Market and Economic Update 09-12-2011
September 12, 2011
The Dow Jones Industrial Average fell 303.68 points Friday, or about 2.69%. Today, Monday, the stock market opened lower. At the same time, the sales price of U.S. Treasuries, which is to say U.S. Government debt, has been rising. Since the interest paid on those government debt securities is a fixed dollar amount, the yield, as a percent of the Treasury securities, has fallen to levels that have not been seen since World War II. In short, money is flowing from stocks into Treasuries.
Because of the size in the two markets, it is also apparent that far more money is flowing into Treasury securities than is flowing out of stocks. Much of the money that is being used to buy those U.S. Treasury obligations is clearly coming from Europe.
This is the physical reality of what is happening. Now, if you will, I would like you to stop for a moment and recall why the stock market dropped so dramatically a little over a month ago. In retrospect we can see that the proximate cause of the stock liquidation was a downgrade in the long-term credit rating for U.S. Treasuries from AAA to AA+ by the Standard & Poor’s rating agency. Once again, the apparent short term logic (or illogic) of those moves makes no sense. Treasuries can go up as long as interest rates can go down. Unfortunately, for shorter term Treasuries interest rates are effectively zero. It is really, really, hard to get lower than that. The Chinese have managed to purchase a large block of two to five year Treasuries that do actually have a below zero yield to maturity, but like I said, that is really, really hard to do.
Looking at these moves from a different perspective provides the underlying cause of all that is happening in the markets. I carefully searched the news reports from Friday and over the weekend for a cause and the proximate reason for the market decline was relatively obvious. Jũrgen Stark, chief economist of the European Central Bank (“ECB”) turned in his resignation in protest against the bank board’s decision to purchase Italian and Spanish Sovereign bonds. Now, if that sounds like a pretty weak reason for the equity markets of the world to decline as much as they did, your sense of that issue is correct.
The key to the reaction is that Mr. Stark is German. A couple of months ago the ECB Vice Chairman resigned as well. He too was German. He was also the person scheduled to be the next ECB Chairman. Then rumors came out on Friday that Germany was making preparations to recapitalize their larger banks to cover a Greek default.
If you have read my missives for any length of time you will recall that I have repeated my warning that the amount and interest of Greek sovereign debt was so great that there was no realistic possibility that the Greek government could do anything but default at some point. There is absolutely nothing new about that realization. That is not an issue. What was (and is) the issue is that the ECB is purchasing bonds on the open market to reduce the interest rates on Italian and Spanish bonds. The irrational fear driving the decline in European markets is that a panic ensuing from Greece’s default might cascade out of control and create a financial crisis not unlike the collapse of Lehman Brothers in September 2008.
The collapse of Lehman Brothers was almost totally unexpected. Bear Stearns, another Wall Street investment banking firm that had issued, and still held, immense quantities of unregulated mortgage derivative securities, had been purchased by J.P. Morgan with U.S. Treasury and Federal Reserve support. The assumption was that Lehman Brothers would be treated the same. When the Bush Administration determined that Lehman Brothers should simply be allowed to fail and bear the effects of its unwise investments, the ripple effects very nearly took down the entire world financial system.
In today’s environment, a Greek default should not surprise anyone. Yes, there are those who assume that the European Central Bank will somehow find a way to rescue the Greeks from themselves and it will do so because the wealthy northern nations of the European Monetary Union (“EMU”) will understand that it is in their best interest to “bail out” Greece. A careful examination of the cost that would probably ensue from such a “bail-out” is finally revealing that the Greeks are not likely to change their ways. Any rescue of Greece is very likely to create a worse problem in the future. More, if the EMU arranges to, in essence, “give” the Greek government hundreds of millions of Euros because it lied when applying for admission to the EMU and then lied about the rate it was spending money, why should the other troubled countries not be similarly rewarded?
The EMU is very much like the bird of the same name (the emu). It is, in essence, a rather large chicken. It has a very tiny head and has a tendency to behave in a notably irrational fashion. It is the emu that actually does stick its head in a hole in the ground when frightened. As I have noted before, chickens can live for quite a long period of time without a head. Obviously, so can the EMU.
So why is there a panic in the U.S. markets, because the EMU is having a problem, and more specifically, because the Germans are prudently preparing for the losses that will ensue from a Greek financial default? Here in America, we too are largely headless. We are embroiled in severe partisan political battles with the Republican leader in the Senate openly stating that his primary objective is to create so much unhappiness that the sitting President will not be reelected. We are fearful because we have heard so much gloom and doom repeated again and again in the broadcast and print media and from the Congress that we expect the worst. Any time we expect a disaster, any hint of bad news tends to cause us to panic.
