Deficits Monetary and Moral
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This essay is excerpted from the most recent version of the HCM Market Letter. To subscribe directly to this publication, please go here.
“[T]he entire Western world has suffered from a deficit of moral authority for decades now. Today we in the West are reluctant to use our full military might in war lest we seem imperialistic; we hesitate to enforce our borders lest we seem racist; we are reluctant to ask for assimilation from new immigrants lest we seem xenophobic; and we are pained to give Western Civilization primacy in our educational curricula lest we seem supremacist. Today the West lives on the defensive, the very legitimacy of our modern societies requiring constant dissociation from the sins of the Western past – racism, economic exploitation, imperialism and so on.”
As we enter the second half of 2010, it is increasingly clear that the S&P 500 is unlikely to return to the 1200 level HCM anticipated earlier in the year. HCM now expects the index to remain in a lower trading range for the remainder of the year bounded by 975 on the downside and 1150 on the upside (admittedly a wide range, but this is a volatile market driven by computers). Based on the sharp drop in Treasury yields, we expect the market to occupy the lower rather than the higher end of this range. The markets are wrestling with the reality of slow growth in the U.S. and Europe, a relapsing housing market, public and private deleveraging, higher taxes in 2011, more regulation and an increasing acknowledgement that our political and business leaders are hollow men.
HCM’s new target range is decidedly lower than the 1250-1275 range set earlier in the year, when we expected market momentum to carry the S&P higher than the economic recovery justified. Obviously the earlier view was wrong. But the Greek crisis coupled with the BP oil spill have focused the market on the fact that the economic recovery was largely a product of government stimulus and not organically based. HCM remains unpersuaded that the economic data is pointing to a sustainable or organic economic recovery, and is therefore lowering its stock market target even though the stock market is inexpensive by historical measures. A survey of 2000 economists by Bloomberg forecasts S&P 500 earnings to come in at $81.27 in 2010, so a 1200 level on the S&P 500 would be a very reasonable (indeed historically low) 12x if earnings materialize as expected.2 Nonetheless, we still don’t think we will get there by year end.
The market is telling investors that both the economy and corporate earnings are going to slow down in the second half of 2010. HCM is inclined to believe that corporate earnings will come in on target because corporations have taken significant steps to lower their cost structures and their interest costs are quite low. At the same time, we believe economic growth will be extremely sluggish and that the possibility of a return to negative growth must be taken seriously, although if the economy does experience a double dip it would not be until the first or second quarter of 2011. Fears of a double dip are one obvious factor influencing the market to place a lower multiple on earnings than in the past.
But there is another non-fundamental factor that is depressing stock prices: the hegemony of quantitative/computer trading. When investors watch stock prices move dramatically without any identifiable reason related to the fundamental business operations or results of a company, it destroys confidence in basic market processes. We are still waiting for a satisfactory rationale or explanation of the May 6th 1000-point plunge in the Dow Jones Industrial Average. Unfortunately, we will probably be waiting another 1000 years because we are looking in the wrong place if we are expecting a fundamental or rational explanation. The reason the market plunged was entirely based on the operations of the computer programs that dominate today’s markets. The answer lies buried within the algorithms of the trading firms that have been permitted by our toothless regulators to dominate modern markets. This has destroyed confidence in basic market mechanisms even among the most sophisticated and experienced traders, not to mention John Q. Public. This type of price action is also inimical to capital formation, which dries up in volatile markets like today’s.3
As HCM has written many times (although we were unable to include a chapter on quantitative trading in The Death of Capital because of our publishing deadline), computer-driven trading strategies are the epitome of speculation and add nothing to the productive capacity of the economy. Instead, they are inexorably destroying confidence in the capital markets and diverting intellectual and financial capital into activities that enrich a small elite at the expense of the rest of society. Moreover, as described further below, many of these activities are little more than legalized theft. Our regulators, politicians and business leaders (in particular those who engage in this noxious activity) are harming the rest of society by allowing these activities to continue. They must be regulated out of business as soon as possible.
A culture of deficits
The word “deficit” has come to epitomize not only our economic dilemmas but also our moral and intellectual failures to address them in an era that should be boasting of new breakthroughs in the social and physical sciences. Instead, our ability to solve complex problems is weighed down by flawed and corrupted government processes and the lack of courage to forthrightly change them.
