Sept, 2001

“the new housing boom is another rapidly inflating asset bubble financed by the same loose money practices that fuelled the stock market bubble.”

Aug, 2002

“While the short-term effects of a housing bubble appear very beneficial—just as was the case with the stock bubble and the dollar bubble—the long-term effects from its eventual deflation can be extremely harmful, both to the economy as a whole, and to tens of millions of families that will see much of their equity disappear unexpectedly. The economy will lose an important source of demand as housing construction plummets and the wealth effect goes into reverse. This will slow an economy already reeling from the effects of the collapse of the stock bubble of 1999, … Unfortunately, most of the nation’s political and economic leadership remained oblivious to the dangers of the stock market and dollar bubbles until they began to deflate. This failure created the basis for the economic uncertainty the country currently faces … [which] will be aggravated further by the deflation of the housing bubble. This process will prove even more painful if the housing bubble is allowed to expand still further before collapsing.”

2003

“I am very pessimistic. We are heading into something in the world which is worse than what we experienced in 1982. It will be the worst recession since the Second World War.”

“The reckless financial policies of leading western powers in the last two decades make it likely that the next seismic debt crisis will be in America, not Argentina. It can be avoided . . . only by serious efforts to bring regulation and balance to the international economy.”

“There will be a collapse in the credit system in the rich world, led by the United States.”

Wake the President

Most days we can coast along, confident that tomorrow will be much like yesterday. On a very few days we need to look hard at the news headlines, click through to read the whole story, and then completely change a large chunk of how we thought the world worked. Today is such a day.

Everything you knew or thought you believed about the European economy – and the eurozone, which lies at its heart – was just ripped up by financial markets and thrown out of the proverbial window.

While you slept, there was a fundamental repricing of risk in financial markets around Europe – we’ll see shortly about the rest of the world. You may see this called a “panic” and the term conveys the emotions involved, but do not be misled – this is not a flash in a pan; financial markets have taken a long hard view at the fiscal and banking realities in Europe. They have also looked long and hard into the eyes – and, they think, the souls – of politicians and policymakers, including in Washington this weekend.

The conclusion: large parts of Europe are no longer “investment grade” – they are more like “emerging markets”, meaning higher yield, more risky, and in the descriptive if overly evocative term: “junk”.

This is not now about Greece (with 2 year yields reported around 20 percent today) or Portugal (up 7 basis points) or even Spain (2 year yields up 27 basis points; wake up please) or even Italy (up 6 basis points). This is no longer about an IMF package for Greece or even ring fencing other weaker eurozone economies.

This is about the fundamental structure of the eurozone, about the ability and willingness of the international community to restructure government debt in an orderly manner, about the need for currency depreciation within (or across) the eurozone. It is presumably also about shared fiscal authority within the eurozone – i.e., who will support whom and on what basis?

It is also, crucially, about stabilizing the macroeconomic situation without resorting to more unconditional bailouts. Bankers are pounding tables all across Europe, demanding that governments buy out their position – or bring in the IMF to do the same. We again find ourselves approaching the point when the financial sector will scream: rescue us all or face global economic collapse.

The White House did not see this coming – and the Treasury’s attention was elsewhere. The idea that we can leave this to the Europeans to sort out is an idea of yesterday. Today is very different and much more scary.

President Obama is wide awake and working hard. Someone please tell him what is really going on.

For example, is Sarah Palin going to be the Republican nominee in 2012? Here are the odds over time that the members of Intrade have set by virtue of their betting. The chart shows the market makes Palin’s odds at about 25%.

Will the U.S. economy enter another recession in 2010? The market speaks:

As you can see, the market has deemed the chances of recession this year to be about 11%, a considerable decrease from the beginning of 2009, when the odds were pegged at about 45%.

What about the odds of a severe stock market crash? The market puts the chances of the Dow closing at under 6500 by the end of the year at just 10%.

Other events you can bet on:

• Will the U.S. establish a cap and trade emissions system by the end of this year?
• Will AIG repay all its TARP funds by the end of the year?
• Will California experience a “credit event” (bankruptcy, default, debt restructing, etc.) by the end of the year?

And what are the odds that you’ll lose your shirt betting on stuff like this?

