Wednesday, November 18, 2009

Minyanville.: Our Economy is on Steroids

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Below is a guest post, reprinted with permission of author Vitaliy Katsenelson who writes often at Minyanville.com.   I don't have as much time to read the site as I used to, but he is definitely one of the more thought provoking writers at the site.

If you are new to FMMF, I wanted to bring over Vitaliy's piece because it summarizes what you can find in hundreds of previous pieces we've written; summarized in one location.  Vitaliy is more generous than I, calling this the economy on steroids... injected by our doctors.  I've likened them more to drug dealers, and America akin to driving at 140 mph on a freeway while on crack cocaine.

But one point I want to stress that many commentators miss out but Vitaliy nails is each iteration of drugs builds up tolerance... to have the same effect in the future you need stronger and stronger drugs.  I've used in previous posts the example of the car companies 0% financing post 9/11.  That worked wonders the first time around at jump starting sales, but then you trained the consumer to expect it, and he/she now demands it - especially with the domestic car makers.  So the handouts have to get bigger, and more outrageous to get the same effect over time.

We've taken that and now extrapolated it across the entire US economy... you can see it in today's housing starts number.  The addicted US home builder (and buyers) rushed in to take advantage of the first time homebuyer HANDOUT.  Then they sat on their hands in October while debate of its extension was happening.  We saw in the past 2 weeks new mortgages (despite almost record low rates!) dropped to a 9 year low as Americans had their hands out waiting for more handouts before they would commit to buying.  Today we see the home builders did the same - pulling back construction until they were assured more debt would be layered onto our grandchildren via handouts.  Without government handouts they know the buyer won't return en masse, and hence they have no need to build homes.  Now with new handout firmly in place until middle 2010, the housing market can continue to "function".  And then next spring we'll be told more handouts are needed to keep the housing market "momentum" going.  (please note - I just used the word HANDOUTS repeatedly for a reason)

This is also why the next (i.e. current) rounds of home buyer credits... and the next cash for clunker programs will lose effectiveness versus the original versions.  You've drawn in the majority of potential car buyers and new home owners on the first tranche of handouts.  To keep the same level of interest you have to make the incentives even bigger.... because the drug addicts need stronger drugs as their bodies have built up tolerance to existing levels. We are a country that no longer can function without the drugs of easy money coursing through our veins. [Jun 3, 2009: A Country that Cannot Function Without Easy Money]  We've squeezed all the blood from the stone, saving rates have been demolished through an adoration of a consumption culture, and our central bank policies have created a bubble burst cycle that used to be seen twice a century, but now twice in 10 years - destroying nest eggs and savers in its path.  So it's come to this - bribing American people to consume with money we, as a government, do not have.

But Vitaliy does a great job summarizing our thoughts in one comprehensive piece; this is like a summation of 50 FMMF posts into one.  This is the type of post to pass along to co-workers, friends, family members who are walking around, not realizing what our leadership is doing.  Don't mistake my stock buying or "partying with the stock Joneses" as a change in thought process... in fact the more I see, the more I am distraught about what will happen to this country down the road.  We've only repeated the same mistakes; but bigger - much bigger.  The stresses have simply been moved onto the backs of the US taxpayer - that is borne in the currency.  I spoke about this in depth in the audio interview with Andrew Horowitz this weekend.  We giggle in joy as speculators each time the US dollars falls because it drives stocks up, but a true currency panic in the US will make 2008 would like a picnic.  Thus far, America has gotten away with murder due to its status as the world's reserve currency, almost any other country on Earth doing what we have done would have caused the IMF to swoop in ... dictating to do the exact opposite. It's a surreal world.  The biggest game of chicken ever seen - but it's no game.

One should be terrified to think what the country will face at 6.5% mortgage rates (once considered "normal"), and long term rates on amassed national debt increasing by 100%; both very viable situations within 3-5 years.  We will pay a dear price... in time.  Enjoy it while the Kool Aid is flowing.

