naked capitalism

By George Washington of Washington’s Blog.

Investors are basically rational, right?

In fact, as many studies have demonstrated, the answer is no.

But instead of wading through all of the investment psychology research, let’s look at research into people’s basic reasoning abilities. Bear with me for a minute. A study in an area unrelated to investing sheds light on people’s basic thinking processes.

Sociologists from four major research institutions investigated why so many Americans believed that Saddam Hussein was behind 9/11, years after it became obvious that Iraq had nothing to do with 9/11.

The researchers found, as described in an article in the journal Sociological Inquiry (and re-printed by Newsweek):

• Many Americans felt an urgent need to seek justification for a war already in progress

• Rather than search rationally for information that either confirms or disconfirms a particular belief, people actually seek out information that confirms what they already believe.

• “For the most part people completely ignore contrary information.”

• “The study demonstrates voters’ ability to develop elaborate rationalizations based on faulty information”

• People get deeply attached to their beliefs, and form emotional attachments that get wrapped up in their personal identity and sense of morality, irrespective of the facts of the matter.

• “We refer to this as ‘inferred justification, because for these voters, the sheer fact that we were engaged in war led to a post-hoc search for a justification for that war.

• “People were basically making up justifications for the fact that we were at war”

• “They wanted to believe in the link [between 9/11 and Iraq] because it helped them make sense of a current reality. So voters’ ability to develop elaborate rationalizations based on faulty information, whether we think that is good or bad for democratic practice, does at least demonstrate an impressive form of creativity.

An article yesterday in Alternet discussing the Sociological Inquiry article helps us to understand that the key to people’s active participation in searching for excuses for actions by the big boys is fear:

Subjects were presented during one-on-one interviews with a newspaper clip of this Bush quote: “This administration never said that the 9/11 attacks were orchestrated between Saddam and al-Qaeda.”The Sept. 11 Commission, too, found no such link, the subjects were told.

“Well, I bet they say that the commission didn’t have any proof of it,” one subject responded, “but I guess we still can have our opinions and feel that way even though they say that.”

Reasoned another: “Saddam, I can’t judge if he did what he’s being accused of, but if Bush thinks he did it, then he did it.”

Others declined to engage the information at all. Most curious to the researchers were the respondents who reasoned that Saddam must have been connected to Sept. 11, because why else would the Bush Administration have gone to war in Iraq?

The desire to believe this was more powerful, according to the researchers, than any active campaign to plant the idea.

Such a campaign did exist in the run-up to the war…

He won’t credit [politicians spouting misinformation] alone for the phenomenon, though.

“That kind of puts the idea out there, but what people then do with the idea … ” he said. “Our argument is that people aren’t just empty vessels. You don’t just sort of open up their brains and dump false information in and they regurgitate it. They’re actually active processing cognitive agents”…

The alternate explanation raises queasy questions for the rest of society.

“I think we’d all like to believe that when people come across disconfirming evidence, what they tend to do is to update their opinions,” said Andrew Perrin, an associate professor at UNC and another author of the study…

“The implications for how democracy works are quite profound, there’s no question in my mind about that,” Perrin said. “What it means is that we have to think about the emotional states in which citizens find themselves that then lead them to reason and deliberate in particular ways.”

Evidence suggests people are more likely to pay attention to facts within certain emotional states and social situations. Some may never change their minds. For others, policy-makers could better identify those states, for example minimizing the fear that often clouds a person’s ability to assess facts …

The Alternet article links to a must-read interview with psychology professor Sheldon Solomon, who explains:

A large body of evidence shows that momentarily [raising fear of death], typically by asking people to think about themselves dying, intensifies people’s strivings to protect and bolster aspects of their worldviews, and to bolster their self-esteem. The most common finding is that [fear of death] increases positive reactions to those who share cherished aspects of one’s cultural worldview, and negative reactions toward those who violate cherished cultural values or are merely different.

Fear in the Economic and Financial Arenas

Has something similar happened in the economic/financial arenas?

Congressmen Brad Sherman and Paul Kanjorski and Senator James Inhofe all say that the government warned of martial law if Tarp wasn’t passed. And Rahm Emanuel famously said:

Never let a serious crisis go to waste. What I mean by that is it’s an opportunity to do things you couldn’t do before.

Last year:

• Senator Leahy said “If we learned anything from 9/11, the biggest mistake is to pass anything they ask for just because it’s an emergency”

• The New York Times wrote:
  

  “The rescue is being sold as a must-have emergency measure by an administration with a controversial record when it comes to asking Congress for special authority in time of duress.”
  ***

  Mr. Paulson has argued that the powers he seeks are necessary to chase away the wolf howling at the door: a potentially swift shredding of the American financial system. That would be catastrophic for everyone, he argues, not only banks, but also ordinary Americans who depend on their finances to buy homes and cars, and to pay for college.