Higher than 50%, I’d say…

Some commentary:

Mish’s Global Economic Trend Analysis

I do not like Munis here. For starters, I think there will be a number of counties in Florida that go bankrupt. Harrisburg, Pennsylvania (the state capitol) is likely to go bankrupt as is Detroit, Michigan.

Yes, everyone is aware of those.

However, when liquidity is flowing everywhere, as it has been since March 2009, nothing seems to matter. Indeed, it is easy to be complacent because nothing matters. The correct way of thinking about this is: nothing matters “now”.

Add in a few cities going bankrupt in California, and in a liquidity crisis I can practically guarantee it will matter. Although there may be some good bets out there, munis seem to be richly priced which means there are better opportunities ahead.

Liquidity is a coward. 2008 in the face of Bernanke’s heroic efforts should be proof enough. Should panic strike again, far better prices lay ahead.

What applies to munis also applies to junk bonds, corporate bonds, and the stock market as well. Whatever you are holding, take some chips off the table.

Bondview.com

Buffet says ” when the tide goes out, you get to see who is swimming naked”.

Harrisburg bonds (41473EFH9) are a mess due to what appears to be wasteful spending. Is this representative of a nationwide muni default? In a word NO. So what happened in Harrisburg?

According to our sources, the Harrisburg incinerator that will likely burn bondholders was a mechanical engineering boondoggle dating back to its inception and went through several refits in an attempt to get it functioning to meet environmental standards. But by then it had acquired so much debt, it could not possibly cover its costs. So now the city and Dauphin County are on the hook for what amounts to about $10k per citizen!

Here is the list of this bond’s trades.

It hasn’t traded Nov 2008. The lack of interest in trading this bear is no surprise since the Harrisburg municipality filed a July 2009 material events notice .

The former Mayor Reed – king of the city for 24 years may have tried to make the city a better place to live but the spending went far out of control. He spent tens of millions building the “national” civil war museum even though Gettysburg is just a 45 minute drive from Harrisburg with it’s own museum run by the national park system. When it was obviously not performing, the Mayor argued it was because the city needed a critical mass of museums before it could be a success. So he planned 5 more including a wild west themed museum! He spent tens of millions on acquiring artifacts, the purchase of which he allegedly personally handled. When finally forced to sell these, the city got less than 20 cents on the dollar. Turns out he’s quite the history buff and many of the artifacts allegedly decorated his office while awaiting the building of the museums. Gee if a small business owner did that an IRS agent would have a field day. But since it was public monies that were spent, no crime but certainly a foul.

This is a case of public spending gone crazy. Where were the auditors? Lumped on top of this self created mess is the local government can’t afford to continue to platinum healthcare & pension benefits to police, fire and teachers. In good times, fat pensions stress cities’ finances and increase our taxes. But In bad times, these debts break the camels back .

Good media sources on this topic include the excellent WSJ article “Muni Threat: Cities Weigh Chapter 9 (2/18/10) Harrisburg Authority, city miss debt payment; Dauphin County pays”

That said, the Harrisburg bond problem doesn’t seem representative of a nationwide muni default. With muni rates still low, the problem is a sick facility pushed over the edge due to unique bad economic times. What is interesting is cities may well choose, or be forced to use Chapter 9 causing sweetheart city employee union contracts to be squeezed followed by layoffs. But bondholders will suffer too. Interest payments may be frozen, effected bonds prices will drop 50%+ and when the dust settles, private equity players will swoop in and buy the distressed assets on the cheap. Bahhh and good luck to all

Economists Do It With Models tries to explain this in a little more detail and in layman’s terms:

Hedge fund guy: I think the housing market is going to go to s**t in the next few years. More specifically, I think I know which parts of the housing market are particularly vulnerable. In order to profit off of this information, I would like to short sell a financial product that is tied to the housing market. In other words, I’m going to borrow one of these securities, sell it at the current high price, buy it back once it’s worthless and then give it back to the original owner, keeping the profit for myself. (Update: Technically the short position was achieved via a credit default swap as opposed to a regular short sale. This doesn’t affect the overall analysis, and you can see my comment below for more detail.) Now, there are a few products out there that would be appropriate for this, but it would be totally better if I could design the product myself, since then I could be extra sure that it would tank as much as possible, thus maximizing my profit. Let me call my buddies at Goldman and see what they can do for me.

