Saturday, December 27, 2008

The most misguided analysis in history

The more I read and study the current economic situation, the more amazed I am that the people with the platforms to speak haven't a clue what happened and what is going to happen in the world economy. In the news media, there is too much talk about the level of consumer spending and too much begging for consumer spending to pick up. This is going to be the great shock of so many, as we have seen the real peak per capita in consumer spending for the forseeable future, maybe 20 to 50 years forward. The banking industry, the consumer goods industry and the capital goods industry are going into a long flat spell worldwide. First the growth will turn negative, then it will flatten out to zero and there will be no growth along with sizable cuts in dividends, as companies struggle to survive. Without growth, the dividend rate has to reflect either the deflationary loss in future income or the real risk of holding stock. In either case, we are looking at dividends in the 6% to 8% range for most stocks and figuring the market in general is about half that, we have another 50% decline in the market at a minimum. This will combine with a 50%decline in dividends, meaning we probably have a 75% decline at a minimum, taking the SPX into the 200 range and the Dow to the 2000 level.

There is a tendency to credit groups and blame groups. I am writing this in response to the blaming of Greenspan and Bernanke in a article I just read. I think Paul Volker has as much to do with this mess as either of these 2, with his death grip monetary policy in the 1980's, but the role of all these 3 guys in all areas of their field is much less than thought. I know this idea will generate an argument 1000 miles long in print.

I have also been reading nonsense about the Chinese and their lending back to the US helping to perpetuate this mess. The money machine was in the US and when combined with the Chinese central bank, only the skids were greased a little more. The nature of a reserve currency is it runs deficits and ends right back in the country of origin, as other countries use it for monetary collateral and long term income. If the Chinese created this money cycle, how did they get the dollars in the first place?

If I were to point a finger at anyone, it would be Robert Rubin. But, much of this ball was rolling when Rubin took office in 1994. Rubin taught Greenie about the non-existance of bubbles, if Greenspans book is to be believed. The 2000 Nasdaq peak was by a factor of 2 or 3, the biggest major market bubble in history. That market alone was 100% of GDP at the peak and I believe the 1929 market peak was only 80%. The then valuations of CSCO, INTC, MSFT, ORCL and WCOM was near the valuation of the entire Nasdaq at the present. Those 5 stocks combined wouldn't buy CSCO at its peak at the present and they were nowhere near being the overvalued portion of the Nasdaq. I believe the Shiller housing index would have had to reach a level double or triple where it peaked in order to mirror such excess. The Nasdaq bottomed at 1300 on October 8, 1998 and peaked in March (I believe the 10th) in the neighborhood of 5200 for a 300% gain in 17 months. Though Greenie helped in this matter, it was the enabling acts of Rubin (collateralizing the issuance of money is what is important in money, not the interest rate, the gold or how much money the Fed says you can have) that produced this bubble. The Clinton administration put more slugs in the fusebox once this market bubble got started than Greenie could have ever managed. There was no 10% margin in this market, aka 1929 and was more a factor of continued support of cash flow through government activity. Rubin, the US treasury secretary, had at least some power over the activities of the IMF. Even so, I can only point a broken finger at Rubin.

Getting back to blame, I mentioned Volker. Volker did the US a favor by shocking it into the idea that borrowed money could get expensive, but he didn't stop inflation. Ronald Reagan stopped inflation. I know the Democrats out there are going to have a fit over this one, especially since Volker is one of your darlings today, but this in fact true. Inflation had become institutionalized and like it or not, Reagan put an end to it, either intentionally or by accident. The biggest factor in inflation was income tax bracket creep. People that are making $30,000 a year today weren't intended to have a tax bracket when the brackets were drawn out or if they were, it was to be 10% or so, maybe 14%. But, if Reagan hadn't have done what he did to taxes, the $30,000 a year guy would be paying taxes like he was a $200,000 year guy. In fact, I don't think the $200,000 a year guy pays taxes like the $30,000 a year guy did in that code. Those of us old enough to remember, recall that $30,000 a year was a magic income around 1970, the dividing line between whether you were doing okay or had arrived. Today, it is a secretarys salary in corporate America. Cutting the taxes and forcing government to cut its rate of growth of expenditures changed the institutional makeup of the US.

