John Mauldin's Outside the Box : James Montier

Roadmap To Inflation And Sources Of Cheap Insurance

John Mauldin — Tue, 24 Mar 2009 14:35:31 GMT

What happens when inflation once again returns. As this week's Outside the Box writer, James Montier, writes, we may want to start thinking now about inflation insurance and he mentions a few ways to do so. But this letter is a must read for his bringing to light a speech by Fed chairman Ben Bernanke in 2000 given to the Japanese, where he suggest inflation targeting:

"In the speech, he laid out a menu of policy options that are available to the monetary authorities at the zero bound. First, aggressive currency depreciation, as per Romer's analysis of the end of the Great Depression. Second on Bernanke's list is the introduction of an inflation target to help mould the public's expectations about the central bank's desire for inflation. He mentions the range of 3-4%!"

I think you will find this week's OTB to be exceptionally thought provoking. Montier is one of my favorite economic thinkers (and a good friend). He works for Societe Generale in London in their Cross Asset Research group.

John Mauldin, Editor
Outside the Box

Roadmap To Inflation And Sources Of Cheap Insurance

by James Montier

As Albert and I regularly point out during meetings, we have never been more unsure on the inflation/deflation outlook. I have previously said I was torn between the deflationary impact of the bursting credit bubble, and the inflationary pressures of the policy response. When we read something by the deflationists we sit there nodding our heads in agreement, then we pick up something by the proponents of a return of inflation and we find ourselves agreeing with that as well. The respective sides seem deeply entrenched in their positions.

In contrast, we are trying to keep an open mind on the subject. Albert is biased towards a Japanese style outcome, and I am biased towards an inflationary outcome, but neither of us has any strong conviction.

Fisher and the debt-deflation theory of depressions

In the face of this uncertainty I decided to return to history and see what it has to say about the way out of a depression. My first point of call was Irving Fisher's "The debt-deflation theory of Great Depressions" published in 1933¹. Fisher is probably most infamous to those in finance for his pronouncements of a new era of permanently high stock prices in 1929. But in the wake of his disastrous calls he turned to trying to understand the experience of the depression. Incidentally, he also invented the Rolodex.

In his debt-deflation theory, he posits "two dominant factors" in driving depressions "Namely over-indebtedness to start with and deflation following soon after... In short, the big bad actors are debt disturbances and price-level disturbances". He continues "Deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debt cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed." That is to say, debt-deflation spirals can easily become self-reinforcing.

The good news is that Fisher is also very clear on how to end a debt-deflation spiral: "It is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors... I would emphasize... that great depressions are curable and preventable through reflation and stabilization". The irony of Fisher's route out of deflation is that, probably only the Fed - after helping lead us into this mess² - can now get us out of it.

Romer's lessons from the Great Depression

After reading Fisher's analysis of the 1930s, I came across a recent speech given by Christina Romer, who is now the head of the Council of Economic Advisers, and who made her name in academic circles studying the events which ended the Great Depression. In the speech, Romer offers six lessons from the Great depression for the current juncture.

Lesson 1 – Small fiscal expansion has only small effects

Romer wrote a paper in 1992³ arguing that fiscal policy was not the key driver in the recovery from the Great Depression. Not because fiscal expansion is ineffectual per se, but rather because the fiscal stimulus that was conducted wasn't large. As Romer notes "When Roosevelt took office in 1933, real GDP was more than 30% below its normal trend level... The deficit rose by about one and a half percent of GDP in 1934".

Lesson 2 – Monetary expansion can help heal an economy even when interest rates are near zero

Romer notes that actually it was the Treasury rather than the Federal Reserve that drove the monetary expansion (a peculiarity of the system under the Gold Standard). In April 1933, Roosevelt suspended convertibility to gold on a temporary basis, and the dollar depreciated. When the US returned to gold at the new higher price, gold flowed into the US, allowing the Treasury to issue gold certificates which were interchangeable with Federal Reserve notes. As Romer notes "The result was that the money supply, defined narrowly as currency and reserves, grew by nearly 17% per year between 1933 and 1936". Romer argues that this "Devaluation followed by rapid monetary expansion broke the deflationary spiral" - empirical evidence to support Fisher's hypothesis outlined above.

Lesson 3 – Beware of cutting back on stimulus too soon

The monetary expansion seems to have produced remarkable results in terms of real growth: the US economy grew by 11% in 1934, 9% in 1935 and 13% in 1936 in real terms. This lulled the authorities into thinking that all was well with the system again. Hence, in 1937, the deficit was reduced by approximately two and half percent of GDP. Monetary policy was also tightened, as Romer notes "The Federal Reserve doubled the reserve requirement in three steps in 1936 and 1937". She concludes "taking the wrong turn in 1937 effectively added two years to the Depression".

Lesson 4 – Financial recovery and real recovery go hand in hand

Romer points out the inseparable nature of the real and financial recoveries. This meshes with our analysis that the banks aren't really the problem in a debt-deflation environment, rather they are a symptom of the problem. The current policy in the US seems to be aimed at "fixing the financial system", witness Bernanke's recent comments "Recovery is not going to happen until the financial markets and the banks are stabilized". This appears to be a misperception, as, Romer notes "Strengthening the real economy improved the health of the financial system. Bank profits moved from large and negative in 1933 to large and positive in 1935, and remained high through the end of the Depression".

Investors seem to be rather excited about banks posting profits at the moment. Frankly, if a bank didn't post a profit in this environment it should be shot out of kindness. The environment for profitability from banks has rarely been better, but that doesn't make them solvent. If you were starting a business today, then setting up a bank would be a very attractive option. However, history - as represented by the balance sheet - cannot simply be ignored when it is inconvenient. As John Hussman noted "The excitement of investors last week about Citigroup posting an operating profit in the first two months of the year simply indicates that investors may not fully understand the term "operating profit." Citigroup could burst into flames while Vikram Pandit sells lemonade in the parking lot, and Citi would still post an operating profit. Operating profits exclude what happens on the balance sheet."

