Sunday, October 26, 2008

From Big Government to Big Inflation

Political leaders are nationalizing an increasing share of our capital allocation process.

This, combined with the likelihood of a near-term decline in personal consumption, should increase government’s share of the economy dramatically in the months ahead.

How much might this actually shore up economic security? How would this affect monetary policy?

In the chart below, we consider both questions in side-by-side measures: government consumption as a percentage of GDP (blue line), and GDP volatility (green line).

(We calculate volatility as the five-year standard deviation of the annual percentage change in quarterly GDP: five years to approximate an economic cycle.)

Since 1953, both measures have trended downwards. Though spiking during recessions, volatility has moderated markedly since 1985. Government spending, meanwhile, took two big steps down: first, between 1970 and 1972 on surging household net worth; and, second, in the early 90s on the massive peace dividend stemming from the end of the Cold War.

Although volatility and government spending show clear association, monetary factors also weigh heavily into this, as during the late 70s and early 80s when inflation skyrocketed (and volatility jumped), or later when it abated.

We should therefore closely watch the risky effects of an enlarged government presence on the Fed.

While Bernanke’s űber-aggressive attempts to stave off deflation would seem justified, a sudden reversal in credit markets could dangerously accelerate money velocity.

And with inefficient banks – and inappropriate business models – still gumming the system, the inflationary effect could be devastating.

Thursday, October 23, 2008

Creative Destruction

Joseph Schumpeter (1883-1950) is widely celebrated for his work on innovation, in particular his invocation of "creative destruction" as capitalism’s key dynamic.

Thomas McCraw's 2007 best-selling biography further popularized Schumpeter’s theory, which now seems almost commonplace in the financial press.

Less well known is his prediction of capitalism's demise, also detailed in his seminal work Capitalism, Socialism and Democracy, which he published in 1942 during FDR's third term as president. This work argues that intellectuals eventually corrupt capitalism's natural process, and thereby contribute to the formation of a welfare state.

He sees this transition taking place in the state’s move towards corporatism in direct response to creative destruction's sometimes violent impact – that is, the social condition of the state exerting itself through corporate bodies. At the same time, he argues that political leaders in a democracy actually manipulate the electorate – eliminating any allowance for individual participation or common good.

Like many others, Schumpeter escaped Nazi Germany for the United States. He disdained the Soviet Union, and criticized Roosevelt’s New Deal, in which he viewed the failings of Keynes, his rival. Dying well before the computer and Internet era, Schumpeter's technological and cultural reference points are now well-removed from today's world.

Transparency as a key foundation of accountability might not have been readily apparent as something feasible in our complex, corporate economy. But if he could’ve comprehended the Internet as an enabling force, would he still propose the same road to demise?

Or would today's environment make him even more confident in his views?

Tuesday, October 21, 2008

Joe, Meet Wall Street

Within a day of each other, Senator Barack Obama and Treasury Secretary Hank Paulson made significant confrontations: the former with Samuel Wurzelbacher (aka "Joe the Plumber"), and the latter with the nation's largest banks.

Coincidence, irony or just the way forward?

In both cases, the message was identical: We're government, and we're here to help.

While the banks reportedly balked at first, they all fell into line in a matter of minutes.

Meanwhile, Joe, a fractional economic rounding error by comparison, stood firm: I don't need your help.

So, here we have it, the essence of today's economic debate: a fierce reprisal of the war between the proponents of John Maynard Keynes and those of the Milton Friedman. Except now it’s happening over weeks, not years – a sudden urgency before what amounts to a national referendum in 14 days.

As pertains to Wall Street, two questions bear consideration:

1. Is it possible to avoid systemic failure and not compromise the underlying system?
2. In taking taxpayer’s money, are banks undermining their core business models?

Desperate times call for desperate measures, argues the government. The risk-return of giving too-big-to-fail banks time to reassemble outweighs the slippery-slope of wider-scale intervention.

