Useful frameworks for investment analysis


The S&P 500 is up 8.5% YTD and matching the level last seen September 15th, 2008, the date that Lehman Brother filed for bankruptcy.  With US stocks up an incredible 79.5% from the March 9th, 2009 low, a pause or even a pullback is to be expected.  Our forecast for the S&P 500 for all of 2010 is only 8%, so reason enough to be cautious 4 ½ months into the year.

The critical question is whether current stock market valuations are justified given gradual improvement in the US economic situation, or in fact are we setting ourselves up for a sucker punch as the economy slips back into recession?

Single dip or double dip recession?  Facts favor the first scenario

A "double dip recession" is defined as a second period of economic contraction followed by a brief expansion."  This can occur because the expansion is not substantial enough to bring enough unemployed workers back into the economy despite, for example, inventory rebuilding, and can also be caused by an exogenous event (the brief downturn in the US economy in 2000 was extended to 2002 by the aftershocks of the 9/11 attacks.

It's not unreasonable to fear a "double dip recession" in the current circumstances.  Unemployment remains high at 9.7% even as job growth exceeded 100,000/month for only the first time since Fall 2007.  Measures of consumer confidence remain deeply depressed.  US housing has leveled off near the levels of 2003.  We are telling our clients to expect NO appreciation in real estate for about the next ten years.  Credit to consumers and small business remain constrained, with consumer debt levels falling for the first time ever.  Still the ratio of consumer debt payments to disposable income is only slightly below the record established Q1 2008.  Consumers can't spend when a high portion of their income goes to service mortgages, credit cards, and car payments.

As a result, Q1 2010 GDP growth is expected to decelerate sharply to 2.9% compared to Q4 2009 growth of 5.6%.  However growth is expected to remain positive for all of 2010 and into 2011 in the 2.8% year over year range.  In that scenario, unemployment is expected to remain high in the 9% range for the next two years.  Previously we had calculated that it would take about 15 million new jobs to take unemployment back to the sub 5% level last seen in the 2005-2007 range, and we have no idea where those jobs will come from. 

This graph shows recession peaks in 1974, 1982, 1992 and 2003.  The worrisome issue is gains in jobs are much slower after the more recent recessions (the so-called "jobless recoveries.")
Bottom line the indicator we're watching the most closely for the rest of the year is jobs growth. 

Despite all these bearish factors, we're ever more confident that the current modest expansion is sustainable.  In particular, statistics on temp workers and over-time hours tell us there's not more output employers can extract from current employees.  Further demand can only be met by hiring permanent workers.  Among the employed, spending is up as bargains are to be had everywhere.  We have often remarked that one of the greatest strengths and weaknesses of the American economy is that the American consumer has no memory what so ever, so the horrible gloom that prevailed this time a year ago has already dissipated.  Here in New York City, ground zero of the financial panic, quite a few stores are vacant, but new restaurants are packed on opening, and the streets are filled with domestic and foreign tourists.  Don't underestimate the "wealth effect" of the stock market rise - anyone who bought stocks in the last 52 weeks is sitting on a healthy profit!

Reiterating the point we've made several times in the last 6 months, this recession was not caused by the usual constriction of money supply and rise in interest rates by the Federal Reserve to stifle inflation, but by the financial system completely shutting down following the Lehman bankruptcy.  As we have seen after similar "credit" crises including the 1987 Stock Market Crash and the 1998 Long Term Capital Crisis, the "real" economy tends to rebound quickly and with it the stock market.

The Red/Yellow/Green Light Macro Model

The fantasy of all economists is to build the perfect macro model which, to 8 decimal places, can calculate the probability of economic rise and fall. The reality is the underlying data is too late, too sloppy, too inaccurate to ever deliver that level of precision. Instead, we have developed a simple visual model based on traffic lights. The more green on the screen, the more positive we feel. At present we feel that the trend in economic reports, the recent gains in the dollar versus other industrial currencies, Federal Reserve policy, and overall technical factors, are bullish/neutral for stocks. Yield curves in the bond markets are shifting higher and the curves are also steepening which is bearish, but rates overall are still low, so net neutral/bearish. Commodity prices have stabilized at modestly high levels, so neutral. The political situation in Washington is ridiculous, so neutral bearish.  

