MarketThoughts' Thanksgiving Greetings
(November 30, 2008)
Dear Subscribers and Readers,
I hope all our subscribers in the US had a wonderful Thanksgiving Holiday! To both our US and international subscribers: While 2008 has been a traumatic year for all of us, we should all be thankful for what we have. In particular, both Rex (my partner and webmaster) and I are very grateful for all your support and words of encouragement during these difficult times. I look forward to working with all of you as we move forward into the new year.
Despite the ongoing financial crisis that began about 18 months ago, and despite the latest terrorist attacks in Mumbai, India, we still live in an era of unprecedented material prosperity and religious and social tolerance. If you are reading this email, chances are you are better off in material wealth than 90% of the world's population (although we haven't done a formal survey of our subscribers' wealth levels!). The world's greatest R&D labs and institutions - the keys to our long-term productivity growth and wealth creation - are still working as hard as ever, with more knowledge and tools than ever to aid them in their quests. According to the National Science Foundation (and not surprisingly), graduate enrollment in the science and engineering fields tends to have a highly positive correlation with the unemployment rate. Given the latest readings of the US and global economic leading indicators, I expect the US unemployment rate to peak in the range of 8% to 9% sometime in the next 12 to 18 months. Rather than charting a career as an investment banker or hedge fund manager, many of our smartest students today will instead go back to fields that Americans have traditionally been known to excel in - and in careers that will expand the growth potential of the US and the world. As the old saying goes, this financial crisis too, shall pass. And once it passes, I believe the US and global economy will embark on its one of its greatest growth trajectories in modern history.
Looking back at 2007, it was painfully obvious that the global economy, and global equities in particular, were exhausting its growth potential - and not just because of the tightening monetary policies as enacted by most of the world's central bankers beginning in 2006. As we discussed in our April 27, 2008 commentary (“Reflections and Black Swans”), there are 7 points we need to be concerned about when evaluating the future earnings power (on an EPS basis) of the US stock market. As of late 2006 and early 2007 - and over the course of the last two years - many events/indicators that had a major impact on one or more of the 7 points were indicating that the market was making a major top. Following is a quick, and obviously, non-exhaustive list:
- The era of the cheapest financing in modern history peaked in late 2006. Many leveraged companies that were not profitable during even "normal times," were expanding their operations wily-nilly. This means many firms were actually destroying capital, as much of their marginal returns from new projects (e.g. Las Vegas Sands building its umpteenth casino in Macau, Wachovia buying Golden West at the peak of the subprime bubble, and First Marblehead's business model of solely relying on the student loan ABS market for financing ) were significantly below their long-run costs of capital.
- US corporate profits as a percentage of US GDP peaked at a 40-year high. Obviously, this abnormally high percentage of corporate profits was skewed by the fact that nearly 50% of earnings of the S&P 500 companies now come from their foreign operations. In addition, companies have had the unprecedented opportunity to widen corporate profit margins by taking advantage of the "global labor arbitrage," resulting in the widest disparities of income in the US since the 1920s. Unfortunately (for equities), such a trend was not sustainable. As housing prices stopped rising, US consumers became tapped out (at least temporarily). At the same time, it became clear that foreign (in particular, Asian) consumers could no more "replace" the American consumer than CDOs could replace traditional mortgage securities. Despite the fact that P/E and P/CF ratios in late 2007 were still at decent levels on a historical basis, it became painfully obvious that ROEs of American and global companies were at an extreme high.
