Is the Stock Market a Discounting Mechanism Par Excellent?

THE ROAD NOT TAKEN

Investment letter – October 16, 2010

IS THE STOCK MARKET A DISCOUNTING MECHANISM PAR EXCELLENCE?

Hardly a day passes that some expert on CNBC or Bloomberg doesn’t remind listeners that the stock market is a discounting mechanism, which anticipates economic events far better than mere mortals. This axiom is repeated so often that it is accepted as a real nugget of Wall Street wisdom. I have never heard an interviewer challenge this precept, since it is accepted as dogma. Somewhere there are a number of Jesuit priests who are smiling, since I’m questioning the notion that the market is effective in discounting the future, as most Wall Street sages suggest.

Most of the time the stock market and economic trends are on the same page. For instance, between 2003 and 2007 the stock market rose in anticipation of further economic growth, and investors’ expectations were fulfilled. In 2008, the decline in the stock market was equally accompanied by an unraveling of the financial system and a plunge in economic activity. It would be tedious to review the last few decades and illustrate how the economy and the stock market have moved almost in lock step most of the time. But there is a big difference between the market and economy moving together most of the time, versus all the time. What makes this distinction so valuable is that the missteps between the stock market and economy have occurred at the most critical junctures. In early 2000, as the NASDAQ soared above 5000, most investors believed a “New Paradigm” had been established. In October 2007, the stock market recorded a new all time high, as investors were confident that a recession would not develop and that the Federal Reserve was correct in its sanguine view of the housing market. In early 2009, most investors didn’t think the sky was falling, they knew it was falling. There are countless other examples I could site that include many other markets (i.e., oil in 2008, real estate in 2006, Nikkei 1989, Gold 1980, Soybeans 1974, etc.).

It is the nature of human beings to drive their expectations by looking in the rearview mirror. This means markets are an excellent discounting mechanism, until the first serious curve appears. This is what happened with the dot.com stocks in 2000, and the global financial system in October 2007 and March 2009. Consider how important this is to most investors. As a sailor, one needs to know when a storm is brewing to avoid trouble, and when the winds of change are shifting so one can tack properly and have the wind at one’s back. The reality is that at every major high and major low in any market, the market is always wrong. The concept that the market is a discounting mechanism that investors can rely on for investment guidance fails miserably, when risk or opportunity is the highest.

How is this possible? At every top and bottom, a gap develops between investors’ perception, which is most affected by recent experience, and reality. In effect, investors don a pair of glasses and look at the world biased by the reasons they are either bullish or bearish. This is called cognitive filtering. Our egos filter out information that doesn’t jibe with our view, and instead selects the information that reinforces what we expect to happen. At market tops, investors selectively ignore that the reasons why the market has rallied are weakening, since that doesn’t support their expectations of the rally continuing. Even though cracks in the bullish ‘story’ are present, they simply don’t see them. This gap between expectations and reality grows until investors recognize reality is not conforming to what they see in their rear view mirror. When perception catches up with reality, that’s when markets experience an ‘adjustment’. If the gap between perception and reality is large or widens further, as it did in 2000, 2007, and 2009, the market experiences a large move.

This discussion is pertinent because a gap between investors’ perception and reality is developing. If I’m right about the economic reality coming in 2011, the gap will be closed as investors’ expectations are not fulfilled. In recent weeks, the market has been driven higher by two factors – the November election and the Fed’s next round of Quantitative Easing (QE). Many investors believe the Republicans, at a minimum, will gain enough seats in Congress to neutralize the Democrats. A small minority think a Republican majority is possible, which would be even better in their view. Gridlock is considered to be the greater good, at least by those who are unhappy with the expanse of government spending and regulation.

Two weeks ago, I heard a respected hedge fund manager say the market would go up if the economy improved. And, if it faltered, the Fed would launch QE2, and the market would go up. In other words, the market can either go up, or go up. As investors have embraced this perspective, an interesting dynamic is created – selling dries up. After all, why would anyone choose to sell, if you’re a winner whether it’s heads or tails. This is why a fairly ugly employment report on October 8 failed to knock the market down, since it increased the odds the Fed would initiate QE2 sooner rather than later, and with more gusto.

