Debt Fuelled Deflationary Death Spiral - Part 1

I figure with a title like "Debt Fuelled Deflationary Death Spiral" there would have to be more than one entry over time hence the Part 1. As each days passes I become more entrenched in the belief that this market is going to break to new lows this year as the economy does not turn the corner in 2009 and expectations of a better second half of the year are not met. The back drop for the "Debt Fuelled Deflationary Death Spiral" is not new news. Western economies have been accumulating debt at a staggering pace for roughly two decades. One just has to look at personal savings rates to realize our balance sheets need work (remember in 2007 when savings went negative). The Asian economies, namely China, have been happy to export all things manufactured to the consuming nations. With its large current acccount surplus the Chinese bought US debt and kept interest rates low. Sort of a wonderful relationship ... until it stops working. This is where we are today. Oh and just for fun throw in the fact that the global financial system is being nationalized in one form or another and that the availability of credit has fallen to depths not seen since the 1929 Depression. I guess systemic risk is real.

I can't help but cringe at analysts, portfolio managers, strategists and economists alike as they talk about how we are through the worst part of the cycle and are looking through trough earnings to better times in the second half of 2009. Essentially what they are doing betting Western spending culture returns. I hate to burst another bubble but this isn't going to happen. From 2002 - 2007 home equity withdrawals accounted for approximately 70% of consumer spending. If consumer spending is 2/3 of GDP then these home equity withdrawals accounted for a full 50% of GDP growth during this period. How much stuff did we really need? Whatever happened to saving for a car, vacation, rental property etc. With house prices rising and credit flowing no one waited. Presto instant gratification. All is well as long as asset prices continue to rise. Remember leverage works both ways. So now you are left with the debt (due to the use of leverage at unprecedented levels) and deflating assets - houses and cars. Since the 3rd quarter of 2007 the US consumer's household net worth has contracted $13 trillion dollars or 20%. I believe we are still nowhere near the bottom in housing prices and if the markets break down again this year there is still much more pain to come.

Credit is tight might be the understatement of 2009. I had a meeting with a junior mining company today. They are literally 6 weeks away from there first gold pour and the project is on time and on budget. The CEO was literally at wits end about how difficult it is to deal with Shell to get the oil needed to run the mill. It is a cash based system. Pay first then you get your supplies. Not a year ago they had 30 days from delivery to pay. I must emphasize that this management team is not new. This is the seventh time they have brought a mine into production. They have no bad debts outstanding. They are sitting on about 7 million ounces of gold and have about a 94% completed facility that will produce 200,000 ounces of gold when production is fully ramped. Oh did I mention they are pouring gold in 6 weeks. Even the group managing operations is paid in advance. Unbelievable. How quickly things have changed. The rate of change going on with the deterioration of credit is amazing. I think this is where the "so-called experts" have missed to boat.

Recessions have to do with inventory cycles and are solved with monetary policy (cutting interest rates). Well since treasury bill yields are basically at zero I guess this hasn't worked so well. This is due to the necessity of the consumer to repair its balance sheet. Remember all the stuff we have pre-bought between 2002 - 2007. As we work through this we will most likely hear more rhetoric about depression. Who cares about the title, this is what will continue to happen: 1)deleveraging will become the new leveraging 2) we will actually want to pay off our debt 3) in order to deleverage and pay down debt we will continue to liquidate assets and 4) we will increase our savings rate to the long term average of 8%. This process cannot happen in a year or two. It takes time and lots of it. Seem excessive. I would argue not! Excesses in one direction ALWAYS lead to excesses in the opposite direction - the financial equivalent of Newton's law.

The above new world order is based on both fear and the reality of this new world. It is a world where unemployment hits double digits and bankruptcies (both personal and small business)explode higher. Just look at mall vacancies if you don't want to believe me. U6 unemployment is 13.5% and going higher. The argument I get here is that fiscal stimulus will come to the rescue. Not so fast. I agree it might slow the pace of the decline but it will not stop the decline. It is a plug figure to step in as personal consumption and investment vacates the building. As unemployment continues higher protectionist banter will surely not be far behind - don't be surprised. Wait a minute didn't we see this with Geithner complaining about renminbi manipulation last week. In the Wall Street Journal today the headline on banks was "Nationalization Gets a New, Serious Look". Oh no the US wouldn't stoop to nationalizing!!!! Oh yes they would, they will and they already have (at least in part with Citigroup, Bank of America and AIG to name a few). This is just starting. Please don't get fooled in here.

Ok enough doom and gloom. There are still lots of opportunities to make money out there. We will eventually discuss them. But for now I'm off to bed. Looking forward to watching my son at his hockey practise tomorrow. Taking the afternoon of to do that.

