Wednesday, May 21, 2008

the next leg lower

the stock market sold off for a second day again today... it's playing out more or less as I expected earlier this year. after being spooked by a two-month knee jerk of bullish optimism, the full gravity of the problems facing US stocks is starting to sink in. originally we were just worried about contagion effects from a credit crunch. now we face multiple problems, many of which have their own unique origins:

1-falling home prices: this is simple enough

2-tighter credit standards: banks and the "shadow banking system" (mainly special-purpose entities such as CDOs and SIVs that functioned as banks by marrying up savings and borrowers) are growing less eager, not more eager, to lend.

3-capitally deficient banks: banks such as B of A need to sell things like preferred stock as they build a cushion against mounting loan losses resulting from the collapse of consumer credit.

4-rising fuel and food costs: oil has obviously hit new records for the last several sessions. it's essentially following the path I predicted about 8 weeks ago. petroleum is becoming the new wampum. after all, for something to be money is has to be both scarce and desired. the dollar fits that bill less and less every day.

5-doomed profitability: as was demonstrated by companies like Whirlpool and Campbell Soup, higher prices have consequences. higher oil prices are of immediate concern to almost everyone. imagine being a baking company in this environment, forced to pay more for everything from flour to natural gas to diesel/gasoline. but that's not all: leverage is harder to come by. it will be harder to boost per-share profits by buying back stock, harder to term out debt and harder to make investments with borrowed money. during the credit bubble of 2005-7, easy borrowing conditions made life easier in most board rooms. those days are history. furthermore, the beneficial deflationary effects of globalization are over. for years, companies could cut costs by finding cheaper suppliers in other countries. with the dollar plunging and incomes rising abroad, that game is also more or less over. profit growth will be constrained for several years, in my opinion.

6-demand destruction is underway: bizarrely, one money manager overseeing more than $20bln told me this week not to worry about high oil prices because "it will soon cause demand destruction." first of all, I am not sure this is even true. the sheer number of people entering the middle class in india and china ensure huge demand growth at almost any price. if you are buying a car for the first time, you are much less effected by higher prices than if you already own one.
but secondly, how can an asset manager see demand destruction as positive? it's essentially another word for less economic activity. assuming he's right, and lower prices will result from less output, that means we need to contract to get there. that process of contraction will be marked by profit warnings, layoffs and bankruptcies... a good example of this was AMR's decision to cut 300 flights and fire 6,000 people.

7-bankruptcies: speaking of bankruptcies -- they're bad for business and bad for stocks. and they're rising. even without higher fuel prices, this is normal at this stage in the credit cycle.

8-lower stock multiples: some research I saw today from Goldman Sachs highlighted how faster inflation hurts P/E ratios on stocks... in other words, even if companies' earnings weren't going to fall, their shares would still trade at lower prices relative to those earnings. this was the case in the 1970s and appears to be the case today. P/E ratios have been falling ever since they peaked out above 30x in 2000. it started as a socio-cultural development as people fled the market in disgust after the dot-com bubble. now, the trend will accelerate as inflation diminishes the value of everything denominated in paper money.

9-secular change in economic paradigm: societies and economies follow big, broad economic paradigms over time. like popular music, politics and art, stock markets reflect these forces. for years, the US society followed a clear paradigm: ever-cheaper products allowed growing consumption and economic efficiency. this started in the 1930s, when the economy found itself capable of producing far more stuff than anyone needed: steel, oil, food, cars, houses, etc. there wasn't enough demand to absorb all this stuff, making prices collapse -- the basic keynesian dilemma. aided with the advent of the car, FDR essentially invented suburban sprawl to find a market for all this extra stuff:

  • fannie mae, freddie mac and the FHA were created to finance home purchases.
  • to make homeowning practical, parkways such as the taconic and merritt were built in the 1930s.. after WWII, the process accelerated with the interstate highway program.
  • projects like the Tennessee Valley Authority and Hoover Dam brought electricity to areas previously outside the realm of the modern economy.
  • after WWII, this process was augmented by the rise of the sunbelt. the government also used military spending to transfer hundreds of billions of dollars from wealthy northeastern states to areas that weren't even on the map a 10-20 years earlier.
underlying this model was the integrated industrial company: firms such as Procter & Gamble, Kellogg, and General Motors. this entity was built upon cheap commodities, which permitted teams of managers, salespeople and other personel to be layered atop. that's why a box of Special K cereal with less than 1 pound of cereal costs over $5. (that's more than a pound of meat!) even with higher prices for commodities, the costs of making the physical product is a small fraction of what we pay in the stores.

as a result, I believe these companies will also struggle in the coming years. so far I don't think the stratospheric rise in grain prices have yet been fully priced in. companies will push through price increases, but as consumers feel increasingly poor, they will opt for other choices such as generics. (generics basically come from companies that don't have to pay for all the extra layers of extra staff. because they don't bother to manage brands or advertising, their jobs are much simpler.) Alfred Chandler's The Visible Hand offers a good history of how the integrated company was developed as a way to keep sales flowing into the industrial beast.

