Agora Financial’s Rude Awakening

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Laguna Beach, California

• The debt spiral and why we may already be beyond salvation,
• Consumer confidence wanes as credit lines are snipped,
• When all of Wall Street’s Gordon Gekkos hit “SELL!” and plenty more…

Eric Fry, reporting from Laguna Beach, California…

Investors are confident…So how come no one else seems to be?

Share prices are rising, CNBC explains, because investors believe the recession is ending. CNBC probably has the story right this time. Share prices probably are rising because a multitude of investors believe the recession is ending.

But the multitude has been wrong before…

Even though confidence reigns among the majority of investors, one particular sub-set of investors is displaying a conspicuous lack of confidence in the market…and in the economy…and, therefore, in the roots that are trying to nourish the “green shoots” of recovery.

“Sales [of stock] by CEOs, directors and senior officers have accelerated to the highest level since June 2007, two months before credit markets froze,” Bloomberg News reports. “Companies with net sellers outnumbered those with buyers by almost 9-to-1 last week, versus a ratio of about one-to-one in the first week of the rally [that started Match 9th].”

Insider selling is not merely more popular buying; it is also pervasive. Executives at more than half the companies in the S&P 500 have unloaded shares since March 10. “[The heavy insider selling] does make you wonder if the market is running out of steam,” one professional investor remarked to Bloomberg News. “If you see broadbased selling among the management team of large holders, that’s generally not a good sign because presumably who knows that business better than they do?”

Good question.

These sizeable votes of “no confidence” are not the only signs that America’s apparent economic recovery stands on feet of clay. All around the world, the folks with the money are refusing to lend it to those without. The nearby chart, compiled by the insightful crew at Soma Asset Management in San Francisco, California, illustrates the alarming volume of consumer credit that is draining out of the U.S. economy. The chart displays the net change in U.S. consumer credit lines. The negative bars at the right of the chart indicate that banks are dramatically reducing and/or withdrawing lines of credit from consumers.

In a previous edition of the Rude Awakening we presented a previous edition of this chart, which featured data through the end of 2008. But this updated chart includes data through March 2009 – a quarter during which banks withdrew an additional $500 billion in consumer credit lines.

If you add up the totals from the last four bars, you will discover that banks have withdrawn an astounding $1.7 trillion worth of credit lines during the last year. Obviously, consumers without credit don’t consume all that much. Less obviously, consumers without credit don’t pull cash advances from their Visa cards to pay their mortgages and auto loans. In other words, without credit, the juggling act ends very quickly. The recent parabolic spike in mortgage delinquencies proves the point.

Not surprisingly, consumers are feeling slightly less ebullient than their stock-buying counterparts. The modest bounce in consumer confidence last spring is fading already…and that’s not a good sign for the stock market. As the chart below illustrates, consumer sentiment trends tend to lead stock market trends. Throughout 2007 consumer confidence flat-lined while share prices rallied. This divergence between sentiment and share prices became particularly extreme in late 2007, as share prices soared to new highs while consumer confidence plummeted. Just a few months later, share prices were plummeting also.

The lesson is clear: If consumers lack confidence, so should investors. During the last two months, share prices have diverged once again from consumer confidence readings. This is not a promising sign.

And yet, despite this warning sign – and despite the grim data points of credit contraction we mentioned above – lots of hopeful investors have persuaded themselves that the mirage of economic rejuvenation is the real thing. We’re not drinking that sand.

…And neither is Marc Faber, editor of the Gloom, Boom and Doom Report.

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Son of Stimulus
By Marc Faber, editor of the Gloom, Boom & Doom Report

An economy addicted to credit growth suffers immediately once credit growth slows down. (Credit doesn’t even have to contract.) Similarly, an economy addicted to fiscal deficit will slow down once the rate of growth of the deficit contracts.

But, not to worry: so many policy makers, including Laura Tyson and academics such as Paul Krugman, will argue for another stimulus package and further monetisation of the government debt, that next year larger (rather than smaller) fiscal deficits are most likely.