In short, what Volker did with interest rates, probably doubled the Reagan deficits after 1984 and created the sudden asset appreciation that produced the trend of the early 1990's that created the bubble mania. Even so, the link I propose here could be weakened by argument and I am not prepared to go at length to crucify or defend Volker. I think the ease out of the interest rate squeeze was 5 years too late at least and should have been done by 1985. Instead of easing in 1984, Volker tightened and that in itself produced a financial crisis of its own. In any case, the move from Volker to normal was an extreme shift in financial valuation and the fuel that created the real ogre of the 1990's to 2007 bubble, home finance.

I was selling real estate when I graduated from college in 1978. At the time, interest rates were a high 9% and the Iranian revolution threw a real bomb into the gearing of the US economy. As I pointed out, the structural composition of the US was such that in order to stay even with inflation, you had to outrun inflation, which produced a spiral. Higher income produced higher taxes which produced a decline in living standards which produced a need for higher prices and the spiral was on. What else this procedure did was produce an automatic tax increase for the government through the progressive income tax, which wasn't indexed to inflation in those days (Reagan could have done nothing more than reverse taxes to inflation adjusted 1976 levels and inflation adjusted the tax rates to 1976 and left them unchanged and done the same thing but left more upper income in the future for the government), so government spending went out of control in the 1970's. The spending and income trends of the 1970's projected on trend from 1960 to 1975 would have produced deficits in the $900 billion range by 1990. I have generated these figures out of actual numbers on spread sheets, so I am not making this one up. In any case, what I am trying to propose here is the shock that interest rates on mortgages going from the 8% to 9% range to almost permanently for 11 years to above 10% and many years above 13%. After moving to mortgage lending, I recall the first refinance boom was a move to under 12% on 30 year fixed money.

There was another psychology created out of this rate structure, the psychology of the CD holder. Conservative people that had cash were able to put their cash in CD's and earn significant income. My father accumulated cash through his own endeavors, inheritance and through a lawsuit for extensive injuries he sustained in a fall and during the 1980's was able to earn more money retired out of CD interest than he made working some years. Of course I am leaving out inflation, but I am also leaving out his travel expenses. It was a shock to a lot of these older people when their income out of their $200,000, $300,000 or $500,000 in cash dropped from $30,000, $45,000 or $75,000 to something like $6000 or $9000 or $15,000 in the first Greenspan thaw around 1991. These people had adapted their lifestyles to high interest rates giving them income and they needed to speculate to support their lifestyles. The stock market had already benefitted for several years from the marginal declines in interest rates along with the gradual restoration of value lost in the 1970's to inflation and the trend drew interest. Remember, the Dow in the early 1980's was in the 800's and despite the 1987 crash, the market was well into the 2000's and rising come 1990. The passing of 3000 together with the decline in the Fed funds rate to 3% from some amazingly high number was a combination that made a mass move into stocks a no brainer. Since very few Americans, including many on Wall Street, had no clue as to financial valuation of stocks, the sky was the limit. (More and more is coming out about the education of those on Wall Street quite often being something besides financial and more connected to what school they went to or who their daddy is than what they know about valuations).

The other side of this coin was real estate. My complaints about Volker are massive and for much of his early term, Greenspan continued Volkers actions. I believe these actions created one of the worst financial recessions in history, the 1990-1992 mess that cost Bush I his office. There were housing crashes around the US and the affordability of homes had been pushed down to lower levels. When the built up decade of high interest rate mortgages suddenly were refinanciable at single digit levels, the gates opened for a housing boom. FNMA and FHLMC became major players in the financial world and the paper machine of the US. Complicit in this matter were the efforts of HUD and the congressional panels that oversaw housing matters. Stemming from an act in the mid 1970's designed to encourage lending to low income people, a 1995 act dictated to these GSE's they find a way to lend more money to these lower income buyers. But, I don't believe this was the real impact behind the housing boom or the stock boom. I do believe that the shift in rates and rising activity in equity extraction created the 1990's stock bubble. It doesn't take a lot of fire to clear a crowded arena, nor does it take much additional money to push a crowded stock market into a mania.