  Some are suspicious of Mr. Paulson’s characterizations, finding in his warnings and demands for extraordinary powers a parallel with the way the Bush administration gained authority for the war in Iraq. Then, the White House suggested that mushroom clouds could accompany Congress’s failure to act. This time, it is financial Armageddon supposedly on the doorstep.

  “This is scare tactics to try to do something that’s in the private but not the public interest,” said Allan Meltzer, a former economic adviser to President Reagan, and an expert on monetary policy at the Carnegie Mellon Tepper School of Business. “It’s terrible.”

Not Just Government

But it’s not just government . . .

If the too big to fails say that the world economy will crash and there will be martial law unless they are bailed out, politicians – most of whom don’t understand finance or economics – will believe them, and sound the alarm themselves.

As Karl Denninger wrote yesterday:

[AIG's CEO] left Geithner with two documents. One was a fact sheet that listed all the attributes of AIG FP [the division run by Joe Cassano that blew the company up] and argued why it should be given status as a primary dealer. The other–a bombshell that Willumstad was confident would draw Geithner’s attention–was a report on AIG’s counterparty exposure around the world, which included “2.7 trillion of notional derivative exposures, with 12,000 individual contracts.” About halfway down the page, in bold, was the detail that Willumstad hoped would strike Geithner as startling: “$1 trillion of exposures concentrated with 12 major financial institutions.”

Was that a threat?

And isn’t threatening the United States (whether directly or otherwise) something you’re not supposed to do?

Sounds like “Bail me out or I will crash everything.”

Isn’t that analagous to walking into a bank, opening one’s coat to reveal an explosives-laced belt, and saying “gimme all the money or everyone dies!”

Yves Smith has previously used a similar analogy.

Fear Among Individual Investors

Investors – as with politicians or Americans in general – believe that “when [they] come across disconfirming evidence . . . . they tend to … update their opinions”, but in reality, they cling to the beliefs they formed during certain heightened emotional states, such as fear.

Fear turns people into sheep. Once they are sheep, they will strive mightily to justify the actions of their “leaders” – whether those leaders gave trillions of dollars in bailouts or got us into war, and even if the leaders’ justifications were false.

I believe this dynamic is also playing out in the fact that many Americans assume that the government has a real plan for fixing the economy, is working as hard as it can to do so, and that – eventually – things will improve.

Just as most Americans believe “since we’re at war in Iraq, and since the government previously claimed that Saddam was behind 9/11, he must have been”, they are probably thinking “since the government gave trillions to the giant banks and said that economists have figure out how to fix things, they must have done what was needed, and things will turn around in a v-shape recovery”.

The lengths people go to rationalize a false link between Saddam and 9/11 is a great example, because it may reveal by analogy how far people will go to justify their trust in our economic leaders and in their own investment decisions.

Of course, the yearning for high returns is the other half of what drives investor psychology. But this essay focuses on fear.

By Edward Harrison of Credit Writedowns

Christopher Wood, the well-noted market strategist at CLSA and writer of the classic Japan crash warning book “The Bubble Economy,” is now warning of a market correction in the West.  According to CNBC India, Wood believes that the markets’ extreme upward move is increasing the chances of a major correction.

Wood is still cautious. He says there is some initial indication of a technical breakdown in the US. “The US market will be vulnerable early next year the US market. If it becomes clear, after this inventory cycle, that consumption, employment is not really recovering, then the market will go down. You will then get renewed stimulus in the US and measures trying to generate growth. The key variable in the West is government policy.” CLSA’s best case scenario is 1,200 on the S&P 500 by year-end, he added.

I agree with Wood that underlying economic demand may indeed be weak and all we may be seeing is an inventory and stimulus induced cyclical upturn (see my July post “ISM: Is this the mother of all inventory corrections?”). Of course, the worry is about the employment cycle not turning up before these measures’ positive effect wears off.  This is the question for 2010. If this happens, we get  a double dip and a huge market-sell off. Even if the employment situation starts to improve slowly while stimulus and the inventory cycle recede, this will lead to a muddle-through scenario, again inducing a correction. This is the heart of Van Hoisington and Lacy Hunt’s call about partial recoveries and stock market weakness.

For those of you who want to believe and want to load up on junk, there’s a clap for that too, via bear turned bull Richard Bernstein:

Richard Bernstein of Richard Bernstein Capital Management is a lot more bullish. “Right now, there is a blurring between the secular issues and the cyclical ones. There are people, including me, who are concerned about the secular issues, but we can’t ignore the fact that the economy is getting better, employment is improving. When that happens you will see a cyclical rebound.”