My take on the underlying assumptions of these factors is a bit different than the consensus. Gridlock has proven better for our country in the past than when either party controlled both the White House and Congress. The problem with this logic is it fails to acknowledge that our country is in the middle of a fiscal and economic crisis. In other periods when gridlock previously ruled, the economy was on a much firmer footing, so a bit of benign neglect was beneficial. That is certainly not the case now. Gridlock will not lead to the budgetary discipline needed to cut the deficit, which must be addressed sooner rather than later. Nor will gridlock provide the leadership necessary to level with the American people about the enormous unfunded liabilities we must get under control. Quite simply, gridlock is not an option.

During the last 50 years, government outlays as a percent of GDP have fluctuated above and below 20%, depending on whether the economy was growing or in recession. The financial crisis in 2008, and the fiscal response it generated, pushed government spending up to 25% of GDP. The only other time it has been higher was in World War II. Tax revenues have plunged from their long term average of 19% to near 15%. This is why the budget deficit is 8% to 10% of the $14 trillion in current GDP, and why we’re expecting deficits north of $1 trillion in the next few years. As bad as this is, it pales when compared to the unfunded liabilities of Medicare, Social Security, and other government programs. Unless spending in these programs is significantly scaled back, or taxes increased to back-breaking levels, government spending as a percent of GDP will soar to more than 50% of GDP by 2060. The sooner this is addressed the less drastic and draconian the solutions will be. But there is no Easy Button available, and the resulting social changes have the potential to be destabilizing. The Tea Party is just the opening act.

The assumption that another round of quantitative easing by the Federal Reserve will solve the numerous economic challenges we face borders on naivete. Anyone who believes the Fed is capable of brewing a magical elixir is conveniently overlooking the Federal Reserve’s recent track record before, during, and in the wake of the financial crisis. In 2007, the Fed forecast that the “drag from housing would wane” by the end of 2007, and growth would resume. Even as the securitization markets became dysfunctional in early 2008, the Fed did not expect a recession to develop. In other words, the Federal Reserve did not see the crisis coming, even after it had already begun!  As the financial crisis intensified in 2008, the Federal Reserve was consistently behind the curve, which forced the Fed to react out of necessity, because the Fed had no other viable options.  The Federal Reserve’s primary monetary policy tool is adjusting the level of ‘real’ interest rates. During the last 50 years, this proved effective, even after the S&L crisis in the early 1990’s. However, after the dot.com bust, the Federal Reserve was forced to drive the ‘real’ rate on Federal funds below zero percent in 2002 and 2003 to resuscitate economic growth. The ‘real’ Federal funds rate has been below zero percent since the fourth quarter of 2008, and, with a fiscal stimulus package of almost $800 billion added to the mix, the economy was unable to establish a self sustaining recovery. This left the Fed virtually no choice but to employ $1.6 trillion of quantitative easing in late 2009 and early 2010.

Although GDP has been positive for four consecutive quarters, most of the strength was derived from a shift in inventories and an artificial boost from the Cash for Clunkers program and the first time home buyers tax credit. Both pulled demand forward, but the superficial strength evaporated once the programs ended. Anyone suggesting this has been a normal recovery would also say a Gremlin is a sports car – zero to 60 mph in under five minutes. Whoopee! Compared to the recoveries that followed the 1982, 1991, and 2001 recessions, this recovery has been woefully weak. With fiscal stimulus winding down, the Fed has no choice but to establish a second round of quantitative easing. What seems to have been overlooked by most investors is that the Fed is doing this because they have no other options, not because they think it is a great idea. Another example of cognitive filtering.

While another round of QE will help, it is unlikely to provide the spark the economy needs. Through September, private sector job growth (excluding the Census Bureau) has averaged 80,000 new jobs, which is less than the 110,000 jobs needed to absorb new entrants into the labor force. At the current pace, it will take until August 2019 before all the jobs lost since December 2007 are recovered. As awful as that statistic is, it does not take into account population growth. In September, the employment to population ratio remained at 58.5%, near its lowest level in more than 30 years. Even if job growth triples from its average so far in 2010, it will take at least three years for employment to approach the 2007 level, and longer for the ratio of employment to population to reach its long term average.