Goldman Sachs, to hedge fund guy: Sure, we can do that, just tell us what you would like the crappy product to look like. But wait a second…you do realize that it’s hard to short sell something unless other people actually hold the product in their portfolios, right? And who in their right minds would buy something that you, as a smart guy, specifically picked as being the bottom of the housing market barrel? That kind of throws a monkey wrench into your plan…but wait, I think we might have a solution to this problem. So here’s the deal – you’re gonna get a call from another financial firm, and you’re gonna tell them that you are looking to create a product to invest in. Now, this is technically true, so all you’re really doing is leaving out the teeny detail that you are taking a short position rather than betting on an increase in value. No big deal, right? Just tell them what you want in the product and they will make it happen.

Goldman Sachs, to other investors: Hey look, we have this new awesome product for you. The assets in the product have been hand-picked by an outside firm who specializes in this sort of thing, so you can be confident that’s it’s going to do well. *snicker*

And then, big shock, the product tanks, the investors lose over $1 billion and the hedge fund guy makes a corresponding $1 billion. Note that the real problem here is not that Goldman Sachs purposely created and sold a crappy product. The problem is instead one of asymmetric information, which in this case is the financial equivalent of Groucho Marx’ “I don’t care to belong to a club that accepts people like me as members” quote. Simply put, if you have a really smart guy trying to sell you something that he owns, he’d better have a good reason for needing to sell it, since otherwise you’re probably getting taken for a ride. This situation is a classic example of the lemons problem- you know, where the shady dude is trying to sell you his used car and not telling you that it’s been in 5 accidents and has a faulty transmission- except that we’re talking about a financial product rather than a Honda Civic with a rolled back odometer.

I try to generally be as objective as possible (and have in fact defended Goldman’s business practices in the past), so I want to stay way more out of the discussion of whether this is a sign that more financial regulation is necessary than Rachel Maddow does in the video above. I will, however, point out that what Goldman Sachs is accused of is already illegal under current law, so I’m not sure how new regulations in and of themselves would prevent this behavior. Cue the oversight conversation…

Also look at this “Risks Interconnection Map,” which shows “an overview of all risks and their interconnections.” It’s a little hard to understand but looks like someone really knew what they were doing when it comes to Adobe Flash.

Risk Interconnection Map

We are heading into the home stretch here at EconomyBeat — the project concludes at the end of April. Thus, this will be our last post on the stock market. Last fall, with stocks enjoying a half-year’s worth of gains, we asked if a September swoon was in the cards. A bullish month later, we wondered if an October apocalypse might prove the market’s undoing. Then, nearing November, we posted a warning from stock guru Jeremy Grantham on a coming correction.

Yep. Wrong, wrong, and wrong. We’re at Dow 11,000, S&P 1200, and Nasdaq 2500 (any moment now). With the bulls running free and the bears still in hibernation, is it as simple as happy days are here again?

Not really. Last week, New York Times columnist Floyd Norris wrote about the lingering pessimism in the face of mounting evidence that the country is experiencing an economic recovery.

Regarding the stock market, he wrote:

Which means a lot of people who pulled their money out of the market in the heart of the crisis have missed out on some big gains over the past year. Which is understandable — once bitten, twice shy; twice bitten (remember the dot-com bust just 10 years ago?), stock up on food, bottled water, and ammunition.

Here are some random opinions from various stock sites about whither and whence the stock market is headed. (Disclaimer: Predicting the future is only possible when using a time machine, which is expensive.)

Prudent Bear: Botox Economy

by Satyajit Das

Stock prices assume a rapid recovery in corporate earnings. Beating much reduced expectations and a return to previous earnings levels are easily confused.

The “E” in the P/E ratio remains difficult to forecast. Equity pricing assumes a return to 2006 levels when U.S. corporate earnings represented a record share of profits in GDP.

In 2009, full year earning per share for the S&P 500 were around $60, down from $65 in 2008 and 30% below peak earnings of $85 recorded in 2006. In 2009, company results reflected the effects of aggressive cost cutting and the benefits of government support. To return to pre-crisis levels and rates of growth, improvements in revenue and underlying demand are necessary.

