Single-day rallies of 900 points or more in the Dow Jones Industrials tend to get our attention, in part because they’re the unicorn of market action: Often imagined but never seen. Well, we saw a unicorn yesterday.
In fact, we’ve seen a lot of things lately that just a few months ago were the stuff of dreams–or nightmares. No wonder, then, that this reporter is at risk of losing perspective amid all the chaos. But let’s try to sober up and reassess where we’re at in the economic cycle. Maybe, just maybe, we can cut through the extreme volatility and venture a guess as to what’s coming. It’s a long shot, but let’s go through the motions anyway.
We begin by speculating that all the government’s efforts at stabilizing the financial industry don’t really change the underlying economic conditions that brought us to this point. The government’s intervention was about stopping the bleeding and shoring up the system to avoid implosion. Perhaps it’s time to label that effort successful, although no one quite knows just yet. As for the real economy, the question mark is much bigger. Indeed, the financial crisis over the past year has only recently been making a mark on Main Street, and it’s our guess that the trend has quite a few more months to run, at the least.
We’re talking here of real estate bubbles and the associated fallout. It didn’t start overnight, nor will it end suddenly. No, we still can’t see the future any better today than yesterday or last year. Regardless, we’re not convinced that the cycle gods are done playing with mortals.
We could cite any number of economic numbers to support our still-cautious outlook, but we’ll start by looking at our proprietary measure of economic activity–CS Economic Index. As our chart below shows, momentum still looks biased to the downside, as it has been for some time. This is hardly news. Your editor has been pointing this out for some time now, along with many others observers of the economic scene. For quite a while, we were premature in calling for a material weakening of the general economy, as in this post from last March. So it goes in forecasting generally: you’re either early or late. A few lucky souls enjoy perfect timing, of course, but repeat performances by the same people are rare, and rest assured that yours truly isn’t likely to ever join that celebrated club.
As for the economy, the above chart strongly suggests that there’s more weakness coming. Economic weakness tends to beget more of the same. Until it stops. Even then, recovery may be preceded by lengthy stretches of treading water. Distinguishing one from the other is as much art as science, of course, and on that note it’s every forecaster for himself. As for our index, let’s decipher its design. The black line is our CS Economic Index, an equally weighted measure of 17 leading, lagging and coincident indicators covering such diverse corners of the economy as housing, the labor market, the stock market, consumer spending, and so on. Roughly 47% of the index is weighted in leading indicators, i.e., those metrics that are thought to be forward-looking gauges of economic activity. Building permits, for instance, are considered a leading indicator because they reflect intentions about future construction plans. The remaining metrics are coincident indicators (29.5%) and lagging measures (23.5%). No, it’s not a magic measure, and to some extent its naive and it may even be misleading. Alas, we can only make that determination in hindsight. For now, we’re reasonably sure it captures the basic ebb and flow of the economic trend, and it’s still telling us that more weakness is coming.
The fact that our index of leading components are falling even faster strengthens our view that we’re still looking at a rough patch for the wider economy. Yes, our economic metrics are only updated through the end of August and we won’t have all of the numbers for the September reading until early in November. But the more-recent numbers we do have aren’t providing much reason to expect that a turnaround in our broad economic index is imminent. A few examples: initial jobless claims are still running hot, nonfarm payrolls are still shrinking, and various measures related to consumer spending look weak.
The stock market, as always, is looking ahead, which contrasts with the big-picture economic reports, which are invariably backward looking. Bridging the gap in that statistical chasm is the terrain of speculators. Of course, huge rallies come and go within the broader context of secular bear markets, and so one should be cautious about equating one with the other in real time. Tactical opportunity, in other words, is always waiting in the wings. But so is risk.
Nonetheless, we think it’s premature for investors to buy equities on the assumption that the economic troubles are now passed. Traders have their own reality, of course, and it may differ at times from strategic investors. As one of the latter, we’re still of a mind to nibble on weakness while keeping enough cash on hand to take advantage of future issues. No, we can’t guarantee that last week was the bottom. It may very well prove to be the trough. But we don’t know, and there’s sufficient evidence to support our view, or so we argue. As such, we still favor cautious rebalancing and redeployment of capital, with the assumption that this part of the cycle will take time to unfold in economic terms.