Maybe banks know their business models are junk, Joe would probably retort, if asked. Government is absorbing all their risk on my dime, and I'm worried the next administration might offer them even more cushion in exchange for more control.

Wall Street is shifting, and so too Main Street.

We'll know soon by how much.

Friday, October 17, 2008

Smart Money

Who is smart money? If it’s Wall Street’s biggest earners, then it has to be the hedge funds – right?

Wrong, according to their shareholders.

These fair-weather supporters are opting to flee, forcing managers to raise cash to meet large-scale redemptions.

It may not be the managers’ smarts in question (we suspect many would hope to be buying now), rather it’s their businesses’ design.

Specifically, the…
  • promise of absolute return.
  • immediate reporting to shareholders
  • high cost of leverage
  • dependency on short-selling (blame the SEC for this one)
  • cult of personality (commitment to an infallible guru)
  • high maintenance and performance fees
Mutual funds, on the other hand, boast the non-smart kind of money. At least that's been the typical view.

They're everything hedge funds aren't: mired in relative return; measured in quarters, sometimes years; unlevered; beset with anonymous managers; low cost.

But if we’re considering shareholder support as the best evidence of success, they’re in good stead by comparison.

Take the table below: it shows net inflows as a percentage of total assets. Notice the jump in the late 80s and early 90s – a portion of which shareholders invested for the long-term, and which is worth much more today despite the market’s gyrations.
While shareholder redemptions make headlines, the percentage amount compared with hedge funds is paltry.

Smart isn’t just good performance, it’s shareholder confidence in managers and the underlying business model.

New business models will, of course, emerge.

This just may take time.

Thursday, October 16, 2008

Why The Market Is So Volatile

The stock market is a discounting mechanism; it continuously prices a multitude of information.

This price discovery process encompasses vast networks of buyers and sellers, each deploying different criteria

Significant among these: time horizon. While some participants trade over narrow periods (minutes, hours, days), others invest for several years.

How the composition of these participants anticipates corporate health – cash flow, profitability, balance sheet strength – determines the market’s price level and its volatility, an assessment also including factors such as interest rates, exchange rates and commodity prices.

The common feature between current volatility and the market's last bout – the six years between 1997 and 2003 – is the alternative strategy universe (hedge funds, proprietary trading desks): then, its rapid emergence as a mass infusion of leveraged money, and now its purging.

Half or more of the market’s volume (and predominantly short-term in focus), this universe and its impact is much larger today, having become Wall Street's foundation.

One principle difference between then and now is the credit freeze. The other difference is uncertainty regarding government intervention: now, government's direct influence over capital allocation; in the months ahead, its potential weight in new taxes and regulation.

So, here we have it: on one hand, a re-composition of the market's participants; on the other, an adjustment to a new landscape.

Only when market participants finish realigning does this combustible combination defuse.

If the result is a shift toward longer-term timeframes, expect more measured responses to government action and the economy.

Tuesday, October 14, 2008

Recessions and the Stock Market

Since 1953 there have been nine recessions, averaging ten months in length.

Applying mid-month start- and endpoints to all nine, the S&P 500 gained an annualized average of 1.9%.

In four of these, the market dropped an average of 10%; in five, it gained 11%.

The average change from period start to period low is minus 18%; the 1973/75 recession recorded the steepest plunge at 39.2%.

Let's take November 15, 2007 as the starting point of the current recession. (It fits the negative GDP reading that quarter and inflections in other key data: employment, income, and corporate sales.)

From this point to the October 10th close (1451.15 to 899.22), the market shed 38.0%; bad, but not as bad as the 70s.

When will this current recession end? Of the nine, the two longest – '73/'75 and '81/'82 – lasted 16 months. A similar length puts the endpoint in March 2009.

How long, though, ultimately depends on balance between Wall Street and Main Street; the government’s now direct influence over capital allocation is about to test this.

From period low to recession end, the average gain is 23% (the market surged to half of this yesterday alone). In '73/'75, the market recovered 38%.

This recession's different – yes. But as bad as the Great Depression? That depends.

