Market Update: October 2011
Market Update – October 2011
Since my last market update, we have witnessed another collapse not unlike the fall of 2008. In many ways this time is different. The markets have lost only 17% from their highs, no banks have failed and many asset classes are still holding onto their fundamental value. But in a troubling manner, this time is quite similar to 2008 when one looks at volatility and fear. Once again at Vodia we are asked the questions about economic Armageddon and depression. New records are set based on daily market movements, and assets bubbles are formed and deflated on a weekly basis.
This market review will look at the major trends over the past two months, both economic and psychological. What I will leave to a different writing are the reasons that we are here – a culmination of factors and behaviors that have come together after decades of erosion to our economic core and serial financial bubbles. Look for our Research Note in mid-October that directly addresses the origins of our economic troubles.
Fear for Fear Itself
At the core of our investment philosophy is the understanding and management of risk. In its simplest form, we as human beings abhor uncertainty. Whether it be the ancients calling on the gods for a rationale behind randomness or the television weather forecasters pinpointing the next storm (with about as much success as the ancients), we simply want to know what happens next. In the converse, the presence of certainty creates a level of value in itself. For instance, those companies that pay an increasing dividend, come thick or thin, are valued far higher than those companies who have a variable dividend policy. And a known income stream from a bond is more attractive than a higher income stream that might include losses.
This dynamic has stretched to a level that we have never seen before. In its most direct form, the bond market with its “knowns” has fared far better than the stock market this year. In fact, despite the downgrade on US Treasuries, they are the best performing asset class for the quarter. But not just on a relative basis. Last month, the return on a 10-year Treasury traded as low as 1.7% per annum. On an absolute basis, the 10-year has never traded at that level – ever. The investment here is a stark one – agree to give the government your money for the next ten years and receive 1.7% (taxable) per year, irrespective of inflation or the value of the dollar. Given that inflation averages 3% per year, you are accepting a known loss for this certainty. That is fear in its simplest version.
There are a number of factors that have driven rates to those levels, many of which relate to the economy and the current political situation in Washington. But one of those factors is indisputable – the wild gyrations of the stock market. The chart below shows the movement of the S&P 500 for the year to date. While all was cozy during the first half of the year, with the market moving in a range of +1 to +10%, August was a collapse. On the heels of Standard & Poor’s debt downgrade of the US (I won’t waste any more of your time or ink on that debacle), the market lost 11% in the span of just two days. It was a movement straight down and one that we highlighted in our August Market Update, when we also indicated that these lows on the S&P 500 would be seen again.
Over the past three years we have seen the S&P 500 go from highs to extreme lows and back again. From where we stand now, the market could easily break in either direction – back to the lows or back to the highs – dependent as much on economic fundamentals as investor psychology. Volatility will have a heavy influence on the next set of moves.
When isolated from the broader movements, the past three months witnessed a steep decline followed by seven weeks of volatility with the market in a holding pattern relative to the overall trend.
Since those few days in August, it has been a form of volatility that I’ve never seen in the markets, either current or historically. While the daily movements regularly range up to 4%, and movements of 10% almost every week, the market has not gained or lost any value. We are “range-bound” – stuck between 1100 and 1218 on the S&P 500, while showing no signs of leaving that range. Yes, we have hit those early August lows again, and again and again (as of this writing, we are hitting them for the 5th time in two months). But never any lower. It is volatility for the sake of volatility.
This has a devastating effect on the markets, not unlike the collapse of a bank. Individual investors are simply driven from the market, leaving just the gamblers and day traders. Mutual funds and institutional investors are forced into defensive positions to attempt to protect their funds and fear becomes the trade. The only ones who benefit, ironically, are the banks who run their own trading desks that profit on fear and volatility.
The impact can be seen across a range of assets and investments. I already touched upon the Treasury market, but all bonds have gone through gyrations and twists that defy a simple explanation. Some examples from the past three weeks alone: Gold was down -16% in September after being up +18% in August. Silver was down -38% in September after a +60% run-up during the year. And junk bonds are down -6% in just a few days being stable throughout the quarter.
The volatility of the equity markets has generated its own trading dynamics, driving up volatility in many of the safer assets and driving down prices. In this respect, we are witnessing a very similar set of dynamics to 2008. Yet the causes are different, and the effects will also render different results.
Economic Stresses
The impetus to these market conditions is surprisingly a set of conditions that are not a surprise. As at least one economist put it on NPR last week, we are coming to realize the full extent of the economic malaise and recession that began in 2006. While the National Bureau of Economic Research pinpointed the recession to the end of 2007, it seems that the economy was in a retracted state for quite some time, and has likely never left that state. And while the economic stimulus from 2009 helped to avert further declines, it was not enough to reverse the contractions on a permanent basis.