The Beginning Of Epic Failures

I was at a dinner party last weekend for my friend's birthday. The birthday girl ended up cooking dinner (not quite sure how that happened but it was great) and I had a lengthy chat with my buddy. Since I had three helpings of dinner as well as desert I had plenty of time. I would categorize him as an utterly great human being (ok truth be told the birthday girl is great as well) who I have all the time in the world to discuss any range of topics. In our conversation we hit upon the usual stuff the markets, Obama and the insane cold weather we are having. But what really caught my attention was when he used "Epic Failure" and described it as a new buzzword. So I have to give CC all the credit for the birth of "Epic Failures".

Does 2009 matter?

I got to thinking today about whether or not any of this awful economic news matters anymore. Somewhat difficult to answer but here is what I have come up with. I think it does matter because the market is already looking to 2010 with expections of recovery. Here's where it all goes sour - let's assume S&P earnings actually hit $50 for 2009 (I think this is on the high end of reasonable. In Q3 2008, earnings growth outside the financials was up 5% yoy and is only now starting to crater. Anybody wonder why GE is trading with a dividend yield of 10%. 3M should be interesting this week). And for sake of this example lets say we assume 15% yoy earnings growth in the S&P so 2010 will be $57.50. **For the record in the no-leverage era we have entered 15% yoy growth will be almost impossible.** Also lets give the 10 year treasury a 2% handle and call inflation zero.

2009

S&P 800
Earnings $50
P/E 16
Earnings Yield (1/(P/E) 6.25%
10 Year Treasury 2.00%
Inflation 0

So the question becomes what is the earnings stream worth in a lower growth / uncertain environment. Today, if my earnings are correct, it is worth 6.25% or 4.25% greater than the 10 year Treasury. Or to take on all the risk of the equity market you are making an additional 4.25%. Doesn't sound like enough to me. Okay lets go to 2010.

2010

S&P ??
Earnings 57.50
P/E ??
Earnings Yield ??
10 Year Treasury 2.00%
Inflation 0

This is a little trickier as we have to make a few more assumptions. To illustrate my point lets use 3 possible P/E's for 2010 (10, 15, 20) to derive where the S&P could trade to. At 10x earnings of $57.50 you get the S&P at 575, 15x equals 862 and 20x equals 1150. Or return from todays level would be approximately -35%, 8% or 45%. Quite a range of 1 year outcomes with earnings so uncertain.

To go one step further if the market trades at 20x earnings your earnings yield (1/20) is 5%. Or better put you will be earning 3% more than 10 year Treasury bonds. Pretty skinny. So 15x and 10x are 7.5% and 10% respectively. Your "reward" for owning equity instead of government bonds is now a respectable 5.5% - 8%. Now I am getting comfortable. However in this scenario my range of equity returns would be from -35% to 8%. Not a nice thought after living through 2008. However in a world that is rapidly deleveraging, growth is going to "muddle through" for some time. Until we have more visibility on earnings I would not get too excited.

So it appears the market is discounting 2010 earnings of about $57 with a multiple of 15. I don't believe there will be any 2009 upside earnings surprise and the only real question is whether or not we step on any more land mines. My guess is yes and with risk to the downside, 2009 certainly does still matter. I would also argue that as growth subsides the multiple you pay should also decrease. This does not bode well for the coming years.

After doing this analysis it begs the question of looking at some capital structure arbitrage. It would seems to me that corporate bonds versus equity on a risk / reward basis look pretty good right now. Big BUT here ... no financial bonds for me. I am renaming TARP to TRAP for all the "investors" who bought financials in the past year without doing your homework. More on this later.

This Doesn't Feel Quite Right ....

Well after a "fun" week at work it is always therapeutic to come home and have your 4 year old utterly destroy you at Mario Kart. Keeps things in perspective. He's sleeping now so I get a chance to write.



The market still doesn't feel quite right in here. Hard to put much more than a gut feel on it at this time. Keeps my portfolio defensive. Very close to printing another good month (5 trading days to go). A couple points come to mind. First Merrill is at $58 for S&P earnings for 2009 (consensus is a bit higher) and I believe when we look back at 2009 $58 will be much higher than what actually happens. If we take a market multiple at stock market bottoms of 10 times (this is generous) then the S&P fair value would be at 580. This is a far cry from where we are now. Earnings are collapsing and I don't see this as ending anytime soon.