- Unlike the busting of the unions and the advent of the PC in the 1980s, the fall of Communism and the advent of the internet in the 1990s, there were no more "killer apps" that had the promise to drive further Ricardian or Schumpeterian growth over the next five to ten years. On the contrary, the spike in commodity and transportation prices during the last two years were threatening globalization and free trade itself (Ricardian growth). To add insult to injury, it became painfully obvious even to a six year-old that this country has failed to invest in her long-term productivity growth and health, as: 1) Our highways clogged up (for the first time in a long time, railroads were able to make sizable economic profits), 2) Steam pipes in New York burst while a bridge in Mississippi collapsed, 3) Despite the build-out of fiber optic networks during the late 1990s and WiMax over the last five years, most homes in urban areas were (and are) still accessing the internet via DSL or cable, 4) Tons of engineers and scientists were leaving for Wall Street in droves as the lure of money became too much (note that CFA enrollment had increased exponentially as well), and as the NIH and other institutions were starved of funding by the Bush administration, and 5) The promise of significant breakthroughs and commercialization in the biotech, nanotech, and alternative energy sectors never materialized. With respect to the biotech sector, the sequencing of the Human Genome in 2000 by Celera actually added further complexties to the drug development process, as scientists found out that genomics was a much more complicated field than they ever expected (in the long-run, however, the sequencing of the Human Genome would inevitably allow scientists to produce gene-specific drugs/treatments).
- While the New York State government was (relatively) masterful in managing the plights of the bond insurers (Ambac and MBIA), the federal government erred when it expropriated and severely diluted Fannie's and Freddie's shareholders in early September - despite the fact that Fannie Mae had just raised $6.5 billion from shareholders in May,. Four months later, shareholders took more than a 90% loss when the government stepped in without much warning in early September. In many respects, this unilateral action to expropriate assets created even more uncertainty for shareholders than the laissez-faire scenario. This resulted in shareholders pulling back from the recapitalization process for financial institutions - i.e. until the US Treasury decided to use $250 billion of the TARP bailout pool to recapitalize financial institutions at a relatively low cost for shareholders. To add insult to injury, the US Treasury did not provide any further help to bring GSE spreads down until last week - despite the fact that it had already explicitly guaranteed the entire agency MBS market in July.
- Two weeks after the "GSE rescue," the government let Lehman file for bankruptcy. While the TED and CDS spreads have been coming down since the March bailout of Bear Stearns, the Lehman bankruptcy triggered another avalanche of liquidation, as hedge funds, investment banks, and even pension and sovereign wealth funds stayed away from the financial markets. To compound the problem, many of the largest companies in the US quickly went into "cash conservation" mode - eliminating stock buybacks - which had been one of the major pillars that had supported stock prices over the last few years. With pension funds, insurance companies, sovereign wealth funds, and retail investors all pulling back, there were no one else left to buy equities or other risky assets.
Fortunately, this malaise in the stock and financial markets, too, shall pass. After a global $2.6 trillion of direct bank recapitalizations and announced fiscal stimulus packages (with more to come from the Euro Zone), and another $2.7 trillion of loan guarantees and low cost loans (with the majority of these announced in the last few months), things are now starting to quiet down. For the first time in a long time, we are not stuck to our computer screens on a Sunday evening to see whether the government is going to bail out another financial institution - the potential GM bailout notwithstanding (but this doesn't come until Monday evening). Moreover, as I have discussed before, the summer spike in commodity prices and the latest shakeout was necessary in that it brought us back to our senses. As the Federal Reserve and US Treasury found out to their dismay a couple of months ago, what we need now as a country are coherent policies - not just in the financial sector but in the energy and most probably healthcare sector as well. Moreover, our smartest students are now going to enroll in science, mathematics, and engineering-related graduate programs instead, as opposed to migrating to Wall Street, London, Hong Kong, Shanghai, or Dubai. Baby boomers will work harder than ever - many recent retirees (those who have the skill sets and the knowledge) will now choose to work part-time or on a consulting basis as they realize they cannot safely rely upon their equity (or for that matter, corporate bonds) investments for a steady retirement income. Business owners who were running capital-destroying businesses (with returns lower than their long-term cost of capital) will find other endeavors to create more wealth. The Obama administration should also react to the 2007 spike in commodity prices by allocating dollars to alternative energy and other science research - which is key to long-term productivity growth not only in the US, but around the world as well. Even assuming that corporate profits remain relatively depressed into 2009, I continue to believe that risky assets (including equities) are a "buy" at current levels.