My contention is that the securitization of mortgages and the effects of lower rates going into the early 1990's and beyond unleashed an amount of equity and spending power out of housing that was totally financed under the guise of government guarantees and Wall Street hype that created this entire world economy. The Chinese buying mortgages and government bonds only explains a part of this mess. Something had to generate the extreme levels of cash in the first place to have moved that much money to China and I believe the above described mechanism was it. China itself is part of this bubble and thus will not escape its effects, not because they are going to lose their money they put back in the US, but because their business model is built on being financed by this Wall Street/GSE machine. So are the earning of the US corporations as well as the European and Asian ones as well, as we are seeing at the present. Toyota has fallen on hard times along with Ford and GM.

Michael Koo, of the Japanese Central bank, is the closest I have seen in coming to grips with what is going on. The populace is spent out and the corporations of which they are customers is over capacity and overleveraged. In some ways, Koo says that the current direction of stimulous packages is the right path to avoiding depression, but that it won't get us back to where we were on the peak or anywhere near it. That will take time. Some speak of the great shape the balance sheets of corporate America are in, but I beg to differ. If they were so cash rich, there wouldn't be a credit crunch would there? Also, some speak of cash on the balance sheet, but I doubt a lot of it is real cash. By this I mean there are current liabilities and current assets and in a lot of cases, I doubt the reliability of the current assets, which exposes the cash to the current liabilities and the company to bankruptcy. Instead of being highly solvent, many of these companies are going to be liable to the full extent of their cash balances.

I have seen some mention brokerage firms as having $X of cash per share and I highly doubt that money actually belongs in whole to the firms involved. In fact, I would be highly watchful of the solvency of any Wall Street firm or its ability to meet withdrawals. I see a lot of cash in the minerals and oil and gas business, but I know enough people that were in the oil business before to have doubts about their receivables. Few people realize the deflationary pull that has set in and how fast cash can evaporate.

My point in all of this is that the roots of this mess go way back. I am not sure that Greenspan, then Rubin, then Bernanke weren't all doing all they could to forstall a collapse that was caused by the interest rate and generational structure of the US in the 1970's and 1980's. I believe from my own experience that Volker kept rates too high for a lot longer than Greenspan and Bernanke kept them too low. I also believe the perceived government guarantees of the GSE's contributed to excessive securitized debt and thus the monetization of consumption in the US and therefore the world. The size of this bubble doesn't meet a a border,nor was it caused by a single asset class like subprime mortgages. It was caused by a series of bubbles that were caused by a shift of perception by a group of people worldwide without the experience and knowledge to intelligently invest in such assets.

Now, the last bubble is bonds. Bonds aren't a bubble, but an asset class. The financial bubble has broken and it isn't possible for there to be another bubble. I think people are going to be surprised, unless the entire mess collapses, how long treasuries stay below 3%. I believe the minimum will be 2020 before we see a sustained rise of treasury bonds above 3%. Aren't we all shocked that Japanese 10 years have spent more than a decade below 2%? Remember, the dollar is the reserve currency.

So many people keep thinking this is a housing problem, but it isn't a housing problem, but a problem with financing and raising more cash. The source of new cash for the US for 2 decades or longer was home equity and to some extent, commercial real estate equity and stock equity. This became the source of cash for the world. The entire world will need to deleverage out of this mess and any attempt to become the US by another country will lead to its immediate collapse. I believe that most mortgages will be under water before this mess is done and that all markets will be affected. I am in the housing business at this time and due to the current condition of the local market, DFW, I have to resist the temptation to buy more all the time. It would be a good idea to see what summer looks like.