Just in September, Bernstein was saying America “practically invites another catastrophe.” What happened to that guy? He better be right on his bullish turn or he is going to have a lot of egg all over his face.

Source

Chances of a deeper correction are rising: Chris Wood – CNBC TV18 India

Nouriel Roubini has officially left the “hedging your bets on the economy” camp. He has declared the markets to be frothy because super low dollar borrowing rates have turned the greenback into the funding currency for the carry trade.

Far more important than the peppy rally in the stock market is the resumption of early 2007 style risk taking in the credit markets. As Gillian Tett of the Financial Times noted last week:

Earlier this month, I received a sobering e-mail from a senior, recently-retired banker. This particular man, a veteran of the credit world, had just chatted with ex-colleagues who are still in the markets – and was feeling deeply shocked.

“Forget about the events of the past 12 months … the punters are back punting as aggressively as ever,” he wrote. “Highly leveraged short-term trades are back in vogue as players … jostle to load up on everything from Reits [real estate investment trusts] and commercial property, commodities, emerging markets and regular stocks and bonds.

“Oh, I am sure the banks’ public relations people will talk about the subdued atmosphere in banking, but don’t you believe it,” he continued bitterly, noting that when money is virtually free – or, at least, at 0.5 per cent – traders feel stupid if they don’t leverage up.

“Any sense of control is being chucked out of the window. After the dotcom boom and bust it took a good few years for the market to get its collective mojo back [but] this time it has taken just a few months,” he added. He finished with a despairing question: “Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?”

In other words, everyone seems to be in on this bubble except most borrowers in the real economy. But that wasn’t the main objective…it was to reflate asset prices to save the global banking system…by rerunning the same movie that drove it off the cliff in the first place (well, this is a sequel, so there are some minor plot changes, like the dollar rather than the yen as the basis for the carry trade).

From Roubini in the Financial Times:

Since March there has been a massive rally in all sorts of risky assets… and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply, while government bond yields have gently increased but stayed low and stable.

This recovery in risky assets is in part driven by better economic fundamentals…. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.

But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally….Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

While this policy feeds the global asset bubble it is also feeding a new US asset bubble….

The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy….This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day.

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

The Journal has a less apocalyptic story on the very same topic: “Dollar Calls the Tune for Stocks, Bonds, Oil“:

A joke making the rounds among stock investors is that they’ve all become currency traders. In recent weeks, the relationship between moves in the dollar and stocks has been incredibly tight; as the dollar rises, stocks fall and vice versa.

And it isn’t just stocks. Links between the dollar, corporate bonds, energy prices and gold have grown closer. Traders and analysts point to one factor as the cause: the Federal Reserve’s efforts to flood the financial markets with dollars. They say the Fed has created an unusual environment where investors essentially have two choices — hold onto dollars or buy something, anything else.

The connections between assets have been growing as investors become more fixated on how and when the Fed will turn off the spigot.

The intensity of the links “tells me there is a lot of nervousness and a lot of fast money,” says Michael O’Rourke, a market strategist at BTIG.

As a result, some believe the markets are in a new bubble, driven by interest rates essentially at zero, which will pop sooner rather than later. That camp includes Pimco’s Bill Gross, who last week wrote that the six-month rally in riskier assets, spurred on by the Fed and U.S. Treasury, “is likely at its pinnacle.”

Wolfgang Munchau has a solid, thoughtful piece at the Financial Times which argues that the widely applauded rallies in stock and commodity markets are already looking very much like bubbles, and the efforts to contend with them (either directly, or as a result of the need to start reining in liquidity) is likely to kick off another crisis.

That much had been said in various ways in other venues, although Munchau does offer valuation data to back up his views. The more novel part of his argument is that instability is the inevitable result of an overly-large financial sector, and the result is bigger and bigger swings in output (meaning GDP growth) and prices.

Ouch. And the two scenarios he sets forth are not pretty either.

From the Financial Times:

On the surface, this looks like 2003 and 2004 when the previous housing, credit, commodity and equity bubbles started to inflate, helped by low nominal interest rates and a lack of inflation. There is one big difference, though. This bubble will burst sooner.

So how do we know this is a bubble? My two favourite metrics of stock market valuation are Cape, which stands for the cyclically adjusted price/earnings ratio, and Q. Cape was invented by Robert Shiller, professor of economics and finance at Yale University. It measures the 10-year moving average of the inflation-adjusted p/e ratio. Q is a metric of market capitalisation divided by net worth…

…they both tend to agree on relative market mispricing most of the time. In mid-September both measures concluded that the US stock market was overvalued by some 35 to 40 per cent. The markets have since gone up a lot more than the moving average of earnings….