Consider the following illustration of the frame of mind of current economic policy makers

My friend Heinz Blasnik, a very accomplished economist, sent me the following quote by Krugman from an interview he gave in Spain in March of this year: “To be honest, a new bubble now would help us out a lot even if we paid for it later. This is a really good time for a bubble… There was a headline in a satirical newspaper in the US last summer that said: ‘The nation demands a new bubble to invest in.’ And that’s pretty much right.”

Blasnik commented that Krugman “appears completely unfazed by the price currently paid for the last bubble, which he also loudly advocated. Again, this proves that Krugman and his ilk are not deterred by failure.” One is reminded of the quote by Douglas Adams that I included at the start of this report: “Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disinclination to do so.”

I don’t wish to embark here on a detailed discussion about fiscal and monetary policies. (I took my PhD in these subjects, and the professor who tested me happened to know something about it since he had invented the “value added tax”.) But, what I want to emphasise is that these policies make it even more difficult to forecast economic fluctuations and market movements.

The problem is similar to Keynes’s beauty contest! What I think about how the economy will perform and how asset markets will move, based purely on market-oriented economic fundamentals, doesn’t matter. Forecasting, which is difficult even in a perfect market, has become a mere guessing game about the extension and duration of expansionary fiscal and monetary policies and their impact on asset markets.

This takes me to James Montier’s critique of the efficient markets hypothesis. According to him, “the worst of its legacy is the terrible advice it offers on how to outperform — essentially be a better forecaster than everyone else”. In his opinion, this is one of the biggest wastes of time, yet it is nearly universal in our industry. “Pretty much 80%–90% of the investment processes that I come across revolve around forecasting. Yet there isn’t a scrap of evidence to suggest that we can actually see the future at all.”

Montier then supports his contention that no one has the ability to clearly see the future with several figures, of which I am reprinting two. It would seem that economists are fairly inept at forecasting US GDP growth rates, as well as analysts at forecasting corporate earnings, and that over time the forecasting errors increase to close to 100%.

In general, I agree with Montier about the uselessness of forecasting; however, I include some caveats. Once in a while, markets or the economy deviate so far from the long-term trend that the likelihood of a correction becomes very high. In these instances, it would seem to me that it’s not all that difficult to predict an impending trend change.

For instance, prior to its peak in December 1989 it wasn’t difficult to predict that the Japanese stock market would decline considerably, and that the Nasdaq bubble of 2000 and the recent housing bubble would both burst. Equally, it wasn’t very difficult to predict that, following a 20-year bear market, commodities would increase in price in the early part of this decade. The reason most economists, strategists, analysts, and investors fail in their forecasts is because they simply extrapolate existing trends into the future, no matter how unsustainable those trends are.

But where I concede that forecasting fails completely is in the precise timing of a trend change. I think that I identified most of the major trend changes over the last 25 years or so, but I admit that my timing was occasionally horrendous.

For instance, it was clear to me for a long time that the US credit bubble had to burst one day, but what I didn’t know was whether the bubble would come apart with debt-to-GDP at 300% or at 370%, as finally occurred in 2008. Moreover, who is to say that we have seen the last chapter of the credit bubble? If the fiscal deficits continue to grow, then — contrary to most investors’ expectations — it is possible, or even likely, that debt-to-GDP will reach far higher levels. This isn’t to imply that additional debt growth would necessarily lead to an improvement in economic growth in real terms (inflation adjusted), but if it were large enough it could lead at the very least to some improvement in nominal GDP growth. But, as I have indicated, debt growth would have to be massive (several additional stimulus packages) because we are reaching the point of no return from additional debt growth. (I think we have already reached it.)

In this respect, I think that Professor Krugman’s wish for another bubble will be fulfilled though it’s unlikely to have the result he is hoping for. The next big bubble, in my opinion, will be in government debt, brought about by the continuous large fiscal deficits. This brings us back to the issue of whether we can expect inflation or deflation in the future.

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[Rude Endnote: So, are we headed irreparably and unstoppably towards the great debt abyss? Given the prevailing winds in Washington, are we likely to see any real “change” soon? And, perhaps most importantly, what can be done?

Thoughts you would like to send us go to the address below. Those you don’t want to send, er…don’t.

We’ll return with more Rude views tomorrow.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com