This post is password protected. To view it please enter your password below:

Password:

“The shares crash; hopes are dashed. People forget…” –The Who

The biggest stock market crash in a generation is less than a year old and, somehow, equity investors have forgotten all about it. I guess a sixty-five percent rally in the intervening months can do that.

A variety of indicators make it clear that complacency has once again replaced panic in the minds of investors and for this reason true contrarians can no longer be bullish. The time for bullishness was back in the early Spring when the stock market crash was tailing off but investors were acting as if it were only beginning, selling anything and everything regardless of its true investment value.

While we do consider ourselves “true contrarians” this is not to say we’ve become exceedingly bearish only that we prefer to raise our guard when the crowd drops theirs. To illustrate just how far away from the bear cave the bull herd has now travelled we would note that Investor’s Intelligence just recorded the fewest bears in their survey of advisors since 1987. Stock market bears, it seems, are once again becoming an endangered species. In addition, the CBOE Volatility Index, also known as “the Fear Index,” has dropped a staggering seventy-five percent over the past year or so in another sign that investors fell a great deal of contentedness with the stock market. When we see extremes like these in either the bull or bear camp we have found it pays to trade in the opposite direction of the herd.

Aside from the troubling sentiment picture, it is also staggering to realize how fast stocks have gone from undervalued to overvalued. Speaking of 1987, according to data provided by Yale economist and “Irrational Exuberance” author Robert Shiller, the recent rally has pushed the S&P 500 to over 20 times the value of its five-year average earnings, roughly the same value it reached during the Summer of that prior year. It wasn’t until October of 1987, of course, that stocks made their famous plunge but investors who sold early weren’t kicking themselves for very long.

Stocks may, in fact, be even more overvalued than the numbers suggest. Bank earnings are arguably inflated to a significant degree due to new accounting rules that allow

them to prop up the value of certain assets, remove certain losses from stated earnings and record some very dubious gains. Essentially, the big comeback for the banks over the past year has been largely created by accounting concessions from the FASB. This is not easy to quantify, of course, but should nonetheless be factored into consideration when analyzing equity valuations.

Things don’t look a whole lot better for stocks from a technical perspective. The S&P 500 recently reached an important point of resistance. The 1121 price level for the index marks the fifty percent retracement of the decline that began in 2007. Ironically enough, November 21^st (1121 on 11/21), roughly the first time the index approached this level, also marked the fifty percent time retracement of the decline. Many skeptics wonder if support and resistance levels such as this one are effective because they are meaningful in and of themselves or if they work simply because traders focus on them so intently. In either case they do frequently mark turning points. For this reason we have been watching the 1121 level very closely for the past couple of months and stocks have, indeed, made little progress so far in surmounting it.

Sentiment, fundamentals and technicals, then, are all flashing a caution signal right now and we are heeding their warning. To take advantage of the potential for a healthy reintroduction of fear into the markets Barclay’s iPath S&P 500 VIX Short-Term Futures ETN (NYSE symbol: VXX) looks to be a logical choice and we do own it in our managed accounts. Should the “Fear Index” rise in 2010, VXX will rise with it and it looks as if there is plenty of room overhead.

To address the current overvaluation and resistance for stocks, we believe it prudent to at least hedge exposure to the stock market. Our vehicle of choice for this is the UltraShort S&P 500 ProShares (NYSE symbol: SDS) which we also own for clients. We prefer this to an outright short position simply because it is much easier to manage. As a short position goes against you it increases in value becoming an even bigger losing position. SDS, however, works more like a long position and decreases in value as it moves against you. A short sale also has the potential for unlimited losses; short-biased ETFs like SDS have limited potential for losses. This is a very simple but very important difference, especially to the average investor or trader who lacks experience in managing short sales.

The Economy in the Balance

The rally of the past ten months, in addition to easing the minds of investors, has seemingly papered over the major causes of the crash. That these problems have yet to be adequately addressed seems to matter little to investors right now. We believe, however, there is a high likelihood that investor apathy towards these issues may disappear just as quickly as it arrived.

The credit crunch is still on and shows no signs of improving. According to research conducted by Asha Bangalore at Northern Trust, net private sector lending fell $2.3 trillion in the third quarter, the first decline ever recorded in this measure. Banks are reluctant to lend money, instead focusing on shoring up their beleaguered balance sheets. In addition, both consumers and business are reluctant to borrow. Just like the banks they are focusing instead on improving their financial strength.

This is precisely the situation Richard Koo, Nomura Chief Economist, has dubbed a “balance sheet recession,” the likes of which has plagued Japan for the past couple of decades. What makes a balance sheet recession uniquely difficult for policy makers to address is the zeitgeist of deleveraging, the process of paying down debt in order to improve the balance sheet. Standard economic stimulus does not have its usual effect when the money pumped into the system by the central bank does not end up in circulation because of lenders’ unwillingness to lend and, perhaps more importantly, borrowers’ unwillingness to borrow no matter how low rates get.

