We’ll admit to being a bit perplexed at Nouriel Roubini’s personal investment strategy and how it compares to the advice he gives on the pages of his RGE Monitor. Last we heard, Dr. Doom was 100% long, and invested in index funds. That was apparently true as recently as February, when it was reported in the Financial Times.
And yet if he really “saw this coming.” which everyone in the media accepts, it’s hard to understand why he’d sit back and watch his 100% long portfolio whither by some 50%. What’s more, the NYU academic is actually giving financial advice, and his advice is to sell.
So, in conclusion and caveat emptor for investors: Dear investors, do enjoy this dead cat bounce and bear market sucker’s rally … 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.
So he’s long but his advice is don’t wait too long to sell. He sees the financial system as a Titanic about to hit the iceberg. How could someone 100% long actually believe this? Something doesn’t make sense.
We also think it’s odd for an academic economist to be predicting stock market movements. Most academics smartly abstain from this. Even Warren Buffett, though he predicts a miserable 2009 for the economy, recognises that his forecasts tell him nothing about the direction of stocks for the year.
Tyler Cowen suggested recently that Roubini’s position on stocks was an extreme case of “mental accounting”, basically suggesting that there’s some kind of convenient disconnect between theory and practice at work here. Maybe.
Another way to think of it is that Roubini is hedging. The collapse has been great for his personal brand. If stocks went on a long rally, it’s doubtful we’d see much Roubini in the media after a while. In such an event, at least his stocks will be up.
In any event, Roubini has been right in the past and always has interesting things to say. So here’s why he thinks it’s just another sucker’s rally. Read the whole thing here >
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 stabilise. 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…
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.
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.
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…
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…
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.
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.
These predictions were made when the S&P 500 was close to 900 and the DIJA was close at 9000. This basic macro approach was the reason why we argued that the latest bear market sucker’s rally – the one going from late November 2008 to early January 2009 – would fizzle out and new lows would be reached. Indeed, like previous bear market rallies of the last year this one went bust – falling over 20% – and the DJIA and the S&P broke below the 7000 and 700 upper limit of our range for US equities. With the DJIA and the S&P now well below the “7” range the next test for the markets may be 6000 and 600 for the two indices.
I have also argued that another bear market rally may occur some time in Q2 or Q3 of this year and may end up like the previous six. Indeed in the last 12-18 every time something dramatic happens (that leads to a lower stock market low) and the government reacts to it with a more aggressive policy action optimists come out and say that this is the dramatic and cathartic event that suggests that a bottom has been reached: they said that after Bear Stearns, after the collapse and rescue of Fannie and Freddie, after Lehman, after AIG, after the TARP was announced, after the G7 communique’, after the $800 fiscal stimulus package was announced last November (the onset of the latest sucker’s rally).
And after a while markets are again “shocked shocked” (to paraphrase the French police inspector in Casablanca) to discover that the macro news are much worse than expected in the US and abroad, that earnings news are much worse than expected not just for financials, realtors, home builders and consumer discretionary firms but also for most other non-financial firms, and that financial markets/firms shocks/news are worse than expected.
As repeatedly argued here these financial markets/firms worse than expected news are many: news that more and more financial institutions are effectively insolvent and will have to be taken over by the government; news that highly leveraged institutions – such as hedge funds – will be forced to deleverage further and thus sell illiquid assets into illiquid markets; news that even non-levered investors (retail, mutual funds, etc.) that lost 50% plus into equities are burned out and want to reduce their exposure to equities; and news that a number of emerging market economies are on the verge o a contagious financial crisis…
Earlier this year – at the peak of the latest bear market rally – I met Abby Cohen – the ever bullish equity markets expert at Goldman Sachs who predicted a 25% equity rally for 2008 and is making again a similarly bullish call for 2009. I asked her if we disagreed on earnings or on the multiple (P/E). It turns out that our forecasts for earning per share for S&P 500 firms are similar: 50-60 range for me, 55-60 range for her. But she argued that a P/E in the 1012 range was too low as investors would ignore the bad earnings numbers for 2009: if a rapid recovery of earnings were to occur in 2010 and beyond investors would discount the 2009 bad number and assign to them a much higher multiple of 17 or even more.
The trouble with that argument is that, with the US and global economy in a massive slump and with deflationary forces at work it is hard to believe that a massive economic recovery will occur in 2010 thus lifting sharply earnings: even in a U-shaped scenario US growth in 2010 would be 1% or lower and Eurozone and Japanese growth would be close to 0%. Thus, with weak growth deflationary pressure would be still lingering thus putting pressure on profits, pricing power of firms and thus profit margins. Thus, even in a U-shaped scenario a rapid rally of equities is highly unlikely.
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.
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