Lesson 5 – Worldwide expansionary policy shares the burdens

Given the worldwide nature of the current slump, Romer makes an interesting point on the effectiveness of competitive devaluations, "Going off the gold standard and increasing the domestic money supply was a key factor in generating recovery... across a wide range of countries in the 1930s... These actions worked to lower world [real] interest rates... rather than just to shift expansion from one country to another".

This is something that Albert and I have been discussing of late. We have been pondering the possibility of competitive devaluation (obviously ultimately a zero sum game in terms of exchange rates) having enough of an impact on local monetary creation to increase inflationary expectations, thus helping countries reflate. It appears as if Romer has sympathy with this view.

Lesson 6 – The Great Depression did eventually end

The final lesson that Romer offers may be of use to investors at the current juncture. She makes the point that the Great Depression did finally end. As Romer puts it "Despite the devastating loss of wealth, chaos in our financial markets, and a loss of confidence so great that it nearly destroyed American's fundamental faith in capitalism, the economy came back. Indeed, the growth between 1933 and 1937 was the highest we have ever experienced outside of wartime. Had the U.S. not had the terrible policy-induced setback in 1937, we, like most other countries... would probably have been fully recovered before the outbreak of World War II" This is a reminder that the current obsession with no scenario being too pessimistic is probably ill advised.

Bernanke and the policy options

The final source for signposts to watch comes from a speech given by Bernanke in 2000 to Japanese policy makers. As I wrote in Mind Matters 6 January 2009, in this speech Bernanke clearly acknowledged the greater threat that deflation poses in a highly leveraged economy, "Zero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era. The modern economy makes much heavier use of credit, especially longer-term credit, than the economies of the nineteenth century."

Bernanke clearly believes that monetary policy is far from impotent at the zero interest rate bound. In essence his argument is an arbitrage based⁴ one as follows "Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero."

In the speech, he laid out a menu of policy options that are available to the monetary authorities at the zero bound. First, aggressive currency depreciation, as per Romer's analysis of the end of the Great Depression. Second on Bernanke's list is the introduction of an inflation target to help mould the public's expectations about the central bank's desire for inflation. He mentions the range of 3-4%!

Third on the list was money financed transfers. Essentially tax cuts financed by printing money. Obviously this requires co-ordination between the monetary and fiscal authorities, but this should be less of an issue in the US than it was in Japan. Finally, Bernanke argues that non-standard monetary policy should be deployed. Effectively, quantitative and qualitative easing. Bernanke has repeatedly mentioned the possibility of outright purchases of government bonds - as the UK is now doing.

This menu should provide us with a roadmap of policy options to watch for. If (and when) the deflationary pressure builds, we should expect to see more and more of these options wheeled out. Note that we aren't talking about trying to 'fix the system', to reflate the bubble (which would be the equivalent of giving crack cocaine to a heroin addict trying to deal with withdrawal). Rather, the suggestion from Fisher is that inflation erodes the real value of debt; it is the most painless way out of our current mess. Whether the authorities can create just a little inflation remains to be seen, as does their ability to actually create inflation in any way. Such imponderables are beyond my ken.

Investment implications – Cheap insurance

Howard Marks recently suggested that today's investment decisions must focus on "value, survivability and staying power". These factors lie at the heart of the three-pronged approach that I have been suggesting since the end of October last year.

The first prong is cash. This is a legacy from the lack of opportunities that characterised markets in the last few years. But it is also a hedge against outright deflation. The second prong is deep value opportunities in both debt and equity markets (as detailed for the equity markets most recently in Mind Matters, 4 March 2009). The third element is sources of cheap insurance. The idea behind this element of the portfolio is to prepare for a wide variety of outcomes by buying cheap insurance (which ideally, although not always, pays off in multiple states of the world). Of course, it should be noted that the purchase of cheap equities also contains an inflation hedge element.

Inflation/deflation insurance I – TIPS

The first and most obvious source of inflation/deflation protection when I first started thinking about this subject was US TIPS. These bonds have a deflation floor on the principal, so in the event of deflation I receive my cash back - representing a real rate of return equivalent to whatever the deflation rate is. In the event of inflation, I get whatever the yield is on the TIPS when I purchase them plus the inflation, of course (buying the new issue TIPS avoids the problem of accrued inflation).

When I started looking at TIPS, the yield was over 3.5%. This has dropped since then, resulting in the 10 year TIPS delivering a 9% return since the end of October. The 10 year TIP is currently yielding 2.1%, against the 10 year nominal bond yield of 3%. This implies that the market expects US inflation to be a mere 1% p.a. over the next decade - this strikes me as an exceptionally low rate.

Inflation/deflation insurance II – Gold

The second inflation/deflation hedge I suggested in late October was gold. Now, gold concerns me for a variety of reasons, not least of which is that it has no intrinsic worth: I can't really value gold - beyond extraction cost.

However, it has some attractive features from an insurance point of view. Most obviously, in a world of competitive devaluations, gold is the one currency that can't be debased. Thus it provides a useful hedge against the return of this sort of beggar-thy-neighbour policy. In the event of significant prolonged deflation, what is left of our financial system is likely to collapse, thus holding a money substitute isn't such a bad idea against this cataclysmic outcome.

Of course, recently everyone has been talking about gold (not hugely surprising given that it is up some 30% since late October) - something that makes me nervous. However, gold is institutionally massively under-owned, so whilst it may have been moving up the list of attractive assets of individual investors (if the EFTs are anything to go by) and sensible hedge funds (such as the likes of Greenlight, Paulson, Third Point, Eton Park and Hayman), the mainstream institutional appetite for it has remained depressed.

Inflation insurance I – Dividend swaps

As we noted in Mind Matters, 2 February 2009 the European and UK dividend swap markets are pricing in an outcome that implies greater dividend declines than witnessed in the US during the Great Depression. The pricing then implies that essentially the dividends won't recover, pretty much forever. This strikes me as excessively pessimistic.

