For years we have talked about deflation - the prospect of a shrinking economy, marked by lower prices, less credit, and falling income.  A deflationary period is marked by what is called the “vicious cycle,” where falling purchases by consumers leads businesses to lower prices for goods, which leads to less revenue for companies, which leads them to lower wages that are paid to workers, which leads the workers to buy less stuff, thereby causing prices to fall again, thereby completing and continuing the cycle.  This is the opposite of the “virtuous cycle,” which goes the other direction, where higher sales lead to growth at the company and higher wages, which lead to higher sales, and so on.

We have discussed the falling prices in our current economy, with housing being the most obvious, but sales at retail stores and cuts in prices for services also being noticeable.  The huge swaths of layoffs and flat out firings are apparent in the unemployment numbers, but what we have been missing is some sort of data on what is happening when people are re-hired.  It is not true that everyone who gets fired cannot find a job.  Many recently unemployed are finding work.  The question is, ”Are they making the same, more, or less than their old job?”  Our forecast has been that the falling economy will indeed lead to lower wages, thereby cementing the vicious cycle.  Unfortunately it appears we are correct.

The NYT ran an article today with some crude, preliminary data on this subject. Several groups, including the Hamilton Project, the Center for American Progress, and the National Employment Law Project weighed in from different angles, but the outcome is the same.  The high end workers (graduate degrees, jobs requiring high degrees of skill) are somewhat insulated, the bottom rung remains at the bottom but is facing mass unemployment, and those in the middle jobs (some college, median income) are falling to the lower rungs of work and pay, displacing those who used to be in those spots.  Essentially, middle income workers are losing their jobs and when they find other employment it is well below their previous work.

This development adds more fuel to the deflationary fire, as those workers will now show up as “employed,” so it looks good on paper, but they will not show up as high spending consumers, which will confound bureaucrats who will not be able to figure out why the employment numbers have stabilized but the economic picture continues to weaken. 

In the Bizzaro Superman world we live in where things mean their opposite, we shave almost a full percentage point off of the estimate of Q2 GDP growth and markets like it.  The estimate had been a revision even lower, 1.2%-1.5%, so this print of 1.6% looks “positive.”  For some reason, I prefer the real world, where our efforts at reviving the economy are failing spectacularly, having spent almost $4 trillion extra (stimulus, bailouts, and deficits) and all we have to show for it is a lousy, shrinking GDP. 

I have been patient with policymakers, but that time has past.  There must be recognition that the issues we face cannot be solved with more debt.  An asset bubble must deflate, and will deflate.  The question is, will we manage it lower the best we can, or hold on to a false hope of propping up the bubble only to watch it fail in a much bigger, more devatstating way down the road? 

Look for Q2 GDP to be revised again next month, most likely close to 1.0%, or even lower. 

The next big thing is Unemployment, coming next Friday (Sept 3rd).  The estimate is for a loss of jobs of 60k-70k, however that includes the US government releasing 110k of census workers, so the net would be a gain of jobs of 40k-50k.   If we are anywhere near negative 60k or less, the markets would most likely rally, because we live in Bizarro world.  We need at least 100k of jobs created every month just to absorb the new workers entering the workforce.  Anything less than 100k new jobs created will do nothing to start alleviating the pain of unemployment for roughly 15mm Americans.

The WSJ ran an article today on commercial real estate owners playing hardball with their lenders.  In essence, the property owners are telling the lenders that they can either restructure the loans - which is code for write-off some of the principal I owe you - or they can take the building back.  Their example in the article is Taubman Centers, Inc., run by Mr. Robert Taubman, which stoppped paying interest on its $135 million loan outstanding on a property in Atlantic City, NJ.  Taubman Centers, Inc. estimates the property is only worth $52 million.

The catch is, this company has the money to make the payments. The implication of the article is that many businesses are in the same situation, they own property that is underwater to a point where there is no realistic expectation of making any profit on the property.  So what to do?  Obviously, you default.

By the way, the article quotes Trepp, LLC as estimating that of the $1.4 trillion in commercial loans coming due in the next 4 years, over half of them are on properties that are underwater.

