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Invert! Invert!


Zorrofan
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I think Charlie is Brk's greatest, somewhat unappreciated intangible asset. I know that Charlie always says to invert, ask yourself "am I wrong". Based on a number of recent threads it seems that many here, myself included, are bearish. Personally I think the market is due for a major correction and the economy is headed for a double-dip, perhaps worse. so I thought it might be a useful (and hopefully interesting exercise) if I laid out my thesis for why the market will crash and the economy enter a double-dip. My challenge is for you to help me "invert" my thinking - if you can!!

 

cheers

Zorro

 

 

Here it is.....

 

1. Approximately 70% of the US economy is based on consumer spending on goods & services.

2. Since about 1974 the average american family has not seen any real growth in income. The majority of the growth in spending has been financed the last 30+ years through the use of debt.

3. Americans have financed much of the the debt they carry through HELOC's, loans the banks were willing to grant as house prices rose.

4. The housing market has collapsed, prices have fallen and banks are reluctant to extend additional credit to consumers.

5. Consumers are reaching the limits of servicable debt. i.e. they simply can not continue to add additional credit even if it was offered because they can't make the payments on more debt

6. With no new credit, high debt loads, high unemployment, consumers are now entering a phase where they are paying down debt, trying to build savings due to fear of job loss etc.

7. We read that US companies hold record levels of cash - true. But they hold these record levels of cash because they have issued record levels of debt. Corporations for the most paart of been extending existing loans and issuing new debt. Debt levels for US corporations are at record levels.

8. The ECRI WLI is at -10 for several weeks now, a level it has never fallen to without there being a recession

 

We are in a balance sheet recession. Consumers, corporations and even government will need to pay down debt. The economy as a result will face slow, even no growth, until the debt is reduced. The economy had a one time bounce (globally) from the massive government stimulus. The market has over-reacted and as a result risen too far, too fast. As stimulus wears off, consumers, business and government retrench, unemployment remains high, the economy slows. The market finally realizes that the growth levels will be dropping and corrects.

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Normally I  really try to ignore trying to predict market or economy as I have done/tried it and am terrible at it. So it may be good to invert whatever I say.

 

Combine:

Another market crash + resulting financial instability would be the last thing governments around the world , especially the U.S. would want.(motivation)

+

We have the benefit of history(knowledge?)-1907 crash, the great depression, Japan the last 20 years

+

the ability of government and large financial organizations to manipulate our markets. Could we not have US treasury either directly buy in falling market to stabilize or influence one of the large financial institutions to buy into a market slide to stabilize.

 

That being said I think there could always be a 10-20% correction.

 

I think we may some further deflation in the short term but then the governments of the world have to inflate there way out of the problems you outline above,which could cause a market melt up in he market (with all the money flowing)

 

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Is this not like the end of a game of monopoly (the game we used to play as kids) when all the players are mortgaged up, except for one player. In the game, the game soon ends and we have to start over  if we want to continue to play---this would not be good-----would alternative be to give everyone more capital (you would have to create more properties as well?) and continue to play

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I like the monopoly analogy.. when I used to play with my brother and sisters.. we ran out of monopoly money and ended up printing new notes to play with... soon though inflation set in though and we resorted to printing more notes in ever bigger denominations. We had (from memory) £5000 notes and larger to get around the rent/property prices we just multiplied by x10 times for example.  Well you get what I am trying to say. Inflation will happen, it just may not seem like it at the moment.

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Zorro, I think your view of the economic outlook is sound.  However, it's way too hard to figure out how that translates to what the market is going to do. 

 

Having said that, I will rather hypocritically make a prediction on the markets that has very little effect on the way I invest.  Prior to the crash, there were signs that there would be an Irving Fisher-style vicious cycle downwards in the capital markets.  There was so much distress selling because investment companies, banks (commercial and investment), and insurance companies were overleveraged and sold all at once when things started to spiral downwards.  Derivatives were a ticking time bomb.  The financial system, comprised of both the regular banking and shadow banking system, was on the verge of collapse. 

 

I'm not sure that the requirements for such an upheaval in the markets are prsent now, at least in the US.  Therefore, I predict that we will not have a crash, though we probably will see markets lower than where they are today.  I am of the view that we will see range bound markets in the US going foward.  Don't know about foreign capital markets. 

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The inversion theory the way it works in math is that you take the final solution and work backwards to the original hypothesis to prove its correctness. e.g: mathematical induction. For instance, you prove that the series of prime numbers is infinite by proving that the series of prime numbers is not finite.

