7 Reasons to Doubt the V-Shaped Recovery Justice Litle, Editorial Director, Taipan Publishing Group Are the markets discounting a V-shaped recovery? Or does the evidence suggest this is still a bear market rally akin to those of the 1930s and 1970s? Ah, V-shaped recovery, how we doubt thee. Let us count the ways... But first, let’s note something about how to make money in markets. (Because, really, that’s what this is all about, right?) Just as there are many business models that successful companies follow, there are many profitable paths up the market mountain. But one of the most time-tested, reliable ways to do well in markets over time is establishing a large position (often after testing the waters with small positions)... riding that position to substantial gains... and then protecting those gains when the market turns. Simple, right? It’s easier said than done, of course. There is a fair amount that goes into it. But that’s the gist. And given that gist, one might say the trader or investor’s job description falls into four categories: • Minimizing losses on positions that aren’t working. • Maximizing gains on profitable open positions (knowing when to add to the position). • Protecting gains when a substantial body of profits has accrued. • Keeping an eye out for the next big investment or trade. This roster of responsibilities highlights why we are at such a critical juncture. For those who have ridden the 2009 rally to major gains, the dilemma is whether to protect open profits with a hedge (akin to buying fire insurance on one’s portfolio)... whether to “take some off the table” and partially cash out... or whether to cash out entirely. (Notwithstanding the fourth option of simply “letting it ride.”) For those who are not sitting on long-side profits (and even for those who are), a key question is where the next big round of opportunity will come from. Will it be on the upside... or the downside? Will it be in “risk-loving” assets (more of the same)... or “anti-risk” assets (a change from the status quo)? How soon might the change arrive? From a practical perspective, these questions highlight the importance of the “what’s next” question. So now, without further ado, let’s take a closer look at some reasons to doubt the V-shaped wisdom. Reason to Doubt #1: Parallels to 1930 “There’s a large amount of money on sidelines waiting for investment opportunities; this should be felt in market when “cheerful sentiment is more firmly intrenched [sic].” Economists point out that banks and insurance companies “never before had so much money lying idle.” Sound familiar? The above headline feels like 2009, but is actually vintage 1930 (courtesy of the “News from 1930” Web site). Those who take the present rally as incontrovertible evidence of a V-shaped recovery are forgetting something important. Investors in 1930 brimmed with a similar doomed confidence. Comparing today’s post-crash move to the one back then, fund manager John Hussman notes that “the market recovered by an almost identical percentage following the 1929 crash, peaking in April 1930, after which it suffered a subsequent decline to fresh lows.” The point is not to say today looks just like 1930, Hussman goes on to add, but rather to point out that, when it comes to economic recovery prospects, a giant rally doesn’t prove that much at all. Reason to Doubt #2: The Biggest Rallies Are Bear Market Rallies From Monday’s Wall Street Journal: Rarely has the stock market seen a six-month rally like the one it just turned in. The Dow Jones Industrial Average's 46% surge was one of just six of that magnitude in the last 100 years. And that is exactly what worries many analysts. All previous rallies of this magnitude took place in the 1930s and the 1970s, according to Ned Davis Research. Those were periods of turbulence for both the economy and the markets, and none of the gains was sustained. Many analysts believe that stocks are again in such a turbulent period, and that this rally could lead to another slump. Stocks did enjoy a rally of 40% in 1982, at the start of a long-running period of stock-market prosperity. That rally wasn't of the same magnitude of the others, however. It came as economic troubles, notably inflation, were finally being squeezed out of the economy. Reason to Doubt #3: It Still Ain’t 1982 In a Taipan Daily piece some months back titled “This Ain’t 1982,” we noted the many reasons why the present environment looks nothing at like that of the early 1980s. In a nutshell, 1982 was the starter year for a 25-year upswing in leverage and credit. Fed Chairman Paul Volcker had just “broken the back of inflation” (at a cost of great economic hardship) and America was on the cusp of