Friday, May 04, 2007

How Loose Monetary Conditions (not economic) Affect Stock Market Returns, and Why I'm Still A Bear

Before I begin a long-winded thought jot-down that was long before due regarding my views on the economic and investment outlook that I personally hold regarding the future, I'd like to say right now that I am not assigning any time-line to when I think my views would come to pass. Any economic view on the market, despite the potential inevitability that views suggest, are by no means ever imminent--as the market is still after-all a voting machine that is run by human psychology rather than the fundamental truths that might be of consequence. I've been bearish on the state of the U.S. economy and stock market for a while now, but that doesn't necessarily mean I want the stock market to fall, and for people to lose their jobs, or for America to lose its economic supremacy in time. What I am is worried, and I worry because I need to know where money can be made in the finance world if making money was the cause of a lot of fundamental disequilibriums in the first place. The problem of excess liquidity (I'm probably one of very few on the street that think excess liquidity is a problem rather than a solution)  have weighed heavily on real returns, and the illusion of capital gains are paid on the backs of an unending quest to build capacity in Asia and the ebullient view of a neverending consumer binge that drives what it means to be American today. Nevermind the fact that the performance of the S&P has been caused mainly by the rise of financial stocks and consumer stocks, and nevermind the reason that much of the core growth in corporate earnings actually came from abroad in the form of a weakened dollar. The question that must be addressed is how America's chronic deficit spending, and the economic liberalization of the previous Greenspan regime effected our futures as investors and every day citizens going forward. And why we should be worried about a potential pitfall in investing in America if things go unaddressed. Difficulties in curbing inflation (i.e. things getting more expensive and our retirements getting more difficult) will be the challenge of the Fed and central bankers around the world as they try and figure out how this financial frenzy of today will affect money supply and velocity, where people give three cheers for M&A activity that make little to no sense simply because it drives stock returns, and where the wealthy simply give money away to anybody with a business plan for a (fill in the blank) fund. One can cite countless deals that have happend over the last few years done by private equity or investor consortiums that have investment yields thinner than Victoria's Secret models, and how if wealthy people really wanted to throw away money they might as well throw away money at kids starving around the world rather than down a black hole of greed and expectations comforted only by the scant hope that maybe someone else will buy the investment at a higher price (because, there's enough liquidity, duh).

Before anything, here's a very interesting piece courtesy of Marc Faber of the GBD Report and John Paul Koning of Pollitt & Co in Toronto:

The Zimbabwe Stock Exchange is growing some three times faster than consumer prices. This relative outperformance versus general prices is a result of stocks being a chief entry point for the flood of newly created money. Keep Zimbabwean dollars in your pocket, and they've already lost a chunk of their value by the next day. Putting money in the bank, where rates are pithy, is not much better. Investing in government bonds is the equivalent of financial suicice. Converting wealth into foreign currency is difficult; hard currency is scarce, and strict rules limit exchangeability.

As for capital improvements, there is little incentive on the part of companies to invest their already-losing enterprises since economic prospects look so bleak. Very few havens exist for people to hide their wealth from the evils created by Mugabe's policies. Like compressed air looking for an exit, money is pouring into shares of ZSE-listed firms like banker Old Mutual, hotel group Meikles Africa, and mobile phone firm Econet Wireless. It is the only place to go. Thus the 12,000% year over year increase in the Zimbabwe Industrials.

Our Zimbabwe example, though extreme, demonstrates how changes in stock prices can be driven by monetary conditions and not changes in GDP. New money gets spent or invested. In Zimbabwe's case, because there are no alternatives, it is stocks that are benefiting.

This sort of thinking can be applied to the stock markets in the Western world too. Though western central banks have not been printing nearly as fast as their Zimbabwe counterpart, they do have a long history of increasing the money supply. It forces one to ask how much of the growth in Western stock marekts over the preceding twenty-five yeras has been created by a vastly increasing money supply, and how much is due to actual wealth creation. Perhaps stock prices have increased faster than goods prices for the last twenty-five years because, as in Zimbabwe, Western stock markets have become one of the principal entry points for newly printed currency.