Stocks are also not cheap. Jeremy Grantham, founder of Boston-based fund manager GMO, recently noted ruefully that after 20 years of more or less permanent overpricing of the S&P 500, the market saw just five months of underpricing after the March 2009 trough.

Investment Watch: P/E Ratios Set tO Rise in Q4 Through 2010

Aug. 2009 – The New Normal theory states that the recovery will be long and hard with GDP at 1.5 – 2.0 for possibly a decade.

If true, Earnings will bump along at a similar pace and will not recover to the high Earnings before the recession. So now we have low Earnings.

Why should the Price part of the P/E ratio rise?

Simple. Once investors that have nearly a trillion dollars earning nothing in money market funds come to accept this new low Earnings rate, they will decide to jump into the market because it is the lesser of two evils. This will bid up the price of stocks based simply on greater demand, not greater performance.

So now you have a new LOW Earnings number and a new HIGHER Price number and the new P/E ratios will jump higher than before the recession.

Again, this will not signify a higher expectation of future earnings as in the past, but instead, will reflect the New Normal of low growth, high unemployment and a long drawn out 5 years of debt defaults in credit cards, commercial loans, and housing mortgages which will force the further consolidation of the banking industry.

WHAT THIS MEANS TODAY IS THAT YOU CAN INVEST IN JUST ABOUT ANYTHING AND YOU WILL SEE A GAIN IN YOUR POSITIONS JUST BECAUSE OF THE NEW MONEY POURING BACK INTO THE MARKET.

The Reformed Broker: Vacillating Bulls and Dogmatic Bears

To complement the slow but persistent grinding higher of the major stock market indices, we’ve now got two new groups of market commentators – the Vacillating Bulls and the Dogmatic Bears.

I’m trying very hard to tune out both camps at this juncture in an effort to hear what the market is telling me. It is not easy, they are everywhere.

The vacillating bulls are predominantly coming from the the asset management/fund complex and they are typically those who have been underinvested or too risk averse. Their public proclamations of “why fight it” and “ok, NOW I’ve finally gotten the economic confirmation I’ve been waiting for” are a distraction. I do not view their recent prominence in the mainstream press as a market positive, their utterances smack of capitulation.

The dogmatic bears are less threatening to the market’s rise than the neo-bulls are, because they are basically repeating themselves ad nauseum at this point and very little of their dogma is any different from what it was a year ago and even two years ago. Their missives are laden with more dropping shoes than the closet of Imelda Marcos in an earthquake. Yawn.

The vacillating bulls should spare themselves these embarrassing media appearances, they are not “furthering their brands” as they say in PR Speak. The dogmatic bears should likewise cease their spewage and rethink a few of the tentpoles of their argument – to continue the rhetoric against the backdrop of comps turning positive across most surveys would at this point cross over into slapstick territory.

It is one thing to change your mind or stick to your guns, it is quite another to become a public spectacle while doing so.

The Reformed Broker: Hypselotimophobia – The Fear of High Prices

f you are uncomfortable buying or trading stocks that are at new highs, this is not your tape.

There are only two categories of investors who are unfazed by the deluge of new 52 week highs – the nimble and the desperate.

The nimble are in a position to act quickly should things change. With every tick, they are tossing blades of grass into the wind to gauge direction in real-time. If you run a machine shop or have a waiting room full of patients, this is not feasible.

The desperate are most likely professional runners of money, those without the luxury of waiting for their pitch. They must get more stocks on the books to show that they “didn’t miss it” and they must do so regardless of the top-tick risk. An ill-timed buy today can quickly be described as an “intermediate-term” pick to the investment committee if need be, but a swollen cash position in a vortex of up stocks cannot be explained at all.

There’s a bumper crop of gaps and breakouts, hundreds of 52 week highs daily – so why isn’t everybody happy?

Most market participants are not incredibly nimble nor are they under career pressure to buy at any price. The drumbeat of daily new highs can be more frustrating than fun for them.

Unless you’re in the habit of buying new highs, the ascent of this market has been way less enjoyable over the last 6 weeks than the headlines would lead outsiders to believe.

If you are a a hypselotimophobe, there isn’t much for you to do at this juncture, so maybe you want to just chill out.