Link to original article
Link to Vitaliy's web home: ContrarianEdge

Along with the article, there is a presentation in pdf format that can be accessed here.

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Our Economy is on Steroids

Birds are singing, the sun is shining, and life is beautiful again. On the surface, the vital signs of our economy are improving with every economic report. In some areas, like unemployment, the rate of decline is decelerating. In others, like GDP, decline is turning into growth.

The stock market is behaving as if the history of the last 20 years is about to repeat itself.  Recession will turn into a robust expansion. Stock prices are discounting an expectation of robust earnings recovery to a level only slightly below the pre-financial crisis level, and risk-taking is in vogue again as the performance of junky stocks trumps quality.

The global economy reminds me of a marathon runner who runs too hard and hurts himself. But now he has another race to run. So he’s injected with some serious, industrial-quality steroids, and away he goes.

As the steroids kick in, his pace accelerates, as if the injury never happened. He’s up and running, so he must be okay -- at least this is the impression we get, judging from his speed and his progressWhat we don’t see is what's behind this athlete’s terrific performance -- the steroids.

Of course, we can keep our fingers crossed and hope that the runner has recovered from his injury and what we see is what we get -- the athlete is at the top of his game -- but there are problems with this thinking.

Serious steroid intake comes at a cost: It exaggerates true performance. Steroids can be addictive; once we get used to their effects it's hard to give them up. The longer we take them the less effective they are. Finally, there's a good reason why steroids are banned in sports: They damage the athlete’s body.

Our economy suffered severe injuries last year, and to keep it going massive amounts of steroids were and are being injected -- they’re what economists call stimulus (or government intervention).

Let’s take a closer look at the extent of the steroidization (to coin a new word) of our economy, and its side effects.


I’ll focus on the US economy, but similar arguments to varying degrees are true for many countries around the world. In the US, things appear to be stabilizing and improving on the surface, but beware, there's a giant IV hooked up to the veins of the economy, through which billions of dollars are constantly being pumped in. The stimulus is everywhere:

  • To help the auto industry, taxpayers were subsidizing the price of autos through the Cash for Clunkers program and thus were creating artificial demand.

  • The housing market, the epicenter of this crisis, is propped up from different directions. On one side there's a buyer tax credit (it used to be just the first-time buyer, now it's any buyer).

    From a different direction, interest rates are kept low by the Fed’s quantitative easing, fancy econ-speak for the Federal Reserve buying long-term bonds and thus keeping long-term rates artificially low.

    Finally we have the (now) defunct government-controlled Fannie Mae (FNM) and Freddie Mac (FRE), which are the mortgage market of our economy because they account for the bulk of mortgages originated today.
  • Because banks are the conduits through which the government pumps stimulus into the economy, the aforementioned government involvement in the housing market helps them generate enormous fees.

    In addition, profitability is boosted (at the expense of savers) by the near zero short-term interest rates, again thanks to the friendly Fed, which allows banks to earn a healthy interest-rate spread.

  • Last, and certainly not least, the giant, multi-hundred-billion-dollar infrastructure projects are coming on line as you read this. Yes, steroided we are.

Now let’s look at the side effects:

  • Our economy’s true, un-steroided, unstimulated performance is a lot lower than the one we observe. Though the government can spend money at a high rate for longer than one would rationally expect, stimulus is a finite endeavor that comes with a heavy price tag. In most cases, the stimuli have been financed with higher future taxes and rising government debt, thus higher future interest rates.

  • Steroids and stimulus share addictive properties, and the longer we take them the less effective they become; but once we’re used to them, it’s hard to give them up. The $8,000 tax credit started as a temporary measure. However, the politicians found it difficult to let go, and the program was extended and supersized by providing the tax credit to anyone with the patriotic ambition to buy a house. 
  • Japan was on the stimulus bandwagon for more than a decade and, with the exception of its government debt-to-GDP ratio tripling, Japan has nothing to show for it. Its economy is mired in the same rut it was in when its stimulus marathon started. It had a hard time giving up stimulus because the short-term consequences were too painful. Also, Japan is proof that a low (zero) interest-rate policy loses its stimulating ability over time and turns into a death trap for the economy as leverage ratios are geared to low interest rates. Now, even a small increase in interest rates (say, from 1% to 2%) would be devastating for Japan’s economy.







