It ain’t over until it’s over
Today’s Financial Times reports of how the bullish market of the past few months has tumbled again. Trust me, I know this personally because my shares in Investopedia’s Stock Simulator are all in the red. Lucky Tan wrote for example on how the stock market tends to anticipate economic recoveries. So did Singaporean Skeptic (although I really don’t see what conditional probability has anything to do with this). The grandfather of value investing, Benjamin Graham, mentor of Warren Buffett, also said likewise.
But enough about who had anticipated what. Back to the FT report:
The downbeat commentary reinforced the view that investors should be more worried about the impact of economic weakness on corporate profits than the possibility of higher inflation and interest rates.
“We have had a great run in equities, emerging market currencies, credit and other risky assets, now people are struggling to justify lofty valuations,” said Alan Ruskin, strategist at RBS Securities. He added: “The ‘green shoots’ argument for the economy was very tentative to start with.”
Executives in charge of the largest US companies sent a signal of their concerns by selling far more shares than they bought this month, according to data based on Securities and Exchange Commission filings.
Share sales by so-called company insiders are outstripping purchases so far this month by more than 22 times. TrimTabs, the investment research company, said insiders of S&P 500 listed companies have unloaded $2.6bn in shares in June, compared with $120m in purchases.
“The smartest players in the US stock market – the top insiders who run public companies – are not betting their own money on an economic recovery,” said Charles Biderman, chief executive of TrimTabs.
The evidence for genuine economic recovery seemed rather weak to start off with. Markets were rallying because economic data for the past few months was not as bad as feared. The results of the sham bank stress tests, which were heavily influenced by the target banks themselves also lent hope to recovery. In reality, the fundamentals were improving, but in the minor sense that they appeared to be not worserning. That’s a whole lot different from it actually recovering. For those who still remember single variable calculus: Just because the second order derivative of a function appears slightly positive doesn’t mean that the first order derivative is. It’s an indication of a possible turning point rather than actual positive growth.
I won’t be dwelling on this lest others accuse me of relying on hindsight’s 20/20 to thrash those who believed the rally was at least weakly sustainable (personally I didn’t know what to believe, apart from expressing the occasional skepticism), especially since I did not explicitly state that I believe the equities rally was unsustainable. Corporate lending fell in May, which is hardly a sign of sustainable economic growth. Of course this data wasn’t available whilst it was being tallied last month.
Also of note was how future mortgage writedowns could easily drag the financial sector down again:
Are The Banks Paying Back TARP Money Too Soon?
Since the beginning of the year, major banks have raised over $200 billion in capital, far in excess of the $75 billion of new capital that the government stress tests had called for. The market prices of major bank stocks have recovered dramatically since March, indicating that Wall Street investors see a recovery in the banking industry.
In addition, the banking industry is enjoying one of the largest net interest margins in history due to a very low cost of funds. Wells Fargo (WFC), for example, in the fourth quarter saw its average cost of funds decline to 1.5% while its net interest margin exceeded 4%. With banks able to access cheap funding thanks to the super low rate money policy of the Federal Reserve, banks almost have a license to print money.
The big question is will the banks be able to earn enough to offset the huge amount of future write downs that will be needed on their troubled loans? Earlier this year, Bloomberg reported that the International Monetary Fund (IMF) estimated U.S. banking losses through 2010 at $1.06 trillion. To date, the banking industry has taken write-downs of only half that amount, indicating further write-downs of an additional $500 billion will be necessary.
One last rhetorical question: Where does this leave fears of inflation? I leave that to the reader.
Update: See this paper for a comparison of the Great Depression with today’s downturn. This graph is particularly striking:
There appears to be a misprint here. It should read April 2009 instead of April 2008.