Sturm und Drang, a German movement emphasizing extremes of emotion, translates roughly to Storm and Stress and that seems an accurate description of the current state of affairs. The storm is the “credit crisis” which has become a convenient scapegoat for everything, from cash strapped local governments to the flailing Big Three automakers who aren’t very big anymore and likely to be less than three sometime in the near future. The stress is being felt by anyone unfortunate to hold any investment other than short term Treasury Bills.
You’ll notice that I put credit crisis in quotation marks and there is a good reason for that – the “credit crisis” is mostly a myth if one believes the statistics released by the Federal Reserve on a weekly basis. Certainly, there has been a tightening in lending standards – at least if bank loan officers are to be believed – but finding concrete evidence of an actual credit shortage is as hard as finding someone who will admit to voting for John McCain. Take a look at Total Bank Credit at Commercial banks:
The spike over the last month was due to companies drawing down existing lines of credit. Financial companies have done that because the financial commercial paper market has collapsed by about 75%. Non financial companies have done that primarily as a precaution. The lines of credit were in place prior to the “crisis” and companies are drawing them down just in case they need cash. In other words they don’t need the cash now but the Bernanke/Paulson/Bush induced panic convinced them they should take the cash while the taking was good. The key is that while the financial commercial paper market has shrunk, total credit has not – at least not yet.
The commercial paper market has changed, but it should not be surprising that financial companies are having trouble raising short term funds:
Notice though that it is financial (red) and asset backed (yellow) commercial paper that is shrinking. The Non-financial sector (blue) is still expanding which is a sharp contrast from the last recession. Consumer credit is also still expanding at least through September:
So what does the financial and asset backed commercial paper market finance? Financial commercial paper is issued by banks and mortgage companies to fund, among other things, mortgages and daily operations. Asset backed commercial paper is issued by companies that use that money to buy things like auto loans and credit card receivables. The drop in issuance of this type of paper has mostly been offset by increases in long term debt and the use of existing credit lines. This isn’t just a matter of demand either; companies are not issuing as much paper because they are using other cheaper and longer term financing sources.
Do we have a credit crisis? It doesn’t appear so, but you don’t have to take my word for it. The Minneapolis Federal Reserve just released a paper entitled, “Facts and Myths about the Financial Crisis of 2008”, in which they conclude that the three widely accepted beliefs about the crisis are indeed false. They conclude:
Our main point is that policymakers have not done the hard work of convincing the public – or even academic economists – of the precise nature of the market failure they see, of presenting hard evidence, not speculation, that differentiates their view of the data from other views, and the logic by which the particular intervention they are advocating will fix this market failure. We feel that a trillion dollar intervention warrants a bit more serious analysis than we have seen.
Yes, one would think that some serious analysis would be required before committing $1 trillion (at least) to combat a problem that may not exist except in the minds of politicians, but that train has left the station. Absent the mindless panic of the political class, we were in for a fairly normal and shallow recession. Now, after spreading the fear of economic collapse far and wide, we face something more serious. The economy basically came to a standstill in October and the economic statistics are starting to bear that out. We have entered the land of the self fulfilling prophecy.
Retail sales are falling:
Durable Goods orders are also falling but notice that the decline is not yet as severe as the last recession:
Payrolls declined again but again the decline so far is modest compared to the last recession:
Industrial production fell off a cliff in September due to the Boeing strike and a hurricane in the Gulf, but bounced back some in October:
Housing starts are still weak and likely to remain that way for a while longer as we work off the excess housing inventory. On the other hand starts are at levels that have been bottoms in the past and once again we find this is not unprecedented as so may have claimed:
The Institute for Supply Management (the old purchasing manager’s report) was also down significantly last month, but again not out of the ordinary for a recession:
Obviously, if this recession turns out as bad as the ones in 1974, 1980 or 1981-2, we’ve got more to go on the downside. I don’t think the comparisons to the 1950s recessions are relevant because manufacturing made up a much larger portion of the economy back then, but the point is that what we are seeing is consistent with a recession, not a depression. The current economic statistics are consistent with a drop in GDP of 3-4% for the 4th quarter. Predicting anything further out than that is just a guessing game. The ISM is a very good coincident indicator for the stock market as well; when the ISM bottoms that will likely be the bottom for the stock market. That has been the case in every recession since the beginning of the series.
