It’s not May yet. But if you believe in the old Wall Street adage “Sell in May and go away,” you may want to consider getting into May early. From Greece, to valuations, to allegations of corruption at BHP, there would be more than a few reasons.
Speaking of Greece, it ain’t over yet. Dow Jones Newswires reports that, “Concerns over Greece were reignited after Moody’s Investors Service lowered its ratings on the country. The ratings firm noted significant risk that Greece’s debt may only stabilise at a higher and more costly level than previously estimated.”
That was enough to rain on Wall Street’s happy earning parade. But the storm clouds have been building for a while now. U.S. economist John Hussman says at current valuations, the S&P 500 is priced to return about 5.7% a year over the coming ten years. But Hussman thinks a correction is due that will lower that annual return to 2.97% – which is lower than bank interest but with a lot more risk.
In a note to investors Hussman wrote that, “Wholly on the basis of current valuations, stocks are priced to deliver unsatisfactory returns in the coming years – a situation that is worsened by strenuous overbought conditions and upward yield pressures here.”
By the way, the Austrians would have predicted this too. This is yet another example of “bringing forward demand” to try and solve one problem but creating a bigger one down the road. In this case, the rebound in global stocks has been led by financial and banks stocks. But their earnings were largely manufactured by policy.
That is, with low short-term interest rates, banks around the world have been able to borrow short at low rates and lend long at higher rates. The spread between the short – and long-term rates is what delivered fat bank profits in the last two quarters and sucked investors back into speculating on higher house prices.
But “bringing forward demand” for stocks to simulate a recovery in the economy is not the same things as a real recovery in the economy. It’s the opposite. The manipulation of interest rates incentivizes speculative behaviour and leads to false price signals in the market (buy banks stocks!). Real people lose real money when the policy failure is revealed as a sham.
Coming to a stock market near you: the sham revealed!
Hussman thinks the low return for stocks is set in stone. He writes that lower annual returns are, “not dependent on whether or not we observe a second set of credit strains, but is instead baked into the cake as a predictable result of prevailing valuations. The risk of further credit strains simply adds an additional layer of concern here.”
There are “further credit strains” coming down the pike. But one last note on risk chasing. Risk, as we noted earlier in the week, isn’t bad. It’s essential. As John Dickerson wrote in Slate this week, for some high-achieving individuals (in any number of disciplines and pursuits), “risk is the animating and organising principle that drives every day.”
The trouble isn’t failure. That’s also normal and essential in life. You just have to learn to fail quickly. The bad kind of failure is being led into taking a risk you aren’t aware of because of bad (or deliberately misleading) information – and then suffering the consequences. The consequences are so dreadful because they were not part of your calculation when you decided to take action. If you didn’t think it was risky, you’ll be surprised when you get punched in the face. And probably not pleased.
That is the essential problem (and indictment) against rigging interest rates or flooding certain markets with government money – it alters perceptions of risk and shifts time preferences. People end doing things they wouldn’t normally do. And those things end up costing them a lot of money. And it takes time to make back money you’ve lost, or pay back money you owe. It’s not just a financial cost here. It’s a lifetime and lifestyle cost.
Eric Johnston makes just this point in today’s Age, albeit indirectly. He writes that bigger loans and rising interest rates threaten to smash to pieces the personal finances of many new home buyers. “Over the past 18 months, first home owners have flooded the market, enticed by government grants and low mortgage rates. But a comprehensive snapshot of the mortgage market by brokerage JPMorgan and Fujitsu Consulting has shown first home owners are borrowing on average about $280,000. Remarkably, this is the same as established borrowers, who tend to earn more.”
Does getting free money (although government money is never free) cause you to take on bigger and more dangerous risks than if you were making decisions with your own money?
Probably so. JP Morgan analyst Scott Manning writes that “”The higher gearing tolerance of first owners results in greater sensitivity to rising interest rates.” He reckons that if interest rates reach pre-GFC levels, the first home-buyers could be spending as much as half their after-tax income to interest alone.
Ouch.
And speaking of rising interest rates, a research note from Morgan Stanley says you can bank on it. Morgan bond market strategist Jim Caron told the Wall Street Journal that the large supply of U.S. Treasury bonds hitting the market this year would push prices down and U.S. 10-year yields up to at least 5.5%. They’re 3.77% now.
