Monday, October 19, 2009

Curb Your Enthusiasm?


Yale economist Robert Shiller was interviewed on Tech Ticker saying that the current market boom can't be trusted:

With the stock market up more than 50% since March and the Standard & Poor's Case/Shiller Index on the rise for the last three months, it's a worry, says Yale Professor Robert Shiller. "Somehow we got into this really speculative mentality and I don't think we're out of it yet."

Given the current economic environment, "these booms [in the housing and stock markets] that we're seeing now can't be trusted to continue," Shiller tells Tech Ticker in the accompanying video, taped at last week's Buttonwood Gathering. (Click here for part one of the interview.)

The author of Irrational Exuberance and Animal Spirits characterizes the stock market rally as an "amazing rebound" without much historic precedence, "you have to go back to the Great Depression to see such a turnaround in the stock market."

According to his cyclically adjusted P/E valuation model - stock price divided by average 10-year earnings - stocks are overvalued today, but "not massively overvalued."

The market's rebound isn't likely to be derailed by valuation in the short term, Shiller says, but if one looks to the classic bear market rally of 1933-1937 as a guide, stocks may eventually crater as they did then.

Professor Shiller also said that the strength in the U.S. housing market is surprising but he doubts another housing bubble will develop:

"This is historic," Shiller says of the recent snapback in the Case-Shiller Index. "It's V-shaped. We've never seen it before. That makes it hard to know from statistical basis what it portends."

Shiller admits to having two conflicting instincts on how this plays out:

  • No. 1. Let the good times roll (again): "Housing has tremendous momentum" and bubbles can occur even with bad underlying economic fundamentals, the professor and author says. "When you see [housing] suddenly turning up" - with sales and permits rising along with his ubiquitous index - "you kind of wonder if tenor of the market has just changed.
  • No. 2. False Dawn: Citing the familiar litany of problems -- including high unemployment, rising foreclosures and ongoing problems in the banking system (commercial real estate is "a crisis in the making," he says) -- Shiller wonders how long the rebound can last. "This is on government life support - massive support," he says. "What's going to happen on the other side?"

So what is Shiller's forecast? "We're going to continue to see more up months but I kind of think it's more likely to fizzle out," he says.

In other words, more short-term gains but long-term pain for housing.

Tech Ticker also discussed about a remarkable gathering which included Soros, Roach and Geithner:

Financial markets have been soaring and the global economy is picking up steam. But encouraging words were seldom heard as some of the biggest names in finance and academia descended on Pace University last week for The Economists' Buttonwood Gathering.

Here's a sample:

  • Tim Geithner: "The first stage of recovery [is] better than expected [but] because of the credit bust, it's going to be slower than a typical recovery," the Treasury Secretary said Thursday afternoon in the event's kickoff session. "We're still at a point where the dominant risk is of growth not being strong [and] self sustaining." (A video of Geithner's comments is available at Economist.com.)
  • Stephen Roach: "The market is in for a rude awakening," said the chairman of Morgan Stanley Asia, whose grim outlook seems to remain constant wherever he's domiciled. "This will be an usually weak recovery," Roach said. "The damage done to the system [will be] lasting - we are not even close to healing. It's ‘game over' for the U.S. consumer. Deleveraging is just beginning."
  • George Soros: The global recovery is "bound to be flat" because China is now the world's motor and it's a "smaller, slower" motor than the U.S. was, said the famed financier and chair of Soros Fund Management. (As an aside - and it's a big one given his track record - Soros said weakness in the dollar has become "a bit overextended" and observed the short-dollar trade is "extremely crowed.")
  • Duncan Niederauer: "Don't be misled by the Dow," said the CEO of NYSE Euronext. The rally "doesn't mean we don't have a lot of work to do."
  • Dr. Jacob Frenkel: "The days of reckoning will come" for all the fiscal and money stimulus; specifically, higher long-term inflation, higher interest rates and lower growth, said the chairman of Group of Thirty and former Bank of Israel governor. "You must articulate today how the book will be closed" on all the extraordinary government support. (In fairness, Frenkel was optimistic relative to Soros and Roach, forecasting "next year will be significantly better" for global growth; his concerns focused on 2011 and beyond.)