Of course, we should not remain oblivious to the current financial crisis. For those that are working in very cyclical industries (such as manufacturing, restaurants, retail, etc.), it is time to batten down the hatches as the shakeout in these sectors will most likely continue into the end of 2009. For our Australian and Canadian subscribers, my best guess is that commodities in general peaked during last summer. Assuming crude oil rises back above $70 a barrel, current projections show that cellulosic ethanol production should be economical by the end of 2010. In parts of California and Texas, solar power should also reach "grid parity" by the end of 2012. With better and more efficient battery technology being commercialized in the next couple of years, I believe crude oil consumption in the developed world will remain stagnant for years to come - if not outright decline. In as little as five years, most of these technologies will have also been adopted by countries such as Brazil, China, Russia, and India. As I have also mentioned in our commentaries, there is now tremendous progress being made in the research of carbon composite materials (e.g. the Boeing 787) and even carbon nanotubes. The boom in Alberta oil sands and Australian iron ore was fun while it lasted - it is now time to be more creative in solving the world's problems and generating more wealth as opposed to "living off the land," so to speak.
In the more immediate timeframe, look for the Bank of England to again cut rates this week. I expect the Bank of England to cut by up to 100 basis points, as the Committee was pondering a cut of up to 200 basis points in its last meeting (it settled on a 150 basis point cut as it worried that a 200 basis point cut may unsettle the markets). Since then, the UK economy has taken a turn for the worse. As for the Euro Zone, there is no question that the European Central Bank is now 150 basis points behind the curve, if not 200 basis points. Unfortunately - just like its ill-considered 25 basis point hike in July - there is no reason to expect the European Central Bank to be any more competent than it has been so far (the Euro Zone yield curve is currently flat - a mind-boggling development given that the Euro Zone is rapidly sinking into a recession). Current consensus has the European Central Bank cutting by 50 basis points, but I will be more optimistic and predict a 75 basis point cut - given the disappointing market reaction immediately after the ECB's last rate cut.
The ECB's lack of urgency is disappointing, as: 1) With the exception of Germany, the majority of the Euro Zone's countries had experienced a housing bubble larger than the US housing bubble, 2) The Euro Zone cannot export their way out of their economic problems, given the still-high Euro and a potential global recession, 3) Aside from Germany, no other country in the Euro Zone can credibly implement a fiscal stimulus to spur economic growth, given the region's high debt-to-GDP ratios and budget deficits. Germany so far has only discussed a potential two-year $50 billion stimulus - which represents only a drop in the bucket. More ominously, the Euro Zone's biggest customers and biggest borrowers (i.e. Central and Eastern Europe) are now plunging into recessions of their own and have huge negative cash flow problems (e.g. Greece is highly leveraged to the depressed shipping industry and is running a current account deficit equivalent to 10% of its GDP). Banks in the Euro Zone, in particular, have lent close to 4 trillion Euros to Central and Eastern Europe. Before this is over in Europe, I expect many more IMF bailouts and a potential global bailout for some European commercial banks. Make no mistake: Bankers in the Euro Zone have been as (if not more) reckless than their counterparts here in the United States.
Assuming the ECB cuts by 75 basis points or more this week, any potential systemic problems from the Euro Zone, and Central and Eastern Europe will most likely be delayed until next year. Other measures that could avert a potential systemic collapse in Europe could include: A larger-than-expected fiscal stimulus, accompanied by income tax cuts, in Germany; more decisive action by the IMF in Central and Eastern Europe, with fewer strings attached; and concerted action by the Bank of Japan and other central banks to bring the Yen down, as many countries in Central and Eastern Europe have borrowed in Yen (as well as in the Euro, the USD, and the Swiss Franc). For now, we will continue to monitor the deteriorating situation in Europe and not hold our breath.
Once again, I hope all of you had an enjoyable weekend. Take good care, everyone.
Henry To, CFA