No Moderation of Economic Decline..posted 2/27/09

February 27, 2009

Some observers had sensed in recent weeks that the economic decline was moderating.  After all, the preliminary 4Q GDP numbers didn’t look all that bad, and the leading economic Indicators had risen for two months. But all the evidence I look at today indicates that any moderation in the rate of decline is wishful thinking.


The revised 4Q GDP numbers released today (-6.2% annual rate) confirm what many of us felt: that the economy was declining much more rapidly through December than the first estimates (-3.80%) suggested.


But more important than the past quarter is what is happening now and through the next couple of quarters. Job losses are continuing at a rapid rate, with initial unemployment insurance claims climbing to a new high.  It now looks as if we have at least 2-3 months ahead of job losses in excess of 500,000.


Economic activity in the rest of the world, with the possible exception of China (and I’m not even sure about China) is falling more rapidly than here.  Mexico, Southeast Asian economies, Taiwan, Japan, the U.K., eastern Europe, Russia, are registering either double digit rates of decline or close to it.  Our exports, a pillar of strength during much of 2008, have been declining more rapidly than our imports, and have thus been a negative for our GDP .


Most worrisome, in my judgment, is what is happening to Consumer Net Worth, a metric that tends to lead actual consumption by 6-9 months. Over the past two years Consumer Net Worth is down almost 25%.  I don’t need to tell readers what has happened to stock prices.  Every further percentage point decline probably has more negative effect than the previous one.  Savings for education and retirement have been very badly wounded. To top that is the continuing erosion of home prices.  Indications are that the housing price decline may have actually accelerated into early 2009, although that’s not a certainty.


I, therefore, expect no letup in the contraction of consumer spending, at least in the few months ahead. While I do no actual economic modeling myself, I study the models of many others, and believe that we are now in the midst of a quarter that will prove in most respects to be almost as bad as the 4Q of 2008, or an annualized decline of -5.3 to -6.0%.


In 2Q I expect some moderation, but a continued slide.  By the 3Q, a combination of the first effects of the stimulus package and monetary expansion (M2 has expanded at an annual rate of over 16% over the past six months)  beginning to provide some traction we may see a 1-2% decline.  Then it’s sort of even money as to whether we get a slightly positive result in 4Q.


There are many earnings estimates that still must be cut, although recent market action following earnings disappointments suggests that actual investors had already downgraded their expectations below analysts’ estimates.


I remain extremely concerned about the banking system, mainly because I think many bank assets have not yet seen their peak troubles.  Commercial real estate loans, the leveraged buyout loans of 2006-2007, credit card debt, and plain old business loans have a bad year ahead, in my opinion.  I believe that evidence that the erosion of bank asset quality is ending is necessary before the stock market can register anything more than range-bound rallies.


Meanwhile, the most encouraging thing I can say about stock prices is that their decline has brought them to a valuation level that is interesting if not outright cheap. If I were 41 instead of 81, I might even get enthusiastic!


Shiller’s PE is at “Interesting” Level

Readers know that for some years I have paid close attention to Robert Shiller’s Price-Earnings Ratio (Shiller PE).  You can see a chart and description of the Shiller PE in my February Musings.  Since I wrote that piece the continued market decline has brought the Shiller PE from over 15 to under 13, compared to a long-term mean of over 16.  It has been significantly lower only thrice before:  during the Great Depression, in the early post-war years when investors still suffered from depression psychosis, and in the mid to late 1970’s when inflation and interest rates were both sky-high.


Like many investors, I have large cash holdings, mostly raised before September last. Also, like many others, I don’t want to step up and catch a falling knife.  Therefore, despite my doubts about the value of technical tools, I think they can be useful at times like these. Currently these tools are telling me to stay out, and be skeptical of any rallies.  But that can change very fast.  I’ll do my best to let you know when they do.




Martin Wolf Proposes Obama Speech to Leaders of Group of 20..posted 2/26/09

February 26, 2009

  The following is an excerpt from Martin Wolf’s column in the Feb 24 Financial Times:

“My fellow leaders, Franklin Delano Roosevelt abandoned his London summit. I wish to make ours the moment at which we save ourselves. Let us resolve to bequeath renewed prosperity to posterity, not a collapse of the global economy we inherited.