    In many cases the simulative measures just accelerate future sales to an earlier date, at the taxpayers' expense. After Cash for Clunkers ran its course, demand for autos fell into the abyss. The same will be the fate of industries exposed to infrastructure projects.







  • Finally, stimuli result in long-term damage. Politicians and central bankers have good intentions; they hope that the stimulus will tide us over in the bad times and buy some time for the economy to heal itself. It’s a logical argument. For instance, as much as we hate banks to be making a lot of money today, it allows them to patch up holes in their balance sheets from past and future losses.

    However, for the most part, stimuli just kick the can down the road and result in higher debt and higher taxes. But the harm doesn’t stop there: Stimuli cause bubbles. The fix for the 2002 recession involved interest rates staying at extremely low levels for a long time, which resulted in the housing/liquidity bubbles we’re paying for today. The present stimuli will leave us with even more serious damage somewhere down the line.
The stock market’s recent rally followed a typical, by-the-book, coming out of recession trajectory -- it was cyclical. The stocks most sensitive to the economy appreciating the most.

(Mark's note - next portion is stock specific, so if only interested in economics and the mess we are creating you can stop here and jump to the bolded area below)

Let me demonstrate what is priced into cyclical stocks by looking at Caterpillar (CAT), your typical American blue chip industrial, cyclical stock -- one that in theory should prosper during global economic recovery.

Third-quarter sales were down 44% from last year. China was its brightest spot as sales there dropped (only) 26%. The stock is around $60, more than double its low in March and not far from $85, its all-time high, reached in 2008 when global growth was its oyster.

The company expects to earn around $2 this year (excluding recurring nonrecurring charges) and expects sales to grow in teens next year from this year’s base. But even if Caterpillar were to earn $3 next year, investors aren't paying for next year’s earnings, as they’d be paying 20 times next year’s earnings.

This cyclical stock isn't worth that; investors are paying for what happens beyond 2010.

To understand what happens past 2010, let’s see what's driving Caterpillar’s next year’s earnings growth. Here's a quote directly from a Caterpillar press release: “[Global] governments introduced more than $3.5 trillion in multi-year stimulus programs with most of the expected impact in the last half of 2009 and into 2010.”

If I owned CAT, the question I’d want to know the answer to is, what’s next after 2010?

Stimulus creates an appearance of stability and growth, but a lot of it is teetering on a very weak foundation of government intervention. Investors must distinguish between what's real and what's not. In this environment, investment success will not only depend on what stocks you own but also on the ones you don’t -- stock selection is important.

The hopes that we’ll transition soon from government steroiding back to an economy running on its own are overoptimistic; there is just too much stimulus in the economy for that to happen. The detox process from the massive consumption of steroids won't be a smooth and painless experience.

This transition will be slow and rocky, as today’s stimulus wears off and we hit the wall in this economic marathon.

It's also important, at this stage, to note the four most dangerous words on Wall Street: This time it’s different.

However, this time, this recession, isn't the same, either. We aren't suffering through your garden-variety corporate recession, it’s a consumer one. Consumers, two-thirds of the economy and its past growth engine, are now the economy’s weakest link: Consumer debt-to-GDP is pushing 120%, double what it was in the 1980s. The financial system, though stabilizing, is hanging on the whims of one economic statistic: employment.

Over the last couple of weeks we've started seeing the first signs of a second (or third, I’m losing count) wave of layoffs. For instance, Johnson & Johnson (JNJ), Electronic Arts (ERTS), and Pfizer (PFE) all announced they’ll lay off a large percentage of their workforce. Higher unemployment will trigger larger loan defaults, and then we may even have another round of bank problems.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here


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