The Pragmatic Capitalist: Morgan Stanley: This Is Not the Utopia Investors Are Pricing In

MS is one of the few big banks that isn’t buying into the utopian environment for equities. In fact, they believe equity investors are ignoring several risks here – primarily the global tightening that is occurring. They were one of the few banks that actually issued a bearish fiscal 2010 outlook and have remained skeptical of the rally thus far.

Morgan’s analysts believe the equity market is pricing in a permanent utopia for risk assets – a period of high growth with permanently low rates, but in reality, they say the Fed is ready to start altering their accommodative approach:

“Clearly the markets are in a utopia-type environment; with the Fed seemingly on perma-hold and upside in growth… We are on the other side of those views. As we see it, strong growth will ultimately be met with withdrawal of liquidity, and the risk markets will not like that medicine.”

MS says equities could be at risk of substantial declines should the tide shift from the “rates on hold” camp to the “rate hikes” camp. With the VIX falling to its lowest level since Summer 2007 it certainly appears like investors are complacent and pricing in a utopian environment. Unhedged investors might find themselves in their own personal hell if an unforeseen risk should creep into the equity markets.

Slope of Hope

Signs of extreme bullishness abound, whether in the plummeting VIX, net long speculative interest in the Nasdaq, put call ratios, bullish percentage indices, new highs, Dow 11000 hoopla, the Newsweek cover story on the Comeback Country, the $SLIX indicator, they almost got Art Cashin to capitulate on CNBC et. al. Someday, maybe soon, this will reverse direction, but who knows if there will be any bears left to see it happen. One measure of declining bearishness is seen in short interest…The upshot — the wall of worry represented by shorts is a smoldering pile. To be short has been to be annihilated. It is within living memory when all these values were much higher, and ETFs were often hard to borrow. Will this evacuation of standing shorts accelerate the speed of the decline should it ever happen? Stands to reason, but reason is not leading the charge right now…

Financial Sense: Sovereign Debt Disaster Will Favor Hard Assets

by Justice Litle

Last week, in “How to Protect Against Currency Collapse,” we talked about the mounting debt problem and how Western governments will deal with it. If the debt is issued in your own currency, you ultimately just print more currency to inflate that debt away. (If the debt is issued in someone else’s currency, you are in deep trouble… as Greece, Latvia, Iceland and others have all found out.)

Right now the global economic recovery has the appearance of being cost-free. This is due to an age-old confidence trick known as “ignoring the bill.” To pull off this trick, you spend huge amounts of money on a high-limit credit card… ignore the mail when the bill comes due… and conveniently forget to reconcile your accounts.

Complacency reigns because the true costs are not being tallied. The Bank for International Settlements – an age-old central banking watchdog based in Switzerland – is having none of it.

The “simmering fiscal problem” of sovereign debt is set to bring industrial economies “to the boiling point,” the BIS reports in a new study. “Bond traders are notoriously short-sighted,” the BIS further scolds, “assuming they can get out before the storm hits… the question is when markets will start putting pressure on governments, not if.”

The Bank of International Settlements further believes that, if we do not turn from this path, inflation will spiral out of control. “Monetary policy may ultimately become impotent to control inflation,” the BIS scowls, “regardless of the fighting credentials of the central bank…”

Where Have You Gone, Joe DiMaggio?

Try as they might, investors will not be able to ignore the sovereign debt problem forever. When the reckoning comes due, the printing presses will kick into hyperdrive… and faith in the system will crumble (or perhaps shatter like brittle glass).

At this point, investors will turn their lonely eyes to hard assets, looking at precious metals and basic building-block commodities in a new light.

Up till now, hard assets have more or less been treated as a “hot money” play on global economic recovery. Price movements have been linked to speculative appetite and the general degree of optimism.

The onset of a sovereign debt panic could thus lead to a short, sharp and temporary drop in hard asset prices, as the “hot money” beats a hasty retreat. But over time, a post-crisis shift in psychology will occur. In a world where all major currencies are being debased, oil and metal in the ground will stop looking like speculative plays and start looking more like stores of value.

A Pending Rocket Ride

…There is widespread belief that the U.S. economy is in a sweet spot, with a goldilocks-like ability to push profits up while keeping short-term interest rates near zero. The Fed is widely revered at moment for having succeeded in its mission. Some bulls are even musing aloud now whether the “great recession” was even all that “great” – as if it were over and done, finis, all consequences postponed indefinitely.