In order to really understand the concept, imagine you are a credit worthy business or an individual with the ability to borrow money for next to nothing. Still, you decide not to take on any new debt no matter the opportunities available to put the money to use because of your rational fear of leverage, a fear developed by your experience of bubbles in the stock market and real estate and their aftermaths. No, you will not go down the path of greed as so many did then; their greed was far too costly. You will use every last penny you earn to pay down debt and to build savings in order to avoid the mistakes you witnessed so many make. After the experience of the past decade in the United States, this should not be so difficult to envision.

This focus on deleveraging further reduces demand in the economy causing a vicious cycle of economic retrenching. Basic economics teaches us that money spent stimulates the economy by becoming the earnings of others which is, in turn, spent in a fortuitous cycle of economic growth. Money saved, however, goes into the banking system which would normally be lent out for investment or other types of spending. In a balance sheet recession this money isn’t lent out (for reasons mentioned earlier) and therefore does not add to economic activity removing a key component of economic activity. Because more money is saved and not then lent out demand drops causing businesses and consumers to further retrench in a vicious cycle that leads to a depression.

Now imagine running a central bank in a country where every business and individual is acting this way. How can you possibly stimulate an economy that has been poisoned by the fear of debt when all of your tools promote precisely that which everyone is afraid of? This is the dilemma Japan has faced for a long time and is now a

very real prospect for America. In fact, there are many signs that this is precisely what we are seeing in the U.S. economy today.

Comstock Partners recently drew some fascinating parallels between our current situation and Japan’s economic problems that began in the late 1980’s:

The similarities between Japan’s deleveraging since 1989 and the U.S. presently are eerie.  Japan’s total debt to GDP increased from 270% when their secular bear market started to just about 350% eight years later (1998) before declining to 110% presently.  The U.S. increased their total debt-to-GDP from 275% of GDP when our secular bear market started in 2000 to 375% presently (10 years later), and we suspect a total debt decline similar to Japan’s even though the Japanese government debt tripled during their deleveraging.  The government debt relative to GDP was about 50% in both the U.S. and Japan when the secular bear market started.  We also suspect that our government debt will grow substantially just like it did in Japan as the private debt collapses.  The private debt in Japan decreased substantially from the peak seven years after the secular bear market started (dropping from 270% of GDP to 110% presently).  If the U.S. were to follow Japan’s deflationary road map, we would expect our government debt to increase from about $7 trillion (net government debt not including the debt used to fund Social Security) to about $21 trillion and the private debt to decrease from about $39 trillion to around $20 trillion.  Also, the Japanese stock market doubled during the three years preceding their secular bear market in 1987, 1988, and 1989 while the U.S. market also doubled during the three years preceding the beginning of our secular bear market in 1997, 1998, and 1999.

Clearly there are distinct similarities between our recent economic experience and Japan’s. America, having followed Japan down the path of economic gluttony is now very likely to undergo a similar, prolonged deleveraging that will manifest as a severe economic challenge for the powers that be. We would do well to learn from their example.

A classic symptom of a balance sheet recession can be found currently in the U.S. mortgage market. The New York Times recently reported that despite the lowest mortgage rates since the 1940s, refinancing of existing mortgages has dropped dramatically. In addition, mortgage applications to purchase property also recently fell to their lowest level in over a decade. Indeed, credit is more difficult to come by but we believe that demand for credit has also diminished dramatically. After more than a decade of binging on credit Americans certainly have some catching up to do in the savings department.

Statistics clearly show just how debt-dependent American consumers have become over the past twenty years. Historically, the household savings rate has averaged roughly ten percent of disposable income. Beginning in the mid 1990’s, as the stock market boomed with the internet bubble which was closely followed by the real estate bubble, consumers felt no need to save at all and for the first time since the Great Depression the savings rate actually went negative by 2005. This caused household debt relative to gross domestic product to soar from an average of sixty percent before the twin bubbles began to nearly one hundred percent over the past fifteen years. Consumer debt relative to income has also risen to similarly astronomical levels and must come back down to earth.

An argument can even be made that the current U.S. economic predicament may be more detrimental than Japan’s. Japanese households maintained a prudent level of saving throughout the economy’s bubble cycle. It was the corporate sector in Japan that really binged on debt supported by rapidly rising asset prices of the country’s real estate and stock market bubbles. Thus the major impediment to Japanese growth over the past couple of decades has been corporate deleveraging in the aftermath of those bubbles. Considering the fact that consumers make up the majority of our economy and both the consumer and corporate sectors need now focus on debt reduction it is easy to see how our economic problems could prove even more troublesome than Japan’s.