“Let me get a big point out of the way: yes, the US messed up. We thought we knew about sophisticated modern finance. We were wrong. On behalf of my country, I apologise. But this disaster did not happen on my watch. So let us move past the “blame game”. We must learn the lessons and look ahead, not backwards.

Ingram Pinn illustration

“We are in a dire state. In the fourth quarter of last year, gross domestic product shrank at an annualised rate of 20.8 per cent in South Korea, 12.7 per cent in Japan, 8.2 per cent in Germany, 5.9 per cent in the UK and 3.8 per cent in the US. Even China’s economy stagnated. Industry has been particularly hard hit: the latest year-on-year declines in industrial output were 21 per cent in Japan, 19 per cent in South Korea, 12 per cent in Germany, 10 per cent in the US and 9 per cent in the UK. In brief, the world is in deep recession.

“The Washington-based Institute for International Finance also forecasts a collapse in net private capital flows to emerging countries, from $929bn in 2007 to a mere $165bn this year. Credit flows are forecast to shrink by $30bn. The International Monetary Fund also forecasts a decline in the volume of world trade this year.

“Behind all this is a collapse in paper wealth and breakdown in credit (see chart). Profligate deficit countries may have created these viruses. They are not the most vulnerable to it.

“So what must we now do?

“First, we must set priorities. I note with consternation Europeans’ obsession with regulating hedge funds and tax havens. Did they cause this crisis? No. Europeans also call for regulation of all markets, products and participants, without exception. This is like calling for research into radar while the Titanic sinks. Do they realise that the systemically significant banks at the heart of this crisis are the most regulated institutions we possess? Let us not be diverted from today’s priorities.

“Second, the highest priority is to halt the free-fall in demand. Nobody can now still imagine this is somebody else’s problem. I have acted and, if necessary, will do so again. You must also do so, within your own constraints. The surplus countries have the biggest room for manoeuvre. China is showing the way. Let Germany and Japan follow. We all need temporary targets for demand growth, to be monitored by the International Monetary Fund.

“Third, we must fix our financial systems. I am far from content with what my administration has achieved. But we will learn. So must you. Toxic assets are no longer just a pile of securitised subprime US mortgages. If we do not act, we are going to find bad debt everywhere. We have to agree on common approaches to recapitalising financial systems and restoring credit, in order to prevent costly spillovers on to one another.

“Fourth, we must avoid both protectionism and false pieties. We must recognise two harsh realities.

“One is that, with taxpayers called upon to rescue financial institutions, finance will be more domestically directed. We also now know that only big countries can afford to insure global institutions. We must minimise the damage done by this upheaval.

“Another reality is that if the US is unable to expand its exports, pressure will grow to restrict its imports, instead. For deficit countries that are trying to save more than before, as critics rightly insist they should, an improvement in net exports is now essential. We cannot employ exceptional fiscal and monetary measures forever, thereby risking destruction of our government’s creditworthiness and our currency’s value. Surplus countries will need to accommodate these essential adjustments through expansions in demand, relative to potential supply. In a trade war, surplus countries have most to lose. This should not be viewed as a threat, but as a warning.

“Fifth, to get through this crisis and improve the functioning of the entire global system we need much larger, more effective and more legitimate international insurance and monitoring systems. The starting point has to be with a big increase in the resources of the International Monetary Fund and restructuring of voting rights in the institution. It is ridiculous that European countries possess about a third of the votes.

“European leaders have called for a doubling of IMF resources to about $500bn. But, in a world with $7,000bn of foreign exchange reserves, the IMF’s resources need to be an order of magnitude bigger than today. I would support a large-scale issuance of special drawing rights – the IMF’s own reserve asset – and a big shift in voting rights, too. The emerging countries that rely on its insurance need a bigger say in how the IMF and other global institutions function. With such an improved system of insurance, not only will it be possible for emerging countries to run current account deficits more safely in future, but they will not be forced to cut back savagely on spending now.

