| 11 May 2010
The Road Ahead
The core of what we do at Thompson Creek is asset allocation, the mix of art and science that tells us how much to put into bonds, cash, stocks and other strategies. We base our allocation on a combination of looking at how expensive or cheap markets are, and scenario analysis. So let us break down the scenarios.
Looking at history we can see that countries (let alone pretty much the entire world) that go through a financial crisis suffer lingering effects over a number of years. So far, we see nothing to change that view. The recovery has so far been quite slow relative to most recoveries, unemployment is worse and the housing sector is still in distress.
Because the market is overvalued, economic risks loom larger in importance. The ultimate outcome as far as market returns probably does not change much. However, the risks of that ultimate outcome being dominated by major moves down (and then up) is increased by economic volatility.
That is not a bad thing from our perspective. If we see lots of volatility, it increases our chances of being able to deploy your capital away from lower return options (but safer in overvalued markets) into higher return options (but safer in undervalued markets.)
Getting back to what our government is doing to save the banks, what is the evidence as to how effective it is? Unfortunately, this strategy has not been very effective in the past.
From Bloomberg:
Like Japan’s response to the real estate collapse in the 1990s, the U.S. flooded the economy with cash only to see financial institutions sock the money away in bonds instead of making loans. Yields on 10-year Japanese bonds ended last week at 1.27 percent.
“It’s the Japanese movie, just an American version,” said Cheah, who worked for Singapore’s central bank. “The next scene is that after banks buy more and more government bonds it will be very difficult for the Fed to raise interest rates because they will lead to massive losses in the banks and cause them trouble all over again.”
Therefore if this works, unlike in Japan, and the economy starts growing at a normal rate with inflation a potential issue, the Federal Reserve as we pointed out earlier runs a grave risk if it tries to raise interest rates of cratering the banks again.
We also believe that the 1.7 trillion in losses already recognized by the banks are not close to the ultimate losses. More is coming.
Housing is likely to continue its recent swoon, as it needs to go down at least another 10-15% to get to reasonably affordable on a long-term basis. This could work out as a long period of flat prices, but with the supply overhang as large as it is the reasonable assumption is that prices will fall some more first.
The issues in China are heating up as the government tries to manage the bubble in real estate. The Shanghai index is already down over 20% since it peaked. When was that? Last August. Is that telling us that the Chinese economy that was a key part of the world getting moving a bit is slowing down, and possibly worse?
The issues in the European banking system may be bigger even than here in the US, and with a potential crisis looming in Greece, Spain, Portugal, Italy and Ireland we are not that bullish on the Euro zone, even with a bailout. However, the stocks there are getting cheaper.
The pickup in consumer spending has been weak, and is due to increased government spending (transfer payments of various types now account for a record 20% of income) and a drawdown in savings. Neither is likely to continue, nor would it be good if it did. High unemployment and declining wages is a long-term drag.
There is a significant chance we go into a double dip recession.
Potential trade frictions, conflicts, the list of challenges go on and on.
None of which would be a concern longer term if the markets were not expensive. I do not remember a time in my life when there was not a laundry list of potential bad outcomes. In fact, despite the challenges we face I expect we will muddle through.
From the standpoint of an investment strategist however, the expense of the markets is daunting and points to low returns even if everything turns out swimmingly. My base case economically remains as it has been for several years until evidence rolls in to change that.
Base case 1: Sluggish, halting growth (averaging 2-2.5%) over the next few years, with inflation accelerating down the road. This type of environment is likely to lead to a wide trading range with stocks slowly growing cheaper until the price is low enough that a long lasting Bull Market can begin.
Shorter term, with interest rates low and Bernanke doing everything he can to boost liquidity the rally continues unless a grave risk presents itself. If it does not, and we see another 30-40% advance we get a horrible break sometime in 2011 as yet another equity bubble bursts. Does our government have enough bullets to bail us out again?
Base Case 2: If risk aversion sets in early enough and we get a correction, maybe we just get the trading range. Let us hope so.
Economic Goldilocks: We get lucky. Despite history’s lessons, the economy begins a broad based recovery. Impaired assets on bank balance sheets are not as bad as feared. Extend and pretend keeps the financial system stable and lending picks up. Interest rates rise well before a bubble starts and the stock market has a decline. No bubble, but disappointing returns. Markets operate in wide trading range due to inflation concerns and rising interest rates, but no crisis either. Due to strong economic growth, equities over the next few years grow into their valuation and we get decent, but not spectacular returns as valuations get reasonable.
Economic Goldilocks 2: Irrational exuberance sets in as market participants assume that risk is irrelevant. Governments will bail us out any time a problem shows up, and only irrational perma bears think we cannot solve problems after the fact. Conventional wisdom's short memory decides the smart thing to do is buy the dips and hold on. We get extremely overvalued and three to five years from now we give everything up yet again. Not only does the long bear market that began in 2000 continue, it is extended in length. While the result is a market that is flat since 2000, it is still only reasonable, not cheap. The economy has done pretty well though.
Japan Redux: We have an extended period of up and down growth that leads nowhere. Banks, saddled with debt do not lend, consumers save and government deficits pile up. We do not have inflation because of stagnant lending. There are many false starts, but we cannot seem to sustain anything. The stock market goes up and down, but the trend is decidedly down.
It is important to realize that some areas of the market are reasonable at this point, maybe if you squint hard enough as much as 30%. A smaller percentage is actually cheap. Most of that opportunity lies in the higher quality end of the market, which has lagged in the rally.
The rest of the market is pricing in perfection, and even then, returns will be only okay until perfection deserts us. The world has rarely stayed perfect for long.
There are many ways to check how expensive the markets are. One of our favorites is the Shiller P/E. Basically it takes the average earnings of the past ten years and looks at how much you are paying for those earnings. You can compare it to the past and look what happened. Let us look at where we are now (May 6, 2010:)
Some quick observations: Notice that each time the market has reached a point above a P/E of 20; it has eventually ended up much cheaper. In fact, the only time that has not occurred within a few years was during the 1990’s. We have all seen what that led to, a market that has gone nowhere for more than a decade (if in a very exciting way) and still not only not being cheap, but still expensive.
In essence, we have a feeling similar to what we warned about in 2006. The market may continue up, but you will eventually give up any returns from here, and there is a good chance a good bit of the gain over the last year.
Regards,
Lance Paddock, CEO/Director of Investment Strategy
Thompson Creek Wealth Advisors