The single reason for this renewed bubble is the extremely low level of nominal interest rates, which has induced people to move into all kinds of risky assets…

But unlike five years ago, central banks now have the dual role of targeting monetary and financial stability. As has been pointed out time and again, those two objectives can easily come into conflict. In Europe, for example, the European Central Bank would under normal circumstances already have started to raise interest rates. The reason it sits tight is to prevent damage to Europe’s chronically under-capitalised banking system, which still depends on the ECB for life support. The same is true, more or less, elsewhere.

Now, I agree there is no prospect of a significant rise in inflation over the next 12 months, but the chances rise significantly after 2010.

Once perceptions of rising inflation return, central banks might be forced to switch towards a much more aggressive monetary policy relatively quickly – much quicker than during the previous cycle. A short inflationary boom could be followed by another recession, another banking crisis, and perhaps deflation. We should not see inflation and deflation as opposite scenarios, but as sequential ones. We could be in for a period of extreme price instability, in both directions, as central banks lose control.

This is exactly what the economist Hyman Minsky predicted in his financial instability hypothesis.** He postulated that a world with a large financial sector and an excessive emphasis on the production of investment goods creates instability both in terms of output and prices.

While, according to Minsky, these are the deep causes of instability, the mechanism through which instability comes about is the way governments and central banks respond to crises. The state has potent means to end a recession, but the policies it uses give rise to the next phase of instabiliy….The world has witnessed a proliferation of financial bubbles and extreme economic instability that cannot be explained by any of the established macroeconomic models. Minsky is about all we have.

His policy conclusions are disturbing, especially if contrasted with what is actually happening. In their crisis response, world leaders have focused on bonuses and other irrelevant side-issues. But they have failed to address the financial sector’s overall size. So if Minsky is right, instability should continue and get worse.

Our present situation can give rise to two scenarios – or some combination of the two. The first is that central banks start exiting at some point in 2010, triggering another fall in the prices of risky assets. In the UK, for example, any return to a normal monetary policy will almost inevitably imply another fall in the housing market, which is currently propped up by ultra-cheap mortgages.

Alternatively, central banks might prioritise financial stability over price stability and keep the monetary floodgates open for as long as possible. This, I believe, would cause the mother of all financial market crises – a bond market crash – to be followed by depression and deflation.

In other words, there is danger no matter how the central banks react. Successful monetary policy could be like walking along a perilous ridge, on either side of which lies a precipice of instability.

For all we know, there may not be a safe way down.

I suppose one might classify the logic here as a tactical loss to secure a long-term gain, or in chess terms, sacrificing a pawn to take the queen.

So get this: the Republicans (well, to be more accurate, House Minority Leader John Boehner, but we’ll treat him as a good proxy) are really really unhappy at all this recovery talk, since it is Team Obama’s only claim to fame thus far. And in case you missed it, it appears that all this great PR is working. They managed to turn a combo relief rally/short squeeze into something bigger by getting the media to play along (this is not just our conclusion, BTW). And then they cleverly pointed to the stock market as proof certain that Things Are Getting Better when the reality is Things Are Merely Getting Worse Less Rapidly. But this is America, the land of open skies, pink flamingoes, Prozac, and plastic surgery, so we’ll happily go along with the idea that maybe the powers that be can restore status quo ante, since the alternative is painful, and we don’t do the hair shirt and sack cloth routine very well.

So what do Boehner and Co. want to do? They want to attack the idea that the economy is getting better! Now if people quit believing that, the stock market would be one of the first casualties. But they are apparently willing to let a little blood from their collective constituents in the hope of winning a bigger prize, that of the mid-term elections and the presidency in 2012.

Frankly, I don’t think they need to go to this much effort. I am no fan of the Republicans (truth be told, I don’t like either party, but I have more antipathy for the Republicans overall). Unless the employment situation turns around (and David Rosenberg has given a very persuasive reading why it is likely to get worse), the cheery talk about recovery will be revealed to be the result of stimulus measures soon to wane and an inventory bounce (although some economists argue even that effect won’t be as strong as is widely anticipated). I suspect it will in the fullness of time become evident to all that things are as rosy as consensus forecasts now assume, and that calendar will play well into the mid-term elections, at least as far as the Republicans are concerned.

