Running Out of Other People's Balance Sheets
Last week was fun, was it not? Nothing like a little volatility to get the blood pumping. My bigger picture view of life at the moment is that the macro generational balance sheet deleveraging cycle is far from over, having only been interrupted by Fed and Government stimulus efforts of the last few years, which really are not repeatable in magnitude anytime soon. Bottom line being that it's going to be very tough to generate domestic private sector credit expansion and ultimately aggregate demand acceleration. The cycle so far since 2009 has been characterized by an alternating series of overoptimistic assumptions of economic growth followed by seemingly unexpected soft patches. Unfortunately in terms of bigger cycle rhythm, I expect this to continue for some time as again, until the cycle of deleveraging is complete we're going to experience point to point subpar economic growth relative to historical economic expansion experience. The world is not coming to an end, but dictates that investment behavior be anything but passive. Periods of stimulus will lift expectations as well as asset prices, but the application of stimulus will not be linear, as we have already seen.
There is really nothing new here as we've already been living in such an environment for the last decade as the prior 2003-2007 supposed economic cycle was nothing but private sector excess "stimulus" in the form of a blow off generational credit cycle peak. A business cycle or a credit cycle? Of course it was a credit cycle. And in many senses we’re still living in a credit cycle driven environment. From the 2009 recession end to present again "credit" stimulus has come in the form of Fed and Government unprecedented balance sheet expansion. You may remember Margaret Thatcher's famous comment regarding socialism being that it works until "you run out of other people's money". Well the corollary in the present is that we're in a macro global economic environment where we are running out of "other people's balance sheets". Of course the fallacy being that a Government balance sheet is somehow separate and distinct from corporate and household balance sheets, which is hogwash. They are one and the same. This does not apply only to the US. China is a prime example. Ongoing investment IS the miracle growth China story. It's not what has already been built in terms of infrastructure, but what must be funded and built ahead to keep growth moving forward in linear fashion. Just remember that at least over the last year, the major source of "funding" in China has been off balance sheet. Running out of balance sheets? Europe is in the same boat. Running out of balance sheets is, a huge macro theme to keep in mind ahead as the whole deleveraging cycle ultimately reaches its final destination.
So just what the heck to we do in the meantime? Although it’s so much easier said than done, we hope to successfully navigate the ups and downs of the macro or secular deleveraging cycle while hopefully remaining very flexible in thinking and decision making. Maybe now more than in any period of the recent past, we need to remember that "being right" about the ultimate direction of the macro cycle and making money over the short to intermediate term are two very different things. We need to remember that the deleveraging cycle of the moment is playing out against the backdrop of the continued evolution of the global economy, which will not be put on pause. There will be plenty of sand traps and areas of quicksand, but also plenty of opportunities along the way. Ultimately the cycle of deleveraging will end and a new longer term secular upcycle of credit expansion and aggregate demand acceleration can begin. We're a good ways off, but that day lies somewhere in our future.
Will recessions come more quickly than was the case during the peak credit cycle expansion decades that were the 1980's and 1990's? I’ve talked about this many a time since 2009 and the answer is without question. Watching the following for pre-recession indications - the Philly Fed States Coincident Index, the ISM new orders to inventory ratio, the Conference Board CEO and the Duke University CFO surveys will be a very important exercise. I will not run through these again today, but will surely be monitoring and talking about these and more in discussions ahead.
One indicator that has served us very well over the years and demands monitoring is the ECRI weekly leading indicator numbers. First, watching absolute levels is very important. Second, please remember that from 1970 really to the present, new highs in the ECRI WLI have accompanied every new high in the broad equity market. At least since 2007, we've been putting in a series of lower highs so far as per the ECRI numbers. When real private sector credit expansion and aggregate demand acceleration is set to resume, the ECRI numbers will "break out" above the lowers highs trend and ultimately move to a new high. But we're not there yet, in fact quite the opposite for now.
If indeed I’m even half correct about the continuation of the fundamental economic deleveraging cycle, then (and as always) risk management will be key to successful investment outcomes. I suggest to you risk management as a process be undertaken via the marriage of fundamental and technical analysis. I’m attempting to do a little bit of that as per the chart above. Since 1990, every single time the ECRI numbers have fallen below their 100 week moving average, it has been a serious recession warning. In fact, the only two times since 1970 this moving average has been broken to the downside and a recession not followed was in 1994 and last summer.
You'll remember that in 1994 the Fed was just starting to raise interest rates after what at that time had been unprecedented monetary accommodation post the S&L and junk bond sector problems of the early 1990's. Equities in that year registered a 5% gain if I remember correctly. The second break came last summer and immediately post that break the Fed launched QE2 lite and then official QE2, turning the leading indicator numbers in five seconds. As a quick aside, we need to remember that in many popular leading indicators (especially the Conference Board series), M2 (money supply) is a key component of the headline. We've seen a recent spike in US M2 which has given a better tone to the LEI numbers as of late, and that’s not sayingmuch. A few things are happening to goose the current M2 numbers. First, the fading away of Reg Q. Second, the selling of public equity mutual funds over the last few months were cash ended up in banks. Third, Fed QE whereby purchases of bonds are made from non-bank entities academically raises M2. And finally a bit of asset movement out of European banks and into US banking conclaves. Just so you are aware.
