Downturn ahead?

With economic data getting worse and markets looking shaky, the question on everyone’s mind seems to be: our we heading into another economic and market downturn?

Specifically, economic and market data in the U.S. are rolling over, Europe seems to be in full-out recession, and China is growing more slowly with its manufacturing sector even pulling back. This makes everyone wish they knew whether recent trends will continue down, or if a rebound (or central bank support) is on the way.

The reason people care is that it makes a BIG difference on short term returns. If the economy and markets roll over, then you want to be in long bonds, which do great under that scenario. If recent numbers are just a head-fake, and we’re going to see growth resume, you want to own stocks and commodities because they’re dirt cheap assuming growth resumes.

But, the above thinking assumes that it’s possible to know whether the economy and markets will turn down or resume growth. Such an assumption is, however, suspect.

Can experts accurately predict either economic or market downturns? Their track record, contrary to popular belief (and the amount of money you pay for it), is terrible.  

Economists and market strategists, brilliant people who parse economic data on a full-time basis, are dreadful forecasters. As a group, they have never–not once–predicted a recession beforehand. 

Individually, most of them are wrong most of the time. Every once in a while, an economist or market strategist “correctly” predicts a recession or rebound, but no one–and I mean no one–gets it right more than a couple of times. 

Keep in mind that a broken clock is right twice a day–that doesn’t mean it correctly tells time. A market strategist who calls for a downturn all the time will look right one third of the time, and an economist who always calls for growth will be right two thirds of the time. That doesn’t make them accurate forecasters, and that won’t help you get into and out of investments at the right time.

If the experts are consistently wrong, maybe the right place to look is the aggregate opinions of millions of market participants.  Do markets correctly predict market downturns or rebounds?  Not at all.  One famous quote is that “the stock market has predicted 9 of the last 5 recessions.” Translation: markets predict recessions and rebounds much more frequently than they actually occur.  Once again, such guidance does investors more harm than good.

Well, if brilliant experts tracking all the data can’t get it right, and the judgment of crowds can’t do it, what’s to be done?  

First off, accept the premise that, at present, no one has figured out how to consistently time markets over the short term. It’s like forecasting the weather–it’s such a complex and adaptive system that no one knows what’s going to happen ahead of time (even though they can tell you precisely what happened in the past). 

If no one can successfully time the market, then don’t try to do it–don’t try switching in and out of stocks, bond and commodities in a failed attempt to get better returns. Channel Nancy Reagan and just say “no” to market timing.

Instead, do what has worked over the long run: buy cheap and sell dear. Instead of spending gobs of time, effort, and money trying to guess market direction, spend your time trying to figure out which companies to buy and then calculating what price to buy and sell them (relative to underlying fundamentals).

It doesn’t work every time, and it won’t necessarily work over the short term, but it does work over the long term with a high degree of confidence.

Avoid the rat-race of unsuccessfully wondering if a downturn is ahead, and focus instead on underlying value. Your results and your psychological well-being will be better for it.  

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Downturn ahead?

Surmountable mortgage mess

I’ve been watching the housing and mortgage markets with great interest for years.

When working for my former employer (2002-2005), I watched (but didn’t follow) as he doubled- and tripled-down on investments associated with the housing market.  As his employee, I worked hard, struggling to understand the individual investments, but never fully got my arms around them.  I knew enough to be very cautious, but that was all. 

Now, after watching the boom and bust over the last decade, I believe I have a much better understanding of how the housing, mortgage and financial markets work (or don’t work) together.  I’ve watched, researched, studied, invested and blogged on the subject over the last six years (my blogs from the spring, summer and fall of 2007 are particularly revealing of my concerns). 

So, it was with great interest that I read an article in the Wall Street Journal today, The Mortgage Hangover.  I highly recommend it to anyone who sincerely wants to understand the boom and bust of the housing and mortgage markets over the last decade (and not just looking for evidence to confirm one’s conclusions beforehand).  The article is not perfect, but it does a great job of highlighting many of the important details.

Specifically, it describes how the mortgage market was distorted over the last decade in the Bronx.  You may think that Bronx real estate has nothing to do with Florida, Nevada, California or Colorado real estate, but it does.  In fact, I believe it represents a microcosm of all U.S. real estate.

The problem started with well-meaning politicians who wanted everyone to have a home.  That problem was exploited by real estate and finance workers who were heavily incentivized to take things to the brink (which was the inevitable result of bad policy).  When those problems led to collapse, the same well-meaning politicians tried to prevent the resultant suffering.  Once again, those efforts are creating new problems instead of solutions.

The good news is that the mortgage and housing problems can be fixed.  It requires that housing and mortgage markets be allowed to reach clearing prices (where free buyers and sellers agree to exchange without any distorting incentives from politicians).  When that happens, housing and mortgage markets can begin growth afresh. 

I’m not saying the process will be pretty, but it will happen.  The destination will be the same no matter how well-meaning those who disagree.  The only question, now, is how quickly or slowly we get there.  Policy can impact the duration of the pain, not its intensity.