In addition, dividends have a relatively close relationship with inflation (as detailed in the aforementioned Mind Matters). Thus dividend swaps look like a deeply distressed asset fire sale, with the added advantage of offering inflation insurance if I buy the longer dated swaps (up around 7% from my original note in February). The most common rebuttal to my fondness for dividend swaps is counterparty risk. However, the European dividend swaps have an exchange listed future, which obviously doesn't have any counterparty issues.

Inflation insurance II – Inflation swaps

The second of the pure inflation hedges comes via the inflation swap market. The charts below show the zero-coupon fixed rate necessary to build a swap against zero-coupon CPI appreciation over 10 years. When I first looked at the US version in January (see Mind Matters, 6 January 2009) the rate was a mere 1.5%. Today it has risen, although not dramatically, to 2.3%.

However, the cheapest inflation swaps in the world seem to be Japanese swaps. They are available for -2.5%! Both the US and Japanese inflation swaps strike me as cheap ways of buying inflation insurance at the moment. Although counterparty risk is obviously a significant factor in these long duration swap transactions.

Eurozone break-up insurance: Spanish and Portuguese CDS

The final element of the insurance policy concerns the risk of a euro break-up. In a world of competitive devaluation, it isn't clear that the Eurozone will be able to stand the pressure. The one area of the world which has anything like the gold standard in place is the Eurozone. As Albert opines during our meetings with clients, this is less a function of economic realities and more a function of political expediency (I'll leave a detailed exposition of this logic to Albert in a future note).

To protect against this risk (or even rising perceptions of this risk) the natural insurance is provided by the CDS market. If even one country was to publicly contemplate leaving the Eurozone then these CDS spreads would explode. I find it hard to believe that Portuguese and Spanish CDS are below those of the UK - where we have the ability (and have used it) to print our own money.

Footnotes:

¹Available from http://www.fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf This is one of few articles published in Econometrica that I have ever read!

²See Bill Flecksenstein's excellent book, Greenspan's Bubbles or John Taylor's insightful paper The Financial Crisis and the Policy Responses: An empirical analysis of what went wrong, available from http://www.stanford.edu?~johntayl/FCPR.pdf, or any of Albert Edwards' myriad of rants on Greenspan.

³Romer (1992) What ended the Great Depression?, The Journal of Economic History, Vol 52

⁴As Stephen Ross once said, to turn a parrot into a learned financial economist it needs learn just one word: arbitrage. To my mind economists are far too happy to rely on arbitrage assumptions to rule out solutions. Indeed the second chapter of my first book, Behavioural Finance is spent detailing failures of arbitrage (both causes and consequences thereof, including the ketchup markets!).

Inflation Is Not The Problem

John Mauldin — Tue, 15 Jul 2008 01:34:58 GMT

This week we are going to do something unusual for Outside the Box. Normally I take an essay and send it to you to read. Today I am going to give you a link and strongly suggest you click to it. Long time readers are familiar with friend and comrade James Montier, who along with Albert Edwards, migrated to Societe Generale earlier this year. They are co-heads of Global Cross Asset Strategy and based in London.

Kate Welling does some of the best interviews anywhere in her Welling@Weeden letter, and this one of Montier and Edwards is typical of her immensely enjoyable style. She gave my good friend Prieur du Plessis permission to reprint the letter, and I provide you with a link to his blog and if you scroll down 6 short paragraphs you get the link to the letter, which includes the graphics and is much more fun than just me cutting and pasting. You can also subscribe to Prieur's blog if you wish. Once a week he provides a very useful review of what was written the previous week.

Montier and Edwards speak quite forcefully about the problems they see in the market today, and they are truly Outside the Box thinkers.

"They are, in a word, skeptics, and at this juncture most deeply skeptical of any and all notions that 'the worst is over.' The recession, which has barely begun, is more likely to be deep than shallow, market valuations are hideously expensive and the -flation policymakers should be worried about starts with de-, not in-. For their reasons, keep reading, if you dare."

The link is: http://www.investmentpostcards.com/2008/07/05/market-fundamentals-are-appalling/

And no, despite the picture, they are not twins separated at birth.

John Mauldin, Editor
Outside the Box

The Road To Revulsion

John Mauldin — Tue, 17 Jun 2008 03:25:00 GMT

What does a bubble look like and how do they end? In this week's Outside the Box, James Montier of Societe Generale in London looks at not only the psychological analysis, but also at the propensity for commentators to continually proclaim the end of the problem and a resumption of business as usual. He includes a fascinating piece from Marc Faber documenting the various quotes about how well the economy was doing from 1928-32. This makes for fun, if a little sobering, reading.

To quote from his summary:

"We have seen the heads of virtually all financial institutions stand up over the last few months and claim the worst is behind us. Why would anyone listen to these people? They didn't see the disaster coming, and yet somehow they are qualified to tell us it is all alright! Perhaps I am just unduly sceptical, but this reeks of a conspiracy of optimism. The recession has barely started, let alone reached its nadir. The market moves of late have all the hallmarks of a classic sucker's rally. This isn't discounting the recovery, this is denial! Far from being behind us, the worst may well still be ahead!"

I think you will find this letter very interesting.

John Mauldin, Editor,
Outside the Box

The Road To Revulsion

by James Montier

A couple of months ago I wrote a note arguing that events unfolding the in the US weren't a black swan but rather an example of a predictable surprise (see Mind Matters, 13 March 2008 http://sgresearch.socgen.com/publication/strategy_periodical(20080313)_408.pdf). To claim the credit crisis as a black swan is to abdicate all responsibility for its occurrence. I argued that bubbles are a by-product of human behaviour, and that human behaviour is sadly all too predictable.

The details of each bubble are different but the general patterns remain very similar. As Marx said, history repeats itself, the first time as tragedy, the second time as farce. It is the general pattern of debubbling that I wish to explore this week, particularly in the context of the market's apparent attitude that the worst of the problems seem to be behind us.

Bubbles: a framework for analysis

We have long been proponents of the Kindleberger/Minsky framework for analysing bubbles (see Chapters 38 and 39 of Behavioural Investing for all the details). Essentially this model breaks a bubble's rise and fall into five phases as shown below.