Now, this is a fabulous way for an individual company to rid itself of a burdensome load in an effort to find greener pastures.  But what about the people who made the loans? Those would be bondholders and banks.  Those people, who tend to be regional banks and then corporate bond investors such as pension funds and endowments, are stuck with the properties, which they in turn try to sell and of course realize quite a loss.  So these lenders take a hit that the business, such as Robert Taubman, did not want to take.  Why do people like Taubman do this?   Because they can.  Their business loans are non-recourse, meaning the lenders cannot go after them personally.  Which is the difference between corporate owners and residential homeowners.

Very few states in the US have non-recourse mortgages.  California does, for the most part, but they still have a way of going after the most egregious “strategic defaulters,” those people that could easily pay their mortgages but choose not to because they think it’s a bad deal.

However, just because businesses that are in strong financial shape can pay their mortgages, does that mean they should?  If I am an investor in a company that bought a property that has turned into a drag, I might want the company to unload it any way it could.  However, if I’m a stockholder in a bank or an stakeholder in a pension fund or endowment  that has lent that company the money, I’m sure I’d see it differently.  No matter which side you fall on, it seems obvious that there will be repercussions from these decisions for many years.  Who will lend to businesses to buy buildings if they can and do choose to walk on loans when times get tough?  I would think twice about it.

At the beginning of the summer we were forecasting 2nd quarter GDP to be in the 1.5%-2.0% range.  We used information from Consumer Metrics (www.consumerindexes.com) and other places to arrive at that modest number.  July 30th, the Friday of the month, was more or less D-Day for us because that was the day that the advance estimate of 2nd Quarter GDP was to be announced.  As the day approached, the consensus estimate was around 3.0-3.5%.  However, our view was that the economy was slowing down even further, so we were concerned that our range of 1.5%-2.0% was high. 

The number came in at 2.4%, which surprised us (too high, we thought) and surprised many mainstream economists on CNBC (they thought it was too low).  The markets shrugged off the news.

Now the revisions are coming.  The first numbers I heard were from JPMorgan and Goldman, where the new estimate of 2nd Quarter GDP was 1.5%-1.7%, which is in line with our views.  Now, as we are seeing durable goods and other measures like the Philly Index get crushed, the estimates of 2nd Quarter GDP are going lower, 1.0%-1.5%.  This Friday we will get the revised estimate of 2nd Quarter GDP, and it looks like it will come in a full 1% lower than the advance estimate just four weeks ago.  I cannot imagine that this will be good for the markets, but I think we are already seeing the larger players become more defensive ahead of the announcement, pulling this market down.

After this Friday’s GDP number, we all get to wait in anticipation of next Friday’s Unemployment report.  What a way to end the summer!

“Individual investors are fed up with the stock market,” writes TechTicker. “Burnt by 10 years of negative returns, two crashes, and a current economy mired with high unemployment and lackluster growth, many are throwing in the towel.”

Perhaps not surprisingly, retail investors have instead poured their funds into bonds in record numbers, helping to send yields to new lows.

Treasury yields are near record lows even while the fiscal position of the United States is the worst its been since the Great Depression–and arguably worse given the looming Social Security and Medicare solvency crises that will boil over with the retirement of the Baby Boomers.

It might seem almost silly to ask. But is there an irrational bubble in bonds?

The short answer, which will be controversial to many, is “no.”

This does not mean, of course, that bonds are an attractive investment at current prices. Unless you are an institutional investor whose investment mandate requires an allocation to longer-term bonds, yields are currently so low as to make Treasuries not worth owning.

But “unattractively priced” does not necessarily mean “bubble.”

This is not just a matter of semantics. There are some real differences here that do matter, and tossing the word “bubble” around indiscriminately can lead you to draw the wrong conclusions.

There is no precise definition of a speculative bubble, though Hyman Minsky gives us a good outline of what to look for. In Minsky’s model, a speculative mania tends to follow five stages, summarized below by Investopedia:

1. Displacement: A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low.
2. Boom: Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be an once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of participants into the fold.
3. Euphoria: During this phase,caution is thrown to the wind, as asset prices skyrocket. The “greater fool” theory plays out everywhere. Valuations reach extreme levels during this phase. During the euphoric phase, new valuation measures and metrics are touted to justify the relentless rise in asset prices.
4. Profit Taking: By this time, the smart money – heeding the warning signs – is generally selling out positions and taking profits. Note that it only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot “inflate” again.
5. Panic: In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate them at any price. As supply overwhelms demand, asset prices slide sharply.