The economic situation is not particularly good right now but neither is it alarming when placed in the context of past recessions. What most people are worried about though is the idea that this is not a normal recession but something much worse. A recession, while painful, is not a bad thing. The mistakes made in the last boom need to be corrected. We borrowed too much, spent too much and invested too much in housing. Those things need to be corrected so we can have future growth. We need to save more, spend less and absorb the excess housing. All of those things take time and anything we do to interrupt or slow that process will just delay the day of recovery.
The only major difference between the current slowdown and recessions of the last 50 years is the level of debt. Total US debt is now roughly 350% of GDP while the long term average is around 130% of GDP. The problem with that level of debt is that if we fall into deflation, the debt becomes ever more onerous. That is what happened in the early 1930s and it led to the Great Depression. The good news is that Ben Bernanke is a Depression scholar and is doing everything he can to prevent that outcome. This can be seen in the growth of the monetary base:
The bad new is that Bernanke is a Depression scholar and is inflating the monetary base. If he doesn’t remove this excess money from the system at some point, we will get massive inflation. Right now, he is just offsetting the deflationary impact of falling asset prices while consumer prices are still rising, but once the asset deflation has run its course, this excess money will start finding its way into the real economy. The result will be inflation.
Right now, I see no reason to believe that this is anything other than a recession. It may be a deep one like we had in the 1970s or early 1980s but it is still just a recession. The debt load will limit growth once the recession is over, but it shouldn’t prevent a recovery as long as the Fed is proactive with monetary policy.
Over the last year, every asset class we use in our portfolios, with the exception of Treasury Notes, has fallen in value. That has never happened in the 25+ years of data we have compiled on this strategy. It is possible that will change before the end of the year but even if it does, this year’s returns are unlikely to change from negative to positive. The question I’ve been asking myself over the last two months is whether this strategy is somehow flawed and if a change of course is required. My conclusion, after extensive research, is no.
The only thing the last two months proved is that just because something has never happened does not mean that it can’t. The economic circumstances of the last two months, while not unprecedented, are extremely rare and that produced an extremely rare outcome for our portfolios. That outcome was a result of extreme risk aversion which encompassed all asset classes. That condition will not persist indefinitely and when it ends, our portfolios will recover. What I can’t tell you right now is which asset class will be the leader when risk taking resumes.
There are a number of possibilities on how the recovery will proceed. As I mentioned above, depending on Fed actions, we could be facing a period of inflation. If that is indeed the outcome, I would expect commodities and real estate (yes, real estate) to lead our portfolios higher. If on the other hand, the Fed is successful in removing the excess money before it affects inflation, I would expect stocks to be the main beneficiary. I have no way of knowing which outcome is more likely, although my best guess is the inflationary one. If that is the case, our portfolios contain assets that will benefit.
For now, I am spending the majority of my time doing research so that when the recovery arrives, I will be able to deploy our cash quickly and efficiently. All asset classes are cheap right now. The stock market is trading in the bottom 20% of valuations that have prevailed over the last century. Commodity companies are trading at multiples that are unprecedented based on the price of the underlying commodities. Real Estate Investment Trusts are trading with dividend yields that are back to the long term average of around 9%. Foreign stocks, particularly in Asia and other emerging markets, have fallen even more than US stocks. In short, opportunities abound. I am just waiting for a catalyst to make further long term investments.
The current environment is marked by extreme pessimism and many have taken that as a signal to avoid risk, but history has shown that it is during times such as this that investors should be doing just the opposite. Some very successful investors are now starting to buy stocks. Warren Buffet has maintained a large cash balance in his personal account and at his company for many years. He is now buying stocks. Jeremy Grantham, another very successful if less well known investor, has been bearish since the late 1990s and is now buying stocks. Marty Whitman, 85 years young and still running the Third Avenue Value Fund, has described his mood as “giddy” at the value being created. The fact is that the fall in the stock market means that future returns are likely to be higher than the recent past. That’s how the market has always worked; buy when things look terrible and build up cash when things look good. The only way an investor can buy low is to buy during times like this. If you’re investing for longer than the next few quarters, this is not the time to shrink from making good long term investments. I will be doing exactly that over the next few months as I try to ignore the Sturm und Drang.