Thursday, May 17, 2007

Reality v. Hyper-Reality

For several months now the US economy has been steadily softening on the back of a real estate recession, the loss of manufacturing jobs, increased prices for fuel and food and, more recently, a developing stall in retail spending. And yet, stocks are making new highs - what gives?

There are two things happening at once:
  1. Individual retail investors are largely absent, at least directly (i.e. outside their pension plans). This leaves the market in the hands of professionals, mostly hedge and private equity funds, i.e. momentum players who amplify existing trends.
  2. The perceived and highly convenient wisdom among such professionals is that the economy is merely going through a temporary soft spot and will soon bounce back - with a boost from a Fed rate cut, if necessary. Thus, they hang on to stocks because current P/E's at around 18x (S&P 500) are not "expensive". Determined buying comes from M&A and LBO activity (i.e. spending OPM to make huge fees, no matter what the outcome).
But... what if the economy is headed towards deeper trouble than expected? What if the combination of (A) high debt + (B) negative saving + (C) lower home prices produces a stubborn consumer spending strike (70% of GDP)? Corporate profits will drop and "low" P/E's will prove very high in retrospect.

What are the chances of this happening? Comparisons with the Depression Era should always be taken with big grains of salt, but it is undeniable that the A+B+C combination has not been seen in the US since... the Great Depression. If the adverse effects of these conditions get established as negative consumer behavior it will be impossible to avoid a stubborn recession.

As a first sign, retail sales are already softening, running at +2-3% vs. last year, i.e. negative when inflation is accounted for (see post from May 11). I believe that such spending is the proverbial canary warning about overall consumer behavior, since cutting down on trips to the mall is the fastest way to achieve immediate savings. In fact, ShopperTrak reports that in April foot traffic at US retailers dropped 13% and sales rose a paltry 2.3% vs. last year. As usual, poor weather is being blamed, but if this persists for several more weeks we could see weakness spreading to other types of non-essential discretionary spending, i.e. services such as lawn care, gyms, car washes, hair and nail salons, etc.

In this respect, I am convinced that momentum players are not properly assessing the rising fundamental risks and are just looking to the market as a guide to the economy. The market's action has thus become disconnected from economic reality, as in "the economy is weak, but the market is up so the economy must be strong". This kind of circular logic is creating a fallacious hyper-reality of wishful self-fulfilment than can readjust suddenly and create a severe market correction.

Let me put it another way: "normal" market extremes are easy to identify because the greater public jumps in with both feet screaming with delight - it is happening in China right now. But the kind of "silent" extreme we are experiencing in US and EU markets right now, is contained within the cerebellums of the professional community and, in my opinion, has zero tolerance for error. If hyper-reality shifts to plain old reality, suddenly EVERYONE in the hedge/private/pension community will become a motivated seller but there will be no willing buyers because the individual investors are long gone and hurting from the popped housing bubble, besides.

Below are some plain "reality" charts:







As for hyper-reality charts... look at any stock market index you choose. I like this one: The Shanghai SE "B" Index, up 75% in ONE MONTH.



  1. Hellasious,

    Another great post.

    I admire your ability to identify relevant macroeconomic trends then correlate those trends with current financial market psychology.

    I think many managers of OPM recognize the potential risks to financial markets should consumer spending drop off a cliff but are simply not willing to risk their careers by positioning portfolios accordingly. It is much easier to stay with the herd even during obvious bubbles and explain losses in a subsequent bust than to try to explain why one missed out on a major upswing.

    Nassim Taleb explains this dynamic in his book Fooled by Randomness. He indicates only a few clients actually call him to thank him for taking out portfolio insurance when perceived risks don't materialize. People are only happy they have insurance when catastrophe occurs. Otherwise,the longer the period of time that goes by without a catastrophe occuring, the more insurance premiums are perceived as a waste of money.

  2. I agree with much of this (much to my chagrin, after a move I'm renting and waiting to see home prices fall, however) but one area that may not be as motivated are PE funds. They, as you know, have 10-year terms and are typipcally entendible for ~3 years so even if prices fall they would not be pushed (at least by investors) to, as from Trading Places "Sell! Sell! Sell!".

    As well, since stale-dating is prevalent in PE (as well as non-listed real estate) there might be less pressure from within as well--not to mention, investors may not know that the prices had dropped between appraisal/valuation dates. This, I believe, is one of the reasons that many pensions (including Ontario Teachers', just a block or so from my rented pad) have taken a liking to PE--even at the risk of criticism that it is buying assets, such as NZ Telecom's Yellow Pages unit, at high multiples in order to take it private and mask price volatility. Basically, there is little the public can comment on if investments are recorded at non-public market prices (which, by the way, might end up being a good thing at the end of the day).

