Do you remember those wonderful cartoons featuring the Roadrunner being chased
by the Coyote? In particular, the bits that made me laugh inevitably featured
the coyote running off a cliff or over a valley, realizing about a few feet
into the peril that terra firma wasn't in evidence anymore. Cue that
wonderfully resigned expression on the coyote's face before it plummeted to the
usual crash.
I saw that look last week not once but many times as various "analysts" and
"strategists" went blue in the face during their regular appearances on
financial media (television as well as video interviews on newspaper websites)
about how their assumptions about such things as "earnings recoveries" and
"economic revival" would soon be proved correct, even if things looked a little
hairy at the moment.
A consistent point I have made in these columns for the past
three months or so has been that the only reason for risk assets to rise since
the beginning of the third quarter (July) has been the notion of ample
liquidity being pushed through to virtually create the next asset bubble. In
other words, the last party trick of the Keynesians unable to hoist the global
economy is to try ushering in an asset bubble that would rescue the global
economy in much the same way that the US housing boom helped in the aftermath
of the collapse in global stocks after the dotcom bubble burst.
A wonderful irony is that the Keynesians are using the same formula as one used
by the person they apparently detest the most, former US Federal Reserve
chairman Alan Greenspan, but then we shouldn't get too bothered about things
like principles at this stage of the global game. (See also
Principal over principle, Asia Times Online, June 6, 2009.)
All bubbles depend on the notion that a marginal buyer of a pricey asset can be
found at any point in time - that is, irrespective of the price and the time,
the asset in your hand will always find a buyer. Assuming that you subscribe to
this theory of making wealth, you would be called the "Fool" and the person(s)
who is expected to buy the asset from you will be called the "Greater Fool".
If you exclude the notion of a Greater Fool lurking behind the next curtain who
will purchase your loftily purchased assets, the world suddenly looks bereft of
any support for asset valuations. It isn't so much a function of a minor
adjustment being called in for risk assets over the near term as perhaps a
wholesale re-evaluation of this year's stunning performance in equity and
credit markets.
Look in this article at some disturbing new facts that have emerged with many
commonly held assumptions. The base case for me remains the same - major stock
indices are likely to retreat to levels some 25-30% below today's levels before
the second quarter of next year; usually we should expect any correction to be
sharp and very painful.
Firstly, that economic data point to an improvement.
The favorite point made by the equity market bulls globally is that economic
data already highlight a bounce; with the global economy likely to emerge from
recession early next year. It may, but then it is also possible that pigs will
fly (no, not swine flu). This commonly made assertion rests on two connected
sub-theories, neither of which stands up to scrutiny.
The first sub-theory involves the actual calculation of "real" gross domestic
product (GDP) growth; trained economists will tell you quickly that virtually
no other economic indicator can be as manipulated because it is easy to
overstate nominal GDP changes just as it is to understate the "price deflator"
element. Combine the two and you can make "real GDP" do pretty much anything
you want it to do. Yes, even that.
The second sub-theory is that economies "always" bounce back from recessions.
This is patently untrue with respect to the experience of Japan since 1989; but
even ignoring that little factoid there are many other countries where despite
positive demographics, the underlying economy hasn't bounced back after many
years of contraction (for example, Zimbabwe). So many otherwise wonderful
economists quote this particular "bounce-back" theory that I am left pondering
about how to beat all of them on the head with the voluminous data from
Japan and the World Bank over the past few years.
Then there are the inconvenient details with regards to GDP numbers; such as
what is happening to consumption data, investment and so on. Last Friday's
durable goods orders in the US for example showed a worse-than-expected decline
in orders for durables, excluding aircraft orders. This suggests both that
businesses do not expect a quick turnaround for the US economy and that removal
of public-spending initiatives inevitably changes the picture back towards a
new normal. (See also
Clunkers for cash, Asia Times Online, August 8, 2009.)
As for consumption, anyone following economic statistics in the United States
and Western Europe should know by now that retail sales, home purchases and
durables (as above) all point to a consistently downward-looking picture. Just
because you happened to see a brand new Ferrari on your last visit to Los
Angeles doesn't mean that the American consumer is back. In any event, the idea
is to reconcile the volume of sales with the prior availability of credit: this
is simply impossible under any circumstances; which means all these economies
will have to settle at a lower level of consumption in their GDP figures, and
permanently so.
Secondly, that employment is a backward-looking indicator.
A common refrain on financial talk shows to the question "if the economy is
bouncing back, how come there aren't more jobs" is the notion that employment
is a backward-looking indicator. This is the case for the part of the economy
focused on production - as typically order volumes rise, prices of certain
goods rise, investments in capital expenditure rise before finally factories
start employing more people; but it is incorrect for the consumption part of
the economy.
For the US and certain countries in Western Europe (Britain, France, Spain and
so on), consumption is typically over half to three-quarters of total GDP; and
to the extent that jobless people don't tend to spend a lot of money on new
cars and houses or indeed even purchase new handbags, employment suddenly looms
as a forward-looking indicator for economic growth.
People likely to default on mortgages or credit cards will not get any credit
at all in the current climate where banks are already hiding billions in
losses. Without employment, there will be no credit provided to these people.
This is the most inconvenient bit about the current asset bubble in stocks and
bonds: such assets aren't usually leveraged at the individual level. In other
words, not a lot of people borrow money against stocks and bonds (unlike banks
and companies, which do borrow a lot of money against them), and even when they
can do so, the amount provided is a fraction of the current value of these
investments. This is very different from leverage provided against home
ownership, for example.
The last point about employment is that "liar loans" and the like are now
impossible to get, thanks to the meltdown in mortgage-backed securities; and
because of that, any credit will depend on your job as well as earnings (as
well as other measures, including income stability). All of which means that
without employment generation, there will be no consumption growth.
Now, that doesn't look like a backward-looking economic indicator, does it?
Thirdly, that fast-growing countries cannot have asset bubbles.
Another item of faith in global markets now is the notion that accelerating
economic growth washes away all sins, including those of asset bubbles. This
percept lulls many investors into a false sense of security with respect to
their investments, with
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