Ultimately, the past two decades of fiscal debauchery by both businesses and consumers have caused an economic hangover that can only be healed with time and increased fiscal conservatism. This, however, is the perfect prescription for a deflationary vicious cycle as described earlier. Signs in the financial markets suggest this is precisely what we are seeing right now.

The once-in-a-generation crash in asset prices, including stocks, real estate, and commodities over the past two years also goes a long way towards making the case for deflation. (Despite the rally in these asset classes of late they are all still a long way from their highs of only a few years ago). Recent trading in the dollar confirms the idea that deflationary forces are in effect. Despite popular sentiment, the greenback looks to be throwing off its long-term malaise and should be poised to rally over the coming months. As the dollar gets more expensive, by definition alternatives must depreciate in value. The “cash is king” mantra of only a few months ago may soon make a comeback. Even commodities uber-bull and inflation prophet Jim Rogers recently said he’s loading up on dollars as the inflation trade has gotten too crowded for his contrarian sentiments. A deflationary dollar rally is now underway.

Aside from deflationary signals there are plenty of signs that our current economic slowdown is more than just your run of the mill recession. We discovered a more obscure statistic while sorting through Robert Shiller’s stock market data: the bear market in stocks was punctuated by the largest earnings crash in history. Earnings for S&P 500 companies declined over ninety percent over the past two years. Even the seventy-five percent crash during 1929-1932 doesn’t quite compare to our more recent history. This is a very important statistic we believe very few investors are aware of that makes a “v-shaped recovery” a long shot, at best. It took earnings twenty years to recover after the 1929 crash. How can we expect our recent earnings crash that was significantly more painful to fair much better in its aftermath?

To further throw water on the stock market rally and the hope for a quick economic recovery, job losses during this “Great Recession” have been roughly three times greater than the average post-World War II recession and show no sign of improving. Mortgage rate resets will continue to grow in 2010 hampering any improvement in the real estate market. Commercial real estate is now following residential real estate into the abyss further weakening the already precarious state of the banks’ balance sheets. In fact, the FDIC recently announced they will be dramatically raising their operating budget to increase hiring in order to accommodate an increasing number of bank failures in 2010. This doesn’t strike us as a vote of confidence from the feds.

Ultimately, the only growth in the economy right now, according to the venerable Paul Volcker, is artificially created by government stimulus which is not self-sustaining. If Richard Koo is correct, continued stimulus will be necessary to prevent the country from falling into a more severe economic predicament. This stimulus must be geared more towards large spending projects on infrastructure and related projects rather than the typical supply side remedies which are impotent in this kind of environment.

All of this is to say that the possibility of continued economic weakness as described by the term “Balance Sheet Recession” is a frighteningly real possibility for our country even it is not the most probable outcome. We believe investors would do well to factor it into their portfolio plans.

Opportunities to do so may be found in shorting some of the major currencies that have benefitted most from the dollar’s weakness over the past few years such as the Euro, British Pound, Australian Dollar and Canadian Dollar. The ProShares UlraShort Euro (NYSE symbol: EUO) is one option that we have owned in client portfolios for the past month or two.

In addition, we believe that over the next few years leading up to the 2012 presidential election the Obama administration will follow through with a policy of massive spending on the country’s infrastructure to create jobs and promote a sense of hope and renewal. According to Richard Koo this is also the most effective form of economic stimulus during a balance sheet recession. From a sector perspective infrastructure plays such as aerospace, heavy construction and industrial equipment, may prove rewarding in this kind of environment. We don’t have any specific recommendations here just yet but we’re keeping our eyes open.

Needless to say we don’t believe the hype surrounding the inflation trade, at least not yet. For those looking to profit from deflation, long-term treasuries yield over four percent currently and if yields decline even back to the levels we saw a year ago, price appreciation will be significant. The Barclay’s iShares 20+ Year Treasury Bond Fund (NYSE symbol: TLT) is an easy way to gain exposure here. This trade, though, requires a careful eye on any signs of inflation for we may, indeed, see inflation at some point down the road. However, until all the money printing actually reaches the official money supply (a dubious prospect) we don’t think inflation concerns need outweigh those for deflation. In fact, it may turn out that we see zero-percent interest rates for a very long time, ala Japan.

What is encouraging about Japan’s example is that despite experiencing an even greater relative loss of wealth than that brought about by the Great Depression, Japan has managed to keep its economy from collapsing through perpetual government stimulus measures. However, while we mark this lost decade for stocks, Japan is now marking two lost decades. We should hope we don’t suffer a similar fate but we should also be prepared if, in the words of Mark Twain, history “rhymes.”

For a printable version of this issue download the PDF version here:

January 2010