Saturday, December 6, 2008

You never get even over the long run

I want to comment on the stock market as it is a financial instrument. Shiller has adjusted this data in a good way I believe. I did a huge study on this data and what I figured out was that inflation from 1926 to 2003 was a compound 3%, that the beginning dividend rate in 1926 was 4.8% and if you bought stocks on that date in the form of the SPX or its equivalent, you would have made 4.8% plus 3% inflation plus about another 1% in real terms. If you take the dividend yield out of the data for 1/26, you get .61/12.65 or 4.822%. The CPI adjusted price for 1/26 is 157.72. The last data on this was for 6/08 where dividends were 28.71. If you adjusted the 6/08 data to a 4.822% dividend, the price would be 595.38, which is a factor of 3.77 over a period of 82 years. This demonstrates a real growth factor of about 1.5%(this would be accurate at 89 years).

Here is the rub of this data though. There are a couple of factors here, what was the price at the peak of the last debt bubble and the 10 year average trailing PE. The factor for 1/26 was 11.34 and the factor for 6/08 was 22.39. This is a rough factor of 2 and if you divide 1341.25 by 2, you get about 670, in the region of the 595 that I mentioned. If you move back to 1929, you get a trailing PE/10 of 32.56. Though much more expensive than 6/08, the 1929 PE paled compared to 43.22 at the peak of the SPX in 3/00. But, at the summer 07 peak the rate hit 27.40, not quite there, but in the region of 1929. This factor peaked in the 1960's, a sweetspot of all time economy in the US at 24.06 and going forward dropped to 6.64 in August 1982. It also dropped to 5.57 in June 1932. This supports real values in the 25% range of the top, maybe lower.

The other factor is if you look at dividend growth between 9/24 and 9/29, you get a growth from .55 to .94, a factor of 1.709 times. This is a little over 11% compound. Dividends peaked between June and December of 1930, another time when corporations failed to conserve capital in time. If you take the same time frame, 10/02 to 10/07, dividends went from 15.88 to 27.22 for a factor of 1.714, almost identical to 1929. There was one difference in the fact that the dividend rate actually went up in 2002-2007 where as it went down in 1929. The other difference was the nature of the credit system. The bubble that pushed stocks higher in the 2002-2007 period was much bigger.

There is one more point. The price in 1929, adjusted for CPI, is 403.79. The dividend yield for 9/29 was 3.003%. If you took the 10/07 peak and adjusted it to a 3.003% dividend, you would get 27.22/.03003 or 906.36. The CPI factor for 10/07 in this demonstration is 1.0681772898 to give a price of 968.15. The factor for peak to peak is 2.39766 for a period of 78 years. This is about 1.15% real growth in price(1.011 divided 78 times into this factor reduces it to 1.0214, meaning it is within .1%). If you took this 79 year period, you would find stocks returned 3% plus 1.1% plus inflation.

Let me say that again: If you took this 79 year period, you would find stocks returned 3% plus 1.1% plus inflation. Do you know what 4.1% over inflation is? It is damn short of what staying in a corporate bond fund would return you. It is about 7%, but this is if you hold from peak to peak. If you take the price of the SPX for November 1985, you get 404.39. What is this? It is when you got back to even for the second time for owning the SPX from the 1929 peak. The first time was 11/58.

People think stocks change form, but buying a basket of stocks is not that much different than buying a basket of bonds. Your yield to maturity is what you get when you buy. There isn't some kind of magic that comes in over night like the tooth fairy and give you a bonus for you losses. These are solid facts about something that mirrors the SPX.

Why my fixation on dividends? Because that is all a stock every pays its holder passively. If a stock is acquired by another company or the company buys back stock to reduce the float, it never pays a dime of dividends, the holder eventually ends up with zero. The return on a stock is its dividend rate plus its growth rate. Thus if you hold the SPX as a stock, which for the great unwashed is the only way to hold stocks (there is too much money for everyone to be buying the few prime stocks or for that matter, move into dividend stocks), you can't do any better long run than what long run is. Markets that pay low dividends as this one has for most of the last 20 years (current dividends are declining and not high and the worst time to hold stocks is when dividends are declining as the growth rate is negative and stocks have to adjust their prices to take into account the declining payout). My point is you get your long run at the price you buy and there are only deep bears and bubbles that present opportunities to buy or sell. I venture a regular non bubble, non bear market is probably in the SPX 500 range or lower.

