THIS TIME GRIDLOCK IS NOT GOOD!

In a post last June, I stated that further fiscal stimulus on the order of $300 to $500 billion might be necessary to keep the economy from lapsing into another recession. I also believed that Bernanke's and Paulson's success in "scaring straight" Congress into passing TARP quickly, along with later fiscal stimulus by the Obama administration, had kept the recession from morphing into a depression. Unfortunately one can't prove a negative--one can't say with certainty what would have happened without these steps. In this mid-term election, Republicans have claimed that fiscal stimulus and the Fed's quantitative easing have done little to free the economy from its Slough of Despond. After all, 2% real GDP growth in the third quarter is only a third to a half the growth that occurred when the economy emerged from the prior comparable recessions of 1973-4 and 1982. Republicans have criticized the heavy debt burden resulting from these attempts, with no apparent significant benefits. After all, unemployment still remains close to 10%. Hendrik Hertzberg of the New Yorker said it eloquently, "The presence of pain is more keenly felt than the absence of agony".

We are now faced with a Republican-controlled House, a slim Democratic majority in the Senate, and a Democratic President--what Wall Street describes as "gridlock". Wall Street has always embraced Congressional gridlock because it means less interference with Adam Smith's "invisible hand". NOT SO THIS TIME!

In previous posts, I have pointed out ad nauseam that: 1) the borrowing binge in the U.S. economy that persisted for fifteen years must be reversed, i.e. deleveraged: 2) according to the Economic Cycle Research Institute (ECRI) during the latter years of the debt binge, economic growth actually was lower than normal and recessions were more frequent: 3) during the deleveraging period, growth should be lower than during the leveraging period; and 4) no one knows WHEN deleveraging will reach a level where consumers and businesses will feel confident enough to resume normal spending, without additional government help. This return to normalcy is known in economic circles as "escape velocity." Escape velocity may take several years to happen, or could happen soon. Since the leveraging process took about fifteen years, if one believes in symmetry, then the deleveraging process still has a ways to go.

I believe strongly that some time in the future the government must reduce the deficit as a percentage of real GDP; but, and here is the rub, NOT UNTIL THE ECONOMY REACHES ESCAPE VELOCITY! Republicans want to attack the problem of increasing deficits and debt burden immediately. Until escape velocity is reached, further fiscal stimulus is likely to be necessary just to keep the economy in slow growth mode!

With a gridlocked Congress, any effort to stimulate the economy is left to the Federal Reserve. Today the Fed will announce what is known as "quantitative easing 2", which is simply printing more money to buy Treasury securities. The Fed hopes that by lowering interest rates on longer maturity Treasury debt, investors will be coaxed into buying stocks, and consumers and businesses will be persuaded to spend more. Also, the dollar might decline more than other currencies, which should stimulate our exports.

As one economist put it: if there are fifteen ways to stimulate the economy, quantitative easing ranks fourteenth or fifteenth in effectiveness. However, the others must go through Congress, thus the importance of gridlock. If quantitative easing fails, and Congress is loath to pass additional fiscal stimulus, we may face the dreaded deflationary spiral--lower prices, a consumer who reduces present spending because prices will be lower in the future, more layoffs, and an ensuing vicious cycle. If that occurs, the S&P 500 Index, now at 1193, would drop to roughly 840, a 30% decline. While normally a less than 5% probability, due to the deleveraging process and a recalcitrant Congress, I am raising that probability to 30%.

The most probable scenario is that the U.S. economy muddles through with 2% real growth until escape velocity occurs. In that case, the S&P 500 would slowly appreciate until normal growth resumes. At that point, the enormous flow of mutual fund money into bond funds over the past few years should be reversed. The ten year Treasury note would quickly jump from a yield of 2.6% now to 4 or 5%. Money would flow out of bond funds into equity funds, creating a stock buying panic or meltup! The S&P 500, which in my opinion is currently roughly 12% to 31% overvalued, depending on normalized earnings growth and interest rate assumptions, would quickly become much more overvalued.

In late 1999 I submitted an article to Barron's, which was published in the Other Voices column on December 27, the last issue before the new millennium. In it I argued that, at 29 times earnings and a 1.2% dividend yield, the S&P 500 Index, at 1435, was vastly overpriced relative to the almost 7% yield one could receive from zero coupon Treasury securities with maturities from 5 to 25 years. I suggested that pension funds sell the S&P 500 Index funds and buy the zeroes. While the current situation is not the exact opposite of 1999, I believe that over the next ten years the S&P 500 Index, even at its current overvalued level, will provide a 6% total return point to point, outperforming Treasury bonds' meager 2.6% yield -- more than justifying the incremental risk.

