Wednesday, October 28, 2009

To the Moon Or to the Sun?


In his November investment outlook, Midnight Candles, PIMCO's Bill Gross tells us that assets are way overvalued:
Let me start out by summarizing a long-standing PIMCO thesis: The U.S. and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades. Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services. American and other similarly addicted global citizens long ago learned to focus on markets as opposed to the economic foundation behind them.
So far I am with you, Bill. We basically forgot that real wealth comes from real production not from trading stocks, bonds, and commodities on-line. Forget the clowns on CNBC where you regularly appear talking up your book, and focus on real work.

Bill goes on to write:

PIMCO long-term (half-century) chart comparing the annual percentage growth rate of a much broader category of assets than stocks alone relative to nominal GDP. Let’s not just make this a stock market roast, let’s extend it to bonds, commercial real estate, and anything that has a price tag on it to see if those price stickers are justified by historical growth in the economy.

This comparison uses a different format with a smoothing five-year trailing valuation growth rate for all U.S. assets since 1956 vs. corresponding economic growth. Several interesting points. First of all, assets didn’t always appreciate faster than GDP. For the first several decades of this history, economic growth, not paper wealth, was king. We were getting richer by making things, not paper. Beginning in the 1980s, however, the cult of the markets, which included the development of financial derivatives and the increasing use of leverage, began to dominate. A long history marred only by negative givebacks during recessions in the early 1990s, 2001–2002, and 2008–2009, produced a persistent increase in asset prices vs. nominal GDP that led to an average overall 50-year appreciation advantage of 1.3% annually.

That’s another way of saying you would have been far better off investing in paper than factories or machinery or the requisite components of an educated workforce. We, in effect, were hollowing out our productive future at the expense of worthless paper such as subprimes, dotcoms, or in part, blue chip stocks and investment grade/government bonds.

Putting a compounding computer to this 1.3% annual outperformance for 50 years, produces a double, and leads to the conclusion that the return from all assets was 100% (or 15 trillion – one year’s GDP) higher than what it theoretically should have been. Financial leverage, in other words, drove the prices of stocks, bonds, homes, and shopping malls to extraordinary valuation levels – at least compared to 1956 – and there could be payback ahead as the leveraging turns into delevering and nominal GDP growth regains the winner’s platform.

WHOA! Did you all get that? Bill says assets are $15 trillion overvalued! The game is over and now we face a protracted period of deleveraging and asset deflation.

He goes on to write:

At the center of U.S. policy support, however, rests the “extraordinarily low” or 0% policy rate. How long the Fed remains there is dependent on the pace of the recovery of nominal GDP as well as the mix of that nominal rate between real growth and inflation.

My sense is that nominal GDP must show realistic signs of stabilizing near 4% before the Fed would be willing to risk raising rates. The current embedded cost of U.S. debt markets is close to 6% and nominal GDP must grow within reach of that level if policymakers are to avoid continuing debt deflation in corporate and household balance sheets.

While the U.S. economy will likely approach 4% nominal growth in 2009’s second half, the ability to sustain those levels once inventory rebalancing and fiscal pump-priming effects wear off is debatable. The Fed will likely require 12–18 months of 4%+ nominal growth before abandoning the 0% benchmark.

I am with you on this, Bill, but I look at it from a jobs perspective. The Fed won't dare raise interest rates until U.S. unemployment falls well below 10% and even then, they'll think twice about it. But what you don't get Bill is that the Fed is convinced they can create another asset bubble and they're betting this will lead to real economic inflation down the road.

Importantly, when confronted between two evils, the Fed will always choose inflation over deflation. And therein lies the kink, we need asset bubbles to keep the fantasy alive.

But not everyone is as pessimistic as Bill Gross. On Monday, James Altucher was interviewed on Tech Ticker, telling us that the economy and the stock market were going to blast off from here:

Ever since the market bottomed in March, a parade of bears have warned about all manner of coming calamities:

  • An end to the "sucker's rally"
  • A collapse of the financial system
  • A double-dip recession
  • A commercial real-estate collapse
  • A decade of "deleveraging" as consumers recover from a drunken debt binge

Ridiculous, says James Altucher, managing director at Formula Capital.

The economy is recovering nicely, says Altucher, and 2010 is going to be a huge year. Companies that stopped making things and fired thousands of employees last winter out of fear of a second Great Depression will restock their shelves and start hiring like mad. The federal stimulus, which has barely kicked in yet, will really get cranking. Consumers will find jobs much easier to get, and the resulting optimism (and income) will prompt them to start spending again.

And the market?

It's going to the moon, says Altucher.

In fact, the biggest thing Altucher is worried about is another monster bubble, which the Fed will have to stomp out by raising interest rates too quickly. But that's a year away. In the meantime, he's confident the recovery will knock your socks off.

I think Mr. Altucher is getting ahead of himself. However, as I stated before, there is an unprecedented amount of liquidity in the global financial system that can easily lead to another bubble sooner than you think. Is the market "going to the moon"? You can call me crazy, but my bet is still that the market is going to the sun and it will melt up faster than it takes Bill Gross to blow out his midnight candles.

So while Mr. Gross worries about a cold wind from the future blowing into his bedroom, I worry about the next bubble in stocks and how many people are going to get burned chasing it higher.

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