Displacement - The birth of a boom
Displacement is generally an exogenous shock that triggers the creation of profit opportunities in some sectors, while closing down profit availability in other sectors. As long as the opportunities created are greater than those that get shut down, investment and production will pick up to exploit these new opportunities. Investment in both financial and physical assets is likely to occur. Effectively we are witnessing the birth of a boom.

Credit creation - The nurturing of a bubble
Just as fire can't grow without oxygen, so a boom needs liquidity to feed on. Minsky argued that monetary expansion and credit creation are largely endogenous to the system. That is to say, not only can money be created by existing banks but also by the formation of new banks, the development of new credit instruments and the expansion of personal credit outside the banking system.

Euphoria
Everyone starts to buy into the new era. Prices are seen as only capable of ever going up. Traditional valuation standards are abandoned, and new measures are introduced to justify the current price. A wave of overoptimism and overconfidence is unleashed, leading people to overestimate the gains, underestimate the risks and generally think they can control the situation.

Critical stage/Financial distress
The critical stage is often characterised by insiders cashing out, and is rapidly followed by financial distress, in which the excess leverage that has been built up during the boom becomes a major problem. Fraud also often emerges during this stage of the bubble's life.

Revulsion
This is the final stage of a bubble's life cycle. Investors are so scarred by the events in which they participated that they can no longer bring themselves to participate in the market at all.

Bull traps in bear markets

Of course, no debubbling process occurs in a straight line. They are punctuated by electrifying bull runs than end up as bear traps. I first came across the wonderful chart below in Marc Faber's Doom, Boom and Gloom report. It struck such a cord that I had to reproduce it here, taken from Colin Seymour's website.

1 "We will not have any more crashes in our time."- John Maynard Keynes in 1927 [NB: The authenticity of this one is a little suspect]

2. "I cannot help but raise a dissenting voice to statements that we are living in a fool's paradise, and that prosperity in this country must necessarily diminish and recede in the near future." - E. H. H. Simmons, President, New York Stock Exchange, January 12, 1928

"There will be no interruption of our permanent prosperity." - Myron E. Forbes, President, Pierce Arrow Motor Car Co., January 12, 1928

3. "No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time. In the domestic field there is tranquility and contentment...and the highest record of years of prosperity. In the foreign field there is peace, the goodwill which comes from mutual understanding." - Calvin Coolidge December 4, 1928

"When the financial and business history of 1929 is finally written, developments of the past fortnight will occupy a prominent place in what will doubtless be the chronicle of an exceptionally brilliant twelve month period." - The New York Times, July 1929

"It becomes increasingly evident that, in many respects, 1929 will be written into the commercial history of the country as the most remarkable year since the World War in point of sustained demand for goods and services." - The New York Times, August 1929:

4. "There may be a recession in stock prices, but not anything in the nature of a crash." - Irving Fisher, leading U's. economist, New York Times, Sept. 5, 1929

"Stock prices will stay at high levels for years to come, says Ohio economist" - The New York Times, II, Page 7, Col. 2, Oct 13, 1929

5. "Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher than it is today within a few months." - Irving Fisher, Ph.D. in economics, Oct. 17, 1929

The market went into decline until Monday, October 21st, 1929

"He dismissed yesterday's break in the market as a 'shaking out of the lunatic fringe that attempts to speculate on margin.'" - Irving Fisher, The New York Times, Oct. 22, 1929

"Security values in most instances were not inflated"

"The nation is marching along a permanently high plateau of prosperity"

"any fears that the price level of stocks might go down to where it was in 1923 or earlier are not justified by present economic conditions"

- Irving Fisher, speech to a banking group, Oct. 23, 1929

"This crash is not going to have much effect on business."- Arthur Reynolds, Chairman of Continental Illinois Bank of Chicago, October 24, 1929

Flashback to "Black Thursday," Oct. 24, 1929:

Stocks opened moderately steady in price, but traders whose margins were exhausted began selling heavily... at one o'clock the stock ticker was recording prices from half past eleven... stocks dropped 11% intra-day... After a bankers' consortium sent NYSE Vice President Richard Whitney to the stock exchange floor to offer to purchase in the neighborhood of twenty or thirty million dollars' worth of stock at the previous selling price [most likely above their quotations], the market eventually closed with only a 2% loss.

Ref: Only Yesterday: An Informal History of the 1920's, Frederick Lewis Allen, Chap. XIII.

Not long after, the stock market plummeted in two days of panic: October 28 became known as "Black Monday" (13.47% decline in the Dow), and October 29 as "Black Tuesday" (11.73% decline in the Dow). Between October 23rd and November 13th, 1929, the Dow fell by 39%.

"There will be no repetition of the break of yesterday... I have no fear of another comparable decline."- Arthur W. Loasby (President of the Equitable Trust Company), quoted in NYT, Friday, October 25, 1929

"We feel that fundamentally Wall Street is sound, and that for people who can afford to pay for them outright, good stocks are cheap at these prices." - Goodbody and Company market- letter quoted in The New York Times, Friday, October 25, 1929

"The fundamental business of the country, that is production and distribution of commodities, is on a sound and prosperous basis."- President Herbert Hoover, October 25th, 1929

"They have lost a few tail feathers but in time they will grow again, longer and more luxurious than the old ones." - The Wall Street Journal, between Oct 24 and Oct 29, 1929

"The investor who purchases securities at this time with the discrimination that as always is a condition of prudent investing may do so with confidence." - New York Times, October 28, 1929

6. "This is the time to buy stocks. This is the time to recall the words of the late J. P. Morgan... that any man who is bearish on America will go broke. Within a few days there is likely to be a bear panic rather than a bull panic. Many of the low prices as a result of this hysterical selling are not likely to be reached again in many years." - R. W. McNeel, market analyst, as quoted in the New York Herald Tribune, October 30, 1929