Frustrations are rising among those of us who write about the markets and watch the continued abasement of our markets by politicians, lobbyists, policymakers and business leaders. On the political front, our friend Christopher Wood writes of Barack Obama, “Anyone who paid the slightest attention to what he was saying in his speeches, or to his legislative record in Congress, would understand that Obama is a socialist. The way bond holders were treated in the GM bankruptcy, the way healthcare reform was pursued and the gratuitously hostile rhetoric aimed at BP all reflect this political disposition. There is a consistency here which seems to have been lost on The Economist and other mainstream media who fell sheep-like in love with an image and not the message.”4 HCM would add that Obama’s latest abrogation of the rule of law – forcing BP to place $20 billion into an escrow account as a down payment on damage payments related to the oil spill – was given a free pass by the liberal press. The rule of law is meant to protect every one – big and small, rich and poor, the innocent and the guilty – from the arbitrary and unchecked power of government. BP will be made to pay for its reckless business conduct, but the Constitution and the rule of law need not become additional casualties of its wrongdoing. It is both frightening and appalling to HCM that Barack Obama chose to surrender to the basest parts of his political nature and act as he did.
A far more trenchant critique of Obama’s first year can be found in a recently published book by progressive political commentator Robert Kuttner, A Presidency in Peril. In 2009, the same Mr. Kuttner wrote what can only be described as a hagiographic account of Obama’s possibilities as a transformational president: Obama’s Challenge: America’s Economic Crisis and the Power of a Transformative Presidency (2009). While it likely would have been impossible for Mr. Obama or any president to live up to Mr. Kuttner’s hopes, Mr. Kuttner makes a persuasive case in his new book that Mr. Obama did little to break with the policies of the past. Mr. Kuttner harshly criticizes the president’s performance during his first year in office and takes particular aim at Larry Summers, who became the Chairman of the National Economic Council when, according to Mr. Kuttner, it was determined that the confirmation process might be difficult if not impossible for Mr. Summers to survive in view of his troubled tenure as President of Harvard University, where he managed to offend virtually every political constituency possible. According to Mr. Kuttner, Mr. Summers is an equal opportunity offender hiding behind the cloak of intellectual superiority.
The gist of Mr. Kuttner’s argument is that rather than break with the failed policies of the Bush administration, Mr. Obama enlisted advisors who were responsible for those policies (primarily followers of Robert Rubin such as Mr. Summers, Timothy Geithner, and others) and extended the regime of socializing losses and privatizing gains that has been operative in this country for the last two decades. Mr. Kuttner writes that, “[g]iven the abject failure of the financial deregulation that Rubin championed as Clinton’s top economic adviser, followed by the collapse of the business model that he promoted as a senior executive at Citigroup, it is remarkable that a consummate political outsider like Barack Obama did not view Rubin (or his protégé Summers) as fatally damaged goods. On the contrary, Obama felt he needed men like Rubin and Summers for tutelage, access, and validation. That itself speaks volumes about where power reposes in America.”5And indeed, as the pending financial reform bill demonstrates, the Obama administration has been unable or unwilling to foment genuine regulatory change on Wall Street or meaningful economic reform or recovery, particularly in the all-important housing market. In every case, it has favored the interests of the rich and powerful over those of the disenfranchised, and the formation of another government agency that will ostensibly protect the interests of consumers will do little to change that if history is any guide (the efforts of the wonderfully outspoken Elizabeth Warren notwithstanding). Investors should be prepared for more of the booms and busts that they have experienced over the past two decades and treat their capital accordingly.
1 Shelby Steele, “Israel and the Surrender of the West,” The Wall Street Journal, June 21, 2010, p. A23.
2 On the upper end of the range, MKM Partners LLC’s chief economist Michael Darda, an extremely smart guy, is looking for $92/share in S&P 500 earnings in 2010, and the legendary Barton Biggs of Traxis Partners is looking for $85-90/share if second half GDP growth comes in at 3 percent and no less than $80/share in any case. As noted above, we do not expect corporate earnings to be the problem.
3 The current dearth of initial public offerings is one example of this. Nonetheless, as The Wall Street Journal reported on June 29, 2010, it did not stop eight Ukrainian and Russian shell companies from sneaking their bogus offerings through the Securities and Exchange Commission over the past several months. The Commission’s response was that the agency is not really responsible for preventing fraudulent offerings if they meet the technical requirements such as disclosing all of the risks involved. In other words, an offering can disclose the risk that a company has no business, no assets, no revenues and no reasonable prospects for profits, and the SEC feels that it must allow the offering to go forward. When I read this kind of stuff before, I didn’t know whether to laugh or cry. Now I just want to scream.
4 Christopher Wood, GREED & fear, June 18, 2010, p. 10.
5 Robert Kuttner, A Presidency In Peril: The Inside Story of Obama’s Promise, Wall Street’s Power, and the Struggle to Control Our Economic Future (White River Junction, Vt.: Chelsea Green Publishing, 2010), pp. 6-7.