It all comes down to how government – especially the next administration – wields its considerable ownership: to what extent this sidelines market-based price discovery, which has so dramatically diminished economic volatility.

Monday, October 13, 2008

Transparency and Medicare Too

Transparency – the clarity of available information – crops up often these days.

When it comes to mortgage-related securities, it's the ability to price complex obligations; and for the institutions trading and investing in them, full disclosure of their exposure.

Had there been more of it, things might not have gotten quite so out of hand.

The consequence, however, is government now controlling – directly and indirectly – a large share of the country's capital allocation process.

Consider an industry where government already allots one in three dollars spent. And add to this zero transparency.

If there's a model for where things could go, think Medicare, a monolith boasting an $85 trillion unfunded liability (that’s $870,000 of additional liability per household).

Since government began inserting itself in 1965, health care has increased from 5% of the US economy to 17% – and is forecasted to rise to 25% by 2025.

Maybe this is why markets are so flustered: having to price an open-ended right to government-backed financing?

While a big Medicare fix is neither likely nor advisable (imagine the compromise), we should put hope in small breakthroughs; top among these: strong bipartisan support for access to claims data.

Covering 44 million people, Medicare processes over one billion claims per year; not dissimilar to the government dictating non-negotiable bid-ask spreads on a third of all stocks, and blocking all counterparty information from the marketplace.

Imagine if this were transparent; the same should hold for financial markets.

Friday, October 10, 2008

Be Careful What You Fix

I'm exhausted. How about you?

The four-week period ending today featured the highest number of 3+% market moves for any month-long period in the last 60 years.

Eleven in total: that’s an average of one big move every two trading days.

For the year, the market has averaged a 3% move every 12 days. The average since 1950 is once every nine months. In 27 of these years, no such day occurred the entire year.

Despite these gyrations, which have become more frequent the last quarter century, economic volatility has steadily declined, and is now the lowest ever.

The chart below shows this downtrend (rolling ten-year standard deviations of annual GDP) against spikes in the equity market.
We wonder whether all those Great Depression references aren't just a little exaggerated. Sure – the credit freeze has its perils. But as bad as it could be, it could ease soon enough without much lasting consequence to Main Street.

What the trigger is, and when it happens, no one really knows. When it does come, expect the enormous rally hinted at by today's massive swings (a thousand points from start to finish).

In contrast to Wall Street’s manic-depressive bouts these past two decades (let alone the past month or year), Main Street has become downright tranquil.

Should we worry that new capital constraints (higher taxes, more regulation) will reverse this relationship?

Would a Wall Street fix dismantle a potent shield over Main Street?

Let’s hope for rational judgment.

Sunday, October 5, 2008

Advantage, Long-Term

On Friday, October 3rd, President Bush signed in to law the Troubled Asset Relief Program ("TARP"), ending a tumultuous week. From its beginning to its end, the stock market plunged nine percent, a value loss of nearly $1 trillion dollars.

As badly as financials performed (-10%), five other industries performed worse.

Materials and energy – the worst two – accounted for 25% of the market's collapse, $240 billion in total. Meanwhile, consumer staples and health care – though down – outperformed the broad market by 7% and 5%, respectively.

The market might have moved beyond the rescue plan to focus instead on the worsening economic slowdown, but don't assume it's efficient, not that it ever was.

That's because a massive transition is underway among its participants. Until Lehman's demise and the SEC's suspension of short-selling, hedge funds accounted for one-third of trading volume (not including all that proprietary trading among Wall Street’s now-defunct bulge-bracket); many are currently sidelined, some even shuttering.

For the moment, high volatility is shortening the discount horizon; however, once things clear this could extend dramatically, especially as market turnover slows from its eye-popping 170% rate.

That's not to say sector rotation favoring a deep recession isn't misplaced, only that it may take longer than usual for the market to sort through this particular inflection: no two are exactly the same.

But as much confusion exists on the macro level, it's pure chaos among individual stocks.

For those taking a long-term view, your time has come.