Juggling Dynamite

Thanks to reader Will for sending me a link to this rare Jeremy Grantham interview clip from November 21, 20008. I have long respected Grantham for his realist views and tactical advice to real life investors. He was one of the few who called the tech bubble in the late '90's and warned investors of the irrational risk to capital invested. As far back as 2005 he was also one of a seemingly small group of us warning about world wide bubbles and the threat that was mounting to the global economy and investors.
I agree with what Grantham says in this interview. He still believes that there is a 2 to 1 probability that stock markets will be lower next year before they bottom this cycle. He acknowledges that they could go a lot lower before this de-levering phase is complete. On the other hand, there is a smaller probability that markets could rally from present levels. Market sentiment is a wild and wooly beast. We have to be develop our plan for a range of possible outcomes.
With world markets falling more than 45% over the past year, there is admittedly a greater chance now of reward to equity investors over the next several years than there has been for more than 10 years. But let us not forget that present valuations are relatively attractive when compared to the period of irrational, crazy equity valuations since the later part of the 90’s. As Gratham says, this is no assurance that asset prices cannot get a lot cheaper still. All 27 asset bubbles in the past few hundred years have all reverted below their mean eventually. So what is a prudent investor to do?
Grantham suggests one might toe back slowly into US equities and some emerging markets, which he sees as relatively inexpensive. But he thinks 20% invested is a reasonable commitment at this point. He also asks that people consider how they are likely to react if markets do drop a further 20 or 30% from here. If one is likely to take this badly, (as most would) Gratham suggests maintaining a large cash position over the coming months.
I like his comments about balancing the dual regrets. On the one hand if people do buy now and stay invested through a further 20 to 30% declines, they will suffer great regret and are likely to panic at some point in the experience. On the other hand, if markets do accomplish the unlikely, and rally strongly in the coming weeks, there will be other regret for buys not made. In my experience, for most people, the regret of missing out on gains is bothersome, but not nearly as bad as the regret of large capital loss. Balancing the threat of the dual regrets is the art of money management.

The late date rally on Friday was long, long, overdue. Sadly even with 5%+ gains, the markets still finished steeply lower on the week. The carnage of 2008 while not unprecedented will be legendary on all metrics. When markets become so relentlessly oversold, it is usual to expect at least interim days and weeks of a counter-trend rally. Maybe we are seeing some follow-through on that hope today. Europe rallied strongly today as news of the Citi bail-out part 2 spurred fresh hope.
The question is will this rally have some staying power over the next few months? Will it be the start of a cyclical shift back to the next bull? I would be content if it were. I doubt that it is. Yet. But we will watch the technicals carefully as always.
Despite the 494 point rise on the Dow late Friday, we see that in the broader market, there were 1245 new lows and only 2 new highs–poor breadth. We also know that the Lowry’s buying pressure broke to yet another new low, while selling pressure broke to a fresh high. This is a menacing combination.
Meanwhile there is no question that fundamental valuations appear much more favourable today than they have for the past several years. One can't help but notice for example that dividend yields on REIT ETFs that were less than 4% in 2006 are now about 12%. Financial shares are yielding more than high quality bonds and this is as it should be. As we have seen vividly over the past 13 months, financial shares can carry a lot of financial risk. A few years ago people were blindly holding risk assets without any likelihood of adequate reward. Investors have now learned the hard way that they need to be adequately compensated for the risk of holding equities. This is a good lesson to learn.
Reading the Citi group headlines this weekend invoked a spate of déjà vu. Weren’t “SIV’s in the Citi” and Bear Stearns how the credit crunch first hit front page news many months ago? I hate to be a party pooper, but bailing out Citi group-encore -won't be the systemic change we need to re-launch our next economic expansion.
The stats on the bail-out efforts to date are incredible:
“The U.S. government is prepared to lend more than $7.4 trillion on behalf of American taxpayers, or half the value of everything produced in the nation last year, to rescue the financial system since the credit markets seized up 15 months ago.
The unprecedented pledge of funds includes $2.8 trillion already tapped by financial institutions in the biggest response to an economic emergency since the New Deal of the 1930s, according to data compiled by Bloomberg. The commitment dwarfs the only plan approved by lawmakers, the Treasury Department’s $700 billion Troubled Asset Relief Program. Federal Reserve lending last week was 1,900 times the weekly average for the three years before the crisis.”
See Fed pledges top 7.4 trillion to ease frozen credit
To put this in modern historical perspective, the savings and loan bailout of the 1990s cost $209.5 billion adjusted for inflation, of which $173 billion came from taxpayers, according to a July 1996 report by the U.S. General Accounting Office, since renamed the Government Accountability Office.
The 1979 U.S. government bailout of Chrysler consisted of bond guarantees, adjusted for inflation, of $4.2 billion, according to a Heritage Foundation report.
U.S. financial firms have taken write downs and losses of $666.1 billion since the beginning of 2007, according to Bloomberg data.
I remember last winter when the US financial firm write down estimates were at 200 billion and many were calling that an ultra-bearish estimate. 200 billion is truly chump change nowadays.
It seems clear that this is already the worst capital markets crisis in modern history. But despite market losses of 45% on most stock indices around the world, this bear market is definitely not “unprecedented” or the worst ever in modern history. In risk premium spread and volatility 2008 already matches other bad bears like 1932, 1974, 1982 and 2002. With the clarity of hindsight all of these years turned out to be end of cyclical bears. In each case the markets rallied for months and years off these market bottoms.
What troubles this conclusion though is that in each of these cases the market had experienced at least a 2 year bear market before hitting bottom. The market crashed from 1929 to 1932, 1973 through 1974, 1981 and 1982, 2001 and 2002. Could it be that these extended decline periods were needed to clear out the over-levered participants from the prior reckless period?
The length of the 2008 bear has so far been just one year. Could it be that we have corrected for all the over-exuberance this time in just one year? If this is the worst capital market crisis in modern times, is it reasonable to expect that we have seen the worst of the stock market declines? Possibly. Only time will tell us for sure. But we need to have an investment plan that is prepared for either outcome.

Watching the auto bailout hearings the past couple of days has been riveting. I believe business history will record this episode as a low point for both capitalism and unions. Business schools will teach the story for decades to come about the classic demise of a mature business devastated by abuse and failed leadership. Everyone from management to unions were resting on past success and their entitlements so hard, they forgot to protect and nurture their franchise.
But as Rick Wagoner stands there with his well-manicured-hands out to the American taxpayers I would love someone to ask him one question from me:
“Ricko, why in 2005 did GM systematically collect and crush its fleet of EV-1 electric cars?
It was among the fastest, most efficient production cars ever built. It ran on electricity, produced no emissions and catapulted American technology to the forefront of the automotive industry. The lucky few who drove it never wanted to give it up. What the hell were you thinking?”
(If you haven't seen the documentary “Who killed the Electric Car?” yet watch it now and be amazed.)
I am very torn on what the government should do now. My intuition is that they should not bail these top heavy, sub-standard companies out. I think any money given to the big 3 will ultimately be money (they don't have) thrown down the drain. For sure, the executives should be summarily fired for the failed leadership they have offered to this cause. My hesitation though is about the 700b they have promised to the banking sector. The banking sector has also been hopelessly flawed and scandalously led for many years. These failures are at the very root of our present global angst. Why should they be saved while the bluer collar auto workers get the punt?
In the end, as painful as it is, I think that the auto makers do need to go down. If there are other American car companies to come they will have to rise out of the ashes by starting with new energy, innovation and lean work ethic.
The government should spend money helping the auto workers to re-learn and re-train to a new, productive and sustainable career. It will be hard for many, but in the end this change has been a long time coming and in many ways stubbornly earned.
Meanwhile the TSX broke through 8,000 today. Over the past many months we have watched as the TSX declined but always a few thousand points above the DOW. I suspected the Canadian market would ultimately catch up and overtake the DOW to the downside. Today it met the Dow as they both broke through 8000.
Other world markets have now already achieved their 2002 low. The TSX today at 7745 still has a couple of thousand points to go before it will re-test the 5678 level of the last cyclical Bear. Time will tell, but I see no reason why the Canadian market would break ranks and not achieve this down side re-test.
Hopefully the indices will hold at the ’02 lows. If this secular bear is like 1966 to 1982, they will not. They will break to a fresh low this cycle below 5678 on the TSX and 7400 on the Dow.
At 750 this afternoon, the S&P today broke through its 2002 low of 776. I am afraid it is leading the way for Canada. And where it will stop, we cannot yet know.