"Buying of sound, seasoned issues now will not be regretted" - E. A. Pearce market letter quoted in the New York Herald Tribune, October 30, 1929

"Some pretty intelligent people are now buying stocks... Unless we are to have a panic -- which no one seriously believes, stocks have hit bottom." - R. W. McNeal, financial analyst in October 1929

7. "The decline is in paper values, not in tangible goods and services... America is now in the eighth year of prosperity as commercially defined. The former great periods of prosperity in America averaged eleven years. On this basis we now have three more years to go before the tailspin." - Stuart Chase (American economist and author), NY Herald Tribune, November 1, 1929

"Hysteria has now disappeared from Wall Street."- The Times of London, November 2, 1929

"The Wall Street crash doesn't mean that there will be any general or serious business depression... For six years American business has been diverting a substantial part of its attention, its energies and its resources on the speculative game... Now that irrelevant, alien and hazardous adventure is over. Business has come home again, back to its job, providentially unscathed, sound in wind and limb, financially stronger than ever before." Business Week, November 2, 1929

"...despite its severity, we believe that the slump in stock prices will prove an intermediate movement and not the precursor of a business depression such as would entail prolonged further liquidation..." - Harvard Economic Society (HES), November 2, 1929

8. "... a serious depression seems improbable; [we expect] recovery of business next spring, with further improvement in the fall." - HES, November 10, 1929

"The end of the decline of the Stock Market will probably not be long, only a few more days at most." - Irving Fisher, Professor of Economics at Yale University, November 14, 1929

"In most of the cities and towns of this country, this Wall Street panic will have no effect." Paul Block (President of the Block newspaper chain), editorial, November 15, 1929

"Financial storm definitely passed." Bernard Baruch, cablegram to Winston Churchill, November 15, 1929

9. "I see nothing in the present situation that is either menacing or warrants pessimism... I have every confidence that there will be a revival of activity in the spring, and that during this coming year the country will make steady progress." - Andrew W. Mellon, U's. Secretary of the Treasury December 31, 1929

"I am convinced that through these measures we have reestablished confidence." - Herbert Hoover, December 1929

"[1930 will be] a splendid employment year." - U's. Dept. of Labor, New Year's Forecast, December 1929

10. "For the immediate future, at least, the outlook (stocks) is bright." - Irving Fisher, Ph.D. in Economics, in early 1930

11. "..'there are indications that the severest phase of the recession is over..." - Harvard Economic Society (HES) Jan 18, 1930

12. "There is nothing in the situation to be disturbed about." -Secretary of the Treasury Andrew Mellon, Feb 1930

13. "The spring of 1930 marks the end of a period of grave concern...American business is steadily coming back to a normal level of prosperity." - Julius Barnes, head of Hoover's National Business Survey Conference, Mar 16, 1930

"... the outlook continues favorable..." - HES Mar 29, 1930

14. "... the outlook is favorable..." - HES Apr 19, 1930

15."While the crash only took place six months ago, I am convinced we have now passed through the worst -- and with continued unity of effort we shall rapidly recover. There has been no significant bank or industrial failure. That danger, too, is safely behind us." -Herbert Hoover, President of the United States, May 1, 1930

"...by May or June the spring recovery forecast in our letters of last December and November should clearly be apparent..." - HES May 17, 1930

"Gentleman, you have come sixty days too late. The depression is over."- Herbert Hoover, responding to a delegation requesting a public works program to help speed the recovery, June 1930

16. "... irregular and conflicting movements of business should soon give way to a sustained recovery..." - HES June 28, 1930

17. "... the present depression has about spent its force..." - HES, Aug 30, 1930

18. "We are now near the end of the declining phase of the depression." - HES Nov 15, 1930

19."Stabilization at [present] levels is clearly possible." - HES Oct 31, 1931

20. "Executive Order 6102 Forbidding the Hoarding of Gold Coin, Gold Bullion and Gold Certificates

By virtue of the authority vested in me by Section 5(b) of the Act of October 6, 1917, as amended by Section 2 of the Act of March 9, 1933, entitled "An Act to provide relief in the existing national emergency in banking, and for other purposes", in which amendatory Act Congress declared that a serious emergency exists, I, Franklin D. Roosevelt, President of the United States of America, do declare that said national emergency still continues to exist and pursuant to said section to do hereby prohibit the hoarding of gold coin, gold bullion, and gold certificates within the continental United States by individuals, partnerships, associations and corporations and hereby prescribe the following regulations for carrying out the purposes of the order...

All persons are hereby required to deliver on or before May 1, 1933, to a Federal Reserve bank or a branch or agency thereof or to any member bank of the Federal Reserve System all gold coin, gold bullion, and gold certificates now owned by them or coming into their ownership on or before April 28, 1933, except the following:

Such amount of gold as may be required for legitimate and customary use in industry, profession or art within a reasonable time, including gold prior to refining and stocks of gold in reasonable amounts for the usual trade requirements of owners mining and refining such gold.
Gold coin and gold certificates in an amount not exceeding in the aggregate $100.00 belonging to any one person; and gold coins having recognized special value to collectors of rare and unusual coins.
Gold coin and bullion earmarked or held in trust for a recognized foreign government or foreign central bank or the Bank for International Settlements.
Gold coin and bullion licensed for the other proper transactions (not involving hoarding) including gold coin and gold bullion imported for the re-export or held pending action on applications for export license..." Franklin D. Roosevelt, The Whitehouse April 5, 1933 20 May 2008

The comments made every time the market rallies are characterised by the ever-present optimism that we have discussed many times. I suspect that is exactly what we are witnessing currently.

The first wave of concerns created by the bursting the housing/credit bubble (and make no mistake they are two sides of the same coin) is subsiding. The optimists believe (or at least hope) that the worst is now over. Indeed the probability of a recession in 2008 has dropped to 39% on the Intrade contract!

However, from our perspective such sanguinity is likely to be misplaced. The slowdown in the US is barely starting. The charts below show that both the demand and supply for .credit. are evaporating. This effective shutdown of both sides of the market should be a serious concern for monetary policy makers, as it is one of the hallmarks of a liquidity trap situation.

