Dr. Doom Strikes Again

I’ve mentioned Nouriel Roubini in past postings.  The NYU economics professor was recently named the #2 public intellectual in 2008 with the following commentary:

The Economist noted last year that Roubini’s “commentary seems carefully calibrated to avoid any hint that economic disaster may be avoidable.” Sadly, the gloomy sage of the credit crunch has been right almost every step of the way. Dismissed as Dr Gloom (sic), Roubini is almost the only economist who can claim to have seen it coming. As one judge put it: “he has consistently marshalled arguments to demonstrate America’s fiscal imbalances-he was right; now his competition is out of business.”

In a recent Roubini column titled, Will Banks and Financial Markets Recover in 2009?, his short answer is “no”. This is an excellent overview article in an unlikely publication, one that I encourage you to read.  He touches on many of the themes I have been exploring for a while:

• The nature of the credit crises and it’s fundamental roll in causing our current economic difficulties
• The near-term threat of deflation
• The severity and potential length of the current crisis (at least through 2009 in his view)

Unfortunately, according to Roubini,

But the worst is still ahead of us. In the next few months, the macroeconomic news and earnings/profits reports from around the world will be much worse than expected, putting further downward pressure on prices of risky assets, because equity analysts are still deluding themselves that the economic contraction will be mild and short.

While the risk of a total systemic financial meltdown has been reduced by the actions of the G-7 and other economies to backstop their financial systems, severe vulnerabilities remain. The credit crunch will get worse; deleveraging will continue, as hedge funds and other leveraged players are forced to sell assets into illiquid and distressed markets, thus causing more price falls and driving more insolvent financial institutions out of business. A few emerging-market economies will certainly enter a full-blown financial crisis.

So 2009 will be a painful year of global recession and further financial stresses, losses, and bankruptcies. Only aggressive, coordinated, and effective policy actions by advanced and emerging-market countries can ensure that the global economy recovers in 2010, rather than entering a more protracted period of economic stagnation.

Home Prices Continue Their Slide

Also widely reported today is the continued decline in US home prices.  The WSJ’s take on it:

Home prices continued to drop as the economic downturn deepened further in October, according to the S&P/Case-Shiller home-price indexes, a closely watched gauge of U.S. home prices, with home prices in the Sun Belt continuing to be hit hardest.

“The bear market continues; home prices are back to their March 2004 levels,” said David M. Blitzer, chairman of S&P’s index committee. He added that both composite indexes and 14 of the 20 metropolitan areas are reporting new record declines. As of October, the 10-city index is down 25% from its mid-2006 peak and the 20-city is down 23%, Mr. Blitzer said.

The outlook remains glum:

The glut of housing remains as credit stays tight and the economic outlook remains bleak as mounting job losses have added more stress to U.S. households. Even intensified efforts to help borrowers stay in their homes have made little headway.

Looking at the Japanese experience, there is reason to believe that the decline in house prices could go on for a very long time.  As this chart shows, Japanese real estate prices hit their bubble peak in 1991 and have declined every year since then.  In fact, Japanese real estate prices today are at 1988 levels.  That’s over 20 years of lost price appreciation in an island nation where they really don’t make any more land. The commentary that accompanies the chart reads in part:

Japan had the same overvaluation problem in their stock and real estate market at the end of 1989. Their real estate market was even more over valued than the U.S. was in 2006 and declined by about 44%. Japan tried to do the same thing we are doing now to alleviate the pain of both asset bubbles bursting. They brought their interest rates down to close to zero, and tried to print their way out. However, by 1991 their money supply collapsed since the banks refused to lend to questionable borrowers and well healed potential borrowers would not bother taking out loans. This is the old concept of “pushing on a string” and the attempt of government intervention dragged out the Japanese deflationary bear market for years. Their stock market declined from 39,000 on the Nikkei Average in late 1989 to about 7,400 in 2003 before doubling since then. Their real estate market is still bouncing around a bottom after declining every year for 18 years.

RGE Monitor (one of the first and most accurate to call the housing bubble) estimates that US house prices will fall 30-40% from their peak, compared to the 44% decline in Japan.  The Case-Shiller numbers are at a current decline of 23-25%, so we may still have a way to go.