This example really hit me, it describes a whole lot of what's going on around the markets in a more extreme manner. The emphasis in bold is mine, and what it's suggesting hints at how any investment return--viewed in absense of a perspective on the general monetary conditions of an economy--is at best illusory and at worst stupid. One might view the 12,000% returns in Zimbabwe industrials as very attractive, but in light of the horrible inflation and the lack of general investment options to preserve capital enough for a meal the next day is scary. Of course, the current inflation in the United States might be viewed as benign in comparison to much of the developing world (some 2.0%+ annualized), and compared to the 20%+ returns in the S&P500 over the last year or so this is a very good deal for anyone that has gotten into the markets, for their wealth in real dollar terms have increased by quite a bit.

But what does it really mean to hold wealth? What is money? To the average joe, the more money the better, and the more things money can buy, the merrier, if only everybody in the world could have money then every problem we have would go away. This is a fantasy not far off from what perhaps 95% of the population would agree with. However, for economists and interested investors, this is far from true. Economics 101 would tell you that if everyone in the world could make fast money, and build wealth in nominal dollars, and have a fatter bank account that grows day by day for some reason or another--with the awesome money their mutual fund managers and their mutual fund manager's fund managers makes--then there would be a case of increasing prices so that everybody loses purchasing value year after year and no "real" wealth is built at all. Certeris Paribus, $100 dollars that used to buy a coffee machine will now only buy a pack of coffee machine filters. Of course, the real world isn't ceteris paribus, but enough empirical evidence has already given us signs of danger that the next recessionary pressure we feel will surely be stagflationary, in consequence to lagging consumer spending, job loss, much higher commodity and raw material prices, and a weakening dollar. So we must ask ourselves is inflation truly under control? Prices in the United States have stayed stable, but any traveler can tell you that staying in other places around the world (developing economies excluded) have become much more expensive. Americans, as usual, are pretty complacent spending their evenings at home and not thinking outside of their own continents--but people really should be more concerned about the falling value of the U.S. dollar, and what implications on inflation it actually has at home.

While stock prices and house prices (until recently) have continued their upward climb slowly but confidently, driven primarily by the reflexive success of financial and consumer markets on the back of increasing asset prices that becomes its own grandpa, the rest of the world seems to have begun a bleek view on the fate of American status and the strength of the American Dollar (once pinnacled as the currency of dicipline and value preservation). A comparative glance at several currencies considered relatively "hard" against the dollar--meaning more fiscal dicipline and less monetary expansion--can tell you something about "true" inflation, in terms of how much it actually costs an American to live in the world (as opposed to his couch in surburbia).

How much Euros to buy one dollar

How much British Pounds to buy one dollar

How much Swiss Francs to buy one dollar

How much Austrailian Dollars to buy One Dollar

How much Korean Wons to buy One Dollar

For any of these foreigners to have invested in American assets in the last five years would have been difficult due to the falling to flattish real returns they would have earned on average (say in the S&P or treasury markets). The story of real inflation for Americans haven't hit home quite yet due to the still relatively cheap goods and cheap capital that is available in China and Japan, respectively. In China, manufacturing capacity and saturation have literally reached its limits, and the endless supply of labor have since cooled the price of consumed goods in America while under normal circumstances Americans would have certainly felt heat. But the China problem (the one that US politicians and economists keep talking about) might have found a solution yet--a gradual appreciation of its currency to reflect global norms and correct trade deficits.