Note in particular how widespread the lack of demand for credit is, as well as the supply! This isn't just about the housing market. Obviously demand for mortgages (both commercial and residential) is lacking, but so is the demand for consumer credit, and corporate credit. This doesn't bode well for the outlook.

The underlying asset adjustment is likely to have much further to run as well. The chart below shows the developments in US house prices and Japanese land prices during their bubble and burst. The point of this chart isn't to say that US prices will follow Japanese prices, but rather to illustrate the long drawn out nature of the healing that has to occur. Indeed, one client recently asked me if this was worse than the S&L crisis. To my mind it is much worse, as securitisation was part of the solution to the S&L problems, whereas it has been part of the problem in the build-up in this bubble.

Indeed, one of the lessons that should be learnt from the Japanese experience is that the banks were second round losers, a point made by Albert Edwards recently (see 3 April http://sgresearch.socgen.com/publication/strategy_update(20080403)_cc0.pdf Global Strategy Weekly). They didn't really begin to underperform the rest of the market until the second Japanese recession of its debubbling process. They really started to suffer when their consumers (Japan Inc) started to struggle.

From a market perspective, financials remain an exceptionally large component of the market itself. As the chart below shows, today's 17% of market cap may be well off the high of nearly 25% but remains a long way above the levels before this bubble started.

One of the other lessons of importance from Japan is that it is never the stocks that led you into the bubble that lead you out. For instance, in Japan's post bubble environment it was the capital-starved autos and electricals that were the winners. Just as the US market recovery after the dot com bubble wasn't led by tech but by mining, material and financials. Those deprived of capital do best in the aftermath of a bursting bubble, not those gorged on it. This argues that it isn't likely to be financials that lead us into any sustained rally.

This makes it all the harder to understand the way in which investors have been cheering the rights issues/capital raisings that financial firms have been carrying out. I recently described investors. responses to rights issues as the investment equivalent of being mugged and then turning around and saying thank you to the perpetrator (and perhaps offering to take them to the cash point and get some more money out for them).

The chart below may just give some pause for thought. It comes from a study by Capstaff et al¹. They study the long-term performance of stocks conducting rights issues in the UK between 1986 and 1995. In particular, they split out the evidence in the pre 1991 and post 1991 periods. This is interesting because it reveals two different motives for a right issue. During the first period, it appears managers issued more equity to take advantage of high valuations. However, the second period reflects a more separate need for cash brought on by the last UK housing recession.

Regardless of the motive, the outcome is clear from even a cursory glance at the chart below. Rights issues are bad news for investors. The poor performance of firms conducting rights issues prior to the issue itself is clearly observable for the 1991-1995 sub-period. Even more noticeable is the increased underperformance once the rights issue is over. If history is any guide, investors cheering such issues now are likely to end up severely disappointed at the end of the day.

From our perspective, the market is enjoying a sucker's rally. The road to revulsion is likely to witness many such events, but the recession reality is only just unfolding. Far from being behind us, the worst may still be ahead!

Footnotes:
1 Capstaff, Ngatuni and Marshall (2007) Long-term performance following rights issues and open offers in the UK, available from www.ssrn.com

Your still thinking sell in May and go away analyst,

John Mauldin

Joining The Dark Side: Pirates, Spies and Short Sellers

John Mauldin — Mon, 26 May 2008 20:43:56 GMT

Is the market over-valued? In this week's Outside the Box, one of my favorite global equity analyst's (and no stranger to regular readers), James Montier of Societe Generale does some very interesting analysis on the European and US markets and finds the number of stocks which make his list as possible for being a "short" is at very high levels. This is a remarkable read and re-enforces my view that we are in a "sell in May and go away" summer. This is really a great Outside the Box. Enjoy.

John Mauldin, Editor
Outside the Box

Joining The Dark Side: Pirates, Spies and Short Sellers

by James Montier

Joining the dark side

It never ceases to amaze me that whenever a major corporate declines the short sellers are suddenly painted as financial equivalents of psychopaths. This is madness, rather than examining the exceptionally poor (and sometimes criminal) decisions that the corporate itself took, the short sellers are hauled over the coals.

As the New York Times recently reminded us, vilifying short sellers is nothing new.

In the days when square-rigged galleons plied the spice route to the East, the Dutch outlawed a band of rebels that they feared might plunder their new-found riches.

The troublemakers were neither Barbary pirates nor Spanish spies -- they were certain traders on the stock exchange in Amsterdam. Their offence: shorting the shares of the Dutch East India Company, purportedly the first company in the world to issue stock.

Short sellers, who sell assets like stocks in the hope that the price will fall, have been reviled ever since. England banned them for much of the 18th and 19th centuries. Napoleon deemed them enemies of the state. And Germany's last Kaiser enlisted them to attack American markets (or so some Americans feared).

Jenny Anderson, NY Times, 30 April 2008

Last week, Albert Edwards took our equity weighting down to its minimum (see Global Strategy Weekly, 8 May 2008), and my own bottom-up valuation work finds little opportunity for investment at the moment (see Mind Matters, 28 January 2008). This suggests to me the main opportunities may lie on the short side in the current market. So I guess I am joining the ranks of the dark side!

This remains anathema to analysts. As the chart below shows the percentage of sell recommendations remains pathetically low. Indeed, the other day my head of research showed me the second chart below showing that SG had the highest percentage of sells amongst investment banks - it makes a pleasant change to see SG at the top of a list on a positive note!

All of this got me to thinking about how to identify potential short candidates. In keeping with my first note for SG (on limited information - see Mind Matters 3 December 2007, I want to focus on just a few key measures that stand out to me as sources of poor underperformance.

Valuation

Most obviously (and unsurprisingly given my value bias) one of my primary sources of underperformance has to be high valuation. There are myriad methods of valuing a stock, of course. However, from the perspective of a short seller, one of the most useful is price-to-sales.

Focusing upon high price-to-sales stocks allows us to hone in on story stocks - those stocks that have lost all touch with reality. During periods of investor enthusiasm there is often a marked tendency to move up the income statement in order to try and keep valuation multiples 'low'. Indeed during the dotcom years, things were valued on measures such as average revenue per user, clicks and eyeballs!

Price-to-sales has always been one of my least favourite valuation measures as it ignores profitability. Reductio ad absurdum demonstrates this clearly. Imagine I set up a business selling £20 notes for £19, strangely enough I will never make any money, my volume may well be enormous, but it will always be profitless. But I won't care as long as the market values me on price-to-sales.

I am not alone in pondering the insanity of this measure. One of my favourite quotations of all time comes from Scott McNealy, the then CEO of Sun Microsystems:

But two years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes that with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don't need any transparency. You don't need any footnotes. What were you thinking?

Scott McNealy, Business Week, April 2002.

So whenever I hear people using price-to-sales to justify a stock I can't help but think they are trying to hide something. However, as always I remain a proponent of Evidence Based Investing, so the proof is in the pudding. Does price-to-sales work as a strategy?

The chart below shows the performance of price-to-sales quintiles within Europe over the period 1985-2007. Unsurprisingly, the cheapest stocks outperform the most expensive stocks.

As a check on this particular valuation measure we regressed the returns from a long short price-to-sales portfolio against the value minus growth returns from MSCI Europe. A significant 'alpha' was found, so price-to-sales adds something extra above and beyond price-to-book (as per the discussion above).

Financial Analysis

The second element of my short strategy is to examine the financial analysis of the company. My outspoken criticism of analysts is sometimes taken as a view that I think financial analysis is a waste of time. Nothing could be further from the truth. I am driven to despair by the fact that analysts spend so long wasting their time trying to do the impossible such as forecast earnings, but I remain a fan of good solid fundamental-orientated research.

In the past I have advocated the use of the F score designed by Joseph Piotroski as a simple but highly effective method of quantifying a fundamental approach. In his original paper¹, Piotroski applied a fundamental analysis screen to help tell good value from value traps. In a subsequent paper², he explored whether a simple financial screen could enhance performance across a variety of styles.

The screen Piotroski developed is a simple nine input accounting-based scoring system. The table below shows the basic variables used in its calculation. Effectively, Piotroski uses indicators based on three areas of financial analysis in order to assess the likelihood of an improving fundamental backdrop.

Current operating profits and cash flow outturns obviously provide information about the firm's ability to generate funds internally, and pay dividends. A positive earnings trend is also suggestive of an improvement in the fundamental performance of the firm. Earnings quality is also captured by looking at the relationship between cash flows and reported earnings.

The next three measures are designed to measure changes in the capital structure and general ability to meet debt-service obligations. If you like, these measures assess the likelihood of bankruptcy and bring the balance sheet into the overall score.

The last two elements of the overall F score are concerned with operating efficiency. The variables used will be familiar to fans of Du Pont analysis as they both come from traditional decomposition of ROA. Having assessed the measures as per the table below, a firm's F score is simply the summation of the various individual components (thus it is bounded between 0 and 9).

Piotroski examines the performance of this score in the US market over the period 1972 to 2001. His main findings are shown in the chart below which maps out raw returns by the overall F score. The average raw (market adjusted) return for firms with low F scores (0-3) is 7.3% p.a. (-5.5%). Firms with medium F scores (4-6) show raw (market adjusted) returns of 15.5% p.a. (3%). Those firms with the highest F score (7-9) showed an average raw return (market adjusted) of 21% p.a. (7.8%). This certainly shows that fundamental analysis can be a source of alpha!

I find the European evidence to be similar. The average raw (market adjusted) return for firms with low F scores (0-3) is 4.4% p.a. (-8%). Firms with medium F scores (4-6) show raw (market adjusted) returns of 13.1% p.a. (0.5%). Those firms with the highest F score (7-9) showed an average raw return (market adjusted) of 15% p.a. (2.5%).

Piotroski also explores how his measure performs in the context of value and growth stocks. As he notes:

It is very difficult for investors to systematically identify meaningfully underpriced (overpriced) glamour firms (value firms), consistent with the gains to financial statement analysis-based strategies corresponding to the expected bias imbedded in each book-to-market portfolio. When FSCORE corresponds to the expected performance of these firms (i.e. strong performance for glamour and poor performance for value firms), each respective portfolio earns near the market return. Effectively, financial signals confirming the expectations that are likely already imbedded in price are assimilated into prices quickly, while contrarian signals are (generally) discounted until future confirmatory news is received. As a result, historical good news for glamour firms is unable to generate excess returns, while historical good news for value firms is a tradable opportunity, and vice-versa for trading opportunities conditional on bad news.

This finding is confirmed by our European data as the chart below shows. Value stocks with high F scores do particularly well (a raw return of over 20% p.a., some 4% better than the average value stock). However, growth stocks with low F scores do particularly poorly (a raw return of -.7% p.a., some 9% worse than the average growth stock).

In the context of our combing for short candidates, this implies we would be best off looking at expensive stocks, so combining the first two components should give a reasonable list of likely short candidates. However, I wish to examine one more important factor before producing a final list.

Capital discipline

The final element of my hunt for potential shorts is a lack of capital discipline. A survey conducted by McKinsey³ (at last something useful from them!) revealed that corporates themselves knew that they weren't great at capital discipline. The survey of "Corporate level executives" said "17 percent of the capital invested by their companies went toward underperforming investment that should be terminated and that 16 percent of their investments were a mistake to have financed in the first place". Those working closer to the coal face (business unit heads and frontline managers) thought that even more projects should never have been approved (21% for each category!).

The survey also asked managers how accurate their forecasts were in various areas of corporate investment such as the time taken to complete the project, the impact on sales, costs etc. The results are shown in the chart below. Nearly 70% of the managers said they were too optimistic with respect to the time the project would take to complete (evidence of the well known planning fallacy). 50% of the respondents said they were too optimistic about the impact the investment would have on sales, and over 40% were too optimistic about the costs involved!