Consumer Confidence at Record Low

It was widely reported today that consumer confidence has fallen to an all-time low.  Here’s the story in the Washington Post. I’ve mentioned the Odd-Lot Theory in prior posts.  It and other contrarian theories of investing would take this as good news.  The general idea is that when things look worst they are about to turn around.  Warren Buffet has been widely quoted as saying, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

There is much merit to contrarian investing, but like all investing theories it has limitations and false signals.  A number of indicators have signaled multiple “bottoms” over the past year only to be followed by new lows.  Consumer confidence, for example, hit a previous new low in October.

It could be that consumer confidence is at a record low because the economy is truly in very bad shape and it may not be a contrarian indicator at all.  In fact, record low consumer confidence could reinforce a deteriorating economy as consumers pull back on purchases.

As stated by George Loewenstein, a professor of economics and psychology at Carnegie Mellon University,

Because I study the role of emotions in economics, a lot of people have been asking me questions about whether the current downturn is driven by irrational negative emotions, such as fear and anxiety, with the implicit assumption that if we could only calm these emotions, things might return to normal.

It’s possible that those emotions do play some role, especially in the collapse of credit markets, but it isn’t obvious to me that the anxiety and pessimism are unfounded. People have good reason to be fearful.

Every investor who doesn’t have his or her head in the sand is struggling with the question of whether the economy and stock markets have bottomed out or have a lot further to fall. Unfortunately, no one knows the answer, which creates a lot of uncertainty and a lot understandable misery as a result of not knowing how one should behave.

Off-Topic: Pandora Internet Radio

Like many I really enjoy listening to music and have a fairly eclectic ear.  I can’t remember how long ago I first came across Pandora.com but it was too early.  I recently re-discovered Pandora, and, wow, what a fabulous music site.

I’ve never really been able to describe my favorite “type” of music, sometimes the label “Americana” is applied, sometimes “singer-songwriter”.  Regardless, Pandora knows how to find the songs I like.

It works like this: you create a “radio station” by typing in the name of a song or an artist that you like and Pandora finds music like that.  I typed in the name of 2 artists – Greg Brown and Cowboy Junkies – and for the past 3 days I have heard songs from artists I know well and from ones I’ve never heard of.  Consistently good to great stuff without any commercials or breaks.  Amazing.  Check it out.

WSJ: IMF Sees Urgent Need for Stimulus

Todays WSJ reports that the International Monetary Fund is encouraging governments worldwide to “quickly develop large, sustainable fiscal stimulus packages” or face a global “fall in aggregate demand that could be larger than in any period since the Great Depression”.

“A further fall in demand will increase the risk that the perverse dynamics of deflation, rising debt, and associated feedback loops to the financial sector, may materialize,” Fund economists wrote.

Pretty sobering.  I’m sticking with my outlook for a lengthy recovery.

Infrastructure Stocks?

One of the themes being promoted heavily in my business right now is infrastructure.  The idea is simple: fiscal stimulus will come from increased spending on bridges, roads, and other types of infrastructure.  Such investments are needed as it has been decades since there was a concerted national effort in this area and the economic stimulus will help fight the recession.

My clients certainly understand the idea and many have called me to ask about investments in this area.  I remain cautious for a variety of reasons.  Recent news that continues to fuel that caution:

• Financial Times: Steel output set for historic drop
• Bloomberg: Caterpillar cutting pay, hiring freeze
  
• Krugman: Fifty Herbert Hoovers, where he reports on states cutting back on spending, including infrastructure

Infrastructure companies may rebound in the future, but right now might be premature.

Interest Rates for Beginners

James Kwak at The Baseline Scenario made a good post yesterday going over some of the basics of interest rates: the Fed Funds rate and how it filters out into all the other interest rates that consumers care about.  Good background reading if you are interested in economics.

This is an interesting blog for people who really want to dive in deep.  It’s from some economics professors at MIT and the London School of Economics, along with a former McKinsey consultant.

