GR-NEAM Reflections: 07/01/2010 - Sovereign Credit -- The Return of the Deutschmark and Credit Deault Swaps

Thanks to Matt for passing this along.

The sovereign debt problem is just getting underway. Protecting oneself will prove for many to be a challenge.

Volcker Pushes for Reform, Regretting Past Silence

JUST before the Fourth of July weekend, Paul A. Volcker packed his fishing gear and set off for his annual outing to the Canadian wilds to cast for Atlantic salmon.

He left behind a group of legislators in Washington still trying to nail down a controversial attempt to overhaul the nation’s financial regulations in the wake of the country’s most serious economic crisis since the Great Depression.

A well-regarded lion of the regulatory world, Mr. Volcker had endorsed the legislation before he went fishing, but unenthusiastically. If he were a teacher, and not a senior White House adviser and the towering former chairman of the Federal Reserve, he says, he would have given the new rules just an ordinary B — not even a B-plus.

“There is a certain circularity in all this business,” he concedes. “You have a crisis, followed by some kind of reform, for better or worse, and things go well for a while, and then you have another crisis.”

How Inequality Fueled the Crisis - By Raghuram Rajan

Before the recent financial crisis, politicians on both sides of the aisle in the United States egged on Fannie Mae and Freddie Mac, the giant government-backed mortgage agencies, to support low-income lending in their constituencies. There was a deeper concern behind this newly discovered passion for housing for the poor: growing income inequality.

Since the 1970’s, wages for workers at the 90th percentile of the wage distribution in the US –such as office managers – have grown much faster than wages for the median worker (at the 50th percentile), such as factory workers and office assistants. A number of factors are responsible for the growth in the 90/50 differential.

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Related book: Fault Lines: How Hidden Fractures Still Threaten the World Economy

Related speech (from 2005): The Greenspan Era: Lessons for the Future

Sticking to What Works

Found via Simoleon Sense.

This month Sequoia Fund marks its 40th anniversary. It's a milestone rarely achieved in an industry where three years is considered long term.

Even more remarkable is that Sequoia is being run pretty much the same as it was when Warren Buffett's friend and stockbroker, the late Bill Ruane, launched the fund in 1970. It's still a concentrated portfolio with two or three dozen stocks, all heavily researched and bought with the idea that the market is valuing them at less than their true worth. Co-managing the fund is Robert Goldfarb, whose tenure at the New York firm dates back to 1971.

In 2008 the fund re-opened its doors to new investors for the first time since 1982. Some wondered whether the reopening of this exclusive club somehow indicated that it was past its glory days. But its managers at Ruane, Cunniff & Goldfarb Inc. don't seem to be resting on the fund's reputation.

Sequoia's returns have bested the Standard & Poor's 500-stock index over the past three, five and 10 years. In 2008, amid the financial crisis, Sequoia held up better than 97% of the competition in Morningstar Inc.'s large-blend category. As stocks snapped back from the bear market, Sequoia initially lagged, but as of June 30, the fund was three percentage points ahead of the S&P over the prior 12 months with a 17.5% gain, beating 90% of its peers.

Still, Sequoia had its worst year in 2008—a 27% decline. In the wake of those losses, the fund's managers made a concession to recent market developments: While continuing to focus on the prognosis for individual stocks, they decided to pay more attention to "macro" market and economic forces than they have in the past.

Hussman Weekly Market Comment: Misallocating Resources

On a valuation basis, the S&P 500 remains about 40% above historical norms on the basis of normalized earnings. The disparity between our valuation assessment and the putative undervaluation being touted by Wall Street analysts is so great that a few remarks are in order. First, virtually every assessment that "stocks are cheap" here is based on the ratio of the S&P 500 to year-ahead operating earnings estimates, and often comes with a comparison of the resulting "earnings yield" with the depressed 10-year Treasury yield. What's fascinating about this is that this is the same basis on which analysts deemed stocks to be about 40% undervalued just prior to the 2007 top, following which the market plunged by more than half. There's a great deal of analysis regarding forward operating earnings that I published in 2007, but probably the most comprehensive piece was Long Term Evidence on the Fed Model and Forward Operating P/E Ratios from August 20, 2007.

To properly understand the price-to-forward operating earnings ratio, you have to recognize that operating earnings exclude a whole host of charges - what some observers correctly call "recurring non-recurring" charges. These include large and often quite regular losses that the companies deem, often on the thinnest basis, to be detached from their core business - even if the losses are directly related to their core business. Items like enormous asset writeoffs come to mind. Moreover, the "forward" means that these are year-ahead analyst estimates, which are typically substantially higher than trailing 12-month reported earnings.

Think of it this way. Suppose your poodle is 40% overweight. Someone sells you a scale where every pound shown on the dial represents 1.4 pounds of actual weight. Guess what? Your poodle will step on that scale, and the dial will pleasantly report that your dog is at its ideal weight. That may be comforting if you don't like to face reality, but the truth is, you've still got one sick puppy.