Thursday, December 4, 2008

I had written something I intended to post here on another site and the internet didn't feed and lost it. It was in response to a challenge about the stock market moving back to the mean and overcorrecting and going even lower. The mean revision that was being discussed was the PE ratio, but I choose to focus on the dividend rate. In any case, if there wasn't a mean, there couldn't be a return associated with stocks and that is what I propose to show.

Back in 2003, I was going to write a book, but I chickened out. The name of it was going to be, "Is it Safe to Get Back in the Water", meaning, is it safe to get back into stocks. During that period, I did my own personal study on long term data posted by Robert Shiller of the housing index fame, dealing with stocks. The famous return on stocks that is quoted uses 2 years, 1926 and 1950. 1926 was the last year prior to the great run up in stocks prior to the Great Depression and 1950 was the peak in dividends, so either would be a likely year to choose to mark stock returns from. 1926 because it would impress upon people that a depression couldn't stop the market and 1950 because dividends were at all time highs and it would clearly be a year to produce a great return.

In any case, Shiller had everything from earnings to dividends and the CPI number for every year from 1870 on and through this I was able to construct a model of how stocks were valued. I had been taught a formula in college about the value of a stock and the market would be valued in the same fashion. In fact, the data could actually verify what the simple model was. The formula, P=d/(k-g) is a simple discount formula where dividends are discounted the required rate of return minus the rate fo growth. Like all financial formulas, it is actually pretty simple, but finding the components was not. Through this, I made assumptions as to why the market itself was so absurdly high, as dividends were only in the 1.6% range after a sizable adjustment down from a price where dividends on the SPX were as low as 1.08%.
I decided I would use 1926 as a base year as well and what I found was that from 1926 to that time, which I believe was 2003, the long term rate of inflation was 3%, the starting dividend rate was 4.8% and the growth rate was in the 1% range, giving a long term return of about 9%. This would confirm a risk free rate of return plus 2.8% to 3% as being about normal for stocks, as treasuries would generally yield inflation plus 3% over the long haul and BBB long term debt about 5% above inflation. Bonds are safer than stocks because they at least recapture some of their value in what is certain eventual default and bankruptcy of a company.

Contrary to the bullish side of the equation, I didn't focus on the price of stocks, but rather the growth of dividends and the starting rate of dividends. A bull might say that 4.8% is too high of a dividend, but if I had used something like 3%, the rate of return would have been much slower. In fact, I could have moved to the 1929 peak and did just that.

This is where I can draw the parallel to reversion to the mean and what the return on a stock really is. If one is going to compare 1926 and 2003, they need to compare based on the dividend rate and not the price of the market, as they are 2 different things. Maybe 4.8% is too high, but then you have to adjust downward what stocks yield. I do know that 1% was too low and 2% was too low and likely 3% was too low because prior to the 1990's every time the yield hit 3%, the market failed to go higher. The best it could do was move higher with growth. There was 125 years of data lying there and suddenly history didn't apply. Anyone with a brain knows better.

To move forward, I must clarify something. This is something no one has ever mentioned in the public arena of buying stocks or an SPX fund, but there is no averaging in on the market. If you buy a stock and hold it forever, you get what you bought and nothing else. Thus, the mistake of buying a bond with too low of a yield can be made up by the end of the term of the bond, but that can't be done with stock. Thus if the historical yield of the stock market is inflation plus 5.8%, you can't pay inflation plus 4% and ever get back to inflation plus 5.8% without the market making a huge mistake. You can only make inflation plus 4% and that is if you hold the portfolio forever. You could hope for a bigger fool to come along and pay a price sufficient to produce a yield lower than 4% then you could make more than 4% by selling, but not holding. Thus the long term success of buy and hold for a market fund is predicated on whether the return in the future is lower or higher and the lower the acceptable return, the higher sales price that can be achieved. But, the forever return is always going to be where you bought in.