“As Morris Goldstein of the Washington-based Peterson Insititute for International Economics argues, we need a “grand bargain” – a phrase picked up by Gordon Brown, the UK’s prime minister. The core of that bargain is surely clear to us all.

“Finally, we must put in train comprehensive reform of the structure not just of regulation, but of global finance itself. We need to push this process forward in London. But the challenges are too complex and the danger of unintended consequences too great to fix all this right now.

“So let us focus our efforts on the crisis before us. In the words of Abraham Lincoln, let us be touched by “the better angels of our nature”. Yet we need fight no war. On the contrary, the aim is to strengthen a peaceful and co-operative economic order. We must merely rise above petty concerns. The challenge is now; we must resolve to meet it together.”

Global equity market value as a share of GDP

Eastern Europe’s Pain, Euro Banks, and the rest of us. posted 2/23/09

February 23, 2009

Keep a close eye on what is happening in Eastern Europe because it is impacting not only the Euro Banking System and the Euro itself, but also Western Europe’s national economies that have been large exporters to the East.  As we have been learning, globalization also brings interconnectiveness; what happens in Europe still matters to the rest of the world. The “Decoupling” theme, so popular among investors in 2005-2007, is being trashed.

The following is an except from the 2/17 Financial Times: 

 No escape from the eastern pain

“Can western banks extricate themselves from the pain of an eastern European collapse?

“These eastern neighbours owe western banks – mainly in Austria, Italy, France, Belgium, Germany and Sweden – about $1,635 billion.

“Such a figure is almost equivalent to the entire balance sheet of a major bank in any one of these countries, so the question is not trivial.

“However, a better question might be: should western banks extricate themselves from eastern Europe?

“For this group of countries, where exposures are largest, is like the canary in the coalmine of European trade. But as Poland, the Czech Republic, Hungary, Romania and Croatia sicken, western Europe cannot hope to survive with a dash back to the clean air.

“Eastern Europe is at the sharp end of the new financial protectionism, a natural consequence of government involvement in banking.

“But it is also a big contributor to western Europe’s economies, accounting for almost one-quarter of German exports for instance.

“There has been a certain amount of vendor finance at work here. High local interest rates as governments tried to cool growth and move in line with the eurozone encouraged consumers to import first western debt in euros and Swiss francs, then more western goods. Sadly, they have also imported the credit crunch through the same channels.

“The quandary is not going unrecognised – Hungary has already had European Union support. But neither is it fully appreciated. Some believe the euro is doomed to trail after its poorer neighbours. The more the Polish zloty or Hungarian florint sicken, the worse the euro will feel. There is a credit trade choice to be made, too: should you buy protection on, say, Austria or Germany? As the canary chokes, the answer looks like the latter.”

Source: Paul Davies, Financial Times, February 17, 2009.

It Sure Ain’t Purty Out There! 2/21/09

February 21, 2009

All the signs I see point to a further deterioration in the economy. This will be confirmed by some key numbers coming this week.


 On Friday we will see revision of the GDP for the 4Q of 2008.  Almost certainly it will be revised downward from the initial estimate of an annual rate of decline of -3.8%, probably to the vicinity of -5.0%. Other reports on initial Jobless claims, both existing and new home sales, durable goods orders, and the Chicago Purchasing Managers Index, are all expected to show unrelenting weakness.  Economists are now in process of revising 1Q GDP down further, with our favorite soothsayers estimating 1Q GDP is declining at a 5% to 5 1/2 % annual rate.  If so, in my judgment we are probably now experiencing what later will be seen as the most rapid phase of deterioration of the downturn.


That said, I don’t think we are on the brink of seeing positive numbers. I see that happening in an anemic way in the 3Q or possibly even the 4Q as the massive monetary easing begins to provide some traction and the stimulus package begins to be felt.