However, the road will be bumpy. There will be several bear markets during the period. While I want to be exposed to equities during this period with a core equity position of 30% of my financial assets, I feel that I can trade around that position. I am currently holding an equity exposure of 40%, down from 60% late last year. If the equity buying panic ensues and bullish sentiment reaches an extreme, I will sell another ten percent and protect the remaining position by buying at the money or out of the money puts. If the economy lapses into another recession with an accompanying bear market, I will take the equity risk exposure back up to 50% or more by dollar cost averaging into weakness The remainder of my financial assets are in 90 day Treasury bills, which yield zilch. Once escape velocity occurs, I plan to switch from these bills into ten year Treasury notes, hopefully with a 4% to 5% yield to maturity.

On another subject, since I started my blog in early 2007, I have written more than thirty posts. They are not equally spaced in time. I am only interested in writing a new post when I change my asset allocation or when I feel that events have occurred that are worth discussing.

MORE STIMULUS OR ELSE?

With May's meager private sector employment growth, weak housing, and slow retail sales growth, the question arises whether we will just experience a slowdown in growth during the second half of 2010 or something worse--tipping back into recession-- the dreaded double dip. A lot rides on the employment report due out next Friday. If private sector employment rose 150,000 or more in June, a hopeful slow growth case lives. Alternatively, another weak report bodes ill.

What could the government do to support the economy in the event another recession looms? Short maturity interest rates are already about as low as they can get. The logical solution would be more fiscal stimulus. We might need as much as $300 to $500 billion more stimulus to maintain reasonable economic growth. We can "afford" it. After all, a lot of the TARP money has been repaid. The problem, however, is that Congress seems loath to pass any further stimulus, especially with midterm elections in November. Battling factions are those wanting austerity versus those wanting more stimulus if necessary -- the former are starting to prevail. In September of 2008, the Treasury Secretary and Fed Chairman went to the Hill and "scared straight" Congress into passing a massive stimulus bill. While it is difficult to prove a negative, had that stimulus not been passed post haste, our economy would have, in my opinion, lapsed into a Depression. It will be more difficult to replicate that tactic now.

I agree that, OVERALL, democracy is the best form of government, but sometimes it can get messy. This may be one of those times when a more authoritative form of government, such as the philosopher king in Plato's Republic, might be preferable. After all, China's leadership can introduce more stimulus to its economy without the normal lengthy legislative process we must go through.

We must avoid a deflationary, vicious economic cycle such as our country experienced in the 1930s and Japan during the last two decades.


VALUATION METRICS

Those of you who have read my posts are aware that I normalize earnings, earnings growth rates, and interest rates when calculating the fair value of the S&P 500 Index. Plugging these variables into a dividend discount model results in a rough idea of the price to earnings multiple at which the Index should be selling. That multiple is historically 15 times earnings. Annual earnings growth has, over long periods of time, been around 7%.

In a post written on June 4, 2009 entitled "What A Difference A Percentage Point Makes!" I discussed the impact a one percentage point decline in earnings growth, to 6% annually, would have on the Index's theoretical fair value. I wrote this post because the current period of deleveraging should have an adverse effect on earnings growth. Unfortunately, a 6% earnings growth assumption results in a double whammy: a lower theoretical price to earnings ratio, reduced to 13; and lower normalized earnings. You might be interested in the following table, which depicts the fair value of the Index at these two earnings growth rates.


Wall Street has a tendency to be optimistic. I do not expect the market to reflect the less optimistic earnings assumption for a long time. Based on the above table, at 1077, the S&P 500 Index is only 5% overvalued. One caveat--if the economy lapses back into recession, theoretical fair value means little because actual earnings will crater

The Impact of Thursday's Stock Market Swoon

In my last posting, I mentioned that the sentiment indicator I follow had reached levels that signaled a correction, but not the end of the current cyclical bull market. I had pared back my holdings in the T. Rowe Price New Asia Fund, but was waiting to reduce holdings in the S&P 500 Index Fund because I anticipated a last leg upward resulting from increasing interest in the stock market by individuals who had preferred the fixed income area since early 2009.

Last Thursday's swoon took the market down to correction levels (a minimum ten percent from the highs in late April) before recovering somewhat. Unfortunately, this decline was exacerbated by a defect in our trading system. The NYSE, which accounted for all of the trading in their listed stocks when I first started on Wall Street in 1968, now accounts for roughly a quarter of the volume. There are a number of computerized exchanges that trade NYSE listed stocks. In addition, with the "retail" (individual) investor not investing in equities as much as during prior bull markets, more than half of overall trading volume is what is known as "high frequency, computerized" trading among computers. The computers are programmed to react to various price points in individual stocks with stop loss or market orders. Last Thursday, the NYSE slowed its trading to mute the downward pressure on stock prices but the other exchanges did not. The market and stop loss orders that were triggered by the computers were filled elsewhere, where there was little liquidity. Thus, the stock of Procter and Gamble, one of the stalwart companies in our economy, fell from around $60 a share to under $40 in less than fifteen minutes!

Since I am a firm believer in the old adage "Necessity is the mother &%*#!& of invention!", there will be new regulations resulting from this debacle. Hopefully, they won't go too far. At the very least, however, all exchanges should adopt the same "circuit breaker" rules, so that a halt in trading at one exchange doesn't divert orders to the computerized exchanges where liquidity has dried up.