From Roll Call (hat tip reader John D):

House Minority Leader John Boehner (R-Ohio) has assembled a group of economic experts to help Republicans lob attacks at Democratic assertions that the economy has begun to rebound as a result of the Obama administration’s policies…

“One of the tools in that fight, [as] the White House gears up to make more outlandish claims about the ‘success’ of the ‘stimulus,’ is a kitchen cabinet of economic advisers that Boehner put together, including [Doug] Holtz-Eakin, Keith Hennessey, Alex Brill, Jim Capretta, Tom Miller [and] Donald Marron,” Boehner spokesman Michael Steel said. “This team helps us assemble the facts to push back and keep the pressure on the Democrats.”…

In his memo, Holtz-Eakin took aim at a letter sent Monday from White House economic adviser Lawrence Summers to Boehner in response to Republican assertions last week that the $787 billion economic stimulus package failed to create jobs or jump-start the ailing economy….

Holtz-Eakin said Summers’ response was “disappointing and often irrelevant.”

“Jobs keep disappearing, unemployment is expected to keep rising, and the Obama Administration’s only apparent plan is to double down on a failed strategy for economic stimulus,” Holtz-Eakin wrote..

Holtz-Eakin said the economic stimulus was poorly designed and placed too little emphasis on infusing state governments with capital and cutting tax rates to be truly stimulative.

If this sort of tit for tat continues, economic discourse will become even less grounded in reality, if such a thing is possible. Both sides seem to be perfecting an art form of making statements that have some truthful or at least defensible arguments and using that to camouflage claims that are utter rubbish. For instance, it is true that the Obama stimulus plan was not stimulative enough. Giving more dough to states to prevent them from cutting their budgets would have been a faster shot in the arm than some of Obama’s measures and therefore is a legitimate bone of contention. But tax cuts? Please.

I keep reminding this would all be great theater if we didn’t have to live with the consequences.

Oooh, I can take only so much double-speak in a single sitting. The object lesson today is a Reuters article reporting on a Larry Summers speech, “Obama policies averted economic “abyss”: Summers.”

Let us not forget that “Obama policies” in this case are “Larry Summers policies.” Obama has never displayed much interest in economics; he has clearly delegated this area to his team, which really means to Summers and Geithner, and it is a given that Geithner largely defers to Summers (based on their history, Summers’ aggressive style, and Summers’ nominal expertise). The only parties on the economics team who might have differed with the the Hamilton Project party line were Paul Volcker and Austan Goolsbee. As we noted, Volcker has been marginalized, and Goolsbee had been largely missing from action (perhaps unfairly, we never saw Christina Romer as likely to have much influence). So Summers is evaluating his own work. It isn’t surprising that he’d view it favorably.

But his revisionist history is pretty ballsy. Pretty much no one liked the first stimulus package. The folks who don’t place any stock in that sort of thing of course hated it (remember, Republicans wanted tax cuts, their default cure for any and all evils), while pretty much every left-leaning economist thought the spending program was too small and too slow in coming (i.e, it was critical that the adrenaline shot be administered quickly). But many of the spending programs took time to gin up. Unfortunately, it isn’t possible to turn investments in infrastructure or clean energy on overnight.

And then we have the Administration through Summers claiming its mortgage mod program is a success. Huh? Half a million people have gotten TRIAL mods. These are typically not real mods, but payment catch-up plans. So it is not clear how many will even get real mods. And of those, the evidence is overwhelming that mere payment restructuring plans, as opposed to mods that involve meaningful principal reductions, have lousy success rates. The industry has every reason to prove that mods don’t work to get the White House off their back and return to business as usual, since the status quo ante was much more profitable to them than doing right by borrowers (and investors, who in aggregate are better served by getting 2/3 of a loaf via a deep mod than 40% via a foreclosure).

The one bit of policy, if you care to call it that, that has worked well is the Administration’s concerted campaign to talk up the stock market. Its success in using the bogus stress tests to goose bank stocks was remarkably effective, particularly since anyone who knew anything about banking and was not in on the con was highly critical of the tests. But the media played them to the max, some saw evidence of short squeezing, everyone celebrated earnings that Meredith Whitney described as manufactured. And the Administration kept pointing to the improved tone of the markets as proof that the economy was on the mend. And some readers have noticed a cheerleading stance in news outlets that were once more evenhanded, particularly Bloomberg.

Can a con job lead to recovery? The continuing lousy news on the employment front suggests not, but as long as the stock market remains relatively buoyant, few want to challenge this thesis. I had drinks with a hedge fund manager who was recently pilloried at a buy side/sell side get together when he dared suggest that the fourth quarter might not look as robust as everyone assumed. He said the argument against him boiled down to, “We are all feeling better and spending more, so everyone else surely is too.” The fact that they are all in the top 1% of the population and beneficiaries of TARP and other government bennies means it is a huge leap to generalize from them to the other 99%, but they didn’t see it that way.

From Reuters:

The Obama administration has helped pull the U.S. economy back from the “abyss” with aggressive efforts to spur growth and stabilize financial markets, a top White House adviser said on Monday…

“Thanks largely to the Recovery Act, alongside an aggressive financial stabilization plan and a program to keep responsible homeowners in their homes, we have walked a substantial distance back from the economic abyss and are on the path toward economic recovery,” Summers wrote to House Republican leader John Boehner….

