It is déjà vu all over again. We have already seen this Groundhog Day movie at least six times over and over again in the last year or so: the market starts to rally – this time around about 8% in a week – and the chorus of optimists starts to say that this is the bottom of the economic and financial crisis and that we are at the beginning of a sustained stock market rally that signals the true end of this bear market.
This is the introduction to the latest Nouriel Roubini’s very long epistle in which he mixes self-promotion with some unnecessary optimists-bashing-ridiculing and his own economic wisdom, sometimes brilliant and instructive, sometimes long in expectations but short in factual evidence . Following is a rather long exposé of his mains points accompanied by my own humble tidbits (bold italics). The full text is available here.
(…) And indeed, as predicted, in the last week another bear market rally has started in earnest; the latest rally is just a dead cat bounce. Let us explain next in much detail why this is another bear market rally…
First, note that since the previous bear market rallies were of the order of a 15 to 20% increase in equity prices the latest 8% rally may still have some steam and time to continue. The drivers of the latest bear market rally are the ones that we have already discussed – and deconstructed recently – in this forum; here are the arguments of the optimists:
1. While the first derivative of economic activity is still negative the second derivative is becoming positive around the world: i.e. output, employment, demand etc. are still contracting but they are – or will soon be – contracting at a slower rate than in Q4 of 2008. As long as the second derivative is positive rather than negative economic activity will bottom out some time in H2 of 2009 and the recession will be over sooner rather than later.
2. The policy stimulus, both monetary but especially fiscal, in the US, China and the rest of the world is starting to have traction and will contribution to the slowdown in the rate of economic decline and eventually –sooner rather than later – contribute to the economic recovery
3. Stock markets have already fallen in the US and globally by over 50% and are now way oversold. Earnings have fallen a lot but will recover soon as economic activity will soon stabilize. And since stock markets are forward looking and bottom out 6 to 9 months before the end of the recession we must be now at the bottom if the economy will recover by H2 or, at the latest, by year end.
4. Banks and financial stocks are way oversold; Citi, JP Morgan, Bank of America and other banks are now saying that they will be profitable this year and that they will not need any further injection of capital by the government. The financial system is solvent and the undershooting of banks’ equity prices was way too excessive.
Let us explain again – as we discussed most of these points here before – and flesh out in more detail why each of these optimistic arguments is incorrect or, at least, too early and exaggerated.
As far as the first optimistic argument is concerned – i.e. that the second derivative of economic activity is turning positive – we have already discussed why that argument is way too early and exaggerated. As discussed here on March 2nd:
“For those who argue that the second derivative of economic activity is turning positive (i.e. economies are contracting but a slower rate than in Q4 of 2008) the latest data don’t confirm this relative optimism. In Q4 of 2008 GDP fell by about 6% in the US, 6% in the Eurozone, by 8% in Germany, by 12% in Japan, by 16% in Singapore and by 20% in South Korea. So things are even more awful in Europe and Asia than the US…
First, note that most indicators suggest that the second derivative of economic activity is still sharply negative in Europe and Japan and close to negative in the US and China: some signals that the second derivative was turning positive for US and China (a stabilizing ISM and PMI, credit growing in January in China, commodity prices stabilizing, retail sales up in the US in January) turned out to be fake starts. For the US, the Empire State and Philly Fed index of manufacturing are still in free fall; initial claims for unemployment benefits are up to scary levels suggesting accelerating job losses; the sales increases in January is a fluke (more of a rebound from a very depressed December after aggressive post-holiday sales than a sustainable recovery).
Roubini dismisses the January US sales increase as a fluke. Yet we now have February sales which have positively surprised everybody (see here) and early March sales reports were also encouraging. Why stop at January when we have February data? And why not mention the positives when they are there?
The US employment has shown signs of stabilization, not of accelerating unemployment.
