts, the U.S. Federal Reserve and other central banks will immediately intervene. They will do so by aggressively injecting liquidity into the system. Eventually, of course, this liquidity will facilitate the creation of future bubbles, but in the shorter term it will abort the forced asset liquidations that normally follow bubbles. In short, with these asymmetric policies, central banks have become promoters of bubbles and insurers against their consequences. What investor would not become complacent?

 

Valuations Do Not Spell “Market Bottom”

 

In spite of the deteriorating economic fundamentals, world stock markets remain pricey by historical standards, even after the recent price corrections. I’ll take the U.S. market as an example, but similar comments could be made about most other markets.

 

John Mauldin, at Thoughts From The Front Line (2/15/07), reminds us that in early 2007 Standard & Poor’s estimated that full year reported earnings for its S&P 500 Index would be about $89 – up almost 10% from 2006. In fact, they came in at less than $72 – down almost 20%. A year ago, the same organization was still estimating 2008 earnings of $92, but it is now projecting only $71. The final number could be lower. Most of the deterioration in outlook so far can be traced to the real estate and financial crisis, but not all.

 

Of course, one should judge valuations on the basis of “normal” earning power – not on the basis of cyclically-depressed, recession earnings. But it also can be argued that the recent huge write-downs in the financial sector (nearly $200 billion and counting) indicate that the $81 of earnings reported in 2006 were partly phantom earnings. The S&P 500 never really earned $81.

 

Before the big write-downs started in earnest, in 2007, financial companies made up more than 20% of the S&P 500 Index (up from 13% in 1999) and accounted for 30% of the index’s earnings.

 

Another sector that seems vulnerable, although it is still doing quite well, is the energy sector. As oil prices tripled in less than five years, the contribution of the energy sector to the total earnings of the S&P index zoomed from less than 7% in 2003 to 15% recently. At the same time, the weight of energy in the price of the total index rose from less than 6% to over 11%. This is not the place to discuss the long-term outlook for the price of oil. But from a cyclical perspective, a global recession or near-recession would likely depress demand for the fuel, which likely would be aggravated by the reversal of speculative positions that have built up in the past two years. Oil prices have a good chance of suffering a price correction in the coming year or two and, with them, energy companies’ earnings.

 

As both these sectors saw their earnings rise even faster than their market prices over the last five years, their price/earnings ratios declined. According to the Bespoke Investment Group, in late 2007 (before the huge write-downs), the price/earnings ratio of the financial sector was around 11, while the energy sector is currently selling at about 12 times earnings, compared to 19 for the overall market..

 

This calls for three remarks:

 

First, based on Standard & Poor’s own, reduced estimates, the market appears to be selling at 19 times earnings. This is lower than the record 30-40 times reached at the peak of the 1999 bubble, but it remains at a level from which, historically, future stock market returns have proven mediocre.

 

Second, the energy and financial sectors together recently accounted for 31% of the index’s price and 45% of its earnings: if their low price/earnings ratios (probably depressed by either phantom or unsustainable earnings) are excluded, it looks like the rest of the stock market is selling for even more than 19 times earnings.

 

Third, models that aim to measure the fairness of the stock market valuation usually compare stock price/earnings ratios to long-term interest rates. Currently, most of these models view price/earnings ratios on “the market” as about right (neither grossly overvalued, nor grossly undervalued). But they generally use long-term Treasury bonds to measure interest rates. Recent uncertainties have pushed down interest rates on Treasuries, which are viewed as a refuge from financial turmoil, while actual borrowing costs for everyone else have risen significantly. Chances are that if models incorporated real-life interest rates, the U.S. market would still look overvalued.

 

Finally, after a quarter century on the decline, interest rates are close to their historical lows. If they should start rising again, when the global economy recovers and price inflation accelerates, price/earnings ratios (which tend to move inversely to interest rates over time) likely would be on a declining trend for years. Even with rising earnings, the market may therefore consolidate on a horizontal trend for several years – as happened in the late 1970s.

With this long recapitulation of what is wrong with stock markets, one may wonder why I want to change my contrarian bias to a more positive one at this juncture.

 

Here are some elements of the answer.

 

Mid-Way Into The Decline?

 

Since early August 2007, the U.S. stock market has declined by around 20% and, at last, the level of fear among investors clearly has been rising.

 

Dow Jones Industrial Average:                                                         -18.1%

Standard & Poor’s 500 Index:                                                          -19.4%

S&P 500 Equally Weighted:                                                              -22.5%

Russell 2000 Index:                                                                            -24.1%

 

The average peak-to-trough move in recession-related slides since 1950 has been 25.6%, according to Citigroup strategist Tobias Levkovich.
 

 

I have some reservations about the definitions. For example, it is quite possible that there would not have been a recession in 1960 without the massive inventories accumulation (from imports) during the four-month long steel strike of 1959 and the equally massive inventories liquidation just as the economic slowdown was getting underway.

 

As to the relatively short recessions of 1980 and 1981-1982, I have a tendency to view them as one long and deep recession briefly interrupted by an investment boom triggered by the second oil shock following the fall of the Shah of Iran.

 

It has now been almost seven years since the last recession and significant stock market decline. Many large excesses have been built during that time and the complexity of the current financial crisis makes it likely that the next episode will be protracted, even if the recession is not particularly deep.

 

I would not be particularly surprised to see an ultimate stock market decline, from top to bottom, of nearly 40%, lasting about a year to next summer (with, of course, intermediate rallies). This is not a forecast but an early evaluation of the potential risk.

 

What this all means is that, under what I consider reasonable assumptions, we might be about half way through the current bear market, since the leading indexes have already lost 20% over six months. However, as the level of fear, and eventually panic, rises, more investment opportunities will arise.