“Every American is asking this administration: Where are the jobs?” Boehner said in a statement. The Ohio Republican noted the economy had lost roughly 3 million jobs since Congress had approved the stimulus package in mid-February.

Responding to a letter Boehner had sent Obama, Summers pointed to a slowing pace of job losses as evidence that the administration’s policies were working. “We have seen a substantial change in the trend of job loss,” he said.

In an interesting bit of synchronicity, reader Skippy sent another take on Summers singing his, whoops, Obama’s praise from the Washington Post:

The White House’s top economic adviser took aim at Republican criticism of President Obama’s economic recovery policies on Monday, delivering a sharply worded letter to lawmakers that credited the administration with pulling the nation back from an “abyss” and faulted the record of recent GOP presidents on the economy….

Summers saved some of his toughest rhetoric for Obama’s predecessor.

“The bipartisan commitment to fiscal discipline that existed during the 1990s evaporated during the 2000s. Every major policy enacted during this period violated the principle of paying for new proposals,” Summers wrote. “As a result of these decisions and a weak economy, when President Obama took office in January 2009, he inherited a deficit well in excess of $1 trillion.”

Um, last I checked, the proximate cause of our economic train wreck was not public sector debt, but a massive balloon of private sector debt that started ramping up in the mid 1990 and started going parabolic in 1999. That in turn was in large measure the result the deregulation of the financial services industry, which started under Reagan but got a real head of steam under Clinton thanks to the tender ministrations of Robert Rubin and Larry Summers.

Bloomberg reports that former Harvard Fund Management CEO, now Pimco CEO Mohammed El-Erian does not buy the idea that US is returning to normal any time soon. El-Erian in particular took issue with some of Larry Summers’ sunnier prognostications:

El-Erian likened Summers’s view of the economy to a three- stage rocket attempting to escape Earth’s gravity to reach space, with government spending programs marking the first boost to economic growth, inventory reductions the second, and consumer demand the final booster stage.

Summers “has this concept of ‘escape velocity,’” El-Erian said at a meeting of financial market professionals in Toronto today. “We don’t have enough to achieve escape velocity.”

El-Erian, who co-heads the world’s largest bond fund manager with Bill Gross, has said the U.S. is facing a sustained period of annual growth of about 2 percent where credit and jobs are less plentiful than in the past, a scenario he called the “new normal.”…

El-Erian’s ideas about a “new normal” have been shared by Lawrence Fink, chief executive officer of New York-based asset manager BlackRock Inc. BlackRock will become the world’s largest manager of bond funds when it completes the purchase of Barclays Global Investors this year.

The “new normal” includes a higher level of government intervention in the economy, with new rules requiring higher capital levels for businesses and stricter reporting requirements, El-Erian said. That will drive up business costs, he said.

El-Erian’s take is wildly upbeat compared to the October 5 report from David Rosenberg, former North American economist for Merrill, now safely ensconced in his native Canada at Gluskin Sheff. Rosenberg is admittedly has a dour outlook, but he also reads the data very closely and with a well honed sense of historical patterns. Some snippets (hat tip reader Scott, no online source):

Nonfarm payrolls in the U.S. slid 263,000 in September, but the details were even more sombre. The Household Survey showed a massive 785,000 plunge in September, and employment on this score has now slid by 1.2 million in the past two months….the Household survey leads the cycle and typically bottoms and peaks before the Payroll survey do…. never before has a recession ended with civilian employment declining this much (on average, it goes down around 70,000 or almost negligible the month the recession ends)….

There were absolutely no redeeming features in the data. The private nonfarm diffusion index sank to 31.9 in September from 34.9 in August (the manufacturing diffusion index fell to 22.9 from 28.3 in August) which means that for every company adding to their staff loads, more than two are cutting back. The labour force contracted by 571,000 and has plunged now by 1.1 million since May. That again is a sign of the labour market seizing up, which is very disturbing when you consider all the government efforts to stem the tide last quarter – from housing subsidies, to cash-for-clunkers, to mortgage modifications…

It is so difficult now to find a job that a record 36% of the ranks of those unemployed have been searching with futility now for at least six months. In “normal” recessions since 1950, this ratio peaked at just over 20%…..the chances that we see a 13% peak unemployment rate this cycle is far from a ludicrous proposition at this point; and just in time for the mid-term elections.