the longest debt binge (among consumers, businesses and government) in all of recorded history. At the same time, consumer savings rates went into a steady decline, from double-digit percentage rates to below zero, as America shopped and shopped. Meanwhile, decades of aggressive financial innovation (under a complacent Alan Greenspan) led to the creation of the “shadow banking system,” a quasi-official means of pumping the economy full of even more leverage and credit by way of investment banks, private investment pools and so on. Now we are at the tail end of all that. After a quarter-century of build-up, a great “deleveraging” is at hand. The consumer is flat on his back, the shadow banking system lies in shambles, and consumer access to credit has gone from a flood to a trickle. Reason to Doubt #4: The Megabanks Are Just as Rotten as Ever Every year the World Economic Forum (WEF) releases its annual “Global Competitiveness Report.” Among the various factors considered by the WEF is the soundness of a country’s banks. By this measure America ranked 108th, a spot behind Tanzania. One could arguably have more confidence making a deposit at the Bank of Burundi than many institutions in the U.S. or the U.K. And in spite of the hundreds of billions (trillions?) poured in via backstops, guarantees and cash injections, some of the major banks still look like ticking time bombs. For instance: Dick Bove, a long-respected banking analyst with decades of experience on the street, has described present-day Wells Fargo as a “volcano, with a number of tremors, that is possibly about to blow.” The new Wells Fargo concern traces back to the big Wachovia merger (a failing bank that Wells swallowed up). In taking on Wachovia, it turns out, Wells Fargo may also have gulped down a number of live hand grenades in the form of unhedged and unaccounted-for derivatives trades. Surprise surprise, Wells Fargo’s management has turned out to be less than forthright about this troubling exposure. That’s just the tip of the iceberg. The real trouble is, the banks haven’t changed much at all... the only material difference, in fact, is that the big have gotten bigger. Tens of trillions of dollars’ worth of unstable derivative contracts are still concentrated in untrustworthy hands. And as the latest Wells Fargo concerns demonstrate, the megabanks have been anything but forthright. With the blessings of the Fed and Treasury, the megabanks’ strategy has been to use every accounting trick in the book to present the appearance of big profits – most of those profits created by way of government bailout funds – while simultaneously burying the remaining toxic time bombs as deep in the balance sheet as possible. This “play for time” strategy hinges entirely on the hope that nothing else will blow up before the patchwork of quick fixes finds time to work. It is, in other words, one hundred percent business as usual. Reason to Doubt #5: Hundreds More Banks Will Fail As of this writing, 94 banks have failed in 2009. Banking analyst Meredith Whitney (who gained fame for calling the collapse of Citigroup in advance) has said she expects at least 300 banks to fail. Institutional Risk Analytics, one of the top bank-analyst services in the country, expects more than 1,000 banks to fail over the course of the cycle. Banks provide credit to consumers and businesses through the form of mortgage loans, auto loans, credit card loans and the like. When banks fail, credit contracts, making it harder for consumers to spend and businesses to stay afloat. Lowered spending as a result of reduced credit then leads to more layoffs and lost jobs in a vicious circle. The vicious circle completes itself as banks pull back even further in a tough economy. Not only are hundreds more banks set to fail, the FDIC (Federal Deposit Insurance Corporation) is on the verge of a public relations disaster as it runs out of money. There is no way the FDIC will be able to handle all these failures. Based on their projections, Institutional Risk Analytics thinks the FDIC could be on the hook for $400 billion-$500 billion if not more. (And that’s not even taking into account a fresh megabank debacle, like a Wells Fargo blow-up). Where in the world is the FDIC going to get $500 billion? As John Mauldin writes, The FDIC can borrow $100 billion in an emergency line of credit, and through 2010 it can get another $500 billion. But if and when that money is borrowed, it will have to be paid back. Remember the money that was lost in the savings and loan crisis 20 years ago? The FDIC had to borrow a mere $15 billion. We are still paying that 30-year loan back. If the FDIC is forced to borrow from the Treasury, Congress (and America’s