 

The main hypothesis here is double digit dip recession for which the root cause is deflation. Let us take some samples to see how things are going:

 

1. US trade with big economies

      Generally higher than 2007 and definitely higher than 2009

 

2. Income gain in the US

      Increasing this year even though at a slower pace compared to historic levels

 

3. Inflation

      Food and clothing prices are trending up world wide - anyone has checked the price of commodities ( coffee, meat, wheat, rice, cotton, sugar, pepper, orange juice and gasoline ) compared to 2009.

 

4. Growth in Asia

      Solid growth in Asia with inflation. India is expected to grow at 10% for the next 10 years - this may be the next big growth story. China will continue to grow as the overall base is still low in that country.

 

5. House/land prices in developing countries on par with the US

      In many developing countries around the world, the housing prices are comparable to that in the US. The US interest rates are so cheap that makes payments cheap.

 

6. Demand for computer products

      Continues to increase with shortage of electronic components as many vendors in Asia have gone to just in time manufacturing model

 

7. Saving rate in the US

     Has gone up. The public and the corporations have deleveraged and have record amounts of money on the balance sheets. This is witnessed in the treasury auctions where > 50% of the trasuries is bought by the US public.

 

8. Quality of life in the US

     Has gone up since 2000 - with HDTV, streaming technology, broadband internet, social networking, cheap phone calls, mobile phone, mp3 players, wi-fi...

 

     I would even say that the quality of life has improved since 2007 : - ). For all the dooms day predictions, most of these inventions have come from the United States.

 

9. Population growth

     The U.S population continues to grow at around 1% a year. This equates to roughly 10% of Canada's population and an economic activity of about 140 billion dollars. Even at reduced rates, we are looking at around 420 billion of additional economic activity since 2007.

 

10. Reconfiguration

     The previous system was not sustainable, it will take time to reconfigure but the US system will reconfigure.

 

 

The odds of deflation? Low in my opinion. Double dip - yeah, please sell your shares to me at low prices, thank you very much! Predicting the future - I dont and can't predict the future.

 

cheers!

Shalab

 

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I found this article worth reading -- it's at least a change of pace from the constantly negative:

 

http://www.forbes.com/2010/08/16/pessimism-recession-economy-money-opinions-columnists-wesbury-stein.html

 

And when your party is out of power, no matter what the economy is doing, it's always good to point out some data, or forecast, or sector that is not doing well. As a result, there is no political constituency for economic optimism and this has created an awfully pessimistic environment.

 

For example, the pessimists are all talking about the fact that real GDP will be revised downwardly to an annualized growth rate of about 1% in the second quarter. What they don't tell you is that this low number was caused by a 35% surge in imports. That's right, consumers and businesses bought more from overseas (lots more), and since imports are a negative in the GDP accounts, it made the economy look worse. When we adjust for this, American households and businesses increased their spending at a 4% annual rate in the second quarter--over and above inflation. In the last 20 years this measure, which looks at just spending by domestic purchasers, increased at an average 2.8% annual rate. In other words, despite high unemployment and low consumer confidence, spending grew rapidly in the spring.

 

So, what about the future? First, consumers are in a better position to spend today than at the start of the year. The personal saving rate is now at 6.4%. Excluding spikes due to special temporary government transfers, this is the highest level since 1992. Meanwhile, due to longer hours and higher pay per hour, private sector earnings are rising. So far this year, real (inflation-adjusted) cash wages are up at a 3.4% annual rate.

 

Although some analysts bemoan lingering excess capacity, they need to look more closely at the data. In the past year the real economy has grown 3%. During that time, the utilization of industrial capacity has climbed from 68% to 74%. That climb, in part, is due to falling capacity as the capital stock depreciates. One more year of 3% growth, and capacity use could be at 80%, which is higher than the average in the past 30 years.

 

Forward-looking companies can see this already and have already started investing, which is why investment in equipment and software is up at more than a 20% annual rate so far this year.

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I'm going to add in a bit more.