Secondly consensus for Chinese GDP in 2009 is around 8% (again a Merrill number). Note ... I am not picking on Merrill. Dave Rosenberg has been spot on with this mess. In my tired state I just happen to recall a couple of salient data points. Ok I really can't wrap my head around this one. The Chinese manufacturing was materially overbuilt and is now collapsing. Unemployment is creeping higher and political tension with the US appears to have begun (both Obama and Geithner are already complaining about renminbi manipulation). The reality is I have difficulty getting GDP at 7% this year.



What does this mean? Well since the market trades on expectations I think we are going lower before we go higher. The back half of the year looks on track to disappoint (growth expectations will not be met) and current valuations are not cheap by any standard (especially with global earnings collapsing). Hopes for the recovery revolve around massive global fiscal stimulus. While this is coming I don't see it as the savior for 2009. These projects take time to get moving. Ultimately fiscal stimulus will only replace a small percentage of the money that is leaving the system via lower private consumption and investment.



History tells us that when a credit bubble bursts there is only one thing that can fix it. TIME. While it is a nice story to believe that we can speed this process up, via government intervention. I am leery to subscribe to that theory. Hence the belief that Q3 and Q4 2009 will be worse than consensus and ultimately this market will go lower. Stay defensive.

Look Out Below ....

Short post today. These regional bank earnings continue to be nothing but awful. Whether you look at Fifth Third, Key, Synovus or Huntingdon it’s the same crap. Common themes include CEO’s commenting how commercial real estate (CRE) is rapidly deteriorating, non-performing loans continue to rise and large increases to loan loss provisions persist. I have yet to talk to a sell-side financial services analyst who wanted to discuss how in the past 10 years the regional banks have been effectively shut out (by the national banks) of the consumer credit card and auto loan business. In order to grow, regional banks have taken a much larger weight in commercial loans than at any time in the past. Oh oh. Maybe someone should have stress tested those risk models

So it shouldn’t be too hard to put 2 and 2 together and realize that since commercial loans lag in losses to consumer loans that there is more pain to come. These stocks have been destroyed in the past year. But my feeling is that whether it is full nationalization or “quasi-nationalization” the equity holder is about to be wiped out. The belief that we need a strong financial system in order to get through a crisis is absolutely true. But what investors forget is that there isn’t a linear relationship between a strong financial system and rising stock prices. Inherently it is easy to assume this but it is wrong. Our strong financial footing will come with a cost – mass dilution. Remember the cock roach theory – where there is one there is always more. Be careful out there. I have zero exposure to financials right now. I’ll talk more in coming posts about earnings expectations and forecasting and what to expect.

Unintended Consequence

Okay time for the first entry. The start of this week has been very interesting. The euphoria of Barrack Obama taking office was offset by the stark realization that the worldwide banking system is still a mess. The majority of the talking heads are absolutely blind to what is going on. Whether it is the “Bad Bank” solution a la Resolution Trust Corporation in the Savings and Loan Crisis or just plain nationalization – the European route with Fortis, RBS or Lloyds – the end result is lower stock prices.

Spent some time today looking at the European financials in detail. Getting tired of revisiting this situation but I found myself drawn to how badly these banks have been managed. Without getting into much detail and generalizing two problems jump out. First the leverage was much higher in Europe than the U.S. and second and even more alarming is the clear lack of transparency within the entire European system. There is much more pain to come.

One of the unintended consequences of the downfall of the European banking system might be the ultimate failure of the Euro to exist as a currency. The United Kingdom is well on its way to nationalizing its system and Germany and France are not far behind with bank bailouts. However the PIGS (Portugal, Italy, Greece and Spain) still have much work to do. Just how big the capital injections / fiscal stimulus will be is still not clear. The question will ultimately be how much stimulus is needed versus what can actually be raised. 10 year bond spreads are widening as more and more risk is being priced into the smaller countries within the EU. Now Spain, Italy and Portugal are trading between 130 basis points and 150 basis points back of German bunds.

At some point this comes back to basic economics. Spain is the prime example of an overbuilt housing market about the come crashing down.. We’ve seen overbuilt regions in Las Vegas, the inland empire of California and parts of Florida. THIS DOES NOT END WELL! There is no central currency to help in Spain so the full economic effects of the crisis lands directly on the taxpayers in Spain – not the entire Euro region. Lower spending and lower taxation revenue lead to falling credit ratings. The only way out is to gain a competitive advantage either through currency devaluation or wage reduction. Since Spain does not control its own currency the only measure it can use is wage reduction. This will not go over well and puts a country like Spain with its back against the wall. The other countries mentioned above are in a similar situation.

I believe it is only time until we start hearing discussion about the Portuguese escudo, Italian lira, Greek drakma and the Spanish peseta. If the bond spreads continue to widen watch for the rhetoric to begin.