The biggest draw back in the case of China is that, although "lowering our deficits to China" and "help save our jobs" sounds good to Americans now, the actual consequences will be dire in the form of much higher prices. China has acted as a cooling engine in world inflationary pressures in consumer goods (a cost that has arguably been passed on to increases in raw materials, energy, food and commodity prices that they are continuing to drive up), and this has enabled many societies around the world to live with relative comfort and still be frugal. Now I say Americans will feel heat, because while China has enabled a much cheaper manufacturing environment and thus cheaper goods to be enjoyed by everyone, Americans have been overspending even in light of this. A quick glance at the household savings rate and the household debt level (manifested primarily in credit cards, auto-payments, and mortgages) in Amerca will tell you the story:

Chart of household financial obligations ratio, 1992 to 2006.

Chart of personal saving rate, 1983 to 2006.

But in light of these increasing pressures in actual finances of the consumer, it's still "okay" to buy the new playstation and the wii because the stock market or the value of the house is going to pay for it. The stock market, specifically, has continued its run over the last two years, and is coming closer to the levels reached in the Tech Bubble--only this time around, it's the consumer-spending-on-frothy-assets-and-financial-stocks-on-M&A Bubble as a result of easy credit expansion and the exponential growth in derivatives that "hedge-out" risk (provided that nobody defaults). A self-reinforcing phenomenon occurs here with two factors: (1) consumer spending and financial returns based on rising asset values (2) rising asset values based on increased consumer spending and financial returns.

Nominal S&P returns in the last 5 years

Nominal S&P returns in the last decade (tech bubble included in 2000)

Again, I repeat, foreigners (who fundamentally would view the dollar as an important consideration in investment decision making, and those more keen to inflationary pressure and American froth than we Americans) have seen little appreciation in the value of their investments if one were to adjust market returns in terms of their currency (look at the charts of dollar value of other currencies above). This tells a true story about the "real" wealth actually being built in the United States.

And the bit going around the market talking about how a "weak" dollar will help the American economy is declaring ignorance of the painful short-term effect of a continuing weak dollar. Namely, a slow-down in consumer spending, and a flatting and falling asset market that Americans pride itself on. Longer-term, the macroeconomy will adjust, and maybe we can see the United States actually making something "tangible" again in the future instead of just shuffling money and intellectual property, but nobody can predict when this long-run is. The case in point is that inflation in Ameica will hit sooner or later, and the factors have already been set in motion: (1) calls for a weaker Chinese Yuan that will increase consumer prices across the board (2) falling real estate prices and defaulting mortgages hurting consumer spending and financial returns over the next year or two (3) drying liquidity as capital loses value in the form of less trading, less M&A, and unwinding of the Yen carry-trade (4) yields too low to chase--which eventually but surely must happen unless the entire investment community collectively lose their minds.

All the money that's been spent in the Iraq War and the war against terrorism, and all of the money funneled into foreign central banks (such as China's and Japan's) will also play a role in increasing the money supply in the US. Although the velocity of these "eurodollars" are not enough to create rampant inflation in their current idle state, it would be interesting to see if any of them would make their way back into the states eventually as the dollar continues to weaken and money floods back to buy American goods. We would all be much poorer when that happens if we don't invest appropriately...

Whatever lessons this situation could tell us paints a picture of much uncertainty in the future. Stock prices will not increase forever, and macroeconomic conditions, although benign currently, are starting to slow. Making "real" money is difficult, but money in large doses as according to hedge funds and private equity funds still is performance since inflation doesn't hit that hard in its current manifestation. The investment outlook of any prudent investor should be one of caution as we move forward. Nobody can predict the timing of the unwinding of this seemingly stable disequilibrium (if it even unwinds in our career), but an investor can always protect against these events by going into foreign markets, and investing in sound businesses uncorrelated with the market at large that are cheap (something that calls for much more qualitative research in the microeconomic perspective). Just don't buy into the easy solution of investing in whatever grows that will most likely continue to grow so long as the economy is doing well and excess liquidity never stops.

w00t, that sure was long-winded. Probably would have tons of grammatical mistakes and concept left out if i were to go back to read it too... but that's my two cents, for whatever its worth (which will probably turn into one cent sooner than we think)

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