For China the growth of credit in China is only driven by firms borrowing cheap to invest in higher returning deposits not to invest; and steel prices in China have resumed their sharp fall. The more scary data are those for trade flows in Asia with exports falling by about 40 to 50% in Japan, Taiwan, Korea for example. Even correcting for the effect of the new Chinese Year exports and imports are sharply down in China with imports falling (-40%) more than exports. This is a scary signal as Chinese imports are mostly raw materials and intermediate inputs; so while Chinese exports have fallen so far less than the rest of Asia they may fall much more sharply in the months ahead as signaled by the free fall in imports.
Recent news from China has been encouraging as excerpts from CHINA WATCH on my blog show:
- Annual growth in China’s retail sales slowed to 15.2 per cent in the first two months from 19.0 per cent in December, the NBS said. But since the figures are nominal and do not account for the fall in consumer prices thus far in 2009, consumption has actually been relatively steady in inflation-adjusted terms.
- Chinese auto sales surged 25 per cent in February from a year earlier, as a tax cut for small cars and other measures helped revive the market, an industry group said Wednesday. February’s sales totaled 827,600 units, up 12 per cent from the 735,000 sold in January, the China Association of Automobile Manufacturers said in a report posted on its Web site.Production in February totaled 807,900 units, up about 23 per cent from the year before, it said.
- Data released on Wednesday shows that activity
in China’s all-important factory sector (more than
a third of its GDP and about 80% of exports) is
improving. The PMI diffusion index compiled by
the Federation of Logistics and Purchasing
jumped to 49 in February, up from 45 in January.
This is very close to the level of 50 associated with an expansion. Even though the firming was spread across a number of components, we were most impressed by the roughly 10 point jump in the new export orders component (from 33.7 to 43.4). As today’s Hot Chart shows, this suggests that the pace of deterioration in global trade flows is not worsening in Q1.
With economic activity contracting in Q1 at the same rate as in Q4 a nasty U-shaped recession could turn into a more severe L-shaped near-depression (or stag-deflation) as I argued for a while (most recently in my Sunday New York Times op-ed). The scale and speed of syncronized global economic contraction is really unprecedented (at least since the Great Depression) with a free fall of GDP, income, consumption, industrial production, employment, exports, imports, residential investment and, more ominously, capex spending around the world. And now many emerging market economies – as argued here for a while- are on the verge of a fully fledged financial crisis starting with Emerging Europe”.
As far as the second argument is concerned – i.e that the policy stimulus will soon lead to an economic recovery – we already pointed out that this argument is also overdone:
Fiscal and monetary stimulus is becoming more aggressive in the US and China – again less so in the Eurozone and Japan where policy makers are frozen and behind the curve. But such stimulus is unlikely to lead to a sustained economic recovery. Monetary easing – even unorthodox – is like pushing on a string when the problems of the economy are of insolvency/credit rather than just illiquidity; when there is a global glut of capacity (housing, autos, consumer durable, massive excess capacity because of years of overinvestment by China, Asia and other emerging markets) and strapped firms and households don’t react to lower interest rates as it takes years to work out this glut; when deflation keeps real policy rates high and rising while nominal policy rates are close to zero; when high yield spreads are still 2000 bps relative to safe Treasuries in spite of zero policy rates.
First goal: stop the death spiral which is scaring everybody and self-feeding. This seems to be happening in spite of megaphoned doomsayers. We will worry about the sustainability and shape of the recovery later, U, L or W.
Fiscal policy in the US and China has also its limits. Of the $800 billion of the US fiscal stimulus only $200 bn will be spent in 2009 with most of it being back-loaded to 2010 and later. And of this $200 half is tax cuts that will be mostly saved rather than spent as households are worried about jobs and about paying their credit card and mortgage bills (of last year’s $100 bn tax cut only 30% was spent and the rest saved). Thus, given the collapse of five out of six components of aggregate demand (consumption, residential investment, capex spending of the corporate sector, business inventories and exports) the stimulus from government spending will be puny this year.
So far, the consumer has shown an appropriate balance between savings and spending. The sharp decline in gasoline prices provides additional stimulus as consumers around the world are spending significantly less on gas than they were last year. The IEA has calculated that if oil stays at about $40 a barrel this year, down from an average of about $100 a barrel last year, it will be worth $1,000bn to oil-importing countries in increased spending power. In the US, lower prices at the pump provide consumers with some $300 billion in additional spending power, right now!