In looking at the Treasury market today, we cannot credibly say that we are following this model. Perhaps it could be argued that the housing and credit market collapse of 2007-2009 qualifies as a “displacement.” But what we are seeing in the market hardly qualifies as a “boom” and certainly doesn’t qualify as “euphoria.”

In judging the temperament of those currently buying Treasuries, it should be obvious that these are not greedy speculators chasing returns. They are shell-shocked investors who have lost their tolerance for risk taking.

No one likes Treasuries. No one is quitting their job to day-trade bonds like they did tech stocks in 1999. No one is taking out a liar loan to “flip” Treasuries like Miami condos in 2004.

It is an entirely different mentality. Retail investors buy them for the simple reason that they are not stocks.

Furthermore, in nearly all examples of bubbles–and in the recent housing and financial bubble in particular–leverage plays a major role in inflating prices. Miami condos would have never reached the absurd prices they did without the loose mortgage financing that was available. You could argue that the Fed’s loose policies are creating the leverage that is being used to buy Treasuries (thus keeping the prices high and the yields low), but this is not entirely accurate either. All else equal, loose monetary policy causes longer-term yields to rise, not fall. The Federal Reserve does not buy every bond put out by the Treasury and cannot mandate what market rates will be at all maturities of the yield curve. The Fed, though powerful, is not omnipotent. And total leverage in the U.S. financial system is continuing to shrink as the private sector deleverages faster than the Treasury can issue new debt (see Figures 1 and 2).

Figure 1: Total Debt Outstanding

 Figure 2: Total Debt Outstanding–Federal vs. “Everything Else”

It would seem unlikely that we would have a bona fide “bubble” in anything during a period of financial system deleveraging.

So, while I have established that there is no “bubble,” per se, in Treasuries, I want to reiterate that this does not mean that the current price is attractive or that yields can continue to fall forever. At this point the potential upside to bonds is small while the potential downside is quite large.

Bonds, unlike stocks, commodities, or other assets, do have a theoretical maximum price. Except during a period of extreme volatility, yields can never fall below zero. In a world in which discount rates across all maturities fell to zero, the theoretical value of a bond would be its face value plus the cash value of any unpaid coupon payments. We’re not to that level of pricing yet, and it would be highly unlikely that we will ever get there. But as Japan’s experience in the 1990s and 2000s proved, yields can stay lower than anyone thinks possible for longer than anyone thinks possible.

I’ll wrap this up with some fairly straightforward trading advice. Given their current yields, Treasuries are not attractive as a “buy” right now. But given the deflationary forces still plaguing the economy, I wouldn’t be shorting them either. It might be best to simply avoid them altogether.

Charles Lewis Sizemore, CFA
Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

My lack of regard for GM is obvious, as I remain opposed to the way the situation was handled and continues to be handled.  However, the facts on the ground are exactly that - facts.  GM rec’d a bailout of $50 billion plus. Secured bondholders were passed over.  Unsecured creditors in the form of Union Pension Healthcare Trusts were put at the front of the line.  Pensioners, existing and prospective, were NOT required to move to the PBGC and begin receiving the PBGC schedule of benefits as required by law, instead these groups were allowed to retain their exceptionally generous benefits.

Now GM is going public and current estimates put a value on the company of $60-70 billion, and show net profits of $12 billion per year over the next several years.  That’s a good thing, because the company will need it.

According to a GAO report from April, GM continues to use “credits” for past contributions to fulfill its current year pension funding obligations, and anticipates using these “credits” next year.  These credits are a hall pass that the company receives because of past contributions.  However, the pension funding at GM, the new and improved debt-free GM, is a negative $26 billion.  While 2009 helped out a little bit because of gains, the liabilities continue to grow while the company is contributing “credits.”  The GAO estimates that in the years 2013 and 2014 GM will have to contribute over $12 billion. 

I fully expect the IPO to go well.  I presume demand will be strong domestically and internationally.  But that doesn’t make the company a good deal.  Caveat Emptor.