What is the impact of last Thursday's swoon on future consumer spending? Historically, on October 19, 1987, there was a worse computerized trading experience when "portfolio insurance" trades were primarily responsible for a more than TWENTY PERCENT DECLINE in the stock market in ONE DAY. At that time, I mistakenly thought a bear market in one day would immediately cause a recession, but one didn't occur for several years thereafter. With that in mind, I don't believe Thursday's milder decline will precipitate a recession, although it may temporarily dampen the spending of those who had felt much wealthier due to the stock market's strong move from the bottom in March, 2009.

As for the impact on the individual investor, last Thursday's experience can only reinforce the prevailing opinion that Wall Street is one big casino with the individual player attempting to plan for retirement in a rigged market. The timing couldn't have been worse because individuals, with low expected future fixed income returns and lower than normal equity exposures, were beginning to return to the stock market. This may still occur for the lack of alternatives but it will be more muted.

I haven't yet reduced my exposure to equities since my last posting, but I am becoming more nervous.

In previous postings I have emphasized that the deleveraging process will be ongoing for years. After all, the leveraging occurred over several decades. Deleveraging, as we are seeing in the case of Greece, involves higher taxes and reduced spending. Several states here with large deficits will be forced to continue engaging in similar austerity measures. Such action argues for lower than normal domestic economic growth.

In that context, I suggest reading an article entitled "The Changing Cyclical Contours of the U.S. Economy", written by Lakshman Acuthan of the Economic Cycle Research Institute. I have been impressed by his previous writing. In this piece, he shows that future GDP growth will be lower and the volatility of that growth higher, with the result that recessions will be more frequent. This scenario, I would think, argues for more trading around a reduced core equity exposure.

The Four Trillion Yuan ($586 Billion) Tell--Or Just Noise

In a posting December, 2008 I discussed how a counterintuitive event, like a "tell" in gambling, can have predictive value.
For example, suppose a company reports worse than expected earnings. Given that news, one would expect the stock to decline. If the stock goes up in the face of disappointing earnings, that is counterintuitive, and probably means the stock is in a bullish trend.

I mention this because Bloomberg News two days ago mentioned that "The China Business newspaper reported on its Web site that China will announce in August a new stimulus package of possibly 4 trillion yuan ($586 billion)." Given that the Chinese economy had advanced a whopping 11.9% in the first quarter, a growth way above trend, and China is trying to rein in a crazy real estate market, I conclude that this mention of stimulus is counterintuitive. Why mention this now? And the amount of the stimulus is mind-boggling. It is roughly the same size as the program enacted during the worst of the recession. If this news item is true, it might indicate that the Chinese government is worried about a much lower economic growth near term and is preempting any stock market downdraft by announcing that it will be ready to provide enormous stimulus in that event.

So far, this story has not gained traction. Perhaps the newspaper is unreliable. Or perhaps this is a case of my overthinking--that this story is just noise, not a "tell". However, the European sovereign debt crisis with Greece, which may spread to other EU countries, has prompted some to reduce risk in their portfolios. That usually means, as Goldman Sachs put it during the congressional hearings yesterday, "getting closer to home". The most volatile portion of my financial assets is my position in the T. Rowe Price New Asia Fund. At the close Monday, I sold enough of that fund to bring my holding down to what I consider a "core" position, one to be held for five to ten years. With this sale, I have now reduced this position by two-thirds of its peak value.

Why not also reduce my position in the T. Rowe Price Equity Index 500 Fund? After all, many companies in that fund have a growing exposure to southeast Asia; and some heavy machinery producers, like Caterpillar, and many raw material producers are heavily dependent on a rapidly growing China. Good question.

On the positive side, corporate earnings during the first quarter have far exceeded expectations; and corporate outlooks are becoming rosier. We remain in the "sweet spot" of the cycle when profit margins expand and interest rates remain low. Wall Street, as is its proclivity, is raising earnings estimates and stock price targets. Money flows, which last year heavily favored the fixed income side, are now beginning to flow back into equities due to less fear of a relapse into recession, the stock market's upward momentum, and a growing distaste for bonds when interest rates are expected to rise sometime soon.

On the negative side, as we know, the stock market discounts the future; and six months from now we will be facing withdrawal of the stimulus program, the prospect of higher taxes to reduce the ballooning deficit, and higher interest rates. The S&P 500 Index, relative to NORMALIZED EARNINGS, is 15% to 20% overvalued. There is mounting bullishness and minimal bearishness among investment advisers--at roughly the same levels as last January immediately prior to a 9% correction in stock prices. However, this contrary sentiment indicator isn't yet at the extreme reading reached in October, 2007 when the last bull market peaked.

I have decided not to reduce my equity exposure to the S&P 500 Index yet. When the monthly employment report shows an increase of more than 300,000, a buying panic may ensue, which would provide a better opportunity to reduce my equity holdings to "core" levels.