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A hedge fund manager scoffs at the climbers of the cliff of doom
by Eric Janszen
A missive by a noted hedge fund manager was sent to us today in confidence. It's titled, "So Is It Time for a Recession and Market Panic?" In sum, it said that all the worry the author is hearing on the street about the economy and markets is due to "superstition and witchcraft."
He playfully suggests that, "we should follow the precedent of our early medieval ancestors and gather in a circle, hold hands and chant, then light the tribal Shaman on fire."
He gets points for noting that the tribal Shaman of the markets is still Alan Greenspan, but I don't recommend lighting the guy on fire. And the rest of the author's argument is nonsense.
In sum:
- The slow demise of the yen carry-trade has nothing to do with the current market turmoil. A rounding error in global liquidity.
- Sub-prime loan problems represent a $15B write-off risk in a $1.5 trillion market. Forgeddaboudit.
- No recession because Bernanke says so. Ignore Greenspan–remember, he's a Shaman.
- Oil price increases of 240% to 500% preceded all of the last four recessions (except the 2001 recession) since 1974. And we haven't seen anything like that.
Does the 600% increase from $12 per barrel in the late 1990s to nearly $70 per barrel today count? Never mind.
Among his various carefully selected and poorly argued points, my personal favorite is this.
"This must be the only bull market in history where P/E ratios declined over the course of a significant run up. It has left P/E ratios quite modest—almost exactly in the middle of their long term range in most markets."
Did he not get the memo? Stock buy-backs are driving P/E ratios down during this extended bear market rally? The entire 2001 - 2006 period is a 1933 - 1937 style bear market rally, driven by Keynesian economic stimulus policy, which may work out as well, although differently, this time as last.He notes that the behind-the-scenes talk is very negative: "While the notion is that a bull market climbs a 'wall of worry' I would almost describe the current mind set of investors, and even some corporate managers, as closer to 'cliff of doom' than 'wall of worry.'
"Climbing a cliff of doom." We like that. We'll take it.
He goes on.
"Both in talking with companies, and examining the cautious tone of the forecasts that have accompanied the release of full-year 2006 results, the caution is notable. Such caution, at least on one level, is profoundly weird."
After pointing out all the obvious reasons why we've never had it so good, he concludes by asking, What the heck everyone so worried about? What a pack of neurotics!We are worried because we can't do without.
Without cheap imports, CPI inflation will go through the roof. If Congress gets its way and forces the Chinese to re-value the yuan, or if any other of several increasingly probable events occur which cause demand for dollars to fall–such as losing the wars in Iraq and Afghanistan or getting bled dry by a protracted stalemate–or a good old fashioned panic out of the dollar, the dollar tanks as many have predicted, admittedly too early, but not wrongly.
If you think inflation is high now as you experience it when paying tuition, insurance, or medical care bills, wait until the U.S. tries to buy imports with depreciated dollars.
The CPI, itself an increasingly suspect concoction created by the Bureau of Labored Statistics, delivers its magically low reading year after year–never mind the fast rising prices on the menu of your local sub shop–because the index sums low inflation traded (T) goods and services which benefit from foreign labor arbitrage with high inflation non-traded (NT) goods and services that don't. Consider how much consumer electronics figures into your monthly budget versus tuition, insurance, and medical expenses, and you decide whether the CPI is valid and what higher import costs portend.
Without continued loose and low rate lending, housing prices will continue to fall, as they have for the past few months. Lending standards will rise, restricting the pool of credit-worthy borrowers, which–in a highly competitive credit market–leads to even more limited access to lenders by borrowers. As housing prices fall, all sorts of unseemly things happen. Fewer want to buy. Fewer want to build. Fewer are employed. And so on.
The leading indicator is housing permits, as we noted in our 2007 Recession series last fall. A decline in construction and other real estate related employment is next. Unemployment is strongly correlated to housing prices. And so on.
As we noted back in October last year, a large drop in housing permits issued preceded every major recession, except for the 2001 recession, since 1974. You remember the early 1990s, don't you? This housing decline, in rapidity and depth, is much more severe.
Without continually increasing deficit spending to generate new government jobs, unemployment will rise. We can't all work either for the government or as sub-contractors to the government, but that's where the job growth has been for the past few years. Over 22 million Americans work for the government today, about the same number as work in the goods producing sector. These are the largest employment sectors of the U.S. economy.
The U.S. economy employs fewer and fewer in the private sector. Within the private sector, finance and housing have been the leaders, as other sectors declined. As housing topped mid-2005 and finance topped a few weeks ago, whither new employment? Might that not feed back into housing price declines?
Without an ever increasing rate of new debt creation, key segments of the U.S. economy–especially consumption and finance–will contract.
Outstanding debt levels–especially mortgage debt–have grown to be so outstanding that by any measure they are incomprehensible.
Without ever more rapid public and private sector debt growth, current GDP growth cannot be maintained. This measure tells you how much new debt is needed to generate economic growth.
In 1983, $1 of debt was needed to generate $1 of GDP. Now nearly $3 is needed. When does this become a problem? When $5 is needed to generate $1 of GDP? $10? $100?
Without an ever more rapidly expanding money supply, the U.S. economy is ripe for a debt deflation, either via a hyper-inflation or credit defaults.
Never mind that getting to the first $1 trillion of Money at Zero Maturity (MZM, a broad measure of the money supply used by the Fed) took 207 years, from 1775 to 1982. Next $1 trillion took a mere five years. Last $1 trillion? Ten months. Nothing alarming about that, right? When does the money supply growth rate become a problem? When MZM grows by $1 trillion a month? A week? A day? An hour?
Without the continued political support of foreign governments expressed as lending, we can't run our government, pay our existing debts, or our pensions or mortgages, or make payments on the last few hundred billion of leveraged by-outs.
Relative to GDP, purchases of U.S. Treasury securities is suggestive of relative levels of tribute to the empire rather than economic need. We miss the nations of "Old Europe," which own practically no treasuries at all. Thank goodness for Asian countries, which need U.S. markets for export growth, military protection, or both. What happens when Asia and Old and New Europe form a strong trade and currency block, and reduce funding U.S. fiscal and consumer profligacy, and propping up the dollar? Uh, oh.
We could go on, but as our intrepid hedge fund manager author only gave us a few items to consider to peel us off the "cliff of doom," we won't go on and on, yanking out the pitons of his case, so to speak.
We conclude that our hedge fund manager author is suffering from a common ailment in the profession: the Desperate Optimism of the Invested. We suspect that the author is motivated by personal risk (owns a lot of equities), or reputation risk (has recommended large stock allocations professionally), or both.
Which fact gives us the opportunity to remind readers why we recommend diversification. Not only does diversification limit your exposure to loss when inevitable crises occur in the markets and economy. Diversification also keeps you from penning strained justifications for your over-weight position in any particular asset, whether it is dot com stocks, or real estate, or gold.
Investing is an art, requiring subtly and sensitivity to change.
Pedants need not apply.
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