The Treasury will issue US$2.4 trillion in bonds this year to pay for, among other things, this year’s annual deficit of $1.4 trillion. The rest comes from the huge amount of short-term debt the U.S. must roll over. It’s bad when you’re selling new debt to pay off old debt. Ponzi finance?
Now not everyone agrees that the increasing supply of Treasuries will drown demand and lead to spiking global yields. This is, at heart, an inflationary argument (and an argument for gold rising $500 by the end of the year). If you really believed it, you’d have a strong preference for non-paper money.
But what does it mean for Australia? Ten-year government bond yields in Australia are 5.82%. You might then, wonder what would happen to Australian bond yields if Treasury yields went up. Would the rising U.S. yields make the dollar more attractive on a yield basis and lead to a weaker currency?
Over a cup of coffee this morning, we reached the following conclusion: a dollar crisis doesn’t make the dollar more attractive. Yes, it’s a stunning conclusion. But what we mean is that Aussie bond yields might actually go lower in a dollar crisis. That would happen if central banks (other than the Fed) really do flee the Treasury market. They have to go somewhere, and higher yielding currencies like the Aussie might be that place.
But this is not how it played out last time. By “last time” we’re referring to the credit crisis. That drove up everyone’s borrowing costs, destroyed the asset securitisation market, and kicked of a wider credit depression. And if THAT is what happens in a U.S. dollar crisis, it will put a lot of pressure on Aussie banks that source their funding abroad (you know who you are!).
That brings us, finally, to the core of today’s Daily Reckoning: not much has changed since 2008. The core of the problem in the world’s financial system was that too much debt had been used to purchase assets (securities tied to U.S. houses) that fell in value, destroying bank collateral. What’s different today? Have those debts been written off? Or in Austrian terms, have the mal-investments been liquidated?
Not really. Most policy measures then have been polite fictions designed to disguise the ongoing deterioration in bank collateral. Mark to market rules have been suspended. Anecdotal evidence has it that many Americans have simply stopped paying their mortgages. This boosts consumption figures in the GDP accounts (not paying your mortgage is a huge boost to discretionary income). And if the government is modifying some home-owner contracts, surely it sends a signal to otherwise law-abiding home owners that they can ignore contract too?
On the part of U.S. banks, they’re happy to let a home slip well past foreclosure. What else is the option? Writing down the value of the asset and crystallising the loss? No thank you! It’s the old “extend and pretend” strategy…just give it more time and hope that somehow, some way, the housing market recovers and loan portfolios do too.
The result of this refusal to confront reality means that the financial system remains propped up by a handful of accounting tricks, according to Nomura analyst Richard Koo, via ZeroHedge. Koo writes that, “If US authorities were to require banks to mark their commercial real estate loans to market today, lending to this sector would be extinguished, triggering a chain of bankruptcies as borrowers became unable to roll over their debt.”
In a normal crisis, he writes, the banking sector is encouraged to write-off bad loans in order to clean up its balance sheet and unleash credit to fund the recovery. “But during a systemic crisis, when many banks face the same problems, forcing lenders to rush ahead with bad loan disposals (i.e., sales) can trigger a further decline in asset prices, creating more bad loans and sending the economy into a tailspin. I think the Fed’s shift in focus from conventional nonperforming loan disposals to credit crunch prevention is an attempt to avoid this scenario.”
All of this many seem like mostly an American problem. But that’s what it seemed like last time…until the credit tide went out and Australian investors found out just how many firms had business models and balance sheets that depended on cheap funding and the ability to roll it over in a short amount of time.
How much has that changed in the last two years? You’re about to find out. But in the meantime, most of our editors here are using trailing stops to lock in gains accumulated over the last year. And as for finding stocks that are actually undervalued? More on that on Monday.
The discouraging aspect of all this is that so much capital remains tied up in non-performing assets. To save the bankers, we have killed off the future prospects for entrepreneurs. An economy that does that retreats from the frontier, where new productive possibilities emerge, and doesn’t take wealth-creating risks anymore. That’s bad for investors. But it’s not the end of the story either.
Dan Denning
for The Daily Reckoning Australia
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