Our mantra in "Sleepwalking Toward a Precipice", now available at Amazon here, was (and is): (i) decades-long structural problems were revealed by crisis, (ii) politicians implementing short-term "solutions" exacerbate these structural issues, (iii) in their place, unelected central bankers have become central planners, distorting markets and eliminating failure, (iv) a number of "unknowns" should be monitored, (v) corporate earnings are highly correlated with GDP growth, (vi) historically, new bull markets start with a single digit market P/E so we may see "P/E compression" in coming years, and finally, (v) investing should be in nimble, tactical "rent don't buy" strategies that provide for participation in central bank reflation but also provide downside protection.
Now, let's take a look at how 2012-2013 is treating some of our themes from Sleepwalking (because as the '70s rock band Lynyrd Skynyrd sang, "there are things goin' on that you don't know").
Stairway to Heaven: In 2011, the S&P 500 experienced big moves up and down ending "unch" at 1258 ("Home, Home on the Range to Unchanged"). In 2012 and early 2013, the S&P 500 methodically marched up the "Stairway to Heaven", with real potential to challenge the all-time high of 1576 from October 2007. The strong up moves followed last minute agreements by U.S. and European politicians and extraordinary actions by the Federal Reserve and European Central Bank (ECB). It appears markets increasingly believe that those in power will do "whatever it takes" to keep countries, banks and economies out of crisis (whether it be political deals or unlimited central bank money). Accordingly, the S&P Volatility Index, or VIX, (a measure of "fear" in the market) reached a near 6-year low of 12.08 on February 19th, signaling an extreme level of complacency.
Fiscal Twits: In 2012, our best and brightest "fiscal twits" were at again, failing to address the toxic mix of automatic spending cuts (sequestration), tax expirations (Bush, payroll), farmer and race car track subsidies and breaks, among many others (all in all, the "fiscal cliff"), until January 1st (the last non-market day they had to get something done). And for all the sturm and drang they settled on a mini-deal of extensions of numerous subsidies and breaks, and the Taxpayer Relief Act raising taxes on the "wealthy" (or, "asking some folks to pay just a little bit more"), and kicking the sequester cuts to March 1st.
Meanwhile, our president averaged a fundraiser every 60 hours, Republicans tripped over themselves to make 47% of the gaffes allotted to them by Grover Norquist, some congress people actually considered the idea of a Treasury minted Trillion Dollar platinum coin to avoid the debt ceiling, while sequestration cuts (March 1st), immigration reform, gun control, raising the minimum wage (sounds great but bad), closing tax loopholes (good) without lowering rates (bad), and a myriad list of new government programs from the State of the Union address dominate debates.
Meanwhilethe entitlement leviathan (very bad) that threatens the Federal budget long term more than any defense program or other discretionary spend is simply ignored like so many lamps, hanging pictures and stairs as Trillion Dollar Sam continues sleepwalking. And, real pro-growth policy in this most divided Washington continues to be a dream.
In a Nutshell: As we delineated in Sleepwalking Toward a Precipice, our nation's debt and deficit issues come down to hard choices. The national debt has grown from $15 trillion in November of 2011 to $16 trillion in September 2012, to $16.5 trillion as of this writing. The $1 trillion in tax breaks that could cover the $1 trillion entitlement budget shortfall are still allowed, and the nation runs $1 trillion annual budgets as a result (going on 5 years). It is amazing that the math illustrates that the uncertainty and nervousness that pervades CEO corner offices and middle class corner bedrooms over debt and the nation's future could be solved if constituents told their congress people they are ready to take their medicine. Instead Trillion Dollar Sam gets some botox, appears at the Academy Awards, and nobody is the wiser.
Fourth Branch Fail Safe: With all the brinksmanship, fear mongering, and lack of shared sacrifice, structural problems remain, and the Federal Reserve has further cemented its role asthe fail safecentral planner for the U.S. markets and economy (growing its balance sheet to over $3 trillion through extraordinary crisis and post-crisis actions via its "Capital Misallocation & Market Distortion Device"). The Federal Reserve instituted QE3 and QE4 in August and December of 2012 (together QE-unlimited) injecting $85B per month in liquidity into the system (or $1T annually) until and after U.S. unemployment reaches 6.5% (down from 7.9% currently). Along with the ECB's unlimited support of troubled Euro Zone countries (below), that liquidity has markets moving upward in "don't fight the Fed" mode. Market reliance on QE-reflation shone in the release of the Fed minutes February 20th as the S&P 500 fell 1.2% on news some central bankers are less than keen on unlimited QE (ending a 45-day run without a 1% down day, the longest streak since November 2006).
Virtuous Cycle: Three years into recovery, first blush fourth quarter real GDP came in at -0.1% annualized. Economists explained that the 4Q decline was due to government spending cuts and pointed to a rise in consumer spending, real income and business investment as positives during the quarter. If government spending continues to be a drag, business and consumers must pick up the slack (business investment, hiring, rising wages and spending in a virtuous cycle).
The most recent Bloomberg Business Roundtable survey of CEOs listed top concerns as "uncertainty over America's fiscal situation, the seemingly never-ending European banking crisis, and global policy response of currency devaluations to weak economic growth." The survey revealed CEO expectations for capital expenditures, investing, and hiring are back down to 2009 levels - not good for the virtuous cycle. Overall, in three years following recession, U.S real GDP growth is trending around 2% (2.4% for 2010, 1.8% for 2011, and 2.2% for 2012).
