January 15, 2011

Wall Street’s Irrational Exuberance

While Wall Street analysts forecast a high for the S&P in 2011 of 1400 - 1450, Robert Shiller, the Yale Professor whose publication of Irrational Exuberance, coincided with the Bull Market top in 2000, and who pioneered cyclically smoothed earnings, does not expect a comparable high until 2020.

Shiller agrees with Wall Street analysts on 15 being the appropriate market multiple, while Wall Street strategists extrapolate current earnings and see further margin expansion in 2011, as usual. Collectively, Wall Street forecasts 9.3% operating margins for the S&P in 2011 — a whopping 30% higher than the average margins since 1997. Shiller on the other hand astutely expects a reversion to the long-term mean.

Shiller’s prediction would appear to coincide somewhat with ours, although it is unlikely that he expects the S&P to drop to anywhere near ~12, nor ~Dow 125. From that level, a rise to his 1430 estimate in just nine years would mean “one hell of a recovery” from the trough! Markets plunge many times faster than they rise. What previously took 68 years to peak could not conceivably rise back near the top in 10 years. One-third the time it took to rise initially, or 23 years, would mean a distinct possibility to recuperate the high of 1550 by 2034. Again, this is a very special situation; although a Diag II, initially drops to an extreme low, it indicates a long bull move will follow to far exceed the previous high of 2000, which marks Supercycle Wave (III). This one would obviously be the longest Bull Run in history. (See Market Letter Dec 18, 2010 for the initial forecast, although the trough was not fine-tuned and alternation resolved in Market Letter Jan 2, 2011).

We have come to the end of the line. The S&P this is the 3rd a-b if we include the Supercycle transition and also the 3rd Diag >. What more, it is overbought. From here the downside should dramatically accelerate.

Seen as a measure of fear on Wall Street the VIX has ticked down to 15.37 intraday, a level not seen since before the 2008 financial crisis hit. From here we climb into another Diag II with a decidedly upward bias with wave iii climbing to at least 26.

The ever-greening of Commercial Real Estate

It was Commercial Real Estate which brought down the Irish banks and echoes of that problem are likely to turn up in the US in 2011. Banks everywhere have been “ever-greening” — extending maturities to avoid recognizing losses. When rates rise ever-greening will be harder to maintain just as the sector is heading for wave of refinancing. According to the Institute of International Finance, a Washington-based lobby group, there were $25bn worth of pre-crisis investment-grade commercial real estate in distress in March 2008. By March 2010 that number had exploded to $375bn (15x as much!), and you can bet it has continued to swell since. So far, banks have been sweeping loans under the carpet by extending loans to 2011-2013. While this avoided defaults, by 2014 $1,400bn ($1.4 trillion) in Commercial Real Estate loans must be refinanced. Yet nearly half of these are underwater — where the loan is worth more than the property’s value. What’s more, with all bad loans already on their books, banks are not making any new commercial real estate loans. Defaults are bound to rise even at rock-bottom rates, but rising rates will greatly exacerbate the problem.

According to Scott Siefers of Sandler O’Neil, the top 100 US banks by assets have an average of 25% of their loan portfolios tied up in commercial real estate, while large banks such as JP Morgan Chase and Citigroup have less than 5%. In California, the level of non-performing loans is double the national average, according to Michael Zaremki of Credit Suisse. That will kill many small and medium-sized banks. Moody’s estimates that banks have barely recognized half of their Commercial Real Estate losses – that’s a far lower percentage than in residential. The identical problems exist overseas in Britain, Ireland and Spain. While we expect US interest rates to revisit their rock bottom levels, this should be a momentary phenomenon, followed by rapidly escalating rates, which will spell disaster for the Commercial Property Market. This is the basis for our entire weighting in US equities is in these two highly interconnected sectors.

Wave i for the inverse Financials index is likely 9.4, to fill in the gap. From there we drop back in wave ii to at least 8.7 to fill the downside gap below the Diag IIs first touch point.

In DRV, inverse real estate, we are waiting for the drop to 17.30 to buy back before the long upside.

Eurozone debt crisis provides a preview of World-wide Depression

The Eurozone debt crisis is moving inexorably from the periphery to the core. What began as a fiscal and banking crisis is expanding to crisis of credibility for the entire region and its currency. According to the price of credit default swaps, Greece has a 60% probability of defaulting over the next five years – higher than Venezuela, Pakistan or even Iraq all of which are considered “unstable” economies.

As you see below, Belgian debt now equals 100% GNP, meaning an automatic 2% is deducted from future GDP according to Carmen Reinhart’s research. While overly optimistic economists are counting on “recovery” to raise tax rolls, severe contraction will be a surprise. A downward spiral brought on from the weight of accumulated debt, aggravated by depressionary woes, likely including 25-30% global unemployment should provide an idea of the misery that lies ahead. Given that GDPs will be contracting as debt continues to snowball, there is likely no way out of this mess other than through default. For one, the vehicle used in the Greek and Irish bail-outs needs to be immediately expanded beyond the €350bn scale, and unless interest rates on these European loans are reduced, there’s no way these debt levels can be sustained, resulting in series of defaults far more extensive than anyone currently imagines.

The entire mess seems allot like a replay of our own sub-prime housing crisis, which expanded before long to “prime” housing as well. It shrank economic activity and brought down stock markets world–wide. For much of it we have Keynesian stimulus to thank, for the rest the unwillingness to let banks fail. While most Americans believe this is strictly a European problem, it is not, we live in a highly interconnected world. The first Great Depression was mostly an American problem which spread to Europe only after Herbert Hoover called US loans and liquidity from European governments, namely Germany. Protective tariffs were countered with retaliatory tariffs all resulting in world commerce being choked off. This time it is truly a global phenomenon coming from all sides. A European Depression will affect US and particularly Chinese exports to a great extent, and in turn spill over onto the rest of the world; the economic pie is going to be getting a lot smaller.