When you hear analysts say that the historical average P/E ratio is about 15, you have to recognize that this is the normal P/E based on trailing 12-month earnings after subtracting all writeoffs and other charges. Forward operating earnings are invariably much higher, and it turns out that the comparable historical norm, as I discuss in that 2007 piece, is only about 12. If you exclude the late 1990's bubble valuations, you get a historical norm closer to 11.5. The 1982 and 1974 market lows occurred at about 6 times estimated forward operating earnings.

A final observation is crucial. Current forward operating earnings estimates assume profit margins for the S&P 500 companies that are nearly 50% above their long-term historical norms. While we did observe such profit margins for a brief shining moment in 2007, profit margins are extraordinarily cyclical. Investors will walk themselves over a cliff if they price stocks as if profit margins, going forward, will be dramatically and sustainably higher than U.S. companies achieved in all of market history.

Reflections on the Sovereign Debt Crisis - By Edward Chancellor

In this white paper, Edward Chancellor, a member of GMO's Asset Allocation team, provides his thoughts on sovereign debt. Specific questions he addresses in the paper include: Why in the past have governments defaulted on their debts? When have deeply indebted countries kept faith with their creditors? Under what conditions do governments opt for inflation rather than default?

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Buffett: 'We’re coming back, no question in my mind'

In an interview today with Yahoo News and The Huffington Post, Warren Buffett reiterates his belief that the United States economy is emerging from recession and is unlikely to suffer a near term relapse. Mr. Buffett, interviewed from Sun Valley where he is attending the annual Allen & Co. conference, has been making increasingly bullish statements regarding the economic outlook in recent months.

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For more of the interview, go HERE.

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TED Talk - Benoit Mandelbrot: Fractals and the art of roughness

Hussman Weekly Market Comment: Implications of a Likely Economic Downturn

A week ago, we accumulated enough evidence to conclude that the U.S. economy is most probably headed into a second leg of recession. It is unclear whether this will be identified as a second recession or a continuation of an existing downturn. In either case, I've repeatedly noted that the apparent strength in the U.S. economy over the past year has been driven almost exclusively by an almost inconceivably large burst of fiscal and monetary "stimulus" last year, whereas intrinsic economic activity has stagnated. Personal income remains at its lows once government transfer payments are excluded, which is in stark contrast to typical post-war recoveries. Weekly jobless claims are pushing again toward 500,000, whereas prior post-war recoveries have seen jobless claims quickly retreat below the 400,000 figure that roughly delineates job growth from continued job losses. The most straightforward explanation of the economic data is that we've observed a stimulus-led recovery that has not translated into private economic activity, and that the effects of the stimulus are now diminishing.

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My most urgent concern over the past few months has been directed toward investors with spending plans (tuition, home purchase, baby, medical, retirement) that rely on the near-term availability of funds. If you are following a disciplined investment strategy, your portfolio is well-diversified, and you are tolerant enough of risk that the declines in 2000-2002 and 2008-2009 did not materially derail your investment discipline, then please, ignore my views and the views of everyone else and just follow your discipline.

My concern is for individuals who will need the money within a small number of years and yet are invested as if they are long-term investors, not in adherence to a specific discipline, but simply because the market was, until recently, advancing. Too many people got their life plans derailed when the tech bubble crashed, and when the credit crisis hit. If a major market loss would derail your life plans, you're taking too much risk here. That said, I have no intent to cheerlead for the bears. In our most defensive stance, the Hussman Funds may be fully hedged, but we do not take net short positions and we don't "bet" on the market to decline.

Over the short and intermediate-term, credit crises are invariably deflationary, because they prompt a frantic demand for default-free government paper, which raises its value relative to goods and services (another phrase for deflation). So despite the huge increase in government obligations during these periods, you generally don't see inflationary pressures in the early years because that supply is eagerly absorbed. Short-term interest rates are pressed near zero, and monetary velocity tends to collapse. Commodities are usually hard hit as well, so investors who are concerned about inflation risk or are chasing gold here may have the long-term story right, but they probably have it too early to weather the interim volatility comfortably.

Over the long-term, massive increases in government liabilities do have inflationary impact. This imposes a real burden, not simply a paper one. If the holder of government currency can command a certain stock of real goods and services, and then the government debases that currency so that it can command a lesser stock of real output, then it is undeniable that the difference in real value has been implicitly transferred to the government to finance its spending. While I do expect that TIPS, commodity exposure and precious metals will be important inflation hedges in the years ahead, investors chasing these assets here may have a difficult road. It is best to accumulate such assets when they are in liquidation, not when they are being chased on the basis of overly simplistic theories of inflation.

Shiller Wary on Economic Outlook

Found via The Big Picture.