 

9. Initial claims for unemployment hit 500,000 - the highest level since November.

 

10. As for the economy gowing, well here is a quote from David Rosenberg

 

Our suspicions have been confirmed — the recession never ended. Macroeconomic Advisers produces a monthly U.S. real GDP series and it shows that the peak was in April, as we expected, with both May and June down 0.4% in the worst back-to-back performance since the economy was crying Uncle! back in the depths of despair in September-October 2008. The quarterly data show that Q2 stands at a +1.1% annual rate (so look for a steep downward revision for last quarter) and the “build in” for Q3 is -1.5% at an annual rate. Depending on the data flow through the July-September period, it looks like we could see a -0.5% to -1% annualized pace for the current quarter. Most economists have cut their forecasts but are still in a +2.5% to +3.5% range. What is truly amazing is that despite all the fiscal, monetary, and bailout stimulus, the level of real economy activity, as per the M.A. monthly data, is still 2.5% below the prior peak. To put this fact into context, the entire peak to trough contraction in the 2001 recession was 1.3%! That is incredible. Interestingly, and dovetailing nicely with our deflation theme, nominal GDP fell 0.3% in May and by 0.4% in June. This is a key reason why Treasury yields are melting.”

 

 

cheers

Zorro

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This is a great post.

 

I too agree with Shalab. Central Banks will continue to debase their currencies in order to re-inflate the economy. This keynesian approach is really the only solution (based on what they believe).

 

The issue is that the mechanism which normally allowed the "inflation" to reach the real economy is no longer in tact. That is of course the whole debt securitization market.

 

Also, like in the great depression, consumers now want to rebuild their nest egg so they are saving and reducing discretionary consumption. This is why the savings rate is going up.

 

I think its a fantastic time for value investors as the truly undervalued companies will perform very well as they are easy buyout targets.

 

I have had two plays get bought out in the last 2 months.  And slowly but surely more interesting scenarios are presenting themselves by the day.

 

 

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I found this article worth reading -- it's at least a change of pace from the constantly negative:

 

 

yes, its interesting, but uses too few data points to make its case persuasively. and there's no analysis of the 2nd derivative of their data. often, its the rate of change in the data that gives us better insights into the future than the data itself.  add to that, Wesbury is the author of It's Not As Bad As You Think: Why Capitalism Trumps Fear and the Economy Will Thrive, which has something of a KUDLOW-esque ideologue's ring to it.

 

my fav site on the economy & markets is an unheralded one, the contrary investor:

 

The Tale Of Two Economies

 

 

<<...Of course what has changed in the current cycle that we believe directly affects small business conditions is the lack of job growth mentioned above plus the lack of personal income growth stripped of transfer payments, as we have also discussed in depth as of late.  Again, over time, the NFIB optimism survey and the rhythm of year over year change in personal income devoid of transfer payments has been very highly correlated.  If the June numbers are telling us small businesses are becoming more somber as they look into the second half of the year, then should we expect the rate of change in personal income to also contract (again, stripped of transfer payments)?  History tells us the answer is yes as the NFIB series has historically led the year over year change in non-transfer payment related personal income growth.  This is exactly why we suggested recently, despite our deep negativity regarding deficit spending, that in the absence of extended unemployment benefits retail sales and consumption in aggregate will slow over the remainder of the year.  Is this what small businesses are "seeing" as they look ahead?

 

Three last charts and we'll call it a day in terms of the "tale of two economies" update.  First, the tale of two economies theme plays out in highlight fashion in the top clip of the chart below.  It's the ISM (large company) new orders subcomponent of the ISM series set against the NFIB business optimism numbers.  Again, very highly directionally correlated until the clear departure seen in the current cycle.  One issue to note is that in recent months these two data points have begun to move in much better directional harmony, as you can see.  And why might that be?  We personally believe it is because the bulk of the macro inventory rebuild cycle is over.  Inventory restocking will now be much more closely linked to demand/sales.  And if inventory activity is any indication of business optimism, which we believe it is, we need to note that in the June NFIB report inventory plans fell back into negative territory after a one month hiatus in the land of the positive.  Although we'll spare you the chart, small business plans to add to inventory have been in negative territory now every single month since December of 2007 with the exception of May of this year.  That absolutely speaks to business confidence, or more correctly lack thereof and reinforces the tale of two economies theme playing out as we have seen inventory rebuilding in aggregate.  Clearly it's the large companies that have driven the macro inventory rebuild.  And we suggest this has been done with an eye to international sales.

 

Of course the two bottom clips of the chart show us the divergence between hiring in the manufacturing sector relative to small business community hiring in aggregate.  Please realize that the NFIB survey is dominated by service sector businesses.  Manufacturers account for less than 15% of total respondents.  And in the spirit of honesty and integrity, 20% of the NFIB respondents are involved in some form of construction.  But the last time we checked, even these folks need jobs and personal income growth that is essentially the basis for macro economic expansion.  To be honest, we see the same dichotomy when look at the manufacturing ISM and non-manufacturing (service sector) ISM numbers and trends.