What when investors begin to logically apply the same criteria to US Federal, state and local government debt rates are bound to soar….besides a 30-year cyclical bottom in rates is likely behind us and the upward trend just beginning to accelerate. It’s a matter of Supply and Demand; too much debt world-wide and a voracious appetite to keep borrowing, in comparison with the limited pool of funds that lenders are willing to lend at these risk/return levels.

While Portugal is soon expected to be bailed out in order to lower interest rates above 7%, up from 4% a year ago, next in line are Spain, Belgium and Italy. Although it may not be apparent why Spain should be so pressured in debt markets, with a ratio of debt to GDP of only 63% it remains at the low end of GDP to debt ratios. However financing needs are projected to increase the deficit by 25% in 2011 to 79%. If the fourth largest European economy, fails to endure austerity, then it’s the German and French banks with substantial Spanish debt holdings that are in trouble.

US budget deficit crisis

Sometime between March 31 and May 16 the Treasury estimates US debt will hit its congressionally mandated limit of nearly $14,300bn. Unless the Administration and Congress can agree on a deal to raise the spending threshold, the US would have to shut down the government and default on its international debt obligations, potentially triggering a debt crisis. While an agreement is likely to be reached, it will merely placate investors in US debt and delay America’s reckoning with its unsustainable public finances rather than correct the course.

The US budget deficit amounted to $1,230bn in the last year - the second highest on record. While the delusional “economic recovery” and the impact of emergency stimulus measures taken to speed up recovery are expected to shrink the country’s deficits over the next several years, we are in for a rude awakening. Rather than the widely expected economic recovery we will instead be well into a severe economic depression requiring higher spending for social programs, while tax rolls continue to shrink. Those emergency spending measures were entirely money down the drain. Then begins the retirement of the baby boom generation and the cost of government healthcare and pension programs is projected to soar.

According to the 18-member bi-partisan commission on fiscal responsibility, by 2025 tax revenues will be only sufficient to finance interest payments – which are projected to soar from the current $200bn to more than $1,000bn, and entitlement programs with no funds left for anything else. Everything else will have to come from further government borrowing. By 2035 the weight of the deficit is projected to reduce per capita GDP by 15%, meaning a harsh reduction in our living standards.

In the chart below you will note that the US has a 2010 budget deficit as a percentage of GNP only second to Ireland. Meanwhile, Spain has a total debt of 63% of GDP versus our 62% by the same measures and in danger of needing a bail-out from the ECB. If US Treasury lenders apply the same criteria to the US as they have to Spain, interest rates can go nowhere but up – 10-year rates are ~5.5% for Spain. Meanwhile proposed budget cuts do not begin to make a dent in the deficit.

Long bonds are near a bottom and due to turn up sharply to complete wave 2 rising to at least 52, to fill in the gap above the Diag II marked by the dashed green line. Diag >s mean “dramatic reversal ahead”, what more, the two large ones further compound the Diag II, which means the beginning of a long drop. It makes sense for interest rates to drop as investors first thought, after selling equities on masse, is safety in Treasuries. But once the dust settles, interest rates should begin rapidly rising again, as investors wake up to the “risk of a Treasury default” given a “double-dip scenario”.

State & Local Austerity

Unlike the Federal government, all states with the exception of Vermont must keep a balanced budget. Both state and local governments have been slashing public programs and in some cases raising taxes to plug the huge recessionary budget shortfalls. Everything from healthcare subsidies for low income people, to university tuition rates and financial aid eligibility are being cut. An estimated 400,000 state and local workers have been fired since August, including teachers and firefighters. Illinois raised both state income tax and corporate tax rates, while in California Jerry Brown proposes $12.5bn in cuts including a 10% pay cut for state employees and $1bn cut in higher education. As typical of recessions, and what the Feds have yet to find out is that the need for services rises sharply as the recession progresses and funds dry up.

Unemployment

Unemployment remains the economy’s Achilles heel. Economic recovery would mean 200,000 - 300,000 new jobs per month to keep up with population increases. Anything less will not pull the economy of the doldrums. With only 103,000 new jobs created in December, while the consensus forecast was 140,000, it no wonder investor confidence remains suppressed by fears that the expected 2011 “recovery” will fail to materialize. No kidding – there is no recovery and there never has been, this is a sucker’s rally, a mere “head fake”, an “upside correction” and the norm for a Bear Market… the last “hopes of recovery” will be extinguished with the onset of a market collapse. As we know, the market is a far better forecaster than the world’s foremost economists.

Fool of the Week

Bill Miller, chairman of Legg Mason Capital Management, believes US large-cap stocks are significantly undervalued and that the S&P 500 could deliver as much as 15% growth in 2011. That’s even more outlandish than Wall Street’s consensus earnings. Large cap stocks are only undervalued if overseas earnings continue to rise, but the “sucker’s rally” in all markets – and the sales they represent, have already peaked. With a looming global depression and the market’s discount mechanism in full gear, a stronger, less competitive dollar, those overseas earnings are likely to take a nose-dive to echo US manufacturing.

The dollar index should rise to 88, to overlap the Diag II at the top left before reversing, likely coinciding with wave 2 in bonds. When we sell stocks, we buy dollars, raising demand given a constant supply. A complex wave ii is nearly complete – wave iii should carry the dollar above 82.5, to overlap the lower Diag II, in August-September 2010.

Lastly inverse emerging markets look ready to spring with the likely upside to 40 a double from the close below 20.

We are very close to the point of widespread recognition.

Best regards,

Eduardo Mirahyes