So for now, the ECRI numbers are above the 100 week MA, but the ECRI folks themselves tell us they expect a period of "pervasive and prolonged" economic slowing dead ahead. No recession yet, but definitive slowing for now. A drop of the ECRI numbers below the 100 week MA would be a warning about potential recession. And who knows, it may even usher in QE3, or whatever the next Fed accommodation will be called. For now, it's a positive that the slope of the 100 week MA has turned up, but stay tuned closely. Without question, the drop in the equity market could be the tipping point spark for recession. Last week I talked to a client I use as a high end consumption barometer (runs a business selling to high end designers and decorators). Business was great April through June. Fell off in July and so far August has been lifeless.
Taking Stock...I can give you a million reasons why equity risk is high. Maybe even two million. But what I "think" is immaterial in terms of trying to be anticipatory or managing investment risk correctly, let alone professionally. As always, the market is the final arbiter. When I see things like social networking companies being floated with quite frankly valuations we've virtually never seen before, it gives one pause. Against this period of macro deleveraging that is so important thematically, we need to stay in harmony with the message and rhythm of the markets in order to expect even a modicum of investment success. Telling the markets what they "should" be doing has no place in rational investment management and is one of the most dangerous and potentially costly exercises of which I am aware. Everyone has opinions. Plenty of folks in the investment business are really smart cookies. Nota bene: Being right and making money are two different things! Inflexibility and ego are death.
My bet is that there will continue to be plenty price volatility alongside volatility in the rhythm of economic activity in the years ahead as the deleveraging cycle moves toward its ultimate final act. The integration of technical, fundamental and behavioral analysis is a must do over the intermediate term. I’ll leave you with a few big picture technical charts I've used for many a moon. Will they continue to be so ahead? I sure hope so, but need to remember that there are no holy grails. Only jigsaw puzzle pieces we can only hope to assemble in proper order in trying to assess and "see" the big picture. Moreover, and it's just my own perception, the equity market in totality is not an efficient economic discounting mechanism as has been the case historically. Why? In a word, HFT. The HFT crowd dominates what now passes or poses, should I say, for daily volume. The HFT crowd could care less about the long term fundamental prospects of either the real economy or individual companies. HFT has the capacity to accentuate directional movement over the short term both north and south. If you think back to the prior cycle, equities peaked for the final time in October of 2007 and recession began in December. An efficient equity market discounting mechanism? Hardly. And this may be more the case in the current cycle than was true in 2007. Will it be that in the clarity of some forward hindsight that we look back and see that equities potentially peaked after a recession had already begun? I would not be surprised at all given current character of market participants and the market itself.
Hence, we need to continually view technical analysis set against fundamentals as a mosaic. Trying to put as many meaningful pieces together to see the whole. And that means viewing life not only from differing angles, but over differing time frames. To the point, one of the indicators that has served me very well historically as been to keep an eye on the interplay between the 15 and 40 week moving average of the major equity indices. In my first discussion of 2008, I wrote a long soliloquy about risk that was a direct warning for equities. What you see below drove that commentary. Had one followed this very simple trading rule over really the last three decades, one would have appeared an investment hero.
In a world of 24/7 information overload, and as trite as this may sound, simplicity contains its own unique and unemotional beauty. Of course one will never pick off a cycle high or low using the indicator above, but one would surely remain on the correct side of major trends. The above is one of my favorite long cycle risk management tools. One can improve the usefulness of the above by conjoining the view with a few higher frequency data points. Shorten up the time frame a bit and the 10 and 40 week EMA picture can act as a bit of an early warning device. Of course the cross of the 10 week EMA through the 40 week EMA is the precursor and the 15/40 EMA relationship the corroboration point in terms of trying to see longer term cycle change both at highs and lows. But what about with a cycle or trend itself? Bringing it down to the shorter term means changing moving average time frames yet once more. Although I won’t drag you through the chart, the 4 and 12 week EMAs can help corroborate change within an shorter term uptrend or downtrend. So as we look ahead again over the deleveraging cycle of the moment, short cycle moving averages act as alerts with longer cycle moving averages being key corroboration points.
Would something like the above have worked throughout Japan's deleveraging cycle to date? As you'll see below, there have been plenty of whipsaws, but had one followed this incredibly simple indicator religiously, one would have largely been on the right side of the Nikkei throughout the last two "lost decades". Of course the reconciliatory generational economic and financial market cycles, avoidance of big draw downs is THE key to successful outcomes. That's really the value add here.
The key point is that as we move ahead, marrying fundamental and technical analysis is not some frivolity or luxury, I see it as a mandate. Exclude either one and you handicap yourself. These are not simply pretty pictures. They are pretty damn important pictures to be conjoined with macro economic and investment specific fundamental data.
About Brian Pretti CFA
Brian Pretti CFA Archive
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