Chinese fiscal stimulus will also provide much less bang for the headline buck ($480 billion). For one thing you got an economy radically depending on trade: trade surplus of 12% of GDP; exports above 40% of GDP and most of investment (that is almost 50% of GDP) going to the production of more capacity/machinery to produce more exportable goods. The rest of investment is in residential construction (now falling sharply following the bursting of the Chinese housing bubble) and infrastructure investment (that is the only component of investment that is rising). With massive excess capacity in the industrial/manufacturing sector and thousands of firms shutting down why would private and state owned firms invest more even if interest rates are lower and credit is cheaper: given the glut of capacity monetary and credit easing is like pushing on a string. Forcing state owned banks and firm to lend more and to spend/invest more will only increase – after a short term boost spending and economic activity – the size of non-performing loans and the amount of excess capacity. And with most economic activity and fiscal stimulus being capital-intensive rather than labor intensive the drag on job creation will continue.
So without a recovery in the US and global economy there cannot be a sustainable recovery of Chinese growth. And with the US recovery requiring lower consumption, higher private savings and lower trade deficits a US recovery requires China’s and other surplus countries (Japan, Germany, etc.) growth to depend more on domestic demand and less on net exports. But with domestic demand growth being anemic in surplus countries (China, Japan, Germany, and emerging economies relying on export led growth) for cyclical and structural (demography, weak household income growth as massive and excessive corporate profits/savings that are hoarded rather than transferred back to households in the form of dividends). So recovery of the global economy cannot occur without a rapid and orderly adjustment of global current account imbalances.
In the meanwhile the adjustment of US consumption and savings is continuing. The January personal spending numbers [addendum: and the February retail sales] were up for one month (a temporary fluke driven by transient factors) and personal savings were up to 5%. But that increase in savings is only illusory. There is a difference between the national income account (NIA) definition of household savings (disposable income minus consumption spending) and the economic defi
nitions of savings as the change in wealth/net worth: savings as the change in wealth is equal to the NIA definition of savings plus capital gains/losses on the value of existing wealth (financial assets and real assets such as housing wealth). In the years when stock markets and home values were going up the apologists for the sharp rise in consumption and measured fall in savings were arguing that the measured savings were distorted downward by failing to account for the change in net worth due to the rise in home prices and the stock markets.
Here, Roubini is doing the same thing he blames others of doing : the measured rise in savings is distorted by failing to account for the change in net worth due to the decline in home prices and the stock markets. Also, it would be useful if he could share with us these “transient factors” that drove higher retail sales in February (which he conveniently forgot to mention above).
But now with stock prices down over 50% from peak and home prices down 25% from peak (and still to fall another 20%) the destruction of household net worth has become dramatic [addendum: -20% in 2008 based on the latest flow of funds data]. Thus, correcting for the fall in net worth personal savings are not 5% – as the official NIA definition suggests – but rather sharply negative. In other terms given the massive destruction of household wealth/net worth since 2006-2007 the NIA measure of savings will have to increase much more sharply than has currently occurred to restore the severely damaged balance sheet of the households. Thus, the contraction of real consumption will have to continue for years to come before the adjustment is completed.
Few are forecasting a strong recovery and just about everybody agrees that growth in the next several years will be constrained by the general deleveraging process.
As far as the third argument is concerned – that stock markets are way oversold and that earnings will soon recover – we have also discussed recently why it is flawed:
If you take a macro approach earnings per share (EPS) of S&P; 500 firms will be – quite realistically in 2009 – in the $ 50 to 60 range (I say realistically as some may even argue that in a severe recession they could fall to $40). Then, the question is what the multiple, i.e. the price earnings (P/E) ratio will be on such earnings. It is realistic to expect that the multiple may fall in the 10 to 12 range in a U-shaped recession. Then, even in the best scenario (earnings at 60 and P/E at 12) the S&P; index would be at 720. If either earnings are closer to 50 or the P/E ratio is lower at 10 then the S&P; could fall to 600 (12 x 50 or 10 x 60) or even to 500 (10 x 50). Equivalently the Dow (DJIA) would be at least as low as 7000 and possibly as low as 6000 or 5000. And using a similar logic we argued that global equities – following the US – had another 20% plus downside risk.