creditors) will scream bloody murder. One alternative, as Mauldin further notes, is for the FDIC to leverage more “special fees” against the banks. But guess what? If the FDIC tries to squeeze blood from a stone in terms of hitting up the banks, that will cause the surviving banks to pull in their horns even further... to lend even less. This is another heart attack waiting to happen for consumer credit and small business credit – in an economy 70% driven by consumer spending and largely powered by small businesses. Reason to Doubt #6: The Housing Bubble Has Not Yet Fully Burst U.S. mortgage delinquencies set a new record in July, with 7.58% of mortgages (roughly one out of 13) at least 30 days late on payments. According to Reuters and Equifax, subprime mortgage delinquencies have hit a whopping 41%. And now the banks have to worry about a new problem: “Strategic Defaulters.” As the Los Angeles Times reports, Who is more likely to walk away from a house and a mortgage – a person with super-prime credit scores or someone with lower scores? Research using a massive sample of 24 million individual credit files has found that homeowners with high scores when they apply for a loan are 50% more likely to "strategically default" – abruptly and intentionally pull the plug and abandon the mortgage – compared with lower-scoring borrowers. The LA Times reports there were more than half a million (588,000) “strategic defaulters” nationwide in 2008. These are individuals with high credit ratings who technically have the financial wherewithal to continue making payments on their mortgage, but simply do not see the logic of pumping money into a more or less permanently-upside down asset. The reasoning runs something like: “Why throw good money after bad in terms of staying committed to a house worth $200,000 less than I paid for it, when the penalty for walking away (damaged credit) will hurt less than throwing future earnings into a hole for 10 or 20 years.” Meanwhile, Iowa attorney general Tom Miller recently went on record saying “Payment option ARMs [adjustable rate mortgages] are about to explode... That’s the next round of potential foreclosures in our country.” Homeowners and banks have only just begun to wrestle with the mortgage “reset” problem, in which monthly payments due suddenly double or triple (or worse) based on fine-print deadlines. As the option ARM problem gets serious, look for the number of “strategic defaulters” to shoot even higher. That’s more horrible news for the already struggling banks... and no wonder previously mentioned forecaster Meredith Whitney think home prices could fall another 25% before hitting bottom. Reason to Doubt #7: Uncle Sam Is a Borrowing Fiend If you thought America was a “borrow and spend” nation before, you ain’t seen nothin’ yet. The past four quarters have dwarfed all previous U.S. government borrowing efforts, and that is a trend that’s guaranteed to continue. What probably won’t continue, however, is the Federal Reserve’s ability to buy hundreds of billions worth of U.S. Treasuries directly – effectively “monetizing” the debt – without leading to either 1) an eventual collapse in the U.S. dollar or 2) an eventual collapse in bond prices and subsequent sharp rise in interest rates. We are headed for an environment of heavier regulations, higher taxes, and more government control of the economy at a time when we can least afford it, and plunging headlong into the debt abyss to pay for it all. Reason to Doubt #8: Black Boxes and Punk Volume Finally, a big reason to doubt this rally is the troubling lack of volume. Bull markets are typically characterized by healthy and rising volume trends as more and more investors decide to participate in the market. But that is not what we are seeing here. Instead, share trading has been dominated by quants, high frequency trading (HFT) shops, and other “black box” type outfits rather than more legitimate buying sources. Not only that, but volume has been alarmingly concentrated in a handful of super-speculative stocks. Reuters recently reported that, over a week’s worth of trading, a full 40% of trading volume came from just four (!) heavily traded names: Bank of America (BAC), Citigroup (C), Fannie Mae (FNM) and Freddie Mac (FRE). So not only are we seeing suspiciously low volume when these super-speculative names are weeded out (Citigroup – 491 million shares per day average volume!), we are seeing heavy activity from quants and other “black box” type trading systems, with the bulk of activity concentrated in the most casino-oriented corners of the market. These are a few (but by no means all) of the reasons why your humble editor tips a hat to the mania, yet continues to doubt.