I don't think the modern integrated corporation is going anywhere. but I do believe their business model will grow less profitable.

getting back to the paradigm shift ... in an economy, money moves in big streams. people learn how to tap those streams to enrich themselves. in the 19th century mass-production created a new stream of wealth by allowing products to be made ever more cheaply. when henry ford introduced the $5 day in 1914, he allowed workers to tap this river of money. this model spread over the next 50 years, pushing up worker incomes as companies shared more of their resources with employees. this reached its peak in the 1970s when companies were run as large bureaucracies and businesses like GM and Ford promised to pay pensions and benefits on millions of retirees.

the next great stream of money was discovered by leveraged-buyout firms, which tore these same industrial companies apart. they got rich by shutting down factories and destroying jobs. larger companies such as GE and IBM followed these patterns by outsourcing and off-shoring production, a process that continues to this day. once again, great fortunes were made from the resulting torrent of money.

running alongside that river was a second related stream: finance. thanks to the defeat of inflation, cheap oil and offshoring, a pair of asics gel running shoes that cost me $110 in 1992 cost $50 by 2005. as money could buy more stuff, people regained confidence in money and wanted to invest. that triggered a two-decade bull market for stocks and bonds.

separately, the original flow of wealth unleashed by henry ford slowly turned on its head to create another steam of money. ford allowed workers to share in the riches that flowed from the efficiencies of modern mass production. over time, companies found they could make that river run in the opposite direction with consumer finance. it started with GMAC in the 1920s, but over the years obviously spread throughout corporate america. over time, consumer finance became a completely new source of earnings... by 2008, many large retailers have some kind of financing operation. in general, this business of lending to consumers became its own stream of money for companies, and later wall street (the mortgage bubble). see the chart below for the growth of household debt.

throw in the financial supremacy of the US, which made everyone willing to hold dollars, and a distinct cycle developed:

  • because of off-shoring, companies imported ever-cheaper shoes, shirts, cars and other stuff from taiwan, malaysia, china and mexico. corporate executives made billions on the savings.

  • awash in US dollars, those countries starting lending that money back to the US by investing in our bonds.

  • banks tapped this new river of money by channeling it back to the consumer with easy mortgage and consumer credit. wall street and hedge funds make billions.
but now the consumer is tapped out. it's unlikely we can continue to borrow against our future. everytime this process makes another cycle, more IOUs build up. household debt is now close to the size of our entire economy:

it seems clear this process reached its apogee in subprime and the housing bubble. now that it has stopped, the economy needs to find a new river of money. exports are slowly becoming a new source of wealth, but this transition will be long and arduous. the Goldman Sachs note today also predicted imports will decline further next year. that means less consumption .. that means a less happy populace and, potentially, social unrest. the big danger is: will our politicians respond to with cures that are worse than the disease?

to me, this future is fairly clear. all of the causation is in place for hard times ahead. and, everyone from warren buffett to george soros agree. as a result, I predict the S&P 500 will close the year around 1190. It may then fall all the way to 1000 or do in the next 1-3 years. by that point, everyone will have given up on stocks, so they will be attractive again and due for a good rally. but even then I feel we won't have entered into a new economic boom. our problems are deep and probably lasting. I think we might have to wait for a significant number of baby boomers to die before things really start improving. but because of growth in other parts of the global economy, the S&P 500 should break back above its 1550 resistence sometime in the next 5-7 years.

one final thing I would like to end with: now that the consumer is leveraged to the hilt, government is next in line.. the federal government obviously faces some huge liabilities. but the less commonly discussed story is the huge trainwreck coming to states and local governments across the country. not only do they face huge retirement expenses for their armies of baby-boom workers.. as the owners of thousands of police cars, road-maintenance machines and other vehicles, they'll also have to grapple with skyrocketing fuel costs. never mind the mounting problems with foreclosed properties! these kinds of municipal money problems could also curse regions with higher taxes, underfunded schools and highways, further discouraging economic growth.

(as a quick side note, it's observing that the military could well be the ones to lead us out of this, as the Wall Street Journal recently reported:
WHITE SANDS MISSILE RANGE, N.M. -- With fuel prices soaring, the U.S. military, the country's largest single consumer of oil, is turning into an alternative-fuels pioneer.
it will be another cruel twist of fate to the peaceniks, but it should come as no surprise. from aviation to the internet, the military has always been one of the principle vanguards of positive technological change -- a subject I addressed in an earlier blog entry.)

the looming crisis in muni-land demonstrates once again how problems first emerge in financial markets. subprime bonds blew up months ago, and foreclosures are still surging now. auction-rate problems rocked municipal finance around the same time, and no one is yet talking about the problems for municipalities -- yet.. in each case, the market foresaw a real fundamental problem that would develop later. this downturn isn't just caused by mean-spirited short sellers. the problems are real.

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