The bad news is that politicians and voters are unlikely to take the fast approach.  This is unfortunate, because U.S. economic and employment growth are unlikely to recover until the housing market recovers.  The longer we put off clearing prices in the housing and mortgage markets, the longer until employment and our economy truly improves. 

Mortgage and housing markets need not wallow in freakish misery.  Recovery, both for those markets and the U.S. economy, could start soon.  But, with continued meddling in housing and mortgages, recovery will take much longer and be much less robust.  It’s time to face the inevitable, hold our noses, and take our medicine.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Surmountable mortgage mess

Exit strategy

It’s no secret, the world economy was propped up last fall and winter by the governments of the United States, Europe and China. If it weren’t for those props, we would probably still be on the way down.

The question now becomes, how will the governments of the world remove those props?

In ancient Rome, building an arch required props, too. Once construction was complete, the props were removed and the arch would stand firmly in place. It is rumored that the builder would stand underneath the arch as the props were removed to show how confident he was in his construction.

The reason why such a builder would confidently stand under his arch is that he knew the arch would hold when the props were removed. My question is: how confident is anyone that world economies will stand on their own without props?

I think current builders have demonstrated their confidence by both not removing the props and by only tentatively talking about their exit strategy, which is a euphemism for removing the props.

How can the central bankers of the world and various treasury departments know when to remove their props? This is a tricky question.

If they remove the props too early, the economy will go back into recession. If they wait too long, then high interest rates and high inflation may do the same thing. The governments of the world have a very difficult task ahead of them. I don’t envy their position.

But, as an investor, I have to wonder what will happen.

Will the world economy stand on its own even though the fundamental underlying problems really haven’t been addressed?

Are government bureaucrats aware that a huge number of mortgage loan resets are coming up and may send the housing and credit markets back into decline?

Have individuals and companies trimmed expenses enough to foster self-sustaining growth?

I don’t have any answers to those questions, but I know I’m not going to be standing under this particular arch as the props are removed.

Instead, I’m repositioning my clients and my own money to prepare for the possibility of a wobbly arch. That means buying high quality companies and perhaps a little insurance against the downside. It means being prepared for the possibility of both deflation and inflation.

It will be interesting to see what happens, even more so a good distance away from the arch.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

It looks like a slow economic recovery is on the way! (but that doesn’t necessarily mean we’re out of the woods)

At long last, there are some pretty solid signs the economy may recover soon.

This week, both the weekly initial jobless claims report and the monthly unemployment report showed improvement. Initial jobless claims have been high, but declining, which usually happens several months before the economy starts growing again. The monthly unemployment report showed high and growing unemployment, but with much fewer jobs being cut by employers.

These reports aren’t saying the employment situation is getting better, just that it’s getting bad less quickly. But, that’s always the first necessary step to an economic recovery.

You see, unemployment almost always peaks long after the economy starts growing again, so it’s normal for the employment situation to be getting less bad when the economy turns.

Not surprisingly, the stock market anticipated this situation. The market has been rallying since March, showing once again its predictive ability. But keep in mind, the stock market has forecast 9 of the last 5 recessions and 9 of the last 5 recoveries.

That’s not a typo, the stock market frequently tanks or moves up falsely, indicating things are getting worse or improving when that isn’t the case. In other words, it’s not a great indicator by itself, but it is a good indicator in concert with others.

Adding to information from employment and the stock market, the Chinese government is working hard to stimulate its economy, and it looks like those efforts have been successful so far. Unlike the U.S. government, the Chinese government actually has money to stimulate their economy instead of simply borrowing from others to stimulate. This doesn’t mean the Chinese government’s efforts are efficient or even sustainable over the long run, but for now it’s working, and they have a lot of money they can spend to get things going.

Putting these data points together, along with retail sales, copper prices, industrial activity, inventory levels, and so forth, it looks like an economic recovery is on the way.

How will this impact investors? Good question. As usual, I don’t really know what will happen in the short run.

This could be a V recovery, a sharp economic rebound, a U recovery, a long slow period followed by faster growth, a W recovery, a sharp rebound followed by another slowdown followed by a sustainable recovery, or an L “recovery,” where we don’t really recover so much as things don’t continue getting worse. An L recover is really a U recovery where the base of the U is very, very wide. Think Japan over the last…well…20 years.

If a V recovery is in the works, the stock market could just keep going up. It won’t move straight up, because conflicting information will cause temporary setbacks, but on the whole it will not reach new bottoms and will trend upward over time. That would be the most fun, but I believe it’s the least likely scenario. It’s possible, though.

A U or L recovery would mean the stock market has gotten ahead of itself, and if companies start pre-announcing that things don’t look that great for the 3rd and 4th quarter, the market would probably tank. The market’s recent move indicates V or W with strong growth and earnings beginning late this year or early next. If that doesn’t happen, market participants will be very disappointed and prices will decline, perhaps significantly.

If a W recovery is in the works, the market could go up for the next year or more, only to crash again as the current nascent recovery turns out to be a false dawn followed by another recession. Unfortunately, I see this scenario as quite likely. Government stimulus may lead to higher inflation and high commodity prices, which could send the economy right back into recession.