Originally published on Oct 14, 2008 at The Capital Spectator and reproduced here with the author’s permission.
One Response to “Mr. Market & Economic Cycles: Imperfect Together”
THE WORLD’S FINANCIAL CRISIS CREATED & MADE BY AMERICAThe skew in the global financial system — commonly called ‘global imbalance’ — seems to be fast spiraling out of control.For some time now economists have been engaged in the mother of all debates: whether the US dollar would collapse by as much as 40% when compared to other currencies (some are even betting on the US dollar going belly-up) or whether there would be an orderly devaluation — that is, a gradual revaluation of other currencies vis-�-vis the US dollar.In effect, the question that is confronting us is not ‘whether’ but ‘when’ and by ‘how much.’This global imbalance can be understood in economic terms by simply examining the massive size of America’s twin deficits — trade and budgetary. Put modestly, Americans have been living way beyond their means, consuming much more than what they could possibly afford and, in the process, borrowing far beyond their capacity for too long.This was facilitated by a policy of maintaining weak currencies across the world, notably in Asia. This policy of maintaining a competitive exchange rate for their currency to boost exports has resulted in a race to the bottom amongst various countries.Nevertheless, this arrangement suited countries, both Asian (with a huge unemployed population) and American, (as it provided cheap imports for its huge consumption binge).While the going was good, everyone profited and expected the arrangement to continue indefinitely. Unfortunately, linearity as a concept has limited appeal in real life, much less is global macroeconomics.No wonder, of late, countries are discovering that this arrangement has its limitations. The current account deficit of the United States translates into current account surplus of exporting countries. To cover this deficit, US borrows: this corresponds to the forex reserves of exporting countries. The crux of the issue is that no other country, barring the US, has such a huge consumption pattern and an ability to absorb this huge export surplus.In substance, countries are producing their goods, exporting it mostly to the US, and parking the resulting export surpluses with the US to facilitate US to finance its imports!Clearly, the global imbalance is a by-product of this mindless competition by various countries to devalue their own currencies and the reckless consumption in US. Naturally, it is indeed tempting to blame US consumption for this crisis. However, one must hasten to add that the emerging economies — notably Asian countries, especially after the1998 currency crisis — with their fixation for weak currencies, are equally to be blamed.The net result? Well, consider these facts:By mid-May 2007, the US National Debt stood at approximately at mind-boggling $8.85 trillion — i.e. approximately $28,000 for every American.The basic structure of the American economy is that the deficit of the US government is 4% of the GDP and the household sector 6%, which are offset by a domestic savings of 3%, largely from corporates, leaving a substantial national deficit of 7% to be covered by the capital flows from the rest of the world.The current account deficit of the United States for 2006 is estimated to be in excess of $850 billion. This approximates to 7% of its GDP. Surely, even for the US, this is unsustainable.In order to ensure that this money is routed into America and to sustain its gargantuan borrowing programme, the US has repeatedly raised its interest rate to its current levels of 5.5%. While the very size of the US debt makes any further increase in interest rates virtually impossible (as it would make borrowings uneconomical), any cut in interest rates to stimulate its economy and make it competitive would mean that the US may not get the money it requires to sustain itself.On March 28, 2006, the Asian Development Bank is reported to have issued a memo, advising members to be ready for a collapse of the US dollar.Since end March 2006, the US Federal Reserve has stopped publishing the quantum of broad money (that is the aggregate of US dollars circulating in the entire world — technically called ‘M3′) in the US economy. This is the worst possible signal that the US Federal Reserve could have sent to the world.Suspended sense of disbeliefObviously, what aids and sustains the US dollar is a ‘suspended sense of disbelief’ amongst countries about the value of US dollar. Yet, common sense tells us that the excess supply will obviously result in a fall in the value of any product. The US dollar is no exception.Late Iraqi leader Saddam Hussein was fully aware of this paradigm. Seeking to exploit