Add that all together and the net effect is bullish/neutral for stocks.  The factor that concerns us the most about stocks right is over-all valuations.  Stocks are priced for really good earnings reports not only for the cycle that started last week, but also for the cycle that starts July 2010.

SEC and Goldman Sachs - return to the "worst trade of all time"

Back in February, we wrote, "What really kills investor's trust in markets is the creation of what we call "negative sum" products - an innovation where some trader profits, but others take a disproportionate loss.  John Paulson was the principal of the relatively modest "Paulson & Co" hedge fund.  Like many, he recognized the bubble in housing from 2005 on.  Unlike most, as documented in Gregory Zuckerman's The Greatest Trade Ever, he figured out a way to profit from the eventual bursting of the bubble. 

Junk mortgages written against junk properties were packaged into junk securities called collateralized debt obligations (CDO's).  Unfortunately, as no one could remember a time when mortgages were not good collateral, these securities were rated AA or AAA by the ratings agencies and sold to pension plans all over the country.  As fast as the CDO's were sold, underwriters of these securities were also selling Credit Default Swaps (CDS) on the same securities.  A CDS agreement says that in the event that the issuer (the CDO) defaults, the owner of the CDS has the right to sell (put) the bond back to the issuer at par (same price as issue price.)

Paulson didn't own the CDO's but bought mountains of CDS.  He actually went to Goldman Sachs and pleaded (colluded?) with them to issue more CDO's so he could buy more CDS.  When the bonds collapsed in value in 2007 and 2008, Paulson's company made $20 billion and he personally made $4 billion.  Good fun for all except that the pension plans, representing the hopes and dreams of millions of ordinary Americans, lost about $1 trillion.  $20 billion gain offset by a $1 trillion loss?  Sound to us like the Worst Trade of All Time!  Here's the value question: can we afford to live in a system where such trades are legal?"

We were highly skeptical that regulators would ever attempt to bring justice to bear on these trades, so we were pleasantly surprised Friday morning when the SEC filed a civil complaint against Goldman Sachs alleging "Goldman Sachs & Co. sold mortgage investments without telling the buyers that the securities were crafted with input from a client who was betting on them to fail."  Paulson was not named in the suit - yet.

The history of Wall Street firms which face SEC scrutiny bodes poorly for Goldman Sachs.  Other firms include Salomon Brothers, First Boston, Bear Stearns, and Merrill Lynch, none of which exist today other than as a name-plate.  Credit and credibility derive from the same Latin root credo - "I believe."  Without credibility, you can't get credit.  Obviously Goldman Sachs is not going out of business tomorrow.  But in hindsight, we understand why Goldman Sachs was not selected as the lead underwriter to sell the US Government's 27% stake in Citigroup - the Treasury knew this indictment was coming.  Multiply that reaction across all of Goldman Sachs' business lines and obviously the bank is going to have a tough time, even if the SEC fails to prove its case (as occurred in their suit against Frank Quatrone of First Boston over destruction of documents related to junky IPO's, and against Ralph Cioffi and Mathew Tanning, who ran a collapsed hedge fund at Bear Stearns.)

We held a small position in Goldman Sachs among our clients' accounts, which will be sold Monday morning.  Bigger picture financial stocks in particular and the stock market in general may sell off over the next couple of days as investors digest a clearly more aggressive regulatory stance.  No matter, our system needs this.


Our forecast for 2010 was about 8% for the S&P 500, and markets have already surpassed that level. Interest rates are rising as we expected and we're not harmed as we've deliberately kept duration of bond investments short to intermediate. There are plenty of companies delivering outstanding earnings reports, Google, Intel and JP Morgan are examples. We continue to invest our clients' funds in the markets, just reminding them to lower their expectations of gains for the rest of the year.