Euro Zone Sovereign Stress Transmitter: Meanwhile, taking a return voyage aboard good ship "XS Leverage", reveals the EU Whack-a-Mole yield spikes of 2010-2012 have taken a hiatus since ECB head Mario Draghi pledged to do "whatever it takes" in August 2012, putting down "Spanish Yield Fever" with the introduction of another acronym to the playing board - OMT (Outright Monetary Transactions, or unlimited secondary market sovereign debt purchases). The OMT, as much as the Fed QE-unlimited, calmed markets in late 2012 allowing for European, U.S., and Asian markets to start furious rallies (reminiscent of late 2011 when Mario Draghi hit the scene to calm sovereign debt yield spikes with trillions in LTRO short term loans). Although OMT has not been used, the mere presence of the ECB "whatever it takes" pledge embodied in OMT has been enough.
OMT requires countries receiving assistance to implement austerity measures (budget cuts, taxes, etc.). But, why implement austerity if the threat of the OMT "bazooka" has calmed yields for you? It is quite brilliant for the time being. Spain, Italy, Portugal, Brutus and the rest don't want to become more like Greece, in austerity-driven perma-depression. Of course the whole thing is just a pass the parcel of debt whereby one is one's own creditor ultimately. But, that doesn't matter really…delay…confuse…
…or does it, the 17-member Euro Zone is officially back in recession, contracting 0.5% in 2012. And, now, recession has spread from the periphery to the core of Germany and France. The 27-nation European Union posted a 0.3% contractionas well. Euro Zone unemployment climbed to a record high of 11.7% in 2012, and EU unemployment climbed to 10.7%, compared with 10.7% and 10.0% respectively in 2011. Economic contraction and still rising unemployment promise more social unrest, political turnover, and continued "Sleepwalking" for the failed Euro Zone experiment in 2013. The transmission of Euro Zone stress outside of its borders is obviously being felt hardest in the rest of Europe, but China is also feeling the pain as its largest trading partner.
An 800 Pound Panda named "Status Quo": Speaking of China, the "Middling Kingdom of Debt" recorded real 2012 GDP growth of 7.8%, the lowest in 13 years, and down from 9.2% in 2011 and 10.4% in 2010. Annualized growth slowed demonstrably in the first three quarters of the year (8.1%, 7.6% and 7.4%) largely due to flagging exports to the West and government credit tightening efforts to curb inflation and real estate speculation in late 2011, which in turn grew out of the massive $580 billion government stimulus and $2.7 trillion in government authorized bank loans to fight flagging exports to the West during credit crisis in 2008 (round and round we go).
So, what did the central government do to get the Panda moving again? The central government authorized more fixed investment projectsto the tune of $160 billion, and local governments reportedly added on another $2 trillion in spending. Wait, I thought China is supposed to be rebalancing towards more consumption, and less wasteful investment and debt? Nah, they dare you to knock that Eveready of debt-fueled infrastructure spend off their shoulder. Growth picked up to 7.9% as China exited 2012, allowing a smooth once in a decade leadership change to take place in November, and the rolling of nearly $500 billion in local government debt due to mature by the end of 2012 to prevent default. China's wildly imbalanced growth model and debt building continues – feeding "Status Quo".
Solid Branches: The root cause of so many global problems is debt that spreads out into other issues like so many solid oak branches stifling growth. Refusing to allow clearing of the system of bad debt, and indeed adding massive amount of deficit spending on top of it has made dealing with long term structural problems and instituting pro-growth policies virtually impossible . Four years after exiting the Great Recession, over half of world economies are currently in contraction again, including the U.S., the Euro Zone, the larger European Union, and Japan. Pro growth policy is sorely needed, but it appears as of now that central banks will remain central planners for the foreseeable future. And, growth in the U.S. seems capped around 2%.
Rent Don't Buy: In Sleepwalking, we discussed how government intervention has helped maintain 2% growth, but structural issues, central bank distortions, and a variety of other "unknowns" make the future prospects for growth doubly uncertain. We also discussed how over the long term nominal GDP growth is highly correlated with earnings. The U.S. markets are in a long-term, or secular, bear market and historically P/E compression in to the single digits has occurred prior to starting a new bull market (currently at 17x). In this uncertain environment, we recommend "renting reflation" through tactical momentum, trend, and mean reversion strategies allowing for riding central bank money printing, and waves of sentiment, while providing for downside protection via risk triggers. We run strategies in house in each of these areas, JBL-Momentum, JBL-Trend, and JBL-Event. These strategies are designed to take advantage of what the markets are telling us and adjust accordingly. For example, right now our Momentum portfolios are long U.S. mid and small cap equities (value, blend, and growth), financial services, and health services, Trend portfolios are 80% invested to a variety of sectors, and JBL – Event has about 35% exposure in one month statistically high probability plays. All that may change in March. The key is to be involved, but be nimble, and mechanically move to Treasuries or cash during times of stress.
Conclusion: Lynyrd Skynrd also recorded a song entitled "Am I Losing?" - a song about the long struggle of years of incessant touring, stress and loss. It has similarly been a long hard march since 2008 for most investors. We at Cravens Brothers believe we are serving clients well through our internally managed strategies to increase clients' probability of success - their winning percentage. In addition to our JBL strategies, we attempt to reduce cost basis for clients' legacy positions using a variety of strategies. On the wealth management side, Cravens Brothers provides (or partners to provide) a range of other small family-office services to including family and business succession, governance, estate, regulatory, and tax guidance. If you would like to discuss our strategies and services offering, please do not hesitate to contact us.
Please pick up a copy of Sleepwalking Toward a Precipice at cost on Amazon here. Or, contact us and we would be happy to send you a copy.
Jason B. Leach, CFA
Previously in this series:
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