Initially, they will appear in troubled sectors and companies. Worldwide, there already are many companies that are selling at prices 60% or more below their two-year highs. Of course, their outlooks are clouded and, especially in the financial sector, some may not survive. But many will, and it is good to remember that a stock does not need to return to its previous highs to offer a significant gain potential. To take an extreme but convenient example, a stock which has declined 75% from its high, say from 100 to 25, only needs to recover to 50 (half its previous high) to double in price.

 

All this to say that it may be too early to aggressively buy into this market as a whole, but it is not too early to change our contrarian bias.

 

What About The Apparently Intractable Financial Crisis?

 

There is very little I can add to the extensive media and experts’ coverage of the current financial debacle. Its depth and surprisingly global reach, as well as its dire implications for many institutions, have been and still are being amply reported and analyzed.

 

No one can understand all the details of the alphabet soup of products that have been sold to ignorant or simply greedy investors and much bad news likely still is waiting in the wings. Commercial mortgages, credit card debt, leveraged buyout loans, etc.: all were securitized and sold to brokers and investors in the same manner that home mortgages were. Many are “sub-prime”, and it seems that, in spite of rising defaults, few reserves have been taken against them by banks and other financial institutions. More, large write-offs are coming and the impact on the “real” economy is likely to deepen recessions and delay recoveries.

 

However, at least the seriousness of the problems has now been recognized by economic and financial authorities worldwide and a patchwork of solutions (though probably still inadequate) is being worked on. There will be many casualties, but the system and its economies will survive.

 

Sort of déjà vu?

 

The second half of the 1970s, after the worst recession in forty years (1975), was just as scary as today’s turmoil. Like today, the United States seemed to be losing control of its destiny, both at home and abroad, in what President Jimmy Carter described as a “malaise”.

 

Two recessions with bear markets (1970 and 1974-1975) and relentlessly accelerating inflation had set the stage for what would become known as the “stagflation” decade. The U.S. Misery Index (inflation + unemployment) rose steadily from 9.0 in 1969 to 20.8 in 1980 (it currently stands at a comfortable 7.5).

 

Political unrest was recurrent throughout the decade: Peace marches; Kent State University shootings; Massacre at the Munich Olympics; Ku Klux Klan riots; Shooting of George Wallace; Abduction of Patricia Hearst by the Symbionese Liberation Army, etc. And environmental catastrophes reinforced the feeling of uncertainty: the Love Canal pollution disaster and the Three-Mile Island partial nuclear meltdown, for example.

 

Of course, the overwhelming source of political strife was the Watergate scandal, which burst out in 1972 and eventually was instrumental in bringing President Nixon’s resignation under threat of impeachment (1974). But so were the last years of the Vietnam War, until the humiliating fall of Saigon in 1975.

 

In the background, the breakdown of the Bretton Woods global monetary system in the early 1970s ushered a period of acute uncertainty on world financial markets, as gold and currencies were allowed to fluctuate freely after years of fixed exchange rates

 

The dollar collapsed and the price of gold in dollars increased 1600%, from 35 to 600 (annual averages).

 

To make things worse, although it can also be viewed as a consequence of the Bretton Woods collapse, an Arab embargo on oil exports to western nations allowed OPEC to quadruple the price of oil overnight in 1973. This acted as both an added prop to inflation, which was already accelerating, and as a tax on Western nations, ensuring that the forthcoming 1975 recession would be global.

 

Soon, the oil price increase created major dislocations in world financial markets: oil producers gained enormous export surpluses which they could not possibly invest in their home economies over the medium term, and oil consuming nations needed to borrow equally large sums to finance their suddenly gaping trade deficits. A huge process of recycling petrodollars thus got underway – largely through the heretofore limited “Eurodollar” market, a market for dollars deposited in banks outside the United States.

 

But the Eurodollar market, mostly based in London, was largely unregulated and allowed banks to lend a much greater multiple of their deposits than traditional central banks allowed their domestic institutions to do. Money was being created with no central bank supervision!  Of course, this uncontrolled money generation promised to greatly increase inflationary pressures globally, while the lack of regulation also eventually promised some sort of credit crisis – as later occurred in Latin America. The world’s monetary system had run out of control.

 

To cap the whole mess, the Shah of Iran was deposed in 1979, in a revolution that brought to power the Ayatollah Khomeini. This triggered a further oil price increase (the second “Oil Shock”), which only reinforced the economic and financial ill winds of the 1970s, leading to the global recessions of 1980 and 1982.

 

Scared, But Optimistically Biased

 

Of course, the current financial crisis hasn’t yet run its full course and things will get worse. But it is hard to argue that the global outlook and the lack of economic and political leadership are worse than they were in the second half of the 1970s. So, let’s look at what happened to the U.S. stock market (as an indication of what happened globally) during that earlier period.

 

·         From top to bottom, the stock market declined about 50% over nearly two years.

·         The price/earnings ratio on the S&P 500 Index fell from nearly 20 to under 8.

·         The bottom of the bear market occurred in the depths of the 1974-75 recession.

·         After the stock market bottom, there was a rally of about 75% over two years, in spite of ongoing concerns about the future of the world economy and financial system

 

From 1976 to 1980, the market was generally flat and the index’s 1972 peak price was not exceeded until 1980.

 

The good news is that, even in a flat-looking market, there is money to be made if you are both contrarian (to adopt an optimistic bias when things look worst) and value-oriented (to buy at attractive prices stocks of companies that will survive). (For more details, you might want to refer to The Long Rear View - June 25, 2007, in “Headlines and Bottom Line” on our website at www.Tocqueville.com.)

 

In summary, don’t dive in wildly, but as the news worsens change your attitude toward swimming.

 

François Sicart (in Mexico)

February 19, 2008

 

 

This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice, nor is there any guarantee that any projection, forecast or opinion will be realized.