the inherent weakness of the US dollar, Saddam wanted to trade his crude in Euros, which would have lead to a lower demand for the US Dollar and thereby triggered a dollar collapse. And those were his ‘weapons of mass destruction — WMD.’And if some analysts are to be believed, Venezuela and Iran too possess the very same WMD. Naturally, it requires some specious arguments and military intervention to protect the US dollar. Never in the history of mankind has a national army protected the national currency so vigorously as the US Army has done is the past decade or so.What is bizarre to note here is that despite the fact that crude is produced mainly in the Middle East; officially it can be purchased in dollar terms from one of the two oil exchanges situated in New York and London. Obviously, should Iran carry out the threat to commence oil trade in Euros or better still an oil exchange, the US dollar would come under tremendous pressure.The US dollar is akin to the promissory note of a defunct finance company. It is common knowledge that a currency, when not backed by anything precious is just a piece of paper. When US abandoned the Gold Standard in early 70s, countries habituated by then to the US dollar under the Bretton Woods arrangement continued to accept the US dollar as an international currency without demur as the world was not prepared for any other alternative. Else, the global economy would have collapsed by 1971.But the diplomatic silence did not solve the problem. It merely postponed it and it has come back to haunt us.Post gold standard, by a tacit approval of the Organisation of Petroleum Exporting Countries (OPEC) and strategic manoeuvring, the US had ensured that its currency is implicitly backed by crude, instead of gold. This explains the American ‘geo-political and strategic interests’ in the Middle East.But over time even this was found to be insufficient and consequently the oil standard of the 70s gave way to an implicit multiple commodity standard of today. Naturally, commodity prices — including crude prices — have soared in the past few years.Unfortunately, this arrangement too is failing the US. No wonder, the US dollar increasingly resembles a promisory note of a defunct finance company.It is no coincidence that global trade in most commodities, including oil, is denominated in US dollars as the respective international exchanges are located in the US. To what extent are the prices of these commodities manipulated to protect the US dollar is anybody’s guess.However, it may not be out of place to mention that a barrel of oil which cost less than $10 to produce is sold approximately at $70 in the international market.But as commodity prices go up it has lead to inflation across the globe. No wonder, countries are forced to increase their interest rates to fight inflation.This has triggered an interest rate hike across continents and the US is finding it extremely difficult to sustain its current borrowing programme: it hardly has any elbow room to manoeuvre.Doomed if it does, damned if it doesn’tMeanwhile, countries are increasingly realizing that the value of the US dollar that they are holding is fast eroding, whatever be the ‘officially managed exchange rate.’ And if fewer people want the US dollar — as for instance when oil is traded in Euro the demand for the US dollar will fall — it would trigger an avalanche.No wonder, the US Fed is unwilling to make public the M3 figures, as it does not want the holding position of the US dollar to be publicised.Interestingly, in such a doomsday scenario, some economists are still betting on central banks of other countries to defend the US dollar. It would seem that the US has ‘outsourced’ even this sovereign function to the central banks of other countries. After all, should the US dollar collapse, the biggest losers will not be the US but those who have US dollar-denominated forex reserves.Naturally, countries holding US dollar reserves are caught on the horns of a serious dilemma — should they seek to correct the global imbalance, it could result in the imminent collapse of the US dollar, and should they continue to defend the US dollar, they would be a long-term loser as the current arrangement has seeds of self-destruction.While every central banker is conscious of this fact and thereby seeks to postpone the inevitable while nervously looking for his counterpart in any other country to break ranks and thereby trigger the collapse.Surely, the emperor is without any clothes. There are only two possibilities from here on: Either we are witness a global meltdown of the US dollar, or allow controlled US dollar devaluation (read, revaluation of other currencies). If it is a global meltdown the global economy is doomed, if is an orderly devaluation, it is damned.