    Hedge funds, or at least those with short lock-up periods and/or hot-handed investors, could be at risk, of course.

    Mutual funds, those investments that are most regulated of the three and, thus, spread amongst the largest and least sophisticated group of investors, might be the quickest movers of all. Investors, while resilient to short-lived (between statement dates) or shallow (<10%) drawdowns, can redeem at any time. Even though not leveraged, global equity and bond aggregates total approximately $85 trillion (2004, Source ) and about 14% of this is held by mutual funds, or about 19% in the U.S. (ibid) so redemptions from these pools to finance where home equity loans left off might be the tipping point.

  3. Hi Hellasious,

    As often with your posts, i can but agree 100% with your post.

    The graphics are straight to the point. To a Frenchman, one graph is a mistery though, employment.

    Why is employment so strong? I have heard a lot of explanations on this subjects. From illegal immigrants running home to employers keeping their staff because the market is so difficult that firing is a risk-taking option... In case the economy would suddenly bounce back.

    I also heard of data spinning. Which I'd discard. Tricking inflation easy is both an easy and effective practice around the globe. Employment is much more difficult to hide, except for a couple of months.

    What is your opinion?

    In France even to-day, a minor reduction in GPD and employment drops. Possibly that's because we boast a highly unregulated labor market!


  4. I thank you all for your kind words.

    1) When they are making money, customers pat themselves in the back. When losing they blame their advisor.

    2) Private equity: those guys are 90% buy and flip, i.e. they have no clue whatsoever on how to profitably operate the companies they bought whole. If markets ease off and they aren't able to flip, they will be bleeding cash profusely - particularly at the leverage they use.

    3)Employment is a lagging indicator in the US. But, more importantly, during the latest recovery from the recession, not as many jobs were created as previously. And let's not forget the US is also fighting two wars. This boosts employment considerably as national guard and reserve units leave work and must be replaced.

    In any case, the way employment is measured in the US one can never be sure of the real level. There are adjustments on top of adjustments.


  5. The only worry I have about your assumption that only professionals are in the market and retails absent, is that stupid retails would finally join in for the last leg of mania.

    Just like the legendary Jeremy Grantham said, typically the last leg of bull is accompanied by a short duration of irrational exuberance, and judging by that, we could likely have a last leg to run with the retails jumping in.

    The stock has disconnected from the US economy for 1 year already. I am close to thorwing in the bear towel and buy in the SP500 international profit growth theory.

  6. H -

    A few questions:

    1. What has the trend line been with individual investors for the past 8 - 10 years? When did it start going down and what is the slope like?

    2. If the "big boys" are, in essence, manipulating the markets to increase their piracy booty, would you conclude that individual investors as a group are wiser in the sense of being able to see through this process? OR, have they capitulated and put their money in with "the big boys?"

    Thanks and please keep these great posts coming.


  7. Dear Hellasious

    Indeed, another excellent post. I sincerely believe we are already in recession. Many of us are aware of how badly distorted the official economic data is; I maintain that were the data to accurately reflect econcomic conditions we would have entered a reccession sometime this quarter.

    The U.S. share market is doomed, but now's not the time that the bottom is likely to fall out as seasonality argues that the four year cycle will top out later this year. The next leg down in the secular bear (in real terms that is) will likely make the 2000-02 leg look like a gentle warm up.

    Having said that, it is the Dow (the most easily manipulated average) that is way out front and gives the lie to this mini-mania being anything more than a short lived but impressive pop, since Generals don't go far without their troops in tow.

    And though I realize that, as Twain observed, "History doesn't repeat, but it rhymes", things do appear very '29 like in that the U.S.'s relative position globally resembles that of Britain eighty years ago, a fading power on the brink of losing its grip on world leadership.

  8. A few interesting and related posts on CPI you may appreciate:

    Want to Measure Actual Inflation? See the Core/Headline CPI Spread

    Inflation Errors (Part II)

  9. thks for the links barry.

    edwardo: actually, if you look at the Russell 2000 (i.e. the lower 2/3 of the top 3000 US companies) you will see that it has way outperformed the Dow, having made new highs as far back as 2004. The "soldiers" have been marching alone for a long time and now the generals are coming up, too.

    This is an upside down market...

  10. Dear H,

    I should have specified, since the February swoon the Rut is not marching with the generals. In any case, the Indoos behaviour relative to the rest of the market is typical of the last stages of a Bull market in shares.

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