This dynamic is evident in the employment figures that we have been tracking since the recession began. As a reminder, we look at total US employment as a measure of economic health, not the unemployment figure as widely reported. While they should intuitively be the corollary of each other, the latter statistic is deeply flawed. Only by looking at true employment do we get a sense of where we have been as an economy and where we might be headed. Looking at the percentage of Americans who are employed today, it has experienced a massive decline from the employment highs of the past 20 years, putting us at sustained levels not experienced since the 1970s.
While the American economy and demographic has evolved since the 1940s, our employment situation has deteriorated to the same levels as forty years ago.
When combined with the very real demographic and cultural shifts in America, our current employment level introduces a new standard of living for Americans. With healthcare and educational costs rising 10-fold since the 1970s, combined with elevated debt levels, our standard of living increasingly depends on dual-income households which have gone from the norm to a luxury in this recession. The shift is not a subtle one, nor a happy one. From recent college grads who bemoan living at home while they take on internships, to 50-somethings who are forced into retirement after corporate downsizing, the changes are inescapable.
Beyond the employment picture, we have the continued overhang from the real estate bubble. With so many mortgages underwater, millions in foreclosure, and banks unwilling to lend to anyone but the perfect borrower, the primary asset class and savings vehicle for Americans is stuck. Given the magnitude of the problem, it will be several years until we begin to see certainty in real estate price appreciation. Although some regions are still faring well, there are entire swaths of homes across the South and West that will need to find buyers or be demolished. A sad waste of resources and economic capital.
Rest of the World
And while we struggle here at home to find our economic footing, alongside a political dysfunction that could be a tale of self-interest for the ages, Europe and Asia are struggling in different but equally damaging ways. Again not new, Greece’s woes are still at the center of a potential European collapse. In this situation, it is not the prospect of a Greek default that is the problem. It is the follow-on failures of the holders of Greek debt that worries the financial world. In a manner not that different from Lehman’s collapse of 2008, Greece could trigger a broader meltdown.
The prospects for stemming this collapse are tangled yet again into political inaction. The solution could be a simple one that begins with shared sacrifice. But it appears that few of the participants are willing to accept responsibility for these decisions while the citizens of these countries cry out in despair at the thought of losing their socialized state. Change and uncertainty is difficult for everyone – whether it be in the form of market volatility or smaller pensions. Yet this is the prospect that we must all face.
So while Europe deals with their decades of indecision and bloated budgets, Asia is facing a far different yet equally daunting challenge. China in particular is starting to show the cracks of an overambitious expansion plan that ignores the impact beyond its borders. Starting with a decade of currency manipulation, China finds itself the lender to the world holding onto collateral that might be worth far less than previously assumed. By being the low-cost provider while effectively banning imports for the past twenty years, China has amassed trillions in foreign currency and foreign debt while the rest of the world struggles to manage their debt obligations.
China pursued this policy in the modernization of one billion people while maintaining tight control of society. The policy extended to research and development, where China unabashedly steals from the world what they view as important to their economy. The disregard for intellectual property (IP), namely the theft of all IP that enters the country, may have shown its first fatal flaws this summer. While there is no definite evidence of such, The Wall Street Journal reported that China’s fatal high-speed train crash might be a by-product of a foreign firm’s unwillingness to share proprietary details on the collision avoidance systems that China employs. Knowing that anything sent to China will be reverse-engineered, the Japanese provider of these systems put the controls into a “blackbox” solution that protects their design. Unfortunately, it also prevents diagnostics on these devices, leaving testing to real-life events. On the heels of short-cuts from rapid development, the entire rail system is now exposed to failures that are absent in high-speed rail systems around the world.
Painful Decade or Bad Century
As we will address in our Research Note, we are facing the pain for decades of failed government policies, a short-sighted consumer society and a financial services sector run amuck. And in the same way that it took decades to get here, it will be at least a decade to get out of this hole. The asset bubbles of the 1990s and 2000s only served to mask the problem, and deepen the hole. Now is time to inch out of that hole. As Thomas Friedman recently said, we can have a painful decade ahead or a bad century.
In the short term, we need for some calm in the markets to restore values to their intrinsic level. What happens on a monetary and fiscal level will help with the short-term loss of values, and maybe even aid in the recovery. But it will require a shift in the way that we function as an economy and society for these troubles to be permanently eradicated.
Fortunately, some signs of those changes are starting to happen. The outsourcing of jobs to China and other countries is no longer a panacea. Ford announced recently that they will bring some of those jobs back, at competitive wages based on negotiations with the labor unions. Americans now have a completely different view of debt, and are far less willing to surrender their financial future to the whims of a monolithic bank. And households will learn to live on a single income and adjust their spending decisions accordingly.
In the meantime, despite society’s kicking and screaming (whether it be riots in Europe or delusional political rhetoric in the US), we are going to suffer through the shift in consumption, savings, and investment that lead to a sustainable economy. There are times when volatility will reign, such as now, and there will be times when it looks like this was all a bad dream. Let us hope in the process we don’t continue to damage what we do have left.
All the best for fall.
Regards,
David B. Matias, CPA
Managing Principal
