Bye-bye 2014, hello 2015

Many things happened both economically and geo-politically in 2014. QE was wound down in the US, while Russia annexed Crimea, civil war raged in Syria, oil prices collapsed, the dollar strengthened, and ebola sent a shot across the bows. The US economy showed steady improvement throughout the year even as Abenomics stalled in Japan, Europe stumbled, and China slowed. Financial markets react to each and every event, and like a boxer, they absorb and go on, seemingly oblivious to that which was important before but now barely registers.

The markets are maddening because they never seem to compute the information in the same way as I. Markets have an intrinsic upward bias that is incessant, dogmatic and resilient. Until the vapor of strength disappears in a smoldering implosion of panic. We are five years into a strong up-cycle. The probabilities derived from history should lead one to caution. The odds are it is long in the tooth. But that was true at the end of last year and the year before that as well. I can't help but think we are in a nether world between the stimulant of recovery and the onset of correction. Markets have been kind and no one wants that to go away. That wishfulness that leads to self-delusion is what is most dangerous. Caveat emptor.

Many things will happen in 2015. We don't know what they will be, but we do know many events will transpire and the market will react. We don't know what will trigger the next major market decline. Faith in the central banks has kept a lid on any falter. Much of what happens is noise. In the broad sweep of history events that we thought momentous are but minor details. It may be that the biggest development of the last 15-20 years was the rise and fall of central banks. That chapter is still being written.

It is hard to frame the present in the context of history, only time will tell, but if we have confidence in man's ability to innovate, growth and expansion are likely to follow even as the markets, which may have got a little ahead of themselves, fail to reflect those secular drivers in perfect cause-effect.

My New Year's resolutions are as follows:

• Focus more on principles and the big picture.
• Make a conscious and concerted effort to get outside my comfort zone. 
• Work on developing new skills, especially in communication and relationships.
• Have a plan each and every day. 
• Be a nicer and better person.
• Don't think more highly of yourself than you ought. 
• Remind yourself that the world owes you nothing and you have to earn everything. 
• Be more positive (in life, in business, in outlook).

The Odds

The odds are that we are getting toward the end of the current upcycle. The market and the economy bottomed in 2009 and have been on an upward or a recovering trajectory ever since.

My prior thesis of a compressed market cycle because the market was not allowed to clear has proven false.

That having been said, a regular (or average) market cycle is about 5 years or so. On that basis we are therefore closer the end of the cycle than the beginning.

I don't see too many people calling for a recession or even of a decline in the economy. It seems to me that the consensus is that growth has been disappointing but that the economy will continue to heal/recover even if it is at a less than stellar rate.

The bond market is confusing the consensus because the consensus is not looking for or fearful of a recession. However, it may well be the canary in the coal mine pointing to the end of the cycle.

My heart is not fearful of an upcoming recession but my head is mulling the probabilities and cautious.

A Little Early On That Call - Now Might Be A Better Time To Brush It Off

I wrote a commentary for the SMID cap strategy at the end of 2009 talking about the likely battle to take place over the next 2-5 years between cyclical forces of recovery coming up against secular headwinds. Here is an excerpt:

"Don't get too comfortable. The economy is fragile, and both short term and long term risks abound. A legion of risks are in plain view. At some point, cyclical tailwinds will run into secular headwinds. Structurally we are in many ways worse off after the recession than before. We lack the political will to make the hard and necessary decisions to get things right. We have, once again, failed to allow the market to clear, and so are left with the burden of accumulated deferments. The lesson from this whole mess is that we haven’t learnt the lesson. There is a price to be paid for profligacy and denying the laws of economics. As a country we (many other developed countries are in the same boat) have lived beyond our means and made promises we are unlikely to keep. Those secular headwinds will be reflected in rising inflation and interest rates, lower growth, increased savings, higher taxes, more regulation, and constraints on government spending going forward."

In hindsight it looks as though I was a little early. But I stick by that general view of the forces and factors in play.

If I might be so repetitive. Now is probably a good time to brush that thesis off and deliver it again.

They say a clock is always right at least twice a day. Perhaps I'll be closer to the truth this time around.

Process = Recovery ==> Transition ==> Normal

The present path to normalization is, and has been, a long one compared to past recovery cycles.