Yves here. I have been arguing unemployment would peak at over 11%, simply based on Reinhart/Rogoff’s norms for severe financial crises (some of those countries had better responses than ours, and none were faced with a synchronized global downturn, so relying on precedent here would seem to be optimistic). Back to Rosenberg:

The share of the unemployed who are not on layoff is at record 54.3% as of September. In prior recessions, this ratio would barely pierce the 40% mark. In number terms, we are talking about 8.5 million Americans who have lost their job due to permanent shutdowns, a figure that is double what you typically see at the peak of the recession….I think there is a nontrivial chance we see zero percent real GDP growth in Q4 (consensus is around 3%)….

the employment/population ratio (the “employment rate”) has fallen to a quarter-century low of 58.8%; it peaked at 63.4% in 2007. To get back to a cycle high, we need to create more than 10 million jobs. Before that happens, deflationary pressures are going to trump whatever inflationary risks arise from the Fed, Congress and the White House.

The last time the ratio was this low was back in December 1983. Back then, household debt per capita was $9,900; today it is six times larger at $58,000. At the margin, one has to wonder what is going to be paid for first. The debt-service payments coming out of the paycheck are looking increasingly vulnerable. Default rates are extremely likely to worsen for the foreseeable future; groceries will not be sacrificed; however, credit will.

This is all sobering stuff. Rosenberg issued an equally downbeat piece later in the week that commented on valuations (again via Scott). Key factoids:

On an operating (“scrubbed”) basis, the trailing P/E multiple on the S&P 500 has expanded a massive 10 points from the March lows, to stand at 27.6x.

While we will not belabour the point, when all the write-downs are included, the trailing P/E on “reported” earnings just widened to its highest levels in recorded history of nearly 140x, which is three times the levels prevailing during the height of the tech bubble….

Bullish analysts like to dismiss the actual earnings because they are “depressed” and include too many writeoffs, which, of course, will never occur again.

The consensus is usually overly-optimistic, which is why so many analysts love to do their analysis on “forward” earnings since the market almost always looks “attractively priced” on that basis. The reality is that the forward P/E multiple is now at 16.2x after bottoming at 11.7x at the market lows. The multiple has not been this high since February 2005 when the economic expansion was already nearly four-years old! Today’s stock market, on this basis, is now being priced as if we are late in the cycle — forget this mid-cycle valuation stuff.

Reader Dwight pointed to an outbreak of bearish calls today on CNBC:

Risk of Double Dip, Investor ‘Bloodbath‘ (from Carl Icahn)

Dollar Fall Can ‘Destabilize Markets’ Like 2008 (Art Cashin of UBS)

Dow Will Fall to 6,300 by Year End (John Lekas of Leader Capital)

Of course, one could cynically note that this equal opportunity programming started on a Friday afternoon before a long weekend.

Jesse, generally of the downbeat persuasion based on fundamentals, but not afraid of a tactical long, points out that mutual funds are now heavily invested: Mutual Funds Are at Cash Levels Not Seen Since the 2007 Market Top.
But Barry Ritholtz argues in “The Most Hated Rally in Wall Street History,” that the fact that so many are skeptical means the equity rally has further to go.

Just remember: for mere mortals and pros, market timing is rarely a winning strategy.

Submitted by Edward Harrison of Credit Writedowns

In my last post, I presented you with a bunch of data on debt levels broken down by sector of the economy (see “A brief look at the Asset-Based Economy at economic turns”).  I found it interesting that a secular pattern seemed to be at play when looking at the household debt charts.

Notice the three areas boxed in red on the chart to the right.

The chart measures the differential between the year-on-year change in household debt and nominal GDP.

The three areas show three distinct periods of household debt accumulation.

1. 1951-1966. The first shows household debt changes generally outstripping nominal GDP by a wide but decreasing margin. This period coincided with a secular bull market in equities.
2. 1966-1982. This second period is more volatile, but with the overall numbers lower.  In general, debt was accumulated less rapidly compared to the growth in nominal GDP. And when recession hit in 1970, 1974 and 1980, it induced a retrenchment (at least relative to nominal GDP growth). This period coincided with a secular bear market in shares.
3. 1982-?. This last period shows an enormous increase in debt growth relative to GDP growth during the 1980s followed by minor retrenchment after the 1990-91 recession and strangely also in 1997 (could this be a butterfly effect to the Asian Crisis?). But after that it was off to the races right through the 2001 recession until mid-2007.  This period coincided with a secular bull market in equities.

The pattern seems to indicate that there is a relationship between debt build-up in the household sector and stock prices.  The build-up in debt relative to nominal GDP troughed in Q3 2008 at -0.4%. As of Q2 2009, the number was +1.2%.

I see this as evidence of the so-called Wealth Effect. The data suggest that the secular bear market may not have begun in 1998 or 2000 as I have generally believed. And they also suggest that, despite the recent rise in shares, a new secular bear market may have just started in 2007. I will be curious to see what the data look like for the second-half of 2009.

