Declaring Failure and Moving On

This is a very rough note. I think it could be fleshed out into a very meaningful article, but for right now it is just some top of mind reflections.

My underlying framework post-GFC was one where the business/investment cycles going forward was going to be more compressed (timewise) and more volatile. I was also heavily influenced by the new normal meme and how the economy was going to be stagnant as it worked through a balance sheet recession.

If I were to attribute a reason to that belief I would ascribe it to my ideological bias toward market economics and the belief that the market had not been allowed to clear properly due to significant artificial interventions. It was also heavily influenced by the recent traumatic past and the idea that modern markets/economies were more integrated, interrelated, more complex than ever before, and were consequently prone to momentum and cascade effects.

Financial marketwise this has not played out and I must declare failure and move on. I think the reason why financial markets have not reflected those beliefs is due in large part to hindsight bias and the massive trauma effected upon the psyche of market participants who endured the brutality and existential angst of a market implosion that could have gone even further. Investors have been fighting the last war. They have been overly pessimistic. They have been unwilling to give the Fed (or the govt) credit for stimulus. The market has climbed a massive wall of worry the whole way.

We are now at a point where the market is coming around to the idea that the Fed may have steered us over the canyon and to other side. The economy may be gaining sufficient strength to be self-supporting and a new cycle of more normal growth is going to ensue (even as the stimulus disappears).

That is the hope. We shall see how things pan out in practice.

Long Cycles, Business Cycles, Market Cycles...Cycles, Cycles, Cycles

We are 54 months into the upcycle (in the market) with a 160% return off the bottom.

Here is an interesting set of reference points:

Are we entering a "more normal?"

Man, have I been out of sync with this market.

"Don't fight the tape," and I've been fighting it since July 09.

Followed the good folks at PIMCO and GMO into the "new normal." Consequently stayed away from the cyclicals (big mistake) and also was way too cautious on the Financials.

With the market trudging determinedly higher, investors are slowly, but surely, convincing themselves that we are moving back to normal and are growing in confidence daily. I'm not a card carrying member of that school (yet), but I am worried that my timing could be a tad off (like years!).

The structural problems are real and unsustainable. In the absence of serious change, we know where we are heading. It is only a matter of timing (and that is the hardest part). Another part of my thesis, is that the changed dynamics of the market (new instruments, new vehicles, new players), in conjunction with the the imbalances outstanding, will lead to more compressed market cycles. So, while the historic market cycle has ranged around 5-7 years, we are now likely to experience market cycles of 3-5 years.

Strategas make some good points

In a piece entitled, "Bar bets for restless financial professionals," Jason Trennert offers several constructive observations.

I think he quite rightly points out that peak earnings this cycle are unlikely to surpass peak earnings from the prior cycle ($91.47). That, despite the fact that we have had a 600% rally in EPS from the pit (GAAP EPS fell 92% top to bottom in the financial crisis), and 2011 estimates are already above the prior peak at $96 EPS (bottom-up estimates are always greater than top down estimates...top down estimates pitch S&P 500 EPS at about $81). The reason is simple and reasonable (but does require buying into a reversion to the mean assumption). "At the peak, Financials accounted for almost 2/3rds of S&P earnings...it is difficult to see another industry that could make up the difference over the next few years." If you believe that we were in an earnings bubble brought on by an oversized Financial sector that also helped leverage Industrial earnings, then it is hard to believe, given the reversal of that trend, that we will be quickly surpassing those bloated earnings. [the only industries with sufficient size and operating leverage to do so would be Energy and Materials combined in a cyclical climax - which would likely weigh upon other sectors). The takeaway from this observation and the concomitant current expectation is that the market is likely to be disappointed.

A second point he makes is that he thinks it unlikely the US savings rate will eclipse 8% this decade. The main reason posited is a "subpar expansion and structurally high unemployment." An unemployed, tapped out consumer makes for someone just trying to hang on, rather than someone with the breathing room to squirrel away savings. And to support his contention, he points to the savings experience during the recession. He is also implicitly disavowing the potential for the current crisis to bring on "a true culture of austerity."

Cyclical Tailwinds Dominating Secular Headwinds

The current cyclical tailwinds of stimulative monetary and fiscal policy, and the natural turn in the cycle have transformed the markets disposition and created a more hopeful outlook.

Beware the Ides of March.

Lying in wait are significant secular headwinds (higher taxes and regulation, ongoing deleveraging, structural unemployment, higher savings/lower consumption, greater govt. involvement in the economy, rising inflation, higher energy & food prices) which when combined with the reversal of the current monetary and fiscal stimulus pose a serious problem for the markets recovery and the economy's long term health.

King Kong vs Godzilla

We're shaping up for a right royal battle between King Kong and Godzilla.

On the one hand, we have King Kong representing the myriad of risk factors likely to weigh on and mitigate against recovery (inflation specter, massive debt funding, twin deficits, global imbalances, dollar deterioration, rising taxes, anemic job market, consumer saving, debt deleveraging, etc., etc.).

And on the other hand, we have Godzilla representing the natural pull of a recovering business cycle (including massive fiscal and monetary stimulus).

You can't stay down forever, but you sure can wallow in the mire for a while.