Market Musings Blog

In our last post we wrote about the potential long term effects of deleveraging the world. These include slow growth, lower living standards and defaults. Despite the negative potential for the economy, stocks won’t necessarily follow suit. Why would the stock outlook be rosier than the economic outlook? Here are a few reasons:

• First is price. We believe that the most important determinant of future return of an asset is its price today. “Cheap” today can translate to high rewards later. On the other hand, buy an asset at a high price, such as real estate in 2007, and it will either do nothing for years (best case), or crater (worst case) until its price comes in line with historical norms. The S&P 500 is up just 4.8% per year for the last fifteen years despite growing earnings and dividends, and reduced debt levels at companies. That is just about half the long term return since 1926. There’s a firestorm of controversy right now about whether this makes stocks cheap, but keep in mind that over this same time frame international and small cap stocks performed far better than the S&P 500. You don’t need to own the S&P to succeed with stocks.
• Second, companies have become more diversified in the last twenty years, largely by increasing their sales and manufacturing ranges to include most of the world. This diversification has helped mitigate earnings fluctuations normally caused by business cycle behavior. As a corollary, companies have learned to manage costs, inventories, and cash far better than in the past. This, too, has helped dampen volatility in earnings streams. Essentially, companies are managing themselves far better than many governments.
• The general popularity of stocks has plummeted. Global pension fund allocations to stocks dropped from 49% to 41% from 1995-2011. That might not sound dramatic, but given that the pension fund assets in question total $27.5 trillion, that’s a lot of bucks. Personal ownership of stocks in 401k accounts has fallen to the lowest level since Gallup began tracking the numbers, at 54%. See here for the data. When equities fall out of favor, that tends to be a good sign for future returns because the population of potential buyers increases.

Exactly when these factors will kick into gear to generate higher stock returns is a big unknown. But each of these factors is contributing to a scenario that will eventually cause a bull market, and in the meantime will at least support stock levels in the trading range that we’ve been experiencing for lo these many years.

Has anyone else noticed that world governments have been using debt to cure the indebtedness that bit us in the first place? While citizens everywhere have been defaulting or paying off their debts, governments have been accelerating their loans to worthless borrowers (Europe); sinking money into so-called stimulus projects (US, Japan); and subsidizing students (US), green energy (US, China and Europe), gas prices (Asia), social programs in aging demographies (Japan, US), property development (China) and so on. The result is that worldwide, debt is increasing despite the work that families have done to restructure their balance sheets. The 34 countries in the OECD (Organization of Economic Co-operation and Development) have seen their aggregate public debt top 100% of GDP in the last year, up from roughly 70% just a few years ago, swamping the debt reductions elsewhere in their economies.

How does this all end? There are various historical precedents for high levels of debt in specific economies (the US in the late ’20s and early ’30s for instance) but no instance in which most countries simultaneously have too much debt. We can hazard a guess however.

• First, expect declining living standards and slow growth. Paying back all this debt will take decades, and it will necessarily take money from other purposes. A great view on this comes from a new app for the iPhone, called Debt Bomb. You can get the app here. The point of the app is to show you that if you had to pay your share of the US deficit along with your taxes when you filed last Tuesday, your tax bill would have amounted to roughly 40% more than what you paid. Where would you cut spending to come up with those extra thousands? No vacations or new clothes maybe? Bingo: the economy slows.
• Declining living standards will lead to social and political instability. In the US, we are already swapping from party to party as elected officials seem unable to solve our problems or even make headway. In Athens, they prefer to bomb storefronts and go on strike.
• Expect a more volatile business cycle. During deleveraging, government regulations, spending, and cutbacks fall unevenly on the economy. Currently, housing and finance are in a funk, looking much worse than other sectors. That can shift, however. If Europe craters because of austerity, our manufacturers will feel it. Furthermore, very slow growth simply leaves less of a buffer for a mishap, like rising oil prices or a new war. Finally, investors will take more risk in a quest for better returns, leaving the economy vulnerable to new bubbles.
• Defaults. Yes, someone is going to lose money. There are hard defaults, like Greece, which won’t be paying back its debt under the same terms that it originally promised. Then there are soft defaults. These are the sneaky kind, like in the US where the Fed has driven interest rates below the rate of inflation for most bonds. If you’re a saver, you are losing money every day to inflation in the US, thanks to The Bernank. You are the victim of a soft default, and it’s contributing to your lower living standard.

Lest you think we can avoid all this because the deficit has never been a problem before, take a hard look at the average inflation adjusted wage in the US over the last several years, and you’ll see it declining as government debt has risen. Our living standards are already falling.

All in all, not a pretty picture. From an investor’s perspective, it’s hard to see the stock market performing very well under this scenario. In fact, you might just want to run out and buy bonds instead, along with everyone else who has reached the same conclusion. But that’s too easy and the markets are never easy. Stay tuned for The Endgame: Part Two for our take on why stocks can still do well despite a gloomy economic outlook.

The Great Bond Swap is underway for holders of Greek debt. In this exercise, Greek bondholders “volunteer” to let Greece default on the bonds they own now in exchange for fewer new bonds structured with lower interest rates and longer maturities. To be effective, over 90% of the holders of Greek debt need to agree to take a beating. At that level of participation, The Great Bond Swap can be called an “orderly default” wherein life as we know it is not supposed to change much, as opposed to a “disorderly default” wherein all hell breaks loose. To be sure, we don’t quite quite understand the nuance. A default is a default. Furthermore, everyone is Greek-fatigued, and has likely accommodated the idea of default over the last two years, so we suspect even a disorderly default won’t have a lasting (a key word!) impact at this stage of the game.

In any event, the Bond Swap agreement is meticulous and complicated, but the general idea is to inflict pain on those who do not participate. Bond holders, of course, are eyeing each other to see what the next guy is going to do or whether they can all stonewall the process to garner better terms. From that perspective it is an interesting economic event for econo-geeks like us, but probably boring for anyone who is normal. But there’s one hole in the Swap agreement that is worth pointing out: many of the holders of Greek debt also bought insurance against default for the debt. These are called credit default swaps, and they pay if Greece defaults. But under the contract, the CDS’s only pay if the default is not voluntary! These people have no incentive to play ball. In fact, they will probably gain more if there is a disorderly, “involuntary” default because their bonds might become worthless but the insurance they bought will pay them back, and more than the Greeks are willing to offer under the terms of the Bond Swap.

Witching hour is this Thursday, roughly 3 pm Eastern time. That’s when the terms of the swap expire. If there’s a shortfall in the number of participants, look out for a rough time in the markets as everyone adjusts to the uncertainty. Unfortunately, there’s no countdown clock tabulating the number of participants who have signed up, so we’ll just have to wait for the news tomorrow.