“It is realistic to expect that the multiple may fall in the 10-12 range in a U-shape recession.” What is the scientific or historical support for this expectation? The same as the one used for the “realistic” macro-derived earnings of $50-60 for 2009? I will shortly publish a thorough analysis of equity valuations at market troughs that will demonstrate that, barring deflation, current financial conditions warrant trough PE multiples between 12 and 14 times.
(…) On the upside one could argue that the aggressive policy stimulus in the US and other countries will lead to a faster sustained economic and financial markets recovery that expected here. We have discussed why this “sustained” as opposed to “temporary in Q2-Q3” recovery is highly unlikely to take place. But the bullish argument for a non-bear market and early persistent recovery of global equities is based on a better than expected recovery of the US and global economy.
(…) It is true that equity prices are forward looking and they usually tend to bottom out six to nine months before the end of a recession as equity prices are forward looking and they see ahead of the curve the light at the end of the tunnel. So the optimists seeing a recovery of growth in the second half of 2009 argue that equities should start to rally on a sustained basis now (or even six months ago). But this severe U-shaped recession in the US may not be over at the 24th month date (December 2009). Most likely the unemployment rate will rise throughout 2010 all the way well above 10% and the growth rate will be so weak (1% or closer to 0%) that we will remain in a technical recession for most of 2010 (36 months if the recession is over only in December 2010). Thus, the bottom of the stock market may occur in late 2009 at the earliest or possibly some time in 2010.
Also the “6-9 months ahead forward looking stock market view” is not always borne in the data. During the last recession the economic bottomed out in November 2001 and GDP growth was robust in 2002 but the US stock markets kept on falling all the way through the first quarter of 2003. So not only the stock markets were not “forward looking”: they actually lagged the economic recovery by 18 months rather than lead it by 6-9 months. A similar scenario could occur this time around: the real economy sort of exits the recession some time in 2010 but growth is so weak and anemic while deflationary forces keep an additional lid on pricing power of corporations and their profit margins that US equities may – like in 2002 – move sideways for most of 2010 – with a number of false starts of a real bull market – as economic recovery signals remain mixed.
Using the 2001 recession to prove this particular point is not impressive, to say the least: the 2001 recession was a very mild one which resulted from the bursting of the tech bubble. In fact US real GDP, rose 0.8% in 2001.
Gross Domestic Product
Equity markets have also declined in the absence of a recession (1962, 1966, 1987 )which does not support anything but that the 2000-2002 bear market might have been influenced by factors other than the very mild recession.
The fact is that all other important market declines since 1929 (10/10) turned before the economy and profits turned.
Finally, regarding the fourth optimistic argument – that banks stocks are oversold, that most banks will be profitable in 2009 and that most banks are not insolvent – it is worth considering both what we have been writing previously and some additional points.
First, notice that it with policy rates – Fed Funds – at 0%, with massive quantitative easing, with credit easing allowing banks to dump toxic assets on the Fed balance sheet and with a new government program that allowed banks to borrow at riskless rates almost $200 billion dollars at medium term maturities the Fed and the Treasury are heavily subsidizing banks and other financial institutions. Second, in its latest incarnation – the TALF – now even hedge funds will be able to borrow – up to a trillion dollars – at government rates – and leverage their investments 20 times to purchases new ABS issued by banks and reap a nice spread over LIBOR with very limited risk (effectively investors in TALF will at most make a
zero return on the investment in the bad state of the world and make a high return – 15-20% annualized – if all goes well). With policy and borrowing rates equal to zero or close to zero for banks and broker dealers their intermediation margins are obviously positive as lending rates are much higher. But this is a direct huge subsidy of the financial institutions that is being paid by savers that are now earning 0% or close to 0% on $10 trillion of bank deposits. Third, add to this massive subsidy various forms of government forbearance – fudging by regulators on the true valuation of illiquid and toxic assets, parking illiquid assets in level 3 “lala land” of valuations, easing of capital requirements, using AIG to bail out its counterparties to the tune of $160 billion and, soon enough, suspension of mark to market accounting – and you get other cosmetic plastic surgery on the earnings and writedowns by financial institutions. Fourth, the government has already committed $9 trillion dollars of bailout funds to the financial system and already disbursed $2 trillion of that amount. Without such support – that has taken the form of at least 12 separate new and unorthodox support programs – most financial institutions in the US would already be literally fully under and bust.So it is no wonder that Citi, Bank of America and JP Morgan can argue that they will be making this year a profit “before provisions”. That is the most important caveat: while operational margins can be positive if you borrow at 0% and lend at much higher rates, the actual P&L; and balance sheet of banks and broker dealers depends also on writedowns. And delinquencies, charge-off rates and writedowns are rising rapidly as both the loans and securities are showing mounting losses given the worsening of the economic recession. Losses are spreading from subprime to near prime and prime mortgages; to commercial real estate; to credit cards, auto loans and student loans; to leveraged loans and corporate boans; to industrial and commercial loans; to loans to real estate developers; to muni bonds and sovereign bonds of emerging markets and European economies where sovereign spreads are rising; and to the entire alphabet soup of credit derivatives that securitized these loans and mortgages (MBS, CMBS, CDOs, CLOs, CMOs, CPDOs, ABS, etc.). So for the major banks to argue that they are profitable before provisions on losses is a joke: such losses are now officially over $1.2 trillion globally (and $900 billion for US financial institutions) and they will be at least $2.2 trillion (according to the conservative estimates of the IMF and of Goldman Sachs) and as high as $3.6 trillion according to the peak time estimates of such losses according to our most recent study.
And according to independent analysts of the financial system – Meredith Whitney, Chris Whalen – charge off rates on loans – let alone additional losses on securities – are rising at alarming rates: they are already at levels twice as high as in the 1990-91 recession and they will soon enough – given recent trends be much higher double further. So, regardless of whether you got smarter management or not (i.e. it does not matter if you are JP Morgan and run by someone as brilliant as Jamie Dimon) the macro picture trumps any other bank-specific factors (the loan book of JP Morgan is as exposed to residential and commercial mortgages, consumer credit and other loans as any other major bank): i.e. with the unemployment rate going above 9% in 2009 and highly likely to reach 10% in 2010, with GDP growth likely to be 1% or lower in 2010, with home prices likely to fall – conservatively – at least another 15%, with commercial real estate rents now falling about 40 to 50% and valuation bound to fall 30 to 40% then losses on any category of banks loans and mortgages and consumer credit will sharply rise over time; and losses on the assets that securitized these loans/mortgages will increase over time.
Can’t argue with that except to say that Roubini’s very long listing of government help, subsidies, guarantees and programs, however repulsive as it might be, is indeed proof that the government is dedicated to making the financial system function.
(…) So when you all add it up together the latest rally is just a dead cat’s bounce or another bear market sucker’s rally. The latest one may continue for a while longer – as the recent ones have been in the 15-20% range and the last one from November to January was actually 25%. If all gets right another 25% bounce cannot be ruled out before it runs out of steam. In recent conversations with many investors I have repeatedly heard the following remark: “Since I have lost 50 to 60% since the peak of 2007 I hope we have a nice 20-30% bear market rally so that I can dump all my stocks at the peak of this temporary rally to minimize my losses and getting out of stocks altogether before they fall again to new lows.” With investors having such a “positive” attitude towards equities you know what the fate of the latest bear market rally will be.
That’s normally how it is near the end. Now, if you have not made it through Roubini’s epistle, you have missed the next paragraph.
Indeed for a while a spate of relatively good news may push this bear market rally further up: some economic indicators showing a positive second derivative, fiscal stimulus in the US, China and other countries reducing the rate of GDP contraction in Q2 and Q3 before a new slump in Q4, monetary easing helping markets and financial institutions, banks earning nice intermediation margins before further massive writedowns that will be delayed through various forms of regulatory forbearance, Chinese monetary, credit and fiscal pump priming leading a drugged recovery that will increase the productive overcapacity and lead to a temporary recovery of oil and commodity prices.
But the fundamentals of the economy and of financial markets and financial institutions are still bearish for the many reasons discussed above.
But many of the reasons “discussed above” are not supported by solid facts.
“most likely we can brace ourselves for new lows on US and global equities in the next 12 to 18 months. Eventually a more sustained recovery will occur once we are closer to clear signals that this ugly global U-shaped recession is not turning into a L-shaped near depression and that the global economic recovery is clear and sustained. Until then expect very volatile and choppy US and global equity markets with new lows reached in the next months and the year ahead.”
We have also argued that it is possible to avoid an L-shaped near-depression and to remain in a U-shaped severe recession that will be over some time in 2010. And that a true economic recovery and true self-sustaining rally in equity markets will depend on the appropriate pursuit of very aggressive economic policies to restore global growth. We have discussed such policies in recent times and we will flesh out in more detail the policies that are required to avoid the L near-depression and make the U shorter than otherwise.
(…) A more robust and sustained recovery of stock markets and financial markets – rather than other temporary bear market rallies – will require stronger, more coherent and aggressive policy actions by the US and other countries – Europe, Japan, China, and other advanced and emerging market economies – that is still – so far lacking. Policies are going in the right direction – monetary easing, fiscal easing, beginning of a real clean-up of the financial system and of its toxic assets, actions to stem the mortgage foreclosure crisis and to reduce the debt burden of insolvent households,
appropriate forms of regulatory forbearance, liquidity/lending provision to emerging market economies suffering from a sudden stop of capital and from a massive reversal of capital inflows, policies to restore the transparency of financial markets and improve the regulation and supervision of financial institutions.Policies are indeed moving in the right direction – the first derivative is positive – but their second derivative is still negative as these actions are reactive rather than proactive to a worsening of the economic and financial outlook. A robust switch of economic indicators to a positive second derivative requires policy actions also having a positive second derivative. As long as this second derivative of policy remains negative the chances that the second derivative of economic activity will become positive – a true sign that economies are closer to bottoming out and thus recover – will remain low. That is why the upcoming G20 meeting should emphasize – as I have argued and as the US policy makers are arguing – policy actions to lead us out of this crisis rather than policies that are relevant for the long term well functioning of the economy and financial system (i.e. the reform of the system of supervision and regulation of the financial system).
Indeed, policy reforms that strengthen the system in the long run may be counter-productive in the short-run as, in the short run, greater regulatory forbearance is part of the tool kit necessary to get out of this crisis. Indeed, in the short run stabilizing regulatory forbearance may include: appropriate easing of capital adequacy ratios that reduce the credit crunch in the short run rather than tightening of them via dynamic provisioning that is beneficial in the long run; appropriate forms of suspension of some forms of mark-to-market fair value accounting that reduce transparency in the short run as opposed to greater transparency that is beneficial in the long run; less short-run reliance on destabilizing rating downgrades rather than reforms that make the ratings more realistic and credible over time.
I agree with the above. Make sure you survive a crash before you start repairing the vessel.
So, in conclusion and caveat emptor for investors: Dear investors, do enjoy this dead cat bounce and bear market sucker’s rally; most likely most of you will jump the ship as soon as this rally loses its steam; and your attempt to jump ship will make the next round of the bear market bust even faster. Today short-selling covering is leading to a more pronounced bear market rally; at some point in the future the capitulation of investors trying to sell their equities at the peak of the latest bear market rally will make the next round of the bear market bust faster and more pronounced. So, don’t wait too long until you jump ship while the financial Titanic hits the next financial iceberg: you may get squeezed and crashed in the rush to the lifeboats.
Well, he has said everything. Very long article, very long on words, prophecies and as-I-have-saids, but shorter on facts than expected from Professor Roubini.
Related posts:
- ROUBINI: Markets ‘way too optimistic’
- Lessons of history point to short-lived rally
- Market bear Roubini sticks to dour forecasts
- Roubini: The risk of a double-dip recession is rising
- LONG AND DEEP RECESSION
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