Fundamentally it looks as though we are exiting recovery and on our way to normalization. Confidence is the key to continuation. I suspect the economy (along with the market which seems to have got ahead of things a bit) will go through a choppy transition period before it comes out the other side to normalization.

How long the transition period lasts is anyone's guess. Given that it has taken extraordinary stimulus (both monetary and fiscal) to get us to this point, it is not unreasonable to assume that the transition will be more painful and volatile than normal.

The trajectory of the market has been significantly different from the trajectory of the economy. The likely tightening of fiscal and monetary policy will throw a spanner in the works for both market and economy.

I'm not bearish...I just don't trust it

I'm not bearish.

I really think the US economy is coming out of its slumber. Most of the signs are pretty good.

The problem is I don't trust the market.

After such a big run over the last year, I can see the market continuing higher. With a little bit of earnings growth (9% projected this year...which could be a stretch, but maybe it isn't) and a little more multiple expansion (say from 15.5x to 18x) the market could easily deliver another 26% return - and even then would not be overly valued. I find myself making these rationalizations. It is easy to do.

The problem is the higher it goes, the less margin for error there is and the more I don't trust it.

When you know you are playing a con(fidence) game, you are always looking to be the first to exit the party (which can make for some bad - kneejerk - decisions). 

The Market and the Economy Re-tethered

After a long period of apparent dislocation, I think the market is now re-tethered to the economy. As such it will rise and fall with the credit/economic/business cycle (all of which have reserves to go higher or improve).

Why?
The negatives and the positives seem pretty evenly balanced. Positives: strong momentum from wealth effect, sense of confidence flowing back into the system, no real signs of overleverage in the system, high earnings level, high profit margins, improving economic indicators (housing, unemployment, PMI, fiscal, output), low inflation, low interest rates, strengthening bank capital, strong credit growth, reasonable valuations, cash on sidelines, no real signs of hubris or greed, still a pessimistic undertone, Fed accomodation, low gas prices, China stabilizing, Japan recovering, Europe recovering. Negatives: political stalemate, above trend profit margins, slowing earnings growth, high earnings expectations next year, growing inequality, market up big, taper not far off, an underlying fragility, corporate leverage increasing, artifice masking underlying weakness, potential reversal of labor/capital trade-off, fiscal exit, stagnation.

The strong move in the market over the past year (with little pullback) indicates a market looking to the future positively.

Making Heads 'n Tails of GDP Components

Refer: https://twitter.com/cullenroche/status/327874531551232000/photo/1

The interesting thing is that it has been a fairly mixed bag quarter to quarter.

If I had to eyeball trends, I'd say that Gross Private Investment has been the dominant factor lifting us out of the 2009 pit, with nice support from Personal Consumption. Strong mean reversion.

Govt is now dragging on the economy and I would expect that to continue into the future, but normalcy is returning.

Speed Bumps or Speed Wobbles

Are we hitting speed bumps or getting speed wobbles.

I would hazard that the current volatility is more like speed wobbles.

The market has risen substantially and really without much correction for more than 9 months. That is a long time in market years. The first inkling toward an arresting of that trend were speed bumps. Signs of a deceleration in market trajectory. We have been climbing the wall of worry, accumulating worrisome baggage even as the market reached higher levels. The previous all time high seemed like a talisman, calling us forward. The problem with a wall of worry is that worry eventually has an effect. Markets can live with self-delusion for quite a while.

It looks to me that we are now entering the next phase of correction. How big will it be? 10% 20%. Calling those things is a mugs game, but with full central bank support, I expect some kind of official response once we get down around 10%.

Balance

I don't see too many imbalances in the system. Equities appear fairly valued. The economy appears to be getting back on track. I guess bonds are the obvious area of imbalance, both in terms of the amount of debt outstanding and the price paid for that debt.

Of course, balance is predicated upon confidence and if confidence evaporates, then balance disappears along with it (or at least adjusts to a lower equilibrium).

The accumulation of overweight (aka as imbalance) is greatest in the sovereign area. But so long as sovereign's can maintain confidence, they can continue to accumulate liabilities.

Look for market reverberations (like in the summer of 2007) for signs of disequilibrium. Japan is the most obvious candidate.

Until then, party like its 1999.

There Is A Price To Be Paid

No economic law is more immutable than, "there is no such thing as a free lunch!" Actually, a more immutable law (at least in my mind) is you can't spend more than you make (at least not for very long). Not surprisingly, the two laws are related. And the truth be told, there are such things as free lunches, but they usually come with strings attached (which is the usual application of the idiom). But in the economic realm, there is a simple reason why there is no such thing as a free lunch and relatedly why you can't keep spending more than you make. It is because the production of a lunch costs something. Whoever is handing out free lunches is limited by how much capital they have. Ergo, there are limits to free lunches (and deficits), and the economic law holds true.

And so it seems with the massive government and monetary interventions we have experienced in the post-GFC world. We have become desensitized to the scale and the scope of the operations, and don't think twice anymore about new initiatives or new "solutions," largely because we have not seen too many deleterious effects. It seems that because none of these actions have led to immediate calamity, then maybe they are alright (perhaps even a free lunch). People who would traditionally and historically have been aghast at the actions proposed and undertaken, are now much less squeamish about each new initiative. We are becoming more comfortable with and more complacent about government interventions. And if that doesn't sound familiar, you may like to remind yourself of the pre-conditions to a bubble* (comfort and complacency are important ingredients).

There is a cost to artifice, and there is a price to be paid for attempts at muting the laws of economics. You can't simply wish new liquidity into existence, or make interest rates whatever level you want, without some cost. We have yet to see or feel the full effects of those costs, and therein lies the danger. The bigger the cause, the greater the effect. Ultimately it will be the encroachment of the previously contingent liabilities that sink us (unless we make the necessary painful changes). Rather than smoothing over the effects, the passage of time may in fact accelerate our day of reckoning.

*Bubble is being used here in the sense of something that is isn't sustainable, and for which there is a rude awakening.

Big picture update

Things unchanged.

Since the crisis, the authorities have propped the system up through QE and fiscal stimulus. But even that failed to stop asset price deflation. Into the bargain, people are still unemployed resulting in contracted incomes, and scared witless consumers. Worse than that, we have seen no credible attempts to address the real flaws in the system (global structural imbalances, unfunded entitlement liabilities, financial moral hazard).

Recovery will ensue, but it will be a languid, stop-start affair. Even as the recovery takes hold and confidence returns, the economy will be racked by secular headwinds (interest rate unwind, higher taxes, delevering consumer, fiscal belt-tightening). None of which means that equities will necessarily be a bad place to reside (they'll be solid because we're starting from a low base, they just won't be spectacular).

The costs of the artificial pumping will be bourne by current taxpayers and future generations.

Implications: multi-year stagnation.

Disconnect

We're seeing signs of a disconnect.

General economic trends are moving in the right direction, earnings are coming through better than expected.

And yet, the market is getting sold!

Welcome to a balance sheet recession.

We have hollowed out core economic institutions (bankrupt state governments, overleveraged consumer, increasing financial risk on the sovereign) which mean bombs can go off anytime (after all it is a confidence game) and there is less margin for error.

Greater market volatility likely to ensue.

2010 - A Year of Reckoning

2010 figures to be a year of reckoning.

It was the best of times and the worst of times in 2009, but 2010 will be a time of transition, a time of honesty, a reality check. A time where the rubber meets the road. Gains will not be so easy. Cracks in the system are likely to be tested. Risk increases as expectations increase.

Govt's will try and pass the economy back to the private sector, while central banks will try and extract themselves from the market, all the while hoping they don't upset the applecart, or have their bluff called.

Fear and trembling dominated 1Q09, while hope and relief characterized the last half of 2009. Unmitigated reality awaits the market in 2010.

The future hinges on...

To a relatively large extent, the future hinges on whether banks return to a more normal lending environment.

If they fail to do so, then deleveraging and deflation will weigh down the growth outlook. If they do come through, then the recovery will receive a much needed capital underpinning.

Supporting the "yes, they will return to normal" camp are improving balance sheets, strong operating profits, a supportive fiscal and monetary environment, cyclical tailwinds, growing investor confidence, and the present low cost of funds.

On the "no they won't" side are an already overly indebted consumer, high unemployment levels, tightening lending standards, secular headwinds, and vestigial bank fears of another run.