 

One last issue to keep in mind when looking at the ISM numbers is what is termed survivorship bias.  Companies formerly responding to the ISM surveys that are no longer around are not being "counted", so to speak.  It's those that have survived and in all probability taken market share from the weak that dominate current period responses.  This is true in each cycle, but probably a good bit pronounced in the current.  So one question we must ask when looking at a series such as this is are current levels of response overstating strength?  Again, just a bit of perspective.

 

Particularly disheartening for the small business community is the depth of lack of pricing power during the current cycle.  The top clip of the next chart is clear on this observation.  We've never seen anything like it.  And certainly the only reason this is the case is that demand is the missing key ingredient for small businesses.  The top singular concern of NFIB respondents in June was "poor sales", as has been the case for many months now.  Also after having emerged into the light of positive territory in recent months, June showed us a return trip to the dark side for forward small biz sales expectations.  In the 2001 recession, small businesses blinked for one month concerning sales outlook.  Night and day compared to the current cycle.

 

Finally, as we have heard it said a million times now in the mainstream media, lack of credit availability is hurting small business.  A key source of business credit historically has been small community and to an extent regional banks.  Licking their CRE wounds, they are in no mood to lend.  This is the key linkage between CRE outcomes and the small business community.  But, only 10% of small businesses said they were dissatisfied with credit availability in June.  In fact as per the top concerns of the small biz community, financing came in sixth.  We strongly suggest lack of credit availability is not a key issue for small businesses, despite mainstream commentary to the contrary.  Maybe lack of credit availability to their customers (households), but not to themselves.  So as we look at small business plans for capital spending, we do not believe this is being held back by credit availability, but is rather a statement on actual forward business outlook.  Inventories and capital spending plans are the telltale real world and real time business confidence indicators.  Both are down for the count relative to historical cycles.

 

Bottom line summary.  The tale of two economies theme remains valid and intact for now.  We are seeing a huge divergence between large and small business condition outlooks at present.  A divergence we have never seen in modern historical experience.  Large businesses represent the micro in terms of the positive of company specific earnings.  They are the large S&P 500 companies whose earnings are more dependent on the rhythm of the global economy as opposed to the domestic US economy specifically.  They are the large companies whose reported "operating" earnings are not falling apart, despite a few bumps in the road now and again.  Alternatively, we see the small business community representing the domestic US macro.   They are the job and ultimately personal income creators.  They are largely the service sector, the largest driver of domestic US economic outcomes.  The NFIB numbers are simply telling us of a deceleration in macro economic activity ahead.  And herein lies the tension for investors.  What will be more important in decision making immediately ahead, the tone and rhythm of the US macro economy inclusive of jobs and personal income, or the micro of reported quarterly "operating" earnings of truly large and globally centric companies whose job and personal income creation activities largely lie abroad?  It's why we need to remain focused on this "tales of two economies" theme.  Is it really going to be the case that the S&P 500 companies alone (as a proxy for large corporations) experienced a headline economic recovery in the current cycle while small businesses never even left the post recessionary starting gate?  It's sure looking that way for now.  In terms of "counting cards" as per a potential US double dip recession outcome, the NFIB puts a checkmark in the plus column for the double dip scenario.  Just keepin' a list.

 

http://contraryinvestor.com/mo.htm

 

 

 

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Well how about this:

 

1) Last I looked it is not different this time than any other time.  Recall Ronald Reagan waving around socks on TV or Clinton campaigning on its the economy stupid.

 

2)  The business cycle has not been repealed.  Stocks crash, Recession ensues, governments stimulate (i was not aware they had stopped, yet), bonds rally, commodities rally, STOCKS rally, expansion starts.

 

3) I am not confirmed on this but it is my understanding that there has never been a down stock market in a 3rd year of a presidents term.  S&P500 is at 1100, how high will it rise.\

 

4) Big companies are flooded with cash - debt is cheaper for large companies than it has ever been.  This week Intel spent 8 B and BHP is trying to spend 40B.  Ultimately they will spend this cash through business investment which means purchases and jobs down the pipe - You didn't think they were going to give it to the shareholders - really?

 

5) Increasing profits and increasing stock prices lead to more tax revenue.  More tax revenue means less government borrowing.

 

6) Consumers saving now means they will have more to spend later as their cars wear out, homes need work, haven't had a vacation in three years.

 

 

 

7) Prem needs to protect an insurance company against a potentially ugly climate.  Rosenberg makes his living a a shill and there is a ready and willing disaster audience right now.

I have not seen FFH slow down in their investing one bit.

 

 

Etc. etc.

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Regarding Prem, I agree that he needs to protect against a potentially ugly climate.

 

However, he must see the odds of that ugly climate as unusually high whenever he hedges an unusually high amount of his portfolio.  93% is practically the entire thing.   At the start of last year he was completely unhedged.

 

So I guess, to borrow from what somebody else said, it's the second derivative that matters.  The slope of his hedging has changed in a major way, even though at pretty much all times he has to protect against that potentially ugly climate.

 

He tends to hedge before the major crashes and closes the hedges near the bottom.  Right now he's hedging.  How many times has he gone as high as 93% hedged and what happened to the market each time?

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Eric, That's too true about FFH.  These are not hedges but investments.  FFH is my largest holding by far.

 

Anyway, the thread said to invert so I inverted.  :D

 

Doesn't mean I am right any more than David Rosenberg is right every three days when he pens another dreary prediction. 

 

The video of Prem from the India Forum was interesting because he said at the end again that we haven't fully taken our medicine yet in terms of a full blown recession and until we do there will be more pain. 

 

Like you, aside from FFH I have been collecting large caps that pay dividends that may actually grow during a crash so I have hedged in my own way.  Staying away from call options, writing puts, and options in general.

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Every Moore's law doubling is now an incredibly large increase in computer power at no additional cost. Further, internet connection speeds now follow a similar improvement. This creates an environment allowing unprecedented easy transfer of knowledge. The sources of growth are access to capital, protection of private property, scientific rationalism, free movement of people and goods and rule of law. A far greater proportion of the world enjoy these preconditions to growth than most of history. The deterioration of these preconditions to growth in US and elsewhere together with risks created by high debt levels while free movement of capital still exists has caused captial to flood places which enjoy better preconditions to growth. The new centres of prosperity also have more educated people whose families have never enjoyed prosperity and they are hungry and hard working. One consequence is that there has been a surge in new methods and new ideas. Further, hard times in US and elsewhere together with fresh capital and new methods and ideas in the new centres of prosperity has created a hyper-competative environment. Comptetition is good. It makes you work harder and forces you to become more efficient. It is painful only if you are part of the fat that needs to be eliminated. Opportunities are huge in the right places.

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Regarding Prem, I agree that he needs to protect against a potentially ugly climate.

.....He tends to hedge before the major crashes and closes the hedges near the bottom.  Right now he's hedging.  How many times has he gone as high as 93% hedged and what happened to the market each time?

Prem's record is 3-for-3; 1987, 2000, 2008

You got to be all ears when Prem sounds the bugle.

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Here are my thoughts, take it for what their worth...which isn't much.

 

I'm bearish for the reasons you stated. Furthermore, if you look at the market from Shiller's CAPE, we are not cheap on a historical level. Given the negative sentiment in the market and economy, the CAPE should be around, I'd guess, 10-12, but is currently over 20. Historically I believe it runs around 18.5.  If the market is worse than it has been since the Great Depression, it wouldn't be too much of a surprise to see it around 7 or 8.

 

A couple reasons why I believe this is happening. 1) the market is irrational and we are not going to go through a double dip 2) the market understands that if CAPE gets to that low of a level again, there would be a time of high potential returns...since the markets are somewhat efficient, the market will not allow the CAPE to get that low again. That is, unless something really, really bad happens, like another Great Depression.

 

As for why I'm somewhat bullish.

 

Based on CAPE, stocks are not extraordinarly expensive on a relative basis. I'd say they are fairly priced. Through in deflation and double dip and that might just go out the window.

 

Sentiment is negative. As Buffett once said "you pay a very high price for a rosy consensus." I don't know of anyone who is very rosy right now.

 

Corporation balance sheets are in excellent overall condition. Corporations are issuing a lot of debt. While that may seem like a negative, if a company can release a 10 year bond and pay only about 50 basis points over the equivalent treasury, it is actually very good. Borrowing long term at low rates, raises the return on equity and makes shareholders very happy! Assuming things don't hit the fan, of course. :)

 

Excellent balance sheets, lot of stimulus, low interest rates could put us back into another bubble....or lead us into another Great Depression.

 

Good luck!

 

 

 

 

 

 

Stocks aren't

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