According to the American Bankruptcy Institute, bankruptcy filings rose 11% to 1.16 million through September, compared to 2009, and were up 3.3% in September versus August. On average last year, 41.7 million U.S. households, or 36.7% of all households, faced housing costs that exceeded 30% of their pre-tax income, which is normally used as the threshold of affordability. That was up 1.5 million from 2007, when mortgage rates were higher and home prices were 20% more expensive in most of the U.S.  This statistic provides a clue as to why the first time home buyers tax credit didn’t have a lasting impact. Despite lower mortgage rates and home prices, too many existing homeowners and potential home buyers have seen their income growth stagnate or decline outright. In September, the number of workers who have settled for part-time work or have given up looking for a job rose to 17.1% of the labor force. For those who have been out of work for more than a year, the underemployment rate was 22.5%. There are 4.7 underemployed people looking for every job opening. In 2007, that ratio was 1.5.

State spending represents 12% of GDP, and the combination of weak personal income and retail sales growth, and lower home values have squeezed most state’s budgets. In September, state and local governments were forced to cut 83,000 jobs, including many teachers. If job growth doesn’t materially improve, state income tax collections won’t pick up much, nor will sales taxes. Cities, counties, and school districts rely on property taxes to fund police, firefighters, and teacher salaries. Since there is a two to three year time lag in property assessments, property taxes are now reflecting the fall in home values that kicked into gear in 2007. The U. S. Census Bureau reported property tax revenue dropped in the first quarter of 2010 compared with the same period a year ago. It was the first such decline in seven years. With property values down about 30% from their peak, property taxes are likely to shrink further, as assessments catch up with the new reality. More importantly, there is no indication that home prices are about to appreciate anytime soon. I still think they will fall another 5% to 10% as the overhang of 4.5 million foreclosures is absorbed. This suggests that property tax revenue will remain at lower levels for an extended period. This will last until politicians fire enough police officers, firefighters, and teachers, effectively bludgeoning homeowners into accepting property tax increases. That should give home prices a lift!

Over the last decade, state and local governments have been on a spending spree and a borrowing binge. In the last five years, they have increased their borrowing to $2.4 trillion, an increase of 35%. State and local governments employ 19.4 million workers, which is more than manufacturing and construction combined. They have promised their workers more than $3 trillion in retirement benefits. About 84% of state and local governments are covered by defined-benefit pension plans, which are supposed to be funded in advance in a trust. Unfortunately, 47 states are saving less than they should for their workers. In a recent study by the Pew Center for the States, states had $2.37 trillion in assets and $3.35 trillion in liabilities, or a short fall of $1.1 trillion. Robert Novy-Marx from the University of Chicago and Joshua Rauh of Northwestern University believe the real shortfall is closer to $2.6 trillion. Their estimate is based on the fact many states would require changes to state laws to lower the obligations promised to state employees and retirees, and states’ low ball estimates of what salaries they will be paying in 30 years.

In estimating how much money they need to set aside each year to meet their estimated funding target in 25 years, states assume a rate of return on the monies they have already set aside. If a state assumes a 7.2% average rate of return for the next 10 years, every $1 already set aside will grow to $2. Most states have maintained an expected average return of 7.5% to 8.0% for many years, and most do not expect to change it. Part of the reason state pensions are underfunded is because the stock market has averaged only a 1% return for the last 10 years. Although stock returns will likely do better over the next 10 to 20 years, 10 and 30 year Treasury bond yields are under 4%. It is not going to be easy for states to average 7.5% to 8% with bond yields so low. If states do lower their expected return from 7.5% to 8% to 7% or lower, they would need to set aside more money every year to compensate for the lower investment returns. Most states can’t afford to increase their annual contributions to fund future benefits, with budgets already forcing cutbacks in services and layoffs. Of course, denial may defer the day of reckoning, but it won’t change the math. Public anger over state spending and pension largesse is just getting started. As the middle class is affected by service cutbacks and tax hikes in 2011 and 2012, it is going to get uglier.