Where Does The Biggest Risk(s) Lie?

In reflecting upon the many doomsayers prognostications regarding systemic risk in the system and their attempts to make the case that it is worse now than in 2008, I see their points but struggle to see the timing. Sure, we are likely to see a cyclical decline or recession. The markets no doubt will be hamstrung by that, but I don't get the sense of a systemic risk event predicated upon a Minskian leverage moment. To be true, corporate balance sheets are not as strong as the aggregate numbers may propose. Much of the cash outstanding is concentrated among a small number of mega sized firms, and that is quickly being netted off against debt issuance to fund stock buybacks. A troubling development in my book and one for caution. There are many who point to the "too big to fail" banks having grown even bigger. There are many who point to the economic recovery being anemic. There are many who point to ZIRP and QE as creating an artifice for asset prices. There are many who point to China. Many who point to the potential for hyperinflation. Many who point to the obesity of the Fed's balance sheet. The global financial system is connected and interconnected. It is a tightly coupled complex system prone to collapse. But I think it takes significant time to build imbalances via increasing leverage brought about by growing confidence leading to complacency and hubris. I don't think we are there yet. The greatest accumulation of debt/leverage has taken place on central bank balance sheets and country debt. I think that is where the next crisis will arise from. But until confidence is punctured, central banks and countries can continue to issue bonds and increase their liabilities. The puncture is likely to be an "emperor has no clothes" moment and will forever re-shape the global financial system as central banks become ground zero for fear and contagion.

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.

One of many dilemmas

One dilemma I have been wrestling with is to what extent is the future economic performance of the economy factored into current equity/asset valuations. With equity prices off over 58% at their lows, an awful lot of future bad news was being factored in. This largest decline since the Depression made sense to me because we were dealing with the largest economic decline since the Depression (in addition to a financial crisis of global proportions). But the question is did we overshoot on the downside and what is a reasonable level for equities given interest rates, growth prospects and a greater appreciation for risk. I do a lot of back of the envelope calculations in order to gauge perspective and am a great believer in normalizing things, especially in the midst of an extreme event. As such back in January when I put pen to paper and tried calculating a ballpark fair value number for the Standard & Poors 500, I came up with normalized EPS of $65 and a normalized PE multiple of about 15 to arrive at a ballpark fair value of somewhere between 900-975 [Note: this calculation was done in the midst of downward earnings revisions taking S&P 500 earnings to $40 and multiples of 8 being thrown around as reasonable - pointing to levels of 320-500 on the Standard & Poors].

P.S. The divergence between all the positive information coming out of China and the performance of the FXI recently may be telling of something. Keep an eye on that.

Disclaimer: I have a personal position in the FXI.