Meanwhile some other problems are coming to the fore.  Just as my friend Dwight Sipprelle warned in his comments to my February Musings, the economic mess in Eastern Europe is now obviously hitting European Banks and the Euro.  Just how long or if the Euro can survive will be an increasingly asked question. For economies with distinctive problems and their own fiscal policies (think Ireland, Spain, Portugal on one hand, and Germany on the other), governing with a single monetary policy has always been potentially problematic.  Just how does a unique, multi-national, major currency die? Or what’s involved in saving it? I simply don’t know what this might mean for markets, except that it cannot be good.


Domestically, we are still searching for an answer to the problems in the banking system.  Nationalization?  Maybe, but how do we decide what banks can be “saved” in only this way. Public-Private Bank?  Will the private capital step up to the plate?  How would a system that is partly nationalized and partly private operate?  On what terms do the two compete?


Can we let a couple of the big banks go out of business? Let a healthy bank take over the deposits and good banking assets, leave the toxic assets behind to be worked out over time, perhaps by the acquiring bank in a separate, insulated module?  And how do we taxpayers come out on all this? I don’t have the answers, and hope that the Obama team can come up with some…….and soon.


Until then, and until we can plumb the bottom of this economic slide, the stock markets of the world will be dangerous places.


Alan Greenspan’s Speech to the Economics Club of New York 2/19/09

February 19, 2009

Alan Greenspan’s speech to the Economics Club of NY is  worth a careful reading.  I have known Alan for about 45 years and am an admirer.  This is despite his being chastized for keeping interest rates too low for too long following the dotcom bust, and being too strong a cheerleader for free, unregulated markets. Many who now chastize him were roaring approval at the time.  Alan was contrite at recent congressional hearings, admitting that he made some serious mistakes.  But believe me, he is one smart cookie!.  His comments two nights ago are a must read for anyone who wants to gain  further understanding of what’s going on. 

CLICK HERE to READ the speech

Diversify, Invest Passively, and Avoid Taxes! Invest Passively??? posted 2/17/09

February 17, 2009


In case you don’t know who Peter L. Bernstein is let me tell you that he is my favorite economic and investment sage.  I have known Peter for over forty years and have subscribed to his letter, Economic and Portfolio Strategy for as long as I can remember. You can subscribe yourself at  Believe me, it’s worth the price if you are a serious investor.  You also would enjoy his books, which have long held an esteemed place in the investment world.


Peter occasionally calls on his friend Mark Kritzman, President and CEO of Windham Capital Management and on the faculty of MIT’s Sloan School to contribute to Economic and Portfolio Strategy . In a recent issue, he wrote “Rules of Prudence for Individual Investors”.  So what are these rules?


Rule 1:   Diversify

            Rule 2:   Invest Passively

            Rule 3:   Avoid Taxes


Rules 1 & 3 appear as incontrovertible, even though we all tend to dismiss them from time to time.  And Kritzman points out that simple correlations between asset classes are not sufficient evidence that a portfolio has achieved diversification.  Correlations should be conditional.  For example, when both international markets and U.S. stocks produce returns greater than one standard deviation above their mean, their correlation is -17%.  But when both markets produce returns greater than one standard deviation below their mean, their correlation rises to +76%


But what about Rule 2?  Can active investors be convinced that giving up the task they most enjoy, the choosing of individual securities, is the best thing for their investment health? We are all well aware of the relentless drive of my friend Jack Bogle, founder of the Vanguard Group, to tell investors that low cost indexing is the best investment strategy.  We nod in patient agreement then turn and go happily about the very activity he eschews: stock picking. What a great sense of victory it provides us when we make good money in a stock! Or choose an industry that does very well.  And who doesn’t tend not to tell others about our mistakes.  Why would we consider investing in funds that are passively managed?


Well, Mark Kritzman analyzes a recent paper by Barras, Scaillet and Werner (BSW) called False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas (downloadable from the Social Science Research Network, which you can join free). The study examined returns of 2,076 mutual funds. Without burdening you with their statistical procedures, here are their conclusions as stated by Kritzman:


·       75% of funds had zero alphas, meaning that their active excess returns just covered their costs.

·       The number of skilled funds, in which alpha exceeded costs was statistically indistinguishable from zero.