Source

Z1 Data Series – Federal Reserve

Submitted by Edward Harrison of Credit Writedowns.

This is a re-post of an article I wrote last night at Credit Writedowns where I stressed a U.S.-centric view of Faber’s comments that the Fed is a money printer. However, here I have re-dubbed the post to reflect Faber’s comments, which are more comprehensive, in effect pointing to the Federal Reserve as a blower of bubbles domestically and internationally, a view I also hold. Commenting in March of ‘08 on the 1990s global economy, I said:

In my opinion, the global economy continued to grow above trend through to the new millennium because these hot money flows created bubbles only in less central parts of the global economy (Mexico in 1994-95, Thailand and southeast Asia in 1997, Russia and Brazil in 1998, and Argentina, Uruguay, and Brazil in 2001-03). But, this growth was unsustainable as the global imbalances mounted.

So, with that in mind, here is the post. Note, there are four videos at the end. Unfortunately, I can’t get video on NC for some reason. So, to see the video, here is the link to the original post. Enjoy.

Below is a synopsis of a wide-ranging interview with Marc Faber over four videos on CNBC TV18 in India explaining view on inflation, currencies, commodities, stocks and more.

Asset-based economy. In general, he thinks we are in an inflationary environment, whereas I think that deleveraging is secular and means any inflation is only cyclical. But he shares my belief that zero interest rates induce money balances to move into consumption or into higher yielding assets. He believes this is a boon over the medium-term (if not the short-term or long-term) for financial assets, whether they be stocks, bonds, commodities, real estate or art. And it is something that will continue, he says. Faber believes Bernanke will be loath to raise rates aggressively given his prior statements and writings.

Currencies. Faber takes the view with which I agree that the Fed’s easy money policies after 1998 flooded the global economy, especially emerging economies with liquidity. This has led to asset bubbles.  Hong Kong residential real estate is one example he cites.  As a result, Faber thinks the U.S. dollar is no longer overvalued at present levels. A snapback rally for the dollar resulting from oversold levels would be bearish for asset markets. But, longer term, Faber thinks the dollar is weak.

Equities. There has been a huge rally everywhere.  He says he is not a buyer at these levels. However, as central banks are going to continue to print money, stocks could continue higher – but he would not bet on a blow off rally from these levels.

Commodities. Faber thinks zero rate levels makes it extremely difficult to value anything.  Pose the question: which would you rather own – the “US dollar at zero interest rates or a ton of gold or a ton of copper or a ton of crude oil?” Of course, commodities are supply constrained, whereas dollars are not, so there is a justification for buying them. But, he anticipates the commodity hoarding by China is about to end and that is bearish for industrial commodities as well as precious metals. As with other commodities, he thinks the huge run up in oil could induce a setback. Long run, he is an oil bull because of limited supply.

Financial Crisis. He is disturbed by the fact that a crisis caused by excessive debt growth, especially as a result of Federal Reserve policy has been allowed to pass with the same players in control. He says enjoy the ride for now. Longer-term, this necessarily means the same bad policies will follow and it will lead to a system-wide financial collapse.

India. Faber is bullish longer-term. Short-term, there could be a correction. India is one of the best protected countries because of less vulnerability to the export sector. He also believes the Reserve Bank of India has one of the best monetary policies in the world – supervise the financial system closely, relatively tight, and mindful not just of core inflation but other price levels like asset prices.

Nouriel Roubini, who has backed off from what was once his signature bearishiness (he has been calling for an U or perhaps a W shaped recovery) nevertheless thinks the current market rallies are considerably overdone. From Bloomberg:

New York University Professor Nouriel Roubini, who predicted the financial crisis, said stock and commodity markets may drop in coming months as the gradual pace of the economic recovery disappoints investors.

“Markets have gone up too much, too soon, too fast,” Roubini said in an interview in Istanbul on Oct. 3. “I see the risk of a correction, especially when the markets now realize that the recovery is not rapid and V-shaped, but more like U- shaped. That might be in the fourth quarter or the first quarter of next year.”…

“The real economy is barely recovering while markets are going this way,” Roubini said. If growth doesn’t rebound rapidly, “eventually markets are going to flatten out and correct to valuations that are justified. I see a growing gap between what markets are doing and the weaker real economic activities.”…

“In the short run we need monetary and fiscal stimulus to avoid another tipping point and to avoid deflation, but now this easy money has already started to create asset bubbles in equities, commodities, credit and emerging markets,” Roubini said. “For the sake of achieving growth stability again and avoiding deflation, we may be planting the seeds of the next cycle of financial instability.”