It is an environment, in other words, that very much favors “paper” (leveraged financial plays) over “stuff” (hard assets).

But when faith in Western governments’ ability to shoulder the sovereign debt load evaporates, that equation will reverse rapidly.

And so, after a period of renewed fiscal panic, in which it is driven home, yet again, that the grossly indebted central bankers of the world do NOT have control – only the illusion of it – a need to take shelter from the ensuing inflationary paper-debasement storm will become paramount.

THAT is when hard assets will become most attractive… not as hot money speculative vehicles, but emergency stores of value. A true rocket ride for commodity prices – the likes of which we haven’t seen yet – could be the result…

As the sovereign debt crisis unfolds, investors may well flock to these “hard” currencies in droves as their home-based scrip turns to confetti.

Business Insider: So, How Are Stock Prices Now That We’re Back At DOW 11,000? They’re 30% Overvalued

So, how do stock values look now that the DOW is back to 11,000?

Not outrageous. But certainly not cheap.

Measured using our favorite valuation technique, Professor Shiller’s cyclically adjusted PE analysis, the S&P 500 has a PE of 22X. The long-term average (1880-2010) is about 16X. The current level is actually close to the big bull market peaks of the past–with the exception of the gigantic one that peaked in 2000.

Note a few things:

* The long-term average for the cyclically adjusted PE is about 16X.
* Stocks have spent vast periods above the average and vast periods below it, usually in multi-decade cycles
* We’ve just descended from the longest period of extreme overvaluation in history, suggesting (to us, anyway) that the next multi-decade cycle is likely to be below average
* At today’s level, 1200 on the S&P, stocks are trading at a 22X CAPE, about 30% above the long-term average

Now…valuation doesn’t tell you anything about what will happen next…. (S)tocks can get a great deal MORE overvalued than they are today. And they can stay even more overvalued for a decade or more.

But what the apparent overvaluation does tell you–or, at least, has told you in the past–is that your future long-term returns will likely be below average. There’s a strong correlation between starting valuations and ending returns (high valuations lead to low returns and low valuations lead to high returns). And today’s valuations can now be described as “high.” (Not extreme, but high.)

Yes, you can argue that “it’s different this time.” You can argue that, since stocks have traded at an average CAPE of more than 20X for the past two decades, we’re in a new normal. And you might be right. But they don’t call “it’s different this time” the “four most expensive words in the English language” for nothing.

The Daily Reckoning: Stop Worrying About the Financial Crisis

by Bill Bonner

When will the de-leveraging bust resume?

When we stop worrying about it.

This afternoon, we realized that deep down, our feelings had changed: we had stopped worrying about a resumption of the bear market.

Not that we’ve stopped thinking about it. We think about it every day. And we’re sure it’s coming. But we have stopped worrying. No matter what we think, we feel that somehow this will work out okay…we’ll be all right. We’ll stumble along…

Thinking and worrying are two very different things.

Thinking is purely superficial. It’s the worrying that counts. When you’re worried about a financial crisis, you sell out your risky positions and hunker down with cash. When you’re not worried, you’re happy to float along… You’ll change course when the danger becomes more imminent, you tell yourself.

But don’t forget:

This is a Great Correction. It began almost exactly three years ago, when New Century Financial – the second largest subprime mortgage company in the US – filed for bankruptcy. It will continue until debt levels in the private sector have worked themselves down to more reasonable levels.

How long will that take? Maybe 5 years. Maybe 20.

Meanwhile, you can’t expect much from this economy. Businesses are not going to add jobs. Consumers are not going to shop.

Is that all there is to it? No, there’s a lot more. That’s why it’s a Great Correction and not just an ordinary run-of-the-mill correction.

…there’s the correction of the huge the expansion of credit

…there’s also the correction of the stock market

…and the correction of the real estate bubble

…and the correction of the world economy and its dollar-based monetary system

Here’s what to expect:

…US stocks will begin falling again

…foreclosures, already running at twice their normal level, will increase

…bankruptcies, now at record levels, will go up too

…bonds will eventually collapse (but may turn out to be decent investments for a while longer…as the de-leveraging continues)

…the dollar too could go up when the crisis feeling returns; over the longer run it will be dangerous to hold it

…China will go through a financial crisis (potentially ‘Dubai times 1,000.’ As Jim Chanos puts it)

…states, cities, and entire countries will declare bankruptcy…

Those things don’t seem like threats to you? Well, they don’t feel like threats to us either. But that’s what makes them so dangerous…

…we’ve stopped worrying about them.