If we want to be successful investors, then we must invest, and even more critically, stay invested, when the market is cheap (low). The actual economic metrics are repeating the same message over and over. That message is that corporations are more profitable today than at any other time since we have been measuring such things. Those same corporations are more productive than ever before. America, the largest exporter in the world, is increasing its exports as fast as or faster than at any time in its history. It is a simple fact that our supposed competitors for world financial dominance are not seeing an inflow of money to their sovereign debt. We are seeing that inflow here in the United States. If you want to see an example of just how different reality is from the media perception, take a look at the Real-Estate Stock asset class which many of you have in your portfolios. It has consistently been one of the better performing asset classes in your portfolio over the past several years. The news media paints the entire real estate market as a disaster. The reality is that there are parts of that market that are making a very good profit.
Yes, we, both as households and as a government, have more debt than we would prefer. That is creating a slow recovery as we focus on debt repayment by “buying down” our personal and business debt. Money we expend paying off credit card debt does not create jobs and in fact causes a decline prices (deflation). That gives greater incentives for retail companies to lay off more workers. The good news is that we are well on the way to reaching a point where we are comfortable with our debt levels. We had a couple of reports last week that reveal a lot about that. The total household debt actually rose for the first time in years, but how it rose was important. Credit card (revolving) debt continued to fall. What increased was non-revolving debt. That type of debt is used to purchase cars and other capital items. It tends to be very low interest debt, and it is what we refer to as “economically healthy” debt.
In short, the U.S economy is recovering, and recovering nicely. Unhappily, that recovery is largely based on a huge growth in productivity and exports. Since the vast majority of employment is in service-related areas, it is not much of a help to the average worker. One of the biggest employment sectors in America is construction, and the biggest part of that sector was residential construction. Right now we have literally millions more residences in American than we have households to occupy them. That metric alone will ensure that we are going to have relatively high unemployment for some time. That same decline in residential value is hurting local governments. The result is very predictable. Private employers are creating far more jobs each month than are being lost in the private sector. Governments are laying off people about as fast as private employers are hiring. Those who wanted less government are getting their wish fulfilled.
This is not a simple or easy recovery, but it is both necessary and healthy. We are shrinking government at all levels while at the same time both making our businesses more productive and competitive and paying down our higher interest debt. This behavior lays the foundation for a serious recovery in the not too distant future.
So what should we be doing now? The answer is also quite simple. We should look at this situation based on the facts and history. We humans have not changed very much in the last few centuries. We are very fond of reacting emotionally and then justifying our actions with some form of rationalization. In short, we are collectively scared and pessimistic. We are primed to panic and make some really bad decisions. Of course the sales force from the financial industry are out in legion promising us “safe, secure, guaranteed” income and growth. The reality is that those promises are bait to lure us into places where the real dangers are carefully hidden.
As for attempting to “time” the market by getting out now and then attempting to jump back in just before it goes up, all I have to say is that quite literally every study on that subject reveals that it does not work. Joe Granville may be a familiar name to some long term investors. He was quite correct in predicting and action on his prediction of the 1987 market crash. Unfortunately, he continued to predict another crash over the following decades and lost all credibility. At any given moment there will be someone who is accurately predicting the next crash. That person will be given great credit when it occurs. Unfortunately, those who have accurately predicted market declines are, almost without exception, absolutely unable to recognize the recovery when it comes. Factually, we are in the recovery now. The S&P 500 closed at 676 on March 9, 2009, two and a half years ago. As I write this that same index is “down” to only about 1,150. That is a 70% rise in two and a half years. Think of the irrationality that goes with considering a 70% increase in value to be a “loss” and a “down” market.
A well diversified and well allocated portfolio remains the safest long-term investment strategy. The difficulty is that we can actually see the variance in market value. We are tired of that disclosure. What we want is for someone else to take responsibility for that and for them to make us some promise. That they may be unable to keep the promise is less important when we are really afraid than the short relief of the façade of security.
Frankly, I am tired of encountering bad news and fear too. I could change the way I do business right now and start selling something like indexed annuities and create, quite literally, millions of dollars for myself in a short period of time. I don’t do that because I am convinced that those millions of dollars I would receive would be at the expense of my clients.
I am also very, very tired of this drought. I am tempted every day to go out and adjust my sprinkler system to dump great quantities of water on my yard. Our grass is dying. We are losing trees. We are and have lost some really beautiful plants. Still, I hold to minimal watering on the days when our local water authority tells me I can do so. What I will do as the drought ends (and it will), is to replace those dead, wet climate plants with dry weather plants that can thrive in dry, hot weather. It is a moral decision. I believe over the long term it will also be a good economic decision.
The world is changing. Change is uncomfortable, but it does not need to be disastrous unless we panic. The future is uncertain and anyone who claims to be able to eliminate that uncertainty is either lying or terribly mistaken. We can look at history and at the real numbers underlying the emotional rhetoric and then follow people like Warren Buffett in creating a rational, value-based portfolio or we can run for shelter down the fox’s hole with Chicken Little.
As always, the choice is ours.
If you have comments or questions, don’t hesitate to write.