·       24% produced negative alphas, that is, their expenses were in excess of their active returns.

·       From 1989 to2006, the fraction of skilled managers (whose returns exceeded costs) declined from 14.45% to 0.6%. BSW attribute this to an increase in unskilled managers who nonetheless charged high fees.


BSW define alpha as active gross return (return in excess of market return) minus costs, with costs defined as management and administrative fees, and transaction costs.


As if these conclusions are not enough of a black eye for active management, Mark Kritzman notes they ignore taxes, a matter of great importance, at least for the individual investor.


Kritzman lives in Massachusetts, where his effective combined state and federal marginal tax rate is 20% on dividends and long-term gains, and 47% on short-term gains.


The higher the portfolio turnover, the more the realized gains and the higher the tax bill.  So low turnover is the investor’s friend. Low turnover also involves transaction costs, which can be considerable.  And where do you get low turnover?  Index funds.


Kritzman says, “Perhaps you still cling to the quixotic belief that you can identify actively managed funds that will generate sufficiently large alphas to overcome the drag imposed by their incremental fees, transaction costs, and taxes.”  If so, take a gander at the table below, constructed by Kritzman as a Massachusetts resident:



Investment Options


                  Index  Fund              


  Mutual Fund

    Hedge Fund


Expected Return






Dividend Yield






Std. Deviation












Transaction Costs






Long-term Gain Rate






Short-term Gain Rate






Dividend Tax Rate






Management Fee






Performance Fee







You might quibble with some of these assumptions, but for now stay with me.  Kritzman, using a ten-year horizon, then simulated portfolios using the above assumptions 1,000 times and liquidated the portfolios at the end of the period.  This is the result:



                                           Simulated Returns Net of Expenses


Index Fund


Mutual Fund

Hedge Fund


Gross Return






Transaction Costs












Management Fee






Performance Fee







Total Expenses






Net Return








Again, quibble with the methodology if you must, but the point is very clear, as stated in Kritzman’s conclusion:


“Net of all expenses including taxes, a typical mutual fund must generate an alpha in excess of 400 basis points to produce more wealth than an index fund, and a hedge fund’s alpha must exceed 1,000 basis points to beat an index fund. These estimates rise to 430 and 1,100 basis points if we extend the horizon to 20 years.”


But, you say you can pick the good mutual funds and hedge funds, and not simply settle for the “typical”?  Good luck!



Is the Stimulus Package Just a Baby-Aspirin? posted 2/15/09

February 15, 2009

 Hey, I voted for Obama, so this is not a question designed to elicit partisan comment.  But the small immediate tax cuts in the legislation are puny.  And there is ample evidence that unless tax payers believe that the boost to after-tax income has some permanency they will tend to save or pay down debt with a hefty portion of it.


While the bill contains some worthwhile infrastructure objectives (along with a bunch of liberal democrat wish items), the economy will not feel the full impact of the spending for them for a couple of years.  There is, of course, the job saving allocation to the states so that during this tough period for tax revenues their layoffs may be more modest than otherwise. That’s job-saving, not job creation. That’s okay but not much of a start on the 3.5 million person objective.


Personally, I believe that what the Federal Reserve and the Treasury will be doing is of more immediate importance.  True, Geithner’s package was lacking in crucial details, but my bet is that between the Fed, Treasury and FDIC there will ultimately be an unprecedentedly immense effort to insulate toxic assets and to inject capital into the system. 



The banking system has two problems: liquidity and insolvencies. So far, not enough attention has been paid to the insolvencies that can only be cured by capital injection. Will that happen without letting some of the big players go bankrupt?  I don’t know, but as long as depositors are protected, bankruptcies may not be such a bad outcome.  Certainly, the whole, global banking system needs massive restructuring and the sooner the better.  For now, however, the blueprint is missing.


I think that the stock markets of the world will continue to be dangerous places until we can see some answers for the financial sector.  At the moment the haze is still too thick.


For an interesting discussion of the current economic slide and the financial system see John Mauldin’s Thoughts from the Frontline