Poor Getting Poorer Index

I have made a number of posts outlining the current opportunity in fixed income investments (bonds and similar securities).  While I believe it is time to be overweight fixed income, most investors should also have equity exposure for a variety of reasons: as a hedge against a quicker than anticipated rebound, a hedge against high inflation, and the simple fact that over very long periods of time stocks have outperformed bonds.

The question is, what equities should be held?  The traditional selections in times like these seem to fit the bill today as well: “defensive” stocks.  Stocks in companies that provide goods that people will buy even when they are pinching pennies.  Common examples include:

• Utilities: you want to turn on the lights and heat your house.  Plus, they usually pay a nice divided.
• Staples: food, beer, toilet paper.
• Health care: I don’t like this one as much since there are so many regulatory hurdles these companies must deal with, but people will continue to go to the doctor and need medicine.

The people at breakingviews.com have put together a basket of 22 stocks called the “Poor Getting Poorer Index” that includes a set of companies that they feel will do well in a recessionary economy.  They claim it is up 9% so far this year.

Messy World of Investing

The Israeli air strikes into Gaza should serve to remind us, once again, just how “messy” investing can be.  Fears of this latest armed conflict broadening and disrupting oil shipments have sent oil prices up and stock markets down.  Nothing unusual there.  Unforeseen and momentous events occur with surprising regularity, along with “Black Swan” events, that disrupt the best laid plans.

It does reinforce, in my mind at least, how much of an “art” investing is no matter how much people would like it to be a science.  If it were a science then it would not be nearly as messy and gut-wrenching.

Just last week I was on the phone with a colleague who was incredulous that I did not see the same value in his CIMA certification that he did (a financial management and accounting designation mostly designed for professionals working in large businesses).  He was angry that with my statement that good investment management and financial planning for individuals was not predicated on earning a professional designation.  In fact it could come from someone who had decades of business experience and an inquisitive mind.

As one with a master’s degree and a passion for constant learning, I think education is an essential process for learning how to learn.  But, the best investors in the world do not rely on simple financial and accounting formulas.

The world is much too messy a place to believe that a CIMA, CFA, CFP, or any other designation is a marker of good investment advice.  (I certainly did not see any professional society warning about the housing or credit crisis before they were obvious to all.) The best investors in the world have taken a different route: a synthesis of economics, investing principles, human psychology, and a passion for research and learning.  Combined these are an art form, not a science, which is why so few do it well.

Barron’s: Corporate Bonds Still Beckon

This week’s Barron’s has another article touting corporate bonds, but warns that investors have started to move on the opportunity.  In a story in November, Barron’s claimed that “the stock market is priced for recession but the corporate bond market is priced for a depression, which implied debt offered greater potential rewards, and with less risk.”

Prices have risen in the last 6 weeks, lowering yields, as investors have starting trickling back into corporates.  Nevertheless, “corporate bonds’ spread — the extra yield investors demand to compensate for risk — has remained near the peaks of the 1930s. The question is whether corporate defaults will equal those the Great Depression.”

The narrowing swap spread is a harbinger of further contraction in corporate bond spreads, according to Michael T. Darda, chief economist of MKM Partners and an early bull on Baa corporates at their peak yields in October. He sees further price gains (and yield declines) ahead. Darda notes that corporate bond yields peaked 17 months before the economy bottomed in the last cycle. That would be consistent with his forecast of a recovery coming not until late 2009 or 2010. Junk bond yields topped out 11 months before the economy’s trough, so there’s still time to buy speculative-grade debt by that schedule.

Similarly, Jeffrey Rosenberg, head of credit research at Banc of America Securities, also thinks high-grade corporates yielding over 8% offer return potential that’s competitive with equities, but with lower risk. He also favors sticking with investment-grade bonds until the default picture in leveraged finance becomes clearer-before being tempted by 22% yields on junk debt.

A “contraction in corporate bond spreads” means that prices will continue to rise.  Investors who get in now may be able to lock in yields that offer equity-like returns while also benefiting from the potential for price appreciation.  The potential for an excellent “total return” opportunity if we assume that the economy does not continue to contract into a Great Depression-like condition.