My guess, and I’ll admit its no better than that, is that we are in a W recovery. That means enjoy the rally for the time being, but be prepared for another downdraft in a year or two. This may sound unpleasant, but it will produce many opportunities to make money both on the up and the downside. That’s what happened in the late 1970’s and early 1980’s. There was a lot of money to be made on commodities during the turmoil, and then the greatest bull market of all time began in 1982.

The next most likely scenario, in my opinion, is a U/L recovery. This would be no fun for most investors, but work out fine–over the long run–for the prepared. It would provide a lot of false dawn rallies and several exploitable downdrafts. That’s what the 1930’s and 1970’s looked like, as well as Japan over the last 20 years.

The V recovery, which I consider least likely, would, I believe, look like the recoveries we saw after the late 1990-91 recession and the 2001 recession. In both cases, the market didn’t really take off until a couple of years after the economy left recession. In both cases, they were referred to as “job-less” recoveries, with economic growth and very slow employment improvement.

As you may have noticed, I didn’t include any scenario where the market just takes off into a 20 year bull market with annualized returns of 20%. That’s because I consider such a scenario so unlikely as to be hardly worth mentioning. It’s possible, but I wouldn’t bet on it.

It feels a lot better to be talking about recovery than it did talking about how bad things were last November or March. However, I believe the market may be getting ahead of itself in predicting robust growth by year end. It might be a good time to take some profits and sit on a little bit extra cash.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

New Bull Market, Or False Dawn?

Has the stock market finally turned the corner? Is the economy really recovering? Is it time to throw all your money at the market?

Everyone would love to know the answer to these questions–including me–but no one does. Someone may guess (like I will below) and be right, but that will be luck, not skill (that’s why market strategists are like diapers, they require frequent changing, and for the same reason).

Why can’t anyone know if the market and economy are finally recovering? Because it’s too complex. Why can’t I gather enough data to figure out precisely how many inches of rain will land in a square foot in my back yard this month? Same reason: it’s too complex. Knowing all the inputs doesn’t tell you the outcome. Markets are even more difficult to precisely predict than rain, because the weather doesn’t possess freewill, but investors do!

There are strong psychological reasons for wanting to know what the market and economy will do. No one wants the regret of investing and then watching the market tank by 50%. For that matter, no one wants the regret of NOT investing and then watching the market double, either.

The fear of regret drives people to look for all kinds of clues, but such searching and wishing won’t bring the answers. You can’t reap the benefit of market returns if you sit on the sidelines. You have to put your money at risk and then either win soon, or win later. Not a bad bargain, when you think about it.

Okay, enough rambling, what do I think about the market and economy? I believe there are faint glimmers that the economy may be starting to turn. Those signs come in lower claims for unemployment, a slight rebound in factory activity, a pickup in activity in China, better than expected retail sales, and stronger than expected exports.

Do those glimmers mean the economy definitely will recover? No (please reread above if you expected the answer to be yes). There is still plenty of bad news out there, like higher credit defaults, higher foreclosures, more bankruptcies, higher unemployment, weak car sales, etc.

What about markets? Does a market recovery require an economic recovery, first? Probably not. Markets anticipate improving fundamentals and tend to turn up first, usually 3 – 9 months before the economy does. The stock market’s rebound is one of the main reasons many believe the economy may be starting to recover.

I tend to think that the market and economy have yet to turn up, but that’s just a guess. The problems that got us into this situation–housing and credit markets–are still in serious pain. Just because housing starts and prices are declining at slower rates doesn’t mean happy days are here again. The economy and markets will probably recover before housing and credit do, but I think there is still a lot of downside there before things turn up.

Also, the stock market has only been going down for 1 1/2 years. This is the worst economic downturn since the Great Depression, so markets will probably be down longer than usual. The 2001 recession was one of the mildest on record, yet the stock market took 3 years to hit bottom. Granted, valuations were higher in 2000 than in 2007, but that doesn’t account for everything.

Also, the consensus of leading economists think the economy will recover late this year or early next. Those folks are almost always wrong! Guess how many of them predicted this severe recession even with over-extended credit markets and declining housing prices staring them in the face? Zero, zilch, nada, not a one. If those folks didn’t see this coming, then why should I believe they correctly see the recovery? I don’t.

It’s possible the economy could start to recover toward the end of this year or early next year, and that would indicate an increasing stock market now, this summer or this fall. But, the stock market could also go down much further into this fall (2009), spring of 2010 or fall of 2010. Who knows? I don’t, and I don’t know anyone else who does or can, either.

It’s also possible the economy starts to recover only to enter another recession in 2011 or 2012. That’s referred to as a double dip recession, and it happened in the late 1970’s and early 1980’s. That was the worst recession we had had since the Great Depression, until this one of course. A Double dip recession could easily be caused by the Federal Reserve raising interest rates too soon, or by raising them too slowly and causing enough inflation to send us back into a scenario like the stagflationary 1970’s. Let’s hope not (but, hope is NOT a strategy).

The best thing to do is invest wisely in sound, low valuation companies and prepare for the market to be bumpy. No predictions will prevent the market from going up and down. Sitting on the sidelines through it all is a sure-fire way to miss the upswing when it does come–whenever that will be. . .

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.