Talking our way to recession!


A client writes, "The talking heads have a million opinions and it seems as if no one has a clue!" Yup, that is the most succinct investment analysis we've seen all summer. After Congress blew up the stock market in late July with the debt ceiling fumble, we endured a stretch of volatility  not seen since spring of 2010, though certainly not as bad as the grim 4th quarter of 2008. Which prompts everyone to wonder, "Are we about to undergo another 50% sell-off in stocks?" No, but most people project the future based on their most recent experiences, especially as the talking heads proclaim daily that "Greece is the next Lehman Brothers."

Two important differences between 2008-9 and now:

  1. The amount of leverage in the system is way reduced. Less borrowing, more equity means that banks only sell when they want to, not because they have to.
  2. We have seen this story before and are better prepared to deal with it. 9/11 was such a shock because Westerners had not been attacked like that before. Subsequent attacks in Madrid, London, and this summer in Oslo just don't resonate the same way. Central bankers lived through the 2008-9 crisis, know where the systematic weaknesses are and can take steps to mitigate problems.

 But clients are hardly consoled. If they look over the chart of the S&P 500, they note that stocks are at the same level as September 2008, June 2005, December 2004, April and July 2001, July and December 1998. Yes, the basket yielded dividends averaging about 2% during that timeframe, but bonds were by the far the better investment. International markets, at least until this year, also far outperformed.

Earnings per share in the S&P 500 peaked in Q4 2007, peaked again in the most recent quarter, and are projected to grow nicely in the first half of 2012..

Earnings are only valuable if the price is cheap enough. Price divided by earnings is a "quick and dirty" ceck on whether stocks are cheap. The P/E ratio was much higher over the last 15 years; the one time it was lower in 2009, stock prices doubled over the following 2 ½ years.

Earnings are even more valuable in an environment of low interest rates:  The yield on the 10 year US Treasury bond is even lower now than during the banking crisis.

As we know, bank money market accounts currently yield 0.0001%. If you don't need the money for 5 years, why wouldn't you buy General Electric with a current dividend yield of 3.75% and a Morningstar fair value estimate 55% higher than today's closing price?

Let Greece default already!

None of this objective analysis matters because the daily narrative is "whether Greece will or will not default." The answer is: of course they will. The only way to service the current high levels of Greek debt, at current usurious interest rates, is to slash government spending and raise taxes. Which will immediately cause the Greek economy to implode, making it even more unlikely that the debt can be serviced. Who suffers as a result? Greek debt totals about $250 billion - assume half is a write-off. European banks are the primary holders of that debt, which means about a $125 billion capital loss. That's not a small sum, but remember that the US was able to recapitalize its banks with $700 billion during a far worse crisis. Given paybacks from banks, AIG and auto companies, the total cost of that bailout is currently estimated at $25 billion.

The Europeans do not yet have a political structure for engineering an equivalent rescue, and that will be the over-hang in Europe through the New Year. The European central bankers and politicians will figure it out - eventually. The risk remains whether Italy, Spain, Portugal, Ireland will require equivalent rescues. The largest unknown risk is: of all the banks and hedge funds that sold "Credit Default Swaps" on Greek bonds, do any have enough capital to pay off their exposure. Remember that the US Treasury directed $62 billion to AIG to cover CDS exposure at that firm in 2009 - AIG had nothing but a credit rating to back the risk. We doubt that the European central banks are prepared to do the same. So, when the dust settles, bond portfolio managers will be obliged to price sovereign risk appropriately and not rely simply on a "hedge" based on a CDS and the attendant counter-party risk.


We hear our clients' frustration daily. US stocks peaked April 29th, rallied again through late July, only to be torpedoed by Congress. It should be noted that this is the second time in 4 years that Congress has clobbered investor and business confidence - Congress voted down the first TARP legislation in September 29th, 2008. The second version was enacted on October 3rd by which time the Dow Industrials had declined 2600 points.

Business and consumer confidence plummeted since February, while unemployment looks to be stuck around 9% through 2012, which is not like any post-recession experience of the last 60 years. Housing prices aren't declining, but sure won't be rising anytime soon. Despite all this, the US stock market is down only 3% YTD, which is a lot better than European markets down 14% YTD or Asian and emerging markets down 16% on the year.