For the record, the theme of the conference was "fixing finance" so rather than "bull vs. bear," most of the debates were about how to reform Wall Street compensation and whether or not we need to regulate derivatives. There was also heated discussion between Harvard's Niall Ferguson and Columbia's Jeffrey Sachs about whether Japan and China will form an economic partnership. (Trust me, it was entertaining.)

A ‘Remarkable' Couple

Secretary Geithner kicked off the event Thursday and Larry Summers, Director of the National Economic Council, was Friday's featured guest. The policymakers have distinctive personalities but spoke with notable similarities.

We have been "remarkably effective" in putting down a foundation of stability, Secretary Geithner said. About 24 hours later, Summers cited the administration's "remarkable accomplishments" in pulling the financial system back from the brink of the abyss.

But even as they patted themselves on the back (and Ben Bernanke in absentia), Geithner and Summers both warned against complacency - and pushed back against those calling for a removal of stimulus.

"We will try to avoid the classic mistake" of "withdraw[ing] support too soon," Geithner said. "It'll be a while before we face a risk of inflation accelerating," given the slack in the economy and rising unemployment.

"It's "crucial to avoid premature withdrawal of expansionary measures," Summers concurred.

Given the remarkably similar comments here from Christina Romer, chair of the President's Council of Economic Advisers, the message from White House's top economic braintrust is clear: Despite howls of protests from inflation hawks and Austrian economists, the administration is not planning to head for the "exits" anytime soon.

One administration official who isn't touting the party line is TARP monitor Elizabeth Warren, who took umbrage with Geithner's "remarkably effective" claim in our exclusive interview. Click here and here for more clips with Warren, and stay tuned for additional interviews from the conference with Robert Shiller, Niall Ferguson and The Economist's economics editor, Zanny Minton Beddoes.

Yesterday on ABC's This Week, the roundtable discussed the stock market and the economy. Paul Krugman said the economy is growing (industrial production growing at 5% annual rate) but jobs are not growing. "There is a disconnect between the real economy and the job market". He added "...businesses are reluctant to hire because they don't trust the recovery."

In his latest weekly comment, John Mauldin asks Muddle Through, R.I.P? I quote on what he dubs the new muddle through economy:

This is not a prescription for a return to normal growth. We are headed for a New Normal that is less than what the market currently believes. Unless the deficit comes under control at some point, we face the real prospect of catching Japanese Disease and suffering yet another lost decade. Can we Muddle Through? We have no choice but to do so. But it will not be fun. It will not be long-term 2% growth and employment going back to 6% any time soon. Can we reverse the course? With a different attitude and leadership in Congress, maybe we can. But it won't happen next year, and it's unlikely in 2011.

I am afraid we will have to put my old friend Muddle Through, as I previously defined him, back in his box for a while. But wait, if my friend at PIMCO, Mohammed El-Erian, can tell us we are going to a "New Normal," then I can decide that we are going to a "New Muddle Through Economy." Just not one as benign as I used to think.

In the end, that is what we will do. We will figure out how to deal with the environment in which we find ourselves. That is what free markets and entrepreneurs do. Things will sort out, but not before we have what could be an even more difficult crisis, which will force us to make hard choices.

As an aside, I am not expecting that we will see the crisis I am thinking of any time soon. We can move along with positive GDP for some time. I am thinking of the longer term, 1-3 years out. We will become complacent. I will get letters telling me I am too pessimistic. Just as I did in late 2006 when I said we would be in a recession by late 2007. But I firmly believe we will see a double-dip recession within another 18 months (at the most). Stock markets drop on average about 40% in a recession. Adjust your portfolios accordingly.

[Update: Mauldin was on Tech Ticker recently saying that the economic recovery currently underway is a statistical mirage, based on easy year-over-year comparisons and inventory rebuilding.]

Finally, Fareed Zakaria GPS had an excellent discussion on Sunday with an international panel that included Lord Skidelsky who believes that a double round of stimulus packages is needed to counteract the real prospect of a double-dip recession. You can watch the entire interview below (fast forward to the section by dragging the cursor next to the pause button on the video).

All I can tell you is that I believe monetary authorities are desperately trying to reflate the real economy by flooding the financial system with a tsunami of liquidity. Asset bubbles are being formed as we speak. Equity and commodity prices will head much higher but it remains to be seen whether higher asset prices will translate into higher real prices. Stay tuned, but in the meantime you might want to curb your enthusiasm and remain very alert as asset prices disconnect from fundamentals.


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