The survey also revealed that nearly 40% of the respondents said that managers "hide, restrict, or misrepresent information" when submitting capital investment proposals! The discouragement of dissent was also strongly noted, over 50% of those taking part said it was important to avoid contradicting superiors (see Mind Matters, 5 March 2008).

Given these kind of views, it isn't shocking to note the findings of Cooper, Gulen and Schill⁴. They explore the predictive power of total asset growth for stock returns. The advantage of using total assets is, of course, that it provides a comprehensive picture of overall investment/disinvestment.

In their US sample covering the period 1968-2003, Cooper et al find that firms with low asset growth outperformed firms with high asset growth by an astounding 20% p.a. equally weighted. Even when controlling for market, size and style, low asset growth firms outperformed high asset growth firms by 13% p.a.

The European evidence is also compelling. Over the period 1985 to 2007, we find that low asset growth firms outperformed high asset growth firms by around 10% p.a. The bottom line is that capital discipline seems to be much neglected by firms and investors alike.

Putting it all together

So we have covered three potential sources of short ideas. What happens if we put them all together? The parameters I used to define my shorts were a price-to-sales > 1, an F score of 3 or less, and total asset growth in double digits.

This proved to be a powerful combination. Between 1985 and 2007 a portfolio of such stocks rebalanced annually would have declined over 6% p.a. compared to a market that was rising at the rate of 13% p.a. in Europe! Although I've not shown the result below, similar findings were uncovered for the US as well.

The basket of shorts generated a negative alpha in excess of 20% p.a. with a beta of 1.3. The basket witnessed absolute negative returns in 10 out of 22 years (45% of the time). Relative to the index it underperformed in 18 of the 22 years (81% of the time).

The average stock selected by the model falls 8% p.a. (median 9.6% decline). Some 60% of the screen picks witness absolute negative returns. Thus the model also tends to pick a few stocks that do exceptionally well on the long side - not good news for a short strategy. Hence, introducing the use of stop loss can improve the performance of our short basket significantly. For instance, putting a 20% stop loss in place raises the return from -6% p.a. to -13% p.a.

As regular readers will know I have described much of the period since late 2002 as being characterised by the dash to trash. This can clearly be seen from the chart above. 2003 saw the shorts outperforming the market by 6%! A feat repeated on a lesser scale in 2005 and 2006.

Despite the rocky road that this portfolio has suffered in recent years, I believe that it remains a sound method of looking for shorts, and if we are right that most of the opportunities are likely to be on the short side then it could prove a useful tool in the times ahead.

Two final charts which echo one of the points I made at the outset of this note are shown below. They illustrate the number of stocks that the screen finds passing our criteria for being short candidates. In Europe, the average over our sample is around 20 stocks per year. Running the screen now reveals an all time high of almost 100 stocks passing the criteria.

In the US, the average number of stocks in our short basket is around 30. Today, the screen finds no less than 174 stocks passing the criteria. This clearly demonstrates to me the lack of value I alluded to at the start of this note, and indeed suggests that the opportunities are now firmly on the short side.

Footnotes:

1 Piotroski (2000) Value Investing: The Use of Historical Financial Information to Separate Winners from Losers, The Journal of Accounting Research, Vol 38

2 Piotroski (2004) Further evidence on the relation between historical changes in financial conditions, future returns and the value/glamour effect, unpublished working paper

3 How Companies Spend Their Money: A McKinsey Global Survey, McKinsey Quarterly June 2007

4 Cooper, Gulen and Schill (2006) What best explains the cross-section of stock returns? Exploring the asset growth effect; available from www.ssrm.com

Your enjoying the holiday analyst,

John Mauldin

Asleep at the wheel, or, How I learned to stop worrying and love the bomb

John Mauldin — Mon, 07 Apr 2008 19:52:47 GMT

For the last few months in my regular letter I have been pounding the table that corporate earnings are going to decline this year, which is always a negative atmosphere for stocks. Since today is the beginning of the earnings season for the first quarter...(read more)

The Dash To Trash And The Grab For Growth

John Mauldin — Mon, 28 Jan 2008 22:15:15 GMT

This week we look at a very thoughtful essay by an old Outside the Box friend James Montier. James is now working at Societe Generale in London. He is one of the truly great minds on the psychology of investing, as well as proving great research on how...(read more)

The Relative Performance Derby And Other Evils Of Modern Investment

John Mauldin — Mon, 25 Jun 2007 18:15:00 GMT

Introduction This week in Outside the Box we take a gander at the always-insightful research of good friend James Montier, who poignantly addresses the pertinent topic of portfolio diversification and the pitfalls that ensue on account of benchmarking...(read more)

Meaty Beaty Big and Bouncy

John Mauldin — Mon, 16 Apr 2007 20:25:00 GMT

Introduction Today's Outside the Box is by James Montier of Dresdner Kleinwort. Quite frankly, the research that James discusses surprised me. In his article "Meaty beaty big and bouncy," James dispels what he calls an urban myth that small...(read more)

'Capital Ideas' Or 'CRAP'?

John Mauldin — Mon, 19 Feb 2007 22:00:00 GMT

Introduction Today I am pleased to present to you an exceptionally interesting article for this week's Outside the Box. But before I do, let me say that it is roughly double in length as normal, so please read it at your leisure. Before I give my...(read more)

CAPM is CRAP, or, The Dead Parrot lives!

John Mauldin — Mon, 29 Jan 2007 22:04:00 GMT

Introduction Within human nature there is a tendency to search for reasoning or logic to validate our own actions. This holds true in the academic sector as models are derived to provide an answer to a scenario, but sometimes such models do not translate...(read more)

Just A Little Patience

John Mauldin — Mon, 23 Oct 2006 21:45:00 GMT

Introduction In my Friday letter, Thoughts from the Frontline (you can view it here ), we looked at how valuation and prices change over market cycles. As I mentioned and have written about extensively in my book Bull's Eye Investing, market cycles...(read more)