Neil Howe, who previously co-wrote several groundbreaking books on demographic trends with William Strauss (Generations, The Fourth Turning, Millennials Rising), published a new book in 2008 with Richard Jackson: The Graying of the Great Powers: Demography and Geopolitics in the 21st Century.
We consider Howe’s prior work with Strauss to be required reading for anyone wanting to understand the role that demographics have played in recent history, particular the interplay between the major generations (Baby Boomers, Echo Boomers, etc.). We would say the same Howe and Jackson’s new book, though readers who are already familiar with Philip Longman’s work, particularly The Empty Cradle, might find it to be somewhat redundant.

Graying covers many of the same themes covered by Longman and others — the usual doomsday (though completely accurate) scare statistics about Europe’s demographic decline, the coming pension and health funding crises and probable wave of national bankruptcies — and combines them with some of the geopolitical themes discussed by Mark Steyn in America Alone and Patrick Buchannan in The Death of the West (though without Steyn and Buchanan’s abrasiveness and charged ideology) and to a lesser extent those covered by George Friedman in The Next 100 Years.
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General Motors filed an S-1, which is the form required for a company to “go public.” This is odd in itself, as GM still IS public, or at least what is called the “old” GM, the one with all those pesky losses in it and the plants that no one wants still trades.  But meet the NEW GM, the one that had all debts forgiven, was cleansed of any burden from the past, given a fresh start by reneging on all of its debts except those deemed important by the US govt.  This new GM, in filing to sell shares of itself to the public, is embarking on one of the hallmark activities of capitalism.  This filing comes only 18 short months after receiving the largest federal bailout in the history of the country in which capitalism was utterly destroyed, where private investors with a legal claim to assets were told to pound sand in favor those the government appointees deemed more worthy.

The government has chosen banks - yes, those it also bailed out and guaranteed - to participate in the underwriting of the shares, thereby guaranteeing another profit, and has launched a feel good campaign to encourage prospective stock buyers to line up at the trough.  And who wouldn’t?  The situation couldn’t be more favorable.  A badly run company goes billions into debt and can’t possibly survive, but it is propped up by the government in the name of, well, something I’m sure.  With a fresh start the company claims operating profits almost immediately.  It’s a miracle!  This company should mint money going forward, right?  Right. 

There will most likely be some gains to be had, especially given that S&P and Dow Jones won’t be able to ignore the new company.  Shortly after it’s IPO, look for the new GM to be added to the two large cap indices, thereby guaranteeing a buying spree, goosing the shares.

If you look under the hood, the facts aren’t so attractive.  None of the money raised for stock will be used to do anything useful.  It will simply be funneled to existing owners - the US govt, the unions, and a pittance for old bond holders.  What does this do for the new GM?  Nothing. No money for operations, no nothing.  The company claims it will throw off the shackles of government control, freeing the company to make bolder, quicker decisions.  That didn’t work out so well last time, and that pesky government control came w/ $50 billion and a get-out- of-jail-free card.  Not bad.

The real meat is in the preferreds.  GM will sell shares of a preferred class that will pay interest.  Anyone with synapses firing should consider these interest bearing certificates as good as US government paper, since the company will still be 50% owned by the government, and the feds have shown a willingness to support the company in the past.  I’d imagine these securities will run up in value dramatically, capturing a hefty profit for whoever owns them.  Oh, that’s right, the securities will most likely be owned  by the same banks that we bailed out, guaranteed, and then gave business to.  Expect the banks to take down the preferreds for their own accounts and the accounts of selected clients, and then mark them up dramatically.

It’s time to sell the Suburban.

An article I wrote was picked up by Morningstar and appears on the front page  today, 8/17 -  Life In The Great Recession. 

Here’s a cheery headline from today’s Financial Times: “Japan looks for positives as it succumbs to the inevitable.”

The article was in reference to China’s recent overtaking of Japan to become the second largest economy in the world after the United States.  But given our research at HS Dent, it could be taken to mean so much more.

Japan is the oldest country in the world by median age of population, and this is only going to get worse.  The population is already shrinking.  The country desperately needs new babies for its future, but young Japanese do not have the means or perhaps the desire to have them.  But even Japan commenced a new baby boom today, the damage has already been done by 30+ years of low birthrates.

Meanwhile, Japan’s debts continue to mount and today total more than 200% 0f GDP.  How will these debts be paid?  Who is going to care for Japan’s elderly in the years ahead?  And what happens to a country that slowly grows old and dies?

These are unanswerable questions.  But they point to an inevitable decline–and possible collapse.

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Charles Lewis Sizemore, CFA
Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy