September 2010
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You Dream Of Columbus

Here In This Blue Light Away From the Fireside, Things Can Get Twisted And Haunted And Crowded.  You Can't Even Feel Right.  So You Dream Of Columbus...Although we’re probably talking to ourselves here, clearly one of the toughest things for investors to do really at all points in time is to differentiate between “noise” and important information.  For our current generation, maybe this has never been truer than is now the case in the current market environment.  Not only has technology upped the ante in a big way in terms of the potential for digital information overload, but real world economic and financial market circumstances in which we now find ourselves are anything but what today’s investors have come to know over their careers or really lifetimes for that matter.  In terms of potential remediation, we have seen the Fed/Treasury/Administration follow the script of the historical playbook in terms of trying to right the economic ship via fiscal and monetary policy paths similarly taken over the last half century.  In fact, it has really been fiscal and monetary policy on steroids that has characterized the current cycle.  But as of now, all to no avail as domestic employment, personal income growth and stability in the housing market remain elusive.  Add in a good dose of a changed daily market environment vis-à-vis the computerization of “trading” (not investing), and we have the table literally set for emotional and behavioral volatility.  Exactly the meal of the moment, no?  Of course this is capped off with the convergence of globalization of the economy unlike anything seen in centuries just to keep it all simple, right?  A lot to swallow and quite naturally an environment where what would have been historic outcomes that could have been anticipated with at least some degree of confidence in prior economic cycles are anything but certain looking ahead.  Can we call it the "new world"?

Very much like the voyage of Columbus, this new world the current generation of investors is now discovering has not been uninhabited.  “People” have before been in this new world of economic and financial market circumstances.  It’s just that the current generation has never yet set foot upon this land as it is now doing.  In one sense, we see this tension and angst reflected in the financial markets themselves.  Although this is a bit of a one off, the following combo chart is simply an update of 2007 peak to 2009 trough Fibonacci price retracement levels for equities, using the Dow, S&P and NASDAQ as proxies for equities broadly.  Of course the obvious observation is that equities reflect the confusion and uncertainty briefly described above.  You already know that in April of this year the Dow and S&P were stopped dead in their tracks literally at their respective 61.8% retracement levels.  At least for the S&P, the correction so far saw a drop back to near the exact 38.2% retracement level before the inevitable price bounce occurred.  It’s infrequent to see this type of near pinpoint precision.  It’s surely a bit of a tangential comment, but when (not if) these major equity indices break out of these classic Fibonacci retracement ranges in one direction or another, the equity market will be making a very loud and strong statement about character and direction.
               

Lastly, before pushing ahead and getting to the point, one more quick look at a number of Fibonacci retracement levels that seem to have already done their speaking, and quite loudly for that matter.  This time around we’re looking at the five and ten year US Treasury yields.  Although the combo chart below has been truncated a bit to cover the late 2007 to current period, the yield retracement levels you see are marked from the yield peaks in 2007 to trough yields into late 2008.  Quite the different pattern story relative to the rhythm of equities, no?  Five year Treasury yields barely retraced to a level just above the 38.2% number prior to peaking in mid-2009, long before thoughts of a double dip even entered mainstream questioning and commentary.  Five year Treasury yields never even made it half way back to their 2007 yield level highs.
                    

At least in terms of Fibonacci rhythm, the ten year UST yield movement has been much more classic and very much like what we are now seeing with equities.  Off of the lows in late 2008, the ten year UST yield retraced almost to the 61.8% level exactly as we have seen with the Dow and the S&P up to this point.  From there it was a trip back down through the 50% level to the 38.2% retracement level, again exactly as we have seen with the SPX and darn close to the Dow pattern also.  For a good year from April of 2009 through June of 2010, yield volatility was the order of the day for 10 year interest rates within the classic Fibonacci band levels, again very much as has been the case with equities up to this point.  But in the last three months the vote of the market has been definitive as UST yields across the board have plunged, breaking below their respective 38.2% Fib retracement levels to the downside.  US Treasury market statement received loud and clear, no?

You already know that the dichotomy between equity market and fixed income market movement has been a point of controversy over this same roughly prior three month period.  Just which market is correct in terms of the message contained in price regarding what it "sees" for US economic fundamentals ahead, the equity or fixed income markets?  Theoretically, history has told us that credit markets are the smart money.  But again in today's world of computerized trading/chasing and levered hedge money whose primary focus is short term performance, recent momentum in Treasury prices at least makes us step back and question short term fundamental messages academically contained in financial asset price movement versus flat out herd momentum.

So we come back to the question of noise versus important information.  And in light of the a bit at odds "messages" of the above charts covering equities and Treasuries, we want to spend just a few minutes looking at longer term and very big picture issues.  A lot of this we have covered in the past.  But what we believe is important right now is this.  To the point, investors are looking into the back half of 2010 and early 2011.  The fact that the macro domestic US economy is slowing is now mainstream consensus thinking, no longer a question mark.  The issue to be resolved, which we believe will determine the Fibonacci "breakout" direction to come of equities, now that Treasury yields have already spoken, is whether the current slowing in the US economy is a normal "mid-cycle slowdown", or something very different.  Of course the correct answer will very much be a key to successful investment outcomes dead ahead.

Long time readers know we are credit cycle junkies by character.  So much of our commentary over the last decade plus has been interwoven with credit cycle analysis and anecdotes.  We need to revisit this in very big picture terms one more time.  For as melodramatic as this may sound, we need to question whether the US has already hit some type of secular "tipping point".  If that is indeed the case, economic and financial market outcomes ahead will be anything but replays of economic cycles of the past century plus.  And we'll draw a bit of a line of key differentiation right here using the word/characterization ALREADY.  As we see it, and this very much relates to the world of Treasuries among other things, many in the investment community expect the US to hit a tipping point somewhere ahead regarding systemic leverage, with particular emphasis in the current cycle on sovereign debt.  No big surprise as this has been exactly what is playing out in the global sovereign debt periphery of the moment with Greece, Spain, et al.  In recent discussions we have even said that at some point Treasuries will be a fantastic short.  But this type of questioning implies the proverbial tipping point is yet to come.  Theoretically that tipping point will come when the global financial community is no longer willing to fund the US at historically low nominal interest rates, or no longer allows the Fed to do the same via the printing press.  But is the consensus or mainstream thinking regarding tipping points too narrowly defined?  We believe that is exactly the case.  And if we are even close to being half right here, we suggest this tipping point that relates to the credit cycle the US has ALREADY hit will have a very meaningful impact on investment outcomes ahead.  We just hope we are focused on the important information and not the noise of the day.

We promise we'll try to run through this relatively quickly.  First up is a chart you have probably seen a million times by now - the very long term history of US credit market debt relative to GDP.  You can see that we have drawn in the line corresponding to the prior peak in this ratio that occurred during the prior generational US credit cycle debacle of the 1930's.  To refresh your memory, in a number of our prior discussions we have asked the question whether this demarcation line was a very meaningful line in the sand for the US economy and financial markets.  As per the tipping point comments above, this is ground zero.  Why?
           

During the 1930's, the relationship you see above exploded to the upside due to a collapse in GDP, although admittedly prior period credit cycle excesses of the 1920's and very early 1930's were generational in character and magnitude at the time.  The ratio peak seen in 1934 was again breached to the upside for the first time at year end 1999.  In brief, since that time, as is completely clear in hindsight, the US equity market has been in an extended trading range (you already know that is a very kind characterization).  The buy and hold strategy that worked so well from 1980 - 2000 has hurt investors materially in both real and nominal terms since then.  Breaching that 1930's peak debt ratio level ushered in a formal US recession that was actually short lived because of systemic leverage acceleration.  And that of course leads to the important question again of tipping points.  When does systemic leverage become too much for an economic and financial system to service and when does it begin to change the very character of an economy in perhaps secular fashion?  Please remember this question as we look at some data.

The table below is again a repeat and update of ones we have shown you in the past.  Question to be answered - decade by decade how much additional leverage has it taken for the US economy to produce an additional dollar of GDP growth?  And of course prior to having this somehow officially confirmed, where does the US economy hit the mythical tipping point at which additional leverage becomes counterproductive?

Certainly the important column in the table is the number of dollars of credit market debt expansion per dollar of GDP growth.  The 1950' s through the 1970's showed us relative stability, but demographics driven by the coming of age of the boomers combined with the "financialization" of the US economy that began in the early 1980's materially changed the character of this relationship.  Again, although we believe the consensus is still looking ahead in the search for a proverbial and mythical tipping point still yet to come, we suggest to you it has already arrived.  Why?  The chart below begins to answer the question.  Again, these are updates of data you have seen in the past, so there should be no surprises here.  The top clip below reviews the prior six decades of US payroll employment growth.  Over the half century of the 1950's through 1990's, US payroll expansion in each decade was very near 20% or greater.  Does the prior decade of the 2000's look like a tipping point to you?

The bottom clip of the chart reviews percentage growth by decade of nominal dollar US GDP and total US credit market debt as a percentage of GDP in each decade.  The message here is absolutely unmistakable.  As credit market debt as a percentage of GDP began to accelerate meaningfully in the early 1980's, decade by decade GDP growth began to decline until we see the lowest GDP growth for any decade of the last six during the prior 2000's decade.  
                 

Growth in nominal dollar US credit market debt in the prior decade was greater than nominal dollar growth in credit market debt in the prior six decades combined!  Yet growth in GDP for the decade alone was slower than any decade of the prior six.  Again, has a tipping point ALREADY been breached?  Yes or no?

You Dream Of Columbus Every Time When The Panic Starts.  You Dream Of Columbus, With Your Maps And Your Beautiful Charts...Very quickly, another way to look at the relationship of total US credit market debt and its secular relationship to GDP growth is again to put the numbers in time period specific format, but this go around we are looking at a more high frequency five year moving average of US nominal GDP growth as opposed to the decade by decade view above.  Why look at it in this light?  Give us just a minute to explain.  We've inserted the red bar into the chart that of course coincides with the post war peak in the five year moving average of US nominal GDP growth.  That red bar also coincides with what we believe was the generational acceleration point for US credit market debt relative to GDP again largely driven by boomer demographics and the beginning of the "financialization" of the US economy.
              

We see the message here as obvious and simple.  Past a certain "tipping point" the more leverage an economic system assumes, the lower will be its ability to grow its economy.  Certainly the irony of the moment is that as per the actions of the Fed/Treasury/Administration, it appears that these merry pranksters not only believe just the opposite, but are practicing such.  Unfortunately the message of historical experience is ruthless and unambiguous.  But just as unfortunate is that the powers that be are still married to the directional fiscal and monetary policies employed during the secular cycle of leveraging up systemically while it is clear as we all know that deleveraging is now the key systemic construct, especially at the household (consumer) level.

As we mentioned, the voyage of Columbus is analogous.  Although it seems we've entered a new world for the US economy and financial markets, history is replete with other new world experiences and inhabitants of "new worlds" that have gone before.  Although it is clearly a poster child example at this point, we all know the Japanese government has been levering up for two decades in an attempt to slay a deflationary/private sector deleveraging dragon, all the while playing don't ask don't tell with financial system collateral values.  Sound familiar?  But what has happened to the reality of the Japanese economy as systemic leverage has accelerated?  Does the following chart tell the story of the outcome?  One more time, below is a similar five year moving average of nominal dollar and non-seasonally adjusted (that's the reason for the spiky chart) Japanese GDP.  Is it fair to say in the clarity of hindsight that the Japanese economy hit an important "tipping point" in 1990?  And this is despite the fact that Japanese government bond yields trended toward zero over this period shown in the chart below, much as we have seen in the trajectory of UST yields as of late.  As of 2001, the Japanese economy had not grown at all even in nominal terms over the prior ten year period.  And through to the present it has actually now contracted a bit over the most recent ten years.  Is this the type of trajectory that lies ahead for the US?  We'll be the first to admit the US and Japanese economies are two very different animals.  But we also suggest cycles of systemic leverage expansion and contraction travel within the immutable laws of economic gravity.
                

One last tiny issue (and maybe not so tiny) as you look back at the US experience of five year GDP moving average growth.  In mid-2008 the five year MA of US GDP broke to a new low for the history of the data at the exact time the US was gearing up for extraordinary fiscal (debt financed stimulus) and monetary policy (printing money, TARP, etc.) implementation.  Think about this very simple statement - as US fiscal and monetary policy was about to go into historic and unprecedented hyper drive a few years back, the longer term rate of domestic US economic growth was just then breaking to new historic lows.  As of 2Q 2010 with unprecedented fiscal and monetary policy already in full bloom, the current five year growth rate of US GDP is now the lowest on official record (over the entire official history of BEA data).  As we see it, a very important tipping point has already occurred.  Simple question, does new historic lows in the long term rate of US GDP growth argue for higher or lower equity valuations in the current cycle?

You Dream Of Columbus And There's Peace In A Traveling Heart...We'll make this summation short as we'll be addressing components of this in discussions directly ahead.  First, why the occurrences of what appear to be macro tipping point anomalies discussed above?  This should not be new news to anyone, but we are in the process of unwinding a generational credit cycle.  This is a balance sheet recession that is fundamentally different than inventory led or Fed induced (taking away the punch bowl) recessions of the post war period.  Yet we see the Fed/Treasury/Administration traveling down a remedial path assuming a typical post war recessionary experience.  It is not.  Secondly, as we hope we have elucidated above, there will be a downward bias to US domestic economic growth as long as the US government is levering up.  Third, economic and financial market volatility and a certain sense of fragility should surprise no one.  They are to be expected in the "new world" of the moment and factored into ongoing decision making.  For now, we find ourselves within the confines of a range bound market where active asset allocation and a focus on risk management are primary behavioral objectives.

As we see it, as per the macro dictates above, what is appropriate thematically is a focus on yield/total rate of return.  In a low nominal rate of return domestic economy buffeted by deflationary private sector tides, income is a scarce resource.  Concurrent with this must be a focus on risk management as yield oriented equities can and will suffer top line pressures that can translate into bottom line "bumpiness".  A second thematic focus we believe to be important is purchasing power protection within the context of a globalizing economy.  Without question, the Fed/Treasury/Administration will do everything in their power to reflate the system.  Monetary debasement has been and will continue to be a reality.  The trick, of course, is navigating how this affects the ongoing rhythm of financial asset prices.  Personally, we want exposure to this theme not only to protect against currency debasement, but with an additional demand/supply kicker behind it.  Is oil the poster child asset class for this theme given increasing emerging market fundamental demand?  Inclusive in this theme is also precious metals, industrial metals in general and importantly ag exposure.

Finally, we want exposure to longer term fundamental economic growth.  Quite naturally, and really in line with current consensus thinking, the emerging markets are a fit.  But again, we expect volatility to be the rule, especially near term as 2H slowing will not be confined to the US solely.  We expect China's GDP trajectory to slow.  Again, within this context of a greater global macro range bound market, we want to buy panic and fear.  You'll know it when you see it and at the appropriate time to buy, the key signal will be no one will want to.  Absolutely no one.  In addition to emerging market equity exposure, the very large global blue chip behemoths offer reasonable valuations, strong balance sheets and cash flow, and longer term exposure to the global/emerging economy.  Remember, current valuations are reasonable, not dirt cheap and not characterized by sheer investor terror.  We'll have a lot more to say about these themes in discussions ahead.

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