The Problem With 'New Normal'

The problem with the 'new normal' meme is that history is against it. Essentially, the argument for a 'new normal' is an argument for 'this time it is different.' And as we all know, 'this time is different,' is a dangerous position to take. Now, I happen to have a lot of sympathies for the argument and think it pretty reasonable (mainly because we're still overlevered and heading into delevering headwinds [higher taxes, lower consumption, structural deficits, structural unemployment, rising rates, etc.]). But, the problem with the new normal (and all the well considered bear cases of the past [and future]) is that they typically discount the resilience and dynamism of the economy. And it is only with the benefit of hindsight, that we see how it was we escaped the myriad of obstacles encountered and imagined. I don't know how we're going to escape the scythe this time around (as I said, I have my doubts), but the trendline of history reveals bumps, large and small, that are overcome in the course of time. Perhaps, this time is different (and we go through a period similar to the 'heisei malaise' or even something resembling the double-dip of The Depression), but it takes a brave person right now to discount all the market factors flashing green:
- Upturn in M&A (indicates pro-cyclical bias and confidence of boards and management),
- Rejuvenation in the IPO market,
- Significant recovery in credit markets,
- A benign bond market and low interest rates,
- Large fiscal stimulus still to come,
- A strong and resilient stock market,
- Increasing confidence among consumers,
- Economy showing rebound,
- Housing moving off the bottom,
- Resolution of healthcare reform,

A Game of Chicken

Since the mid-80s, playing the stock market has essentially been a game of chicken. The market's normal condition is one of overboughtness and overvaluation. Naturally there are times when it is more overbought and more overvalued than at other times, but the game has been to stay long and stay the course (and hope you can get to the exit before the music stops). This was logically underpinned by technological revolution, a generally robust economic environment, and the ideas of free market liberalism. Unfortunately, the period was also marked by a significant increase in leverage among governments, corporations and consumers. All good things must come to end, and it would appear that the financial crisis, sweeping electoral victory of Barack Obama, and coincidental recession of 2008-09 mark the end of that era. It remains to be seen what the future holds, but the early money is upon higher savings, lower consumption, higher taxes, increased govt spending, and greater regulatory constraint. Not a particularly exciting mix. But companies will still grow and make money, and investors will still be able to derive a decent return on investment (a 60% mark-down in asset prices does wonders for long term expected returns). However, the transitional pains of recalibrating from one state to another imply greater dislocation within and among economies, with a concomitant increase in volatility effecting asset prices and asset markets. Welcome to the new game of chicken.

It takes a brave man to...

...call a double dip.

The 'new normal' thesis is both eloquent and reasonable. But it takes a brave man to call a double dip. Originally the bears were calling for some sort of mega-recession. Now that we're showing signs of bottoming, they've had to revise that to a double dip. That makes some sense, but it is a big call.

History and current economic signs weigh against the thesis. We have seen very few double dip recessions in history. Usually they are caused by some sort of policy mistake (which I think has a greater than normal chance of happening - both monetary and fiscal). Probably most likely is some sort of muddle through in which the economy struggles to find traction, but doesn't actually go down again.

Time will tell, as they say. But the future seems more murky than normal.

We're Almost Guaranteed A Policy Mistake

The Fed is walking such a tightrope that we are almost guaranteed a policy mistake.

Will it be staying at the party too long, or will it be taking the punchbowl away too soon?

Either which way, it is highly unlikely they will maneuver successful through the minefield.

For my money, it seems to me they have given every indication that they will stay too long at the party. But with so much slack in the system, I don't see CPI-type inflation coming through anytime before mid-2011 (at the earliest). With the pedal to the metal, this means bank reserves will continue to leak out into asset prices.

Now, where have I seen this before...

...oh, that's right.

2000-2007. Tech bubble bursts==>Cascading decline in global equities==>Economy in recession==>Fed stimulates with historically low rates==>Govt. provides its share of fiscal stimulus==>Proportional recession averted==>Markets rebound strongly==>Economy gets back on the growth path (although unemployment lagging)==>Global equities continue to demonstrate strength==>Housing and increasing debt become backbones of the recovery==>Energy and commodity prices skyrocket==>All is well with the world.

Fast forward to 2007-2009. Housing bubble bursts==>Cascading decline in global equities==>Financial crisis ensues==>Economy in recession==>Fed stimulates with historically low rates==>Govt. provides its share of fiscal stimulus==>Proportional recession averted==>Markets rebound strongly==>Economy stabilizes (although unemployment lagging)...Increasing debt becomes backbone of the economy==>

I wonder how this ends! The only question is what asset class/area will become the investor's bubble of choice? Stay long until they take the punchbowl away.

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.