InvestorsInsight.com: Is This a Recovery?

by John Mauldin

I think we are in for yet another Muddle Through period, at least for 5-7 years and maybe for the decade, depending on a few scenarios I will come to in a minute. …(I)f we measure the stock market by either earnings or dividend yields, valuations are in the top 10% historically. Average (!) returns, going out for ten years, are 2.6% real, with some historical 10-year periods being negative. Below is the range of returns, based on dividend yields. It does not look much different from the chart based on earnings. We are currently at the far right-hand bar.

This does not suggest a happy outcome for those who espouse buy-and-hope portfolios, at least not if you have expectations or needs of 7-8% or more.

Financial Armageddon: Time for the Bulls to Reconsider

Based on data going back 90 years, whenever the 12-month rate of change (ROC) in the Dow Jones Industrials Average has exceeded 40 percent, it has generally signaled trouble ahead.

In three cases, a 12-month ROC above that level has only marked a short-term pause, after which the market traded higher.

But on 11 other occasions, similarly rapid advances have been followed by notable corrections, including the collapses that followed the 1929 and dot-com era peaks, as well as the 1987 crash.

Given those odds, increasingly exuberant bulls might want to have a rethink.

Here is the complete paper, titled “WARNING: Physics Envy May Be Hazardous to Your Health,” by Andrew W. Lo and Mark T. Mueller. From the introduction:

The Financial Crisis of 2007–2009 has re-invigorated the longstanding debate regarding the effectiveness of quantitative methods in economics and finance. Are markets and investors driven primarily by fear and greed that cannot be modeled, or is there a method to the market’s madness that can be understood through mathematical means? Those who rail against the quants and blame them for the crisis believe that market behavior cannot be quantified and financial decisions are best left to individuals with experience and discretion. Those who defend quants insist that markets are efficient and the actions of arbitrageurs impose certain mathematical relationships among prices that can be modeled, measured, and managed. Is finance a science or an art?

In this paper, we attempt to reconcile the two sides of this debate by taking a somewhat circuitous path through the sociology of economics and finance to trace the intellectual origins of this conflict—which we refer to as “physics envy”—and show by way of example that “the fault lies not in our models but in ourselves”. By reflecting on the similarities and differences between economic phenomena and those of other scientific disciplines such as psychology and physics, we conclude that economic logic goes awry when we forget that human behavior is not nearly as stable and predictable as physical phenomena. However, this observation does not invalidate economic logic altogether, as some have argued.

In particular, if, like other scientific endeavors, economics is an attempt to understand, predict, and control the unknown through quantitative analysis, the kind of uncertainty affecting economic interactions is critical in determining its successes and failures… Fully reducible uncertainty is the kind of randomness that can be reduced to pure risk given sufficient data, computing power, and other resources… (O)ur taxonomy is reflected in the totality of human intellectual pursuits, which can be classified along a continuous spectrum according to the type of uncertainty involved, with religion at one extreme (irreducible uncertainty), economics and psychology in the middle (partially reducible uncertainty) and mathematics and physics at the other extreme (certainty).

However, our more modest and practical goal is to provide a framework for investors, portfolio managers, regulators, and policymakers in which the efficacy and limitations of economics and finance can be more readily understood. In fact, we hope to show through a series of examples drawn from both physics and finance that the failure of quantitative models in economics is almost always the result of a mismatch between the type of uncertainty in effect and the methods used to manage it. Moreover, the process of scientific discovery may be viewed as the means by which we transition from one level of uncertainty to the next….

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A common view is that the U.S. can’t tick off China by pressing them on this issue, because China finances so much U.S. debt, which, in case you haven’t heard, the country has run up a lot of. Recently, New York Times columnist (and Nobel economics prize winner) Paul Krugman wrote an op-ed called Taking on China. Krugman argues that we have nothing to lose in confronting our No. 1 banker over its harmful weak-currency policy.