Why can't the growth be higher? There may be times when it is higher, but in truth there is only so much money in the system, so many resources and real growth is quite likely to not involve more money, but lower prices. Another thing is the differential in compound returns. If you take 3% for instance and compound it for 24 years, it doubles. 6% takes 12 years to double, but in 24 years it is 4 times its original size. In 48 years it is 16 times its original size while the 3% is only 4 times. Thus over the 48 years that the typical person would accumulate and live off stocks, the economy would have to support something that could be 4 times its size when it started. The factors don't work and the value of the stock market cannot grow at any appreciable pace greater than the economy as a whole. If you took the more extreme numbers of 9% and we were looking at 6% nominal in the economy, we would have a double in 12 years for the economy and 8 years for the stocks, meaning stocks would have to relatively double the economy over 24 years, as 9% produces an 8X while 6% produces a 4X. The compounds cannot be sustained on any real basis. This is actually true whether you pay dividends or buy back stock.

So, there is only 1 way that you can get an after inflation return on stocks of 6% and that is to price them that way. Stocks haven't been priced in that fashion for 25 years. The question is, why? Growth hasn't been that fantastic, actually pretty normal and below historical for a long period of prosperity. I can only offer 2 reasons, one being the natural, debt bubble that produces excessive money in search of a return and the other being an adoption of a fiction in investing. I believe today that the first reason is the primary reason, but the stock bubble couldn't be so persistent and defended without the fiction.

Here is the fiction. When I went to college, they were teaching something called portfolio theory. What portfolio theory actually meant was you could take several properly correllated risky assets and put them in a portfolio and the portfolio would over time produce the return expected out of the assets. To invest in any one of the assets would produce a return that ranged from either a total loss to a huge bonanza in excess of anything planned. Thus, you could take history and buy it and it would work as long as the assets themselves were priced reasonably going in. Nothing could be done if the assets were bought at yields much lower than necessary.

In seeing this, I wrote a paper years ago called "Who destroyed Portfolio Theory"? My contention was and still is that Wall Street took statistics and came up with this idea that stocks returned X% over time and that all you had to do was buy a portfolio and you would get the return. With the adoption of that attitude along with the credit bubble (money bubble)people started pouring money blindly into S&P funds. Over a period of 10 years or so they drove the yields down on stocks to near 1% before the bubble sprung a leak that was repaired 3 years later. Thus the assumption that all you had to do was pour money into a mutual fund and the fund would make you rich. There is really little chance that once this procedure started that Wall Street set out to take full advantage selling stocks at as high of prices as they could.

Which is the return for stocks? Is it inflation plus 2% or inflation plus 6%? I have seen about everything inbetween adopted in my lifetime. I believe that in 1982 the dividend yield on the SPX topped 6%. Thus from that time on, you could expect a real rate of return of almost 7% plus inflation. IN 2000, you could only expect a return of about 2% plus inflation. This is one reason the market could only make a double top in 2007 against its value 7 years earlier and have only dividends to show for it.

This is what mean reversion is all about. I don't know if the reader has been able to follow what I have written, but figure this one. There is a lot of talk about the 10 year bond being below the dividend rate. They talk about this like it has never happened when in fact the entire period between 1900 and 1950 the dividend rate on the broad market was higher than the yield on treasuries. I would venture that most of the following 15 years were also a period when bond yields were lower than stock dividends. This is in part because inflation wasn't certain and growth was even less certain.

If we return to normal money in a normal growth market, we will again see t-bills priced at inflation plus 3% over any given time frame. We will see long term growth on stocks of between 1/2% and 1% above inflation and we will see risk premiums above 4% again. In fact, the 1966 and 1929 tops were met with 3% dividend rates and the latest dividend I have on the SPX is 28.71 which gives a 957 price on the SPX for a historical top. As dividends fall and stocks fall out of favor and the bubble deflates, we have a long way to go down. We aren't talking about getting 10% on stocks when inflation might be zero and dividend and profit growth negative.